What is a Break Even Analysis, and why your business needs it

What is a break even analysis?

The break-even point is a crucial figure when it comes to the financial health of your business. It helps you assess when your revenues equal your costs, thus helping determine how much room you have in your budget to spend, and how you should price your products. In short, this widely-used analysis tool helps determine how many products you need to sell in order to cover all of your business costs and make a profit.

Why is a break even analysis important?

A break even analysis can:

• indicate how many products you need to sell in order to keep your business financially viable

• help you identify exactly what your standard costs are and what the price points of your products should be in order to make a profit, thus serving as a guide for your margins

• show you how much you can afford to spend on “fluctuating” costs, like whether or not you can hire an additional employee, or if you could sustain unpredictable costs such as returns, lost shipments to customers, and damaged inventory

• help avoid overspending or undercharging because you’ll know exactly how much room you have in your budget after all established costs are considered

• help secure financing for your business by demonstrating to potential financiers, investors, and lenders that you have a firm grasp on your business’ financial projections

Because this figure is so essential and will impact how you price your products, the analysis should be done before you start selling to customers. However, best practice is to re-run the analysis at least 1-2 times a year as your business grows and your costs and revenue shift.

How do I perform a break even analysis?

Essentially, you do this by comparing your fixed and variable costs against your profit. However, before diving into the calculations, let’s start by outlining some key definitions that are used in the analysis:

• Fixed costs. Costs that you consistently have each month, such as utilities, storage/warehousing fees, or software licensing fees.

• Variable costs per product. Costs that are associated with individual products, and tend to go up as you manufacture or sell more products, such as materials used in the manufacturing of the products you sell.

• Contribution margin. The excess between a product’s selling price and their total variable costs.

  • For example, if your product retails at $10 and your total variable costs are $7, your contribution margin is $3.

• Contribution margin ratio. The ratio between your variable costs and your product.

  • For example, if your product retails at $10 and your variable costs are $7, your contribution margin ratio is 30%.

• Profit earned. The profit you earn after reaching the break even point.

Ask us about how we can set up your accounting software to help you find some of this information by tracking and monitoring expenses. Read more about our Accounting System Setup services.

How do I calculate the break even point?

The formula helps you determine how many units you need to sell in order to hit your break even point.

First, calculate your contribution margin:

(Price of Your Product) - (Variable Costs) = Contribution Margin

Example: If you’re charging $100 for your product and each one costs you $40 to make, your contribution margin is $60.

Then, use the following break even point formula:

(Fixed Costs) / (Contribution Margin) = Break Even Point

Example: If you have $200 in fixed costs per month and your contribution margin is $30, you’ll divide 200 by 30. This will give you an answer of 6.6, telling you that you need to sell 6.6 products in order to break even. Since you can’t sell two-thirds of a product, in most cases you’ll need to sell 7.

What costs should I consider?

Essentially, you need to be taking into account all of your costs - including both direct product manufacturing costs, as well as indirect costs, such as:

• The cost of warehouse storage

• Distribution and shipping costs

• Product packaging, including branded boxes, packing materials, price tags, and brand tags

• Ongoing business fees associated with licenses and permits

• Taxes

• Accountant fees, SaaS software costs, and the eCommerce solution you use

• Your salary, employee salaries, and fees for third-party contractors

• Marketing costs

• Utilities costs (electricity, water, gas, etc.)

• Other such costs of running your business, as applicable

The limitations of a break even analysis

Like any other tool for financial management, a break even analysis also has some limitations. Some of these include:

• Exclusive focus on contribution margins, particularly when used to price products. While the contribution margin will inform your decision about cost and price, other factors such as market conditions, competitive landscape, and customer preference and budget should all play a role in the final decision you make.

• An overly simplistic view of the business, which results in omission of impacts of the following:

  • Fluctuating customer behavior

  • Shifts in market trends

  • Seasonal demands

  • The impact of sales pricing or discounts

Schedule a meeting

Small business owners find a break even analysis to be an extremely useful tool at all stages of their business, not just before official product launches. As your business grows and evolves, you’ll also want to reassess your break even analysis.

At Arria CPA, we work with our clients to regularly conduct a thorough and objective break even analysis of their business, and also provide access to the tools to automate this calculation so that it can be performed regularly. They are then able to determine how changing product prices influences the required unit sales to cover costs and optimize profits. Contact us for a free, no-obligation consultation to learn more about how we can help your business find it’s break-even point and derive valuable insights.

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Disclaimer: Please note that this is only a brief summary and is based on current accounting regulations and tax law interpretations. Accounting regulations and tax laws are subject to continual review and change, so should the facts provided to us be inaccurate or incomplete, or should the law or its interpretation change, our summary may be inappropriate for your uses. This article is written for educational purposes only, and as such, we recommend you consult a professional before making an accounting or tax decision. If you have any concerns, or would like further consultation regarding this matter, please contact us.