The break-even metric is used to determine the correlation between a business’s costs, revenue, and profit while the actual break-even point is when the total revenue and total cost are equivalent. Performing a break-even analysis will allow you to determine the number of units and specific amount of revenue that is needed to cover your total business costs and help pinpoint at what point your business will become profitable. This analysis is also important for investors because it allows them to see when they will recover their investment and start making money. Performing this analysis can identify when you will be turning a profit and also allows you to better answer questions like:
- Will my operations support my predicted sales volume?
- Is my marketing strategy good enough to drive the level of sales needed to turn a profit?
- Are my products or services priced correctly? Should I lower or increase the cost?
- Is a new service or product worth adding to my business? Should I wait or can I successfully introduce it now?
- Which product or service will drive my bottom line?
- Am I losing a significant amount of money on some aspect of my business, especially with fixed or variable costs?
Once your business reaches the break-even point, you are in the position where, while you are not losing money and all business costs are covered, you are also not turning a profit. After breaking even, the accrued revenue is pure profit.
Executing the Break-Even Analysis
Performing a break-even analysis should be one of the first tasks when starting a new business or introducing a new product or service. It is a necessary part of any solid business plan and should be revisited and adjusted when making changes to your business, especially if these changes cause costs to differ dramatically.
While important, the break-even metric is just an optimistic estimate that is built through several criteria like market research, competitor analysis and realistic projections. With that said, there are a few metrics that are needed to even perform the analysis which include:
Sales Per Unit: This metric defines how much a business charges customers for a product or service. Established businesses already have identified the sales price, and it is expected that the price level is either an approximation or has widely varied over time.
Fixed Costs (or Overhead Costs): These are business expenses that stay consistent monthly and include costs such as:
- Office Supplies
- Insurance Payments
- Business License Fees
- Marketing Ads
Variable Cost Per Unit: This metric is how much you pay to produce your product or service. This price will increase if your units (products or services) increase.
The variable cost formula is variable cost per unit = total variable costs ÷ number of units. Examples of this cost are:
- Raw Materials
- Factory Overhead
- Shipping Costs
- Direct Labor Costs
- Sales Commissions
Contribution Margin Per Unit: This a margin that determines how much a product contributes to overall revenue and is the difference between the sales price and variable cost of a product.
To calculate this margin, you will need to use the formula: contribution margin per unit = sales price per unit – variable cost per unit. It can also be calculated as a percentage using the formula: contribution margin ratio = contribution margin per unit ÷ sales price per unit. If you find a product or service’s margin is negative or low, your business could lose money producing it.
With these metrics in mind, you can now start to calculate the break-even point. This can be calculated in two ways:
To calculate the analysis in units, use the following formula:
break-even point in units = fixed costs ÷ contribution margin per unit (sales price per unit – variable costs per unit)
To calculate the analysis in dollars, use the formula:
break-even point in dollars = sales price per unit × break-even point in units
Moving Beyond the Break-Even Point
While the break-even point means you are covering your basic expenses, most businesses do not want to linger in this area. Because the goal of business is growth, one of the best ways to move past the break-even point is to lower it. Luckily, there are plenty of ways to lower a business’s break-even point that allow it to be more obtainable regardless of business size such as:
- Decreasing the amount of fixed costs
- Reducing variable costs per unit
- Increasing selling prices without decreasing the number of units sold
- Improving the sales mix
- Consulting with an attorney about relevant costs
- Buying efficient equipment
- Refinancing debt/reducing monthly debt payments
- Revisiting and revising marketing initiatives
- Looking for insurance alternatives
- Finding supplier alternatives for raw materials
- Performing proper inventory management to reduce storage costs
- Revisiting production methods
After taking all information into account and performing the break-even analysis, you can have a solid estimate of when your business will reach its break-even point. Additionally, this analysis introduces you to possible changes you can make to your business, and identifies when you will start seeing a profit.
The break-even analysis is proving to be one of the most useful tools when starting and maintaining a profitable, stable business.