What it is:
How it works/Example:
The basic idea behind break-even point is to calculate the point at which revenues begin to exceed costs.
The first step is to separate a company's costs in to those that are variable and those that are fixed. Fixed costs are costs that do not change with the quantity of output. Examples of Fixed cost include rent, insurance premiums, or loan payments. Variable costs are costs that change with the quantity of output. They are zero when production is zero. Examples of common variable costs include labor directly involved in a company's manufacturing process and raw materials.
For example, at XYZ Restaurant, which sells only pepperoni pizza, the variable expenses per pizza are:
|Fixed Costs||Variable Costs|
Based on the total variable expenses per pizza, we now know that XYZ Restaurant must price its pizzas at $5.56 ($0.50 + $0.05 + $0.01 + $3.00 + $2.00) or higher just to cover those costs. But if the pizzeria charges $10 for the finished product, then it receives $4.44 per pizza to contribute to the fixed costs and ultimately the restaurants overall profits.
How many pizzas does XYZ Restaurant need to sell at $10 each to cover all those fixed monthly expenses? First we must add up all the fixed expenses ($1,500 + $3000 + $200 + $500 + $450) which the total comes to $5,650. And then we simply dividend this amount by the $4.44 left over after the variable costs are covered. ($5,650 / $4.44 = 1,272) XYZ must sell 1,272 pizzas in order to break even for the month. Each pizza sold after that contributes to the bottom-line.
It is important to note that some fixed costs increase "stepwise," meaning that after a certain level of revenue is reached, the fixed cost changes. For example, if XYZ Restaurant began selling 5,000 pizzas per month rather than just 2,000, it might need to hire a second manager, thus increasing labor costs.
Why it matters:
The break-even point helps business owners determine when they'll begin to turn a profit and assists them with the pricing of their products. Typical variable and fixed costs differ widely among industries. This is why comparison of break-even points is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" break-even point should be made within this context.