Profitability is a key metric used to measure whether a business is generating a profit or not. What is break-even analysis, then, and why should you know what it is? To start, a break-even analysis is part of the profitability equation. It’s simple math, but it can get more complicated as your business grows and scales. Today, I want to give you a clear definition of break-even analysis, outline how to conduct a break-even analysis for a small business, and discuss its importance to small business profitability. Some key takeaways:
- Your break-even point can be calculated by dividing your total fixed expenses by the contribution margin of your product or services.
- Break-even analysis is more complicated when your company sells multiple products or services with different price points.
- Understanding how a break-even analysis works can help you make better business and financial decisions.
What is break-even analysis?
Let’s begin this exercise with a profit/loss calculation: Subtract your total expenses from your gross revenue and take a look at the results:
- If the number is positive, you’re profitable.
- If the number is negative, you’re showing a loss.
- When the result is “0,” your company broke even.
Outcome number three is a significant milestone in profitability calculations. Your business must exceed it to be “in the black,” so that zero is your north star if you want to know how to conduct a break-even analysis for a small business.
Why should small business owners care? If your business deals in products, assessing the profit margin on each unit sold is crucial to maximizing profitability. Services, on the other hand, can be more complex than products at the outset, but what’s important here is that products and services come with costs and expenses. We want to know if and when we have a sustainable business.
Running a break-even formula sharpens purchasing and pricing decisions for growth. In the realm of financial analysis, the break-even point is an essential variable for comparisons with industry benchmarks and past performance.
Is your product or service scalable? Should you invest more in this business or move in a different direction? It depends on the maturity of your business and the use case.
Break-even points separate promising start-ups from duds.
Start-ups use the break-even point as a metric to distinguish the before-and-after of their “burn rate.” Small businesses often refer to it when launching new products or services. It’s also used in financial planning, but there are limitations when companies have diverse product lines or service models.
Let’s take a deeper look into how to conduct a break-even analysis for a small business by examining how the break-even formula works. Then we’ll get into specific scenarios.
How does the break-even formula work?
The difference between the selling price per unit and the variable cost per unit is known as the “contribution margin.” It doesn’t factor in the fixed costs of running the business, such as rent, insurance, salaries, and loan payments, so those need to be added to the equation. Here’s how to calculate the break-even point incorporating all necessary variables:
Break-Even Point (in units) = Total Fixed Costs ÷ (Selling Price per Unit – Variable Cost per Unit)
Here’s an example: Your company sells a $50 product with an average variable cost of $30. That’s a contribution margin of $20, meaning you must sell 200 units ($ 4,000 ÷ $20) to break even. Any units sold after that will net you a $20 profit, because your fixed costs will be covered; however, the variable costs to produce the units remain the same.
The formula gets more complicated with multiple products. Different products have different contribution margins because production and distribution costs are variable. That’s an accounting challenge you might need a professional accountant to help you with. Schedule an appointment with me if you’d like to go over it. A scheduling link is available at the end of this article.
How does break-even analysis help you make better business decisions?
Understanding the break-even formula gives you valuable insights into your business. I’m repeating this, and I’ll continue to repeat it. Trade “information” for “insight,” and we end up with terminology that’s a little less cliché. Either way, we’re talking about utility.
For instance, your contribution margin tells you if you need to raise prices or lower costs. Your company can decrease the number of units sold to break even if you increase the margin. Doing this for all products will make your business more profitable.
Take a closer look at contribution margins and your relationship with suppliers and vendors.
There are several ways to increase your contribution margins. One is to renegotiate your vendor and supplier contracts, which gives you a better understanding of economics and market conditions. Renegotiation could inform a decision to increase prices. You may choose to launch a new product that’s cheaper to produce. Contribution margins are particularly important in today’s environment.
Do not be afraid to discuss prices with the partners who sell you core materials or provide core resources. Just like you pass on the cost to your customer, vendors pass on their costs to you. There’s room for a conversation.
Assess and manage risk with reliable data.
Risk management is another area affected by break-even analysis. Knowing what you need to cover costs and expenses tells you how much risk you can take. Is that new business venture a good investment, or do the numbers tell you the projected revenue won’t cover the costs? You can’t make that decision if you don’t know what the numbers are.
There are limitations to break-even analyses. Here’s how to manage them.
I’ve already mentioned the complexity of performing a break-even analysis with a diverse product line or set of services. Don’t make the mistake of trying to do that with averages. Those scenarios require a more sophisticated analysis that factors in hypothetical sales numbers.
Another flaw in the break-even formula is the assumption that fixed costs remain fixed. Rent increases and decreases; Insurance premiums rise and fall. Loan payments will stay constant, but only if the interest rates are fixed. And let’s not forget consumer demand: There’s no guarantee that you can sell the number of units you need to break even.
I treat break-even analysis as one piece in a complex financial puzzle. It’s a valuable tool for financial planning, but it should not be treated as an “immortal” integer. Recalculating it monthly or quarterly can ensure that your business decisions aren’t made with flawed data. You should also compare it to your revenue and expense reports for real-time accuracy.
We’re here to make your business run better and grow faster.
Find your break-even point and use it to make better financial and business decisions. It’s different for every business, but the mathematical and accounting principles are the same. Let’s see what the situation looks like in your business right now and put together some action points.
Talk soon,
Jeremy A. Johnson, CPA