Breakeven analysis is crucial for accurate financial planning. Are you using it correctly?
Recently, Oracle’s executive chairman Larry Ellison stated that they expect to earn three times more revenue from cloud contracts instead of licensed software, at roughly the same margins.
Is that too optimistic, or not?
And if they reach the goal, did they break even? Does breaking even matter?
With a breakeven analysis, you can determine when your company will generate enough revenue to cover its expenses and earn a profit. The same holds true for a particular product or service. For companies like Oracle and smaller companies, this data is often used for financial projections.
Related Article: Tips for Creating a Favorable Financial Forecast
Why Is Breakeven Analysis Important?
While there is a lot to know about conducting a breakeven analysis, let’s focus on the most common uses.
To Determine Point of Profitability
A business that doesn’t turn a profit is one that could take a turn for the worse at any time. This is why every company needs to focus on its point of profitability.
- How much revenue do you need to generate to cover all your expenses?
- Which products or services generate a profit?
- Which products or services are sold at a loss?
Your company, just the same as others, shares a common goal: to become profitable as soon as possible. To ensure that you are on the right track, it is a necessity to focus on your numbers upfront.
If you need help calculating your breakeven point, Harvard Business School provides a toolkit full of information and analysis tools. Here is a brief excerpt regarding its use:
“This downloadable interactive workbook, one of several workbooks/tutorials from the HBS Toolkit used by Harvard Business School students, is designed to help calculate a break-even point or target profit level based on the fixed costs, variable costs and unit price of the product or service being analyzed.”
With the right approach, it doesn’t take much to determine the point of profitability. However, this doesn’t mean every company goes through the process. Instead, some make the mistake of ignoring this data, just to find later on that they are not generating a profit or not generating as much of a profit as they believed.
To Price a Product or Service
In an overall sense, it is good to have a solid understanding of your company’s breakeven point. You need to generate x-amount of revenue to break even and begin to turn a profit.
But for you to understand the big picture, you have to examine the finer details. This means finding the breakeven point for pricing a product or service.
Image via Business Tool Pro
This process is simple if you only have a couple of products or services. As the number grows, however, finding the breakeven point is more challenging.
Here are the types of questions to address as you search for the breakeven point of a product or service:
- What are the fixed costs?
- What are the variable costs?
- What is the total cost?
- What is the cost of any physical goods (if applicable)?
- What is the cost of labor?
As you answer these questions, you should have another one on your mind: what adjustments can you make to lower the cost of manufacturing or generating the end result?
For example, you may be able to source some products from a cheaper distributor, thus saving you money. Or maybe you can revisit your hiring process to save money on the cost of labor.
Once you know the breakeven point for all your products and services, it is easier to understand the big picture.
To Analyze Information to Implement the Best Strategy Moving Forward
The steps you have taken in the past may not be the steps you take in the future. After all, you are always looking for ways to improve your business, such as lowering your out of pocket expenses to increase revenue.
You can use a breakeven analysis to analyze information when creating a strategy for the future. If a company's profitability is determined by the success of one or more products, using the breakeven point for each product will provide a timeline for the company. This can be used to implement a better overall financial strategy that fits the projected costs and profits.
The University of Baltimore provides information on breakeven analysis and how to use this analysis to help make strategic decisions. Furthermore, the University has published two break-even calculators that allow you to analyze quickly information to help make more confident decisions regarding the future direction of the company.
If you don’t fully understand the ins and outs of a breakeven analysis, if you don’t have a firm grasp on how to calculate accurate numbers, it is important to rely on tools and resources provided by others.
In addition to those detailed above, such as Harvard Business School and the University of Baltimore, here are three additional resources to help you better understand how to calculate a breakeven analysis and use the data accordingly: