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Black Sky

AS LONG AS WE BREAK-EVEN WE ARE SAFE

The concept of break-even is one of the most important aspects to consider in business. But it does not stop there; it finds its usefulness in many other areas beyond the world of business finance and accounting. Break-even, in its most straightforward way, shows when the money we make exactly matches the money we spend. It gives us a meaningful insight into how healthy our cost structure is! So let me get right to it! 

Three elements basically drive any business:

  1. The money it makes (by selling lots of its services or products)

  2. The fixed costs it incurs, regardless of whether it sells any of its services or products

  3. The variable costs, which move with the level of output (liters of beer brewed or cars produced)

In the graph below, you see how these three elements interact with each other. The x-axis marks the units (no matter what it is: liters of beer sold, cars sold, or service hours invoiced). It shows the ultimate driver of cost and revenue because, as you can see, the more we move toward the right, the more units we sell, which drives the cost and revenue upwards.

The y-axis shows the corresponding £-value. For example, selling 100 liters of beer will earn us £150, selling 300 liters of beer will give us £450, and so on. 

This does not only apply to sales but also to costs, which are equally depicted on the y-axis. But there is a catch here. You need to look at the horizontal line on the graph. These costs stay the same regardless of selling 100 or 300 liters of beer. These costs are fixed! Please think of the Jolly brewing Ltd, which we discussed throughout the homepage. They have fixed costs: rent for £1,000 per month and online marketing expenses of £2,000 per quarter, giving them a fixed cost basis of £5,000 per quarter. The horizontal fixed cost line is our base from which the costs start to climb further. 

Break-even = Make or Break

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Next, we have to look at all the costs that move in sync with the units sold, called variable costs.

We know that the "Jolly Brewing Ltd" has variable costs of £10,800 per quarter (£10,000 for all the brewing ingredients and £800 for the additional bottling help).

With the fixed and variable costs determined we can start painting the pink line, which depicts the Total costs. 

For the "Jolly Brewing Ltd." the total cost equals the Fixed costs (£5,000) + Variable costs (£10,800) = £15,800

We also know that we have total revenues of £15,000. 

Now that we know what value we have to mark on the vertical axis, the final step is to determine the corresponding units of sale that match the total revenues of £15,000 and the total fixed costs of £15,800.

For the "Jolly Brewing Ltd" we know these are 10,000 bottles of beer. These are marked on the horizontal axis. For the "Jolly Brewing Ltd" company, we only have one data set, but ideally, you have multiple data sets, such as the total cost and revenue for 12,000 bottles, 13,000 bottles, and so on. This will allow you to draw the pink and purple lines and ultimately find the break-even point by drawing lines and determining where the intercept is called the "Break-Even Point."

We know that the "Jolly Brewing Ltd" is making a loss by applying the following formula: Total revenues - variable cost - Fixed costs: £15,000 - £10,800 - £5,000 = -£800

So the question to ask is, how many bottles of beer should have been sold to break even?

To find out, we simply use elements of the formula before and turn it around to get the following:

Remember, the Jolly Brewing Ltd sold 10,000 bottles for £1.5 each. We know that our total variable costs are £10,800. To find the variable cost per unit, we simply divide these by 10,000 bottles to get £1.08 variable costs per bottle. Now you insert these values into the above formula, and bosh: The Jolly brewing company should have sold 11,904 bottles of beer to at least break even. Someone hasn't done his homework here!

He should have charged a higher price! And to get the break-even price, he could have used the following formula:

If you input all the values before into the right place, you will arrive for £1.58. The founder of Jolly Brewing Ltd should better rush to the German customer and renegotiate for the next quarterly delivery!

To warp things up

I hope you see how essential the break-even calculation is to every business wanting to avoid making a loss and determining a healthy balance between cost, price, and volume. If you are sloppy and don't bother with this calculation, you might risk getting into big trouble when push comes to shove! So be smart and apply it

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