What is break-even analysis?
Break-even analysis is a way of calculating when a business will become profitable. It determines how many sales a company needs to make in order to “break even” or pay for all of their operating costs. Businesses can perform a break-even analysis using different price points or costs to forecast how different scenarios might impact their profitability.
Why is break-even analysis important to business owners?
Break-even analysis gives business owners a direct understanding of when to expect a profit, which allows them todevelop a strategy for covering costs in the meantime or accelerating growth. If your break-even point is too far off in the future or requires a high number of unit sales, it could indicate that you need to adjust your business plan in order to have a sustainable business. Business owners use a break-even analysis to set goals based on fixed and projected costs, giving them an idea of their company’s gross profits.
Other statistics like sales data do not show the full picture of a company’s financial situation, while break-even analysis collects a variety of relevant expenses and income streams to determine how much you can pay yourself or reinvest into the company. A break-even analysis gives you insight into how your business makes money, helping you set ideal price points to maximize profits and find places to cut costs if necessary.
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What impacts the break-even point?
All forms of business revenue and expenses have an influence on your break-even point. During a break-even analysis, you will count all of your fixed and variable costs over a period of time, then calculate how much you need to sell to cover those costs.
Your break-even point tells you how many items you have to sell to become profitable, but you also need to factor in non-sales income. Savings account interest, dividends on investments, and fees paid to the business can all lower your break-even point. If you license your intellectual property to other businesses, you can take licensing fees into account.
Costs can fluctuate over time, but a break-even analysis requires an informed prediction about spending. Review past expenses or collect quotes to make an accurate forecast. Some of the biggest costs that can impact your break-even point are:
- Labor costs
- New employees
- Processing fees
- Debt payments
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How to calculate the break-even point
To determine your business’s break-even point, follow these steps:
1. Categorize your costs
The break-even formula requires you to know both your fixed costs and your variable costs. Fixed costs are expenses that stay the same regardless of how many sales you make, such as rent. Variable costs have a direct relationship with how much you sell, such as raw materials for making your products. Determine which of your costs are influenced by sales volume.
2. Select a logical time frame
Determining accurate costs requires you to pick a time frame for your analysis. Fixed costs over a year will naturally be vastly different from a month’s fixed costs.
3. Decide on a price
To calculate your break-even point, set a price point for your products. If you are using break-even analysis to choose the most viable price for your inventory, select multipleprices and run a break-even analysis on each one to see how price changes could impact when you break even. Keep in mind that raising prices could decrease sales and vice versa, so it is important to conduct market research when determining a reasonable starting price for your products and services.
4. Use the formula
Once you understand your costs, plug your business data into the break-even formula. The formula for break-even point is:
Break-even point = Fixed costs ÷ (Item price – Variable costs)
For example, Neon Tectonics sells hair color and wants to know how many units they have to sell at $8 per bottle in order to break even. Their main costs are:
- $1 per bottle for ingredients
- $0.25 per bottle for packaging
- $200 per month for website maintenance
- $500 per month on advertising
- $5,000 per month for employee wages
To calculate their break-even point, they would add up their fixed costs (website, advertising and labor costs) and divide them by their profit per item (price per bottle minus the cost to make each bottle). The formula would look like:
Break-even point = ($200 + $500 + $5,000) ÷ ($8 – ($1 + $0.25))
This simplifies to 5,700 divided by 6.75, or about 844 bottles of hair color each month.
5. Reverse engineer the formula
Get more out of the break-even analysis formula by rearranging it to suit your business needs. For example, if you have a limited inventory and want to make your money back selling it, you can adjust the formula to calculate how much you need to charge instead of how many units you need to sell:
Price = (Fixed costs ÷ Item quantity) + Variable costs
Using break-even analysis to grow your business
Once you perform a break-even analysis, use that data to gain insights into your business and reach the point of profitability faster.
Assess your profitability
Run a break-even analysis in the beginning stages of your company to determine if your business has the ability to make a profit using your current business plan. If a business runs a break-even analysis and determines they have to sell 5,000 units a month to break even, they can then determine if they can hit those sales goals in their current market. Compare the break-even analysis to your market research and adjust your sales techniques or pricing accordingly.
Find out where you make money
Perform a break-even analysis on each of the products or services you sellto identify what products are driving the bulk of your business. Focus advertising on products that have high enough margins to help you break even with fewer sales, or emphasize bulk orders of cheaper products if those are what your market buys.
Test different prices
Calculate multiple break-even points with different prices. You may be able to sell more products at a lower price or charge a premium to make up for lower demand and fewer sales. Setting an appropriate and competitive price ensures that you can reasonably cover your overhead costs.
Plan for the future
Once you break even, the next goal is to make a profit. Regularly perform new break-even analyses to reflect growth in your business and plan for funding future business expansion. Your break-even analysis is a data-driven way to make decisions about business strategy and sales goals and can give you an idea of when to start investing profits back into the business.