Sales to a business are like rain to spring flowers. Without it, they wither and die. Finding what works to generate sales and earn a profit for your company is essential to your long-term success.
In much the same way, performing a break-even analysis to figure out how much product you need to sell to cover your costs of doing business is one of the most important aspects of running your company.
Let’s look at what the break-even point is, how to perform a break-even analysis, and why it’s important for the financial health of your company. You’ll see how determining your target profit, using financial analysis, and creating a company dashboard ties everything together, and of course, you’ll learn why calculating your break-even point is so important for your company.
What is the break-even point?
The break-even point (BEP) is the point when your forecasted revenue equals your estimated total costs. When you’re just starting out, your business may face losses for a few years. But when your company reaches a break-even point, your business and your product or service become financially sound. This is a time for celebration.
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It also means that your company’s product or service is bringing in the amount of money needed to run your business. You’re not generating a profit or a loss — you’re breaking even.
Calculating your company’s break-even point is important to the overall health of your business. It can be used to make informed decisions and develop a long-term business plan for your company’s future success. But first, you’ll need to know how to perform a break-even analysis.
The break-even analysis formula
The break-even analysis calculates the margin of safety for your business. The margin of safety is based on what you need to earn in revenue collected to offset associated costs. Your company will use a break-even analysis to determine the level of sales necessary to cover your total fixed costs and variable costs.
By analyzing your break-even point, you can better decide if you need to cut expenses, increase your prices, or both. Knowing your break-even point will help you make a profit in the long-term.
The break-even formula can be stated in several ways, but the most common version is:
Fixed costs ÷ (sales price per unit – variable costs per unit) = $0 profit
Here’s how it works: Sales price is what you charge for each unit sold, and variable costs are the costs that you absorb to produce each unit you sell. Variable costs can include material and manufacturing costs.
Fixed costs are any non-fluctuating costs that you pay on a regular basis, such as monthly or yearly. These are the same regardless of how many items you sell and include things like rent and business insurance. Fixed costs are stated in the equation as total dollars.
It’s important to avoid looking at fixed costs on a per unit basis. To break even, you need to cover all of your fixed costs, regardless of the number of units sold.
Profit is set to zero, so that the formula provides the level of sales that covers all costs (variable and fixed) without generating any profit. Thus, you’re neither earning nor losing money: You’re breaking even.
What is a break-even analysis example?
Let’s say your company sells a product for $500. The variable costs per unit are $380, and your annual fixed costs equal $200,000.
Let’s revisit the break-even formula to determine your company’s break-even point, assuming that “X” equals units sold to break-even.
Fixed costs ÷ (sales price per unit – variable costs per unit) = $0 profit
$500X – $380X – $200,000 = $0 Profit
$120X – $200,000 = $0
$120X = $200,000
X = 1,667 units
In this scenario, your company must sell 1,667 units to cover all of your costs and break-even each month. You can also change any of the variables in the formula, and calculate your new break-even based on new assumptions. If, for example, you increase the price per unit, the number of units to reach your company’s break-even point will be lower.
How does the break-even formula help you reach your target profit?
The break-even formula can be adjusted to calculate the number of units that must be sold to reach a specific amount of profit. This is also called target profit.
Let’s assume you keep the same sales price, variable costs, and fixed costs the same, and set the profit to $30,000. The new formula is:
Fixed costs ÷ (sales price per unit – variable costs per unit) = $30,000 profit
Here are the number of units sold to reach the $30,000 target profit:
$500X – $380X – $200,000 = $30,000 profit
$120X – $200,000 = $30,000
$120X = $230,000
X = 1,917 units
To increase your profits from your break-even point to $30,000, you must increase your sales from 1,667 to 1,917 units.
Why is the break-even analysis important?
The break-even analysis is a great tool to use to make informed business decisions. Here are a few of the business analyses that the break-even analysis will help you with.
Determining the number of sales needed to avoid business losses
This is the most obvious benefit and the goal of the break-even analysis. It can show you how many units you need to sell to break-even, or show no profit and no loss. It’s an important tool to compute your sales price, variable costs, and fixed costs for a new product launch. The formula can also help you determine if your sales price and projected units sold are enough to generate a reasonable profit.
Performing cash flow forecasting
Cash flow forecasting ensures that your business has the necessary cash to meet its obligations. Assume that your company wants to sell 50,000 units of a particular product during the year. You know your fixed costs (cost of materials, wages, rent, utilities, etc.) and your variable costs (commissions, credit card fees, shipping costs, etc.).
The break-even analysis shows you how your sales price offsets — or more importantly, doesn’t offset — the fixed and variable costs of producing your product, which can then be used to determine your total budgeted costs for the year. Your company can use the cost totals to estimate the cash needed to generate sales of 50,000 units.
Creating a realistic pricing strategy
Changes in pricing of your products can affect your break-even point. Using the break-even analysis can help you decide if you need to raise or lower your pricing. For instance, if you increase your selling price, the number of units you need to sell to break-even will be reduced. Conversely, if you lower your selling price, you will need to sell more units to break-even.
Growing your business
If you know your break-even point, you can set targets for growing your business. This is because your break-even analysis shows you at what point your business will realize a profit. It can also help you determine the sales needed to ensure you make a profit.
Increase profits using financial analysis
The break-even analysis helps business owners perform a financial analysis and calculate how any changes will affect the time it takes to break-even and, therefore, turn a profit.
To make your business more profitable, you should look at ways to increase sales and decrease operating costs. It helps to prioritise the strategies below.
- Sales price: You can experiment by increasing the price of your product(s) and assessing any change in sales. Many business owners don’t realize that customers may be willing to pay more for a particular product. If, however, the price increase turns customers away, you can lower the price back to the original level.
- Variable costs: If your biggest variable cost is wood, for instance, you can start requesting bids from multiple vendors in order to lower the material costs for wood.
- Fixed costs: By definition, fixed costs cannot be changed in the short term, but you can take action to reduce costs over the long term. For example, you might renegotiate a lower lease payment when your building lease is up for renewal, or ask your insurance agent for a lower quote on business insurance premiums.
Remember to plug any change you’re considering into the break-even analysis formula so you’ll know how many units you’ll now need to sell to break even. By using financial analysis and working on each component of the target profit formula, you may be able to lower costs, increase total sales, and generate a higher profit margin for your company.
Why apply the contribution margin formula?
After you know your break-even point, you can calculate the contribution margin of each item you sell. The contribution margin tells you how much money each item will contribute to your profits after you break even. You calculate your contribution margin by subtracting a product’s variable costs from the selling price. The formula is:
Total sales – variable costs = contribution margin (CM)
This formula is the amount of money your company has on hand to cover your fixed costs after you pay all of your variable expenses. It also includes any money left over after covering fixed costs and constitutes your company’s net operating profit or loss.
The contribution margin formula is a useful tool that you can use to plan sales and costs of sales. To put it a different way, the contribution margin is the dollar amount that will cover fixed costs before you reach your break-even point, and it’s the dollar amount that will go toward company profit after you reach your break-even point.
For example, let’s assume that 2,000 units are sold and compute the profit this way:
$500 (2,000) – $380 (2,000) = CM
$120 (2,000) = $240,000 CM
The contribution margin is $120 x 2,000 units, or $240,000. We already know that we have $200,000 in fixed costs. When those fixed costs are subtracted, that will leave the company with $40,000 profit. The contribution margin further demonstrates that increasing total sales or decreasing fixed costs over time will generate higher profits.
Many business owners use the break-even point formula, target net income, and contribution margin to make business decisions, such as devising a per unit pricing strategy or determining which factors will affect the profitability of the company and its long-term success.
Create a company dashboard
To further analyze your company’s profitability, you should create a company dashboard to keep tabs on all your metrics. Every business owner has a set of financial metrics that are useful for decision-making. These metrics include:
- Your company’s pre-tax profit margin — or how much profit you’re making on every dollar in sales
- Your company’s current and quick ratio — or how well you can meet all of your company’s current obligations
- Accounts payable and accounts receivable — or how much is going out vs. how much is coming in
A company dashboard is a financial reporting tool that helps you visually track and graph your key performance indicators (KPIs) and monitor the financial health of your company. It’s also effective for cash management as it helps you look at your expenses, sales, and profits in detail.
By creating a “financial dashboard” you can monitor your company’s performance, reduce costs, and increase profits over time. Plus, understanding the financial metrics of your company will help you become a more effective business owner.
Breaking even is the first step toward a healthy business
When you determine your company’s break-even point, you can better access your true cost of doing business. A break-even analysis will tell you if you need to increase prices, reduce expenses, cut costs, or discontinue a product altogether.
It may also help you determine whether you need to take cost-saving measures to try and achieve the same quality at a reduced price. Maybe it’s time to scale-back labor costs. Maybe you just aren’t bringing in enough revenue to cover all your expenses. Whatever challenges your facing, conducting a break even analysis can help you find solutions.
It’s also important that you, as a business owner, know the total contribution margin of each of your products or services. Only then can you make strategic business decisions that will ensure your company thrives and gains an advantage in your market.
This article was produced by the Quickbooks Resource Center and syndicated by MediaFeed.org.
Featured Image Credit: DepositPhotos.com.