How To Do a Break-Even Analysis Before Starting Your Business

The break-even point is the point at which total revenue and total cost of doing business are equal. Determining a break-even point by conducting a break-even analysis is critical to any business plan. Entrepreneurs use this financial analysis to determine if their new business idea can succeed.

This article explains how to calculate the break-even point for the business idea you've chosen for your startup business.

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What a Break-Even Analysis Can Tell You

A break-even analysis is applied in many different situations in business, from stock and options trading to project budgeting. Doing a break-even analysis helps a small business owner avoid investing in product lines or business ideas that have a slim chance of being profitable. It helps an investor see when they may begin to recoup their investment.

When used in the context of a startup business, a break-even analysis calculation can help:

• Determine at what point a company, or a new product or service, will be profitable.
• Provide a basis for setting a sales price per unit. You can explore different pricing strategies, and the impact selling price may have when you reach a break-even point.
• Determine the number of product units or amount of revenue that's needed to cover your business's total costs. You can use it to identify a desired level of production, sales volume, and sales targets over a period of time.

Once a company has reached its break-even point, which may be different than the original calculation due to incorrect assumptions, a break-even analysis explains the margin of safety.

Tools To Do a Break-Even Analysis

You can create a break-even formula in Excel or use the Small Business Administration calculator. Refer to the following formula:

• Break-even point = fixed costs ÷ (unit selling price – variable costs per unit)

You can also use a preexisting break-even analysis template, such as the one provided on the website of the Senior Corp of Retired Executives (SCORE). The break-even point (BEP) is calculated by dividing the total fixed production costs by the difference between the price per unit and the total variable production costs.

Fixed Costs

Fixed costs remain the same regardless of how many units you sell. These are the basic costs of doing business. Depending on your business's nature, you may add or subtract fixed cost categories. When a company needs to cut costs, these are harder to cut.

• Overhead (including month-to-month expenses such as rent, insurance, utilities, phone)
• Salaries and payroll
• Professional services such as accounting and legal services
• Real estate taxes
• Debt servicing, including loan repayments
• Licensing and permit fees

A company with low fixed costs will often have a lower break-even point. It'll have fewer expenses to worry about before turning a profit.

Variable Costs

Variable costs are those costs that relate to the type and volume of products produced.

• Raw materials
• Direct labor and supplies for production
• Inventory
• Cost of goods sold
• Delivery costs
• Commissions

Variable costs will fluctuate. These are different costs every time they arise in your small business. You can project them as you settle into your business and collect data.

How To Start Your Break-Even Analysis

The estimates needed for a realistic break-even analysis include the following:

• Sales revenue is the total money from your business's sales activities per month and year. Be sure to base your estimate on the realistic volume of business that you expect.
• After deducting the direct cost for each sale, average gross profits are the amounts left from each sale. If you make a toy for $4 and sell it for $10, then your average gross profit is $6.
• Average gross profit percentages tell what portion of each dollar of your sales income is gross profit. Gross profit percentages are calculated by dividing the average gross profit amount by the average sales price. If you receive an average profit of $6 on each toy you sell for $10, the average gross profit percentage is 60%.

The first part of calculating your break-even point is accuracy when estimating fixed costs, variable costs, and revenue streams. To ensure your estimates are as accurate as possible, research similar businesses, identical metrics, the industry in your state, and potential suppliers. Every state has resources to help with this research, including Small Business Development Centers.

Finding Your Break-Even Point Using a Formula

After you have recorded the estimates listed above, you are ready to find your break-even point. Divide your estimated monthly overhead by your gross profit percentage. This quotient is the amount of sales revenue you need to break even.

For example, suppose your monthly overhead is $5,000, and your gross profit percentage is 50%. In that case, your break-even point is $10,000 per month ($5,000 divided by 50%). So, you would need to make $10,000 a month to pay your overhead and direct sales costs.

Unless you calculated wages for yourself as part of the overhead, remember that this amount does not include a salary for you or any profit. It shows how to break even between your overhead and revenue. The SCORE break-even template includes an owner's draw.

If Your Break-Even Point Is Too High

If your break-even point is higher than you expected, don't fret. Consider your options.

You could:

• Shop around for less expensive raw materials or supplies
• Decrease the number of units produced
• Reduce the number of employees needed for production
• Work from home
• Raise your sales prices (sales dollars)
• Increase your total sales
• Consider forms of business financing

If your break-even point is still too high after changing some of these factors, your business idea may not be attainable. Nobody wants to give up, but if you end up scratching an unfeasible business plan now, you may save yourself a lot of time, money, and headaches down the road.

Once you reach a desirable break-even point, you can continue with your business plan. Now that you have an idea of your budget, you can focus on a winning contribution margin.

Limitations and Weakness of Break-Even Analysis

A break-even analysis is only as accurate as the data you've put into it. It will require you to assume some things that can't be known for sure:

• It assumes that business conditions will remain the same. For example, it assumes that the selling price will remain unchanged regardless of market demand, raw materials supply, or competition.
• It assumes that production and sales quantities are equal.
• It assumes that all costs can be separated into fixed costs and variable costs.
• It assumes that fixed costs remain constant at all levels of activity and that you can apportion those fixed costs across a variety of products.
• It assumes that variable costs vary in direct proportion to the volume of output.

A break-even analysis may need to be more complex a measure to use if you have multiple products with multiple price points.

Furthermore, a break-even analysis doesn't consider startup costs or the amount of capital invested in the business. Capitalization is a critical factor in profitability.

Next Steps in Financial Analysis

Suppose your break-even analysis gives you a favorable break-even point. In that case, you can continue to the next steps in your financial analysis for a stronger sense of the future profitability of your business.

Continue your financial analysis to identify:

• Startup costs
• Net profit margin
• Profit and loss forecast
• Cash flow to determine if your company has enough liquidity to pay bills on time

Consult with a business attorney about your next steps, what sort of timeframe you should follow, and any legal requirements.

Get Legal Help Starting Your Business

A break-even analysis formula is the baseline measure for determining whether your business idea can be successful. Armed with a break-even calculation, you're better equipped to make important business decisions. Having a knowledgeable business attorney for legal advice and guidance can be the difference between success and failure.