July 4, 2022
The break-even analysis is arguably the most commonly used concept in financial analysis. Whether you are an aspiring entrepreneur, manager, financial planner, or already running a business, getting familiar with the break-even analysis is an essential financial planning tool to add to your business decision arsenal.
Break-even analysis equips you with the means to estimate and determine beforehand the exact point at which you can begin to make a profit on your initial investment. In this article, we introduce you to the break-even analysis tool, and how it can assist you in managing and adjusting your investment risks.
The Break-Even analysis is a business, economic, and cost accounting method of identifying a precise point where you make back the exact amount you have invested in a business venture. In mathematical terms, a business reaches a break-even point when total revenue equals total production cost.
Break-even analysis is used as a risk management and safety tool in a variety of financial assets, from stocks and real estate investment to internal project budgeting. The analysis is popular among business owners because it tells you the exact unit of a particular product/service that needs to be sold to cover its costs of production (fixed and variable).
For example, a break-even analysis could tell you that you need to sell 50 lemonades priced at $10 each every day to cover the $200 lemonade ingredients and the $300 daily cost of renting a space on a popular parking lot.
Break-Even analysis is mostly for a company’s management use only, since it determines the internal target level of production, and calculation metrics aren’t readily available to external parties and investors except disclosed. Break-Even calculations depend on two major parameters, fixed costs, and variable costs.
Fixed costs are costs that stay the same for a long period regardless of a change in the number of goods produced. On the other hand, variable costs are costs that change as the number of goods produced changes. Generally, lower fixed costs mean a lower break-even point and vice-versa.
The formula for break-even point (BEP) is gotten by dividing the total fixed costs of production by the contribution margin per unit of product manufactured.
Break-Even Point in Units = Fixed Costs/Contribution Margin
Contribution margin = Selling price per unit – Variable cost per unit
The BEP Formula can be further expanded as:
Break-Even Point in Units = Fixed Costs/ (Selling price per unit – Variable cost per unit)
• Fixed Costs as earlier defined are costs that stay the same for a long period regardless of a change in the number of goods produced
• Variable Costs as earlier defined are costs that change as the number of goods produced changes
• Selling price per unit is the selling price for each unit of produced good or service
Liveflow can help with your break-even analysis (Using the Liveflow Break-Even Template) by transferring all the cost figures you need to calculate your break-even point directly from your synced Profit and Loss report. After this analysis, you'll get the result in an easy-to-read Google Sheets report. However, if you need to estimate your break-even point manually, you can follow the outlined steps below.
1. Gather your data
The first step in calculating your break-even point is to get an outline of all the costs that go into your business. From warehouse rent to labor and more. After this, you’d want to classify the different costs into fixed or variable costs.
2. Plug in your data
After classifying your data into variable and fixed costs, what is next is to calculate the break-even point using the BEP formula earlier discussed.
3. Make adjustments if needed
Once you get the hang of the process, then you can play around with the formula by inputting experimental numbers to see what happens if you increase your average price or reduce some fixed costs.
You can utilize the break-even analysis in several business events ranging from starting a new business to creating a new product, adding a new sales channel, and changing your business model. Asides from these instances, break-even analysis also gives you more benefits like:
1. Smarter Pricing: innumerable economic game theory considerations go into effective product pricing. However, break-even analysis lets you know the optimal average price to set your prices. So your business does not run at a loss for long.
2. Access to funding capital: the break-even analysis is one key component a prospective investor will check in your business proposal. Because of its ability to portray viability, a break-even analysis could ensure that you secure funding or loans from an investor or banking institution more easily.
3. Helps with revenue targets: Break-even analysis assists you with coming up with feasible and realistic revenue targets. Thus, improving your overall business decisions because you know how many products you need to sell to be profitable.
4. Helps you reduce expenses: Oftentimes, business owners tend to forget the total costs accrued in the long process of establishing their business. A break-even analysis keeps these costs in sight, helping you limit future costs.
As Dr. Lis Sintha, an economic professor at Universitas Kristen Indonesia notes, “Break-even analysis is a way to find out the minimum sales volume so that a business does not suffer losses.” In sum, doing a break-even analysis is essential for making profitable and informed business decisions.