You may have an idea that spurs you to open a business or launch a new product on little more than a hope and a dream. Or, you might just be thinking about expanding a product offering or hiring additional personnel. It’s wise, however, to limit your risk before jumping in. A break-even analysis will reveal the point at which your endeavor will become profitable—so you can know where you’re headed before you invest your money and time.
A break-even analysis will provide fodder for considerations such as price and cost adjustments. It can tell you whether you may need to borrow money to keep your business afloat until you’re pocketing profits, or whether the endeavor is worth pursuing at all.
What Is Break-Even Analysis?
A break-even analysis is a financial calculation that weighs the costs of a new business, service or product against the unit sell price to determine the point at which you will break even. In other words, it reveals the point at which you will have sold enough units to cover all of your costs. At that point, you will have neither lost money nor made a profit.
- A break-even analysis reveals when your investment is returned dollar for dollar, no more and no less, so that you have neither gained nor lost money on the venture.
- A break-even analysis is a financial calculation used to determine a company’s break-even point (BEP). In general, lower fixed costs lead to a lower break-even point.
- A business will want to use a break-even analysis anytime it considers adding costs—remember that a break-even analysis does not consider market demand.
- There are two basic ways to lower your break-even point: lower costs and raise prices.
How Break-Even Analysis Works
A break-even analysis is a financial calculation used to determine a company’s break-even point (BEP). It is an internal management tool, not a computation, that is normally shared with outsiders such as investors or regulators. However, financial institutions may ask for it as part of your financial projections on a bank loan application.
The formula takes into account both fixed and variable costs relative to unit price and profit. Fixed costs are those that remain the same no matter how much product or service is sold. Examples of fixed costs include facility rent or mortgage, equipment costs, salaries, interest paid on capital, property taxes and insurance premiums.
Variable costs rise and fall according to changes in sales. Examples of variable costs include direct hourly labor payroll costs, sales commissions and costs for raw material, utilities and shipping. Variable costs are the sum of the labor and material costs it takes to produce one unit of your product.
Total variable cost is calculated by multiplying the cost to produce one unit by the number of units you produced. For example, if it costs $10 to produce one unit and you made 30 of them, then the total variable cost would be 10 x 30 = $300.
What is Contribution Margin?
The contribution margin is the difference (more than zero) between the product’s selling price and its total variable cost. For example, if a suitcase sells at $125 and its variable cost is $15, then the contribution margin is $110. This margin contributes to offsetting fixed costs.
Unit Contribution Margin = Sales Price – Variable Costs
The average variable cost is calculated as your total variable cost divided by the number of units produced.
In general, lower fixed costs lead to a lower break-even point—but only if variable costs are not higher than sales revenue.
Why Does Your Business Need to Perform Break-Even Analysis?
A break-even analysis has broad uses on its own merit. But it’s also a critical element of financial projections for startups and new or expanded product lines. Use it to determine how much seed money or startup capital you’ll need, and whether you’ll need a bank loan.
More mature businesses use break-even analyses to evaluate their risks in a variety of activities such as moving innovative ideas to production, adding or deleting products from the product mix and other scenarios. One example is in budgeting the addition of a new employee. A break-even analysis will reveal how many additional sales it will take to break even on expenses associated with the new hire.
What Is a Standard Break-Even Time Period?
An acceptable break-even window is six to 18 months. If your calculation determines a break-even point will take longer to reach, you likely need to change your plan to reduce costs, increase pricing or both. A break-even point more than 18 months in the future is a strong risk signal.
When to Use a Break-Even Analysis
Basically, a business will want to use a break-even analysis anytime it considers adding costs. These additional costs could come from starting a business, a merger or acquisition, adding or deleting products from the product mix, or adding locations or employees.
In other words, you should use a break-even analysis to determine the risk and value of any business investment, especially when one of these three events occurs:
1. Expanding a business
Break-even points (BEP) will help business owners/CFOs get a reality check on how long it will take an investment to become profitable. For example, calculating or modeling the minimum sales required to cover the costs of a new location or entering a new market.
2. Lowering pricing
Sometime businesses need to lower their pricing strategy to beat competitors in a specific market segment or product. So, when lowering pricing, businesses need to figure out how many more units they need to sell to offset or makeup a price decrease.
3. Narrowing down business scenarios
When making changes to the business, there are various scenarios and what-ifs on the table that complicate decisions about which scenario to go with. BEP will help business leaders reduce decision-making to a series of yes or no questions.
How Do You Calculate the Break-Even Point?
ERP and accounting software with managerial accounting features will typically calculate your BEP for you, but you may want to understand what goes into that equation.
Break-even analysis formula
Break-even quantity = Fixed costs / (Sales price per unit – Variable cost per unit)
You can also use our break-even analysis template.
Break-even analysis example
Beth has dreams of opening a gourmet cupcake store. She does a break-even analysis to determine how many cupcakes she’ll have to sell to break even on her investment. She’s done the math, so she knows her fixed costs for one year are $10,000 and her variable cost per unit is $.50. She’s done a competitor study and some other calculations and determined her unit price to be $6.00.
$10,000 / ($6 – $0.50) = 1,819 cupcakes that Beth must sell in one year to break even
The Limitations of a Break-Even Analysis
The most important thing to remember is that break-even analysis does not consider market demand. Knowing that you need to sell 500 units to break even does not tell you if or when you can sell those 500 units. Don’t let your passion for the business idea or new product cause you to lose sight of that basic truth.
On the flip side, you’ll need to decide how much effort and time you’re willing to expend to reach the break-even point. For example, are you willing to invest a substantial percentage of your sales team’s time and effort over several months to reach the break-even point? Or, is producing and selling something else a better and more profitable use of time and effort?
If you find demand for the product is soft, consider changing your pricing strategy to move product faster. However, discounted pricing can actually raise your break-even point. If you’re not careful, you’ll move product faster at the lower price but will incur more variable costs to produce more units in order to reach your break-even point.
How to Lower Your Break-Even Point
There are two basic ways to lower your break-even point: lower costs and raise prices. But neither should be done in a vacuum. Weigh your options carefully in pricing methods and consumer psychology to make sure you don’t sell more product but lose money in the bargain.
Further, consider all elements of costs, such as the associated quality and delivery, before slashing them to prevent damage to your brand. Outsourcing products or service can also reduce costs when demand or volume increase.