Why Break-Even Analysis is Important for Your Small Business
One of the most important accounting ratios that new business owners can perform is break-even analysis. A break-even analysis is used to determine when your company will become profitable.
It can also be used when introducing a new product or service to your company, allowing you to determine the number of products or services you will need to sell in order to begin making a profit.
Overview: What is a break-even analysis?
A break-even analysis helps you determine when your business will become profitable. Useful for businesses of all sizes, a break-even analysis is used in managerial accounting and is particularly useful for small business owners that are operating with much tighter cash flow.
In fact, if you’re a small business owner whose cash flow statement is consistently in the red, one of the best things you can do is to perform a break-even analysis on your product lines or on your business.
In order to understand and use the break-even analysis formula, you and your small business bookkeeper need to be familiar with the following accounting terms:
- Fixed Costs: Fixed costs are those costs not related to production. Things like rent, depreciation, administrative costs, and non-production wages are considered fixed costs. You can find your fixed costs on your profit and loss statement or income statement.
- Variable Costs: Variable costs are always related to production, and vary with production levels. Variable costs include raw materials, direct labor, fuel, and anything else that may fluctuate depending on production. You can also find your variable costs on your profit and loss statement or income statement.
- Contribution Margin: Contribution margin is a product’s price after all variable costs have been removed. Contribution margin can be helpful in determining whether a product or service is priced too high or too low. In other words, if you’re selling coffee mugs for $15 and the cost of the materials to produce the coffee mug is $9, your contribution margin is $6.
What is the break-even analysis formula?
There are two break-even calculations you can use to determine when your business will become profitable: a break-even formula that uses units sold and a break-even formula that uses total sales dollars.
The break-even analysis formula to calculate break-even point in units sold is as follows:
Fixed Costs ÷ (Average Price - Variable Costs) = Break-Even Point
The first step in preparing break-even analysis is to determine all of your costs. This can be done by examining all of your operating expenses as well as your cost of goods sold.
You can also calculate your break-even analysis using sales dollars rather than units sold by using your contribution margin, which is determined by subtracting all of your variable costs from the price of a product.
Fixed Costs ÷ Contribution Margin = Break-Even Point
A real-world break-even analysis example
The first example we’ll use is for creating a break-even point using the number of units sold. Jim is thinking of starting a new business selling specialty flashlights.
The flashlights will be priced at $29.99, with the material cost of manufacturing each flashlight $18.00. The rent on the production plant will be $2,500, with additional fixed costs of $500 for a total of $3,000 each month.
Do not include regular operating expenses when calculating fixed costs. Before starting his business, Jim wants to know how many flashlights he will have to sell each month in order to break even. The calculation would be:
$3,000 ÷ ($29 - $18 ) = 273 Units
This means that Jim will need to sell at least 273 units in order to break even.
If Jim wants to see break-even sales dollars, he would take his contribution margin and subtract his variable or material costs and then divide that by the sales price. There are two calculations you would need to do in order to calculate break-even point in sales dollars.
First, you’ll have to calculate your contribution margin. The contribution margin calculation is:
$29 - $18 ÷ $29 = .379
Now that you have your contribution margin, you can calculate your break-even point by dividing your fixed costs by your contribution margin. That calculation is:
$3,000 ÷ .379 = $7,916
This means that Jim will need to earn $7,916 in sales of flashlights before he will break even.
Why should a small business perform a break-even analysis?
If you’re starting a new business or adding a new product line to your current business, performing a break-even analysis can help you determine the timeframe before your new business or product line becomes profitable. Here are some other reasons why a break-even analysis can be helpful:
1. Product/service vetting
Knowing when your product, service, or business will become profitable is important for both new and existing businesses. Great ideas can lead to a best-selling product or service, but only if that product or service can be sold at a profit.
For instance, you decide you would like to sell vegan dog treats, but as you calculate potential fixed costs and research local suppliers, you realize that the cost of creating those treats will cost nearly as much as they should sell for. That’s why break-even analysis is a must before launching a business or a new product line.
2. It’s a necessity for investors
If you’re actively looking for investors to fund your new business or add an influx of cash to your existing business, you will need to perform a break-even analysis. This calculation is one that investors and financial institutions take a long look at. After all, if your product isn’t profitable, your business will ultimately fail.
3. If you’re making the move to a brick and mortar store
If you’ve been selling your products online and want to make the move to a storefront, before signing a lease, be sure and prepare a break-even analysis to see how quickly you will be able to make a profit after adding your additional fixed costs such as rent and insurance.
How to use the results of your break-even analysis
Creating a break-even analysis provides you with the resources you need to make educated business decisions in areas such as pricing levels and supplier costs.
For instance, if your break-even point is unsustainable, are there things you can do to improve it such as finding another supplier with more reasonable costs, or locating a smaller building in order to pay less in rent? Can you operate the business from your home and forego rental costs altogether?
Keep in mind that while a break-even analysis can be useful, it’s not an exact science, particularly if your business sells a variety of products.
In that case, it’s best to use an average cost when calculating your break-even analysis, or combine the results with other resources such as your balance sheet or general ledger report.
Learn when your business will start earning a profit
It may sound complicated, but calculating your break-even analysis for your business is simple. Whether you’re creating a budget for your new business or your bookkeeper is calculating financial projections for your new product line, calculating your break-even analysis can provide you with the information you need to become and remain profitable.
If you’re tired of tracking your business costs on spreadsheet software, be sure to check out The Ascent’s accounting software reviews.
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