Once you know what your variable and fixed costs are, you are able to calculate the point at which you breakeven.
In other words, the volume of goods you need to sell to cover all your costs.
This model is also useful if you are considering expansion. (You would increase your fixed cost component.)
The formulas that apply to calculating breakeven are as follows:
PRICE PER UNIT – VARIABLE COST (PER UNIT) = CONTRIBUTION MARGIN PER UNIT.
CONTRIBUTION MARGIN PER UNIT/PRICE PER UNIT = CONTRIBUTION MARGIN RATIO.
BREAKEVEN VOLUME = FIXED COSTS/CONTRIBUTION MARGIN RATIO.
Let’s revisit Tom Smith and his widget business.
We know that Tom Smith’s widget company has a financial position as follows:
Annual Widgets Produced – 300,000
Sales revenue – $300,000 (Price = $1.00 per unit)
Raw Materials Costs – $20,000
Direct Labor Costs – $50,000
Fixed Costs – $110,000
Tom Smith’s variable costs per widget are 0.23 cents ($70,000/300,000).
A widget sold for $1.00 contributes .77 cents towards meeting the fixed costs.
HOW TO CALCULATE BREAKEVEN:
To calculate the breakeven, Tom Smith’s fixed costs ($110,000) need to be divided by the contribution each widget sold makes (.77 cents).
This will give you the breakeven quantity.
In other words:
$110,000/$0.77 = 142,857.
Once sales surpass 142,857 widgets, Tom Smith earns a profit.
If this sales target is not met, Tom Smith’s business experiences a loss.
READ: More about pricing strategy.