Break-even analysis: a financial tool to make profit

August 26, 2014

Break-even analysis: a financial tool to make profit

So you have the great idea, the idea that you feel passionately about and cannot wait to share with the world – but can it make you a profit? This is one of the first questions you should be asking yourself when looking to start a business or expand your current operations.

A break-even analysis will help you determine what your sales need to be in order for you to earn a profit. As such it is the first financial tool you should look towards when you have that amazing idea.

Below I am using a cupcake bakery as an example to explain how to calculate the break-even point and analyze this.

Terminology: fixed and variable costs

Before calculating the break-even point, it is important to understand two financial terms around the dynamics of your business.

  • Fixed costs (also known as overhead expenses) Represent your organization’s costs that generally do not fluctuate based upon your production. Examples of these would be rent or insurance.
  • Variable costs – Represent the costs to your organization that fluctuate based upon the level of output. Good examples of these would be costs used to produce our product. For the cupcake bakery it would include ingredients such as flour, eggs and sugar.

Calculating the break-even point

Now that you know the differences between these costs, let’s look at calculating our break-even point: the number of cupcakes we need to sell in order to cover our costs and have zero profit.

Let’s assume the following expenses on a monthly basis and assume the price of a cupcake is $2.50.

Fixed costs are $1,500 per month and variable costs are 50 cents. This takes a bit of time to figure out, and is important to look into so you can be as realistic as possible.

To calculate the actual break-even point, you first have to subtract the variable cost from the price per unit, in our example that is $2.50 – $0.50 = $2. Let’s call that the unit profit. Second, divide the fixed cost by the unit profit: $1,500 / $2 = 750 cupcakes you need to sell to break-even.

The formula is simple:

Break-even point in units = Total fixed costs / (Price per unit – Variable cost per unit)

In order to cover costs and have a zero profit, the business needs to sell 750 cupcakes. This allows you to understand whether or not the business has a chance for success. On a monthly basis you may assume that you can sell 30 cupcakes a day on average which means we can sell 900 cupcakes a month and can therefore earn a profit.

Not breaking even?

If you could only sell 700 cupcakes a day and were therefore operating at a loss, then think about three ways to break even:

  • Reducing fixed costs, or
  • Reducing variable costs, or
  • Increasing price in order to decrease our breakeven point.

Examples of dealing with operational and financial loss are renegotiating rent, finding a new supplier of flour and sugar or increasing the price of our cupcakes.

To have a realistic break-even analysis, you could plug in 700 cupcakes as the break-even point. This would help you or your bookkeeper isolating fixed costs, variable costs or price. The purpose of doing so is to find out how much costs or price need to change in order to break-even.

Place a value on your time

Whether a business is breaking even, operating at a loss or earning a small profit, you also need to consider the opportunity cost of investment and time.

Let’s assume the analysis is completed and you determine the profit is $1,000 per month. If you worked 250 hours in your business every month and made $1,000 profit, you effectively made $4 per hour. Not quite what you were hoping for!

Many start-ups and entrepreneurs forget this key point; place a value on your time. If you were to work those 250 hours somewhere else earning a minimum wage of $11 per hour you would have made $2,750 in that month!

Most start-ups require time just like a steam engine, and you will often operate at a loss in the beginning. That is why it is important to revisit this analysis every so often and re-evaluate how you are progressing.

Key things to remember

  • Be realistic – avoid calculating your break even using your best-case scenario. Try to be as realistic as possible about sales and expenses by doing research. For example, ask real estate agents about average rents in an area and research the typical price per unit for the good or service you are going to offer.
  • Revisit the break-even analysis often – when there is a significant change in your organization (such as a change of suppliers or moving to a larger space) revisit and update your break-even analysis.
  • Ask questions – not sure if something is a fixed or variable cost? Not sure how to apply the calculation to your business model? Ask for help, there are many people that can guide you in the right direction!

Image credit: by grahamc99 via flickr.com.

Author

Nav Dhaliwal

Nav Dhaliwal is a Chartered Accountant based in Toronto, Ontario with several years of experience and a partner at ND LLP. Believing in doing accounting differently, he integrates the accounting world with technology by providing virtual solutions to organizations of every size.