A break-even analysis is an essential element of financial planning. Here's how to apply it to your business.
Financial planning is essential for any business, regardless of its size. Understanding revenues, expenses and cash flow are critical to keeping your doors open and your business profitable. One tool in an entrepreneur's financial planning toolbox is the break-even analysis.
If you're not already using it, you should be.
This guide explains the basics of the break-even analysis and how it can help your business.
What is a break-even analysis?
A break-even analysis is a financial tool that helps you determine at which stage your company, service or product will be profitable. It's a financial calculation for determining the number of products or services a company should sell to cover its costs, especially the fixed costs.
Here's an example of the elements that go into a break-even analysis:
- Fixed costs: These are the costs that stay the same no matter how much the business sells, also referred to as overhead costs. They include things like utilities bills, salaries and wages, rent and insurance.
- Variable costs: Variable costs are based on a business's sales. They can include things like additional labor from independent contractors, materials, payment processing fees and more.
- Average price: This is the average amount at which your competitors price their products and services.
Break-even analysis formula
Taken together, these elements creae a formula known as the break-even analysis formula. It is a relatively simple calculation, but it is critically important to planning for profitability. The break-even analysis formula is:
Fixed Costs / (Average Price - Variable Costs) = Break-Even Point
The term "break-even" refers to a situation where you are neither making nor losing money, but all of your costs have been covered. With a break-even 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. This data is often used for financial projections.
Here's an example of the break-even point analysis formula. The price of one of the products you sell is $100. Your total fixed costs are $10,000 per month, and the variable costs are $50 per product. So, when using the break-even analysis formula to calculate how many products you must sell to break-even, it would look like this:
$10,000 / ($100 - $50) = 200
Based upon the formula, you would need to sell 200 products to cover all your fixed costs, effectivly "breaking even." To be profitable, you would have to sell at least 201 products.
Why is a break-even analysis important?
A break-even analysis informs you about the bare minimum performance your business must meet in order to avoid losing money. It helps business owners understand at which point they generate profits so they can set production goals accordingly.
The third benefit of a break-even analysis is that it helps businesses in the planning stages determine whether an idea is feasible or not. Once a business has been established, a break-even analysis can help develop cost structures as well as identify opportunities for promotions and discounts.
While there is a lot to know about conducting a break-even analysis, let's focus on the most common uses.
1. To determine the 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 I need to generate to cover all of my expenses?
- Which products or services generate a profit?
- Which products or services are sold at a loss?
Your company (and others, e.g., investors) share a common goal: to become profitable as soon as possible. To ensure that you are on the right track, it is necessary to focus on your numbers upfront.
If you need help calculating your break-even 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.
Not every company determines its break-even. Some business owners aren't aware of it, and some never calculate their break-even point, only to discover later that they are either not generating a profit or not generating as much of a profit as they believed they would.
2. To properly price a product or service
Finding your break-even point will help you price your products better. You need to generate X amount of revenue to break even and begin turning a profit.
But to understand the big picture, you have to examine the finer details. This means finding the break-even point for your products or services. When most people think about pricing, they primarily take into account how much their product costs to create.
Image via Business Tool Pro
If you offer only a couple of products or services, determining your break-even is simple. As your product/service offering increases, finding the break-even point is more challenging.
As you determine your break-even for a product or service, ask yourself the following questions:
- 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?
Last, but not least, you should ask yourself, "What adjustments can I make to lower the cost of manufacturing or generate the end result I envision?"
For instance, you may be able to source some products from a cheaper distributor, thus saving you money. Or perhaps you can make some changes to your hiring process to save money on labor costs.
Once you know the break-even point for your products and services, it is easier to understand the big picture.
3. To analyze information to implement the best strategy moving forward
Using your break-even analysis, you can create a strategy for the future. If your business's profitability is determined by the success of one or more products, using the break-even point for each product provides a timeline for the company, which can help you implement a better overall financial strategy that fits the projected costs and profits.
This analysis also can help you determine ways to reduce your company's break-even point, including reducing your overall fixed costs, reducing the variable costs per unit, improving the sales mix by selling a greater portion of the products that have larger contribution margins, and increasing the prices (as long as the number of units sold doesn't decline significantly).
The University of Baltimore provides information on break-even analysis and how to use it to make strategic decisions. Furthermore, the university has published two break-even calculators so you can quickly analyze information and make more informed, confident decisions about the future of your company.
More financial planning resources
If you don't fully understand all of the ins and outs of a break-even analysis, besides the tools mentioned above, here are three additional resources to help you better understand how to calculate a break-even analysis and use the data accordingly: