Not gonna lie, up until recently I didn’t even know what a break-even point was (I’m not a business owner!), so let us clarify the basics before we begin.
A successful for-profit enterprise is characterised by its profit – duh -, i.e., that its revenues exceed its costs. Ultimately, a positive balance sheet at the end of the month determines whether you can build a long-lasting business as a freelancer or SME.
Now, the break-even point is reached when your revenues fully cover the costs of running your business. Once you break even, every dollar you earn beyond that becomes profit.
The break-even point is usually calculated both monthly and annually, depending on your industry, location, and individual preferences. If you think about it as a freelancer, our annual break-even point is the number of months we have to work and earn revenue to cover our annual expenses. So once the rent is paid, the Macbook paid for, the travel covered etc, money we earn beyond that (for luxuries, savings etc) is beyond the break point.
But why exactly is this indicator important? Well, don’t you want to make a profit? Yes, of course you do! However, with the help of the break-even formula, you can determine how much work you need to do, so your company doesn’t make a loss, which is something you want to avoid as a profit-oriented entrepreneur.
The key benefits of knowing your break-even point:
- Know your cost structure: one of the most important decision-making tools for your business is your costs. If you don’t fully understand them, you’ll be making your future decisions on the wrong basis and could fall into the trap of wrongly assuming that you should be making a profit now, but for some reason, your bank account tells a completely different story .
- Pricing: this can easily lead to a situation where although you’re working hard, you can’t support yourself. Calculating your break-even point is, therefore, a great help when setting your prices.
- Profit calculation: if you know your break-even point, you can easily calculate your profit and manage it more efficiently.
- More transparent operation: a freelancer or entrepreneur who’s aware of their finances can run their business in a much more transparent manner. This will help you in the long run and is a distinct advantage, when the IRS requests your records for an audit.
Now for the mathematical point; how to calculate the break even point…To calculate this, all you have to do is determine and track your costs for a given period, as you will need to show an equivalent amount of income.
Every business has fixed and variable costs. Fixed costs are those that do not depend, at least not directly, on how many products or services the company sells. Typical fixed costs include labour, the cost of a store or other property, software subscriptions, or overhead in general.
However, it’s reasonable to assume that these expenditures fluctuate over time, since as sales rise, new staff must be employed, and as sales fall, old employees must be laid off. In other words, in the long term, practically all expenses are ultimately variable.
Some goods are fixed costs in one company, while they are variable costs in another. In most companies, electricity costs are fixed: they are more or less the same from month to month: office lighting, printers, a refrigerator in the canteen, and so on. In a bakery, however, the electricity bill is one of the variable costs because most of the electricity is used to heat the ovens, which depends on the amount of bread being baked.
How to calculate fixed costs
For fixed costs, we assume that they do not depend on the quantity produced or delivered, so they are the same every month, even if you have many customers, and even if you have none.
Our fixed costs will depend heavily on the nature of your business, your location, and your operating model, and only you can accurately determine these. We will show you how to do the maths using the example of a freelancer.
Our protagonist is a freelance project manager with years of experience who has multiple clients. They work from home and use their own tools. Let us see how high his fixed costs will be:
- Proportionate share of rent or loan repayments;
- The monthly cost of a computer (either as a monthly repayment or if it was bought in one lump sum, you can still plan with fixed monthly portions);
- Office furniture and other office supplies;
- Software subscriptions (e.g. video chat, project management tools);
- Training courses.
For costs like rent, only the time and location apply to the business.
Variable costs are much more difficult for freelancers and small businesses to plan because they rarely know in advance how many products or services they will sell. Therefore, for planning and costing purposes, it pays to set a number that is a realistic/optimistic estimate.
You also need to consider that the unit price may increase or decrease with the quantity sold. A good example of this is the cost of storage, which can be a variable cost for a small business that manufactures and distributes products. You can store 100 products in the rented space you have now; if more orders come in, you will need additional storage space. However, if you need storage space urgently (and temporarily), you may only be able to rent it at a higher cost than, so your total storage cost per product will increase.
An example of the opposite case is a wedding organiser company that can charge its subcontractors lower catering prices as the number of guests increases, so its variable cost per person can decrease.
The most typical variable costs are:
- Production materials;
- Hourly paid labour;
- Transport costs;