The Importance of Breakeven Analysis for Business Owners

When embarking on your new business venture, one of the first and most important concepts that you will be introduced to is break-even analysis which, very simply, is the amount of revenues you need to generate to cover your direct and indirect expenses.  A good grasp of this is essential for business owners since even businesses with significant sales revenues can incur losses if they are not able to cover their costs. While break even analysis tends to be used more for businesses that sell physical products, it can also help to the determine the price for services

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what are the inputs for break even analysis?

The starting point of any breakeven analysis is to determine your business’ variable costs which are effectively costs that are directly incurred with each product made. These include the materials used (see pickle example below), packaging, labels, shipping etc..

The next step is to determine fixed costs that your business has to incur regardless of whether you are actually making any product. These include rent of the premises, fixed salaries paid to employees, office/computer expenses, subscriptions, bank fees, professional fees (paid to accountants and lawyers etc), supplies, telephone and utilities and anything other costs that are specific to the business for which a fixed periodic amount is paid.

There are direct costs such as labour and machinery which are a bit tricky since, although you can identify the specific number of labour or machinery hours to make a certain amount of product, these might still have to be paid regardless. An employee that is hired full time will have to be paid irrespective of whether they work to their full capacity. Labour in this case would be a fixed cost. However, overtime paid to employees can be included in variable costs since these wages can be specifically linked to additional amount of goods that are produced. Machinery is a cash flow outlay, however, a unit of production depreciation method allows you to identify the approximate usage of the machinery over its useful life and connect it to each product used. If this method is used, then depreciation of machinery can be a variable cost.

How is Break Even calculated?

The formula for the break even point is:

Fixed Costs/(Price per unit - Variable cost per unit)

Let's make the following assumptions for a company that sells pickles:
Sales Price per (organic handpicked vegan cucumber) pickle = $1

Cost of cucumbers, vinegar and other ingredients, per pickle = $0.50

Cost of packaging, labels and shipping per pickle = $0.05

Cost of machinery for each pickle using the units of production method = $0.05

Total fixed costs including factory labour, rent, insurance, admin salaries, dues for pickle association and utilties, per month = $10,000

Breakeven Point = $10,000/($1-$0.50-0.05-0.05) = 25,000

Based on these (very simple) assumptions you would need to sell 25,000 pickles, per month, to basically cover your costs.

For every pickle sold in excess of 25,000 units you would make a profit of $0.40 per pickle ($1-$0.50-0.05-0.05).  So 30,000 pickles would bring in a net profit of $2,000 calculated as (30,000-25,000)X$0.40.

Use our break even calculator to help you determine your break even point in number of Units (i.e. number of units that need to be sold in order to break even)

What is the importance of break even analysis ?

The importance of a breakeven analysis, particularly when you are a startup, is to establish the baseline of sales revenue and/or volume that has to be generated to cover costs, ensure that they are realistic and estimate what your monthly cash flow requirements are going to be so that you can meet, and exceed, your sales goals. For example if you only sell 10,000 pickles in the first month, at $0.40 gross margin before fixed costs, you would have $4,000 to cover $10,000 of fixed costs. This leaves you with a $6k deficit which will have to be covered through other funding sources. It is normal for a startup to have a deficit in the beginning as they ramp us sales. It is however important to estimate your cash flow and set up a bank loan, line of credit or other sources of capital to cover this deficit.

Ultimately, a breakeven analysis is only as strong as its underlying assumptions.  As such, it is important to ensure that a) you try, to the extent possible, to include ALL costs that relate to your business, and b) to estimate the actual costs and sales prices as accurately as possible.  If you think you might have to sell your pickles at a discount to bring in customers, ensure that these are reflected in the calculation.  Also, it is important to update the analysis as the underlying assumptions change.  Since breakeven analysis is an estimate at best these should be refined and honed over time to ensure as much precision as possible. If you have a good accounting system which is updated regularly, a review of the profit-loss (income statement) can give you excellent insights into how your business is doing.

Like many forecasting metrics, breakeven point can is subject to it's limitations; however it can be a powerful and simple tool to provide a small business owner with an idea of what their sales need to be in order to start being profitable as quickly as possible.

Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. She is the author of several books for small businesses and also provides financial consulting services.

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