Break-even analysis is a practical and popular tool for many businesses, including start-ups.
However, you also need to know about the limitations of the method.
Here is a summary of the key issues from the perspective of a startup or new business, for whom breakeven analysis is particularly relevant and important.
It’s always risky to start a business, but to find out how risky, you may need to do a break-even analysis. Giving you insight into exactly what you need to do to make back your original investment, break-even analysis is an important financial metric for any entrepreneur or small business owner to have a handle on. But what is break-even analysis? Find out everything you need to know, including how to do break-even analysis and the strengths and weaknesses of break-even analysis, right here.
Break-even analysis explained
The break-even point is the point at which total revenue and total cost are equal. Break-even analysis determines the number of units or amount of revenue that’s needed to cover your business’s total costs.
At the break-even point, you aren’t losing or making any money, but all the costs associated with your business will have been covered. After breaking even, the sales made by your business are pure profit. Put simply, break-even analysis helps you to determine at what point your business – or a new product or service – will become profitable, while investors also use it to determine the point at which they’ll recoup their investment and start making money.
So, when do you need to do a break-even analysis? It can be an excellent tool to use when you’re starting up a new business, as it helps you to decide whether the idea is viable. Plus, it provides you with information you can use when designing your pricing strategy.
In addition, it’s a good idea to do a break-even analysis when you’re creating a new product, particularly if it’s particularly cost-intensive. Finally, whenever you make any kind of adjustment to your business – such as adding a new sales channel or switching your distribution model – your costs can change dramatically, so it’s always a good idea to do a break-even analysis.
How to calculate break-even point
Break-even analysis is relatively simple. You can use the following break-even analysis equation to calculate the break-even point:
Break-Even Quantity = Fixed Costs / (Sales Price Per Unit – Variable Costs Per Unit)
Let’s look at an example to see how this works in practice. Company A sells and manufactures tennis racquets, and they have fixed costs that total £250,000 (lease, payroll, property tax, etc.). The variable costs associated with producing tennis racquets are £10 per unit, and each racquet sells for £50. You can use the break-even analysis equation to work out Company A’s break-even point:
250,000 / (50-10) = 6,250
So, Company A would need to sell 6,250 tennis racquets to break even.
Break-even is the point at which revenue and total costs are the same, meaning the business is making neither a profit nor a loss. The break-even level of output informs a business of the amount of products they need to sell in order to reach the break-even point (BEP). This information can be displayed on a chart, called a break-even graph.
Break-even analysis is an extremely useful tool for a business and has some significant advantages:
- it shows how many products they need to sell to ensure a profit
- it shows whether a product is worth selling or is too risky
- it shows the amount of revenue the business will make at each level of output
- it shows whether costs need to be reduced to lower the BEP
- it can be used to persuade investors or banks to finance a business
- it is quick and easy to analyse
However, break-even analysis does have some drawbacks:
- break-even assumes a business will sell all of the stock (of a particular product) at the same price
- businesses can be unrealistic in their calculations
- could change regularly, meaning the analysis could be inaccurate
- they can be time consuming to create
Strengths and weaknesses of break-even analysis
There are lots of reasons why it could be a good idea for your business to do a break-even analysis:
Pricing – Break-even analysis gives you a much more solid basis from which to price your products. Look at your current financial situation and work out how patient you can afford to be when it comes to reaching your break-even point.
Setting revenue targets – In addition, doing a break-even analysis can be a great tool for setting concrete sales targets for your team. If you have a clear number and a timeframe in place, it’s always going to be easier to decide upon revenue targets.
Mitigate risk – Sometimes, business ideas just aren’t meant to be pursued. Break-even analysis can help you mitigate risk by avoiding investments or product lines that aren’t likely to be profitable.
Gaining funding – It’s worth noting that break-even analysis is often a key component of business plans. If you want to get funding for your business or start-up, you’ll probably need to do a break-even analysis. Plus, a manageable break-even point is likely to make you more comfortable with the prospect of taking on extra financing or debt.
However, the limitations of a break-even analysis shouldn’t be underestimated:
Doesn’t predict demand – Although a break-even analysis can tell you when you’ll break even, it doesn’t give you any insight into how likely that is to happen. Plus, demand isn’t stable, so even if you think there’s a gap in the market, your break-even point could end up being a lot more ambitious than you initially thought.
Depends on reliable data – In short, the accuracy of your break-even analysis is dependent on the accuracy of your data. If your calculations are wrong or you’re dealing with fluctuating costs, break-even analysis may not be the most useful tool in your arsenal.
Too simple – Break-even analysis is best for companies with one price-point. If you have multiple products with multiple prices, then break-even analysis may be too simple for your needs. In addition, it’s worth remembering that costs can change, so your break-even point may need to be evaluated and adjusted at a later time.
Ignores competition – Another limitation of a break-even analysis concerns the fact that competitors aren’t factored into the equation. New entrants to the market could affect demand for your products or cause you to change your prices, which is likely to affect your break-even point.
All in all, it’s best to conduct a break-even analysis alongside other profitability metrics, such as net profit margin, to ensure that you’re getting the best overview of your business’s financial health.
Strengths of breakeven analysis
Focuses entrepreneur on how long it will take before a start-up reaches profitability – i.e. what output or total sales is required
Helps entrepreneur understand the viability of a business proposition, and also those who will lend money to, or invest in the business
Margin of safety calculation shows how much a sales forecast can prove over-optimistic before losses are incurred
Helps entrepreneur understand the level of risk involved in a start-up
Illustrates the importance of a start-up keeping fixed costs down to a minimum (higher fixed costs = higher break-even output)
Calculations are quick and easy – great for giving quick estimates
Limitations of breakeven analysis
Unrealistic assumptions – products are not sold at the same price at different levels of output; fixed costs do vary when output changes
Sales are unlikely to be the same as output – there may be some build up of stocks or wasted output too
Variable costs do not always stay the same. For example, as output rises, the business may benefit from being able to buy inputs at lower prices (buying power), which would reduce variable cost per unit.
Most businesses sell more than one product, so break-even for the business becomes harder to calculate
Break-even analysis should be seen as a planning aid rather than a decision-making tool
