Let’s imagine an example. Imagine we run a very simple coffee shop that only sells cups of coffee. The fixed costs of the business including rent and salaries are £2,000 per month. The variable cost of each cup of coffee sold are 20p including the paper cups, coffee, sugar, milk and spoons. Each cup of coffee sells for £2.20.
This is the amount of unit sales required in order cover all costs (not make a loss). If the variable costs are 20p, I can take this away from the selling price of £2.20 to see how much is left to contribute towards fixed costs. £2.20 – 20p = £2.00. Each cup can contribute £2.00 to pay for the fixed costs. In order to cover all of this the business would need to sell 1,000 cups of coffee. This formula is simplified below.
Break-even = Fixed Costs / (price – variable costs per unit)
£2,000 / (£2.20 – 20p)
Margin of Safety
This is the amount the amount of sales that could be lost without making a loss overall. If the coffee shop currently sells 1,400 cups of coffee per month, we know that we would need to lose 400 sales before we would make a loss. These 400 sales are like a safety net – we don’t need to panic about losing a few sales, but when it gets closer to 400 it’s time to worry. The calculation below is simple:
Margin of Safety = sales in units – the break-even point
1,400 – 1000