Why do a breakeven analysis?
Conducting a breakeven analysis might look like a daunting task if you haven’t done it before. But by accurately forecasting sales of products or services and your business costs, you can quickly identify expenses and the projected sales. You will soon see how much revenue from the sales of products or services is needed to cover your expenses. In a nutshell, if you’re breaking even, it means that your costs are equal to your revenue.
How conducting breakeven analysis helps a business
The break-even analysis is a subset of Cost Volume Profit (CPV) Analysis. It’s important to do the analysis:
- If your business is planning to launch a new product – recognising the breakeven point is going to help you determine the selling price and the volume you need to sell. This can help you with your pricing strategies.
- When you’re planning a cash and profit strategy for your business, even though breakeven does not equal profit, it will help you to determine well the profit points of a product line.
- If you’re planning to get additional finance for your company, having a breakeven point for your business will improve your case when applying for a loan. Lenders and banks want to check the break-even chart and cash flow of a company before approving a loan.
What information will you need to determine the breakeven point?
If your company is manufacturing as well as selling various products, it’s crucial to know if these products are really profitable. Conducting a breakeven analysis is the only way to determine this.
Create a breakeven table that represents breakeven points for different sales volumes.
Potential investors and lenders will want to see this information, so include it in the financial section of your business plan.
Determining the best sales price for your product is possible only when you have this information. You will get the most revenue when you set the price at a point where the revenue is nearly at its peak. The margin of safety is simply the margin between the breakeven point and budgeted/actual sales. It indicates the margin of safety a company enjoys before it incurs losses.
Simple steps to create breakeven analysis
Here are some quick steps you can follow to determine breakeven:
- Define your variable unit costs
First, identify the variable cost per unit of a particular product. All expenses that you can associate in producing a product or purchasing it wholesale fall under variable costs.
For example, if you are manufacturing pens, your variable costs include items such as the ballpoint, ink cartridge, thrust tube, spring, clip and push-button. All these are required to make one pen, and it will cost your business to get them into a single product. After calculating, your variable cost may come up to $10. This figure helps get an accurate determination of the product costs.
2. Define your fixed costs
In order to operate, a business needs to cover fixed and variable costs every month. Total fixed costs are those a company needs to pay even though they do not manufacture a product. Adding the costs of operating a manufacturing unit or factory for a month will help you to determine this amount. You include rent, utility expenses, mortgage, insurance, and other fixed costs that aren’t affected by the volume of good and services produced. Include all costs except the amount you spend on producing a product. For example, you may identify that your total fixed cost is approximately $20,000.
3. Define your unit selling price
It’s essential for you to determine the price per unit or the unit selling price of the product.
Be aware that this price is going to change depending on the breakeven point. In this example, let’s say the unit selling price of the ballpoint pen is $20. The revenue per unit depends on how well you price your product. The number of units you produce and the total sales you can make in a month will determine how much profit you can make.
4. Define unit price and sales volume
It’s important to know that the breakeven point is going to change when the sales volume of a product or when a unit price fluctuates.
5. Create a spreadsheet
Using a spreadsheet is the best way to calculate a breakeven point. You can later turn the spreadsheet into a graph. If you do this, you can plot breakeven for sales and each level of product sales.
Breakeven formula and example
With this information, you can use the break even point formula to determine the breakeven point for a particular product or service.
Breakeven Point = Total Fixed Costs ÷ Selling Price of Unit – Variable Costs
For example, when it comes to pen manufacturing company, we can determine the breakeven point using the formula above:
$20,000 (fixed costs) ÷ ($20 (selling price) – $10 (variable costs)) = 2000 breakeven point (units sold)
Additional breakeven analysis example
XYZ company manufactures t-shirts. They spend almost $10 (variable cost) to make a high-quality t-shirt. For each unit sold, they make $10 (not including fixed costs) as the selling price is $20. Their fixed costs are $40,000 which they spend on salaries, rent, utility and property taxes. They have to sell 4,000 units to cover fixed costs.
Cutting costs can affect the breakeven point. Let’s take the same example and reduce th rental expense by moving to a new location, which will significantly reduce the fixed costs to $35,000 from $40,000. In this case, the breakeven point is:
$35,000 (fixed costs) ÷ ($20 (Unit Selling Price) – $10 (Variable Costs)) = 3,500 breakeven point (units sold).
Using the contribution margin to analyse your business
The contribution margin is calculated as the difference between the sales price of a product and the variable costs associated with the product and sales revenue from the product. With this number, you get the contribution margin ratio by dividing by the sales revenue.
The formulas are:
Contribution margin = Sales revenue – Variable costs
Contribution margin ratio = (Sales revenue – Variable costs) ÷ Sales revenue
So from the first example the contribution margin is $20 – $10 = $10 per unit.
The contribution margin ratio ($20 – $10) ÷ $20 = 0.5 per unit
Once you have this information, you can make decisions and any changes needed.