Using the Breakeven Point in Cases

The breakeven point comes up pretty frequently in market entry / new product introduction type cases. We touched on it briefly in February’s Business Terminology for Non-Business Majors article, but because it’s such an important concept we’re going to expand on it more.

Today’s article will be on what the breakeven point is, how to calculate it, and how to interpret it.

What is the Breakeven Point?

Let’s say you’re planning to make an investment in something. It might be a factory upgrade, a new product, a marketing campaign, etc.

A really, really good question to ask yourself is – how many units of my new / upgraded product would I have to sell to make good on my initial investment (AKA what is the breakeven point for my investment).

Why? Because it might be impossible for you to sell that many units. Maybe that number is larger than the entire market. Maybe there’s intense competition and its unlikely that you can increase your market share to reach that goal.

How to Calculate the Breakeven Point

First, I’ll just lay out the equation and define all of the terms. Then, I’ll derive it just so you know where it comes from, in case you ever need to rearrange it.

Breakeven Point = Fixed Cost of Investment / Contribution Margin

Contribution Margin = (Price – Variable Cost) / Unit or Price / Unit *Profit Margin

Derivation

The Breakeven Point is the Volume at which Revenues = Costs (1)

Revenues = Price / Unit * Breakeven Point (2)

Costs = Fixed Cost of Investment + Variable Cost / Unit * Breakeven Point (3)

If you put equations (2) and  (3) into equation (1) you get:

Price / Unit * Breakeven Point = Fixed Cost of Investment + Variable Cost / Unit * Breakeven Point

which rearranges to:

(Price / Unit – Variable Cost / Unit) * Breakeven Point = Fixed Cost of Investment

Breakeven Point = Fixed Cost of Investment / (Price / Unit – Variable Cost / Unit) (4)

Contribution Margin = (Price / Unit – Variable Cost / Unit) (5)

then, you put (5) into (4) and get

Breakeven Point = Fixed Cost of Investment / Contribution Margin

How to Interpret It

Once you calculate the Breakeven Point you can use it to tell you something about the feasibility of your investment. Look at how many units you have to sell. What percentage of the market is that? Can you capture that part of the market with that investment? Can you even produce that number of units?

These are all questions to ask yourself. Sometimes a case boils down to the fact that the investment is so large that there’s no way you can sell enough units to pay it back. In that case, it’s time for you to think about ways to lower the initial investment, justify a higher price, sell more units, offer additional products or services, and lower operating costs.

Conclusion

The Breakeven Point is a highly useful calculation that can tell you how many units of something you’d have to sell to pay back its initial investment. It can help you decide whether or not to introduce a new product, enter a new market, or whether or not to make a new investment in a process, software, factory upgrade, etc.

Usually you can calculate it by taking the ratio of the fixed cost of investment to the contribution margin (the profit per unit). At that point, you can compare it to the total addressable market, look at your market share and how it’s been changing, and examine long term market growth to see if this investment is a good option.

Sometimes, it will be. Other times, you may need to brainstorm other ways you can reduce the investment cost, justify higher prices, and lower operating costs to make the investment worthwhile. Sometimes the economics don’t work out no matter what you do. Either way, you learn something important.

Good luck!

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s