Are you currently writing a business plan and want to do break even analysis? If YES, here’s a beginner’s guide on how to calculate break even point for a business.
Every business is established with the aim of making profits. No entrepreneur wants to go through the stress of establishing and running a business that would not be able to pay its bills after a particular time frame. This is the major reason why it is very pertinent to run a break even analysis whenever one thinks of starting a business.
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What is a Break Even Analysis?
Break even analysis is a calculation that will tell you how many units of products you need to sell or how many people you have to offer services to in order to break even in your business. In essence, your break-even point is the sales level that is required for your business to operate without incurring financial loss. To succeed in any business you are doing, it is pertinent to determine this point as the viability of your business is reliant on staying above this number.
For instance, as an entrepreneur selling umbrellas, you need to know how many umbrellas you need to sell to cover your overhead costs. You need to know that anything you sell above your break-even point will mean profit for your business.
A break-even analysis is a key part of any good business plan as it would help you know if your business idea is worth pursuing, and it can remain helpful in the long run as a way to figure out the best pricing structure for your products.
It is a fact that experienced entrepreneurs would not even think of starting a business until they are sure, from their break-even analysis, that their predicted revenue would be greater than their costs, and that they can break even at a certain point that is predictable. Once this point is established, the entrepreneurs can then continue creating their business plans. A break-even analysis is the best way to determine whether your business idea is a winner or a loser.
A company can be said to have achieved break even when its total sales or revenue equals its total expenses. No profit has been made at the break even point, and no losses have been incurred either. It should be noted that any revenue that is made above the breakeven point is pure profit for the business.
4 Times When It is Important to Carry Out Break Even Analysis
- When starting a new business
Like we have already established, whenever you want to start a new business, your first thoughts should go to conducting break even analysis. Not only will it help you decide if your business idea is viable, but it will force you to do research and be realistic about costs, as well as think through your Pricing Strategy.
- When you want to create or introduce a new product line
If you already have a running business, you are still required do a break-even analysis before adding a new product line, especially if that product is expected to add significant expenses to your business. Even if your fixed costs, like an office lease, stay the same, you will need to work out the variable costs related to your new product and set prices before you start selling.
- When adding a new sales channel
Any time you add a new sales channel, your costs will change—even if your prices don’t. For example, if you have been selling online and you are now thinking about opening a pop-up shop, you will have to make sure you at least break even so as not to add a strain to your business.
- When changing your Business model
If you are thinking about changing your business model, for example, switching from a retail store to eCommerce, you are required to do a break-even analysis. Your costs could change significantly and this will help you figure out if your prices need to change too.
How to Do a Business Plan Break Even Analysis for Beginners
When conducting a break-even analysis, you need to take note of certain variables. The first step basically is to list all your costs of doing business. You need to put down everything, from the cost of your product, to rent, to bank fees and others. Think through everything you have to pay for and write it down.
The next step is to divide them into fixed costs and variable costs.
- Fixed Costs
Fixed costs are any costs that stay the same regardless of how much products you sell. This could include things like rent, software subscriptions, insurance, deposits or contingency funds and labour. You have to make a list of everything you have to pay for no matter what.
In most cases, you can list the expenses as monthly amounts unless you are considering an event with a shorter time frame. If you are starting your business from the scratch, you should never rely on guesswork to estimate your costs. You can check with trade associations for information on average costs in your particular industry.
- Variable Costs
Variable costs are costs that fluctuate based on the amount of products you sell. This could include things like materials, commissions, payment processing, labour, shipping costs of the product, and inventory etc.
Some costs could go in either category, depending on your business. If you have salaried staff, they will go under fixed costs. But if you pay part-time hourly employees who only work when it’s busy, then they will be considered as variable costs.
- Average price per unit
Finally, you need to decide on a price for your product. Don’t worry if you are not ready to fix a final price yet, you can change this later. Keep in mind that this is just the average price. If you offer some customers bulk discounts, it will lower the average price. To determine your price, consider these factors:
- What is your competition selling the same thing for?
- Do you want to be at the low, middle, or high end of the price range?
- What is your cost for the unit, and how much profit do you want to make above that?
You can also use informal focus groups to see what people might be willing to pay for your wares or services.
Importance of the Breakeven Point for Businesses
It is very possible for a business to be turning over a lot of money and still be running at a loss. By determine your breakeven point, you will be able to decide the appropriate price, sales budget to have and it also helps in preparing the business plan. The breakeven point analysis is a very useful parameter for determining the critical profit driver for your business including sales volume, average production costs and average sales price.
The other importance of a breakeven point is that it will help you to be able to:
- Determine the productivity of the current product or service you are into
- Know how far you can sustain declining sales in your business before you will start incurring loses.
- Know how many units of your products that you will need to sell before you will be able to make profits
- Know how reduction of sales volume or price will affect your business
- Know how much of an increase in price or volume of sales you will need to make up for an increase in fixed costs.
Calculating Your Break-Even Point
In order to determine your break even point, you will have to arrange the above figures into a break-even analysis formula. A breakeven analysis formula looks like this:
- Break-even point = fixed costs / (average price per unit – variable costs)
Using the formula above, and using the example of an entrepreneur that retails shoes. Let’s just say his fixed costs are $2,000 a month, and his average sales price is $100. It costs him $40 to buy each shoe, which leaves $60. Divide that into $2,000 (monthly fixed costs) and the entrepreneur must sell 33 shoes a month to break even. Any units he sells above that are profit.
Another example, if you have a business that is selling digital information products online at a rate of $100 (that is, the selling price is equal to $100), and the variable cost is $20 and the fixed cost for a particular period in question is $2,000. To get the breakeven point in number of units, you should divide the fixed cost by the contribution.
To get the contribution or gross profit, you will have to subtract the selling price ($100) by the variable cost ($20) which will give you $80. Therefore dividing the fixed cost ($2,000) by the contribution ($80) will give you a breakeven point of 25 units (2,000 ÷ 80 = 25). What this answer means is that 25 units of the information product must be sold in order to cover the costs of running the business.
What Will Happen to the Breakeven Point If Sales Change?
So, what would be the fate of your breakeven point in the event that sales change? Take for instance, if the economy of the country was in recession, the sales that the business has may drop. If this should happen, then you may stand the risk of not selling enough to meet your breakeven point.
Using the business that is selling digital information products above as an example, you might not sell up to the 25 units that are needed in order to breakeven. In this scenario, you will not be able to pay all your expenses, so what can you do to remedy this situation?
There are two possible solutions to this problem. You can either decide to raise the price of your product or you can find ways to cut your costs, both fixed and variable.
- Analyzing your Outcomes
A break even analysis is not just conducted for fun, the analysis if done well is meant to speak volumes about your intended business. In this wise, it’s important to understand what the result of your break even analysis is telling you. The above analysis has told us that the entrepreneur will break even in business when he sells 33 pairs of shoes in a month. This is great, but the next step is to decide whether this can be done at a particular point in time.
If you don’t think that you can sell 33 pairs of shoes within one month as dictated by your financial situation, patience, personal expectations, location and other variables, then this may not be the right business for you. This is because the business would not be able to produce the cash that would sustain it.
If your break-even point is higher than you expected but you still have hopes for the business, you may consider manipulating certain factors to yield a desirable break-even point. You can consider shopping around for less expensive shoes, reducing the number of, or eliminating employees altogether, working from home and raising your sales price.
If after changing some of these factors your break-even point is still too high, then your business idea may not be attainable. This realization is what makes break-even analyses so important. If you end up scratching your supposed business plan, then know that you have saved yourself a lot of time, effort and money.
Furthermore, you need to understand that a break even analysis cannot accurately predict demand. If you go to the market with the wrong product or the wrong price, it may be tough to ever hit your break-even point.
Drawbacks of Break-Even Analysis
Though conducting breakeven analysis for your business is quite necessary before even writing business plan, it is a fact that this analysis also has its drawbacks or limitations. Some of these drawbacks include;
- It doesn’t take note of future changes
One typically ignores the future when calculating breakeven analysis. Although your analysis would show you how many units of products you need to sell over the course of the month, but you won’t see how things would change if your sales fluctuate week to week.
And it won’t tell you how the fluctuation would affect your break-even point. It also doesn’t take the future into account. Break-even analysis only looks at here and now. If your raw materials cost doubles next year, your break-even point will be a lot of higher unless you raise your prices. If you raise your prices, you could lose customers.
- It cannot predict demand
It’s important to note that a break-even analysis cannot predict market demand. It won’t tell you how much you are going to sell at a particular point in time, or how many people will even want what you are selling. It will only tell you how many units you need to sell in order to break even. Since demand is generally not stable, the number of people willing to buy your product will change if you change your price.
- Too simple for complex businesses
The break-even point formula is quite simplistic. Many businesses have multiple products with multiple prices. It won’t be able to pick up all the variables. You’ll likely need to work with one product at a time or estimate an average price based on all the products you might sell. If this is the case, then it is best to run a few different scenarios to be better prepared.
- It doesn’t give account of competitors
As a new entrant to the market, you are going to have competitors on ground, and they of course would be wary of you. They could lower their prices, which can in turn affect demand for your product, causing you to change your prices too. This can equally affect your break even point.
The most common mistake entrepreneurs make when conducting break-even analysis is forgetting things, especially fixed and variable costs. Forgetting things would make your break-even calculation not to be accurate, and to correctly predict the viability of your business, your break even analysis should be as accurate as possible.
To make sure you don’t miss any costs, think through your entire operation from start to finish. If you think through packing a fragile product to ship it, you might remember that you need to add some protection to the box. If you are thinking through your festival setup, you might remember that you’ll need to provide drinking straws along with the drinks you will be servicing.