With so many economic headwinds facing companies identifying when your business has broken even is more important than ever. Healthy cash flow and profitability are key to the survival of any new business, but with today’s concerns about inflation, vulnerable supply chains and the fight for talent, they are vital.
If your company does its analysis accurately, you’ll be in a much better position to handle these challenges and make sure the company stays financially viable and commercially successful.
In this article, we will cover:
- What is the break even point?
- What is a break even analysis and what is its purpose?
- Break even analysis: purpose
- What is the break even formula?
- How to calculate the break even point in units
- How to calculate the break even point in dollars
- Break even point: examples
- Final thoughts
What is the break even point?
The break even point is based on a simple equation. It’s equal to your fixed costs (e.g. rent, property taxes, equipment costs and interest), divided by your average selling price, minus variable costs.
These are outgoings such as utilities, commissions paid to salespeople and shipping costs. This calculation shows you the point at which your revenue is equal to your costs, and that’s the break even point. Anything above this represents your profits and means that your business is profitable.
In general, the lower your fixed costs, the lower your point for breaking even. The sooner you can get to this point, the sooner you’ll be able to stop relying on external funding such as investment from your bank or other financial supporters.
This can save on interest payments and other funding costs. It also means that if you need to look for a more investment to fund expansion or other growth plans, you’ll be able to demonstrate your track record on profitability making you a more attractive proposition for lenders.
What is a break even analysis and what is its purpose?
A break even analysis is an essential part of your business plan and your financial forecasts. It is a financial calculation that takes the costs involved in a new business, service or product and compares them with the unit selling price to identify the point at which you will find your business breaking even.
This is the moment at which you’ll have sold enough units or services to cover all of your costs. In other words, the good news is that yours is now a profitable business.
Break even analysis: purpose
This analysis can provide essential information about the financial viability of your company. This is particularly important when you’re putting together financial projections or when you’re expanding your product lines. It can tell you whether you’ll need further investment to keep your business going until you reach the point at which you’re making a profit.
If you’re starting a business, having a clear and accurate estimate of when you’ll find that your business is breaking even will determine how much seed money or startup capital you’ll need. Lender and investors will expect to see it as it gives them a good indication of when they might see their loans repaid or when they’ll get a return on their investment.
Even if your business has been going for a while an analysis when it will be profitable is still useful. It can help you to make projections and manage cash flow if you’re launching a new product or making changes to an existing one. With inflation continuing to bite and many raw materials costs increasing it can be particularly informative.
You might also use it to model the effect on recruiting new staff or opening a new site as it will show how many more sales you’ll need to make to balance outgoings and income on any additional costs. Carrying out an analysis can help you to find the best price for your products or services in terms of your profitability.
What is the break even formula?
This formula takes into account both fixed and variable costs relative to the price that you charge per product—or the service delivered and—the profit. It is relatively simple: break-even point = fixed cost / (average selling price – variable costs).
There are also a number of online calculators that you can use.
How to calculate the break even point in units
First, you’ll need to make sure that you know all of the various costs of doing business. Checking through your outgoings will help here. You’ll then need to separate your costs into your fixed costs and your variable costs.
Next you need to consider your price. If you haven’t already decided on it yet, here’s your opportunity to find one that will deliver the profitability point at the right time for you and for your investors or lenders—as well as your customers, of course. If you have a published price and perhaps you’ve already been in business for some time, you can decide whether to stick to this price or adjust it.
If you’re planning to increase what you charge for your products, be prepared for an adverse reaction from customers and even the loss of sales in these challenging economic circumstances. You also need to bear in mind any discounts you offer. From this you can calculate the number of units that you need to sell in order to stop losing money. This tells you when you have broken even in terms of units.
How to calculate the break even point in dollars
To calculate your break-even point in dollars, you need to divide your total fixed costs by what is known as the contribution margin ratio. The contribution margin is the difference between the price at which you sell your product and your total variable costs.
Just imagine that one of your products has a price of $100, your total fixed costs are $25 per unit, and your total variable costs are $60 per unit.
Break even point: examples
In this example, the contribution margin of your product is $40, in other words, $100 minus $60. The $40 contribution margin covers your remaining fixed costs, since these fixed costs aren’t included when calculating this contribution margin.
Taking the $40 contribution margin per item and dividing it by the $100 sales price gives you your “margin ratio” of 40%. So, if you imagine that the value of your entire fixed costs is $20,000 and you have a contribution margin of $40, you divide the $20,000 by $40.
This means that once you’ve sold 500 units, you’ve paid all of your fixed costs, and you will have broken even in dollars.
To take another example, imagine that your company makes hairbrushes. Your fixed costs add up to $100,000. The variable cost associated with producing one hairbrush is $2 and you sell the hairbrush at $12. To calculate you’re the point at which you’ll stop losing money, you take your $100,000 in fixed costs and divide it by the sales price of each brush ($12) minus the variable costs to produce it ($2), which works out at $10. This means that you’ll have to sell 10,000 hairbrushes to reach profitability.
As with any financial projection or planning, to ensure that your analysis is correct you need to include all your expenses in your calculations. No one likes to think about money flowing out of their business but being honest and realistic about it is essential. Similarly, it’s important to be practical when it comes to pricing; what can you really charge your customers? What will they be willing to pay?
Once you’ve made these calculations, you’ll be in a good position to carry out your analysis. It’s a good idea to do these sums on a regular basis, especially if your business is just starting up. The performance of your company and your plans for it, will develop over weeks and months, while external factors can change suddenly and unexpectedly. Knowing when and how your business will find itself breaking even and moving into profitability is essential for any successful enterprise.
Identifying when you’ve broken even is an essential part of any business strategy. With corporations facing so many economic challenges it’s more important today than it has been for a long time.
You need to develop an accurate understanding of your cash flow as well as your income and outgoings. You’ll see whether you have to drive down your costs or perhaps raise your prices, as well as if and when you might need to go for extra funding. Using the techniques and formulas above to calculate when you’ll become profitable will provide a strong foundation on which to build your business.
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