What is a break even analysis?
This is a very useful tool if you are setting a price – it tells you how many you have to sell and what price you sell before you are in profit.
It’s a simple calculation of fixed costs. So, if you’re making a low level of sales at a low price, that’s fine unless you have certain costs to pay in building/developing the unit, once these are included you may make a loss. In order to make a profit, you’ll need to sell enough of your products (or deliver enough of your services) at a good price.
The break-even point is reached when your revenue from sales matches the costs expended in making/developing the product, software or service. By applying the break-even formula to your company, you they can plan what levels of production and what price you need to sell at in order not to make a loss – and hopefully make a profit!
Output = Total Revenue
You need to understand what your output (expenditure) is – what your fixed costs, variable costs, total costs, and total revenue will be according to your level of output.
So if you are selling shoes you will have certain amount of fixed costs, including the cost of manufacture and supplies, which were needed for the creation of a batch of shoes to be sold.
Your variable costs are the costs that delivering or selling each pair of shoes will incur above the fixed costs – this may vary depending on the sale. The cost of delivery for 10% of your units (pairs of shoes) may differ to the cost of another 10%, so your variable costs are an approximation.
The sum of your fixed and variable costs makes up your total costs. Your total costs will rise above the fixed costs the more units you sell of the variable costs which selling each unit incurs.
So if you were producing 500 pairs of shoes and had fixed costs of £5,000 and variable costs of £1.50 per unit, say, you will know what your rising total costs will be per unit sold. So if you sold 250 pairs of shoes, your variable costs won’t be as high as if you’ve sold 500 because there will have been less variable costs per unit, but at the same time, you will need to have sold a certain number of pairs of shoes in order to cover your fixed cost.
Your output will be the total cost you have incurred for the amount of products you have sold. If you’ve sold 250 pairs of shoes, your output will be the fixed costs (£5,000) plus the variable costs of the 250 pairs of shoes (250 x £1.50 = £375), which in this case is £5,375.
To calculate your break-even analysis, you will next have to calculate your total revenue – you do this by multiplying your sales unit price by the number of units sold.
So if you’ve sold 250 units (pairs of shoes) at £12 each, you will have made £3,000 from selling those units.
So at the stage of having sold 250 pairs of shoes, you’ve got a total output of £5,375 and total revenue of £3,000. So at this stage you’re making a pretty significant loss.
Your break-even point is where your output is the same as your revenue, so there are two ways you could go about finding your break-even point. You can either plot the number of units you need to sell, or the price at which you need to be selling each unit.
Number of units sold
So if you sold the entire batch of shoes (500) your total costs will be £5,000 for your fixed costs plus 500 x £1.50 for your variable costs which is £750 making your output £5,750.
Your total revenue, selling at £12 per unit, will be £6,000. So you’re making a profit at this stage.
Your break-even point will be your total output divided by your unit price, which comes to around 480. So, in order to break-even with your fixed and variable costs for this batch of 500 shoes, you will need to sell 480 of them.
Raising your price
Try raising or altering the price will determine a new break-even point as this will change the total revenue you will make having sold a certain amount of units – (price x number of units sold = total revenue).
So you know your total costs are £5,375 so your break-even point would be the point where the number of products sold will be multiplied by your price to reach this number. So if you want to break-even having sold 250 pairs of shoes, the calculation is the total costs divided by the number of units sold (£5,375 / 250) so your unit price will now be £21.50.
Using a break-even analysis
So knowing how many units you need to sell and what price you need to sell them is a useful exercise. There are other considerations you need to make of course.
For example, you might want to raise your price so you can break-even having sold fewer units, but you wouldn’t want to set a price that no one would pay for your product.
Or, if your break-even point requires you to sell 480 out of 500 products, you might be concerned that you’re putting pressure on your business to sell the entire batch, and even if you do sell the entire batch, the profit you will make will only be made from 20 units – could you make a bigger profit?
Either way, a break-even analysis is a useful way of seeing what your minimum sales requirement is to avoid making a loss. This is an important bit of information to inform your pricing strategy and to help you understand how many products you will need to sell in any new market.