Conducting a breakeven analysis is important to determine precisely when you can expect your business to cover all expenses and start generating a profit. This is a pivotal milestone in the early days of any startup business.
As daunting an undertaking as it may seem if you've never done one, the reality is it boils down to simple math. You can accurately forecast the costs and sales your business will be working with for the coming periods by looking at your current earnings. It's critical that you identify your costs and determine your projected sales figures. 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. You are without profit at the breakeven point, but you haven't incurred any losses either. This calculation is paramount 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. These two are the most relevant:
- Fixed costs: These are costs that are the same regardless of how many items you sell. All startup costs, like rent, insurance, and computers, are considered fixed costs because you have to make these expenditures 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 stationery company for $1 each, that dollar represents a variable cost. As your business and sales grow, you can begin allocating labor and other items as variable costs if it makes sense for your industry.
Setting a Price to Get to Breakeven
Setting the right price is crucial 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 or service.
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 the pricing strategy and the psychology of pricing before choosing how to price your product or service.
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 into a competitive industry.
The cost-based pricing 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 competitors can make the product for less and easily undercut you on price.
According to David Bakken, Founder and Managing Director at Foreseeable Futures Group, price-based costing 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." 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
To determine breakeven, take your fixed costs divided by your price minus your variable costs. As an equation, it's 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 equation is:
Unit Contribution Margin = Sales Price - Variable Costs
Costs change over time, so it's recommended to record this information in a spreadsheet where you can easily make adjustments. It also lets you play with different pricing options and easily calculate the resulting breakeven point. 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 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.