A break-even point is simply the point at which your business’s revenue equals the costs and expenditures of operating the business. This data is infinitely valuable as it sets the framework for pricing structures, operations, hiring employees, and obtaining future financial support. Without a break-even point, how will you identify how much you have to sell your product to become profitable? How will you identify costs inside your business that should be alleviated or eliminated? No one goes into business to offer products at a loss, so before you ever sell a single thing, a break-even analysis should be at the top of your priority list.
Break-even analysis reports are crucial to any and every investment. Without proper forecasting on when your business will begin being profitable, you may lack the proper data to answer questions for potential investors and even banks when asking for a loan. Lucky for us, there are some great techniques available to aid us in calculating a break-even point.
The equation you’ll need to familiarize yourself with is simple and has two different variations depending on which break-even point analysis you’d like to conduct. There is a break-even point analysis for the products you sell, and there is a break-even point for overall sales generated. Before you get started on either of these analyses, you’ll want to understand the two different categories of costs your business will incur.
Your fixed costs are costs that do not change, despite the number of products you sell. For example, this may be rent or the monthly cost of internet.
The variable costs are costs that change depending on how many products you manage to sell. These are costs such as manufacturing, shipping, and labor required to sell your products. The more you sell, the higher these costs will be, and since you likely won’t sell the same amount of products (hopefully more as time passes), these costs will change month to month.
As a last tidbit, before we get started, we need to define revenue and contribution margin.
Revenue is the money generated by the operation of your business before taking into consideration the costs associated with the operation of the business. (Total Sales = Revenue)
Contribution margin is the measure of the profitability of a product and is calculated by subtracting the variable costs from the price of the product and then dividing the number by the sales to get a percentage.
(Sales - Variable Costs ÷ sales x 100 = Contribution Margin %)
Break-Even Point (Products) = Total Fixed Costs ÷ (Revenue per Product - Variable Cost per Product)
To determine the break-even point by product, we’ll be dividing fixed costs by the revenue per product and subtracting that value from the variable cost of each product. We want to see how many units we need to sell in order to cover the costs associated with each product.
Break-Even Point (sales dollars) = Fixed Costs ÷ Contribution Margin
To determine our break-even point for the operation of sales, we’ll need to divide our total fixed costs by the contribution margin to figure out how profitable our entire business model is.
Consider the example below.
Company XYZ sells a product for $1,000 with variable costs at $200 and fixed costs at $300. This means XYZ has a total revenue of $1,000, while it’s contribution margin is $800. To figure out profitability, we’ll subtract those $300 in fixed costs from our $800 contribution margin to get $500 in profit.
Figuring out our break-even on 50 products would look like the process below.
Variable costs = $200 x 50 = $10,000
Revenue on 50 Products sold = 50 x $1,000 = $50,000
Contribution Margin = $50,000 - $10,000 = $40,000
Profitability on 50 products = $40,000 - 15,000 = $25,000
Break-even by products on 50 products would be the sale of 25 products to cover our costs of goods.
Break-even by sales dollars would be $25,000 since we would need that amount to cover our costs.
In this example, since our contribution margin is 50%, we would need to sell half, or 25 of our units to generate $25,000 for our business to cover its costs to hit its break-even point.
It’s at this point that your business will be judged by investors, banks, and ultimately, by you. If your company has to sell more products than it purchases to break-even, that means your company will operate at a loss, which means you’d be hard pressed to find investors or get a loan to start your business.
If your business is operating at a loss, you need to figure out what went awry. Perhaps your cost to acquire each product is higher than what you can sell it for, meaning you’ll need to find a cheaper source of products or choose a different product. Maybe your fixed costs are too high, meaning you could move your business to an area with cheaper rent or cut costs by eliminating processes that aren’t necessary to business operations.
Say you don’t sell all of your units, or you need to discount units to sell them, drastically changing your break-even point. It’s for this reason a break-even point that is close to your total profit should be a warning of possible losses. If anything goes wrong and your break-even analysis shows you have to sell 95% of your products to break-even, you may end up in the red, despite your forecast showing you should be profitable. The less product you have to sell to achieve break-even, the safer this venture may be!
Break-even analysis points make for fantastic goal setting. Using your break-even forecast to notify your sales team of sales goals is a powerful motivating tool and may help to create a bonus reward system if needed.
Ultimately, performing a break-even analysis is one step of the business planning process and should be conducted before launching a new product into the market. One of the top reasons why a business fails is a failure to plan ahead. Break-even analysis is just one part of a large-scale plan that you should have prepared long before launching. By using the Hubworks Zip Forecast software, you can accurately create a plan that reflects the amount of inventory you need to break-even as well as calculate and organize your fixed and variable costs!