When you’re first starting a business, there are several different formulas and analyses to use in order to evaluate risk, pricing, and return on investment.
One of these is the break-even analysis.
A break-even analysis is used to measure what is called the margin of safety.
The margin of safety is a principle in the investing world that means an investor will only buy securities when their market price is lower than their intrinsic value.
Basically, you’re buying at a lower rate, and you have this margin of safety that you know you will make money on.
It’s a way for investors to minimize risk and keep their money safe.
By using a break-even analysis, you are looking at several factors of your business to evaluate risk and find the break-even point.
The process is fairly simple.
You need to take your fixed costs like rent and insurance and then the variable cost which could be the cost of materials.
Once you have these numbers, you add them together.
Then you can toggle the price of your product to see where the break-even point is based on different levels of demand.
You can move the price up and down to see how much you’ll be making at certain prices.
This will help determine the number of sales you need to make to cover the total fixed costs.
What you don’t want to do is price yourself too low and never make any money.
The break-even analysis helps show you what the cost of doing business is.
The break-even analysis uses a simple formula that should be used by owners and upper management.
Investors, financial institutions, and regulators shouldn’t have access to this information.
The formula should look like this:
Fixed costs ÷ (Price per individual unit – Variable costs of production) = Break-even point (BEP)
It could take a little time and research to figure out the costs, and you’ll want to toggle with the variables to see what happens when prices go up on certain things.
For example, if you use a certain material, let’s just say a metal, and that price is currently $1 per unit now you’d still want to put other dollar amounts in the formula to make sure you’re covered for inflation or a market spike.
You also want to look at what happens if you sell 10 units versus 50 units.
Maybe your product will spike around the holidays but will be slow other months.
You don’t want to run a break-even analysis that plans for a high amount of production.
You want to be realistic and also see what happens if you have slow months.
Another term you’ll commonly hear when talking about a break-even analysis is contribution margin.
This is the excess between the selling price and the variable costs of production.
The contribution margin doesn’t take into account fixed costs, which are critical when analyzing your business.
It’s important for businesses of all types to use this formula to determine their break-even point.
It doesn’t matter if you offer a service or a product.
Some examples could be:
- Catering company
- Veterinary clinic
All of these businesses offer something to their prospective customers and all of these businesses have fixed and variable costs.
Some are possibly simpler than others, but process and formula remain the same.
Other ways to calculate break-even analysis
If you have inventory that you want to move and want to see what it will cost to make your money back on it, change the formula around to this:
Price = (Fixed costs ÷ Item quantity) + Variable costs
As a business owner, you need to know the ins and outs of every variable that could happen to your business.
It helps you calculate risk and prepare for situations when business is slow.
Being risk-averse means that you understand how changes to the market and to demand can affect your business and your bottom line.
When you use a break-even analysis, you are taking the time to prepare for any number of situations that could happen.
Even traders take the time to do analyses and look at the risk of their investments.
For some people, doing their own break-even analysis could be too overwhelming.
Looking at all the variables and scenarios is a lot, and you have to be prepared and set aside time to do it.
If you’re someone who needs a little help in this department, you can hire a professional to take a look at your numbers and assist with the break-even analysis.
It can seem daunting to new business owners when they sit down to calculate the break-even analysis.
It’s important to remember that this is a crucial step and is a key in creating a pricing strategy, which is how you’ll make money!
Make sure to include all variable and fixed costs.
Here are some examples:
- Raw materials
- Hourly wages
- Utilities that change each month (electric, water)
- Shipping costs
- Credit card fees
- Property taxes
- Utilities that stay the same (internet)
Once you have the break-even analysis complete and you’ve found your break-even point, you are on the track to creating a pricing strategy that will work for your business.
Calculating a break-even point is a key part of assessing a business's success when it first starts.
In the early stages of running a business, it's important that you understand your costs and potential revenue so you can understand at what time you're able to start making profit.
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