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A break even analysis is used to figure out how much product your business needs to sell to cover its costs of doing business. It can also be used to figure out when your business will begin to make a profit. Essentially, it’s the point at which a business’s total costs and total revenue are exactly equal.
If you are just starting out, you can use a break even analysis to figure out if your business idea is worth pursuing.
Performing a break even analysis should be the first step of any entrepreneur looking to start a business. After all, don’t you want to be sure that your investment will eventually pay off?
Here’s what you need to know about a break even analysis.
So how does this work?
Your company has broken even when its sales equal its total expenses. At the break even point, you’ve made no profit but you also haven’t incurred any losses.
A break even analysis lets you know either how many units of things—phones, tables, or hours of legal service—you need to sell to cover your costs. Or, it lets you know how much revenue you need to be generating in order to cover your costs.
Every product you sell or service you offer generates a cost—because products or services are made up of cost of materials or cost of wages. Thus, 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 $1000 in monthly overhead expenses.
Because out of a $1,000 gross profit, a certain amount of that may be the wholesale price. When you deduct the wholesale price from $1000 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.
Performing a break even analysis sounds like a daunting task, especially if you haven’t even started your business. Hopefully, before starting your business, you’ve done a bit of market research and know generally how much it costs to sell your product, or how much you might have to pay workers who offer your services.
From there, how do you calculate a break even point? With the Break even Analysis Model, of course!
You will need to know 3 key things before getting to the break even analysis formula:
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 analysis because you can’t calculate what your revenue will be if you don’t know how much you will charge for the product.
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.
Fixed costs are what your business has to pay no matter how many units you sell.
Include expenses that don’t change with sale volume, so even if you don’t sell a single product, they still have to be paid.
Variable costs are costs that you incur for each unit you sell. These change depending on your sale volume. For instance, if you run a manufacturing business that manufactures tables, and the materials for each new table costs $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, use this equation to find your break even point:
Break Even Point = Fixed Costs/ (Sales Price Per Unit – Variable Costs)
This break even analysis equation 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 the 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. So:
Unit Contribution Margin = Sales Price Per Unit – Variable Costs
You can use the break even formula to compare different pricing strategies. 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.
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 $1000, the number of tables you must sell to break even would be:
If you sell a table at $100: $1000/($100-$50) = 20 tables
If you sell a table at $200: $1000/($200-$50) = 6.7 tables
This break even analysis examples is a great demonstration of how selling a product for a higher price allows you to reach the break even point significantly faster.
Here’s the thing about break even analyses: They’re useful, but they aren’t perfect.
Back to the table manufacturing business, you might think that you’ll be running a profitable business the second you sell 21 tables (if they’re priced at $100).
The important, non-mathematical side of this break even analysis equation is to think whether selling 21 tables is feasible. Thing about the your time and resources (both materials and human) available to you. Will you get to 21 tables quickly enough to keep your business up and running? You might, but it also might take a lot longer than you think. Plus, you’ll need capital to cover the various startup costs you’ll incur along the way.
This 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.
Ready to get started on your own break even analysis? Then we invite you download our free break even analysis template here. Good luck!