The equilibrium point, neutral point or profitability threshold, is that minimum sales level that equates total costs to total revenues .
Therefore, the deadlock is nothing more than that minimum necessary to avoid losses and where the profit is zero. From it, the company will start to make a profit. This concept is essential to know what is the vital minimum to be able to survive in the market. But, in addition, it has a simple way of calculation as we will see below.
Components and way of calculating the equilibrium point
We are not going to develop the steps to arrive at the final expression since the idea of this article is to show the breakeven point in a simple way. Keep in mind that total income is calculated by multiplying quantity sold by unit price. The total costs would be the sum of the fixed costs and the total variables, these as the unit costs for the units produced. But first of all, let’s look at the components of the expression.
First, we have the equilibrium quantity (Qe) which is the one to be calculated. On the other hand, the fixed costs (Cf) which are those that the company has, whether it produces and sells or not. For example, rentals, amortizations or insurance. In addition, a unit sale price (Pvu) of the products and a unit variable cost (Cvu) which is one that does depend on production. The latter is related to raw materials or direct labor.
As we see in the image, the way to calculate it is very simple, as long as we talk about a single product. The company’s Cf will be in the numerator and the contribution margin in the denominator, such as the difference between Pvu and Cvu. In this way, the necessary amount will be that which allows to cover the amount of the Cf in which the company incurs.
Like everything in economic theory, a series of conditions are required. Without them, this simple calculation becomes much more complicated. Even so, most statistics and business management programs already include modules that allow you to calculate averages and provide approximate values for each product based on expected sales. Let’s see what those requirements are:
- In the first place, it is assumed that the company operates in a perfectly competitive market and that, therefore, it can sell all that quantity at the established price. This is done like this in order to understand the deadlock concept and make simple calculations. Something that is more than enough for academic purposes.
- On the other hand, a constant variable cost is considered at any level of production. This does not usually happen in reality, but in it we have the help of computers.
To finish, an example
Let’s imagine a company that sells its products at a Pvu of 20 currency units (um) and that has a Cvu of 10 cu, in addition to a Cf of 350 cu. The graph has been made with a spreadsheet. For example, up to 50 units are used, the Pvu and CVU are calculated for each of them and a Cf of 350 um is included in all levels We can see that the equilibrium point (indicated by the arrow) is 35 units, as we had calculated with the previous formula.
From this amount, the company would have benefits. Below this you would have losses. In the graph, below this point, there are two situations, one in which the CFs are covered but not the Cvu, it would be after the point where both are equal. the other is the one before this, where neither is covered. From the point of equilibrium benefits are obtained.