Many tools are available for forecasting and cost evaluation, but few are as important as a break-even analysis.
Our guide offers businesses an in-depth resource to refer to that explains break-even analysis. Read on to learn how to perform a break-even analysis, interpret the results, and understand its limitations.
What is break-even analysis?
Break-even analysis is a way for owners and managers to determine how much they'll need to earn or how many products they'll need to sell before the company generates a profit.
Break-even analysis considers various factors to determine how many units a company needs to sell or how much money it must earn to cover its costs. When conducting a break-even analysis, managers should consider sales price, variable and fixed costs, and the contribution margin per sales unit.
The break-even point represents the number of unit sales where a company generates enough revenue to cover its expenses. An organization that doesn't break even will result in losses, while a business that exceeds the break-even point will produce a profit.
Business owners and managers use the results from break-even analysis to determine the potential profitability of a product line or service. Using the details obtained from the report, business owners can evaluate the feasibility of the organization to cover its expenses and generate a return through product sales.
Break-even analysis formula and calculation
Business owners can calculate a company's break-even point in units sold or in the amount of earned revenue. These are two separate formulas.
The break-even quantity determines how many units a business must sell before it becomes profitable. To calculate the break-even quantity, use the following formula:
Fixed Costs / (Sales Price per Unit - Variable Cost per Unit) = Break-even Quantity
Total fixed costs represent overhead and administrative expenses that remain the same no matter how many units the company sells. Typical fixed costs include rent, executive salaries, and ERP software expenses.
Variable costs are the direct expenses of producing a unit, such as raw materials and hourly labor costs. Total variable costs go up and down depending on how many units the business creates.
Consider the break-even analysis example here:
An Italian restaurant plans to open a business selling only one product, the Vegetarian Deluxe pizza. The variable costs associated with preparing a single Vegetarian Deluxe pizza are $4. The sales price for the pizza is $12. The restaurant has monthly fixed costs of $1,500 for rent, $2,000 for salaries, and $100 for software. To break even, the restaurant will need to sell 450 pizzas, as calculated below:
($1,500 + $2,000 + $100 Fixed Costs) / ($12 Sales Price per Unit - $4 Variable Costs) = 450 Break-even Units
So, if the restaurant has a sales volume of 450 Vegetarian Deluxe pizzas per month, it will make enough revenue to cover its costs. If the restaurant sells more pizzas, it will earn a profit. If it sells fewer pizzas, it will lose money.
Break-even point in sales revenue
Managers can also calculate the break-even point in total revenue. The formula for calculating the break-even point by the amount of sales revenue is:
Sales Price per Unit x Break-even Quantity Units = Break-even Point in Total Revenue
Using the previous example, the break-even point in revenue is $5,400.
$12 Sales Price per Unit x 450 Break-even Quantity Units = $5,400 Break-even Point in Sales Dollars
Why businesses should conduct a break-even analysis
There are a variety of reasons why a business should utilize break-even analysis.
Break-even analysis is an effective way to analyze product costs and determine how many units the business must sell before it realizes a profit. The process of calculating costs, including fixed and variable costs, allows businesses to track business expenses and determine when changes might be necessary.
For instance, if a break-even analysis reveals fixed costs are excessive and result in the organization needing to sell more units than is reasonable, businesses can make efforts to enhance the net profit margin by cutting unnecessary expenditures.
Establish a budget
Break-even analysis is incredibly useful for organizations that need to establish a budget and set sales targets to earn a profit. Once the break-even point is known, the company can narrow down how many units it must sell to meet specific earnings targets.
Whether your organization seeks to enhance ecommerce cash flow or build the foundational metrics for sales objectives, break-even analysis provides essential insights that companies can't ignore.
Act as a catalyst for sales and efficiency
Sharing the break-even analysis amongst team members incentivizes everyone to meet the desired objectives. The sales and customer service team can seek to meet the appropriate number of unit sales each month to keep on track with the organization's overall profit goals.
Other departments can explore ways to trim costs and enhance savings, improving profitability and reducing the number of units the organization must sell to earn a return.
Develop a pricing strategy
The sales price is a crucial component of break-even analysis. Changing the sales price of a product or service can have a dramatic effect on the number of units required for a business to break even.
Using the known factors of total fixed costs and variable costs, businesses can assess the impact of changing sales prices on the number of units it needs to break even.
Of course, the sales price cannot be an arbitrary number. Increasing the sales price too much may result in less consumer demand, while decreasing the unit price may lead to too many customers and problems with quality.
Why is break-even analysis important for startups?
A new business must find its footing before it's able to grow its customer base. A break-even analysis calculation forces small business owners to examine the components of their business plan and business idea, including pricing strategy and startup costs. Using the information from the analysis, managers can determine if the company is likely to make enough sales to cover its monthly expenses.
Break-even analysis isn't just appropriate for pricing and cost analysis—it can also help businesses to attract potential capital. Many startups need funding from investors or banks to scale the company for growth. To attract investors, the company will need a comprehensive set of financials and a complete break-even analysis to help lenders understand the challenges that the business faces and determine if they can help.
Commonly, startups seek financial assistance from lenders and investors through business loans, programmatic funding, and venture capital. Alternative funding sources such as startup corporate cards, inventory financing, and accounts receivable financing are also viable options.
What a break-even analysis doesn't tell you
Break-even analysis has certain limitations that business owners and managers must understand.
Garbage in, garbage out
Like any mathematical formula, the break-even analysis is only as accurate as the details used to calculate it. Inaccurate variable and fixed costs will leave managers with an incorrect break-even quantity that doesn't accurately reflect the company's needs to turn a profit.
Your accounting team needs to maintain accurate records of each period and ensure the proper recording of all expenses. Without meticulous accounting, break-even analyses are useless.
Remember that a break-even analysis is fixed and relies on cost and sales price details that may change in the future. It's vital for businesses to regularly update the factors used in break-even analysis as circumstances change. Hiring new employees, purchasing new technology, and changing the sales price for a product all impact the results of break-even reporting.
Sales price changes and discounts
It's not uncommon for organizations to provide discounts to their customers if they purchase products in bulk. For instance, a company may decide to offer clients a deal if they buy a certain quantity of the product at once. Break-even analysis does not account for selling price modifications.
Companies that use discounts to attract more customers must consider how the markdown impacts their break-even unit point.