How to Complete a Breakeven Analysis
A break-even analysis is done to determine when your business will make enough money to cover costs and begin to make a profit. Break-even analyses are performed before a business is started to gauge if the idea can be successful and it’s also done long after a company is up and running to help determine the price of new and existing products. It’s important to identify costs for any small business in the early stages.
Why is it important to identify costs for small businesses in the early stages?
Identifying costs for small businesses in the early stages is crucial because it allows entrepreneurs to have a clear understanding of the financial requirements and potential risks associated with their business idea. By accurately estimating costs, they can conduct a break-even analysis to determine how many units they need to sell in order to cover expenses and make a profit. Having this knowledge helps in making informed decisions and implementing effective business strategies.
When is a break-even analysis typically performed?
A break-even analysis is typically performed before starting a business to assess the viability of an idea. It helps determine if the business can generate enough sales to cover costs and eventually make a profit. Additionally, a break-even analysis can be conducted even after a company is already established to assist in pricing decisions for existing and new products.
What is the break-even point (BEP)?
The break-even point is the specific point at which your expenses, both fixed and variable, equal your revenue. At this point, your business has covered all costs but does not make a profit. It signifies the threshold for profitability.
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A break-even analysis provides information on how many units of product you must sell to cover your business costs. It helps determine the point at which your revenue equals your expenses.
What happens if you sell fewer or more units than the break-even point?
If your business sells fewer units than the break-even point, it will make a loss. This means that the revenue generated is not sufficient to cover the expenses, resulting in a negative profit. On the other hand, if your business sells more units than the break-even point, it will make a profit. This indicates that the revenue exceeds the expenses, leading to a positive profit.
How to Reduce the Break-Even Point
To reduce the break-even point, several actions can be taken:
- Evaluating production and sales quantity: Begin by analyzing whether it is possible to manufacture and sell a lower quantity of products. For instance, if the current target is 20,000 bottles of shampoo per month, assessing whether a lower quantity could be achieved is essential.
- Reducing fixed costs: Examining fixed costs thoroughly to identify areas where cost-cutting measures can be implemented is crucial. This may include downsizing office space, optimizing the usage of resources such as telephone bills and office supplies, and minimizing other fixed expenses.
- Minimizing variable costs: Reviewing the variable costs associated with the production process can help identify opportunities for cost reduction. For example, finding a new shampoo supplier who offers better pricing or negotiating more favorable terms with the existing supplier could help decrease variable costs.
- Adjusting selling price: Another strategy to lower the break-even point is to consider increasing the selling price of shampoos. By determining the optimum balance between price and demand, it may be possible to generate higher profit margins and decrease the number of shampoos that need to be sold to cover fixed costs.
Calculating Your Break-even Analysis
To calculate your break-even analysis, you’ll need a few pieces of information:
- Fixed costs per month
- Variable costs per unit
- Average price per unit
Fixed Costs
Fixed Costs do not change from month to month. They include costs associated with rent, payroll, insurance and taxes, along with much more. No matter how many units you sell, your fixed costs will remain the same. When starting a business, it’s important that you don’t roughly estimate what your fixed costs will be. To figure out your fixed costs, call your insurance broker and get an estimate, call the utility company and find out what your utilities will likely cost and heavily research any other industry costs you may incur to ensure your calculations are correct.
Variable Costs
Variable costs are recurring costs that are directly related to your sales. If you’re selling more products, your variable costs will go up and if your sales go down, so will your variable costs. Variable costs include things such as production supplies, credit card fees, labor and direct materials. To estimate your variable costs, do some research on your industry and talk to vendors to see what others in similar situations are paying. You can often reduce variable costs easier than fixed costs. For example, you may be able to find a lower cost supplier to manufacture your products easier than you can find a cheaper location or decrease your number of employees.
Average Unit Price
Average unit price is the amount you will charge your customers to buy one unit of your product. Setting the right price for your products is crucial to your business’s success as well as your break-even analysis. The price of your product is what will determine when your startup will begin to turn a profit. To learn how to price your product, look at your competition and how they price their products. You can also create focus groups with potential customers to see how consumers accept the price of your products. After you’ve figured out how much it costs to produce one unit of your product and you’re still unsure of the exact amount to charge, a break-even analysis can help.
To Perform a Break-even Analysis
Break-even point = Fixed costs / (Average price per unit—variable costs per unit)
For example, let’s assume you’re starting a small bakery and selling your home-made baked cakes. You have $1,000 per month of fixed costs (bakery rent and equipment and utilities). Your variable costs for the baked goods are $30 for labor and materials. You’d like to charge $50 per cake since that’s the going rate in the area for home-made cakes.
Break-even point = $1,000 / ($50-$30) = $1,000 / $20 = 50
This means you’d need to sell 50 cakes each month at $50 per cake to break even. Startup owners can use this break-even formula to compare different pricing strategies to analyze which price points will work best. The higher you make your prices, the harder it may be to attract buyers, but if you keep your prices low, you’ll have to sell more products to turn a profit. You can also examine the differences in your break-even point if you can decrease your variable or fixed costs. To be able to investigate these different scenarios, use these free and helpful break-even templates online.
The Outcome
Once you understand the outcomes of a few different options for your analyses, you must determine if the prices are attainable for your business. Can you produce as many products as you need to in one month or year to break even? If none of your analyses are doable, you may need to look into other business ideas or determine where you can cut costs to meet your break-even point. It’s important to understand that a break-even point is not a predictor of demand. If demand is super high, you may be able to get away with a lower price, or if demand is low, you may not ever be able to break even. Research on your industry and target audience is the best way to determine if your break-even point can be met to turn a profit.