Break-even analysis is a great tool that helps guide your pricing structure and lets you know how many products or services you need to sell before your business becomes profitable.
In order to conduct your own break-even analysis, you’ll need three pieces of information.
- Monthly fixed costs. These are the business expenses that remain the same every month, such as your rent, payroll, insurance premiums, and utilities. These expenses stay the same whether your business is thriving or experiencing a dry spell.
- Variable cost per unit. These costs go up or down, depending on the amount of sales for that month. They include things like sales commissions, shipping costs of the product, and inventory.
- Average price per unit. When pricing your product or service, you’ll have to take a few things into consideration. After all, if you get the price wrong, people probably won’t buy it. To determine your price, consider these factors:
- What is your competition selling the same thing for?
- Do you want to be at the low, middle, or high end of the price range?
- What is your cost for the unit, and how much profit do you want to make above that?
Determining Your Break-Even Point
Next, you’ll need to plug the above figures into a break-even analysis formula. It looks like this:
Break-even point = fixed costs / (average price per unit – average cost per unit)
The result is the best prediction you’ll find regarding when your business will begin to support itself. Using the formula above, let’s imagine that a woman has just opened a designer bag shop. Her fixed costs are $2,000 a month, and her average sales price is $100. It costs her $40 to buy each bag, which leaves $60. Divide that into $2,000 (her monthly fixed costs) and we learn that she must sell 33 bags a month to break even. Any units she sells above that are profit.
Another way you can use this formula is to determine when you will recoup your initial investment in a business. Let’s say our business owner invested $25,000 in special equipment and production design at the beginning of the business. If she wants to know when she will earn back her investment, she should use the $25,000 investment figure in place of the fixed monthly costs.
Assuming that the costs and average sales price stay the same, she would earn back her investment and break even after selling 417 bags. Any fewer bags and she would take a loss, and if she sells more, she’ll turn a profit.
Adjust Prices to Change Your Results
Now is where it gets fun. Suppose our fictional bag shop owner of wanted to sell fewer bags per month to meet her monthly expenses sooner. She might decide to raise her prices and sell the bags for $150 each, which would result in her breaking even when she sold just 18 bags per month. Or imagine the opposite. The owner wants her bag on the arm of every woman on the street, so she decides to lower her price to sell more of them and get some product exposure. If she lowered the price to $80, she would break even after selling 50 bags.
Another way to play with the numbers is to look at costs. If our designer bag store owner wanted to break even by selling even fewer bags per month, she might want to look at reducing her costs. If she found another supplier or shipping company and reduced her expenses per unit, she could reduce her costs and reach the break-even point sooner.
The break-even formula doesn’t rely on projections or guessing. Instead, it uses hard data to give you real answers about the future profitability of your business.