5 Easy Steps to Creating a Break-Even Analysis
Break-even is one of those vital numbers that can mean success or failure to a small business. If you are breaking even your income is are equal to your costs. You have no profit or loss at this point. But, above the break-even point, every dollar of sales is pure profit.
How to Use a Break-Even Analysis in Financial Planning
A break-even analysis is important in several different situations:
- As your business plans new products, knowing the break-even point helps you price more efficiently.
- As you plan your overall business cash and profit strategy, break-even can be used to determine profit points for product lines.
- As your business plans for financing, knowing your overall company breakeven point can help make your case for a business loan.
A lender or investor will probably want to see this information in the financial report section of your business plan.
Gathering Information for Analysis
Before you begin your break-even analysis, you'll need some information. Let's say you're dong an analysis for a potential new product. Make a list of all your costs and expenses relating to that product, including facilities, the cost of materials and supplies, machines or equipment, and costs for paying employees to make the product and prepare it to ship.
You'll also need to know two other pieces of information:
- The range of prices you are considering, starting at $0.00
- The range of quantities you estimate being able to sell, starting at none (0)
You will need to separate out fixed costs and variable costs. Fixed costs are those you must pay even if you have no sales (like rent and utilities). Variable costs are those you spend to make and sell and ship products (like raw materials, supplies, and labor).
5 Steps to Creating a Break-Even Analysis
Here are the steps to take to determine break-even:
- Determine variable unit costs: Determine the variable costs of producing one unit of this product. Variable costs are those costs associated with making the product or buying it wholesale. If you are making a product, you will need to know the cost of all the components that go into that product. For example, if you are printing books, your variable unit costs are paper, binding, and glue for one book, and the cost to put one book together.
- Determine fixed costs: Fixed costs are costs to keep your business operating, even if you didn't produce any products. To determine fixed costs, add up the cost of running your factory for one month. These costs would include rent or mortgage, utilities, insurance, salaries of non-production employees, and all other costs. Don't forget the cost to design the product and packaging, make the prototype, and maybe patent your product.
- Determine unit selling price: Determine the unit selling price for your product. This price may change as you see where your break-even point is.
- Determine sales volume and unit price: The break-even point will change as the sales volume for this product and the unit price change.
- Create a spreadsheet: To do a break-even calculation, you will construct or use a spreadsheet then turn the spreadsheet into a graph. The spreadsheet will plot break-even for each level of sales and product price, and it will create a graph showing you break-even for each of these prices and sales volumes.
A simple formula for break-even is:
Break-even quantity = Fixed costs/(Sales price per unit –Variable cost per unit).
This formula is best expressed in a spreadsheet because variable cost changes. The spreadsheet shows you break-even for a range of costs and sales prices.
Analyzing a Break-Even Chart
Now that you have break-even, what do you do with this information? You want to find the highest price you can sell the product at and still make a profit. See what happens when you change either fixed or variable costs to see what happens if you reduce them. Maybe you can increase the volume by finding new markets. What happens when output volume rises or falls. All of these can affect your business profits on this product.
Of course, a break-even analysis isn't created in a vacuum. If you're creating a new product that no one's ever seen before, you have no idea what the volume would be or how soon competitors might pop up. But at least it gives you a way to begin your search for the "best" price for your product.