Break-Even Analysis Make a Profit; Avoid a Loss You want your business to make a profit, but at the very least you want to avoid it taking a loss. It is worth knowing how many sales you need to make in order for the business to cover all of its costs – this is called ‘breaking even’. Knowing your break-even point lets you know when your business is going to start making a profit. You can also use a break-even analysis to give guidance on pricing and profit targets. By making a slight change to the break-even formula, you can: Work out how many sales you would need to make in order to achieve the amount of profit you are aiming for. See what impact changing your prices will have on the quantity of sales you need to make to achieve your desired profit levels. You will need to decide whether or not the sales quantities from your break-even analysis are realistic for your business. If they aren’t, you will need to consider reducing the price you charge. Key Points At the ‘break-even’ point, a business makes no profit but takes no loss either. Past this point, the business will start to make a profit. Although a break-even analysis is used to work out how many sales you need to make to break even, you can use the formula to work out how many sales you need to make in order to achieve your target profit levels. Working Out Your Break-Even Sales Quantity Two formulae for working out your break-even point are shown below. The first formula calculates the number of items you need to sell per year to break even, and the second formula calculates the value of sales you need to make each year to break even. The second formula is more useful when you sell a range of products at very different prices. The disadvantage of the second formula is that, if you are new to business, you will need to forecast your gross profit margin before you can use the formula. In comparison, if you are already in business, you can look at your past financial statements or reports from your accounting software to find out your gross profit margin. The Break-Even Sales Quantity Formula The Break-Even Sales Value Formula You can use figures from your Profit and Loss Statement to help use these formulae. However, if your business is quite new or if you plan to make changes to your costs, it is best to forecast your figures. Use the total expenses figure (from your Profit and Loss Statement) as your fixed costs. Do not include the cost of goods sold. Key Point Keep in mind that a business owner working in the business needs to be paid as well. Include your required wage in your costs before you work out how much you need to break even. Tip If your business is service-based and you charge per hour, it’s simpler to work out the break-even point. This is because you probably won’t have any variable costs if you treat your own wages and any other wages as fixed costs. For example, if you have total fixed costs of $200,000, and you charge $100 an hour, your break-even number of hours to charge to customers is 2,000 (calculated as $200,000 divided by $100). You would then need to check to make sure it is realistic you could work (and bill to customers) this number of hours per year, given the number of employees you currently have. Example: Break-Even Analysis Anahere makes wooden picnic tables and has decided to turn this into a business. She does a break-even analysis to help decide on a sales price. Her fixed costs per year are $70,000. This includes her salary of $50,000 per year and other expenses of $20,000. Each table has a variable cost of $200. She looks at her competitors’ prices and sees there is quite a range of prices charged. However, the higher priced tables do have nicer designs and require more time to make. Anahere picks several sales prices and calculates how many picnic tables she will need to sell at each price to break even. Putting these into the break-even formula, she works out the quantity of tables she would need to make (and sell) each year. Assuming she will work for 48 weeks per year, Anahere then works this out what this means for weekly production and sales. Break-Even Sales Quantities for Different Prices Price Formula Quantity per Year Quantity per Week $500 = $70,000 ÷ ($500 – $200) = $70,000 ÷ $300 233 5 $750 = $70,000 ÷ ($750 – $200) = $70,000 ÷ $550 127 3 $1,000 = $70,000 ÷ ($1,000 – $200) = $70,000 ÷ $800 87 1.8 $1,250 = $70,000 ÷ ($1,250 – $200) = $70,000 ÷ $1,050 66 1.3 If Anahere sells her tables for $500 each, she would have to make five tables each week just to break-even. Anahere can make a table in a day, but would struggle to keep up the pace for every working day of the year. She would have no time left to actually sell her tables. On the other hand, if she sold them for $1,250 each she would only have to make 66 sales each year to break-even. This is only 1.3 per week. Although making this quantity is appealing, trying to sell them is not. Competitors which sell at this price have very well-known brands which Anahere feels would be difficult to compete with. Anahere decides to make three tables per week. However, instead of selling them at $750 to break even, she sells them at $1,000. Anahere has a high quality product and is confident she can both make, and sell, three tables per week at this price. This will give a profit margin of $250 per table. If she sells the target of 127 per year, this will be a profit of $31,750. Next: How Much Do You Need to Sell to Meet Your Profit Goal?