Many of the best tools in business are quite simple in their concept and application. The break even point, or break even analysis, is a helpful signal that takes little effort to calculate and monitor.
Despite that simplicity, many practitioners overlook it.
Others misunderstand it, often because of the way it is presented in business school textbooks. Or they misuse it, not understanding the difference between fixed and variable costs, or how to separate them in the analysis.
Before we go on, a few definitions:
| Fixed costs: | Fixed costs are expenses that remain constant regardless of the quantity of goods produced or services provided by a business. These costs are also known as overhead or indirect costs and are not directly tied to production levels. Think things like rent, insurance, and utilities. |
| Variable costs: | Variable costs are business expenses that fluctuate directly with the volume of goods produced or services provided. When production or sales increase, variable costs also increase, and when production or sales decrease, variable costs decrease. Examples include raw materials, direct labour, and packaging materials. |
| Unit Contribution Margin | This is the amount of the sales revenue that remains after paying the variable costs. Think of it as the profit on a single unit of sales. |
| Contribution Margin Ratio | This is the contribution margin expressed as a percentage of the selling price. |
Why the Traditional Break Even Model Falls Apart
Do a web search on the term “break even point” or browse any business school’s first-year textbook and you’ll see that they almost universally present a graph that looks like this:
For a given period of time the fixed costs are determined. Then the Total Costs are identified by adding the variable costs (yellow line).
A separate (blue) line shows how total revenues grow with volume.
The point where they cross is where you are moving from a cumulative loss position (not having yet covered your total costs) to where each sale now adds to your cumulative profits.
And note that the answer comes out in units.
You’ll find the formula for all of this:
Break even (in units) =
Fixed Costs ÷ Unit Contribution Margin (profit on one unit)
It’s not untrue.
It’s great on paper.
From a teaching point of view, it’s even somewhat useful for demonstrating the concept, but here’s the thing…
What number will you use for Unit Contribution Margin? Remember, that’s the $ profit on one unit.
One unit of what?!
No real-world business sells just one product at one price with one tidy margin.
If you’re like 99% of businesses, you’ve got a range of products and services that have different levels of margins and sell at different prices. What is the unit contribution margin for a restaurant?
They sell a soda pop for $3.99, with a contribution margin of approximately 98%, and a $79 steak with a 60% contribution margin. Which one would you use?
The textbook approach to break even point analysis is not possible with this data set, but there is an approach that can be useful to the small business owner, and on a daily basis.
Ditch the unit count. Track break even in dollars.
Most companies have an overall average margin that they’re trying to achieve. This is driven largely by one’s industry and the forces at play at any time. An average fast casual restaurant might be aiming for a 65% contribution margin ratio, while some retailers settle for 30%. Some distributors work on single-digit margins!
So, rather than calculating some theoretical unit break even volume figure for your company, we use the same formula but instead make the answer come out in TOTAL $ sales.
Then, turn that into a daily sales target. And monitor it every day!
It’s way more useful, more manageable, and — importantly — more actionable.
There are just three numbers that every owner needs to make that daily check-in real. To calculate the break even sales figure you need to know your monthly fixed costs and your average contribution margin ratio.
Then just compare that to the third number, which is your sales on any given day.
If you’re unsure of your industry’s average contribution margin ratio, you should be able to easily find it through a web search. Fullratio.com published a list of industries with average gross profit margins (a very close proxy to contribution margin) which you can access here.
A More Useful Break Even Formula
(Monthly Fixed Costs ($) ÷ 21 working days) ÷ Average Contribution Margin (%) = Daily Break Even $ Revenue
Example:
- Monthly Fixed Costs = $10,500
- Average Contribution Margin = 35%
- Daily Fixed Cost = $10,500 ÷ 21 = $500
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Break even = $500 ÷ 0.35 = $1,429
If you don’t sell at least $1,429 today, you’re not covering your overhead costs.
The 5 PM Gut Check: A Real-World Habit
Back when I was running a bricks-and-mortar operation, I had a ritual. At the end of each day, usually around 5 p.m., I’d ask my controller or one of the accounting people one simple question:“What were sales today?”If they gave me a number above our daily break-even, I’d drive home relaxed and somewhat satisfied. If the number was below our daily break even, or hovering near the edge, on any kind of semi-regular basis then I’d start turning over rocks:
- Is traffic down?
- Are we discounting too much?
- Is our labour cost out of line?
- Do we have the wrong product mix?
What This Approach Gives You
- Real-time clarity: You’ll know, daily, if things are going well.
- Smarter decisions: About pricing, staffing, promotions, and purchasing.
- Less stress: You’re not wondering how you’re doing. You’ll know.
-
>Better use of your energy: You’ll focus on the right levers.
Bottom Line
If you’re running a small business, forget the five-tab spreadsheet.You need three numbers, one formula, and the discipline to check in daily.
Because if you don’t know whether you made money today… You probably didn’t.
If you need help applying this principle please reach out.
