When you’re starting or growing your business, you want to have the tools in place to forecast future financial circumstances. This means better understanding when you’re likely to break even on your investment. Performing a break even analysis - usually as part of a business plan - can help you see where your business is headed.
What is a break-even analysis?
A break-even analysis is a financial planning calculation that determines the point at which a company will generate enough revenue to cover its costs and the revenues and expenses are equal. This is called the break-even point (BEP). You’re neither at a deficit, nor are you profiting. You’ve simply made back what you spent.
How does a break-even analysis work?
The BEP is the number of sales required to cover all fixed and variable costs associated with running your business.
Fixed costs remain the same regardless of how much you sell. For example, in most cases, your rent is the same every month, no matter what your sales are. Variable costs can increase or decrease along with sales or other factors. Think expenses like commissions and utilities.
A break-even analysis can be used to help assess the financial feasibility of a new business venture, or to determine the optimal price point for a product or service. It’s also likely something that potential investors will consider.
What is the formula for a break-even analysis?
To determine the break-even point in unit sales, you want to divide the total fixed costs by the unit selling price minus the variable costs.
It looks like this:
Total fixed costs ÷ (Selling price per unit – Variable costs per unit) = Break-even point (in units)
To illustrate this further, if a company has fixed costs of $200,000, a selling price per unit of $100, and variable costs of $50 per unit, the break-even point would be 4,000 units. Here’s how the numbers break down.
$200,000 ÷ ($100 - $50) = 4,000 units
In other words, this company needs to sell 4,000 units of its product/service in order to make back its investment, or break even.
When to use a break-even analysis
Business owners can’t predict or plan for everything, but performing a break-even analysis can help you prepare for the future and potentially avoid significant financial losses. Here are a few times when you’ll likely want to conduct a break-even analysis:
Starting a new business
Starting a business can be costly. There are all sorts of expenses, like computers, software, hiring, training your team, supplies, and inventory.
Your break-even analysis can help determine how much you need to sell to make that money back, helping you manage your budget. By better understanding this data, you’ll be better equipped to find more creative and efficient ways to use your resources and have a better understanding of your profits or losses at different levels of sales.
As an added bonus, your break-even analysis will help you determine if you’ve priced your products appropriately, given how much it’s going to cost you to offer them.
Expanding a current business
If you want to launch a new product line, build a new team, or expand into a new market, you will likely incur additional expenses from purchasing more products or hiring more people.
Information about how much it will cost, and the point you could become profitable, can generally come from your break-even analysis.
Lowering Your Pricing
If you want to drop the price of some of your items, but your expenses won’t necessarily drop with it, you’ll likely want to redo your break-even analysis to determine the number of additional units you’ll have to sell to generate the same amount of revenue.
The same applies if you’re eliminating entire products or services.
How to improve your break-even point
If your break-even analysis shows you’re going to have to sell way more than you planned in order to make your money back, consider reassessing.
There are two ways that you can lower your break-even point, meaning make your money back more quickly:
- Lower your costs.
- Raise your prices.
Lowering your costs means that you don’t have as much money to recoup. Raising your prices means that you’re generally going to make that money back faster (though, that’s assuming you continue selling the same number of units).
Your break-even analysis matters
Finding your company’s BEP can help empower you as a small business owner. Whether you’re starting or expanding your business, the future can sometimes seem unknowable and intimidating. A break-even analysis may help give you concrete numbers to work with and help you set achievable business goals. A break-even analysis helps make the future a little less hazy and can help make you, as a small business owner, more confident in the future prospects of a thriving business.
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WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.