What Is Break-Even Analysis and How to Calculate it?
Before investing money, time, and effort into launching a company, how can anyone know if their small business idea will make money? The answer: With a very simple formula called break-even analysis .
Break-even analysis is valuable for understanding your business's financial health and making informed decisions. Learn more about this important financial concept, understand its significance, methodology, and how it empowers decision-makers to steer their enterprises towards financial success.
Content
- What is break-even analysis?
- How Is The Break-Even Point Calculated?
- Formula for Break-Even
- Interpretation of Break-Even
- Break-Even Analysis Example 1
- Break-Even Analysis Example 2
- What To Do If You Don’t Break Even
What is Break-Even Analysis?
Break-even analysis is a financial calculation that calculates and examines the safety margin for a product/entity based on the revenues collected and associated costs. In simpler terms, it reveals the point at which you will have sold enough units to cover your costs, also known as the break-even point.
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How Is The Break-Even Point Calculated?
To calculate the break-even point, you need to know your company’s fixed costs, the variable costs per unit of product/service, and the selling price of the product/service.
The difference between the selling price of each product or service and its variable cost is the margin you earn. By dividing the fixed costs by the margin per product or service, you will obtain the number of products you will need to sell to cover all your fixed costs. At this time, you will find your balance point.
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Break-Even Formula
The break-even formula is as follows:
Break-Even Interpretation
The analysis of the break-even point allows the company to make projections, knowing the cost-volume-utility relationship of its products. The contribution margin of products determines the company's strategy.
- If the contribution margin ratio is higher, the company’s sales volume to generate profits is lower. This suggests that products with a lower contribution margin must have a higher turnover to cover fixed costs and achieve a profit.
- Based on the above results, the company can make decisions regarding the price and costs of its products.
You can perform simulations to determine to what extent it is feasible to decrease the price of your products without generating losses or, on the contrary, if you must increase the price of these products to cover your fixed costs. At the same time, you can determine if your fixed costs need to be revised in case the contribution margin is insufficient to cover them.
Break-Even Analysis Example 1
We will give a basic and simple example to explain how the break-even point is calculated.
Suppose you run a company that manufactures scarves with fixed costs of Rs. 10,00,000. The variable cost of the scarves you make is Rs. 200, and their selling price is Rs. 300.
Considering this data, we can calculate the margin of each scarf. If we subtract the variable cost of making it (Rs. 200) from the selling price (rs. 300), we find that the margin on the sale of each scarf is Rs. 100.
Sales margin = 300 – 200 = 100
To calculate the break-even point, we will divide the fixed costs of the company (Rs. 10,00,000) by the sales margin of each product (Rs. 100):
The result is that you will need to sell 10,000 scarves to break even. You will not start earning money until you sell unit 10,001. And if you sell less, your company will lose.
The break-even point can also be determined based on the percentage margin, considering the percentage of commercial margin obtained with each sale.
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Break-Even Analysis Example 2
We can calculate the percentage margin by dividing the sales price by the variable costs. In other words, following the previous example, you would have to subtract Rs. 200 (variable costs) from Rs. 300 (sale price) to get the profit (Rs. 100) and divide it by the sale price (Rs. 300). The result would be 0.333, which is then multiplied by 100 to get a margin of 33.33% on sales.
Using this data, we will divide the total fixed costs (Rs. 10,00,000) by the margin (0.3333) to calculate the break-even point. The result shows that it would be necessary to sell Rs. 30,00,000 to break even.
This method of calculating the break-even point is suitable for scenarios in which a company offers products with different final prices and applies the same sales margin to all.
What To Do If You Don’t Break Even
When calculating the break-even point, it is possible that you discover that it is challenging for your business to reach that number of sales. In this case, we recommend evaluating your alternatives, as this is an essential indicator that your business is not profitable.
The key will be to look for aspects of your product or service that you can modify and improve, such as:
- Reach an agreement with your suppliers to have better prices and lower costs
- Strengthen processes and reduce times to increase production without cost overruns
- Increase the sale price of your products
- Manage strategic alliances
- Find a way to differentiate your product in the market
- Freeze any discounts
- Drive innovative marketing actions
Conclusion
Break-even analysis is a very helpful tool for understanding when your business will start making money. It enables you to analyse the number of products you need to sell to cover your costs and whether your current pricing and cost structure are working. If you think breaking even is difficult, you must review your pricing, cut costs, or improve your product strategy. You can move closer to profitability and make better financial decisions for your business by making smart adjustments.
FAQs - Break-Even Analysis
What are some limitations of Break-Even Analysis?
Some limitations of Break-Even Analysis include:
- Assumes constant costs, which may not hold true in dynamic business environments.
- Oversimplifies the real-world complexities of business operations and market dynamics.
- Distinguishing between fixed and variable costs can be challenging.
- Does not consider external factors like competition or economic changes.
- Relies on accurate cost data, which may not always be available or precise.
- Focuses solely on covering costs, ignoring desired profit margins.
- More suitable for short-term decision-making and may not account for long-term strategic considerations.
How can Break-Even Analysis be used for decision-making?
Break-Even Analysis aids decision-making by providing a clear understanding of the minimum level of sales or production needed to cover costs. It helps businesses assess pricing strategies, production volume, and potential risks, enabling informed choices that optimize profitability and resource allocation. Additionally, it assists in setting realistic sales targets and evaluating the financial viability of various business initiatives.
What does it mean if the Break-Even Point is high?
A high Break-Even Point indicates that a business must sell a large quantity of products or services before reaching profitability, which can be risky in some cases.
Can Break-Even Analysis be used for non-profit organizations?
Yes, Break-Even Analysis can be adapted for non-profit organizations to assess their cost structure and financial sustainability.
Is Break-Even Analysis a one-time exercise, or should it be regularly updated?
Break-Even Analysis should be regularly updated to reflect changes in costs, pricing, and market conditions, ensuring its ongoing relevance for decision-making.
Rashmi is a postgraduate in Biotechnology with a flair for research-oriented work and has an experience of over 13 years in content creation and social media handling. She has a diversified writing portfolio and aim... Read Full Bio
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