When you are planning for your business, you need to know when you will earn a profit. Calculating when is usually done through a break-even analysis, and it is always a necessary part of any business plan. The report will help identify when you will reach profitability and if your business will make money through the break-even point. Many beginners in companies get to be overwhelmed by the idea of creating a break-even analysis, but it is critical to know how a business can be successful.
A break-even analysis is essential because it will show if your anticipated revenue will be higher than your costs. Do you have a great business idea in mind? You need to know your break-even point first. Read on below to learn more about learning more about break-even analysis.
How to Begin With Your Break-even Analysis
Estimate expenses and revenue streams
To generate an accurate estimate of your expenses and revenue, you can do some research on the current market that is related to your business. These estimates are essential in calculating your break-even point:
- Overhead expenses or Fixed Costs – these include your monthly expenses like rent, utilities, and insurance.
- Variable costs – these are expenses that are dependent on the number of items produced for the business. Examples are raw materials and labor
- Revenue – this is the amount you expect to make from all of your sales. These numbers could be estimated monthly or annually.
- Contribution Margin – this is calculated by subtracting a good’s variable cost from its selling price. If you are going to sell a product for $100 and the cost for materials and labor costs $50, your contribution margin is $50. The remaining $50 is used to cover overhead expenses, and whatever is left from that is your net profit.
Calculate Break-even Point
After having the estimates identified above, you can calculate your break-even point. There are several ways to calculate your break-even point. One way is to calculate it based on units. You divide the overhead expenses by the revenue per unit produced minus the variable cost per unit of manufactured goods.
Break-Even Point (Units) = Overhead Expenses ÷ (Revenue – Variable Cost) per unit
In calculating the break-even point in terms of dollar sales, you will divide the fixed cost by the contribution margin.
Break-Even Point (dollars) = Overhead expenses ÷ Contribution Margin
How Break-Even Analysis Can Help You Launch Your Business
Based on numerous definitions, profit is defined as the amount of revenue a business gained that exceeds all the expenses involved in the business activities. Your business’ need to get enough profit depends uponyour business goals. Having a break-even analysis can help you with that. The second part of the break-even analysis will help you identify how soon you can earn profit and what you need to do to improve the time it takes.
Here are other benefits of generating a break-even analysis before creating a business plan:
It helps you plan to avoid losses.
When you have the numbers from your break-even analysis, you can determine the sales quantity for you to generate enough revenue to keep the activities going. Knowing how much you need to produce or how long you need to provide services will avoid potential losses in the future.
It helps you determine your profit levels.
Just like what was mentioned above, using break-even analysis can help owners to determine how much they can earn at different sales volumes. Any sales volume or number that goes beyond the break-even point is already a profit. When you already determine the sales volume you need to reach a certain profit level, you can plan your business needs accordingly, like materials, labor, and other costs.
It helps you set the right price for your goods and services.
Your price offering is one of the significant factors that you must consider when you start a business. Setting the right price for your goods and services will dictate if you will succeed or not. Selling price affects business profitability in several ways.
You may be tempted to underprice your product if you want to compete in the market. Many people may think that lowering sales prices can increase sales volume. However, cheap goods or services can be perceived by the masses as something of poor quality. Setting the price low is also a tricky strategy if you want to be present in the market scene for the long term since people might not trust you in case you suddenly increase prices due to rising variable costs.
If you have your break-even analysis, you can set different price levels and evaluate break-even numbers for each level. The numbers will help you study the effect of each price level taking into consideration other factors like competition, affordability, and inventory management.
It helps you with scheduling your inventory requirements.
Generating your break-even analysis can help you with maintaining healthy product inventory levels. It is critical for any non-service business to stock enough inventory and has products available over a given period. You can set your inventory volume based on the number to provide by the analysis when you use the constant quantity of units needed to be sold at a given period to have stead profit. It will help you prepare your initial inventory and plan on the restocking based on your cash flow. For service industry businesses, you need to know what level of employment is needed in the same way as product based businesses.
It helps you create your business timeline.
One of the primary reasons why having a break-even analysis is essential before creating a business plan; it is because it will dictate your business timeline. Any business owner would want a stable income flow that is also sustainable. A good standard for measuring optimum sustainability for any business is when it earns profit within the first four years of operation.
Profitability is affected by several factors like the nature of business and the current market status or competition. According to reports, advertising, marketing, banking, and insurance businesses tend to profit the fastest. Meanwhile, companies in the food and medical industry tend to earn longer due to high competition in the market. Considering all the factors that affect profitability, industry-wide data, and your break-even analysis, you can plan your business timeline accordingly.
It will help you increase your profit faster.
Provided that you already have a realistic timeline, you will know when you can earn your profit. However, if you want to be aggressive in your business and take calculated risks, using the break-even analysis can help you increase your profit faster. To reach a certain profit level, business owners need to stay focused on fixed and variable costs. It would be best if you optimized revenue while reducing your costs.
If profits are getting smaller, considering that there are no issues in the current market and sales volume, you should look into the expenses. Break-Even analysis always has the expense side of the equation. Through the study, you will have an idea to continually review your spending habits and ensure that everything brings value to the business. If you reduce the costs, even without increasing the sales volume and price offer, you will see an increase in profit.
It can help you determine the tools to help you in your business.
Make sure that you have the right tools and equipment to keep business activities running smoothly. Since the break-even analysis will show you how much you need to spend and how much you need to produce, you can plan finances accordingly.
Most businesses need to borrow funds as a source of capital. Loans are already considered in your fixed costs. You might need to borrow money to produce a certain number of products, and the amount you will loan is included in your break-even analysis.
In reality, the need for capital will often decline over time. This is because it is expected that you will have growing revenue. However, if you are planning for your business to stay for longer periods, you can expect to borrow again to sustain the operations and have a steady cash flow.
Numbers generated from your analysis will give you an idea of how much you need to produce to reach that break-even point or achieve your target profit or margin. Aside from that, break-even analysis is also used for daily operations and planning.
The break-even point can dictate if the prices of the goods and services are already enough to gain decent revenue or profit. Aside from that, it can also help you with deciding which variable costs are sustainable. Apart from that, it can also help determine the need for new products and services to increase profitability.
The bottom line is, calculating the break-even point is useful not only during the beginning of a business plan but also for its continuity. It is an essential tool for business planning and ensuring that any business opportunity can provide profit. That is why it is never wise to skip this critical step when creating a business plan. Always consider generating an analysis before engaging in any business activity.
On the other hand, we see a lot of companies that are not as concerned about break-even as they are about market share. Some of those companies are loosing significant amounts of money as they build their brand in the hopes of huge profits in the distant future. The WeWork fiasco of 2019 is a perfect example within the office space industry how things can go very badly with that strategy. WeWork lost $1.61 billion in 2018, up from $884 million in 2017 and $429.7 million in 2016. And yet, their founder walked away with a $1.7 billion dollar payout. In 2018 the Wall Street Journal identified that 80% of IPOs in 2018 have been for money-losing companies.
So what’s the best strategy? Let us know what you think?