We briefly touched on Break-even Analysis when we covered Contribution margins. If you remember, the Contribution Margin is the amount of net revenue you generate per product sale (sale price minus COGS). This allows you to calculate how many units you need to sell for that net revenue to cover the fixed costs of your business and, in doing so, break even.
Here is the simple example we spoke about previously:
As you can see, as the number of units sold increase the amount of net revenue increases until it passes the Fixed Costs line, which is the break even point. As long as the business sells more units than the Breakeven point, it will be profitable.
Now, in the real world things are never so simple. Specifically, two factors will complicate your break-even analysis:
- It’s likely that your fixed costs will go up with higher unit volumes. You might need more sales people, more warehouse space or more manufacturing capacity. This means that your Fixed Costs can be a moving target, depending on volume.
- Economies of scale mean that your Contribution Margin may change as your unit volumes increase. Specifically, your COGS should decrease over time because it will be cheaper to manufacture larger quantities of your product!
The result is a Break-Even analysis that looks more like the following:
Note that there is not just one Break Even point, there are two! That is because, in this example, there is a big jump in the fixed costs at a certain volume that exceed the growth in Contribution Margins. Such traps are very important to catch before they happen, as you will be burning through capital when it does.
Quote of the Day: “Don’t get mad, get even,” ― Robert F. Kennedy