The services you provide or products you sell are important, but the right pricing and financial management is what makes your business profitable. It’s crucial that you know the amount it takes to break even financially to keep your business going, then beyond that point is where you start making a profit.
Break-even analysis is arguably one of the most critical functions for any business. Your break-even point is the place where you’re not making any profit, but you’re also not incurring any losses; it’s where you’re covering your expenditures but hitting zero-profit.
Your break-even point will provide you with a target that tells you how much cash you need to cover costs. As such, break-even analysis is an essential calculation in the profitability of your business. Without it, you’re shooting blind, never really knowing what your critical financial targets are. With it, however, you have comprehensive goals that can help you determine what needs to change in terms of pricing and financial strategies.
If you’re a small business owner, it is imperative that you understand your break-even point, as this financial metric is the defining calculation when it comes to understanding profits and losses. If you’re not covering your expenses, it doesn’t matter how much revenue you’re bringing in; you’re still losing money.
Where Do You Start in Determining Your Break-Even point?
Before you can begin to know your break-even point, you need to have a handle on your costs. Both fixed and variable costs factor into the equation, and since you’re certainly paying for both on a monthly basis, you’ll want to make sure you’re factoring them into your analysis.
Understanding Fixed Costs
Fixed costs are exactly that -- fixed. They do not change when your sales volumes fluctuate. They're set amounts that are due regularly, usually monthly, and usually only change when a contract is renegotiated or a planned annual increase occurs.
Common fixed costs include:
- Exempt employees' salaries
Understanding Variable Costs
Variable costs are the exact opposite of your fixed costs. These costs do change as your sales volume increase or decrease.
Examples may include:
- Hourly employees' pay
How Pricing Impacts Your Bottom Line
The pricing of your business’s product or services can make or break your bottom line. When it comes to pricing, it's not uncommon for leaders of small and medium-sized businesses to miss the importance of spending time to figure out the right pricing model. You need to be clear on The Importance of Pricing for the Profitability of Your Business.
Tracking and accounting for the cost of doing business is much easier said than done, particularly if you aren't employing tools that can help you maximize your pricing model and leverage every aspect of your business.
If you're not performing proper break-even analysis, you may be selling like crazy but still not covering your costs. When you understand your break-even point, this should enable you to know that you have to sell at least X services or X products to break even. From there, you will be able to determine how to adjust your pricing strategies so you can make a profit.
What's the Break-Even Formula?
Break even = Fixed Costs / (Selling Price - Total Variable Costs Per Unit)
If mathematical formulas make you want to run away and hide, hold tight! It's really not that scary, and given the essential nature of this formula, as it relates to your profit and loss statements, you'll want to stay tuned.
Let's look at a simple example...
You run a company called ABC Ltd. Your company has created an app that easily finds parking spaces so your customers don't have to drive around in circles every time they enter a parking lot.
You've identified all of your fixed costs as follows:
- Monthly Lease = $3,000
- Monthly Executive Salaries = $37,000
Total cost of your fixed assets = $40,000
You've identified the elements associated with your variable costs as follows:
- Technology Fees
- Sales Commissions
In total, you've calculated your variable costs at $0.50 per unit, and you're selling the app to consumers for $3.00.
Using the above example, along with the break-even formula, your break-even point is as follows:
$40,000 total cost of fixed assets / ($3.00 per unit price - $0.50 variable cost per unit) = 16,000 units (or apps, in this case) to break even.
How the Numbers Make a Difference
When it comes to profit and loss, everything matters. Using the above example, you would break even if you sold 16,000 units. If you sold 16,001 units, you would begin to make a profit. Alternatively, if you increased your price, you would have to sell fewer apps to achieve the same break-even result. On the other hand, if you were selling your app for $0.99 in an app store, you would have to sell 81,633 units just to break even. As you can see, a few dollars can make a huge difference when it comes time to pushing your product and making red turn into black on your budget statements and balance sheets.
Once you understand how your fixed costs and variable costs per unit impact your bottom line, you can use this information during your forecasting and budgeting endeavors.
Armed with your break-even point, you'll be able to modify your pricing model accordingly to ensure you're not only breaking even, but you're making a profit and fulfilling the vision of many more successful years in business. It's the simplest way to determine a number of factors relative to your company’s future success and optimize pricing and financial strategies.
When you know what your break-even point is, you can discuss and finalize long-term pricing strategies. You can take into account projected market fluctuations so you're better prepared if your industry is expected to experience ebbs and flows. Although hindsight is 20/20, reactive approaches are seldom positive in the business world. You want to be proactive and break-even information will give you the knowledge you need, so you can make positive decisions before you're hit with unexpected downturns.
How will you know when you need to increase sales if you don't know when you're breaking even? Naturally you want to sell as much as possible, but if you're only focused on selling, and don't know your bottom line, it's likely that your business won't be profitable.
A solid break-even analysis will tell you when you need to increase prices so your profit margin reaps the fruits of your efforts. It will also tell you where you need to reduce expenses and cut costs. This analysis, for example, may help you determine that you need to reduce interest-bearing debt or seek cost-cutting measures that would afford you the same quality for a lesser price. Maybe you need to scale back on hourly labor or reduce the number of machines you're running at certain times. You won't know any of this until you analyze the numbers.
Determining the Point of Profitability
Are you bringing in enough revenue to cover all of the expenses you need to pay? Are your products or services profitable, or are you selling yourself at a loss? The answer to these questions can mean the difference between surviving and thriving. You didn't go into business to go out of business, so it makes perfect sense that you would want to feel confident in your points of profitability.
You need to be sure to understand your break-even point, and be able to make data-driven decision so your business is profitable. Here at GrowthForce, we help you to understand the KPIs (Key Performance Indicators) of your business and develop a strategy for profitability and growth. After all, that's what we do.