Break even relates to situations where a firm covers all of its costs, but generates no profit. In other words, revenues equal costs. Decision makers first need to know their break-even point to decide whether to enter a market or not. Secondly, they should optimize their strategy to lower the break-even point. This often allows for higher returns at lower risk.
- Break even relates to a situation where a firm covers all of its costs, but generates no profit. In other words, break even is when revenues equal costs. While this formula seems simple enough, a profound understanding of break even analysis is at the heart of many economic decisions. So let's see how to calculate the break even point, and to identify a break even point in the revenue-costs diagram. To better understand the concept, let me share with you my first entrepreneurial adventure.
So I'm a kid of the '80s and while in high school, my friends and I watched Flashdance and listened to Madonna, and we had the idea to organize a mobile disco. Saturday after Saturday, very much to the discontent of our parents, we would rent the concert hall, light shows, sound system, and engage a DJ. We sold tickets for nine francs. Of course, at that age, the big question for us was not whether we broke even, but whether the girl we liked would show up. But for the purpose of this course, let's focus on the questions of profit.
For our disco, the question was how many tickets do we need to sell to cover our costs? In order to calculate the break even point, let's start with the fixed costs. For renting the venue, the van, paying the DJ, and all the other stuff, we came up with total costs of 1,870 francs. This number alone does not tell us much, except it's a lot of money for a bunch of teenage kids. If we calculate the ticket price of nine francs, minus 10% tax, we have net revenues of 8 francs 10 cents per ticket.
By dividing the total costs to the revenue per ticket, we learn that we must sell 231 tickets to break even. This does not even include all the free tickets we gave to our friends and to girls I mentioned before. With a break even of 231 tickets, we realize that we run the risk of losing money and that we had very little upside potential to actually make money. So we decided that we had to bring down the break even point without knowing at the time what the break even point is.
On the costs side, we found two sponsors who would advertise on our posters which covered all the printing costs of 500 francs. And instead of paying the DJ a flat-fee of 150 francs per night, we paid him one franc for each ticket sold. This reduced the fixed costs to 1,220 francs. On the revenues side, we calculated that we could sell beverages and sandwiches at a profit. We estimated that the average guest would spend three francs and with a margin of 50% we would make a profit of 1.50 per guest.
Based on these calculations, the new net revenue per guest increased to 8.60. Taken together, we could reduce the break even point from 231 tickets to 142 tickets. Which drastically reduced the risk of losing money and increased the likelihood of making some profit. Which meant we could then invest in an even bigger and better disco. For those of you who like graphs better than spreadsheets, let's see how we can illustrate this.
In the first case, 8.10 net revenue per guest means that we make 810 frans for 100 guests or 1,620 francs for 200 guests. The chart shows the net revenue in red depending on the number of tickets sold. All we need to do next, is to draw the fixed cost line at 1,870 francs. The break even point is where the two lines meet. This is at 231 tickets.
We can pretend that we are surprised about this, but we already knew that. Given that this break even was considered to be too high, we had to lower the fixed cost curve to 1,220 francs. Simultaneously, we could slightly increase the net revenue per guests to 8.60. Leading to a new break even point at 141 sold tickets. Now, after all these numbers I'm sure you want to know how many tickets we actually sold. As far as I can remember, and I'm a very unreliable source for anything that happened during my teenage years, we had an average of 250 ticket sales.
The lowest was 21 tickets and the record was something like 1,500 tickets where we organized the first unofficial Swiss championship in video gaming. But that's a story for another day, what my disco years told me, however, is that understanding the break even point for every project, firm, and product development, is crucial to help businesses make better decisions.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action