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What Is the Break-Even Point?
The break-even point, for a business, investors, or just an average citizen reflects the point at which an endeavour is not suffering a loss but also earnings no gain.
It's easiest to present the concept of break-even from an investor's standpoint. Let's assume an investor purchases 100 shares of ABC Corp at $15/share. The stock drops, and they purchase another 100 shares at $13/share. The break-even point for this 2000 share position is $14/share.
A business has quite a few more variables to consider in establishing a break-even point. A manufacturer of irons will assess how much labour will cost to build the irons, and what the cost of the materials is estimated to be. How much will the company pay salespeople to sell the iron, what will the cost of transportation be etc. Management may attempt to add up these costs and determine that they need to sell irons for, let's say, at least $36 each to avoid losing money on the irons. In this example, $36/iron is the break-even point.
If a certain venture seems unlikely to succeed in reaching at least a break-even point, it may be best to scrap the idea altogether.
What is a Break-Even Analysis?
In the business world, break-even analysis is a tool, or mechanism, that helps managment make important business decisions about individual projects, or collectively for the entire firm. The break-even analysis will consider both the expected revenues and business expenses incurred to earn those revenues.
Note: Most businesses won't pursue endeavours that settle near the break-even point. Managers are unlikely to take a business risk unless there's a high likelihood of an attractive level of anticipated profits. Most businesses will pursue a certain internal rate of return on projects before deeming them worthwhile.
Uses of the Break-Even Analysis for Investors
A break-even analysis is crucial for a business owner but can also be helpful for investors, too. When investors make investments in the market, they buy at the current market price. And the break-even point could be increased if there are trading costs associated with the purchase. Then the gain or loss associated with the investment will be compared to that original cost to gauge performance.
Break-Even Point Formula
Breakeven Sale Price = Variable Costs Per Unit - Fixed Costs per Unit
- Fixed costs: costs that are paid no matter the circumstance; think about things such as rent or lease contracts, insurance premiums or salaries.
- Variable costs: costs that fluctuate per project, potentially based on current market conditions and supply chains; could include things like the cost of acquiring raw materials, shipping expenses, or bonuses paid to staff.
Management may have a confident estimate in their cost structure, or they may not. If there's a good degree of uncertainty involved, they may choose to conservatively model costs higher than expected.
The question of whether the break-even sales price is achieveable is paramount. This is the minimum price the company needs to sell their product for in order to not lose money.
It's qute possible that company management concludes that the break-even sales price is higher than customers would reasonably pay, or priced above competiting products, resulting in a decision to scrap the product launch.
Break-Even Point Calculation Examples
First Example
Assume a company has $250,000 in fixed costs and a gross margin of 20%. The company's break-even sales level would be $1,250,000. Therefore, if the project is expected to generate more sales than that, the project may be viable. Although some businesses will abandon even profitable projects, if the returns are sufficient to offset the risks.
Second Example
Consider the following example of an investor's break-even point. An options investor buys a September $60 strike call option on stock ABC that is currently trading at $50/share. The premium paid for the option was $2/share. If ABC stock rose to $62, exercising the option would be worth exactly the $2/share that the investor paid for the option, meaning $62 is the breakeven price level for this strategy.
Important: While it may seem foolish to pursue a product or initative that isn't expected to break-even, sometimes businesses will do it anyhow for strategic purposes! For instance, a local store may sell fresh baguettes for less than their cost in order to bring customers into their store, OR a tech company may sell cheap semiconductors to boost their market share.
Bottom Line
Break-Even Point is a concept that's universally important, for businesses, investors, and consumers. Knowing the conditions necessary to avoid taking a financial loss is valuable.
