Running a small business can be a costly endeavor, and with cost always comes risk. As a small business owner, you might find challenges in measuring whether the risks and associated expenses are worth it. Is your business plan sustainable? Is your small business profitable? If not now, will it ever be? How do you get there?
If you find yourself asking these questions, it’s time to perform break-even analysis. Read on to learn all about how break-even analysis can serve your small business.
Break-even analysis, also known as break-even point analysis, involves calculating the point at which a business breaks even and what steps it might take to become profitable. This “point” is known as the break-even point.
The break-even point (BEP) is the point at which the costs of running your business equals the amount of revenue generated by your business in a specified period of time. In other words, your company is neither making money nor losing it.
If a business is at the precise break-even point, the business is neither running at a profit nor at a loss; it has simply broken even.
Whether you're an existing business or just starting out with a new business idea, performing break-even analysis is a great way to learn more about your business’s financial performance and make sure you’re budgeting effectively. Here are four ways businesses can benefit from break-even analysis.
The biggest use for break-even analysis is to determine whether or not your company is breaking even. Finding the break-even point of your business allows you to determine how much more revenue you need to generate in order to reach a profit. Conversely, it can also help you determine how many costs you need to cut to reach profitability. Out of the several ways to measure your business’s profitability, calculating the break-even point is one of the most simplistic.
Break-even analysis is great for entrepreneurs or companies that are just starting out and unsure of what to sell, how much to sell, or where to allocate their budget. This simple analysis can help that decision-making process by determining how much product you’ll need to sell to be profitable and how long that product will last. You can adjust variables, fixed costs, sales price, and volume metrics in each analysis to determine how much to budget for each of those costs.
Running a small business is all about taking risks. Should you bring a product onto the market? Should you pull one off? Break-even analysis can help determine those answers before you make any big decisions. For example, if the demand for your product is smaller than the number of units you’ll need to sell to breakeven, it may not be worth bringing the product to market at all. Finding your break-even point gives you a better idea of which risks are really worth taking.
Once you’ve determined your break-even point, you’ll be able easily view how many products you need to sell and how much you’ll need to sell them for in order to be profitable. If you won’t be able to reach the break-even point based on the current price, it may be an indicator that you need to increase it. This is beneficial for businesses that have been selling the same product at the same price point for years or businesses that are just beginning and are unsure of how to price their product.
In order to perform break-even analysis, you’ll need to be aware of the following factors:
Before you can begin your break-even analysis, you’ll first need to determine your business’s break-even point. The break-even point can be found by using one of two formulas:
Calculating the break-even point in sales dollars will tell you how much revenue you need to generate before your business breaks even.
The break-even point formula in sales dollars is:
Break-even point (sales dollars) = fixed costs ÷ contribution margin
The contribution margin is the profit of a single product or service. To find the contribution margin ratio, use the following formula:
Contribution margin = (sales price per unit – total variable costs per unit) ÷ sales price per unit
If you’d prefer to calculate how many units you need to sell before breaking even, you can use the number of units in your calculation.
The break-even point formula in number of units is:
Break-even point (units) = fixed costs ÷ (sales price per unit – total variable costs per unit)
Once you’ve decided whether you want to find your break-even point in sales dollars or units, you can then begin your analysis.
Break-even analysis is an essential financial analysis for all businesses, from startups to established businesses looking to roll out a new product or increase total revenue. Here are two examples of the break-even analysis template in use:
Let’s say your company has developed a new widget. You’re trying to determine the break-even point of your new business. Here’s what you know:
First, you’ll need to calculate the contribution margin:
Contribution margin = ($30 ÷ $10) ÷ $30
The above formula calculates your contribution margin at $0.10.
Break-even point (sales dollars) = fixed costs ÷ contribution margin
In this scenario, that formula will look like this:
Break-even point (sales dollars) = $20,000 ÷ $0.10
According to this formula, your break-even point will be $200,000 in sales revenue. This analysis shows that any money generated over $200,000 will be net profit.
Let’s say you’re trying to determine how many units of your widget you need to produce and sell to break even.
Again, here’s what we know about your business:
Remember, the formula for the break-even point in units is:
Break-even point (units) = fixed costs ÷ (sales price per unit – total variable costs per unit)
In this scenario, we’ll calculate the following:
Break-even point (units) = $20,000 ÷ ($30 – $10)
According to the above formula, you’ll need to generate and sell 1,000 units to break even. Any more than that will generate profit. How does that compare to your total sales forecast? If the units sold to break even is greater than your forecasted sales volume, you may want to:
When analyzing your break-even point, not only do you want to see that your business is breaking even, you’re looking to make sure your business is profitable as well. Here are a few ways to lower your break-even point and increase your profit margin.
If you won’t be able to reach the break-even point based on your current price, you may want to increase it. Increasing the sales price of your items may seem like an impossible task. Does the product have that type of demand? Will the financial risk be worth the possible gain? For many businesses, the answer to both of these questions is yes.
By raising your sales price, you're in turn raising the contribution price of each unit and lowering the number of units needed to break even. With less units to sell, you lower that financial risk and instantly boost your cash flow.
When you outsource fixed costs, these costs are turned into variable costs. Variable costs are incurred only when a sale is made, meaning you only pay for what you need. Outsourcing these nonessential costs will lower your profit margin and require you to sell fewer products to make a profit.
Fixed costs that can be outsourced include:
By reducing variable costs, or direct costs associated with the product, you’re increasing the contribution margin of your sales and the margin of safety of your business. A major way to reduce these costs is to redesign your product with less expensive materials. However, reducing variable costs doesn’t have to mean reinventing the wheel.
A few simple ways you can reduce your variable costs are:
As a small business owner, there are risks you take every day. Break-even analysis is an important way to help calculate the risks involved in your endeavor and determine whether they’re worthwhile before you invest in the process.
If you’re looking for other small business tips and accounting tools, we’re here to help. QuickBooks can assist with tasks from bookkeeping and payroll to inventory analysis and profitability. Contact us today to discover what QuickBooks can do to help you with all of your small business accounting needs.
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