Break-Even Analysis: What It Is, How It Works, and the Formula

Definition

A break-even analysis determines the sales volume required to cover both fixed and variable costs. The break-even point (BEP) is where a business’s net profit equals zero—sales exactly cover total costs.

Key components

• Fixed costs: Costs that do not vary with production or sales volume (e.g., rent, salaries, insurance).
• Variable costs: Costs that vary directly with units produced or sold (e.g., materials, direct labor, shipping per unit).
• Revenue: Sales income.
• Contribution margin: Revenue per unit less variable cost per unit; the amount available to cover fixed costs.
• Break-even point (BEP): The sales level (units or dollars) where total revenue equals total costs.

The break-even formula

BEP (units) = Total fixed costs / (Price per unit − Variable cost per unit)

Because contribution margin = Price per unit − Variable cost per unit, you can also write:

BEP (units) = Total fixed costs / Contribution margin

To express BEP in sales dollars:

1. Contribution margin ratio = Contribution margin per unit / Price per unit
2. BEP (sales dollars) = Total fixed costs / Contribution margin ratio

Worked example

Assume:
* Price per unit = $100
Variable cost per unit = $60
Total fixed costs = $20,000

Contribution margin = $100 − $60 = $40
BEP (units) = $20,000 / $40 = 500 units
Contribution margin ratio = $40 / $100 = 0.40 (40%)
BEP (sales dollars) = $20,000 / 0.40 = $50,000

Upon selling 500 units (or $50,000 in sales), the company covers all costs and reports zero profit. Additional sales generate profit.

Other useful measures

• Margin of safety: The difference between actual (or expected) sales and break-even sales; indicates how much sales can fall before the firm becomes unprofitable.
• Contribution margin per product helps prioritize higher-margin items for profitability.

Who uses break-even analysis

• Entrepreneurs and business owners evaluating new products or pricing
• Financial analysts and management for budgeting and planning
• Investors and traders to assess minimum required outcomes for investments or strategies
• Government agencies and nonprofits for project planning

Why it matters

• Performance metric: Clarifies how far current sales are from profitability.
• Pricing: Informs pricing decisions to ensure costs are covered and desired margins achieved.
• Decision-making: Aids choices on product launches, expansion, or cost-cutting.
• Cost management: Identifies impacts of fixed and variable costs on profitability.

Limitations

• Assumes fixed and variable costs remain constant—real-world costs can change with scale, time, or market conditions.
• Assumes a linear relationship between costs, price, and volume (no bulk discounts, capacity constraints, or price elasticity effects).
• Ignores external factors such as competition, demand fluctuations, and changing consumer preferences.
• May oversimplify situations with multiple products unless weighted-average contribution margins are used.

Practical tips

• For multi-product firms, calculate a weighted-average contribution margin based on sales mix.
• Recompute break-even when costs, prices, or sales mix change.
• Use margin of safety to assess risk and set conservative targets.

Bottom line

Break-even analysis is a straightforward, practical tool to determine the minimum sales needed to avoid losses. While valuable for pricing, planning, and decision-making, it should be combined with market analysis and sensitivity testing to account for changing costs and demand.