Break even analysis is arguably one of the most critical functions of any business. Your break-even point is the place where you’re not making any profit, but you’re also not incurring any losses; it’s where you’re covering your expenditures but hitting zero-profit.
Your break-even point will provide you with a target that tells you how much cash you need to cover costs. As such, break-even analysis is an essential calculation in the profitability of your business. Without it, you’re shooting blind, never really knowing what your critical financial targets are. With it, however, you have comprehensive goals that can help you determine what needs to change in terms of pricing and financial strategies.
If you’re a small business owner, you must understand your break-even point, as this financial metric is the defining calculation when it comes to understanding profits and losses. If you’re not covering your expenses, it doesn’t matter how much revenue you’re bringing in; you’re still losing money.
WHERE DO YOU START IN DETERMINING YOUR BREAK-EVEN POINT?
Before you can begin to know your break-even point, you need to have a handle on your costs. Both fixed and variable costs factor into the equation, and since you’re certainly paying for both monthly, you’ll want to make sure you’re factoring them into your analysis.
Understanding Fixed Costs
Fixed costs are exactly that — fixed. They do not change when your sales volumes fluctuate. They’re set amounts that are due regularly, usually monthly, and usually only change when a contract is renegotiated or a planned annual increase occurs.
Common fixed costs include:
- Exempt employees’ salaries
Understanding Variable Costs
Variable costs are the exact opposite of your fixed costs. These costs do change as your sales volume increases or decrease.
Examples may include:
- Hourly employees’ pay
WHAT’S THE BREAK-EVEN FORMULA?
Break-even = Fixed Costs / (Selling Price – Total Variable Costs Per Unit)
Let’s look at a simple example…
You run a company called ABC Ltd. Your company has created an app that easily finds parking spaces so your customers don’t have to drive around in circles every time they enter a parking lot.
You’ve identified all of your fixed costs as follows:
- Monthly Lease = $3,000
- Monthly Executive Salaries = $37,000
Total cost of your fixed assets = $40,000
You’ve identified the elements associated with your variable costs as follows:
- Technology Fees
- Sales Commissions
In total, you’ve calculated your variable costs at $0.50 per unit, and you’re selling the app to consumers for $3.00.
Using the above example, along with the break-even formula, your break-even point is as follows:
$40,000 total cost of fixed assets / ($3.00 per unit price – $0.50 variable cost per unit) = 16,000 units (or apps, in this case) to break even.
How will you know when you need to increase sales if you don’t know when you’re breaking even? Naturally, you want to sell as much as possible, but if you’re only focused on selling, and don’t know your bottom line, likely, your business won’t be profitable.
A solid break-even analysis will tell you when you need to increase prices so your profit margin reaps the fruits of your efforts. It will also tell you where you need to reduce expenses and cut costs. This analysis, for example, may help you determine that you need to reduce interest-bearing debt or seek cost-cutting measures that would afford you the same quality for a lesser price. Maybe you need to scale back on hourly labor or reduce the number of machines you’re running at certain times. You won’t know any of this until you analyze the numbers.