A break-even analysis is commonly used to determine the point at which a new product or service will become profitable. The analysis is a financial calculation that tells the business how many products it must sell to cover its production costs. A break-even analysis is a small business accounting process that tells the business what it needs to do to break even or recoup its initial investment.
- Understanding a break-even analysis
- Calculating the break-even point
- When should a break-even analysis be performed?
- Key takeaways:
- Connected Frameworks To The Break-Even Analysis
Understanding a break-even analysis
For example, a break-even analysis may tell a business how many hours of service it needs to sell to cover its office space costs. Another business may use the analysis to determine how many cars it needs to sell to cover the cost of import tariffs.
Regardless of the context, the break-even analysis enables businesses to determine the point at which their endeavor becomes profitable. The results of the analysis may encourage the business to borrow money until the break-even point is reached. Alternatively, it may abandon the endeavor entirely.
Calculating the break-even point
The break-even analysis involves a relatively simple calculation, with the equation as follows:
Break-even quantity = fixed costs / (sales price per unit – variable costs per unit)
Also note that:
- Fixed costs are those that do not change with varying output, such as depreciation, rent, and management salaries.
- The sales price per unit is the price the product is sold at, and
- The variable cost per unit includes the variable costs incurred during product creation. Variable costs are affected by increases or decreases in production output.
Let’s break down the above equation by considering the example of a television manufacturer.
The company has fixed costs of $750,000, which include machinery depreciation and the lease on the factory.
The company also has variable costs of $100 which are derived from the purchasing of components, sales commissions, and production taxes. Each finished television sells for $1500.
Thus, the break-even point for the manufacturer is 750,000 / (1500-100) = 535.71. In other words, the company would need to sell at least 536 televisions to break even.
When should a break-even analysis be performed?
The break-even analysis is useful in four common scenarios, including:
Starting a new business
The break-even analysis is particularly important in determining whether a new business venture is economically viable. The analysis forces entrepreneurs to define realistic costs and pricing strategies.
Adding a new sales channel
When a new sales channel is added, costs will change even if the prices do not. For example, an eCommerce shoe retailer looking to establish a new physical store will need to ensure the store breaks even. Otherwise, it may put the more profitable online store at risk. Costs may also increase if the retailer decides to sell shoes on Instagram and expenses associated with advertising and marketing must also be considered.
Creating a new product
A break-even analysis should always be performed before committing to product development. Even if fixed costs remain the same, it is important to quantify the important variable costs that could make or break the initiative.
If, for example, the shoe retailer wants to transition from holding physical inventory to drop shipping, a break-even analysis will determine whether prices need to change to reflect the new business model.
- A break-even analysis is a small business accounting process that tells the business what it needs to do to break even or recoup its initial investment. The break-even point tells the business how many products it must sell to cover its production costs.
- Calculating the break-even point involves accurately determining fixed costs, variable costs, and the sales price per unit.
- A break-even analysis is commonly used in four scenarios, including starting a new business, adding a new sales channel, creating a new product, and changing the company’s business model.
Connected Frameworks To The Break-Even Analysis
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