Break-even analysis is a financial tool used to determine the point at which a company’s revenues and expenses are equal, resulting in no profit or loss. It is used to determine the minimum level of sales or units that a company must achieve in order to cover its total costs. This point is known as the “break-even point” and is represented by a specific number of units or sales dollars.
To perform a break-even analysis, a company must first identify its fixed and variable costs. Fixed costs are expenses that do not change regardless of the level of production, such as rent and salaries. Variable costs, on the other hand, are expenses that change with the level of production, such as materials and labour.
Once these costs are determined, the company can calculate the break-even point by dividing the total fixed costs by the difference between the selling price per unit and the variable cost per unit. This will give the company an idea of how many units it must sell in order to cover its costs and start making a profit
Break-even analysis explained
The point at which total revenue and total cost are equal is known as the break-even point. The amount of income or units required to pay all of your company’s costs is determined by a break-even analysis.
You won’t be losing money or making any at the break-even point, but all of your business’s expenses will have been paid. The sales that your company generates after breaking even are pure profit. Simply put, break-even analysis aids in identifying the point at which a new product or service will become viable for your company. Investors also use it to identify the point at which they will recover their investment and begin to profit.
So when is a break-even analysis necessary? It can be a great tool to utilise when beginning a new business because it allows you to assess the viability of the concept. Additionally, it gives you data you may utilise to create your pricing plan.
Additionally, if the development of a new product is very expensive, it is a good idea to conduct a break-even analysis. Finally, it’s always a good idea to perform a break-even analysis if you make any kind of change to your organisation, such as introducing a new sales channel or switching your distribution model, as your costs can change significantly.
How to calculate break-even point
The break-even analysis is not too complicated. To determine the break-even point, apply the break-even analysis equation shown below:
Break-Even Quantity = Fixed Costs / (Sales Price Per Unit – Variable Costs Per Unit)
To illustrate how this actually functions, let’s have a look at an example. Tennis racquets are sold and manufactured by Company A, and their fixed expenses come to £250,000. (lease, payroll, property tax, etc.). Tennis racquet production has variable costs of £10 per unit, and each racquet is sold for £50. The break-even analysis formula can be used to determine Company A’s break-even point:
250,000 / (50-10) = 6,250
Therefore, for Company A to break even, 6,250 tennis racquets would need to be sold.
Strengths and weaknesses of break-even analysis
There are many reasons why conducting a break-even analysis for your company might be a smart idea:
- Pricing – You may price your products from a far more reliable base using break-even analysis. Determine how patient you can afford to be by taking a look at your current financial condition and estimating the time it will take you to reach your break-even point.
- Setting revenue targets – Additionally, conducting a break-even analysis can be a wonderful tool for helping your team define specific sales goals. Making decisions about revenue targets is always going to be simpler if you have a specific amount and a time frame in mind.
- Mitigate risk – Some company concepts are simply not meant to be pursued. By steering clear of investments or product lines that aren’t likely to be lucrative, break-even analysis can help you reduce risk.
- Gaining funding – It’s important to remember that break-even analysis is frequently a crucial element of business plans. You’ll likely need to conduct a break-even analysis if you want to secure finance for your startup or company. A modest break-even point will also probably make you feel more at ease with the idea of taking on further debt or funding.
However, it’s important to recognise the limits of a break-even analysis:
- Doesn’t predict demand – A break-even analysis can tell you when you’ll break even, but it cannot tell you how probable it is to occur. In addition, demand fluctuates, so even if you believe there is a market gap, your break-even threshold may be much higher than you previously anticipated.
- Depends on reliable data – In other words, the correctness of your data will determine how accurate your break-even analysis is. Break-even analysis might not be the most helpful tool in your toolbox if your calculations are inaccurate or you have to cope with shifting prices.
- Too simple – For businesses with a single pricing point, break-even analysis works well. Break-even analysis can be too basic for your needs if you have many goods with different prices. Additionally, keep in mind that expenses might fluctuate, so your break-even threshold could need to be reassessed and modified in the future.
- Ignores competition – An additional drawback of a break-even analysis is that competitors are not taken into account. New competitors may alter consumer demand for your goods or force you to adjust your prices, which will probably have an impact on your break-even point.
All in all, to receive the most accurate picture of your company’s financial situation, it’s ideal to perform a break-even analysis in conjunction with other profitability measures, such as net profit margin.
Conclusion
Break-even analysis is an important tool for businesses to determine the point at which their revenue and expenses are equal. By understanding the break-even point, businesses can make informed decisions about pricing, production, and other factors that impact profitability. Additionally, break-even analysis can be used to assess the potential profitability of new products or services, and to identify areas where cost savings can be achieved. Overall, break-even analysis is a valuable tool for businesses of all sizes to help them make informed decisions that improve their bottom line.
With over three decades of experience in the business and turnaround sector, Steve Jones is one of the founders of Business Insolvency Helpline. With specialist knowledge of Insolvency, Liquidations, Administration, Pre-packs, CVA, MVL, Restructuring Advice and Company investment.