What is a Break-Even Analysis?
A break-even analysis is a useful tool for determining at what point your company, or a new product or service, will be profitable. Said another way, it’s a financial calculation used to determine the number of products or services you need to sell to at least cover your costs. When you’ve broken even, you are neither losing money nor making money, but all your costs have been covered.
The equation used to perform a break-even analysis is:
Fixed costs/Price of product – Variable costs per unit
Your fixed costs are the administrative expenses you incur by starting your business or developing a new product. Fixed costs are the same no matter how much you sell. They include things like:
- Interest paid on debt
Variable costs are expenses that increase with the production of products or services and include things like:
- Raw materials
- Distribution costs
So, if it costs $100 to produce a smartphone, on top of $10,000 of fixed costs, the break-even point if the phone sells for $500 is 25.
$10,000/$500-$100 = $10,000/$400 = 25
But Can You Sell it For That?
The one thing that a break-even analysis does not take into account is market demand. That is, can you sell your product or service for the price you’ve used to calculate your break-even point? Using a high price tag will certainly allow you to break even faster, but is it at all realistic?
Let’s see what your break-even point is on the sale of a smartphone if you can sell it for $1,500.
$10,000/$1,500-$100 = $10,000/$1,400 = 7.14 (which you round up) = 8
Clearly, it will take you a lot less time to break-even if you only have to sell 8 phones. But will anyone really pay $1,500 for a new phone? That’s kind of unlikely unless it has some amazing new feature. So your $1,500 price tag may not be realistic.
When Would You Use It?
A break-even analysis is frequently used to assess the viability of a new business idea.
Performing a break-even calculation can give you a general sense of whether the idea is worth pursuing. If your analysis suggests that you would have to sell 8,000 bottles of wine before you’d make a profit, and it will require an investment of $20,000 to get going, you can make a more informed decision regarding whether that’s how you want to invest your resources.