A break-even analysis is an invaluable tool for any small business. Simply put, a break-even analysis shows you when your business will break even—when you will cover all the costs of being in business and making your product and start to turn a profit.
The core of a break-even analysis is a simple equation:
Break-even point = Fixed costs ÷ (Unit price – variable costs per unit)
Let’s take a closer look at each of these terms.
Your fixed costs are the costs of just keeping your doors open. Think about what your budget would look like if your business didn’t make or sell any products, but you still had a store and employees. You’d be paying only your fixed costs, which would include things like:
- Utilities and phone bills
- Equipment (bought or leased)
- Interest on debts
Any bill you have to pay before you sell a single thing, and any bill you have to pay every month regardless of how many items you sell, is a fixed cost.
Variable costs are the costs of actually making your product. If you’re operating a restaurant, for example, this includes the cost of purchasing ingredients. If you’re making jewelry, the cost of your raw materials is a variable expense—something you only have to pay when you’re making your product. No matter what your business is, marketing and advertising is a variable cost because you pay it when you’ve actually got something to sell.
Staffing costs can actually be split between fixed and variable costs. If you operate a clothing store, for example, and you pay your employees a base rate plus commission, that base rate is a fixed cost and the commission is a variable cost.
Here’s where the break-even analysis really gets interesting. You set your own prices, and your break-even analysis will look vastly different based on the prices you set. A higher price would help you break even faster—but only if you can actually sell enough product at that high price.
Setting the right price for your products involves some additional calculations, and some important judgment calls. Basically, you want to price your product high enough that you make at least a small profit on each unit sold, but not so high that customers are turned off and it’s hard to make sales.
Using the formula
Now that you know what your costs are and how much you will charge for your product or service, you can plug those numbers in to the break-even analysis formula and see what happens. Use this interactive break-even calculator to play with some numbers and see how it works.
Let’s say you make hand-knit sweaters that you sell for $100 each. If your fixed costs to start up shop are $10,000, and you pay $30 per sweater in materials and other variable costs, you will break even once you sell 143 sweaters. If you discount your sweaters to $75 to drum up more business, you’ll have to sell 223 sweaters to break even. If you use cheaper yarn and cut your variable cost per sweater to $20, you only have to sell 125 sweaters at $100 to break even.
When to use it
Obviously, a break-even analysis is incredibly useful when you’re thinking about starting a new business. Doing this analysis will show you how long it will take you to cover your startup costs. If you need to sell 143 sweaters, and you estimate you can sell 10 sweaters a month, it’ll take you more than a year to break even. If you’ve got the savings to make that work, great. If not, you’ll either need to cut your costs or sell sweaters faster.
You can use a break-even analysis in an established business, too. It’s a great exercise to do before launching a new product, for example. You can use the break-even formula to help you figure out the best price for your new product. You could also use this tool if you’re thinking of making a big investment in new equipment, additional staff, or a new marketing campaign. A break-even analysis could show you how long it will take to cover the costs of that investment.
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