What is the Breakeven Point (BEP)?

In corporate accounting, the breakeven point (BEP) is when a company’s operations transition from being unprofitable to profitable. This point is reached when total revenues for a product equal total expenses. The breakeven point concept is also applied in various finance areas, such as trading.

Key points:

• In accounting, the breakeven point is determined by dividing the total fixed costs by the difference between the price per unit and the variable production costs.
• The breakeven point signifies the production volume where production costs match product revenues.
• In investing, the breakeven point occurs when the market price of an asset equals its initial cost.
• Breakeven analysis aids in identifying overlooked expenses, making rational decisions, setting goals, securing financing, and establishing optimal pricing strategies.

Understanding Breakeven Points

The breakeven point (BEP) applies across various contexts. For instance, in real estate, it represents the sale price needed for a homeowner to cover all costs associated with purchasing and owning a property. This includes closing costs, taxes, fees, insurance, mortgage interest, maintenance, and home improvements. Achieving this breakeven price ensures the homeowner neither gains nor loses money from the sale.

Traders also use BEPs to determine the price a security must reach to cover all costs associated with a trade, such as taxes, commissions, and management fees. Similarly, a company’s breakeven point is calculated by dividing its fixed costs by the gross profit margin percentage.

Business Breakeven Points

The breakeven formula for a business provides the dollar amount needed to break even. This can be converted into units by calculating the contribution margin, which is the unit sale price minus variable costs. Dividing the fixed costs by the contribution margin reveals the number of units needed to break even.

Business Breakeven = Fixed Costs ÷ Gross Profit Margin

Assume a company has $1 million in fixed costs and a gross margin of 37%. To find its breakeven point, divide the fixed costs by the percentage of revenue represented by the gross margin:

Breakeven point = $1 million ÷ 0.37

Breakeven point = $2.70 million

In this example, the company must generate $2.7 million in revenue to cover its fixed and variable costs. Generating more sales will result in a profit, while generating fewer sales will result in a loss.

To calculate the number of units needed to cover the fixed costs and break even, first determine the contribution margin (the sale price of the product minus variable costs). We’ll look at that calculation next.

Breakeven Point and Contribution Margin

The breakeven point is closely related to a company’s contribution margin, which is the amount by which a product’s selling price exceeds its variable cost. It is calculated as follows:

Contribution Margin per Unit = Selling Price per Unit − Variable Cost per Unit

The contribution margin indicates the portion of each unit’s sales revenue that contributes to covering fixed costs and generating profit once those costs are covered. For instance, if a product sells for $10 and incurs $3 in variable costs per unit, the contribution margin would be $7 per unit. It’s important to note that a product’s contribution margin can fluctuate over time, impacting the efficiency of producing additional units.

The relationship between contribution margin and the breakeven point is crucial. Each dollar of contribution margin helps offset a company’s fixed costs. A higher contribution margin lowers the breakeven point because each unit sold contributes more towards covering fixed costs. Conversely, a lower contribution margin raises the breakeven point, necessitating more units to be sold to cover fixed costs.

Consider another example: If a product has a contribution margin of $7 per unit and a company has $70,000 in fixed costs, the company must sell 10,000 units to break even. If the company can increase its contribution margin per unit to $8 (perhaps by lowering its per unit variable cost), it would only need to sell 8,750 units to break even ($70,000 / $8).

In summary, fixed costs are covered by the contribution margin. The higher the profit a company makes on each unit, the fewer units it needs to sell to break even.

Benefits of a Breakeven Analysis

A breakeven analysis can assist with many aspects of business, including:

• Identifying Hidden Expenses – A breakeven analysis can help uncover expenses that might otherwise be overlooked. By determining your financial commitments, it ensures there won’t be any unexpected costs down the line.
• Making Objective Decisions – Business decisions based on emotions are rarely beneficial. A breakeven analysis provides hard facts, offering a solid foundation for making informed business decisions.
• Setting Goals – After conducting a breakeven analysis, you will clearly understand the goals needed to achieve profitability. This clarity helps in setting realistic targets and working towards them.
• Securing Funding – A breakeven analysis is often required to secure funding, as it demonstrates to investors the financial viability and strategic plan for your business.
• Pricing Products Correctly – A breakeven analysis can guide you in pricing your products appropriately from a business standpoint, ensuring profitability.

Limitations of Breakeven Point

While the breakeven point is a valuable tool for decision-making, it has several limitations. One major downside is its reliance on the assumption that costs can be neatly divided into fixed and variable categories. In reality, some costs may not fit well into these categories. For example, semi-variable costs, which have both fixed and variable components, can complicate the accuracy of the breakeven calculation and subsequently alter the breakeven point in units.

Another limitation is that the breakeven point assumes that sales prices, variable costs per unit, and total fixed costs remain constant, which is often not the case. The price of goods sold can fluctuate, and the cost of raw materials may not remain stable. Additionally, changes in the relevant range may cause fixed costs to vary. This variability makes it difficult to maintain an up-to-date, accurate breakeven point.

Finally, breakeven analysis often ignores qualitative factors such as market competition, customer satisfaction, and product quality. While the breakeven point focuses on financial metrics, successful business decisions require a holistic view that considers factors beyond the numbers. For example, it may not be feasible to sell 10,000 units given the current market conditions.

Stock Market Breakeven Points

Imagine an investor purchases Microsoft stock (MSFT) at $110 per share, establishing their breakeven point (BEP) for the trade. If the stock’s price rises above $110, the investor starts to profit. Conversely, if the price falls below $110, they incur losses. Should the price remain exactly at $110, the investor breaks even, neither gaining nor losing money.

Options can provide a strategy known as the option repair strategy, which assists investors who find themselves holding a losing stock position.

Call Option Breakeven Point Example

For options trading, the breakeven point represents the market price of an underlying asset that an option buyer must reach to avoid a loss if they choose to exercise the option. For a call buyer, the breakeven point occurs when the underlying asset equals the sum of the strike price and the premium paid. Conversely, for a put buyer, it occurs when the underlying asset equals the strike price minus the premium paid.

The breakeven point often excludes commission costs, although these fees can be factored in if desired.

For example, if an investor pays a $5 premium for an Apple stock (AAPL) call option with a $170 strike price, they have the right to buy 100 shares of Apple at $170 per share at any time before expiration. Therefore, the breakeven point for the call option is $175 ($170 strike price + $5 premium). If AAPL is trading below $175, the option has not yet become profitable.

Conversely, if AAPL is trading at $190 per share, the call owner can exercise the option, buying AAPL at $170 and immediately selling at the market price of $190. This results in a profit of $15 per share ($190 market price – $175 breakeven price).

Put Option Breakeven Point Example

Assume an investor pays a $4 premium for a Meta (formerly Facebook) put option with a $180 strike price. This allows the put buyer to sell 100 shares of Meta stock (META) at $180 per share until the option’s expiration date. The breakeven price for the put position is calculated as $180 (strike price) minus the $4 premium, resulting in $176. If the stock price is above $176 at expiration, the option has not recouped its cost.

For instance, if the stock is trading at a market price of $170, the trader realizes a profit of $6 ($176 breakeven price minus $170 current market price).

Conclusion

A breakeven point indicates the minimum level of price, yield, profit, or other metric required to avoid losses or to recover an initial investment in a trade or project. For instance, if a project costs $1 million to execute, it needs to generate $1 million in net profits to reach breakeven.

Businesses often calculate breakeven points to assess profitability, while traders use them to determine the underlying price required for a trade to end profitably. Calculations often include fees, commissions, taxes, and occasionally account for inflation effects.

DISCLAIMER: This article is for informational purposes only and is not meant to supersede official business advice. Please consult an accountant for precise breakeven calculations.