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Here’s all you need to know about break-even analysis and how to calculate your break-even point.
You have a great business idea, and now you want to know if it will be profitable. Alternatively, you may have already kickstarted your startup and are wondering when it will become profitable. Or, you may be thinking of launching a new product and want to know if there’s a chance of it succeeding.
Whether you are a budding entrepreneur or have already ventured into your entrepreneurial journey, one tool that can help you determine if and when your startup will turn profits is break-even analysis. A break-even analysis can tell you if your venture or a new product is worth pursuing, when your business will turn profits, and whether you may have to borrow money, and more.
What is break-even analysis?
A popular business tool, break-even analysis estimates the point at which your business will break even or will be profitable. It helps you estimate how much revenue your business will have to generate to cover your expenses and how long it will take to generate the required revenue.
At the point you break even, you neither gain nor lose money. Instead, it helps you determine the number of products or services your company should sell in order to cover your costs. What you sell beyond your break-even point is what makes the profit.
Uses of break-even analysis
Considered a risk management strategy, break-even analysis helps you evaluate the various risks associated with your business. It helps you determine the right mix of products as well as the number of products to sell, set revenue targets, and catch any missing expenses.
If you are just starting out with your business, a break-even analysis will help you determine the amount of seed funding or startup capital you would need to start your business. You would also be able to find out if you will require a bank loan to cover your expenses.
Finding the break-even point can also help you price your products adequately. Considered one of the secrets to business success, the correct pricing can improve how much you sell and help create the foundation for a prosperous business.
If you already have a business, you can use break-even analysis before launching a new product to set the pricing. If you are expanding the business or changing the business model, break-even analysis can help change the product pricing if needed and help determine how long it will take for any planned investments to become profitable.
Additionally, break-even analysis can be used to lower your selling prices to tackle competition. It will help you determine how many more products you will have to sell to offset the price decrease.
How to calculate the break-even point
Before you set out to carry a break-even analysis, you have to first understand its various components – fixed costs, variable costs, and contribution margin.
Fixed costs: These are expenses that stay the same regardless of any increase or decrease in sales. These include rental lease (or mortgage) costs, insurance, taxes, salaries, accounting fees, equipment costs, and energy costs, among others.
Variable costs: These are expenses that change in proportion to production output. They increase or decrease according to the production volume or sales – as production increases, variable costs also increase, and vice versa. These costs include the cost of raw material, packaging cost, fuel, direct hourly labor payroll costs, and advertising, among others.
Contribution margin: This is the difference between the product’s selling price per unit and its variable cost per unit.
The break-even point is calculated as follows:
Break-even point = fixed costs/(sales prices per unit – variable costs per unit)
In other words, break-even point = fixed costs/contribution margin
To carry out the break-even analysis, you have to note down all your expenses to calculate the total fixed and variable costs. If you are just starting out, you can base your sales price on competitors’ prices – you can always change this later. For accurate results, it is important to ensure that you do not miss adding any expenses, however small they may be.
For example, imagine that you are selling bags. Let’s assume that your variable costs to make each bag is US$20 for materials and $30 for direct labor. This would bring your total variable costs to $50. If you sell the bag for $70, you will make a contribution margin of $20.
Now, let’s assume you incur fixed costs of $25,000 to produce and sell a bag. By calculating the break-even point, you can find out how many bags you would have to sell to cover your fixed costs of $25,000.
Break-even point = fixed costs/contribution margin = $25,000/$20 = 1,250 bags
This means that you can cover your fixed costs – or break even – by selling 1,250 bags. If you sell more than 1,250 bags, that will be your profit.
If the number seems too high, you can lower your break-even point by making various adjustments such as lowering your fixed or variable costs or increasing your price.
While doing a break-even analysis is crucial to making smart decisions for your business and helping you prepare better for the risks, it is important to know that it has several limitations. For instance, it does not consider market demand. While it will tell you that you have to sell 1,250 bags as per the above example, it does not tell you if or when you will be able to sell all the bags. Similarly, it does not consider competitors in the market and depends on the accuracy of the data you input.
Ultimately, before starting a business or making significant changes in your existing business, it is important to substantiate your break-even analysis with other research and financial calculations.
Header image courtesy of Sharon McCutcheon on Unsplash