If you’re starting a new business, it’s important to assess its financial ratios and overall performance regularly so you can make appropriate adjustments for its stability and growth. One key assessment involves conducting a break-even analysis.
A break-even analysis determines how much revenue must come in to cover the business’s expenses. It shows how many products must be sold (or alternatively, how much revenue must come in) to bring the business to the point at which there isn’t a profit or a loss. This is known as the break-even point. Read on to learn more about this important business metric.
Why Conduct a Break-Even Analysis?
The results of a break-even calculation can help you set or adjust pricing, create or modify your budget, and determine or tweak production goals. They can spur on cost-controlling measures and you can show them to your employees to demonstrate the benefits of reaching sales targets. They might also reveal that you could benefit from taking out a small business loan or otherwise accessing more funding.
Here’s a look at one example of how break-even analysis can be an important part of the small business budgeting and price setting processes. Some business owners don’t account for all of the costs that are involved in making a product when they set their prices. Direct costs — such as materials used in a product, manufacturing supplies, and direct labor costs — may be relatively obvious. But indirect labor costs, overhead costs, marketing expenses, and others that are less obvious might not be properly accounted for.
The result could be an under-priced product and a company that struggles to keep its books in the black. Break-even analysis can help you identify that situation so you can rectify it.
So how do you calculate break-even points accurately and use them appropriately? To help you find the answers, here are some useful definitions and some strategies.
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How to Calculate Break-Even Points
To understand this calculation, it can help to know the meanings of all of the factors used in it.
• Fixed costs: These are the company costs that stay the same over a defined period of time. They are costs that have to be paid even when your company isn’t producing anything, like rent payments for building space, salaries, insurance payments, utilities on a budget, fixed loan payments, and so forth.
• Variable costs: Compared to fixed costs, variable costs can change based on business activity. One example might be sales commissions. If a team sells more products, then its commission amounts would increase. If it sells fewer, then this amount would decrease. You may need to estimate what these will be to arrive at a number to use in this equation.
• Product sales price per unit: This is the cost that a business would charge a customer to buy one of its products.
• Contribution margin: This is the unit’s sales price minus its variable costs.
Example of Break-Even Analysis Calculation
The formula to calculate break-even point is:
Fixed costs ÷ Contribution margin = Break-even point (expressed in number of products)
Let’s say that a company sells a technical guide and the fixed costs associated with it total $75,000, the variable costs involved in producing one guide equal $3, and the guide sells for $20. This is how this example of break-even analysis plays out:
The break-even quantity = $75,000 ÷ ($20-$3) = $75,000 ÷ $17 = 4,411.8. This company would therefore need to sell 4,412 copies of the technical guide to reach their break-even point.
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Leveraging Break-Even Calculation Results
Picture discussing these results at a work meeting. The response may be that this is a wonderful break-even point. It could also be discouraging — or something in between. If results are deemed less than desirable, then a review of the business cash management plan, including pricing and more, may make sense.
Solutions can include:
• Raising prices
• Finding ways to cut costs
• A combination of cost cutting and price adjusting
Here’s more information on these actions.
Pricing Strategies
When considering a price change, you’ll probably also want to think about what competitors are charging to make sure your company doesn’t price itself out of the market. If your prices would be higher than those other companies are charging, is your product more valuable in ways that can justify the higher prices?
In certain industries, surge pricing (also known as dynamic pricing) could apply. In this situation, prices rise and fall based on market and customer demand. Concerts and other events might charge higher ticket prices if a certain performer is in high demand, for example. And hotel room prices can go up if the hotel is near a popular event. Assuming that company costs remain relatively stable, it will take fewer units to reach the break-even point when demand is high and prices are higher. It will take more units when demand and prices go down.
A similar strategy called discount price strategy focuses on charging more for popular products. For example, the technical guide company may come out with another publication on a topic that’s highly relevant at present. At that point, the company may be able to sell this new publication at a higher price. The idea behind this strategy’s name is that the product is eventually put into clearance or otherwise discounted after a period of time. This strategy may work especially well with seasonal products or products that go in and out of style, such as clothing.
If a company is just entering the market with a product that already has competition, it might use a penetration strategy in which it prices its offering very low so that the company can “penetrate” the market before raising prices. A break-even analysis would quickly show how larger numbers of products would have to be sold before costs could be covered. That’s why this is typically a short-term strategy to draw attention to a product and start earning revenue from it.
Penetration strategy is related to loss leader pricing, where a few products are priced exceptionally low to grab attention, but other products are still sold at full price.
Cost-Cutting Strategies
Can materials needed for a product be purchased for a better price? What kind of discounts can the company get if the materials are bought in greater quantities? What impact could changes based on these factors have on cash flow management, overall?
Ways to reduce fixed costs might include cutting back on rent, either by negotiating for better rates, moving to a smaller and/or less expensive space, or shifting to a partly or all-remote working model. This last option could help the business save money on rent, as well as on taxes, insurance, utilities, and so forth. If this seems like a possibility your business would like to pursue, check to see what local zoning and other codes may apply.
If your cost for office space can be lowered, check to see what impact this has on the break-even points of your product(s).
Returning to our earlier example of break-even analysis, let’s say that a new rental agreement will reduce the fixed costs of $75,000 by $15,000. Here’s what the break-even analysis would now look like:
$60,000 ÷ ($20-$3) = $60,000 ÷ $17 = 3,529.4. This savings in rent lowered the number of technical guides that would need to be sold from 4,412 to 3,530.
Other cost cutting measures that can lower the fixed costs include:
• Cutting back on vehicle expenses
• Strategically using freelancers in the business
• Price-comparing supplies
Plus, as the proverb has it, time is money. Finding ways to work more efficiently can be real money savers, too. Strategies include improving organization, using productivity apps, and outsourcing strategically.
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The Takeaway
When you own a small business, you want it to make money. Understanding what your break-even point is is crucial to your bottom line. And using that tool to figure out what changes you might want to make in producing your products and in the fixed costs you pay may also be very valuable to your company’s bottom line.
One more useful strategy: when your business needs to borrow money, one option that may be beneficial is to get a small business loan that offers the best deal for the company, from the interest rate to the fees charged.
If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.
Photo credit: iStock/Dima Berlin
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