Break-even analysis is the sales level that is required for your business to operate without incurring a financial loss.
Sam’s Beach Umbrella Store: A Sample Analysis
Let’s take a look at Sam’s Beach Umbrella Store, a retail hut that sells beach umbrellas. Sam buys his umbrellas from the manufacturer for $10 and sells them for $20, making a gross profit of $10 on each umbrella.
Gross Profit Formula
Sales Price / Cost of Goods Sold = Gross Profit
$20 / $10 = $10 per umbrella
Gross profit is the profit he makes after subtracting the costs of the item that he is selling, excluding general expenses of running the business. So, in Sam’s case, the direct cost is the $10 he pays per umbrella to the manufacturer. The indirect costs or overhead costs would be the costs of running the store. So, his direct cost of buying the umbrella will fluctuate based on how many umbrellas he sells, whereas his indirect costs will remain fixed.
Sam is the only employee and pays himself no salary. Sam figures he doesn’t need to advertise because his retail hut is located across the street from a busy beach. Sam’s only expense is his rent of $2,000 per month, which also includes the electricity to power the one light bulb in his hut. Sam only takes cash for sales.
Sam determines his break-even cost by starting with his fixed cost of $2,000 per month. Then he divides that by the gross profit of $10 that he makes on the sale of each umbrella. So, his break-even in terms of unit sales is $2,000 divided by $10, or 200 umbrellas per month.
Fixed Cost / Gross Profit per Unit = Break-Even in Units
$2,000 / $10 = 200 Units (Umbrellas)
Since break-even is often thought of in terms of units of items sold, his sales break-even would be 200 umbrellas. He could also think of his break-even in terms of total sales: 200 umbrellas multiplied by $20, which would be $4,000.
Break-Even Formula in Sales $
(Fixed Cost / Gross Profit per Unit) x Sales Price per Unit =
Break Even Sales $
($2,000 / $10) x ($20) = $4,000
If Sam’s sales are fewer than 200 umbrellas (or $4,000) per month, he is losing money—he would lose $10 for every umbrella sold. But, if his sales are greater than $4,000 per month, he is making a profit—$10 for every 200+ umbrellas that he sells each month.
A Break-Even Analysis Is an Important Reality Check for the Potential Viability of Your Business
A break-even analysis helps you determine whether your overhead is realistic or needs to be reduced. Maybe for Sam’s Beach Umbrella Store it is impossible to sell more than 190 umbrellas in a month. If that is the case, then the fixed cost of $2,000 per month is too high for his business model and Sam needs to make some changes—negotiate a lower rent, add an additional product line, or move to a new beach!
Cash Flow versus Break-Even
Note that this break-even analysis has nothing to do with cash flow. Let’s say Sam buys 300 umbrellas every single month, generating $6,000 in sales (300 x $20), $3,000 in gross profit (300 x $10), and $1,000 in pretax profit ($3,000 – $2,000 fixed costs). However, one month the manufacturer offers Sam a deal: if he buys 2,000 umbrellas at once, he will get a special price of $9 each. The manufacturer will also give Sam 60 days to pay the bill.
To Sam, being a simple guy, this sounds like a great idea. By buying umbrellas at just $9 each his gross profit on each umbrella jumps 10 percent to $11 ($20 minus $9 cost). Furthermore, his break-even is reduced in unit terms to (2,000/11, or 182). Sam is excited and can’t wait for his higher level of profits to roll in!
For the next couple of months, Sam continues to sell 300 umbrellas per month. He feels great about his lower costs, and that he is making a much higher profit. With his sales of $6,000 (300 x $20), his gross profit is now $3,300 (300 x $11), and his net profit is $1,300 ($3,300 less $2,000 fixed costs). So, while his gross profit on each sale has increased 10 percent, his net income each month after fixed expenses has surged 30 percent!
However, in 60 days, Sam has a problem. The bill for the 2,000 umbrellas is due and he doesn’t have enough money to pay for it. He still has lots of extra umbrellas, but it will be many months until his business sells them to satisfy demand.
Unless Sam can quickly sell the umbrellas, or get a loan, or dip into his savings, he will have to default on the payment for the large umbrella order.
This example is a lesson in the importance of projecting your cash flow needs as well!