Pratikkumar P. Gaikwad | 15 min read | August 04, 2020
Starting a business often carries risk. As the saying goes, “You have to spend money to make money.”While that’s not always true, there is one very effective way to lower your risk: do a break-even analysis. A break-even analysis will tell you exactly what you need to do in order to break even and make back your initial investment.
Whether you are running a company — or are considering beginning one — you should learn how to do a break-even analysis. It’s a key corporate decision-taking practice.
2. What’s break-even analysis?
A break-even analysis is a valuable method to evaluate where your company, or a new product or service, would be profitable. To put it another way, it’s a statistical equation used to calculate how many goods or services you need to deliver to cover at least the expenses. If you’ve already broken even, you ‘re neither losing money nor making money, but you’ve covered all your expenses.
A break-even review, for example, may help you decide how many mobile phone cases you need to sell to offset your warehouse costs. And how many hours you’ll need to sell to pay for your office space. Everything that you sell above and beyond your break-even point would bring value.
There are a couple of terms that you need to use to understand break-even analysis.
- Fixed Costs: Expenditures that stay the same regardless of how much you sell.
- Dynamic Cost: Expenditures fluctuating with revenue
3. Why do you have to do a break-even analysis
A break-even approach has many benefits to offer.
Finding the break-even point will help you make decent offers for your goods. A lot of research goes into effective pricing, so it’s just as critical to learning how that can impact your profitability. You ought to make sure that all the bills are payable.
Covers operating expenses
As most people think about pricing, they think about how much it costs to make a product. Those are called cost variables. You do have to pay the fixed charges, such as premiums or site creation fees. Running a break-even analysis will help you.
Catch missing expenditure
Once you go about a new business idea, it is possible to forget the expenses. You have to map out all your financial obligations and work out the break-even point while you do a break-even analysis.
Set revenue targets
Once a break-even analysis is complete, you know just how many you need to sell to be competitive. It would allow you and your team to set more realistic revenue goals for you. It would be much easier to follow along because you have a clear number in mind.
Make smarter decisions
Entrepreneurs often make emotionally based business decisions. If they feel good about a new undertaking they will be going for it. It’s relevant how you feel but it’s not enough. Successful business people make their choices based on evidence. Deciding when you’ve put in the effort and have valuable evidence in front of you would be a lot simpler.
Limit financial burden
Conducting a break-even study tends to reduce damage by telling you where to skip an idea. It can help you escape mistakes and reduce the financial impact that poor business decisions will have. You can actually be realistic about the potential outcomes instead.
Financing your company
An overview of break-even is a vital aspect of every business strategy. If you want to take on equity or other leverage to finance your venture, it is generally a necessity. You need to show that the strategy is workable. Other than that, if the report looks fine, you’ll be more comfortable to take on the financial burden.
4. When should a break-even analysis be used?
There are four situations where performing a break-even analysis is useful.
Venturing into a new business
A break-even review is a must if you ‘re contemplating beginning a venture. This will not only help you determine if your business plan is feasible but will also push you to do analysis to be cost-realistic as well as look about your pricing strategies.
Creation of a new product
If you already have a business, before committing to a new product, you should still do a break-even analysis — especially when that product will add significant expenses. Even if your fixed costs, like an office lease, remain the same, the variable costs associated with your new product will have to be worked out and prices set before you start selling.
Adding a new channel of sales
Your expenses will change every time you add a different distribution channel — even if the rates don’t. For starters, if you’ve been selling online and you’re looking to do a pop-up store, you ‘re going to want to make sure you break even at least. Otherwise, the financial strain could endanger the rest of your business.
This also applies to the addition of new online sales channels, such as shoppable Instagram posts. Are you planning any additional channel-promoting costs, like Instagram ads? These costs will be part of the measurement of break-even.
Adjust the operating model
For example, if you are thinking about changing your business model, switching from dropshipping products to inventory carrying, you should do a break-even analysis. Your costs may change substantially, and this will help you figure out if your prices need to change too.
5. The formula for Break-even analysis
Let’s break down how the formula works before we start measuring break-even percentages.
Your break-even point, divided by your market price, is equal to your fixed costs minus variable costs.
Break-Even Point = Fixed Costs/(Average Price — Variable Costs
Basically, you have to work out what the net income per unit sold is, and split by that amount the fixed costs. This will inform you how many units you will sell before you begin to make a profit.
As you now know, sales of your product need to pay more than just the cost of making them. The residual income is known as the margin of contribution because it adds cash to the fixed costs.
6. Limitations to break-even analysis
Break-even analysis plays an important role in making business decisions, but the amount of knowledge that it can offer is limited.
Not a demand predictor
It’s important to remember a break-even analysis isn’t a market indicator. This will not tell you what the profits will be, or how many buyers will buy what you have. It’ll tell you exactly how many units you need to sell to break even. It is important to remember also that the market is not constant. As you change your price, so too will the number of people willing to buy your product.
Depends on accurate data
Often the prices fall into divisions of both fixed and variable. This will make difficult equations and you’ll definitely have to wedge them into one or the other. For example, you might have a cost of baseline labor as well as an extra cost of labor that could fluctuate depending on how much merchandise you deliver.
Your break-even point accuracy depends on the quality of the data. If you don’t fill in the formula with good results, you won’t get an accurate result.
The formula for break-even points is simple. Many businesses have many goods at different rates. It’s not going to be able to pick up that complexity. You’ll either have to work on one product at a time or predict an overall price based on all the items that you could offer. If this is the case, the best way to be better prepared is to run a couple of different scenarios.
When markets fluctuate, so do the costs. The model assumes that only one aspect varies at a time. Instead, if you lower your price and sell more, your variable costs may decrease because you have more purchasing power or are able to work more efficiently. It’s just a guess at the end of the day.
Does not take time into account
The break-even measurement over time excludes any variability. The time period will depend on the amount of time you use to measure the fixed costs (the most common is monthly). While you’re going to see how many units you need to sell over the course of the month, you ‘re not going to see how things change if the sales fluctuate week after week or seasonally over a year. You will need to rely on good cash flow management for this, and probably a solid revenue forecast.
It does not take into account the future, either. The study on break-even is just here and there. If the cost of your raw materials doubles next year, the break-even point will be much higher unless you raise prices. You could lose customers if you raise your prices. This delicate balance is inherently unpredictable.
Ignore the competition
Being a potential industry entrant, you should have an impact on the competition, and vice versa. They might change their prices, which might affect your product ‘s demand, causing you to change your prices too. If they expand exponentially, and the raw material that you all use is scarcer, the cost will rise.
In the end, break-even analysis will give you a very good view of the basic criteria for performance. It is a must-have. But it’s not the only work you need to do before you start a company, or make adjustments.
7. Strategies for lowering your break-even point/h2>
What if you complete your break-even analysis and find out that you need to sell too many units? Don’t worry if the figure feels impossible or unattainable. Few modifications can be made to lower the break-even point.
Lower fixed cost
See if there’s a way to push down the fixed costs. The cheaper you can get them, the fewer units that you’ll need to sell to break-even. When you are dreaming about opening a convenience store, for example, and figures aren’t working out, try selling online instead.
Increase your prices
If you raise rates, you ‘re not going to have to sell too many units to break even. The cumulative output would be higher per product delivered. Be mindful of what the consumer is prepared to pay and perceptions that come with a premium as you talk of raising the rates. You ‘re not going to have to sell too many products, but you’re still going to have to sell enough — and if you charge more, customers may demand a better product or better service.
Lower the costs of variables
Reducing your variable costs is often the hardest option, especially if you’re just getting into the business. Yet the higher you scale, the better it becomes to cut back on variable costs. Trying to lower your prices by bargaining with your vendors, moving vendors, or modifying the method is worthwhile. Perhaps you’ll find, for example, that packing peanuts are cheaper than bubble wrap to ship fragile products.