Starting a business often carries risk. As the saying goes, “You have to spend money to make money.”
While that’s not always true, there is one very effective way to lower your risk: do a break-even analysis. A break-even analysis will tell you exactly what you need to do in order to break even and make back your initial investment.
If you run a business—or you’re thinking about starting one—you should know how to do a break-even analysis. It’s a crucial activity for making important business decisions.
What is Break-Even Analysis?
Break-even analysis sounds complicated, but it’s actually quite simple. It’s a calculation that will tell you how many units of something you need to sell to break even.
For example, how many laptop cases you need to sell to cover your warehousing costs. Or how many hours of service you need to sell to pay for your office space. Anything you sell beyond your break-even point will add profit.
There are a few definitions you need to know in order to understand break-even analysis.
- Fixed Costs: Expenses that stay the same no matter how much you sell.
- Variable Costs: Expenses that fluctuate up and down with sales.
Why You Must Do a Break-Even Analysis
There are many benefits to doing a break-even analysis.
Finding your break-even point will help you price your products better. A lot of psychology goes into effective pricing, but knowing how it will affect your profitability is just as important. You need to make sure you can pay all your bills.
Cover Fixed Costs
When most people think about pricing, they think about how much their product costs to create. Those are considered variable costs. You still need to cover your fixed costs like insurance or web development fees. Doing a break-even analysis makes sure you do.
Catch Missing Expenses
It’s easy to forget about expenses when you’re thinking through a business idea. When you do a break-even analysis you have to lay out all your financial commitments to figure out your break-even point. This will limit the number of surprises down the road.
Set Revenue Targets
After completing a break-even analysis, you know exactly how much you need to sell to be profitable. This will help you set more concrete sales goals for you and your team. When you have a clear number in mind, it will be much easier to follow through.
Make Smarter Decisions
Entrepreneurs often make business decisions based on emotion. If they feel good about a new venture, they go for it. How you feel is important, but it’s not enough. Successful entrepreneurs make their decisions based on facts. It will be a lot easier to decide when you’ve put in the work and have useful data to work with.
Limit Financial Strain
Doing a break-even analysis helps mitigate risk by showing you when to avoid a business idea. It will help you avoid failures and limit the financial toll that bad decisions can have on your business. Instead, you can be realistic about the potential outcomes.
Fund Your Business
A break-even analysis is a key component of any business plan. It’s usually a requirement if you want to take on investors or other debt to fund your business. You have to prove your plan is viable. More than that, if the analysis looks good, you will be more comfortable taking on the burden of financing.
Doing a break-even analysis leads to better financial planning for your business. [Click to Tweet]
When to Use a Break-Even Analysis
There are four common scenarios when it helps to do a break-even analysis.
1. Starting a New Business
If you’re thinking about starting a new business, a break-even analysis is a must. Not only will it help you decide if your business idea is viable, but it will force you to do research and be realistic about costs, as well as think through your pricing strategy.
2. Creating a New Product
If you already have a business, you should still do a break-even analysis before committing to a new product—especially if that product is going to add significant expense. Even if your fixed costs, like an office lease, stay the same, you’ll need to work out the variable costs related to your new product and set prices before you start selling.
3. Adding a New Sales Channel
Any time you add a new sales channel, your costs will change—even if your prices don’t. For example, if you’ve been selling online and you’re thinking about doing a pop-up shop, you’ll want to make sure you at least break even. Otherwise, the financial strain could put the rest of your business at risk.
4. Changing the Business Model
If you’re thinking about changing your business model, for example, switching from a retail store to ecommerce, you should do a break-even analysis. Your costs could change significantly and this will help you figure out if your prices need to change too.
Break-Even Analysis Formula
Before we start calculating break-even points, let’s break down how the formula works.
Your break-even point is equal to your fixed costs, divided by your average price, minus variable costs.
Break-Even Point = Fixed Costs/(Average Price — Variable Costs)
Basically, you need to figure out what your net profit per unit sold is and divide your fixed costs by that number. This will tell you how many units you need to sell.
As you now know, your product sales need to pay for more than just the costs of producing them. The remaining profit is known as the contribution margin because it contributes cash to the fixed costs.
Now that you know what it is, how it works, and why it matters, let’s break down how to calculate your break-even point.
Before we get started, get your free copy of the break-even analysis template here. After you make a copy, you’ll be able to edit the template and do your own calculations.