You can have an idea that motivates you to start a business or introduce a new product based just on hope and dreams. Or perhaps you're merely considering adding more employees or broadening your selection of products. However, it's a good idea to reduce your risk before diving in. A break-even analysis can show you when your project will start to turn a profit so you can plan and spend your time and money.
A break-even analysis will give rise to questions about things like pricing and cost modifications. It can inform you if the project is worthwhile to pursue at all or whether you would need to borrow money to keep your business viable till you're pocketing profits.
What is break-even analysis?
A small-business accounting method called “break-even analysis” can be used to estimate when a business, or a novel item or service, would become successful. The number of products or services you must sell to at least pay your production expenses is calculated from a financial perspective.
According to the break-even theory, there is a minimal product level below which a business cannot turn a profit or a loss.M.B. Ndaliman, An Economic Model for Break-even Analysis
A break-even analysis, for instance, might assist you in figuring out how many smartphones covers you need to sell to cover your storage expenses or how many service hours you'll need to charge to cover the cost of your office space. Anything you sell after reaching break-even will increase your profit.
You should be aware of your fixed and variable costs to completely comprehend the break-even analysis for your business.
- Fixed costs: expenses that stay the same no matter how much you sell.
- Variable costs: expenses that fluctuate up and down with production or sales volume.
Benefits of a break-even analysis
A large number of small and medium-sized enterprises never do any significant financial analysis. They are unsure of the number of units they will need to sell to realize a profit.
A business can determine the minimal sales volume necessary to avoid losses by using break-even analysis.Lis Sintha, Importance of Break-Even
A break-even point analysis is an effective tool for planning and decision-making that can be used to emphasize important data such as expenses, sales volumes, pricing, and much more.
You will be better able to price your items once you have determined your break-even point. Effective pricing involves a lot of psychology, but understanding how it will impact your gross profit margins is just as crucial. Make sure you can afford to pay your expenses.
Cover fixed costs
Most people consider variable cost, or how much it costs to produce a product when thinking about price. However, you also need to pay for your fixed expenditures, like as insurance or web development fees, in addition to your variable costs. An examination of the break-even point can help you achieve that.
Catch missing expenses
When you're working through a small business concept, it's simple to overlook expenditures. To determine your break-even point while performing a break-even analysis, you must list all of your financial obligations. This will reduce the number of unexpected events in the future.
Set sales revenue targets
You will know exactly how many sales you need to earn to break even after performing a break-even study. You may use this to assist you and your team comes up with more specific sales targets. It will be much simpler to follow through if you have a certain number in mind.
Make smarter decisions
Entrepreneurs frequently base their business decisions on feelings. They pursue new ventures if they have confidence in them. The way you feel is significant, yet it's insufficient. Entrepreneurs that are successful base their decisions on the truth. Making judgments will be much simpler if you've put in the effort and have access to helpful information.
Limit financial strain
A break-even analysis demonstrates when to reject a business plan, which reduces risk. It will assist you in avoiding failures and minimizing the financial impact that poor choices may have on your business. Instead, you may consider the possibilities realistically.
Fund your business
Any business plan must include a break-even analysis as a crucial element. If you want to hire investors or borrow money to support your business, it's typically a prerequisite. You must demonstrate that your strategy can work. Additionally, if the analysis comes out well, you will feel more at ease taking on the responsibility of funding.
How to calculate a break-even point
Your average selling price less variable costs, divided by your fixed costs, is your break-even point. When income and costs are equal, it is the moment at which the business becomes profitable.
Formula: break-even point = fixed cost / (average selling price – variable costs)
Let's talk about the break-even analysis formula's operation before calculating the break-even point. The following formula's structure can be understood to assist assess profitability and possible future earnings.
You must calculate your net profit per sold item and split it by your fixed costs. This will reveal how many units you must sell to turn a profit.
You now understand that your product sales must cover more expenses than just the price of making them. Because it adds sales money to the fixed costs, the residual profit is sometimes referred to as the contribution margin ratio.
Now that you are aware of what it is, how it functions, and why it is important, let's discuss how to determine your break-even threshold.
Get your free copy of the break-even analysis template before we begin. You can alter the template and do your calculations after making a copy.
Step 1: Gather your data
Making a list of all business expenses, including product costs, rent, and bank fees, is the first step. Write down everything you need to pay for after giving it some thought.
The last step is to separate your expenses into fixed and variable costs.
Any costs that are constant regardless of how much product you sell are referred to as fixed costs. Rent, software subscriptions, insurance, and labor may fall under this category.
Make a list of things you will always have to pay for. Most of the time, unless you're discussing an event with a shorter term, like a three-day festival, you may include total costs as monthly sums. Total everything. The break-even analysis worksheet will perform the calculations automatically if you use it.
Costs that vary according to how much of your product you sell are known as variable costs. This may involve expenses for labor, processing payments, commissions, and supplies.
Depending on your business, some expenses may fall under either category. If you employ people on a salary, they will fall under fixed costs. However, if you pay hourly part-time workers who only show up when business is brisk, they will be seen as variable costs.
List all of your expenses that change according to how much you sell. List the cost per unit sold and total the expenses.
Choose a price above all else. If you're not quite prepared to commit to a final fee, don't worry. Later, you can modify this. Remember that this is the average cost. Offering certain clients huge discounts will bring down the average price.
Step 2: Plug in your data
It's time to connect your data now. Your entire fixed costs and total variable costs will be added together in the spreadsheet's break-even analysis. You only need to enter your average price in the relevant field. The math will then be done automatically after that. The quantity of units you must sell to break even is indicated in the top right cell under Break-Even Units.
In the break-even analysis example above, the break-even point is 92.5 units.
Step 3: Make adjustments
Feel free to play around with various figures. Check the results of reducing your fixed or variable expenses or attempting to alter the pricing. It's possible that you won't get it right the first time, so make changes as you go.
Warning: Don’t forget any expenses
Remembering things—especially variable costs—is the most frequent break-even-point analytical mistake. Break-even studies are a crucial first step in the process of making crucial business choices. Because of this, you must ensure that your data is as precise as possible.
Consider your complete process from beginning to end to ensure you don't overlook any charges. If you consider your previous experiences with ecommerce packaging, you could recall that you require branded tissue paper and that one order covers 200 shipments.
You could remember to give napkins along with the food you're selling if you plan your event setup carefully. These are variable costs that must be taken into account.
If you need further help, use a break-even calculator to help you determine your financial analysis.
Break-even analysis examples: when to use it
There are four typical scenarios when conducting a break-even analysis is beneficial.
1. Starting a new business
A break-even study is essential if you're considering starting a new business. It will push you to conduct research, be honest about costs, and consider your pricing strategy, in addition to assisting you in determining whether your business concept is practical.
2. Creating a new product
Even if you currently have a business, you should still conduct a break-even analysis before investing in a new product, particularly if it will result in a sizable increase in costs. You must determine the variable costs associated with your new product before you start selling, even if your fixed costs, such as an office lease, remain the same.
3. Adding a new sales channel
Even if your pricing doesn't change when you add a new sales channel, your costs will. For instance, if you sell products online and are considering opening a pop-up shop, you need to ensure that you at least break even. If not, the financial burden can endanger the rest of your business.
This also holds for integrating additional online sales channels, such as shoppable Instagram posts. Will you be budgeting any additional expenses, such as Instagram advertisements, to promote the channel? You must include such expenses in your break-even analysis.
4. Changing your business model
You should perform a break-even analysis if you're considering altering your business strategy, for as moving from dropshipping to carrying inventory. You may use this to determine whether you need to adjust your rates as a result of any substantial changes to your launch costs.
Break-even analysis limitations
Although break-even analysis is crucial for bookkeeping and business decision-making, the information it can give is constrained.
Not a predictor of demand
It's crucial to understand that a break-even study does not forecast demand. It won't reveal your projected sales figures or the estimated demand for your products. Only the number of sales required to run financially will be shown.
Dependent on reliable data
Costs can occasionally be classified as both fixed and variable. Calculations may get challenging as a result, and you'll probably need to cram them into one or the other. For instance, you may have a constant base labor cost as well as a variable supplementary labor cost depending on how many products you sell.
Accurate data is necessary to determine your break-even point accurately. A break-even calculation won't yield a trustworthy result if you don't input accurate data.
Numerous firms provide numerous products at various pricing points. Sadly, the break-even point method does not account for this level of complexity. Working with one product at a time or calculating an average price based on all the possible products you may sell will probably be necessary. Run a few different scenarios if this is the case to be better prepared.
Costs change along with pricing. According to this paradigm, only one item may change at once. Instead, if you drop your pricing and sell more, your variable costs can go down as a result of increased purchasing power or improved productivity. In the end, it's only an estimate.
The break-even approach disregards changes over time. Your timeline will rely on the time range used to determine fixed expenses (monthly is the most common). Although you'll be able to see how many units you need to sell in a month, if your sales vary from week to week or seasonally over a year, you won't be able to observe how things alter. You'll need to make use of effective cash flow management and perhaps a reliable sales prediction for this.
Furthermore, future considerations are not taken into account in the break-even analysis. If your raw material costs double the next year, unless you boost your prices, your break-even point will be much higher. You risk losing clients if you increase your rates. This fine equilibrium is always shifting.
You will have an impact on rivals as a new player in the market, and vice versa. They could alter their pricing, which might have an impact on the demand for your products and prompt you to alter your rates as a result. The price can increase if they expand swiftly and a resource you both rely on becomes increasingly rare.
In the end, a break-even analysis will provide you with a very thorough grasp of the prerequisites for success. It is necessary. But you should conduct more study before beginning a business or making modifications to it.
Tips to lower your break-even point
What happens if you do your break-even analysis and discover that the number of units you must sell appears implausible or unachievable? You might be able to make some tweaks to decrease your break-even point, so don't worry.
1. Lower fixed costs
Check to see if you can reduce your fixed costs. Less units must be sold to break even, therefore the lower you can get them. Consider selling online instead of building a physical store, for instance, if the statistics don't add up. Does that change your fixed costs in any way?
2. Raise your prices
You won't need to sell as many units to break even if you boost your prices. There will be a larger marginal contribution for each sold unit. Consider the market's willingness to pay as well as the expectations that come with a price when considering price increases. If you price more, customers could anticipate a better product or better customer service. You won't need to sell as many units, but you will still need to sell enough.
3. Lower variable costs
Especially if you're just starting in business, reducing your variable expenditures is sometimes the most challenging strategy. However, reducing variable expenses will be simpler the more you scale. It is worthwhile to make an effort to reduce your expenses through supplier negotiations, supplier switching, or process modifications. For instance, you could discover that bubble wrap is more expensive to send fragile products than packing peanuts.
Download your free break-even analysis template
Grab your free break-even analysis template now. Additionally, it may be saved as a Microsoft Excel sheet. Click File > Make a copy to save your editable copy of the spreadsheet.
Making wise business decisions requires doing a break-even analysis. Do a break-even study the next time you're considering establishing a new business or making adjustments to your current one so you'll be better prepared.
Break-even analysis FAQ
The break-even point in cost accounting is reached when the total revenue and the entire costs of your business are equal. It is computed by taking your sales price and deducting your variable costs per unit, then dividing the outcome by your total fixed costs per unit. It aids a business in forecasting its time of profitability.
A break-even analysis has several applications on its own. However, it's also a crucial component of budgets for new businesses and enlarged or extended product lines. Use it to evaluate whether you'll need a bank loan and how much seed money or startup cash you'll require.
Break-even studies are used by more established organizations to assess their risks when engaging in various activities including putting creative ideas into production, introducing new products into the product mix, and other scenarios. Budgeting for the hiring of a new employee is one instance. How many more sales are necessary to cover the costs of the new hire, according to break-even analysis?
The margin of safety, or the distance you are from becoming unprofitable, is the gap between your break-even point and sales. The margin of safety is any income you receive that is more than your break-even threshold. The lesser your chance of turning a loss is, the higher this figure.
The difference (more than zero) between the product's selling price and its total variable costs is known as the contribution margin. For instance, the contribution margin is $110 if a bag sells for $125 and its variable cost is $15. The fixed costs are somewhat mitigated by this margin.
Your total variable cost is divided by the number of units produced to determine your average variable cost.
Generally speaking, reduced fixed costs result in a lower break-even point—but only provided variable costs do not exceed sales income.