How to Define and Calculate a Break-Even Analysis
According to data from a U.S. Small Business Administration (SBA) Office of Advocacy report published in August 2018, businesses have varied longevity. Nearly 80 percent (79.8 percent) of business startups in 2016 lasted until 2017. Between 2005 and 2017, the SBA mentions that 78.6 of new businesses lasted 12 months. Similarly, nearly 50 percent lasted at least five years.
While there are many reasons why a company goes out of business, a major one is profitability – or lack thereof. To determine when your business is breaking even and project when it will start making a profit, consider performing a break-even analysis.
Defining a Break-Even Analysis
As the SBA explains, a Break-Even Analysis is a useful way to measure the level of sales necessary to determine how many products or the amount of services that must be sold in order to pay for fixed and variable costs. This is known as the “break even” point. It refers to the time at which cost and revenue reach an equilibrium.
In order to get the Break-Even Quantity (BEQ), as the SBA uses, businesses must take their fixed costs per month and divide this figure by what’s left over after subtracting the variable cost per unit from the price per unit – or the product’s selling price.
These are costs that remain constant over time. Fixed costs include items such as rent or lease payments, property taxes, insurance, interest payments or monthly machine rental costs.
In addition to fixed costs, business owners must also deal with variable costs. These are costs that vary from period to period, such as utilities or raw material expenses.
Looking at electricity costs, the amount and price of kilowatts used per month will vary based on the amount and length of usage of lights, climate control equipment, production runs and the rate of kilowatts from the supplier.
Looking at raw materials, such as oil or precious metals, these costs can decrease or increase frequently as a result of tariff or commodity fluctuations.
Sales Price Per Unit and Further Considerations
When it comes to determining for how much an item is ultimately sold, there are different considerations for different products. If a company is selling a product for $100 on the retail level, and the business’ fixed costs are $4,000 and there are $50 in variable costs, the Break-Even Quantity can be calculated like this:
$4,000 / ($100 – $50) = $4,000 / ($50) = 80 products (to break even)
If those products are surfboards priced at $100 each, then sales of the 81st surfboard and onward would represent profits for the company. It is important to consider how changes to either fixed costs or variable costs can make a difference in the break-even point.
Reducing Fixed Costs
If a business owner refinances a loan to a lower, fixed interest rate, or reduces a salary for the next 12 months, their overall fixed costs will go down. Take a look at the same example as above, but with a lower fixed cost:
$3,500 / $50 = 70 products (to break even)
Reducing Variable Costs
If a business owner searches for another supplier, such as one that’s not subject to import tariff costs that get passed on to consumers, variable costs can be reduced for the same scenario. In this example, the variable cost is reduced to $45.
($100 – $45) = 55
$4,000 / $55 = 73 products (to break even)
While each business has its unique costs and industry conditions, a break-even analysis can help business owners determine future moves.