What is a Break-Even Analysis? Formula & Strategies

Break Even Analysis Equation September 18, 2020

Chloe Henderson

Writer

Everything involved in business management, from ordering products to operational expenses, directly impacts a company's profitability. High or excessive fees can hinder profit margins, significantly affecting the bottom line. It is essential for businesses to understand how much revenue inventory can generate versus its cost, to determine safety margins.

The break-even analysis measures safety margins by defining the point at which their total cost and revenue are equal. This is also known as the break-even point, and it determines exactly how much income a business needs to generate to cover mandatory expenses, including fixed and variable costs.
By learning how to conduct a break-even analysis, businesses can ensure their ability to cover costs to remain profitable.

Break-Even Analysis- 3 Steps

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To conduct a thorough break-even analysis, management needs to gather and assess key financial metrics, including costs and profit margins. Only then can the break-even point be calculated.

1. Gather Data

First, management needs to gather and list all of the company's expenses, from inventory costs to rent. Everything that comes out of pocket needs to be written down and categorized into fixed and variable costs.

Fixed Costs are any expenses that remain constant regardless of how much the company uses or sells. Standard fixed costs include-

Rent
Software
Insurance
Hourly Labor Wages

These costs can be listed in monthly amounts for standard operating companies or customized time frames for specialized businesses. For example, food vendors can list all expenses necessary to vend at a week-long carnival event.

Variable Costs are expenses that fluctuate depending on how much the company sells. Some variable costs include-

Supplies
Commission-Based Labor
Payment Processing

Some costs could fit in either category. For example, full-time staff wages should go into the fixed costs group. However, while their wages may stay constant, hourly seasonal employees should be in the variable cost category as their work depends on the business's needs during busy seasons.

All of the variable costs need to be listed, along with the price per unit the company sold their products. Based on previous retail prices, management then needs to determine the average price. This price should be adjusted to reflect any discounts given for bulk purchases.

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2. Plug in the Data

Using the list of costs, management can now determine the break-even point with the analysis formula-

Break-Even Point = Fixed Costs / (Average Price Variable Costs)

For example, a clothing retailer sells tennis shoes at an average price of $55. However, they have three variable costs, including inventory expenses, commissions, and packaging, which adds up to $30. The store also has to pay to store the shoes and ensure deliveries, which totals up to $1,1000.

$1,100 / ($55 - $30) = 44

This means that the store needs to sell 44 pairs of tennis shoes in order to break-even. Selling less than this point indicates the store would be in a deficit while selling more than 44 units would generate profit.

3. Make Alterations

Making adjustments to the expenses and retail prices allows businesses to see how they can lower their break-even point to drive profits. Reducing storage usage or finding more cost-efficient packaging can minimize costs to promote profit margins. Businesses can also plug in various price points to determine how increasing rates affect the break-even point.

When to Conduct a Break-Even Analysis

Discovering the break-even point allows businesses to make data-driven decisions that reduce their financial strain. There are several events when it is necessary to calculate the break-even point, such as-

Starting a New Business - Running the analysis when developing a new business helps the owners determine if their idea is feasible and lucrative. However, it will require research on market prices and pricing strategies, as the company will not have any real values to plug into the formula yet.

Creating a New Product Line - An established business looking to launch a new product should perform the break-even analysis, especially if it has high expenses.

Adding a Sales Channel - Whenever companies add a new sales channel, their expenses will increase regardless of whether their retail prices change. Businesses need to determine what extra costs, such as added promotions, are necessary to sustain the new channel and how it will impact the break-even point.

Altering the Business Model - Organizations wanting to change their business model should conduct an analysis as they may handle entirely different expenses. For example, a company switching from carrying inventory to shipping goods will have more packaging costs rather than stock expenses.

Strategies to Lower the Break-Even Point

For businesses that find that the number of units they need to sell is too high or simply not feasible, there are various ways to lower the break-even point. Management can make minor adjustments to lower the threshold, such as-

Lowering the Fixed Costs - Companies should investigate their fixed costs to determine if there are any opportunities to minimize them, such as downgrading storage units. Management needs to remember, the lower the fixed costs, the fewer units that need to be sold to break-even.

Raising the Retail Prices - When companies raise their prices, the marginal contribution per unit that is sold increases, lowering the break-even point. However, increasing the price significantly can lead to lost sales. Therefore, businesses should monitor the market and competitors' prices to determine how much consumers are willing to spend.

Reducing the Variable Costs - Minimizing variable costs is often a difficult task as these expenses fluctuate frequently. However, management should negotiate lower prices with vendors or consider changing to suppliers with economical options. Businesses can also limit smaller expenses, such as packaging, to reduce the total variable costs.

Conducting a break-even analysis enables companies to make better business decisions, such as pricing and product launches. With a clear idea of how many goods need to be sold, management can ensure sales and revenue are able to sustain the business.