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A break-even analysis determines when a small business is expected to cover all expenses while simultaneously making a profit. Identifying startup costs can help small business owners determine the sales volume needed to business expenses on an ongoing basis. Even after the doors have been open for a given period, a break-even analysis remains a helpful financial tool in determining the best pricing structure for new products and/or services.
Additionally, as an essential part of a business plan, this type of analysis can also help an entrepreneur before deciding to pursue a business venture. If number show that the idea is not worth pursuing, the entrepreneur can make modifications or look into another business.
For example, your business could have $5,000 in product sales, but this would not be enough to cover the $5,000 monthly expenses. The cost of selling those products could easily reach $3,000 at wholesale cost, which only leaves $2,000 in gross profits. Your small business reaches the break-even point when revenues from product sales equal all business expenses.
Calculating the Break-Even Point
After attributing all costs to bringing your product or service to market are deducted, a certain amount of profit remains for each unit sold. This contribution to your profits is divided into fixed costs, which will determine how many units you need to sell to break even.
Unless you have an accounting background, this might sound complicated to the average business owner. In simple terms, however, conducting a break-even analysis tells you how many units you need to sell to cover all costs. Performing the analysis requires three basic pieces of information that are discussed below.
Analysis on Fixed Costs
Generally, the fixed costs in your small business are operational expenses such as payroll and building lease payments that do not change from month to month. The number of units you sell does not affect these costs. Nevertheless, you need to know the full amount on everything.
Guess work is a poor approach to estimating costs if you are a startup. Most utility companies can provide the previous year's total for the location of your business. Get a real insurance quote for your type of business. Use concrete numbers to get a realistic view of how much it will cost to run your business.
Analysis on Variable Costs
Variable costs include sales commissions, shipping and inventory – anything that can rise or fall with sales volumes. Again, if you are just starting out, you can talk to other business owners, vendors, etc. to calculate a realistic estimate. Review financials of public companies that are in your industry. Size down figures from larger companies to match what you expect to pay for your business. If you have been in business for a period of time, capture the variable expenses for six to 12 months.
Analysis on Pricing
Analyzing pricing is the trickiest part between all three pieces of data. You choose where to set prices for your products or services, but you do not have the final say for fixed and variable costs. Generally, you are not limited to one way of looking at pricing.
Begin setting prices by looking at how your competition sets prices for their products or services. An informal focus group can also help you determine how much your target market might be willing to pay. Do you want to be on the high-end, low-end or midpoint of pricing within your industry?
While you do not control your costs, you want to consider these when setting prices for products or services. If you spend $2 on materials to make a widget, your sale price will obviously need to be more than $2. The question you need to answer is how much more – $4, $5, $7 – is necessary for you to eventually break-even?
The Formula for Performing a Break-Even Analysis
After determining your cost data and target pricing, you can plug those figures into a formula. Typically, the formula you can a break-even analysis formula that gives you the break-even quantity of single units sold, which is the number of units your business must sell to cover costs. Any sales you make above that amount are purely profits. Any amount below means your business is losing money.
A practical example of this is to look at how the formula is applied to a jewelry-making business. Fixed monthly expenses total $1,000 and variable costs for each piece of jewelry are $50. This covers materials and labor. Since similar pieces of jewelry can cost $70, you decide this is your price per unit.
BEQ = $1,000/($70 - $50) = $1,000/$20 = 50
This means you would need to sell 50 pieces of jewelry at $70 each per month to break-even.
Your break-even formula can be used to compare different pricing strategies. Following the same example, you could raise the price of the jewelry to $80. All other things being equal, you would only need to sell 33 necklaces before reaching the break-even point. However, you might find it harder to attract enough buyers at a higher price. On the other hand, you could lower the price to $60, attract bargain shoppers and sell 100 pieces of jewelry to break-even.
Additionally, the formula for a break-even analysis can assist you with comparing different cost structures. To illustrate, you might use less expensive materials and pared down the cost per unit to just $45 from the original $50. To break even, you would need to sell 66 jewelry pieces.
Guarantee the Accuracy of a Break-Even Analysis
Guaranteeing the accuracy of a break-even analysis depends on carefully studying costs and prices related to your business. You need to know the total costs to deliver your products or services to customers. In addition, you must know the correct price to charge for the products or services. All miscellaneous expenses involved with operating your business should be deducted to get an accurate figure.
Start by analyzing every product or service your business produces and sells – or plans to sell – on a regular basis. Begin the list with the largest volume seller and end with the smallest. Organize each by priority based on the profitability contribution to your business.
Not only does this practice help you in determining the break-even point, but you might decide to discontinue a product or service. Unless it is a loss-leader, investing time and money into continuing the product or service could keep you from ever reaching the break-even point.
Every business has fixed costs that must be paid each month, even if nothing sells for that month. Variable costs are incurred when you produce and sell your product or service. External market conditions change where customer desires evolve and a once profitable product or service no longer turns a profit. You might decide to offer a different product or sell popular items at a higher price to yield better profits. A break-even analysis offers the easiest way to determine how much of either product must sell to reach your desired profitability level.
Many small business owners will bring a product or service to the market before having a full understanding of the total costs. Eventually, this impacts how much you can charge for any single product or service, which can have negative consequences on your profits. Not only do you face the volatility of the market, but you could lose customers with inconsistent pricing. Why should customers trust the value of your product or service if you do not know how to market that value?
Conducting a break-even analysis on your business is one of the most important tools for making good business decisions. You can accurately determine whether you have a profitable idea and the best pricing strategy to meet those goals. There are templates available to assist you with comparing different pricing strategies. If you prefer, a basic spreadsheet can also help to run different scenarios. The format that you select is not as important as deciding to evaluate the products or services of your business.