The break-even analysis is a useful tool that lets you see what you need to sell, either monthly or annually if you want to cover the costs of doing business. This would represent the break-even point, where the total cost and the total revenue are equal. Today we are going to see what is a break even analysis and what formula is used for it.
What Is a Break Even Analysis?
A break-even analysis is a calculation and examination of the margin of safety for a company. The entity needs to be based on the revenues it collects, as well as the associated costs. The business uses the break-even analysis to see what level of sales they need to cover the total fixed costs. A demand-side analysis offers a seller a better insight into the situation, regarding the selling abilities.
Simply put, the break-even analysis means determining the level of production or a certain targeted sales mix. The analysis usually helps only the management, since the information isn’t to be disclosed to other external sources, such as regulators, investors, or financial institutions. More exactly, this tool analyzes the fixed costs relative to the profit earned by each extra unit that is produced and sold. In general, if a company has lower fixed costs, it will have a lower break-even point of sale.
Here you can find out more about how to conduct a break-even analysis:
Break Even Analysis – The Formula
Now that you know what is a break even analysis, it’s time to move on to the formula. The formula used is rather simple. If you need to conduct a breakeven analysis, you should take the fixed costs and divide them by the price, excluding the variable costs. The equation would look like this:
Breakeven Point = Fixed Costs / (Unit Selling Price – Variable Costs
This calculation shows you how many units of a product you need to sell for you to break even. At this point, you have recovered all the costs that went into producing the both, both variable and fixed. Every extra unit that is sold after this point increase profit. The latter is increased by the amount of the unit contribution margin.
What Is the Contribution Margin?
The contribution margin refers to the amount each of the units contributes to covering the fixed costs and thus increasing the profit. The equation here looks like this:
Unit Contribution Margin = Sales Price – Variable Costs
It is a good idea to record all this information in a spreadsheet. In this way, you will be able to adjust easily as the costs will change in time. Moreover, you can play around with various pricing options and it will be easier for you to calculate the respective break-even point. A suggestion would be to use special programs, such as Goal Seek in Excel.
Limitations of the Break-Even Analysis
As we mentioned until now, it’s essential to pay attention to what the results of the analysis are telling you. For example, if you see that the break-even point will be 500 units, the next step is to assess whether this is feasible or not. In case you don’t think it’s doable to sell 500 units in a reasonable time, according to your financial situation, personal expectations, or simply patience, then you may not be in the right business. The problem is that the business may not offer a profit quickly enough for you to stay alive in the industry.
On the other hand, if you think it is possible to sell 500 units, but in a bit of time, you should consider lowering the price and calculating another break-even point. Look at the costs, both fixed and variable, and see any areas where you can cut some funds from.
Another thing you need to understand here, besides knowing what is a break even analysis, is the fact that this is not a predictor of demand. The break-even point is merely an indication, so if you start on the market with a wrong product or price, you may not reach it at all.
How to Set the Right Price?
The first question most people have after they learn what is a break even analysis is how to set the right price. This is a critical step for your analysis and even for your odds of making a profit with the startup. If you don’t know what is the price per unit, you can’t start calculating the expected revenue. Here, the unit price refers to the amount you want to charge customers to buy one unit of your product.
Surprisingly or not, there is an entire psychological strategy here. The consumer goes through a complicated decision-making process, and you need to do a lot of marketing and psychology research if you want to know how consumers perceive price. This is a good area to start reading, so make sure you have the right information.
Moreover, there are various schools of thought regarding how to treat price when you’re having a break-even analysis. Although there is no exact science, this is a mix of both qualitative and quantitative factors. If you’re offering a unique product that is new on the market, you can charge a premium price. However, you’ll have to keep the price in line with the rate or even offer customers discounts if you are entering an already competitive market.
Cost-Based Pricing or Price-Based Costing?
There are two main approaches here: the cost-based pricing and the price-based costing. With the first option, you will need to figure out how much it costs to produce one unit of an item and then set the price to that amount. Add a predetermined profit margin to it and you’re set. The other option consists of starting from the price your consumers are willing to pay even when they have competitive alternatives. Next, pull down the costs of production to meet the price.
It’s not hard to learn what is a break even analysis, but it might be difficult to achieve the break-even point. Many startups are struggling with setting the correct price for their products and matching the initial investment in the business. Luckily, this analysis is there to offer you all the information you need.
image source: depositphotos.com