Accounting Break-Even & Operating Cash Flow

Instructor: Darlisha Oliver

Darlisha has a Master of Science degree in Accounting

In business, it's important to know how much product to sell in order to cover your expenses. This is what we refer to as the break-even point. Let's take a look at how to calculate the break-even point and how it relates to operating cash flow.

Break Even Point

Lemonade Stand
Lemonade Stand

As a child, a lemonade stand seemed to be the perfect way to make money. It seemed so simple. All you needed were lemons, water, sugar, and a location! One thing I never considered though was how much lemonade I needed to sell to make sure all of my costs were covered: the break even point.

A company's break-even point is the point at which the total of fixed and variable expenses equal sales revenue. This is also the point at which profit equals zero and cash flow is neither positive or negative.

Fixed expenses are costs like rent and salaries that remain the same regardless of how much product the company sells. In our lemonade stand example, the cost to rent the space we put our lemonade stand would be a fixed expense. Variable expenses increase or decrease based on sales activity, and include things like commission and shipping expenses. The cost of the lemons, water, and sugar are the variable expenses in our lemonade stand example.

The formula used to calculate the break even point in sales dollars is:

Break-Even Point in Sales Dollars = Fixed Expenses / Contribution Margin Ratio

Break Even Point Graph
Break Even Point Graph

Contribution Margin Ratio

As you can see, to calculate the break-even point you're going to need to know the contribution margin ratio, which means you'll also need to know the contribution margin. The contribution margin is the sales price per unit minus the variable expenses per unit. Thus the contribution margin ratio is the contribution margin divided by the sales price you are charging for the product. For example, I'm selling each cup of lemonade for $5. The amount of lemons, water, and sugar needed per cup is $2. The contribution margin per cup of lemonade is therefore:

Sales Price - Variable Expenses per Unit = $5 - $2 = $3

The contribution margin ratio is:

Contribution Margin / Sales Price = $3 / $5 = .60 or 60%

Let's Calculate Our Break-Even Point

Let's assume we pay $30 per week to rent the space we use to sell the lemonade. This is our fixed cost, since this cost does not change based on how much lemonade we sell. Now we can calculate the amount of lemonade we need to sell in order to break even:

Break-Even Point in Sales Dollars = $30 / .60 = $50

Based on this calculation, we need to sell $50 worth of lemonade per week to cover our weekly fixed and variable costs (or to break even). Since we are selling the lemonade for $5 per cup, we want to sell 10 cups ($50 in revenue).

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