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A break-even analysis is a critical step in managing small business finances. If you are just starting a business, you can use this analysis to figure out if your business idea is worth pursuing. And if you are already knee-deep in your business, this analysis can help you determine if you need to take cost-cutting measures or develop new strategies to increase revenue.
Performing a break-even analysis is an essential task because a business investment should eventually pay off. With a break-even calculation under your belt, you know exactly how many products or services you need to sell in order to cover your costs. Here's what you need to know about a break-even analysis.
What is break-even analysis?
Break-even is the point at which a business’s total costs and total revenue are exactly equal. With a break-even analysis, you can figure out how much product you need to sell to cover the costs of doing business.
At the break-even point, you’ve made no profit, but you also haven’t incurred any losses. A break-even analysis is a formula that lets you know either how many units of things—phones, tables or hours of legal service, for example—you need to sell to cover your costs. Stated in a slightly different way, it lets you know how much revenue you need to generate in order to cover your costs.
Every product you sell or service you offer has an associated cost—the cost of materials or the cost of wages, or both. In your accounting books, these costs show up as the cost of goods sold (COGS). The more you sell, the more your expenses will be.
If you gross $1,000 in product sales in one month, that amount will not cover $1,000 in monthly overhead expenses. Out of a $1,000 gross profit, a certain amount of that may be the wholesale price. When you deduct the wholesale price from $1,000, you may end up with only $500 in gross profit. The break-even point is when the revenue equals all business costs, wholesale and overhead included.
Break-even analysis formula components
Performing a break-even analysis sounds like a daunting task, especially if you haven't even started your business. Hopefully, you've done a bit of market research and know generally how much it will cost to sell your product, or how much you might have to pay the workers who provide your services.
More specifically, you need three main pieces of information for the break-even analysis formula:
1. Sales price per unit
This is the amount of money you will charge the customer for every single unit of product or service you sell. This is critical to the break-even analysis formula because you can’t calculate what your revenue will be if you don’t know how much you will charge for the product or service.
Make sure you include any discounts or special offers you give customers. Look at competitors to see how they are pricing their product or look to an informal focus group to figure out how much someone would be willing to pay. If you sell multiple products or services, figure out the average selling price for everything combined.
2. Fixed costs per month
Fixed costs are what your business has to pay no matter how many units you sell. Fixed costs you may need to include in your break-even analysis formula are:
Business loan payments.
Accounting and legal services.
These are expenses that don’t change with sales volume, so even if you don’t sell a single product, fixed costs still have to be paid. These are usually calculated on a monthly basis.
3. Variable costs per unit
Variable costs are costs that you incur for each unit you sell. These will change depending on your sales volume. For instance, if you run a manufacturing business that manufactures tables and the materials for each new table cost $50, that cost is variable.
Here's a list of common variable costs that could show up in a break-even analysis:
After you have those numbers, you can calculate your break-even point.
Break-even analysis formula in units
Once you have your sales price per unit, fixed costs and variable costs, plug them into your break-even analysis formula:
Break-Even Point in Units = Fixed Costs / (Sales Price per Unit – Variable Costs per Unit)
This break-even analysis formula gives you the number of units you need to sell to cover your costs per month. Anything you sell above this number is profit. Anything below this number means your business is losing money.
Once you’re above the break-even point, every additional unit you sell increases profit by the amount of the unit contribution margin. The unit contribution margin is the amount each unit contributes to paying off fixed costs and increasing profits. To find it, you would use the following formula:
Unit Contribution Margin = Sales Price per Unit – Variable Costs
Break-even analysis formula in dollars
Eventually, you'll want to calculate your break-even point in dollars. This is the dollar amount of revenue that you have to achieve in order to break even. Any revenue above that is profit, and if you have sales below that, it's a loss.
Break-Even Point in Dollars = Sales Price per Unit x Break-Even Point in Units
You can use these break-even formulas to compare different strategies to price a product. For example, if you raise the price of a product, you’d have to sell fewer items, but it might be harder to attract buyers--or vice versa, you can lower the price, but would then need to sell more of a product to break even.
This analysis can also help you compare different cost structures like using less expensive materials to keep the cost down, or taking out a longer-term loan to have less fixed costs per month.
Break-even analysis example
Let's say you're thinking about starting a furniture manufacturing business. The first unit you're going to sell is a table.
How many tables would you need to sell in order to break even?
If it costs $50 to make a table and you have fixed costs of $1,000, the number of tables you must sell to break even would vary depending on price. Let's look at two examples:
If you sell a table at $100: $1,000/($100-$50) = 20 tables
If you sell a table at $200: $1,000/($200-$50) = 6.7 tables
This break-even analysis example is a great demonstration of how selling a product for a higher price allows you to reach the break-even point significantly faster. However, you need to think about whether your customers would pay $200 for a table, given what your competitors are charging.
When to do a break-even analysis
A break-even analysis is helpful whether you're starting a business or already have an ongoing operation. There are some specific situations where a break-even analysis is especially useful:
Starting a new business - When launching a new business, break-even analysis can help you figure out the viability of your product or service. If you do this analysis along with writing a business plan, you can spot weak points in your company's financial strategy and develop a plan to address them.
Launching a new product or service - Whenever you launch a new product or service, you'll need to determine your pricing. Using a break-even analysis, you can see how different prices per unit affect your profitability. Eventually, you can choose a price that's fair to customers and realistic for your company.
Adding a new sales channel - If your business model changes to incorporate a new sales channel, that's a good opportunity to do a break-even analysis. For example, if you have a brick-and-mortar store but want to start an ecommerce business, your costs and pricing might change. You should make sure you at least break even so that you don't put too much financial strain on your business.
These are three common situations where you should do a break-even analysis, but it's best to do them on a regular basis even if none of these scenarios apply to you. That way, your pricing and profits are always one step ahead of the game.
What to remember about break-even analysis
A break-even analysis is useful, but not perfect. From a mathematical perspective, you'll learn exactly how much of your product or service you need to sell in order to achieve profitability. However, there's an important, non-mathematical side of the break-even analysis formula. You'll need to think about what pricing and sales strategies are realistic for your business given your time, resources and the competitive market in which you operate.
These considerations shouldn't stop you from going after the business of your dreams, but be sure to keep these caveats in mind when you're performing a break-even analysis.
This article originally appeared on Fundera, a subsidiary of NerdWallet.