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Break-Even Analysis. How to Ensure Stability in Managing Business?

Starting a business without a break-even analysis is like going on a treasure hunt without an accurate map of that treasure. At best, you’ll just get lost. So it is with business. Important decisions can only be made when you have calculated all the risks and know exactly when you can start making a profit and recoup your initial investment.

How does Break-Even Analysis work? Expert’s Opinion by Kateryna Miliutenko, COO

Unfortunately, most small and even medium-sized enterprises still need to conduct a truly thorough financial analysis. Sometimes owners need to learn how many units they need to sell for them to make a profit. A break-even analysis will help you understand when your company, new service, or product will finally become profitable.

Needless to say, the analysis of the break-even point in modern business is a powerful tool for decision-making and planning. In addition, it helps you determine aspects such as sales volumes, costs, prices, and most importantly, understanding how your products should be priced. After all, correct pricing is a complex matter that requires an understanding of how prices will affect gross margins. In the end, every businessman has to pay his bills.

The Break-even point formula is quite simple if you know what you are doing. Simply put, your break-even point equals fixed costs, which you divide by the average selling price (minus variable costs). This is the point where your revenue equals your costs. Anything beyond that will make your business profitable. Well, successful entrepreneurs always make decisions based solely on facts.

Break-even analysis can be considered the main ingredient of any business plan. Moreover, it is usually required from you if you are seeking to obtain a loan for your project or attract investors. This is nothing less than proof that your plan is viable and the business is potentially profitable. In addition, a good analysis will help you make decisions easier, reduce risks and avoid losses. The Break-even point in a business plan will help you evaluate your future results realistically.

How to find the break-even point?

In all economics textbooks, the process of calculating the break-even point is too complicated, I say this as a graduate economist. Therefore, I usually use a slightly different algorithm, which I would like to share with you. After all, where it is simple – growth will go, where it is difficult – there is something wrong.

For companies that are already active players in the market

To calculate the break-even point, use the average monthly costs for the cost items for the previous year of the company’s operation. We will count 2 break-even points. Why? How to find them? I’ll explain everything, it’s not difficult, but it will take time, so…

The first break-even point is the minimum income of the company, at which this income will compensate for the costs of production and sale of products, and with the production of each subsequent unit of production, the company will begin to make a profit.

The second break-even point is the planned monthly income, which is provided to the staff (top managers) as a “minimum for survival”, such a level of income that will allow the company to stay afloat, avoiding bankruptcy.

Next, we begin to calculate the first break-even point

Take all the company’s payments and distribute them to different items of cash flow, here it is important to take into account the payment date. Remember everything – rent, salary, phone expenses, postage… As a result of the distribution, you will have several categories and their total amount and monthly amount. Try to avoid missing a single expense, because the more accurately we calculate the break-even point, the sooner you can achieve profit.

The calculation of the second TB begins with the division of all costs into fixed and variable costs. Variable costs are costs that depend on the volume of production (costs of raw materials and components). Fixed costs are costs that do not depend on the volume of production (premises rent, communication costs, etc.).

It is necessary to determine the share of each variable cost to the first TV, and then add to the variable costs the % that we want to accumulate in the company (let’s call it – % return on investment) as a share for the return of the investment in the company by the owner. Now, to keep the proportion, you need to calculate what % of the income falls on fixed costs:

1) Total percentage of variable costs = Sum of shares of each article of variable costs to the first TB + % return on investment.

For example, 88.2% + 2% = 90.2% – variable costs

2) Next, you need to save the proportion and calculate what % of expenses will be allocated to fixed expenses 100%-90.2%=9.8% – fixed expenses of the company.

If the first TV was (virtual numbers) 120,000 thousand – fixed costs, then we can calculate the 1% of income in the new cost structure: 120,000/9.8=12,245.

Knowing the value of 1% of income, we can calculate the second TB: 12,245*100=1,224,500 u. at. month.

Weekly break-even point = 1,224,500/4.3 (weeks) = 284,768 u.o. for a week.

This is our weekly income quota that will ensure the operation of the enterprise.

For a new business, you will have to “invent” a little, that is, look for market averages and look at the average costs for this or that work, raw materials, office…

Make adjustments

Feel free to experiment with different numbers. After all, you need to understand how to work with the formula. Look at what happens if you try to change the price, reduce variable or fixed costs. Try, learn, experiment.

However, never forget about the costs! Forgetting variable costs is one of the most common beginner mistakes when analyzing the break-even point. But this is an important step on which all business decisions are built. That is why it is better to check the data several times, ensuring everything is correct. To do this, you need to think through all your operations from beginning to end. As a rule, it helps to remember something important. For example, you need to consider the order of napkins for a banquet (variable costs) or to order the of wrapping paper for regular shipments.

BEP examples

It is generally accepted that there are four main scenarios in which break-even analysis should be used.

1. Business Reorganization

If you haven’t seen profits for several months in a row, the business’s profitability is close to zero, then it’s time to sit down and calculate the break-even point. After all, you need to understand how to continue doing business, and the break-even point will help with this.

2. Starting a new business

A break-even analysis is the first thing a businessman should start with when working on a new business. After all, this not only determines whether your business idea is viable in principle, but also serves as an incentive for you to research your niche, think through your pricing strategy, and be realistic about costs.

3. Create a new product

However, this work will be useful not only for beginners. The Break-even point for any business is becoming essential nowadays, and even those who have worked in their niche for many years should do it every time before launching a new product on the market. After all, although fixed costs such as office rent may remain the same, the variable costs associated with your new product have yet to be calculated, and then set prices for future products.

4. Adding a new sales channel

Even if your prices remain the same, all your costs will change when you add a new sales channel. Let’s take a simple example. If you are trading online and want to create a store pop-up, you should know that it will at least break-even. Otherwise, it can negatively affect your entire business. This also applies to adding new online sales channels, such as Instagram shopping posts. After all, if you plan additional spending on advertising on Instagram, then such costs are recorded in the break-even analysis.

5. Change your business model

Break-even point for business is also useful if you plan to change your business model. For example, you are thinking about switching to inventory storage from direct delivery of products. To do this, you should conduct a break-even analysis. After all, your initial costs can change a lot. In turn, such an analysis will help you understand what prices will be justified and whether they need to be changed.

When is best to apply BEP in financial planning?

Although break-even analysis allows you to determine your break-even point, there may be a different point than the end of your calculations. You should ask yourself: “Is my plan realistic?”, “Should I raise prices?”, “Or maybe I should cut costs?”, “Maybe both options?”… Ask yourself, will your product be popular in the market, maybe new, useful ideas for business will come to your mind. After all, the break-even analysis itself only determines how many products you need to sell to make a profit, but there is no guarantee that these products will want to buy.

That is why it is so important to carry out any analysis before starting business processes to understand all possible risks better. However, if you already have your own business, conduct a break-even analysis before launching a new service or product to market. This will allow you to understand better whether the potential profit is worth all the upcoming costs.

However, the company will also need a break-even analysis in day-to-day activities and planning.

Prices

If your break-even analysis confirms that product costs are too low to break-even, you should increase them. However, it is important not to over-price yourself in the marketplace, so be sure to check the cost of comparable products before you do so.

Materials

A break-even analysis will help you understand whether the cost of labor and materials is unacceptable for the business. With the help of the analysis, you will understand how you can reduce costs without losing the quality of products and services.

New products

You must consider fixed costs and new variables every time you launch a new product.

Planning

If you are looking to move to a more expensive but spacious location as you expand your business, then you can use analysis to determine the level of sales that will allow you to cover the new fixed costs. Such planning makes it easy to carry out long-term tasks.

Goals

Everything is simple here. Clear goals are the key to good motivation for you and your team. After all, knowing how much money you need to earn for a specific goal or how many units of goods you need to sell to break-even, you understand how your business is developing.

Key takeaways

It is no exaggeration to say that almost every small business owner often thinks about reaching the break-even point and what will happen after that. To determine these processes, there is just a break-even analysis. It allows you to determine when and under what circumstances your business will reach the break-even point. This approach offers a clear plan of action to achieve your goals, allowing you to plan the development of your business.

However, after a break-even analysis, it seems that you need to sell some unrealistically large number of units. Look at your second break-even point, and remember, any change should be done gradually, so just set realistic plans and see how you can get more. 

By the way, it is better to involve your team in such a brainstorming session and write down every idea, no matter how strange it may seem.

1. Lower fixed costs

Look for ways to reduce fixed costs. The lower they are, the fewer units you will need to sell to break-even. In the simplest example, if you’re looking to open a retail store but the break-even analysis says it’s a bad idea, you might want to consider selling online.

2. Improve pricing

The easiest way to increase profits. After all, raising prices means you need to sell fewer units to break even. Simply put, you will have a higher marginal investment per unit of output sold. However, in addition to the competition, you should always keep in mind buyers’ price expectations. And when prices go up, shoppers will expect better customer service or a better product.

3. Lower variable costs

In contrast to the previous point, reducing variable costs can be called one of the most challenging options, especially for those who are just starting their business. However, it will be easier to reduce variable costs when you scale. We advise you to try to reduce costs by changing suppliers, negotiating with your suppliers, or changing your process.

In any case, no matter what goals you pursue, a break-even analysis will help you understand what needs to be done to start making a profit. Break-even analysis is essential for any business to make sound business decisions and grow. So the next time you start a new business, launch a new product, or change an existing business, doing a break-even analysis should be one of your first steps. 

After all, it helps you reach new heights and take your business to the next level!