How break-even analysis works
You have a business idea—now what? Unarguably, developing a sustainable strategy is essential. You need to know how much it costs to build your product or service, how much you make selling it, and how early you can realistically expect to break even. But what exactly is breaking even, and what does a break-even analysis do?
The answer is straightforward: the break-even analysis shows you whether your business idea is worth pursuing. You can’t make a profit from day one, but you should be able to reach a point where what you make accounts for what you invest. That is called the break-even point and uncovering it will be of great help down the line.
Conducting this analysis takes time, but it’s an invaluable financial planning tool. Through it, you’ll identify your expenses—even those you might have overlooked at first—and be able to set your pricing accordingly. Also, it will give you clarity in terms of goals, allow you to make short-term and long-term predictions, and ensure your decision-making stays rational rather than emotional. And should you need funding, having a proper break-even analysis will aid you in securing investors.
How to calculate break-even point
To find the break-even point, what you must do is a simple calculation:
Break-Even Point (Units) = Fixed Costs ÷ (Revenue per Unit – Variable Cost per Unit
The equation looks simple enough. But what does it mean, and how do you use it efficiently?
First, let’s establish what each element means. In simple terms, the break-even point is the stage where your company’s revenue equals its expenses. For instance, if you sold pens, the break-even point would be that moment when the costs of making pens would be entirely covered by what you make selling them.
Next, you have fixed costs. Consider them your company’s basic needs. They are stable expenses that you must cover regardless of sales and profit—think rent and property taxes. On the other hand, variable costs depend on the sales. The more pens you sell, the more production equipment and labor force you need to keep up with the demand.
Within the break-even point formula, you calculate fixed costs at a company level and variable costs per unit. The rent for your pen production facility is the same regardless of how many pens you make. However, to make any number of pens, you must first establish what it costs to make one. That is the cost you must deduct from the revenue per unit, which is what you are paid for that one pen. The number you get after this subtraction is your contribution margin, the amount you are left with once the production expenses are covered. If it costs $2 to make a pen and you sell it for $3, then the remaining $1 is your contribution margin.
What the break-even formula tells you
You understand the elements of the formula, know your numbers, and calculate your break-even point. You’re neither losing nor making a profit. However, you are quite a few steps closer to your goal, and here is why.
When you’re not making the profit you wanted to make, you might be tempted to just raise your prices. However, that’s not the only trick in the book, or at least not when you have an efficient business strategy. You may notice that your variable expenses are very high and that you might have room to reduce them. Similarly, you may not produce as much as you should to sustain, then steadily grow your company. While identifying your break-even point cannot inform your every decision, it surely points you in the right direction.
Break-even point example
Let’s imagine a mug-selling company called Happy Mugs. Before we think of the profit, we must calculate the break-even point step by step.
- Identify the fixed costs.
To operate, Happy Mugs has a series of basic expenses. By basic we mean those costs that are here to stay. While they differ from business to business, in this case, let’s imagine they include the lease of Happy Mugs’ factory and offices, followed by property taxes and executive salaries. If we add everything up, we reach a grand total of, say, $100,000.
- Identify the variable costs.
While some companies may sell services, Happy Mugs sells goods that imply unique expenses. While it has a factory, it also needs something like clay or porcelain to build the mugs, along with specialized workers who can turn the raw material into a finished product. With that in mind, we can establish how much it costs to make one mug: say, $6.
- Identify the revenue per unit.
When starting out, the team behind Happy Mugs decided that given all their expenses, a mug should sell for $10. This being the last element in the formula, we can now calculate how many units they must sell in order to cover all its costs:
$100,000 ÷ ($10 – $6) = 25,000 units
If Happy Mugs manages to sell 25,000 mugs, it will break even.
If you think this is all too simple to be the end of the story, you are probably right. For every puzzle piece the formula offers us, it raises new questions that we must answer through other business strategy and financial management tools. And while these tools are another story, let’s uncover the aspects where we must seek them.
The limitations of the break-even formula
Life is not always what it looks like on paper—not even in the most exact of sciences, like accounting. To see that, let’s rewind to Happy Mugs’ fixed costs for a bit.
The company might decide to lease a different factory, an additional one, or expand its offices. That changes the terms of the equation. Similarly, the variable costs might be so varied that those terms (and results) could change monthly.
Happy Mugs might decide to switch from ceramic to porcelain materials. They might change their supplier, thus receiving a bigger—or smaller—discount for the quantity or raw material they purchase. There might be a shortage of their preferred material, thus increasing production costs dramatically. Speaking of production, the equipment may sustain damage, become outdated, or simply become less efficient as time passes. And we have yet to mention the workforce which, by nature, is subject to constant change. These are all real-life scenarios that would require recalculating the break-even point.
Besides meeting the unexpected, the break-even formula is also limited in how much information it offers when it comes to the mere act of selling. Sure, you know how many units you need to sell, but how do you identify and appeal to the buyers? What chance does your product stand on the market? What is the economic landscape you are operating in, and how do you use its ups and downs to your advantage?
In the case of our fictional company, Happy Mugs, what if they decide to create a limited-edition product or run a special sale during the holidays? They can calculate the break-even point for those unique situations, but how do they fit within their yearly financial strategy? To answer these questions, you might need a couple more tools.
Conclusion
For all its limitations, the break-even formula is essential in developing a realistic, practical, and success-oriented business plan. Whether you are an aspiring entrepreneur or a hands-on CEO with an ambitious idea, figuring out where and when you would eventually break even could be a true deal-maker or breaker.
