If you’re starting a new business, it’s important to assess its financial ratios and overall performance regularly so you can make appropriate adjustments for its stability and growth. One key assessment involves conducting a break-even analysis.
A break-even analysis determines how much revenue must come in to cover the business’s expenses. It shows how many products must be sold to bring the business to the point at which there isn’t a profit or a loss. This is known as the break-even point.
Read on to learn more about what a break-even point is, how to calculate the break-even point, and how to leverage the results of the break-even point.
Key Points
• Break-even analysis identifies the sales volume needed to cover total costs, helping businesses understand their required revenue to avoid losses.
• It evaluates financial risk by highlighting how changes in sales, costs, or pricing impact profitability.
• To calculate the break-even point, divide fixed costs by the contribution margin.
• A lower break-even point means less risk and faster profitability for a company, as fewer sales are required to break even.
What Is a Break-Even Analysis?
A break-even analysis is a financial tool used to determine the point at which a business’s total revenue equals its total costs, resulting in no profit or loss. This point is called the break-even point.
The analysis helps businesses understand how much they need to sell to cover both fixed and variable expenses. By knowing the break-even point, companies can make informed decisions about pricing, cost management, and sales strategies. It’s particularly useful for startups and small businesses to assess financial viability and set realistic sales targets to ensure profitability over time.
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Why Conduct a Break-Even Analysis?
The results of a break-even calculation can help you set or adjust pricing, create or modify your budget, and determine or tweak production goals. They can spur on cost-controlling measures and you can show them to your employees to demonstrate the benefits of reaching sales targets. They might also reveal that you could benefit from taking out a small business loan or otherwise accessing more funding.
Here’s a look at one example of how break-even analysis can be an important part of the small business budgeting and price setting processes. Some business owners don’t account for all of the costs that are involved in making a product when they set their prices. Direct costs — such as materials used in a product, manufacturing supplies, and direct labor costs — may be relatively obvious. But indirect labor costs, overhead costs, marketing expenses, and others that are less obvious might not be properly accounted for.
The result could be an under-priced product and a company that struggles to keep its books in the black. Break-even analysis can help you identify that situation so you can rectify it.
So how do you calculate break-even points accurately and use them appropriately? To help you find the answers, here are some useful definitions and some strategies.
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How to Calculate Break-Even Points
To understand this calculation, it can help to know the meanings of all of the factors used in it.
• Fixed costs: These are the company costs that stay the same over a defined period of time. They are costs that have to be paid even when your company isn’t producing anything, like rent payments for building space, salaries, insurance payments, utilities, fixed loan payments, and so forth.
• Variable costs: Compared to fixed costs, variable costs can change based on business activity. One example might be sales commissions. If a team sells more products, then its commission amounts would increase. If it sells fewer, then this amount would decrease. You may need to estimate what these will be to arrive at a number to use in this equation.
• Product sales price per unit: This is the cost that a business would charge a customer to buy one of its products.
• Contribution margin: This is the unit’s sales price minus its variable costs.
Break-Even Point Formula
The formula to calculate break-even point is:
Fixed costs ÷ Contribution margin = Break-even point (expressed in number of products)
Let’s say that a company sells a technical guide and the fixed costs associated with it total $75,000, the variable costs involved in producing one guide equal $3, and the guide sells for $20. This is how this example of break-even analysis plays out:
$75,000 ÷ ($20-$3) = $75,000 ÷ $17 = 4,411.8
This company would therefore need to sell 4,412 copies of the technical guide to reach their break-even point.
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Leveraging Break-Even Calculation Results
If the results of your break-even point are deemed less than desirable, then a review of the business cash management plan, including pricing and more, may make sense.
Solutions can include:
• Raising prices
• Finding ways to cut costs
• A combination of cost cutting and price adjusting
Here’s more information on these actions.
Pricing Strategies
When considering a price change, you’ll probably also want to think about what competitors are charging to make sure your company doesn’t price itself out of the market. If your prices are higher than other companies are charging, is your product more valuable in ways that can justify the higher prices?
Surge Pricing
In certain industries, surge pricing (also known as dynamic pricing) could apply. In this situation, prices rise and fall based on market and customer demand. Concerts and other events might charge higher ticket prices if a certain performer is in high demand, for example. Assuming that company costs remain relatively stable, it will take fewer units to reach the break-even point when demand is high and prices are higher. It will take more units when demand and prices go down.
Discount Price Strategy
A similar strategy called discount price strategy focuses on charging more for popular products. For example, the technical guide company may come out with another publication on a topic that’s highly relevant at present. At that point, the company may be able to sell this new publication at a higher price. The idea behind this strategy’s name is that the product is eventually put into clearance or otherwise discounted after a period of time. This strategy may work especially well with seasonal products or products that go in and out of style, such as clothing.
Penetration Strategy
If a company is just entering the market with a product that already has competition, it might use a penetration strategy in which it prices its offering very low so that the company can “penetrate” the market before raising prices. A break-even analysis would quickly show how larger numbers of products would have to be sold before costs could be covered. That’s why this is typically a short-term strategy to draw attention to a product and start earning revenue from it.
Penetration strategy is related to loss leader pricing, where a few products are priced exceptionally low to grab attention, but other products are still sold at full price.
Cost-Cutting Strategies
One way to cut costs is by looking at your current materials. Can they be purchased for a better price? What kind of discounts can the company get if the materials are bought in greater quantities? What impact could changes based on these factors have on cash flow management, overall?
Another way to reduce fixed costs is to cut back on rent, either by negotiating for better rates, moving to a smaller and/or less expensive space, or shifting to a partly or all-remote working model. This last option could help the business save money on rent, as well as on taxes, insurance, utilities, and so forth.
If your cost for office space can be lowered, check to see what impact this has on the break-even points of your product(s).
Returning to our earlier example of break-even analysis, let’s say that a new rental agreement will reduce the fixed costs of $75,000 by $15,000. Here’s what the break-even analysis would now look like:
$60,000 ÷ ($20-$3) = $60,000 ÷ $17 = 3,529.4. This savings in rent lowered the number of technical guides that would need to be sold from 4,412 to 3,530.
Other cost cutting measures that can lower the fixed costs include:
• Cutting back on vehicle expenses
• Strategically using freelancers in the business
• Price-comparing supplies
Plus, as the proverb has it, time is money. Finding ways to work more efficiently can be real money savers, too. Strategies include improving organization, using productivity apps, and outsourcing strategically.
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The Takeaway
When you own a small business, understanding your break-even point is crucial to your bottom line. You can then use your break-even point to figure out what changes you might want to make in producing your products, whether that’s by adjusting your fixed expenses or variable ones, or adjusting both.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is the purpose of a break-even analysis?
The purpose of a break-even analysis is to determine the point at which a business’s revenue equals its total costs, meaning no profit or loss is made. It helps businesses understand the minimum sales needed to cover expenses.
What are the limitations of a break-even analysis?
The limitations of a break-even analysis include it doesn’t account for changes in variable costs, economies of scale, or market demand. It assumes all products will be sold at the same price and may not account for sales, discounts, or unsold inventory. Additionally, it focuses solely on profitability, overlooking cash flow and long-term financial health.
What is a good break-even point?
A good break-even point is one that allows a business to cover its costs quickly and consistently at a reasonable sales level. Lower break-even points indicate lower risk and faster profitability, as fewer sales are required to start generating profits.
Photo credit: iStock/Dima Berlin
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