When will you earn a profit? You start your small business precisely for the reason of generating profit. As such, it vital to conduct a breakeven analysis, which will help you determine what your total costs are so that you can set the right prices for your goods or services. Though the task seems daunting, it all boils down to simple math.
Ideally, you should be doing this analysis before you start your business or before launching new products so you can anticipate risks. Identifying costs and determining projected sales will also help you forecast if your venture is profitable. Of course, you want to determine how much revenue is necessary so you can pay all your expenses. The last thing you want is to suffer a loss.
When you conduct a breakeven analysis, you are using a financial planning tool to understand your cash flow, revenues, and expenses, which are key determinants of whether your business stays afloat. The most critical concept of this tool is the breakeven point (BEP).
You can say your business has achieved a breakeven point when your revenue or sales equal all your total expenses or costs. Though you are working without profit at this juncture, you also have not incurred any losses.
Making this analysis is paramount for any owner because the BEP is the lower limit of profit when calculating margins. Once you have this figure, you must evaluate all your costs, from fixed to variable, vis-a-vis your pricing structure. You must ask the following:
You can find out your company’s breakeven point using sales units or sales dollars. Let’s dive deep below:
In units, the formula is:
Breakeven Point = Fixed Costs ÷ (Unit Selling Price – Variable Costs)
The fixed costs, like rent or loan payments, are those that remain the same and never change, no matter how many goods or services you sell. In the meantime, the unit selling price is the price of your goods/ services or your revenue, while the variable costs are elements that change like raw materials, utilities, and labor.
The equation above shows how many units of goods or services you must sell to breakeven. It indicates you’ve covered all costs associated with manufacturing your goods or implementing services. Every additional unit you sell increases the profit by the contribution margin, which is the amount that each unit sold contributes to increasing profits and covering the fixed costs. The formula is:
Contribution Margin= Unit Selling Price – Variable Costs
For example, a beverage company is launching a new canned soda in the market. They want to know how it will impact their financial health. They calculate the breakeven point to see if it is worth the investment and effort. The accounting details are projected as:
Fixed Costs= P2,000
Variable costs= P5
Sales price= P12
To compute the breakeven point:
Contribution Margin is P7 from P12 minus P5.
The breakeven point is P2,000 ÷ P7, which is equal to 285.7 units. This means they need to sell over 285 cans of soda in a month to reach a breakeven point.
In sales dollars (pesos), the formula is:
Breakeven Point = Fixed Costs ÷ Contribution Margin Ratio
CM Ratio= (Unit Selling Price – Variable Costs) ÷ Unit Selling Price
The CM Ratio is a figure expressed in percentage. From there, you can determine what you need to do so you can breakeven, such as raising the price of goods or cutting production costs. Using the same example above, you have the following:
The CM ratio is (12 – 5) divided by 12 equals .5833.
To get the breakeven point in sales dollars is P2,000 divided by .5833 equals P3,428.77.
It means that the company needs to sell P3,428.77 worth of soda in that month to breakeven. Anything above that figure is the beverage company’s profit.
To check this figure, you can take the first calculated value of 285.7 units and multiply it by the sale price of P12, and you’ll get the amount of P3,428.77.
The breakeven analysis provides the bare minimum performance, so you won’t lose money. It helps you identify at which point you will earn profits to set the proper production goals.
With these formulas at your disposal, you can try out different pricing schemes to see which gives the best profits. Of course, this value should also not compromise the sellability of your product or services. You can use this analysis, not just for startup planning, but for the following scenarios:
As you can see, breakeven analysis is crucial for your business because it will help you assess if your plans are feasible. If you don’t turn enough profit within your expected time frame, think of lowering the price or cutting expenses. You must also understand that the breakeven point is never a predictor of market demand.