Break-Even Analysis

Key terms

• Fixed costs — costs that do not change with output. Rent, insurance, salaries of permanent staff. Even if you sell zero units, you still pay these.
• Variable costs — costs that change directly with output. Raw materials, packaging, delivery costs. More units = higher variable costs.
• Total costs — fixed costs + (variable cost per unit × number of units).
• Revenue — selling price per unit × number of units sold.
• Contribution per unit — selling price − variable cost per unit. This is how much each sale “contributes” towards covering fixed costs.

The formula

Worked example

A small bakery has:

• Fixed costs: £2,000 per month (rent, utilities, insurance)
• Variable cost per cake: £3 (ingredients, packaging)
• Selling price per cake: £8

Contribution per cake = £8 − £3 = £5

Break-even = £2,000 ÷ £5 = 400 cakes per month

The bakery must sell 400 cakes each month just to cover its costs. Cake number 401 is the first one that generates actual profit.

Margin of safety

The margin of safety is how far above break-even the business is currently operating.

If the bakery sells 550 cakes, the margin of safety is 550 − 400 = 150 cakes. This means sales could drop by 150 before the business starts making a loss. A higher margin of safety means the business is more secure.

Break-even chart

A break-even chart plots total costs and total revenue against output. The point where the two lines cross is the break-even point. Below this point, the business makes a loss (the gap between the lines is the loss). Above it, the business makes a profit (the gap is the profit).

Limitations

• Assumes all output is sold (no waste or unsold stock).
• Assumes selling price stays constant (in reality, discounts happen).
• Assumes costs are neatly fixed or variable (some are semi-variable, like electricity).
• Only works for a single product (multi-product businesses need a weighted average).