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The Breakeven Point is a Return on Investment analysis that determines the number of units or amount of sales that are needed to accumulate enough benefit to pay for the cost of the project.

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Quick reference

Breakeven Point

The Breakeven Point is a Return on Investment analysis that determines the number of units or amount of sales that are needed to accumulate enough benefit to pay for the cost of the project.

When to Use Breakeven Point

Like all project ROI techniques, this analysis is done as part of the preparation of the business case used to justify a project.  Breakeven Point ROI analysis is a market focused analysis.  This technique is normally used with projects that are creating new products or services for sale.  The question often asked is whether the market is big enough to provide buyers for that many units.  This technique does not work well when there are large operating expense costs and benefits that continue year after year.  It is difficult to know how many years of those costs and benefits should be included. 

Instructions

This ROI technique is the least dynamic of the ROI techniques.  There is no formal time dependency in the technique.  However, there is a market dependency.  The result of the analysis is the number of units that must be sold at an assumed price.  With this analysis the business then turns to sales and marketing and asks the questions, “Is the market big enough?” and “Can we sell that many?”  Unless the answer to both questions is a resounding, “Yes!” the project should be cancelled.

This analysis can be done using the ROI spreadsheet that we illustrated in the module on ROI.  However, for this analysis, we often do not need to spread the costs and benefits across the years.  Since there is no time component in this calculation, that work is not needed.  Cost should be entered as negative numbers and benefits should be entered as positive numbers.  When entering costs, if you have large operating expenses costs or benefits, you should not use this technique.  If these costs are small relative to the sales costs and benefits, then include one year’s worth of these costs. 

The basic formula for this analysis is:

Gross Profit – Operating Expense = 0              

However there are several components in each of those terms.  The Gross Profit term has a price component, a sales volume variable (this is what we solve for) and a variable cost per unit.  The Operating Expense term includes all project costs, other operating expenses and benefits for an assumed time period (I normally use one year).  That makes the equation:

(# units sold x price) – (# units built x COGS) – (project costs) – operating (costs – benefits) = 0

Most of these numbers are on the ROI spreadsheet and those that are missing can be easily determined based upon project assumptions.  Let’s look at an example.  In this case “A” will represent the number of units that must be sold to hit the Breakeven Point.

Notice in this example there was no Operating Expense impact beyond the project cost.  Also, in this example an additional 25 units had to be built for manufacturing inventory reasons.  That effect may or may not be needed for your projects.

 

Hints and Tips

  • This technique will tell you how many units you need to sell, but it does not tell you how large the market is.  Your sales may fully saturate or barely penetrate the market, which means the long term potential is not evaluated using this technique.
  • I find this to be an excellent technique for evaluating product line extensions and “one-off” products.  For those circumstances there is often a limited market and this technique is an excellent method for evaluating whether the product line will ever make money or not.
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  • 00:03 Hi, this is Ray Sheen.
  • 00:05 Let's take a look at the ROI technique known as breakeven point next.
  • 00:09 >> Break even point is the ROI technique that focuses on what happens
  • 00:13 in the market.
  • 00:15 Its answer will be the number of units sold.
  • 00:17 The breakeven point is the number of incremental units that must be sold
  • 00:21 to earn enough benefit to pay for the project.
  • 00:24 It's similar in some ways to the payback period in that both are searching for
  • 00:28 the point at which cumulative benefit equals the cumulative cost of the project.
  • 00:32 But with breakeven, that point is measured by the number of units that are sold,
  • 00:36 not when they are sold.
  • 00:38 If the market size or
  • 00:39 sales forecast is less than the breakeven point, the project should not be done.
  • 00:44 If the market size and sales forecast are greater than the breakeven point,
  • 00:47 then do the project, it will yield a profit.
  • 00:50 As you can see, this technique focuses on the market.
  • 00:53 I have found this to be an excellent technique,
  • 00:55 when deciding wether to create a derivative product for market niche.
  • 00:58 After calculating the breakeven point,
  • 01:00 I compare that to the size of the market niche.
  • 01:03 In some cases I have found that the market niche much larger, and
  • 01:06 we created a successful product.
  • 01:08 In some cases, I found the market was not big enough to ever reach the breakeven
  • 01:11 point, and we avoided wasting money on product that could never be profitable.
  • 01:16 Let's look at some of the assumptions or
  • 01:17 constraints that apply to the breakeven point analysis.
  • 01:21 The first assumption is that the business desires this project and
  • 01:24 product to be profitable.
  • 01:26 If the project is being done for other reasons, such as to comply with
  • 01:29 a regulatory mandate, don't waste your time on the analysis, just do the project.
  • 01:34 This technique relies on sales benefits and internal productivity.
  • 01:38 There must be new sales or existing products must have a lower product cost,
  • 01:42 which is the cost of good sold, or COGS, so
  • 01:44 as to increase the gross profit per unit.
  • 01:47 Also, it assumes that there is no significant long-term impact on overhead
  • 01:51 or operating expenses.
  • 01:53 The costs are a one-time project cost, not recurring costs.
  • 01:57 The reason for this assumption is that the technique does not have a time component.
  • 02:01 It calculates the number of units to be sold, but
  • 02:03 does not say when those sales will occur.
  • 02:06 They could be occurring in year one or year three.
  • 02:09 If there are large annual cost or
  • 02:11 benefit impacts that are not tied to sales volume, the technique does not have a way
  • 02:15 of estimating how many years of annual impact to include.
  • 02:19 This technique does allow for changes in the product cost of goods sold.
  • 02:23 It can be higher or lower.
  • 02:24 So projects that are focused on product productivity can use this technique.
  • 02:28 Just keep in mind that when the benefits are counted,
  • 02:31 you can only include incremental benefit, which means that only the gross profit
  • 02:35 from the lower costs can be included, not the original gross profit that was earned
  • 02:39 back by the product, using the original product cost.
  • 02:42 New sales are definitely included in the calculation.
  • 02:45 For incremental sales above the normal sales volume,
  • 02:48 the entire gross profit can be included.
  • 02:50 One thing to watch, is that some projects introduce a new product and
  • 02:53 cannibalize the sales or obsolete an existing product.
  • 02:57 The gross profit from the sales loss needs to be included as a project cost.
  • 03:02 The breakeven point calculations appear simple, but
  • 03:04 they can be a little bit tricky.
  • 03:07 The basic equation is gross profit from the sales minus operating expenses of
  • 03:11 the project equal zero.
  • 03:13 And of course, we know from our definition of gross profit that it is the sales
  • 03:17 revenue minus the product costs or costs of goods sold, for the units sold.
  • 03:21 That means that our equation becomes, sales revenue minus cost of goods sold,
  • 03:25 minus operating expenses due to the project, equals zero.
  • 03:29 While the sales revenue is the price times the number of units sold.
  • 03:33 This can get a little more squirrely if the product has multiple price points
  • 03:36 depending upon the channel or packaging.
  • 03:39 The total cost of goods sold is the total to produce each unit
  • 03:43 times the number of units sold.
  • 03:45 If there are extra units that must be produced for logistics or
  • 03:48 shelf life reasons, this can also be a tricky calculation.
  • 03:52 Operating expenses are the project cost, and the net of any other overhead or
  • 03:56 operating expenses.
  • 03:57 Again, that number needs to be very small for this ROI technique to work.
  • 04:02 I usually just include one year of the other overhead and
  • 04:05 operating expenses in the calculation.
  • 04:08 With all of these values and assumptions, we solve the equation for
  • 04:11 the number of units to be sold.
  • 04:14 Let's look at an example.
  • 04:16 This project will create a new product that is projected to sell for $100.
  • 04:20 The product will cost $40 to make.
  • 04:21 The project cost is $100,000, and in this case we need to build
  • 04:27 25 units to load the logistics and supply chain before we can start selling any.
  • 04:31 This information would normally be found in the first few
  • 04:34 columns of the ROI spreadsheet.
  • 04:36 You won't need the annual period columns for this ROI calculation.
  • 04:40 Fortunately, there are only a few items we need to work with.
  • 04:42 We start with the formula of sales minus cost of goods sold
  • 04:46 minus project cost equals zero.
  • 04:48 Plugging in the numbers, we get 100 times a, which is the number of units,
  • 04:53 minus 40 times A plus the extra 25 units in inventory,
  • 04:57 minus the project cost of $100,000.
  • 04:59 Multiply and separate terms,
  • 05:01 we have 100A minus 40A minus $1,000 minus $100,000 equals 0.
  • 05:07 Combining terms we have, 60A equals $101,000,
  • 05:11 which means A equals 1,684 units.
  • 05:15 So the breakeven point is 1,684 units,
  • 05:19 which is after we have achieved $168,400 in sales.
  • 05:24 >> The breakeven point ROI calculation is great for
  • 05:27 determining if a market is big enough to support a product development project.
  • 05:32 Don't worry about time dependency with this technique.
  • 05:34 Get the product pricing and cost correct.

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