As the saying goes, "you can't run a business without taking risks."
But how you handle those risks can make all the difference.
It's no surprise why you always want to play safe being a startup. Your initial capital is low. You need to pay for fixed expenses no matter what. And there is so much workflow to execute.
Not sure what you need to do to make back your initial investment?
A break-even analysis can be the best next step.
Today’s post will help you learn everything about break-even analysis. What is it? How does it work? How to calculate break-even analysis for your business? What are the limitations of break-even analysis? And a few tips to make the most of it!
So let’s tie the facts together...
What is Break-even Analysis?
Unless you're a seer, predicting profitability in business is no joke.
A break-even analysis is like an old faithful friend. It will help you make better business decisions and financial plans.
It is a tool you can use to assess the margin of safety.
Like, how many products should you sell to cover the cost of running a business?
Or how many sales should you make to cover your electricity expense?
A break-even point calculator will help you find answers to these questions. Anything you sell beyond a break-even point will increase your profit.
So what other benefits do you get when you perform a break-even analysis for your business? Let's find out in the next section.
Benefits of Performing Break-Even Analysis for Your Business
Price your products better
We all know the amount of psychology that goes into the pricing process. But can you pay your bills by taking wild guesses? No, right?
By performing a break-even analysis, you can price your products smartly.
The sooner your business breaks even, the better profit margins you can extract.
But that’s not all...
Pricing isn’t the only factor that affects your profits. Your expenses (both variable and fixed) also contribute to the business revenue.
So, how do these two factors impact revenue generation?
Let’s figure this out in the following section.
Cover fixed (unavoidable) costs
Do you have any idea what these terms actually mean?
Fixed costs are an expense a business incurs every month. Examples may include salaries, electricity expenses, etc.
Variable costs, as its name hints, change. You can avoid variable costs sometimes. But you can’t run away from the fixed costs.
How does a break-even analysis help maintain costs?
Break-even helps you identify the point where you’ll be making enough money to pay your fixed costs.
You can only expect some profit rolling in once you're able to bear your monthly fixed costs.
Another benefit of using break-even analysis for your business is...
It limits the number of surprises down the road
You need to line up all your fixed and variable costs when performing a break-even analysis.
Now, what does that mean?
It means you'll have a realistic idea about costs before you step into anything new.
With this info at hand, you can measure the viability of your plan and make better business decisions.
Helps with debt financing!
In case you need financing, break-even can help with that too. By performing a break-even analysis, you can prove your plan is profitable.
Any funding source will give you a loan if your break-even looks good.
Break-even analysis also helps with business decision-making. Here’s how...
Helps with business decision-making
You can’t put your thousands of dollars into something you FEEL seems profitable.
Successful entrepreneurs give a damn about how they feel and take action based on facts.
Because break-even analysis works on data, it will help you make better business decisions.
But the question is, how can you calculate break-even for your business? The next section answers that...
How to Calculate Your Break-even Point?
You’re not alone if you want to buy products at low cost from the suppliers and sell them at higher prices to customers.
Every online seller wants to do the same.
But there is a problem - your expectations.
Let me explain...
Let's say you buy a product from a supplier at $50 and sell it at $70. If you do the quick math, it will lead you to $20 in profits.
But that's not how things work.
What about shipping costs, taxes, and processing fees?
By using a break-even analysis, you can determine the number of products you need to sell to break even.
You can use this formula to calculate the break-even point:
I know the formula looks super simple and easy. But there is a 3-step process behind it.
Here's how everything goes…
Step 1 - Collect data
List down all the costs of doing business.
Don’t rush. Give this step the time it deserves.
List down every cost you can think of in an Excel sheet.
Also, decide on an average price based on fixed and variable cost estimates. Don’t worry if you’re not sure about it yet. Fill in a random average figure as you can change it later on.
Done? Let's jump onto the next step...
Step 2 - Plugin data
Plugin your totals into the formula to calculate your break-even point (as demonstrated below).
Step 3 - Tweak it a bit
Don’t be afraid to experiment with different numbers once you have this sheet handy. Increase/decrease variable/fixed costs to see how they affect your profitability.
Pro tip: You can also use a break-even point calculator to take your financial analysis to the next level.
Wondering where you can put break-even analysis into practice?
Here are some practical use cases I'd like to share...
Break-even Use Cases
Launching a new business
Perform break-even analysis when you're planning to start a new business. This will help you measure the viability of your business plan.
Also, it will help you become more realistic about your costs.
Introducing a new product
Planning to introduce a new product?
Perform break-even analysis to figure out the costs related to your product.
You can set prices according to costs and earn more profits.
Switching from one business model to another
Startup costs vary when you change your platform. This goes without saying that it also affects your expenses and profit margins.
Break-even analysis can be helpful when you're moving from one business model to another.
Adding a new sales channel
Adding a new sales channel will also add to the financial strain. Break-even analysis allows you to track rising startup costs. Also, you can figure out new prices to match the costs.
You can see break-even isn't only about predicting profitability. It does a lot more than that.
But just like anything else in the world, it also has its limitations.
Want to know what those limitations are?
Break-Even Limitations You Need to Know
You need to feed good data to get reliable results
Semi-variable costs make it harder to perform break-even analysis.
For instance, the labor/employee cost could be fixed or variable. You may have a fixed number of employees. Also, you hire freelancers or extra laborers. The cost of extra hiring could fluctuate per-project basis.
The same is the case with electricity expenses.
You can’t depend on break-even analysis if you’re unsure about your data input.
It’s quite BASIC!
Break-even analysis can be ideal if you work with one product only. But you can't expect it to be too efficient if you have a massive product range.
Ignores fluctuations over time
The Break-even model ignores time fluctuations.
Now, what does that mean?
You’re lucky if your sales flow remains constant throughout (happens not too often). But you won’t see how things change if it fluctuates.
You then need to invest in a solid sales forecast or cash flow management system.
You're not the only seller in a market.
Your competitor's pricing and selling strategies will also affect your revenues.
For example, if they change the prices of their products, there will be a change in your product demand too.
Break-even analysis doesn't pay heed to competition. That means you may need some other tools to figure this out.
Not a Demand Predictor
You can't predict your future sales with a break-even analysis. It can only tell you the amount you should make to run a profitable business.
External factors can influence sales volume
Running a business comes with many challenges.
It's not just your competitors who impact sales. But many external factors, such as inflation and economic policies, can also affect your sales volume.
Break-Even Point - the lower, the better (tips to nail it)
Fret not if these limitations make you sad. Break-even analysis is quite adaptable when it comes to adjusting data.
Want to make the most of your break-even analysis?
These tips will help you get started:
- Increase your prices
If your prices are too low, you may have to sell many units to break even.
You can increase the per-unit cost of your products.
But there is a catch...
What if your competitors sell the product you sell for $10 at $7?
So, you have to be mindful of your pricing strategies. Research the market and see what buyers will pay for your products.
Also, upgrade your product quality and customer service to exceed buyer’s expectations.
- Lower your fixed and variable costs
Another thing you can try is to lower your fixed and variable costs.
The lower you can get those costs down, the fewer units you have to sell.
I know reducing variable costs isn't as easy as it may sound.
But there are ways you can get this step right. For example:
- You can negotiate with your suppliers
- Partner with different vendors
- You can move to cheaper alternatives (For example, you can choose a different packaging process if bubble wrapping costs your business an arm and a leg).
Over to you!
Sure, break-even analysis has its limitations. But it is still effective and important for making smart business decisions.
If you’re a new seller or want to expand, break-even analysis will help you prepare well.
For better results, I'd suggest you use it with other data forecast and cash flow solutions.
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