One of the key calculations you can make as a small business owner is a break-even analysis. A break-even analysis determines at what point your company will “break even,” or earn enough money to cover your expenses. An realistic analysis requires you to accurately forecast your costs and sales, but there are different ways to calculate it, including how many units you must sell, how much time it will take to reach break-even or how much revenue you need to make.
The formula below shows how many units of a product you would need to sell to reach the “break-even point.”
While the goal is to exceed the break-even point and therefore generate profit, it’s still important to understand this threshold. Below a five step plan for how to conduct a solid break-even analysis.
1. Determine the Time Period for Which You’ll Conduct Your Analysis
If your company is new, you might want to do an analysis for a shorter period of time, say six months, as opposed to starting off with a year. You may find it easier to manage a shorter analysis period from a record-keeping standpoint. A shorter period also allows you more flexibility if you want (or need) to revise your break-even analysis once you have a few months of business under your belt.
If you’re an established business, a one-year timeframe is considered the norm.
2. Define Your Costs
This is by far the most challenging aspect of the analysis and will require the most time, so don’t worry if it takes you a while to get it right. The most important costs to define are:
- Fixed Costs: These are all of the costs that your business incurs on a monthly basis that cannot be changed. Different types of fixed costs include rent, insurance premiums, salaried payroll, equipment rental, cleaning services and more. Keep in mind that if you’re a new business, you want to use the ongoing fixed costs as part of your analysis, not the initial startup costs, like a down payment on a property or equipment costs; these costs will not be ongoing (unless they are part of a payment plan) and, therefore, shouldn’t detract from your bottom line.
- Variable Costs: These are costs that are incurred monthly and may fluctuate depending on different outside factors. Your primary variable costs are the amount of income you generate from sales revenue. Additional variable costs include advertising and marketing, payroll taxes and benefits, sales taxes, utilities, repairs, professional services (e.g. legal fees) and more.
3. Price Your Product
The other key factor of your analysis is the projected revenue you believe you’ll earn. The most important piece of that projection is the price of your goods or services. You can estimate that you’ll sell 500 widgets, but if you don’t know what the widgets should cost, then you won’t know if that will allow you to make a profit.
Generally, there are two ways to price products: cost-based pricing and value-based pricing.
- Cost-based pricing: This is the most common method of pricing. Cost-based pricing involves determining how much it costs to produce the good or service, and then applying a profit margin to that amount. So if it costs three dollars to make a widget, and you want a 100% profit margin, you would set the widget’s retail price at six dollars. The only trick to this method is to keep the consumer and the market in mind. You don’t want to price your goods too low (which may keep you from collecting lost revenue) or too high (making you lose sales to lower-priced competitors).
- Value-based pricing: This method requires you to price your product based on how much you determine consumers will value it. If your product or service is deemed highly valuable to the consumer, then you will be able to charge more for it. This method requires you to have a strong understanding of your product position in the marketplace. Some tricks to using this method can be found here.
4. Do the Math
The overall formula for a break-even analysis is actually pretty simple. You’ll want to take your fixed costs, divide it by your product price, and then subtract your variable costs.
The free template below can easily help you to determine how best to calculate your analysis.
5. Review the Results
Keep in mind that, while it’s great news if your break-even analysis comes out with your business making a profit, there are other considerations to make. Namely, if your break-even point relies on you selling 500 widgets, take a moment to determine if that’s a realistic goal for a one-year time period. If it’s more likely that you’ll sell 300 widgets over twelve months, analyze your fixed and variable costs, and see where you might be able to make cuts before revisiting your break-even analysis. Remember: you still have to sell your product or service in order to eventually break even, so keep your forecasts in line with your performance and reasoned expectations.
Your break-even analysis is one of the most important calculations you’ll make and will be especially important to investors who want to see what it will take for you to turn a profit. By following the steps above, and being honest with yourself and your organization about your costs, you can easily add this necessary figure to your financial arsenal.
To download a free customizable Break-Even Analysis Template, click the image above or click here.