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A break even analysis is used to figure out how much product your business needs to sell to cover the costs of doing business. 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 when your business will begin to make a profit.
A break even analysis is a critical step in managing small business finances. If you are just starting a business, you can use a break even analysis to figure out if your business idea is worth pursuing. And if you are already knee deep into your business, a break even 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 essential 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.
Your company breaks even when sales equal 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. 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. 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 $1000 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.
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. More specifically, you need three main pieces of information in order to conduct a break even analysis:
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 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.
Fixed costs are what your business has to pay no matter how many units you sell.
These are expenses that don’t change with sale 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.
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, you can calculate your break even point.
Once you have your sales price per unit, fixed costs, and variable cost, plug them into your break even analysis formula:
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 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.
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.
You can use these break even formulas 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 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.
If you’d like more guidance in calculating your break even analysis, use our free break even analysis template. The template is broken down by month, so you can do a break even analysis for individual months or for an entire year. If you’re forecasting for the entire year, you’ll need to predict the number of units that you’ll sell in each month.
You can also account for different variable costs and fixed costs throughout the year. For instance, rent payments might increase part way through the year, and wage costs might change if you hire new employees. The template makes it easy to account for such changes.
A break even analysis is helpful whether you’re starting a business or already have a going operation. There are some specific situations where a break even analysis is especially useful:
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.
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’re operating.
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.