What is a Break-Even Analysis?
According to Businesstown.com, a break-even analysis helps you figure out the level your business needs to reach to continue operating without incurring financial loss. Simply put, it’s how many units of something you need to sell to cover your costs. According to the U.S. Small Business Administration, creating a break-even analysis will help you paint a full financial picture that’s crucial for success. It also helps you figure out whether your overhead is realistic or needs to be simplified, how you should price items, and more.
Why is a Break-Even Analysis Important?
Harvard Business Review claims that businesses typically use break-even analysis data to set pricing for goods and services. According to this Harvard Business Review article, setting the right price can boost profit much faster than increasing the volume of items sold. Using break-even analysis data can also help assess how sales volume would need to change in order to justify other costs like more marketing, customization opportunities, and new add-ons.
So How Can I Make My Own?
We’re about to dive into a simple, sample break-even analysis. But first, let’s set the scene. Let’s say you have a sock business. You’ve been buying your toe warmers straight from the manufacturer for $2 and have been selling them for $5 per pair.
Before you start crunching numbers, you’ll need your fixed and variable costs per month. Some expenses like licensing and equipment, have clear-cut expenses, while others like utilities and marketing may vary from month to month. According to this Inc.com article, fixed costs don’t really change regardless of how many units you sell. Variable costs, however, usually change frequently based on how many units you sell and include business facets like inventory, shipping, and sales commissions.
The U.S. Small Business Administration recommends identifying all of your fixed and variable business expenses in your break-even analysis, including software, insurance, licensing, equipment, utilities and marketing. If you’re just setting up your business, you can check with trade associations, utility companies or websites like Bizstats.com for information on how much average costs typically run for what you’re offering.
The Break-Even Formula
Now it’s time to get to the math. The equation to find your gross profit per unit is your selling price minus the original cost of goods sold. Based on the simple sock-selling scenario above, your gross profit margin is $3.
Gross Profit Per Unit = Selling Price of Each Item – Original Cost of Each Item
$5 (Selling Price Per Item) - $2 (Purchase Price Per Item) = $3 (Gross Profit Per Unit)
However, for each $3 you make per pair of socks sold, you have to factor in your fixed and variable costs. This matters because the amount of socks you purchase each month (your inventory) will fluctuate based on how many you’re selling and how much extra money you have to spend on ordering more.
Let’s say you only sell your socks online, out of your home. Your only expenses are fixed costs associated with your website, which amount to $50 per month. To figure out your break-even cost in terms of how many pairs of socks you’ll need to sell before you start making a profit, take your monthly fixed costs (plus the average total of your monthly variable costs if you have them) divided by your gross profit per unit that we figured out earlier.
Break-Even Formula in Units = Fixed and Variable Costs Per Month / Gross Profit Per Unit
$50 (Monthly Costs) /$3 (Gross Profit Per Unit) = 16.66 or Roughly 17 Pairs of Socks
Based on the math, you need to sell 17 pairs of socks to break-even. But you can also think of your break-even numbers in terms of total sales revenue you need to make. To figure this out, take the number of pairs of socks you need to sell and multiple it by your selling price.
Break-Even Formula in Sales $ = (Fixed and Variable Costs / Gross Profit Per Unit) x Sales Price Per Unit
[($50 (Monthly Costs) / $3 (Gross Profit Per Unit)] x $5 (Sales Price Per Unit = $83.33
What Does it All Mean?
So, now that you’ve crunched the numbers, you know you need to sell 17 pairs of socks (or make roughly $84) to break-even. This is your baseline. Sell less than that and you’re losing money. Sell more than that and you’re making a profit.
Imagine a new sock shop has popped up and is taking away some of your business. And unfortunately, because of this new competitor, last month you didn’t hit your goal. If that’s the case, then you might want to think about making some changes like shopping around for another sock supplier or a cheaper website host. Your break-even analysis will come in handy to help you figure out how to compete with this new sock vendor by examining factors like raising or lowering pricing, lowering monthly costs or even using a different vendor. Try running various break-even scenarios in an Excel document or using one of the free templates available here or here to keep all of your data together and figure out your ideal selling strategy.
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