It's always risky to start a business, but to find out how risky, you may need to do a break-even analysis. Giving you insight into exactly what you need to do to make back your original investment, break-even analysis is an important financial metric for any entrepreneur or small business owner to have a handle on. But what is break-even analysis? Find out everything you need to know, including how to do break-even analysis and the strengths and weaknesses of break-even analysis, right here.
What is break-even analysis?
A break-even analysis is a useful tool for determining at what point your company, or a new product or service, will be profitable. Put another way, it's a financial calculation used to determine the number of products or services you need to sell to at least cover your costs. When you've broken even, you are neither losing money nor making money, but all your costs have been covered.
For example, a break-even analysis could help you determine how many cell phone cases you need to sell to cover your warehousing costs. Or how many hours of service you need to sell to pay for your office space. Anything you sell beyond your break-even point will add profit.
How Break-Even Analysis Works
Break-even analysis is useful in determining the level of production or a targeted desired sales mix. The study is for a company's management's use only, as the metric and calculations are not used by external parties, such as investors, regulators, or financial institutions. This type of analysis involves a calculation of the break-even point (BEP). The break-even point is calculated by dividing the total fixed costs of production by the price per individual unit less the variable costs of production. Fixed costs are costs that remain the same regardless of how many units are sold.
Break-even analysis looks at the level of fixed costs relative to the profit earned by each additional unit produced and sold. In general, a company with lower fixed costs will have a lower break-even point of sale. For example, a company with $0 of fixed costs will automatically have broken even upon the sale of the first product assuming variable costs do not exceed sales revenue.
Although investors are not particularly interested in an individual company's break-even analysis on their production, they may use the calculation to determine at what price they will break even on a trade or investment.1 The calculation is useful when trading in or creating a strategy to buy options or a fixed-income security product.
The concept of break-even analysis is concerned with the contribution margin of a product. The contribution margin is the excess between the selling price of the product and the total variable costs. For example, if an item sells for $100, the total fixed costs are $25 per unit, and the total variable costs are $60 per unit, the contribution margin of the product is $40 ($100 – $60). This $40 reflects the amount of revenue collected to cover the remaining fixed costs, which are excluded when figuring the contribution margin.
Calculations for Break-Even Analysis
The calculation of break-even analysis may use two equations. In the first calculation, divide the total fixed costs by the unit contribution margin. In the example above, assume the value of the entire fixed costs is $20,000. With a contribution margin of $40, the break-even point is 500 units ($20,000 divided by $40). Upon the sale of 500 units, the payment of all fixed costs are complete, and the company will report a net profit or loss of $0.
Alternatively, the calculation for a break-even point in sales dollars happens by dividing the total fixed costs by the contribution margin ratio. The contribution margin ratio is the contribution margin per unit divided by the sale price.
Returning to the example above, the contribution margin ratio is 40% ($40 contribution margin per item divided by $100 sale price per item). Therefore, the break-even point in sales dollars is $50,000 ($20,000 total fixed costs divided by 40%). Confirm this figured by multiplying the break-even in units (500) by the sale price ($100), which equals $50,000.
Strengths and weaknesses of break-even analysis
There are lots of reasons why it could be a good idea for your business to do a break-even analysis:
Pricing – Break-even analysis gives you a much more solid basis from which to price your products. Look at your current financial situation and work out how patient you can afford to be when it comes to reaching your break-even point.
Setting revenue targets – In addition, doing a break-even analysis can be a great tool for setting concrete sales targets for your team. If you have a clear number and a timeframe in place, it's always going to be easier to decide upon revenue targets.
Mitigate risk – Sometimes, business ideas just aren't meant to be pursued. Break-even analysis can help you mitigate risk by avoiding investments or product lines that aren't likely to be profitable.
Gaining funding – It's worth noting that break-even analysis is often a key component of business plans. If you want to get funding for your business or start-up, you'll probably need to do a break-even analysis. Plus, a manageable break-even point is likely to make you more comfortable with the prospect of taking on extra financing or debt.
However, the limitations of a break-even analysis shouldn't be underestimated:
Doesn't predict demand – Although a break-even analysis can tell you when you'll break even, it doesn't give you any insight into how likely that is to happen. Plus, demand isn't stable, so even if you think there's a gap in the market, your break-even point could end up being a lot more ambitious than you initially thought.
Depends on reliable data – In short, the accuracy of your break-even analysis is dependent on the accuracy of your data. If your calculations are wrong or you're dealing with fluctuating costs, break-even analysis may not be the most useful tool in your arsenal.
Too simple – Break-even analysis is best for companies with one price-point. If you have multiple products with multiple prices, then break-even analysis may be too simple for your needs. In addition, it's worth remembering that costs can change, so your break-even point may need to be evaluated and adjusted at a later time.
Ignores competition – Another limitation of a break-even analysis concerns the fact that competitors aren't factored into the equation. New entrants to the market could affect demand for your products or cause you to change your prices, which is likely to affect your break-even point.
All in all, it's best to conduct a break-even analysis alongside other profitability metrics, such as net profit margin, to ensure that you're getting the best overview of your business's financial health.
Some of the advantages of break-even analysis are as follow:
- Catches Missing Expenses: One has to figure out all the committed cost as well as the variable cost while reviewing the financial commitment to figure out the breakeven point and in this way, some missing expenses which are caught out.
- Set Targets for Revenue: As and when the break-even analysis is complete, one comes to know their projected sales revenue so as to earn the projected profit, and it also helps sales teams to set more concrete goals.
- Powerful Decision Making: As the top management has more defined data, it will help them in good decision making to expand the business or taking any new contract by offering a good minimum price by considering the sunk cost.
Some of the disadvantages of break-even analysis are as follow:
- Unrealistic assumptions as the selling price of a product can't be the same at different sales levels,s and some fixed costs might vary with the output.
- Sales can't exactly be the same as to that of production. There can be some closing stock or wastage as well.
- Businesses selling more than one product: It will be tough to analyze break-even as apportioning of fixed cost among two products will be a challenging one.
- Variable product or services cost will not always remain the same. As the level of output will increase one's bargaining power to procure material or service will also increase.
- It is a planning aid and not a decision-making tool.
- Break-even analysis tells us at what level an investment has to reach so that it can recover its initial outlay.
- It is also considered as a measure for the margin of safety.
- It is used broadly, be it the case of stock and options trading or corporate budgeting for various projects.
Break-even analysis is very important for any organization so that it can know its overall ability to generate profit. Suppose for any company if its break level is coming near to the maximum sales level, which the company could reach, then it is impractical for that company to earn profit even in the all-positive scenario. Therefore, it is the responsibility of the management that it should monitor the organization breakeven point constantly as it helps in cost-saving and resulting in a decrease of the breakeven point.