Marketers often have to make the call on whether a certain marketing investment is worth the cost. Can you justify the price tag of the ad you want to buy or the marketing campaign you’re hoping to launch next quarter? One of the most straightforward ways to answer this question is to perform a breakeven analysis, which will tell you how many incremental units you need to sell to make the money back that you put in.
While the concept may be straightforward, the calculation and the assumptions underlying it are far from simple. I talked with Jill Avery, a senior lecturer at Harvard Business School and co-author of HBR’s Go To Market Tools, to better understand how to use this important calculation.
What is breakeven quantity (BEQ)?
“Breakeven quantity is the number of incremental units that the firm needs to sell to cover the cost of a marketing program or other type of investment,” says Avery. If the company doesn’t sell the equivalent of the BEQ as a result of the investment, then it’s losing money and it won’t recoup its costs. If the company sells more than the BEQ then it not only has made its money back but is making additional profit as well.
“It’s one of the more popular ways that managers calculate marketing ROI,” says Avery, pointing out that other common ones include calculating the investment payback period, calculating an internal rate of return, and using net present valueanalysis. “I like breakeven analysis because it is easy to understand and it’s often the simplest way to think about return on investment.” The other forms of ROI often require a more complex understanding of financial concepts such as the firm’s cost of capital or the time value of money.
How do you calculate it?
To figure out BEQ, start by setting up an equation where Total Revenue = Total Costs, which will mathematically represent the point at which profit is equal to zero, i.e., where you will break even:
Then you have to find a unit quantity — your BEQ — that makes both sides of the equation equal. The BEQ will be present on both sides of this equation because the number of units sold affects both the revenue the firm earns as well as the costs it must incur to earn it. Revenue is the unit quantity sold multiplied by the selling price per unit. To figure total costs you first multiply the unit quantity sold by the variable costs per unit, then you add the fixed costs. So it looks like this:
You then reorder the equation to solve for BEQ. Like this:
Note that Price per unit – Variable costs per unit is equal to the Contribution margin per unit.
So to calculate BEQ you need to know the fixed costs for your program and the contribution margin per unit.
Take this example of a company that sells flip flops from Avery’s teaching note, “Marketing Analysis Toolkit: Breakeven Analysis.”
The company sells each pair of flip flops for $24.00. The variable costs to make each pair of flip flops are $14.00. (Note: variable costs are per unit costs that vary depending on a company’s production volume. They rise when you increase production and fall when you decrease it.) The fixed costs to advertise the flip flops are $2,000. So, how many flip flops does the company need to sell to breakeven on its advertising expense?
First, look at fixed costs. No matter how many flip flops are sold the cost of advertising remains the same: $2,000. Note that most companies’ fixed costs are much more complex and often include rent, advertising, insurance and office supplies but since we’re trying to evaluate the BEQ for the $2,000 advertising campaign, we focus just on this number.
Then you take the price of the flip flops and the variable costs and put them into the equation like this:
BEQ = $2,000 / ($24-$14)
or
BEQ = 200 units
So if the managers at this flip flop company believe they will be able to sell more than 200 extra pairs of flip flops because of the advertising campaign, they will recoup their costs and it will be a worthwhile investment. But, if they don’t believe that the advertising campaign will drive enough incremental demand for flip flops, then they shouldn’t run it. It will not breakeven.
How do companies use BEQ?
The above is a simplified example but most companies use BEQ in a similar way. “It’s a pretty universal tool. It can be used to evaluate any investment from a marketing campaign to a decision about whether to build a new factory,” says Avery. However, she says, it’s particularly useful for marketing because it relates the cost of a marketing program to the program’s ability to affect consumer demand for a product. “It most closely relates one of our main goals in marketing, to generate demand, to the costs that we incur to achieve it.”
Among marketers, it’s most often used to do one of several things:
Assess the feasibility of a marketing expense, such as an advertising campaign (as we did in the flip flops example above). This is most common use, says Avery. Typically the campaigns are more expensive then the $2,000 the flip flop company was considering. So a manager may consider, If I’m going to spend $10 million on a marketing campaign, how many additional units of my product do I need to sell to breakeven on the investment? The formula will tell the manager how many units will result in $10 million in profit.
Managers will also use BEQ to assess the feasibility of a permanent price change, either an increase or a decrease. “Pricing changes are complicated because when you change price, you inherently effect demand. You have to think through what happens to demand before you can determine the effect of the price change on your business,” says Avery.
So the question for marketing managers here is How many more units of a product must be sold to compensate for the lower price? You can use the same BEQ equation above to determine how much additional demand you need to generate. You start by setting an equation with the current contribution margin equals the contribution margin with the new price:
For example, let’s say your current demand is 100 units at a price of $10.00, but you want to lower it by $2.00. If the product has a contribution margin of $5.00 (at the $10.00 price) and therefore $3.00 (at the $8.00) price, then the equation would look like this:
$5.00*100 units = $3.00*(100 + BEQ)
Then you solve for BEQ:
3*BEQ = 500 units – 300 units
BEQ = 200 units / 3
BEQ = 66.7 units
So you have to be confident that you will sell at least 67 additional units at the lower price (or 167 units in total) to justify the price decrease.
The calculation works similarly if you’re considering raising your price but instead of looking at the number of additional units you need to sell, you’re considering how many units can be sacrificed if you’re getting the higher price. So again, you set it up so the contribution margins are equal:
Contribution margin (at existing price) = Contribution margin (at new price)
Then, let’s say you wanted to raise your price by $2.00 and therefore your contribution margin at the $12.00 price would be $7.00.
$5.00*100 units = $7.00*(100 + BEQ)
Solving for BEQ:
7*BEQ = 500 units – 700 units
BEQ = -200 units / 7
BEQ = -28.6 units
In this case, you need to be sure that you will lose 29 units or fewer if you raise your price (or sell 71 units in total).
Marketing managers can also use BEQ to assess the feasibility of a short-term marketing expense, like a coupon promotion, or the feasibility of a new product introduction that will cannibalize existing product sales.
What are some of the common mistakes managers make when using BEQ?
First off, it’s important to keep in mind that the BEQ is a measure of the incrementalunits needed to be sold to justify the investment. So these are additional units that you have to sell because of the price decrease or the marketing campaign. “Some managers think, ‘Sure, we can do 200,000 units.’ But the real question is can you do what you did yesterday plus 200,000 units,” Avery explains. And for many managers, says Avery, determining what is incremental can be tough. Would you have sold the same amount without the coupon or the sales promotion? Or has the coupon forced people to “pantry load” — stock up on a product because it’s cheaper now? If razors are on sale at Costco some consumers will buy all the razors they need for the next year. “We want marketing investments to generate incremental demand and not cannibalize what we would sell anyway, switching tomorrow’s demand for today’s demand,” says Avery.
This is where “the art of marketing comes in,” she says. You have to look at the data available to you — including internal and external benchmarks — to assess whether you believe that you can sell that many more units. Avery suggests asking: What have we done before and what has that yielded? And what have competitors done and what has that done for them?
Another mistake that managers make is forgetting to consider the length of time it will take to hit the BEQ. “If the 200,000 additional units represents two months of sales, that may seem reasonable but if it will take two years to sell 200,000 units, that’s often a different story,” says Avery. This is where payback period comes in, and it can often be helpful to run a payback period analysis in conjunction with BEQ (for help on how to do a payback period analysis, check out the HBR TOOLS: Return on Investment).
There is also room for error in the various assumptions that go into the BEQ calculation. Avery says that the cost of the marketing program, for example, can be difficult to pin down ahead of time. She gives the example of a couponing program, where you won’t know the total cost until the redemptions come in. In these cases, you want to do a sensitivity analysis and run the calculation using several different numbers. “If you want to be conservative, overestimate the cost,” says Avery. “That will give you a higher BEQ number and therefore a higher threshold to meet.”
The biggest mistake people make, however, says Avery, is not even running a breakeven analysis. “Too often, marketing budgets are just spent because that’s the way we’ve always done business and there is little effort to justify the expense,” she says. Many managers don’t even run an ROI because the costs of programs and the incremental demand can be hard to determine ahead of time. “There’s often a lag time between when we spend and when we see results so programs can be hard to measure.” Even if the numbers are tough to get right in advance, Avery says, it’s simply good marketing management to understand how well you’re spending your dollars, even if you run the analysis in retrospect to help you make future decisions.
“Breakeven analysis imparts discipline into marketing decision making,” she says. You need to understand what you are trying to achieve, what it will cost you, and then how likely it is to succeed.
Amy Gallo is a contributing editor at Harvard Business Review and the author of the forthcomingHBR Guide to Managing Conflict at Work.