Break-even analysis: definition, calculations, examples, pros & cons
Achieving profitability is a major milestone for any small business owner.
But, before you can focus on turning a profit, you need to focus on balancing out your revenues and your expenses.
This is where break-even analysis comes in.
In this article, we’ll discuss:
what a break-even analysis is
how to conduct a break-even analysis (in multiple ways)
the advantages and limitations of break-even analyses
how to reduce your break-even point and reduce the time it takes to achieve profitability.
Let’s get started.
What is a break-even analysis?
A break-even analysis is an accounting process that determines the point at which a business investment will be on the verge of becoming profitable.
Put more succinctly, the break-even analysis is used to find your break-even point.
The break-even point of a business venture is met when the revenues generated by the initiative equal the amount invested into it. Once this point is met, any additional revenue generated from the venture is considered profit.
Break-even analyses can be applied to individual business ventures — such as a new product or service — or to your business as a whole. As such, it’s a vital tool to help small businesses make the most of their efforts and stay on the fast-track to growth.
Why are break-even analyses important?
Break-even analyses serve 2 key purposes.
First, it enables you to assess the validity and viability of a potential business investment (or, again, your business as a whole). If your break-even point is too far out into the future, or is unattainable in terms of sales numbers and revenues, you might need to think twice about making the investment.
A break-even analysis is also important for strategic planning. In conducting this analysis, you’ll be able to identify and diagnose potential risks within your plan — and can start focusing on making the necessary improvements right away.
Keep all this in mind, as we’ll revisit it when discussing the advantages and drawbacks of conducting break-even analyses.
How to calculate your break-even point
Your break-even point is calculated using the following formula:
Break Even Point Formula
= Fixed Costs / (Average Price - Variable Costs)
As a quick review:
Fixed costs refer to standard, unchanging expenses, like rent, salaries, and insurance payments.
Variable costs are those that fluctuate regularly, and/or with business operations. A few examples: material costs, hourly/overtime pay, and shipping fees.
The overall goal of a break-even analysis is to identify how much you need to make to cover these costs, and ultimately to turn a profit.
Read this next: Business expenses guide for SMBs
Examples of break-even analyses
When conducting a break-even analysis, you can use either sales revenue or sales quantity as a point of reference.
Here, we’ll use each method to calculate the break-even point(s) for the following scenario:
You own a small shop that specialises in selling a unique widget. Each widget sells for $25, and costs $2 to make. Your fixed costs are $10,000 per quarter.
Break-even sales revenue
Here, you’ll be finding the total amount of sales revenue you’ll have to generate for your business to be profitable.
To calculate your break-even point in this way, you’ll first need to calculate your contribution margin. This is found using the following formula:
Contribution Margin = (Sales Price Per Unit - Variable Costs Per Unit) / (Sales Price Per Unit)
The break-even point formula, then, is:
Break-Even Point = (Fixed Costs) / (Contribution Margin)
Using the example from above, we have:
Break-Even Point = ($10,000) / [($25-2) / ($25)]
Break-Even Point = $10,869.57
So, you’d have to generate $10,869.57 in revenues to break even every quarter.
Break-even sales quantity
You also want to know how many actual units you’ll need to sell to hit your break-even point.
Break-Even Point = (Fixed Costs) / (Revenue Per Unit - Variable Costs Per Unit)
Using our example scenario, we have:
Break-Even Point = ($10,000) / ($25 - $2)
Break-Even Point = 435 units
In other words, you’d need to sell 435 units every quarter to achieve profitability.
As you may have noticed, both of these numbers are closely related: Your revenue-based break-even point is roughly the same as your unit sales target multiplied by your profit per sale.
(Since you can’t sell a fraction of a unit, we round up when calculating the quantity-based break-even point.)
That said, it’s still important to understand your break-even point from both angles, as this will help you determine the best course of action moving forward.
Pros and cons of using the break-even analysis method
Done correctly, conducting break-even analyses can lead to great things for your business.
But, it can also lead you in the complete wrong direction if you aren’t careful.
Let’s take a closer look at what we mean here.
Advantages of the break-even analysis
First, let’s dig into the good stuff — much of which we’ve touched on already.
Identify the true cost of doing business
Conducting break-even analysis means combing through your expenses with pinpoint accuracy.
And, in conducting this audit, you’ll gain a true sense of what it will actually cost to get a specific business venture off the ground.
At the very least, you’ll know what it’ll take to keep the lights on – and will have a clearer idea of how long it will take to recoup your investment.
Minimise financial risks
A break-even analysis can also help you avoid taking on business ventures that are much too risky.
A few examples of what may be revealed through break-even analysis:
your break-even sales quota is out of reach
your production costs cut too far into your profits
you’ll run out of money before you turn a profit.
Based on what you find, you may need to make some changes to your plan — or scrap the plan altogether. Either way, you’ll avoid taking on financial risk that you otherwise may have fallen prey to.
Similarly, you may find that a given venture could be even more profitable by cutting certain costs. In addition to eliminating risk in future investments, you’ll actually be plugging holes in your current operations, as well.
Improve your pricing strategy
For many small business owners, doing break-even analysis can lead to an “Aha!” moment in their approach to pricing.
In gaining an overview of what it will take to break even, you can then focus on tweaking your pricing to get there faster without increasing expenses. While there’s more to pricing than looking at costs, break-even analysis can help you get moving in the right direction.
4. Set clear revenue goals
To review, conducting break-even analyses leads to:
fewer financial risks
more strategic pricing.
With all this in place, you’ll be equipped to set clear revenue goals moving forward.
Once you know when your business will start generating profits, you can start planning for future growth well ahead of time.
Limitations of the break-even analysis method
As valuable a tool as break-even analysis is, it doesn’t do it all — and you shouldn’t expect it to.
(Again, thinking that break-even analyses will give you all the answers you need will almost certainly lead you in the wrong direction.)
That said, let’s take a look at the main limitations of the break-even analysis method.
Extra steps for service-based businesses
While product-based businesses can easily calculate their break-even point by plugging in the right variables, service-based businesses have to first define what these variables refer to.
First, they’ll need to define what a “sales unit” is in their business. For some, it may be individual clients; for others, service hours. Either way, this can muddy the waters a bit when trying to nail down a finite break-even point.
Service-based businesses will also need to more clearly differentiate between fixed and variable costs, which isn’t always easy. Hourly wages, for example, can be mistaken as a fixed cost of a given service, though they technically should be seen as a variable cost for the purpose of break-even analysis.
This isn’t to say that break-even analysis isn’t important for service-based businesses; it definitely is. Still, you’ll need to be wary of these additional challenges while getting started.
Inadequate data for complex businesses
To be blunt, the break-even analysis doesn’t provide all that much value to companies with large, varied product catalogs.
Yes, you can calculate your break-even point using the average price, cost, and sales numbers for your entire product catalog. But, this alone won’t help you identify specific ways to improve your approach to selling your individual products.
To get this more granular view, you’ll need to conduct break-even analysis for each of your products. While this isn’t impossible, it’s simply more work than teams with smaller product catalogs have to deal with.
Doesn’t account for outside variables
Conducting break-even analysis allows you to project your break-even point, so long as conditions stay similar to the current state of things.
Of course, your business doesn’t operate in a vacuum — and a lot can happen to throw your initial projections off course.
demand will fluctuate over time (for better or worse)
competitors will enter and exit the industry
supply chain issues and such can and will arise.
This and more will cause your costs and revenues to fluctuate. This, in turn, can render your initial break-even point null and void.
How to reduce your break-even point
Reducing your break-even point means reaching profitability quicker and more efficiently.
Let’s see how to make that happen.
Lower fixed costs
First things first, you’ll want to start paring away at any unnecessary or extraneous fixed costs your business incurs.
Perhaps you’re paying too much for your rental space. Maybe your insurance rates are too high. Or, maybe your phone service charges too much for monthly service.
Worse yet, you may find that you’re paying for a tool or service you don’t even use. Similarly, you might be paying for a premium piece of software, while only using the basic features offered by the tool.
In any case, minimising your fixed costs will inevitably bring you to break-even faster than anticipated.
Lower variable costs
You’ll also want to do what you can to lower your variable costs, as well.
Again, your focus should be cutting down on superfluous costs — that is, those which don’t add any value to the product or service you provide. Looking at this another way, you only want to lower a variable cost when you can be sure that it won’t decrease the value of your product or service.
Overall, the goal is to provide the same value (and more) to your customers while simultaneously optimising the processes it takes to do so.
Increase selling price
This is pretty straightforward:
By increasing the price of your product, you’ll need fewer sales to hit your break-even point.
Of course, you need to be strategic here: Increase your prices too much, and you’ll risk seeing a drastic decrease in sales. With this change in demand, even this lower break-even point may be unattainable.
Raise your margins
Raising your margins can also lower your break-even point — and it’s a bit more involved than simply increasing your prices.
Basically, it involves taking an objective look at your prices, your costs, and the value you provide your customers.
With this more holistic understanding of how each relates to one another, you can then identify a profit margin that lowers your break-even point without negatively impacting demand.
Keeping close tabs on your business’s cashflow is important for many reasons — reducing your break-even point being just one of them.
By improving your overall cashflow, you’ll have more money on hand to pay down investments, loans, and other financed costs quicker. This will cut down on interest payments — and will get you closer to your break-even point in the process.
Reduce your break-even point with MYOB
Simply put: the faster you hit your break-even point, the faster your business can start generating profit.
As we said above, one of the key ways to reduce your breaking point is to minimise operational costs by streamlining your processes.
Which is where our accounting software comes in.
MYOB software can help you reduce the resources needed to manage invoicing and payroll. In optimising these processes, you’ll see a major reduction in overhead, which will in turn make it easier to hit your break-even point. Ready to get started? Try MYOB software for FREE for 30 days!
How to do an accurate bank reconciliation in 6 simple steps
Budget vs. forecast: 3 key differences
Cashflow statements: preparation, examples and a template