Breaking even for a new company, product or service is a great achievement. It means that you have reached a stage where you can start reinvesting in your business or build reserve funds for unexpected events.
“Whether a start-up or established business, small or large, break even analysis helps ensure your business remains viable, is realistic about costs, understands the sales required to remain in profit, and can be realistic about pricing strategy,” says John Edwards, CEO of the Institute of Financial Accountants.
Here we look at what a break even analysis entails, how to go about doing it, and the key benefits (as well as drawbacks) for your business.
What is a break even analysis?
A break even analysis is used to understand when a new company, product or service, is likely to be generating enough revenue through sales to meet the costs involved in making or delivering it. This is known as the break even point.
How does a break even analysis work?
A break even analysis details all the costs involved in making and delivering your new product or service and your average sale price per unit. It then uses this data to calculate the number of units you need to sell, or the total amount of revenue you need to generate, in order to fully meet these costs and start making a profit. To calculate break even point, it's important to know the distinction between different types of overhead costs: fixed costs and variable costs.
Fixed costs do not change and must be paid regardless of whether or not you sell any units. For example, equipment, salaries, utilities and insurance. Variable costs change according to sales volumes, and include items such as sales commission, raw materials and shipping.
While businesses typically use a break even analysis before launching a new venture, Edwards says it can be beneficial to perform a break even analysis more regularly. For example, in times of rising and high inflation when business costs spiral, Edwards says it's essential to understand how that might impact your break even point.
4 benefits of a break even analysis
As well as the baseline benefit of knowing what you need to sell to meet your costs, there are other, more strategic benefits of carrying out a break even analysis.
Smarter pricing
“A break even analysis will help you to price smarter, knowing that it will not only cover your fixed and variable costs, but make a profit,” says Edwards. Once you’ve inputted the data, you can explore different scenarios, for example by looking at how a price increase will affect your profit, or what the lowest acceptable sales price is for your new product or service.
“For making smarter decisions, a break even analysis can turn your gut feeling into pounds and pence,” Edwards says, giving you the data you need to understand if and when a new venture has the potential to become profitable. And as you grow, the extended payment terms of an American Express® Business Gold Card, which offer up to 54 days to clear your balance, can support you in more efficiently managing your cash flow, by giving you greater control over when you pay expenses¹.
Set accurate sales revenue targets
A break even analysis shows you how many units you need to sell or how much revenue you need to generate to cover costs. You can use this to set monthly, quarterly and annual sales targets that enable you to reach your break even point as quickly as possible.
Limit financial strain
Understanding how many products you need to sell or how much money your business needs to earn in order to cover its costs, supports you in making funding decisions to limit financial strain. For example, you can see whether or not you have sufficient cash reserves to support your new venture before it breaks even or whether you need to source more funding. It will also quickly highlight products or services that will never make you money, says Edwards.
Curb costs
Once you’ve calculated your break even point, you can explore ways of lowering it, such as through cost-cutting, in order to improve your operating profit. For variable costs, this could include negotiating with suppliers.
For fixed costs, Edwards says it’s about how and where you innovate and take a new approach. “For example, bricks and mortar offices or retail outlets carry more costs than working from home or selling online."
How to do a break even analysis
There are two main break even formulas you can use. The first looks at the number of units you need to sell to reach break even point and the second looks at the sales value you need to generate to break even.
Let’s take a closer look at how these calculations work.
The break even formulas
Break even point (target sales)
To calculate your break even point based on the number of units you need to sell, take your fixed costs and divide this by your average product price, minus your total variable costs.
Break-Even Point (Quantity) = Fixed Costs / (Sales Price Per Unit - Variable Costs Per Unit)
Break even point (confirmed sales)
To calculate break even point based on sales, you first need to work out the ‘Contribution Margin’ which is calculated as follows:
Contribution Margin = (Sales Price Per Unit - Variable Costs) / Sales Price Per Unit
Once you have this number, take your total fixed costs and divide it by the contribution margin.
Break-Even Point = Fixed Costs / Contribution Margin
Limitations of a break even analysis
Relies on a steady market
A key limitation of break even analysis is that it does not account for market fluctuations or competition. It also assumes that all products are sold at the same price. Further, it relies on the accuracy of the data inputted and it’s not uncommon for businesses to underestimate or omit relevant costs when determining prices, says Edwards.
Remember to update regularly
Less a limitation and more a point to note is that a break even analysis is effectively a projection or a best guess at any point in time. This means that if the process isn’t embedded into what you do, the information can quickly become out-of-date, and even damaging, if relied upon too heavily.
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