A break-even analysis determines when a business’ revenue equals its costs. This is an important analysis to make for startup companies and new businesses because it defines the point at which the business begins to become profitable.
Business ventures should not be pursued unless the break-even point is reachable. Thus, a proper business plan should include some form of break-even analysis to help guide the company’s decisions.
Using break-even analysis, a company determines its break-even point (BEP). Investors and regulators use it as an internal management tool, not as a computation. When you apply for a bank loan, financial institutions may ask for it as part of your financial projections.
In the formula, both fixed and variable costs are considered in relation to unit price and profit. Regardless of how much product or service is sold, fixed costs remain the same. Fixed costs include facility rent or mortgage, equipment costs, salaries, interest on capital, property taxes, and insurance premiums.
Changes in sales affect variable costs. Costs for raw materials, utilities, and shipping are examples of variable costs. Each unit of your product has variable costs, which are labor and material costs.
The total variable cost is calculated by multiplying the cost per unit by the number of units produced. You would incur a total variable cost of $300 if you produced 30 units for $10 each.
Contribution margin refers to the difference between the selling price and the product’s total variable costs. If a suitcase sells for $125 and its variable cost is $15, the contribution margin is $110. This margin offsets fixed costs.
Taking the total variable cost and dividing it by the number of units produced gives you the average variable cost.
Low fixed costs generally lead to a lower break-even point, but only if variable costs are not higher than sales.
Break-even analysis should include the following points:
A comparison of all the figures will be conducted to determine when the company will break even. The company must consider this goal separately from other goals, such as profit. Many figures and calculations are estimates, especially if the business has not yet begun. When implementing new changes, an existing business may need to perform a break-even analysis.
Data from previous years can also be used in those cases.
By itself, a break-even analysis has a wide range of applications. A financial projection is also vital for new or expanded product lines and startups. Calculate how much seed money you’ll need, as well as whether you’ll need a bank loan.
More mature businesses use break-even analyses to assess their risks when moving innovative ideas into production, adding or removing products from their product mix, and in other situations. Budgeting for the addition of a new employee is one example. A break-even analysis will reveal how many additional sales will be required to break even on the new hire’s expenses.
Six to 18 months is an acceptable break-even window. You may need to reduce costs, increase pricing, or both if your calculation determines a break-even point will take longer to reach. It is a strong risk signal when the break-even point is more than 18 months away.
Any time a business considers adding costs, it should perform a break-even analysis. Additional costs may result from starting a business, merging or acquiring, adding or deleting products from the product mix, or adding locations or employees.
To determine the risk and value of any business investment, you should conduct a break-even analysis, especially if any of these three events occur:
Using BEP, business leaders can reduce decision-making to a series of yes-or-no questions.
Legal issues and disputes can arise from break-even analyses.
These can include:
Many legal issues can be involved, as the company’s budget includes all the different costs and expenses. An incorrect or inaccurate representation of revenue and income could lead to financial or legal problems in the future.
In some cases, a lawsuit may be necessary to rectify a company’s losses. If the figures used are fraudulent, the company might lose profits as well as be fined and penalized. The defendant party may be required to pay damages to compensate for the losses they caused in such a case.
It is important to remember that break-even analysis does not consider market demand. Having to sell 500 units to break even does not tell you when or if you can sell them. Do not lose sight of that basic truth because of your passion for the business idea or new product.
You’ll also need to decide how much time and effort you will devote to breaking even. Do you intend to invest a significant amount of your sales team’s time and effort over several months to reach break-even? Would it be better and more profitable to produce and sell something else?
Consider changing your pricing strategy if the product demand is soft. Discounted pricing, however, can actually increase your break-even point. Without care, you may move products faster at a lower price but incur more variable costs to produce more units to break even.
A break-even analysis can often be quite complex and involve a variety of factors. You may need to hire a commercial attorney near you if you need assistance or have questions regarding a break-even analysis.
Your attorney can provide guidance during the process to ensure that your business plan complies with local, state, and federal laws. A lawyer can also represent you in a court of law in the event of a legal dispute over a business plan.
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