What is break-even analysis and how can it help my business?
Whatever stage you’re at in your business planning, it’s essential to understand how and when your company, product, or service will become financially beneficial. Break-even analysis offers a simple yet effective way to gain insight into your business's potential profitability.
From helping you to price your products and services to setting realistic sales and revenue targets, it’s an important aspect of financial planning.
In this article we’ll explore break-even analysis, including how it’s carried out, when it can be useful, and what you can learn from it.
What is break-even analysis?
Break-even analysis is an accounting process that helps you to calculate the point at which your business will break even – when you neither make a profit nor a loss. You can use it to find the minimum number of products or services you need to sell to cover your costs.
These costs may include:
- Purchasing raw materials
- Storage and warehousing
- Shipping and handling
- Software and equipment
- Maintenance and repairs
- Office space
- Employee wages
Anything you sell after you have broken even will create profit. By understanding what you need to sell to make back your initial investment, you can optimise your business processes to meet and exceed your break-even point to increase profitability. We’ll explain exactly how you do this below.
How to calculate your break-even point
To figure out your break-even point, you need to gather this information about your business:
- Your fixed costs
- Your variable costs
- Your average selling price
With this information, you can use the break-even analysis formula to refine your prices to improve your profitability, or to determine whether a certain product or service is a good investment for your business.
Break-even analysis formula
You can use the break-even formula to determine how many products or services you need to sell to break even, and at what price. In most instances, it makes sense to use monthly amounts to calculate your break-even point. This will give you the number of units you need to sell each month to cover your business costs.
First, you’ll need to find out the net profit per unit sold. This is done by taking your variable costs away from the average price. The remaining profit is known as your contribution margin, as it goes towards paying your fixed costs. The contribution margin is often represented as a percentage or ratio, and the higher it is, the better, as this means more money is available to cover your overheads.
Once you know your net profit, you just need to divide your fixed costs by this number to figure out how many units you need to sell in order to break even.
The break-even analysis formula is:
Break-even point = fixed costs / (average price – variable costs)
Let’s look at each element in the formula in more detail.
Your fixed costs stay the same regardless of how many units you sell. These are usually the essential costs of running your business and may include:
- Utility bills
- Software subscriptions
- Salaried staff
Usually, you won’t have much control over these costs. However, finding ways to bring down your fixed costs can help if you’re struggling to turn a profit. This could mean moving to cheaper premises, switching energy or insurance providers, or downsizing your workforce.
Your variable costs are those that fluctuate based on how much you sell. The more products or services you sell, the higher these costs will be. They tend to include:
- Raw materials
- Packaging and shipping
- Payment processing fees
- Seasonal staff wages
Whether a cost is fixed or variable may depend on your business. For example, salaried staff would be classed as fixed costs, whereas paying seasonal staff who only work during busy periods would be considered a variable cost.
In some cases, a cost can fit in either column, so it’s up to you where you include it. Just make sure you’re including all your overheads and expenses when performing a break-even analysis.
For the purposes of the break-even analysis, you don’t need to decide on a set price for your product or service. In fact, calculating your break-even point is a great way to figure out what your prices should be in order to turn a profit.
To simplify the calculation, an average price is used rather than including the price of each separate product or service you sell. If you offer any bulk order or early payment discounts, this will reduce the average price, so you may need to bear this in mind for your calculations.
Average price is calculated by dividing the total amount of revenue by the number of sales.
Calculating your break-even point
Once you’ve got all the information to hand, simply add your numbers into the formula to calculate how many units you need to sell per month to break even. Remember that this is the amount needed to cover your costs, not to make a profit.
Let’s look at an example:
|**Monthly Fixed Costs**||**Average Price**||**Variable Costs**|
2,000 / (80 – 40) = 50
In the above example, you would need to sell 50 units per month in order to break even and cover your costs. Any additional sales would be profit.
You can find Excel spreadsheet templates with the break-even analysis formula built in to make things simpler. This is handy when it comes to making adjustments to lower your break-even point, so you can try out a few different values without having to completely re-do the calculations.
When to perform a break-even analysis
Break-even analysis is useful whether you’re already running a business or starting a new venture. Three common instances where it’s useful to perform a break-even analysis are:
When starting a new business
Understanding the break-even point is critical to any new business venture. It helps you to know whether the planned products or services are viable or not so you can adjust your company’s financial strategy accordingly.
When expanding your product portfolio
Many businesses grow by adding new products or services to their existing offerings. When doing so, ensuring that pricing is both fair to customers and profitable for the business is key. Break-even analysis can help you determine the optimal pricing for a new product range.
For sales channel planning
New sales distribution channels often have different cost bases and require changes to your pricing models. Let’s say you run a direct-to-consumer ecommerce business that’s looking to add a wholesale sales channel. In this example, break-even analysis can help you to figure out if the potential higher volumes but reduced net profit per item would be financially beneficial for your company.
Advantages of break-even analysis
Break-even analysis is a quick and easy way to evaluate the profitability of your products and services. Without much effort, you can gain valuable insights that can help you to make key business decisions. Other advantages include:
Informs pricing and profit margins
Figuring out what to charge for a product or service can be overwhelming. Break-even analysis gives you a solid starting point to base your pricing decisions on, ensuring that you at least cover your costs. It also helps you gauge the potential impact on your profits if you increase or decrease your prices.
Allows you to set realistic sales and revenue goals
Motivating your team to make sales is much easier when you can provide them with concrete targets based on real numbers. Once you know the precise quantity of products you need to sell to hit a specific revenue goal, you can better understand the timeframe required and plan accordingly.
Helps you to get funding
If you’re a startup looking for funding, you’ll likely need to perform a break-even analysis to demonstrate to potential investors that your business model is sustainable. Making sure you have a relatively low break-even point will also make it easier to pay back any business loans.
Limitations of break-even analysis
As it’s a fairly simple process designed to give business owners an overall view of their profit margins, there are a few important limitations of break-even analysis that you should be aware of. These include:
Offers a very simplified approach
The break-even analysis formula only allows you to consider one variable at a time. It also only works with one product at a time, or an average price. If you have hundreds of different products, a break-even analysis may not give you the detailed insights you need.
Doesn’t take the reality of business into account
In reality, purchasing more materials from a supplier may lead to increased demand that causes them to raise their prices. This might mean that you have to charge more for your products, and you may lose customers as a result. Break-even analysis isn’t able to take these changing factors into account.
Can’t offer business forecasting
Predicting demand, seasonal fluctuations, market trends, and the actions of your competitors are all important aspects of business forecasting when planning your business model. While it has many uses in your financial planning, the break-even formula isn’t able to support this level of analysis.
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