Are you running a fledgling company? Or in charge of developing sales goals for your team? Trying to determine a price for your new product or service? Are you seeking investment in your organization?
Then a break-even analysis is a tool you want in your repertoire. You may have heard the term and have a rough idea of what it implies (“break-even” can seem fairly intuitive, after all), but understanding this concept more deeply can benefit you and your team.
A break-even analysis is essentially a model that helps managers (a) identify the level of operations needed to cover all costs and (b) evaluate the profitability of various levels of sales. A break-even analysis can be incredibly complicated – I’ve seen break-even spreadsheets with dozens of tabs, hundreds of inputs, and thousands of data points – but at its core, the concept is pretty simple and revolves around the break-even point.
The break-even point is when a company, division, product, or investment is making enough money to cover its costs. And, if you remember a bit of algebra, it’s a pretty simple formula:
Break-even point: Fixed costs / (Price – Variable costs) = $0
Or, the break-even point is when your fixed costs are covered by total sales after deducting your variable costs – when you are neither making nor losing money.
This first step in finding a break-even point is identifying and separating fixed costs and variable costs. Fixed costs are steady, at least in the short term, regardless of sales volume; rent, for example, is a fixed cost. Variable costs are directly related to sales volume; raw materials or shipping costs are examples of variable costs.
This exercise can often be a challenge and where it’s easy to overcomplicate. Some costs seem fixed until you reach a certain point; eventually, you’d need more space (and therefore more rent) if you keep growing indefinitely. Some costs are variable, but not as a function of sales – computers for new hires on your team, for example.
The key is to simplify to the point where the data is still meaningful and a generally accurate picture of reality. If you have to double your headcount before you need more space but your current team can absorb your realistic potential growth easily, maybe don’t worry about rent increases unless something changes. For computers, you could build an estimate into your fixed costs and now you have created a little buffer for those costs without overcomplicating. Keep it realistic – don’t pretend you won’t incur additional costs if you probably will – but try to start as simply as possible. You can always add complexity later if you determine it needs more detail.
Once you have determined which of your costs are fixed and which are variable, break-even analysis can be performed. For example, assume that Susan’s Bikes, a small bicycle retailer, has fixed costs of $5,000 per month; this may include rent, her own salary, utilities, et cetera. She sells each bike for $200, and she buys each bike wholesale for $100 – her variable costs. Susan’s break-even point is:
$5,000 / ($200 - $100) = 50 bikes
After selling 50 bikes, Susan‘s net income should just equal zero. She must sell at least 50 bikes per month to make a profit; if she sells any fewer, she is losing money.
Once Susan has the fixed and variable costs identified, she can modify this formula to provide more feedback than just current break-even point. If Susan believes she can sell 75 bikes per month, she can calculate that her monthly net income would be $2,500. Or if she can sell 50 bikes but raise the price to $220, now her net income is $1,000 per monthly.
These are examples of break-even analysis – building scenarios around the break-even point to see how your results change depending on how you adjust your costs or selling prices. There are also opportunities to use the data in a break-even analysis even if a company is profitable:
- Set sales targets: use the desired profitability level to determine sales goals
- Determine price points: ensure that a new product or service is adding to an organization’s bottom line, not hurting it
- Identify cost-cutting measures: calculate which cuts will accomplish the desired outcome most efficiently without having to cut back unnecessarily.
- Calculate investment need: for a currently-unprofitable division or organization, determine the amount of capital needed to cover costs until the break-even point is reached.
If you can, take the time to develop a break-even analysis for your organization; ideally, it would allow you to quickly update changes in price, volume, and fixed and variable costs so it’s as dynamic as your business. If this isn’t in your team’s skill set, you can often find help with an outsourced finance and accounting firm. As your organization evolves, having a flexible break-even analysis can allow you to develop thoughtful strategies that improve your profitability for years to come – do more than just “break-even”.
Ashley Jajtner, MAcc. Optima Office Consulting Sr. Controller
