A break-even analysis or break-even point is the point at which expenses and revenue equal each other. Basically the point where you've made back the money that you've invested. Total Revenue = Total Cost (TR=TC). There is no net loss or gain.
A break-even analysis can give a business owner a good idea of the viability of the company. If you are going to have to sell an extreme amount of product just to break-even, the likelihood of the company succeeding is small. Say you sell computers out of your garage, you are the only employee and you can build three computers a week. If it requires you selling 100,000 computers just to cover costs and your initial investment, the business stands a good chance of failing. But if you find that you only need to sell 100 out of your garage to break-even, then the business might seem more viable.
So let’s pretend you have a handmade jewelry business. To calculate your breakeven you would use the equation: Total Fixed Cost / (Selling Price - Variable Cost) = Breakeven
These are costs you incur in operating the business, even if no product is produced. These costs don’t change based on the amount of product you sell or don’t sell.
Fixed Cost Examples:
Cell Phone Plan: $1,200/year
Total Fixed Costs: $8,225/year
Note: Your fixed costs could be different for next year since you won't be buying a new desk every year, computer etc. Be sure to factor that into your year two expenses.
These are the costs that change as you do business. For example- if you buy inventory or supplies, you would need to buy more inventory or supplies as your demand or sales increase. This cost changes depending on how much or how little you sell. This is how much it will cost to create 1 piece of your product.
Variable Cost Examples:
Chain for Necklace: $.16 per
Clasp for Necklace: $.03 per
Pendant for Necklace: $2.40 per
Gift box for Necklace: $1.05 per
Total Variable Cost Per Necklace: $3.64
You’ve done some market research, shopped around to local boutiques and noticed that similar necklaces to yours sell within a range of $25 - $45. You decide you will sell your necklaces for $30 per.
To calculate your break-even: Breakeven = Total Fixed Cost / (Selling Price - Variable Cost)
BE = $8,225 / ($30-$3.64)
BE = $8,225 / $26.36
BE = 313 pieces must be sold to cover total costs.
You decide that 313 pieces is too many. You only wanted to make 500 for the year. If you break-even at 313 pieces you must make 314 pieces to make any profit. Obviously, we want to lower our break-even point so that we can make more profit. We can then input a few different scenarios to manipulate our break-even.
1. Negotiate some of your variable costs down. There are typically price breaks when more inventory is ordered. So instead of pendants being sold at $2.40 a piece, after ordering 100, the price may be $1.96 per. Break-even would then be 276 pieces and you would begin making a profit at 277 pieces sold.
2. Raise your selling price. What would happen if you sold each necklace at $35? Break-even would be 263 pieces and you would begin making a profit at 264 pieces sold.
3. Negotiate some of your fixed costs down. If we move into a space that only charges $4,000/year in rent and we cut our cell phone plan to $900 a year, break even is now 225 necklaces and you would begin making a profit at 226 pieces sold. Big difference.
4. What happens if we do all three of the above mentioned? Breakeven = $5925 / ($35 - $3.20) Breakeven = 187 pieces. Making a profit after 187 pieces instead of 313 sounds pretty great right? And you thought you’d never use algebra again… tsk. tsk.
There are many limitations to the break-even analysis, but by doing one, you can determine price point, feasibility, production and help form your sales goals.