Have a business idea that you can’t get out of your head? Conduct a break-even analysis first to minimise your risk by making an informed decision. It is much simpler than it sounds but involves a bit of mathematical computation and thinking time.
Doing a break-even analysis prior to venturing out to start a new business helps you in many ways, so it’s always a good idea to understand the concept well. Read this article to find out how to go about it.
Defining break-even analysis
Based on fixed and variable costs and your product’s selling price, a break-even analysis is simply a calculation of how many units you will need to sell to pay for your necessary expenses before making a profit.
You can do this at the business planning stage as part of your marketing plan, because knowing the break-even point helps you set a better selling price and realistic sales goals. How exactly do you calculate your break-even point? By using the formula below:
Break-even = Fixed costs/ (Average price – Variable costs)
In other words, the break-even point is calculated by dividing your business’s fixed costs by the average price per product minus your product’s variable costs.
- Fixed costs include expenses like office space rent, salaries, advertising, utilities, insurance and tax. Basically, any expense that stays constant irrespective of how many units you sell is categorized as a fixed cost.
- Variable costs include cost of goods sold, inventory and raw materials. This expense is directly proportionate to the number of units sold.
You can even use templates available online to get started on the right track.
Key steps in a break-even analysis
Conducting an accurate break-even analysis depends on three main steps:
- Understanding the concept and key terms and definitions involved, as explained above, including the formula, types of costs and selling price.
- Gathering all input data and ensuring that it’s reliable. Make sure that you have not missed any major or minor expense. You can do this by running your list of inputs past another staff member who has a good idea of your company’s expenses if you don’t have an accountant per se.
- Plugging the data into a template or the formula and refining the results as you try out different combinations of data to see how each element in the equation affects the outcome.
Important considerations to lower your point of break-even
You can lower your break-even point by doing either of the following:
- Increasing per unit price such that the number of units sold does not reduce significantly as this will have a negative impact on your profitability.
- Lowering your fixed costs by taking on a lean approach towards spending your hard-earned capital on office space, stationary, insurance and other similar expenses. Look for ways to ensure that your money is not being frittered away by getting a good handle on your accounting system, including cash-flow.
- Lowering your variable costs as the business scales.
- Strategizing ways to sell products that yield a higher contribution margin to make profit faster.
Benefits of doing the analysis
The determination of the break even point is one of the most popular tools in practice and is dealt with in most textbooks on controlling and cost accounting. In the simplest case of a one-product company, your goal is to determine the required sales volume in order to avoid losses, the so-called break-even point.
The break-even analysis determines the sales volume from which a company starts making profits. However, it becomes difficult to determine if there are several different products. However, all forms of break-even analysis only consider the risk of loss without being able to quantify the risk in monetary terms or as a probability. The latter is important for business decisions.
The stochastic simulation can be easily integrated into existing spreadsheets and can take into account a wide variety of practical conditions of products, markets, etc. Overall, the stochastic break-even analysis offers several advantages: It allows the monetary quantification of the risk of loss, which in turn is a preliminary work for entrepreneurial decisions in dealing with this risk, and it can be easily integrated into planning, management and control.
The break-even analysis considers a risk from the outset: namely the risk of losses. However, it is not further quantified in terms of probability of occurrence or heights of occurrence; only the sales volume necessary to avoid losses is calculated. Nevertheless, a number of analyzes can be carried out with this simple model, for example the effects of changes in quantities, prices and costs.
Due to the lack of short-term degradability of fixed costs, these represent a further risk for a company. In the event of falling sales volumes, the company that has higher fixed costs or which cannot be reduced for a longer period of time has a disadvantage. On the other hand, the same company has an advantage with increasing sales volumes due to the higher proportion of fixed costs. This risk of volume change is also known as “operating leverage”. In simplified terms, it is determined as the ratio of the respective contribution margin to profit.
In practical application, the simple form of the break-even analysis is no longer sufficient: On the one hand, most companies sell several products; on the other hand, the break-even calculation is a static view and omits the development over time and a large part of the uncertainty of its input variables.
