Estimating Breakeven Sales for Your Small Business

PURDUE EXTENSION
EC-725
Estimating Breakeven Sales
for Your Small Business
Cole Ehmke and Alan Miller
Department of Agricultural Economics
The breakeven amount of sales for a business venture is the
dollar amount of sales at which your business earns neither a
Audience: Owners and managers of a family
profit nor a loss. Annual sales that exceed this breakeven point
business or other small business
generate profit for the business. Annual sales that fall short of
Content: Presents a simple calculation for assessing
the breakeven point result in a loss. Estimating breakeven
the cost and revenue relationships in a venture
sales and conducting a sensitivity analysis relative to break-
Outcome: Users will be able to conduct a
even sales can help you answer questions such as:
breakeven analysis of their venture
• What is the minimum dollar volume of sales needed
to cover costs?
Estimating Breakeven Sales
• How low must variable costs be to break even, based
on price and sales forecasts?
You can calculate breakeven sales using a relatively simple
formula. To use it, you will need the information below about
• How low must fixed costs be to break even?
your operating costs. An example of a new small business,
• How sensitive is breakeven sales volume to changes in
Sonora Winery is used to illustrate the computation.
prices or costs?
• Annual fixed cost: the costs of being in business,
• How do changes in price levels affect the breakeven
also known as overhead. These costs don’t vary with
sales volume?
the level of output of the business and would be
incurred if production were to cease. They include
• What dollar volume of sales is required to not only
rent, insurance, depreciation, salaries, property taxes,
break even, but to also generate a desired profit
and other costs that aren’t directly associated with
amount?
making or selling your product. Sonora Winery
Estimating breakeven sales for your business venture can help
expects annual fixed costs of $80,000.
you set goals concerning the sales volume you will need to
• Annual variable cost: the amount it costs you to
achieve to be profitable. The time you invest in doing a
buy or create the product you sell. Variable costs
breakeven analysis can help you make better decisions about
include raw material costs, direct labor, sales
how to manage your new venture.
commissions, freight costs, packaging, and energy
costs (fuel, electricity, natural gas) associated with

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producing the product. Sonora Winery expects annual
The contribution margin ratio of 0.40 indicates that 40% of
variable costs of $120,000.
every dollar of sales is available to pay fixed expenses. This
• Annual sales revenue: the revenue you receive
$.40 per dollar of sales in excess of breakeven sales is profit.
from sales of your product. When estimating this
With fixed expenses of $80,000, the breakeven sales analysis
number, you will want to multiply the price actually
shows that Sonora Winery won’t make any profits until it
charged to customers (so make sure you include
generates $200,000 in gross revenue.
discounts and special offers) by the number of units
Mistakes are easy to make, and the breakeven point is
you expect to sell. If you have created a sales forecast
important to your business planning. So it’s a good idea to
as part of a projected cash flow or income statement,
check your calculations. To do this, compute the contribution
then use that number. Sonora Winery expects annual
margin based on sales of $200,000 and variable costs of
revenue of $200,000.
$120,000. The breakeven point occurs at the dollar amount of
• Contribution margin: the dol ar amount by which
sales that generates a contribution margin exactly equal to
annual sales revenue exceeds annual variable costs. This
fixed costs. If the amount was computed correctly, the
margin contributes to the payment of annual fixed
resulting contribution margin should be exactly equal to the
costs and, if larger than fixed costs, to profit. Sonora
$80,000 amount of annual fixed costs. The calculation below
Winery’s contribution margin is expected to be $80,000.
for Sonora Winery indicates that the breakeven sales amount
calculated above is correct.
Some expenses may not be easy to separate into their fixed
and variable components because they contain elements of

Sales
$200,000
both. An example is Sonora Winery’s energy cost. A portion of

minus Variable costs
$120,000
the energy cost is attributable to heating office space, and the



rest is attributable to producing their product, wine. Only the
equals Contribution margin
$80,000
part associated with actually producing the wine should be
considered in variable costs. Bills for heating and cooling the
To convert the breakeven sales number to the equivalent
office will need to be paid as long as the business operates,
number of units sold at the breakeven point, divide breakeven
regardless of how much wine is sold, and so are fixed costs.
sales by the average selling price per unit. If Sonora Winery
sells each case of wine for an average of $200, then they need
The formula to calculate the breakeven annual sales is:
to divide $200,000 by $200 to find out that they must sell
1,000 cases in order to break even.
Breakeven
Total annual fixed costs
sales ($) =


Contribution margin / Total sales
Sensitivity Analysis
Once you have estimated the breakeven sales amount, you
The formula in the denominator (below the line) is used to
should use the breakeven sales computation to evaluate a
calculate the contribution margin ratio. This is the percent-
variety of “what if” questions that will help you better
age of each sales dollar available to cover fixed costs and
understand the sensitivity of your new venture to changes in
contribute to net income.
sales volume, prices, and costs. With sensitivity analysis,
Sonora Winery anticipates fixed costs of $80,000 per year,
managers can look at the potential effects of undesirable
variable costs of $120,000 per year, and sales revenue of
outcomes like a shortfall in sales or an overrun on costs.
$200,000 per year. For Sonora Winery, the calculation would be:
If Sonora Winery receives $200 for each case of wine, then its
breakeven unit sales are 1,000. If the owners of Sonora Winery
Breakeven
estimated the total market demand for their product at 1,050
sales ($) = $80,000 ÷ ($80,000 ÷ $200,000)
units, or cases of wine, then they should be concerned about
= $80,000 ÷ 0.40
having a breakeven of 1,000 cases of wine. At 1,050 cases of
wine, fixed costs are still $80,000, and variable costs will be
= $200,000
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$126,000 (variable costs per case of wine are $120, and there
realize that customers will at some point react negatively to
are 50 additional cases). The contribution margin will be
higher prices by buying fewer units.
only $4,000, which is hardly likely to be enough profit to
One way to improve the contribution margin is to cut variable
sustain the business long term.
costs. This scenario is illustrated in the second-to-last column
What if Sonora Winery’s owners have overestimated the
in Table 1. Cutting variable costs by 25% increases the
number of cases of wine the business can sell, or what if the
contribution margin ratio from 0.40 to 0.55 ($110,000 ÷
economy slows down unexpectedly after business start-up?
$200,000). This would reduce the breakeven sales level
Such a small margin for error may put the business’s ability
because more margin would be available from each unit sold.
to cash flow at risk. The $4,000 difference between expected
So fewer units would be required to cover fixed costs. Thus, if
sales and breakeven sales indicates how much sales can
Sonora Winery could maintain sales at $200,000, then
decline before the business loses money and, as a result, is
$30,000 more profit would result.
called the margin of safety.
Adding a Profit Objective
If the owners of Sonora Winery would like to achieve a
minimum net income to sales ratio of 15%, then sales of
to Breakeven Sales
1,250 cases of wine won’t even get them close to that goal. In
Sonora Winery may wish to target a particular profit level. For
fact, they will have to sell 1,600 cases at $200 each to achieve
example, Sonora Winery’s capital investment in its business is
that goal. The larger the contribution margin ratio, the less
$500,000. The company wants to earn 10% return on the
that sales will need to exceed breakeven in order to achieve a
investment. In this case, the $50,000 profit required to achieve
particular profit objective. If Sonora Winery could increase its
the objective can be viewed as a fixed cost of doing business.
contribution margin per unit, it could gain more profit from
The dollar amount of wine Sonora Winery will have to sell not
each case of wine sold.
only to break even, but to also produce the desired profit can
Table 1 illustrates that increasing the quantity of product sold
be calculated using the following formula:
is not the only option for improving profitability. If Sonora
Winery can manage to cut either variable costs or fixed costs,
Breakeven
net income will increase because breakeven sales will decline.
sales +
Total annual fixed cost + Profit objective
Sonora Winery can achieve an even greater effect on its net



profit ($) =
income by raising the price of the product by 25% (from $200
Contribution margin / Total sales
per case to $250 per case). While increasing the sales price of
the product produces a benefit to net income, you should
Table 1. Sensitivity Analysis for Sonora Winery’s Breakeven Sales
Breakeven
Sales Price
Unit Sales
Unit Sales
Variable Costs
Fixed Costs
25% Higher
25% Higher
25% Lower
25% Lower
25% Lower
1. Annual Sales
$200,000
$250,000
$250,000
$150,000
$200,000
$200,000
2. Unit Sales (1/sale price)
1,000
1,000
1,250
750
1,000
1,000
3. Variable Cost
$120,000
$120,000
$150,000
$90,000
$90,000
$120,000
4. Contribution Margin (1-3)
$80,000
$130,000
$100,000
$60,000
$110,000
$80,000
5. Fixed Cost
$80,000
$80,000
$80,000
$80,000
$80,000
$60,000
6. Net income or profit (4-5)
$0
$50,000
$20,000
-$20,000
$30,000
$20,000
7. Net Income/Sales (6/1)
0%
20%
8%
-13%
15%
10%
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Again, the contribution margin ratio for Sonora Winery is
However, a breakeven analysis is limited by the accuracy of
0.40 based on variable costs of $120,000 and fixed costs of
the expense estimates you have. Also, when breakeven
$80,000. Doing the math indicates that Sonora Winery will
analysis suggests that expansion may be necessary or
have to sell 1,625 cases of wine at $200 per case, which means
desirable, you should follow up the breakeven analysis with
total sales will have to be $325,000 in order to not only break
an investment analysis to evaluate whether to buy capital assets.
even but also to earn $50,000 in net income.
You can find information on investment analysis tools in
Capital Investment Analysis and Project Assessment (EC-731).
Final Comment
Resources
Breakeven analysis is a useful tool for developing an under-
standing of the cost, volume, and profit relationships of a
Effective Small Business Management: An Entrepreneurial
business. It provides some very useful information that will
Approach, Seventh edition. 2003. Norman Scarborough and
help new business owners make management decisions. It is
Thomas Zimmerer. Prentice Hall.
useful in setting the sales price of your product relative to your
Managerial Accounting: Creating Value in a Dynamic
profit goals and analyzing the effect of changes in business
Business Environment, Sixth edition. 2005. Ronald W.
volume and costs.
Hilton. McGraw-Hill/Irwin.
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