The goal of every company is to become profitable, but it often takes time for a business to achieve that goal. Most companies have fixed costs it has to cover as part of doing business, and there are often additional costs tied to the company's production volume. Knowing how to calculate when sales will exactly match its fixed and variable costs will tell a business owner how much the company has to grow in order to become consistently profitable. Below, we'll go through the steps necessary to calculate the breakeven point.
Costs vs. sales The general idea behind calculating the operating breakeven point is to determine the amount of marginal profit from the sale of an additional unit and compare it to the fixed costs of the business. For most start-ups, you can use simple assumptions because small businesses typically have little impact on the supply and demand dynamics of an entire industry, and so a single company's production won't have a material impact on industry pricing.
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Take a simple example. Assume that you open a cookie-making business and have to pay rent of $1,000 per month. Your marginal costs for ingredients, utilities, and other costs amount to $0.20 per cookie, and you sell the cookies for $1 each.
In the example, the marginal profit from the sale of an additional cookie is the $1 selling price less the $0.20 in variable costs, or $0.80. If you divide the $1,000 in fixed costs by $0.80, you'll get 1,250 cookies. Therefore, production of 1,250 cookies monthly is the operating breakeven point. If you can increase production beyond that amount, then the business will make a profit.
Changing assumptionsThe example above used very basic assumptions that aren't always realistic. For instance, fixed costs might remain fixed up to a certain production level, but increasing capacity beyond that level can require more capital investment. As a result, it isn't always a simple linear exercise to determine the operating breakeven point.
As long as you can express total revenue and fixed and variable costs in mathematical terms, you should be able to solve for the breakeven point. It won't always be simple to figure, and if costs vary dramatically with production increases, you might get more than one point at which profit goes from negative to positive.
The operating breakeven point marks a goal of every start-up. Once a business has established that it can be profitable, its potential increases markedly, and investors start to believe in much more lucrative prospects for the company.
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