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 a critical part of any business plan. This financial analysis is used by entrepreneurs to determine if their new business idea has a chance of success.
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 aren't likely to be 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 be used to:
- 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.
- Break-even analysis determines 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 Breakeven Analysis
You can create a break-even formula in Excel. Refer to the following formula:
- Breakeven point = fixed costs ÷ (unit selling price – variable costs per unit)
You can also use a pre-existing 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 costs of production by the difference between the price per unit and the total variable costs of production.
Fixed costs remain the same regardless of how many units are sold. These are the basic costs of doing business. You may add or subtract categories of fixed costs depending on the nature of your business. 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 usually have a lower break-even point because it will have less expenses to worry about before turning a profit.
Variable costs are those costs that relate to the type and volume of products produced.
- Raw materials
- Direct labor and supplies for production
- Cost of goods sold
- Delivery costs
How to Start Your Break-Even Analysis
The first part of calculating your break-even point is making an accurate estimate of fixed costs, variable costs, and revenue streams. To ensure your estimate are as accurate as possible, research similar businesses, the industry in your state, and potential suppliers. Every state has resources to help with this research, including Small Business Development Centers.
The estimates that are needed for a realistic break-even analysis include the following:
- Sales Revenue refers to the total money from all sales activities that your business will make monthly and annually. Be sure to base your estimate on the volume of business that you realistically expect, rather than on how much revenue is needed for a profit.
- Average Gross Profits are the amounts that are left from each sale, after deducting the direct cost for each particular sale. If a toy costs you $4.00 to sell, and you are selling it for $8.00, your average gross profit is $4.00.
- 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 your toy gives you an average profit of $4.00 on each toy that you sell for $8.00, the average gross profit percentage is 50%.
Finding Your Break-Even Point Using a Formula
After you have recorded the estimates listed above, you are ready to find your break-evenpoint. 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, if your monthly overhead is $5,000, and your gross profit percentage is 50%, 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 monthly overhead, remember that this amount does not include a salary for you or any profit at all. It is merely how to break even between your overhead and revenue. If you use the SCORE break-even template, it does include 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
If after changing some of these factors, your break-even point is still too high, your business idea may not be attainable. If you end up scratching the business plan, you have saved yourself a lot of time and money.
If you reach a desirable break-even point, you know you can continue with your business plan, and you have an idea of your budget.
Limitations and Weakness of Break-even Analysis
Break-even analytics limitations can be considerable. A break-even analysis is only as accurate as the data you've put into it, and it will require you to assume some things that can't be absolutely known:
- It assumes that business conditions won't change. For example, It assumes the selling price will remain unchanged regardless of market demand, raw materials supply, competition, etc. (Recall, for instance, how the Coronavirus Pandemic turned business conditions upside down.)
- 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 be too simplistic a measure to use if you have multiple products with multiple price points.
Furthermore, a break-even analysis doesn't consider start-up costs or the amount of capital invested in the business. Capitalization is a key factor in profitability.
Next Steps in Financial Analysis
If your break-even analysis gives you a favorable break-even point, 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: An estimate of all the costs your business will incur before it even opens its doors
- Net profit margin
- Profit and loss forecast
- Cash flow to determine if your company has enough liquidity to pay bills on time
Get Legal Help Starting Your Business
A break-even analysis is the baseline measure to determine whether your business idea is a winner. If it looks like your business has a chance at success, consult with a business attorney about your next steps and any legal requirements.
You Don’t Have To Solve This on Your Own – Get a Lawyer’s Help
Meeting with a lawyer can help you understand your options and how to best protect your rights. Visit our attorney directory to find a lawyer near you who can help.