When you’re new to the world of business, determining the right selling price of your product might seem like the easiest and most difficult aspect of making your idea into reality.
Don’t fret, that’s where the break-even analysis steps in.
This handy tool helps you determine at what point our product or service will be profitable for your business. It helps you understand the number of units you need to be selling in order to cover your business costs.
Whether you run an online store or want to sell your services, the following formula will help you set the correct selling price for your product or service.
What a break-even analysis is?
When you sit down to do a break-even point analysis, you’re basically evaluating the sales volume you need in order to cover your costs.
A break-even analysis helps you to understand all the costs it takes for your business idea to work, from fixed costs to total variable costs. It’s also a great tool for determining the number of units you need to sell in order to not be losing money.
In business terms, a break-even analysis is often referred to as a margin of safety. It’s widely used in all forms of business and project management where money is involved.
When does a break-even analysis come in handy?
A break-even analysis helps you understand many aspects of your business, on top of simply communicating the break-even point for a product or service you’re selling.
A well-performed break-even analysis can answer questions like:
- At any given output level, what are the predicted earnings and losses for the product or service you’re selling?
- What is the bare minimum sales volume required to avoid a loss? How many units do you need to sell in order to cover all the costs?
- Do your new product’s sales predictions exceed the break-even point? If not, how long are you willing to operate at a loss?
- Will your break-even point improve if you drop a product that’s not bringing in enough sales dollars?
- What effect would raising or lowering prices have on your profit margins and break-even point? Do other pricing strategy changes, like sales or discount campaigns, affect your breakeven point?
- What impact will rising costs have on your break-even point and total revenue?
- What effect does making upgrades to your production facility have on your break-even point?
Especially if you’re a new business and mainly operate online, chances are that you’re already keeping total costs down compared to your brick-and-mortar competitors.
An effective break-even analysis determines whether you can or should introduce new products that are cheap to produce but can be sold for a decent profit. This way, the financial toll of a product that has high total costs is easier to justify and cover in the long run, while making money.
What is the formula of break-even analysis?
Calculating the break-even point is pretty straightforward. The basic formula looks like this:
Break-even quantity = Total fixed costs / Contribution margin (Sales price per unit – Variable cost per unit)
Thankfully you can use online calculators or include the break-even formula into your budgeting spreadsheet. Chances are that most accounting software already calculates your break-even point for you.
Let’s look at each key component of the break-even calculation in more detail.
Total fixed costs
A fixed cost in your business is a cost that remains the same regardless of how many or few products you’re producing at any given point in time.
Most often, fixed costs consist of things like rents, insurances, and employee and executive salaries. You’ll pay a fixed amount of rent every month even if you’re making 1000 products in March and only 100 in April.
In the break-even calculation, your total fixed costs are the sum of all fixed costs that you have regarding the production of a specific product (if you’re looking at the break-even point of a particular product) or your business as a whole (if you’re determining whether the overall break-even point and profitability of your company).
Sales price per unit
The sales price per unit refers to how much a single unit of your product costs to the end-user.
For example, you might sell the finished product to your customer for $20 per unit.
Unlike fixed costs, variable costs are tied to the production of your product and can vary from month to month depending on how many units you need to produce.
Things like raw materials, electricity, product packaging, and sales commissions are all variable costs and depend on how many units you’re selling in a given month.
For example, the variable costs for a company selling skincare could be higher around Christmas time but then drop significantly for January and February, and start picking up again around March.
In the break-even point calculation, the variable cost per unit is used. This refers to the variable costs that occurred to create a single sales unit, as opposed to the total amount of variable costs.
Pro tip – Calculate the variable cost per unit by dividing your total variable cost by the total number of produced sales units.
Break-even analysis example
Your fixed costs that remain the same month after month consist of things like:
- Your website plan
- The price of your domain
- Your business insurance
Your variable costs, on the other hand, are things like:
- Cost of jewelry materials (you need to get the gems, stones, and other materials you need to create your jewelry)
- Marketing costs (whether you try out a new sales channel or send out marketing emails, chances are that you have some costs that change from month to month, depending on the campaigns you’re running)
- Shipping and payment processing costs
- Utilities related to your manufacturing process (maybe you use electric tools to create your jewelry, for example)
If you end up creating and selling 100 pieces of jewelry in March, but only 50 in April, the amount of money you’re spending on the variable components of your costs is significantly lower in April.
On the other hand, the cost of your website plan, domain, and business insurance remain the same regardless of how many pieces of jewelry you sell.
What are the strengths and limitations of break-even analysis?
Like most things in life, not even the mighty break-even point calculation is perfect for everything.
There are some major advantages and disadvantages to break-even analysis.
Strengths of break-even analysis
A break-even calculation is great for preliminary planning. It helps you get a clear idea of exactly what you need to do to make your business ideas a reality, from understanding how many sales you need to make and what your net profit and the total cost will be.
It’s also a great way to analyze the relationship between fixed and variable costs. Production costs can impact the price of your product and further the total number of units sold.
By understanding the financial commitments you have when it comes to your production level you can keep an eye on the total expenses your business has, and make informed business decisions.
You could, for example, reduce the financial strain of your fixed and variable costs by moving your production to a different location or by streamlining the production process of multiple products at once.
You can also use the break-even calculation to predict the effect of changes in sales prices.
As the break-even analysis tells you how much you need to sell in order to cover your base costs, it can help your sales team to get an idea of how much an increase or decrease in the price for each unit sold can increase revenue targets.
When it comes to business analysis, break-even calculations also help you measure profit and losses at different levels of production or sales volume.
Especially if you work in a fluctuating industry, getting an idea of whether you need to introduce multiple prices for different seasons or set your sales targets higher for certain quarters or months can help you gain operating leverage overall.
Limitations of break-even analysis
Unfortunately, the break-even point can become restrictive in more complex calculations.
In other words, if the legal makeup or overall business model of your company isn’t straightforward enough, chances are that a simple break-even calculation won’t tell you the total revenues and potential outcomes of your business.
The break-even analysis also doesn’t consider the cash flow, as it looks at your total costs from a somewhat clinical perspective. Similarly, the calculation is dependent on reliable data, meaning that it won’t necessarily catch missing expenses if they are not part of your source material in the first place.
It’s also not a predictor of demand. It’s not a given that you’ll find buyers just because you’ve managed to plan your fixed costs and total variable costs in a way that allows you to break even. You should do market research and determine the best sales and marketing channels for your business first.
The tool also ignores competitors and other existing business in the field. Your unit price might be significantly higher or cheaper than those around you. A competitor’s new marketing campaign or reduced unit price could change dramatically your break-even point in the long run and even affect demand overall.
A break-even analysis also doesn’t consider time fluctuations. This is something to keep in mind especially if you operate in a highly seasonal field, where the bulk of the whole year’s profits is made within a quarter or a number of months annually.
How to use breaking-even analysis as a decision-making tool?
Break-even analysis can help you to make important decisions for your business.
You should use your break-even calculations to gain deeper insight into your business and how you can keep it as profitable and operational as possible.
Tips on how you can lower your break-even point
If you want to increase your profits and lower the point at which you break even, you can consider three different things:
- Lower your fixed costs. Can you decrease the number of salaries you’re paying? Or maybe you could look at cheaper office alternatives to keep your rent down?
- Lower your variable costs. Can you buy your raw materials for a cheaper price? Or could you cut down the amount of packaging your products need, in order to cut down costs?
- Raise your end-product prices. If you’re unable to touch either the variable or the fixed cost of your product, you should consider raising the price of the product you’re selling to your end customers.
Use break-even analysis for your business success
By understanding the number of units you need to sell in order to cover your variable and fixed costs can help you increase your overall profits in the long run.
Spot places where you might lose money and evaluate each variable and fixed cost critically.
Scale your business and the number of units sold by understanding how much money you need to make in order to cover your costs and start turning a profit.