To evaluate the profitability of any business, it is crucial to analyse the break-even point. The Break-even Point is the one wherein your total expense matches the total revenue without any loss or profit, also defined as the point wherein a business ultimately recovers all its capital costs involved in setting up the venture.
What are Essential Components of Break-even Analysis?
- Variable Costs: These are expenses directly related to the production volume, including transportation, packaging, raw materials, and others related to production.
- Fixed Costs: These are determined when the business idea enters the production stage. The cost depends on the total level of production. Fixed costs comprise of labour, depreciation, salaries, rent, tax, and other types of operational costs. These costs remain free from the process of production.
Importance of Calculating Break-even Point for Your Business
When a business is making ample money, it does not necessarily mean that it is being profitable. When a business owner is aware of the break-even point, it helps in deciding the overall costs, preparing business plans, and allocating sales budgets. Calculation of the break-even point is also important in identifying core sales drivers –including sales price, average production cost, and sales volume.
When a business understands the break-even point, it is capable of identifying:
- Total number of units for sale before gaining profitability
- Profitability of existing products or services
- Impact of reducing sales volumes or price
- Point of reducing sales when business starts incurring a loss
- Increase of sales volume or price for making up the increase in fixed costs
Calculating Break-even Point
There are different strategies to calculate the break-even point for any business, based on the number of units or the total sales.
- Break-even Point as Per Units
Break-even point (units) = Fixed Costs / (Revenue per unit –Variable Cost per unit)
Here, fixed costs are expenses that remain the same without any regard to the total number of units sold. Revenue is the price at which products get sold minus variable costs including labour, materials, and so more. To calculate the break-even point, it is required to divide the fixed cost by revenue/unit, minus the variable cost/unit.
- Break-even Point as Per Sales
Break-even Point = Fixed Costs / Contribution Margin
For calculating the break-even point on the basis of sales, businesses can divide fixed costs by contribution margin. Businesses can determine contribution margin by subtracting variable costs from the product’s price.
Application of Break-even point Analysis
Once a business has calculated its break-even point, it is required to apply the break-even point analysis on actionable tasks to be achieved at a particular point.
At the given stage, the current business plan might appear infeasible. A business owner will be expected to sell more products to achieve the break-even. Therefore, it is a good time to analyse the condition with a holistic approach.
This is the reason why businesses undertake break-even point analysis before starting any operation or marketing a new product or service. This helps businesses determine whether or not a new product or venture will deliver ample profits to make the overall expenses worthy of achieving that goal.
Break-even planning for businesses is executed for several operations and activities, and is not just limited to analysing product and start-up launches. With break-even planning, it is possible for businesses to accelerate the day-to-day operations and planning, including:
- Launch of New Products: Fixed and variable costs should be considered before the launch of any new product.
- Goals: Businesses can achieve both short-term as well as long-term goals in a highly viable manner and can even depict clear objectives within different levels of the company.
- Planning: With break-even analysis, it is possible for businesses to come up with long-term growth strategies. This is achieved by identifying the total time-frame needed for covering new fixed costs like increase in total rent while adopting better techniques or moving to some bigger facility.
- Labour and Material Cost: Break-even analysis can help in calculating the labour & material costs. If the business spending is significant on labour & materials, it is important to strategize as well as implement mechanisms for lowering production cost without making any compromise on quality.
- Adjustment of Price: Businesses can adjust the product costs if they realize that the current price is too low for achieving the desired results in the targeted time frame.
Break-even analysis is itself a component of scenario analysis or sensitivity which is carried out for financial modelling applications. With the help of break-even analysis, businesses can resolve the number of units required to sell, the cost needed to bring about break-even, and price of individual units. Then, businesses can start reaping the profits.
Importance of Break-even Analysis
Break-even analysis is needed in the following conditions:
- Launching a New Business: Break-even analysis is quite important for start-ups as it helps businesses in deciding the viability of the business idea while calculating costs and pricing strategies.
- Creation of a New Product: Break-even analysis is also a major focus area for businesses whenever there is a launch of any new service or product in the market. This stands true especially when higher costs are involved in operating the services or manufacturing the product.
- Business Model Alteration: Whenever a business alters the business model, costs can change significantly depending on whether they are scaling up or downsizing. This makes break-even analysis is also crucial for organizations towards determining selling prices while altering the business models.
Conclusion
A break-even analysis helps in determining the break-even point. At the given point, businesses should ask whether the current plan is realistic or not and consider whether or not products will be successful in the market. Just because the break-even analysis helps in determining the number of products businesses are required to sell, there is no guarantee that they will sell.