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.
Component
Description
Origin
Break-even Analysis is a financial management tool that originated from accounting and financial analysis practices.
Overview
Break-even Analysis is a technique used to determine the point at which a business or project neither makes a profit nor incurs a loss. It helps organizations understand the minimum level of sales or output needed to cover all costs and achieve a balance between revenue and expenses.
Key Elements
– Fixed Costs: These are expenses that remain constant regardless of the level of production or sales. Fixed costs include rent, salaries, insurance, and depreciation.
– Variable Costs: Variable costs change in direct proportion to changes in production or sales volume. Examples include raw materials, labor, and direct production costs.
– Total Costs: The sum of fixed costs and variable costs represents the total expenses incurred by a business.
– Revenue: Revenue is the income generated from the sale of goods or services. It depends on the selling price and the quantity of units sold.
– Break-even Point: The break-even point is the level of sales or output at which total revenue equals total costs, resulting in zero profit or loss.
How It Works
Break-even Analysis involves the following steps:
1. Identification of Costs: Identify and classify fixed costs and variable costs.
2. Calculation of Contribution Margin: Calculate the contribution margin per unit, which is the selling price per unit minus the variable cost per unit.
3. Determination of Break-even Point: The break-even point (in units or dollars) is calculated by dividing total fixed costs by the contribution margin per unit.
4. Analysis of Profit Scenarios: After determining the break-even point, businesses can analyze different profit scenarios by comparing actual sales levels to the break-even point.
Applications
– Business Planning: Break-even Analysis helps businesses set sales targets, pricing strategies, and production plans.
– Investment Decisions: It assists in evaluating the financial feasibility of projects and investments.
– Cost Control: Organizations can identify cost reduction opportunities and optimize their cost structure.
Benefits
– Decision Support: Provides insights for making informed decisions related to pricing, production, and budgeting.
– Risk Assessment: Helps assess the financial risk associated with different business strategies.
Drawbacks
– Simplistic Assumptions: Break-even Analysis relies on the assumption that costs and revenues remain constant, which may not hold true in real-world scenarios.
– Limited Scope: It focuses primarily on cost-volume-profit relationships and may not consider other factors affecting profitability.
Key Takeaway
Break-even Analysis is a financial tool used to determine the level of sales or output at which a business covers all its costs, resulting in neither profit nor loss. It assists in business planning, investment decisions, and cost control. While it provides decision support and risk assessment, it may oversimplify complex business dynamics and overlook certain factors.
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.
Changing business model
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.
Case studies
Restaurant Break-Even Analysis:
Fixed Costs: Rent, utilities, staff salaries.
Variable Costs: Cost of ingredients, kitchen supplies.
Steps:
Calculate total fixed costs.
Determine contribution margin (selling price per meal – variable cost per meal).
Divide fixed costs by contribution margin to find the number of meals to break even.
Software Development Break-Even:
Fixed Costs: Development team salaries, software licenses.
Divide fixed costs by contribution margin to find the number of items to break even.
Key takeaways:
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.
Key Highlights:
Break-Even Analysis: A financial calculation used to determine the point at which a product or service becomes profitable. It tells a business how many products it must sell to cover its production costs and break even.
Calculation: Break-even quantity = fixed costs / (sales price per unit – variable costs per unit). Fixed costs are those that do not change with varying output, while variable costs are affected by production output.
Example: A television manufacturer with fixed costs of $750,000, variable costs of $100 per unit, and selling each television for $1500 would need to sell at least 536 televisions to break even.
Scenarios for Break-Even Analysis: It is useful for starting a new business to determine economic viability, adding a new sales channel to consider changing costs, creating a new product to evaluate costs and pricing, and changing the business model to assess profitability with new strategies.
A failure mode and effects analysis (FMEA) is a structured approach to identifying design failures in a product or process. Developed in the 1950s, the failure mode and effects analysis is one the earliest methodologies of its kind. It enables organizations to anticipate a range of potential failures during the design stage.
Agile Business Analysis (AgileBA) is certification in the form of guidance and training for business analysts seeking to work in agile environments. To support this shift, AgileBA also helps the business analyst relate Agile projects to a wider organizational mission or strategy. To ensure that analysts have the necessary skills and expertise, AgileBA certification was developed.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
A paired comparison analysis is used to rate or rank options where evaluation criteria are subjective by nature. The analysis is particularly useful when there is a lack of clear priorities or objective data to base decisions on. A paired comparison analysis evaluates a range of options by comparing them against each other.
The Monte Carlo analysis is a quantitative risk management technique. The Monte Carlo analysis was developed by nuclear scientist Stanislaw Ulam in 1940 as work progressed on the atom bomb. The analysis first considers the impact of certain risks on project management such as time or budgetary constraints. Then, a computerized mathematical output gives businesses a range of possible outcomes and their probability of occurrence.
A cost-benefit analysis is a process a business can use to analyze decisions according to the costs associated with making that decision. For a cost analysis to be effective it’s important to articulate the project in the simplest terms possible, identify the costs, determine the benefits of project implementation, assess the alternatives.
The CATWOE analysis is a problem-solving strategy that asks businesses to look at an issue from six different perspectives. The CATWOE analysis is an in-depth and holistic approach to problem-solving because it enables businesses to consider all perspectives. This often forces management out of habitual ways of thinking that would otherwise hinder growth and profitability. Most importantly, the CATWOE analysis allows businesses to combine multiple perspectives into a single, unifying solution.
It’s possible to identify the key players that overlap with a company’s business model with a competitor analysis. This overlapping can be analyzed in terms of key customers, technologies, distribution, and financial models. When all those elements are analyzed, it is possible to map all the facets of competition for a tech business model to understand better where a business stands in the marketplace and its possible future developments.
The Pareto Analysis is a statistical analysis used in business decision making that identifies a certain number of input factors that have the greatest impact on income. It is based on the similarly named Pareto Principle, which states that 80% of the effect of something can be attributed to just 20% of the drivers.
A comparable company analysis is a process that enables the identification of similar organizations to be used as a comparison to understand the business and financial performance of the target company. To find comparables you can look at two key profiles: the business and financial profile. From the comparable company analysis it is possible to understand the competitive landscape of the target organization.
A SWOT Analysis is a framework used for evaluating the business’s Strengths, Weaknesses, Opportunities, and Threats. It can aid in identifying the problematic areas of your business so that you can maximize your opportunities. It will also alert you to the challenges your organization might face in the future.
The PESTEL analysis is a framework that can help marketers assess whether macro-economic factors are affecting an organization. This is a critical step that helps organizations identify potential threats and weaknesses that can be used in other frameworks such as SWOT or to gain a broader and better understanding of the overall marketing environment.
Business analysis is a research discipline that helps driving change within an organization by identifying the key elements and processes that drive value. Business analysis can also be used in Identifying new business opportunities or how to take advantage of existing business opportunities to grow your business in the marketplace.
In corporate finance, the financial structure is how corporations finance their assets (usually either through debt or equity). For the sake of reverse engineering businesses, we want to look at three critical elements to determine the model used to sustain its assets: cost structure, profitability, and cash flow generation.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Value investing is an investment philosophy that looks at companies’ fundamentals, to discover those companies whose intrinsic value is higher than what the market is currently pricing, in short value investing tries to evaluate a business by starting by its fundamentals.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.
Financial accounting is a subdiscipline within accounting that helps organizations provide reporting related to three critical areas of a business: its assets and liabilities (balance sheet), its revenues and expenses (income statement), and its cash flows (cash flow statement). Together those areas can be used for internal and external purposes.
Post-mortem analyses review projects from start to finish to determine process improvements and ensure that inefficiencies are not repeated in the future. In the Project Management Book of Knowledge (PMBOK), this process is referred to as “lessons learned”.
Retrospective analyses are held after a project to determine what worked well and what did not. They are also conducted at the end of an iteration in Agile project management. Agile practitioners call these meetings retrospectives or retros. They are an effective way to check the pulse of a project team, reflect on the work performed to date, and reach a consensus on how to tackle the next sprint cycle.
In essence, a root cause analysis involves the identification of problem root causes to devise the most effective solutions. Note that the root cause is an underlying factor that sets the problem in motion or causes a particular situation such as non-conformance.
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.
Stanford University Professor Ronald A. Howard first defined decision analysis as a profession in 1964. Over the ensuing decades, Howard has supervised many doctoral theses on the subject across topics including nuclear waste disposal, investment planning, hurricane seeding, and research strategy. Decision analysis (DA) is a systematic, visual, and quantitative decision-making approach where all aspects of a decision are evaluated before making an optimal choice.
A DESTEP analysis is a framework used by businesses to understand their external environment and the issues which may impact them. The DESTEP analysis is an extension of the popular PEST analysis created by Harvard Business School professor Francis J. Aguilar. The DESTEP analysis groups external factors into six categories: demographic, economic, socio-cultural, technological, ecological, and political.
The STEEP analysis is a tool used to map the external factors that impact an organization. STEEP stands for the five key areas on which the analysis focuses: socio-cultural, technological, economic, environmental/ecological, and political. Usually, the STEEP analysis is complementary or alternative to other methods such as SWOT or PESTEL analyses.
The STEEPLE analysis is a variation of the STEEP analysis. Where the step analysis comprises socio-cultural, technological, economic, environmental/ecological, and political factors as the base of the analysis. The STEEPLE analysis adds other two factors such as Legal and Ethical.
Activity-based management (ABM) is a framework for determining the profitability of every aspect of a business. The end goal is to maximize organizational strengths while minimizing or eliminating weaknesses. Activity-based management can be described in the following steps: identification and analysis, evaluation and identification of areas of improvement.
PMESII-PT is a tool that helps users organize large amounts of operations information. PMESII-PT is an environmental scanning and monitoring technique, like the SWOT, PESTLE, and QUEST analysis. Developed by the United States Army, used as a way to execute a more complex strategy in foreign countries with a complex and uncertain context to map.
The SPACE (Strategic Position and Action Evaluation) analysis was developed by strategy academics Alan Rowe, Richard Mason, Karl Dickel, Richard Mann, and Robert Mockler. The particular focus of this framework is strategy formation as it relates to the competitive position of an organization. The SPACE analysis is a technique used in strategic management and planning.
A lotus diagram is a creative tool for ideation and brainstorming. The diagram identifies the key concepts from a broad topic for simple analysis or prioritization.
Functional decomposition is an analysis method where complex processes are examined by dividing them into their constituent parts. According to the Business Analysis Body of Knowledge (BABOK), functional decomposition “helps manage complexity and reduce uncertainty by breaking down processes, systems, functional areas, or deliverables into their simpler constituent parts and allowing each part to be analyzed independently.”
The multi-criteria analysis provides a systematic approach for ranking adaptation options against multiple decision criteria. These criteria are weighted to reflect their importance relative to other criteria. A multi-criteria analysis (MCA) is a decision-making framework suited to solving problems with many alternative courses of action.
A stakeholder analysis is a process where the participation, interest, and influence level of key project stakeholders is identified. A stakeholder analysis is used to leverage the support of key personnel and purposefully align project teams with wider organizational goals. The analysis can also be used to resolve potential sources of conflict before project commencement.
Strategic analysis is a process to understand the organization’s environment and competitive landscape to formulate informed business decisions, to plan for the organizational structure and long-term direction. Strategic planning is also useful to experiment with business model design and assess the fit with the long-term vision of the business.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
