How to Do a Breakeven Analysis
A Breakeven Analysis Determines When Your Revenues Equal Your Costs
Have you been wondering how to do breakeven analysis for your business? It turns out, doing a breakeven analysis is a matter of simple math if you can accurately forecast the costs and sales your business will be working with for the coming periods.
Moreover, the purpose of doing a breakeven analysis is to determine exactly when you can expect your business to cover all expenses and start generating a profit—which is a crucial milestone in the early days of any company. Therefore, it's important to identify your costs, determine your projected sales figures and you'll then see how much revenue is necessary in order to pay your expenses.
A company has achieved breakeven when its total sales or revenues equal its total expenses. No profit has been made at the breakeven point, nor have any losses been incurred. This calculation is critical for any business owner because the breakeven point is the lower limit of profit when determining margins.
Several types of costs should be considered when conducting a breakeven analysis. Here's a refresher on the most relevant:
- Fixed costs: These are costs that are the same regardless of how many items you sell. All start-up costs, such as rent, insurance, and computers, are considered fixed costs because you have to make these outlays before you sell your first item.
- Variable costs: These are recurring costs that you must absorb with each unit you sell. If you're operating a greeting card store where you must buy greeting cards from a stationary company for $1 each, that dollar represents a variable cost. As your business and sales grow, you can begin appropriating labor and other items as variable costs if it makes sense for your industry.
Setting a Price That Helps Your Business Hit Breakeven
Setting the right price is critical to your breakeven analysis and eventually turning a profit with your startup. You can't calculate expected revenue if you don't know what your unit price will be. Unit price is the amount you plan to charge customers to buy a single unit of your product.
- The psychology of pricing: Pricing can involve a complicated decision-making process on the part of the consumer, and plenty of research has gone into the marketing and psychology of how consumers perceive price. Take a little time to review articles on pricing strategy and the psychology of pricing before choosing how to price your product or service.
- Pricing methods: There are several schools of thought on how to treat price when you're conducting a breakeven analysis. It's a mix of quantitative and qualitative factors. You should be able to charge a premium price if you've created a brand new, unique product, but you'll have to keep the price in line with the going rate or perhaps even offer a discount to get customers to switch to your company if you're entering a competitive industry.
- Cost-based pricing: This method calls for figuring out how much it will cost to produce one unit of an item and setting the price to that amount plus a predetermined profit margin. It's often frowned upon because it allows competitors who can make the product for less to easily undercut you on price.
- Price-based costing: This encourages business owners to "start with the price that consumers are willing to pay when they have competitive alternatives, and whittle down your costs to meet that price," according to David G. Bakken of Harris Interactive. This allows you to lower your price and still turn a profit if you encounter new competition. Different pricing methods can be used.
The Breakeven Formula: How to Do a Breakeven Analysis
This is fairly simple. To conduct your breakeven analysis, take your fixed costs divided by your price minus your variable costs. As an equation, this is defined as:
Breakeven Point = Fixed Costs/(Unit Selling Price - Variable Costs)
This calculation will clearly show you how many units of a product you must sell in order to break even. You've recovered all costs associated with producing your product, both variable and fixed, when you've reached this point.
Every additional unit sold after this increases profit by the amount of the unit contribution margin, which is defined as the amount each unit contributes to covering fixed costs and increasing profits. This is defined as an equation as:
Unit Contribution Margin = Sales Price - Variable Costs
Recording this information in a spreadsheet will allow you to easily make adjustments as costs change over time. It also lets you play with different pricing options and easily calculate the resulting breakeven point. Use a program such as Excel's Goal Seek. If you want to give yourself a goal of a certain profit, say $1 million, then work backward to see how many units you would have to sell to hit that number.
Limitations of the Breakeven Analysis
It's important to understand what the results of your breakeven analysis are telling you. If the calculation reports that you'll break even when you sell 500 units, your next step is to decide whether this seems feasible.
If you don't think you can sell 500 units within a reasonable period of time as dictated by your financial situation, patience, and personal expectations, then this may not be the right business for you—it may not turn a profit quickly enough to stay alive. If you think 500 units is possible but would take a bit of time, try lowering your price and calculating a new breakeven point. You might also take a look at your costs, both fixed and variable, to identify areas where you might be able to make some cuts.
Lastly, understand that a breakeven analysis is not a predictor of demand. If you go to market with the wrong product or the wrong price, it may be tough to ever hit the breakeven point.