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Every good business starts with a good business plan, including a break even analysis. As a business owner, especially when you’re starting out, it’s important to understand at what point you will break even in terms of revenue. Knowing this so you can finally begin to make a profit is an essential part of financial planning and budgeting. Fortunately, there’s a break even formula that can give you this exact figure. Up until that point, you will have spent a lot of money to launch the venture. If it takes too long to recover that money, the business will be doomed. This is why it’s essential to learn more about this topic and share some valuable information to help you succeed. Read on to learn more about break even analyses, how to make one, and how to use a break even point formula to calculate your business’s break even point.
What is a Break Even Analysis?
A break even analysis is a process that helps you determine what pricing structure to use to estimate when the business will become profitable. By using some simple math, you can calculate both variable and fixed costs. This helps you determine at what point the business will simply cover costs, or “break even.” It also helps you calculate when you will begin to turn a profit.
Why Should You Conduct a Break Even Analysis?
At the end of the day, you need to clearly know whether your entity will be sustainable or not. If your pricing is too low and your costs are high, for example, you will have to close your business rather quickly.
What would happen if it took your establishment two years to reach its break even point? Do you think you would be able to remain open? This is why forecasting how long it will take to reach this point is essential.
In addition, knowing how to calculate your break even point will ensure you conduct a proper analysis to forecast when this new pursuit will generate gains. Not to mention, this will help you create more efficiencies in your supply chain strategy now and in the future.
Thankfully, there are some break even point (BEP) formulas to help you discover this as part of your analysis. Read on to learn how to calculate break even point figures for your business.
Take a good look at the cost of your materials and calculate how much labor is used as well. Is this figure feasible?
There are two types of costs to examine:
- Fixed Costs: These costs remain the same no matter how many units of a product or service you sell. For example, your rent, equipment, hosting, or insurance, to name a few.
- Variable Costs: this type of cost is dependent on each sale. These are costs like materials and labor. If you sell a toy product, for example, the more units you sell, the more of these you’ll need.
Once you look at these costs and write them down, it’s now time to set your goals and target unit sale amounts. This next step is essential for your break even analysis.
Set financial goals & targets
Goals are powerful motivators. After conducting a thorough cost and cash flow analysis, it will become clear how many units will need to be sold to reach the breakeven point at your current price per unit. You may decide to set a target such as selling 1000 units by the end of the quarter. Perhaps you know the revenue generated will lead to a $100,000 profit after the 3 months. This money can help you reach larger goals. For example, expanding your labor force, marketing more aggressively, or increasing product quality. Whatever goals you create, they must be realistic and inspire you and your workers to reach them. Don’t forget about creating a business impact analysis in case disaster strikes. The future is uncertain and it’s better to be over-prepared than under.
Like with any good goal, it’s important to communicate a clear expectation of when that goal will be reached.
To help you price more efficiently
Many times, after identifying costs, business owners find they have either been pricing their products too low or too high. This prevents them from reaching the break even point in their desired timeframe. In these scenarios, it will be important to analyze the competitors in the market. This will help you see where you can price items more appropriately. Additionally, it will help you achieve your financial goals in the desired time frame.
Having a clear and defined pricing strategy will also eliminate the need for guesswork later down the road. Knowing a rough figure of what you can make in a time period is essential in creating your break even analysis.
How to Calculate Break Even Point
To make life easier, a break even point formula is used to calculate the BEP. There are a couple versions we will cover. One is based on the number of units sold. The other is based on a points system derived from the sales price. Which is best for your business will be up to you and the type of goals and products/services you have. In the next section, we will share how to use each formula and help you understand how they work. It will become much easier to choose a formula to use in your analysis once you compare them.
Calculating your break even formula
There are two common ways to calculate your break even formula: by units and by points. Based on the nature of your business, you’ll be able to decide which break even formula will work for you. The two most common formulas are:
- Based on Points = Total Fixed Cost / (Revenue per Unit – Variable Cost per Unit). Revenue is how much the sale of a unit made minus the variable cost.
2. Based on Units Sold = Fixed Costs / Contribution Margin (Sales Price of a Unit – Variable Cost)
Break Even Analysis: Don’t Let It Intimidate You
As you can see, the math is relatively simple no matter which break even formula you use. Do not let this component of your business plan scare you. The benefits of conducting this type of analysis far outweigh the costs associated with NOT performing one.
After you have completed a break even analysis, you will have a better idea of how to price your items. Many entrepreneurs make the mistake of bringing a product or service to market without fully understanding the total costs involved. Not knowing this and the prices you can charge could prove to be a costly mistake.
A break even analysis will help you discover if you need to reduce or improve your material and labor costs. It will also tell you at what point you will break even, and help you form a long-term plan for when you will achieve your next goal. Begin analyzing your costs today and you will be done with your BEP analysis in no time! Whether you just registered your business or have been operating for years, you will thank yourself for completing this vital step.