Breakeven analysis helps determine when your
business revenues equal your costs
By Daniel Richards
If you can accurately forecast your
costs and sales, conducting a breakeven analysis is a matter of simple math. A
company has broken even when its total sales or revenues equal its total
expenses. At the breakeven point, no profit has been made, 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.
There are several types of costs to
consider when conducting a breakeven analysis, so 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 since you have to make these outlays before you sell your first item.
- Variable costs: These are recurring costs that you absorb with each unit you sell. For example, if you were operating a greeting card store where you had to buy greeting cards from a stationary company for $1 each, then 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
This is critical to your breakeven
analysis; you can't calculate likely revenues if you don't know what the unit
price will be. Unit price refers to the amount you plan to charge customers to
buy a single unit of your product.
- Psychology of Pricing: Pricing can involve a complicated decision-making process on the part of the consumer, and there is plenty of research on the marketing and psychology of how consumers perceive price. Take the 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 different schools of thought on how to treat price when conducting a breakeven analysis. It is a mix of quantitative and qualitative factors. If you've created a brand new, unique product, you should be able to charge a premium price, but if you're entering a competitive industry, 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.
One common strategy is cost-based pricing, which
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. This
approach is frowned upon since it allows competitors who can make the product
for less than you to easily undercut you on price. Another method, is 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 costs to meet that price." That
way if you encounter new competition, you can lower your price and still turn a
profit. There are always different pricing methods that can be used.
The
formula
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 let you know
how many units of a product you'll need to sell to break even. Once you've
reached that point, you've recovered all costs associated with producing your
product (both variable and fixed).
Above the breakeven point, every
additional unit sold 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. As an equation, this is defined 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, as well as play with different price options and easily calculate the
resulting breakeven point.
Limitations
It is important to understand what
the results of your breakeven analysis are telling you. If, for example, the
calculation reports that you would break even when you sold your 500th unit,
decide whether this seems feasible. If you don't think you can sell 500 units
within a reasonable period of time (dictated by your financial situation,
patience and personal expectations), then this may not be the right business
for you to go into. If you think 500 units is possible but would take a while,
try lowering your price and calculating and analyzing the new breakeven point.
Alternatively, take a look at your
costs - both fixed and variable - and identify areas where you might be able to
make cuts.
Lastly, understand that breakeven
analysis is not a predictor of demand, so if you go into market with the wrong
product or the wrong price, it may be tough to ever hit the breakeven point.
