In Pursuit of Profit: Applications and Uses of a Break-Even Analysis

What is a break-even analysis?

A break-even analysis is a financial tool that helps determine when your company, service or product will be profitable. This calculation determines the number of products or services a company must sell to cover its expenses, especially fixed costs.

Here’s an example of the elements that go into a break-even analysis:

• Fixed costs: Fixed costs, also called overhead costs, are the expenses that stay the same no matter how much the business sells. They include utilities, bills, salaries and wages, rent and insurance.
• Variable costs: Variable costs are based on a business’s sales. They can include additional labor from independent contractors, materials and payment processing fees.
• Average price: This is the average amount you charge for your products and services.

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What is the break-even-point formula?

Taken together, these elements create a formula known as the break-even-point formula. This relatively simple calculation is essential for planning for profitability.

Fixed Costs / (Average Price – Variable Cost) = Break-Even Point 

The term “break-even” refers to a situation in which you are neither making nor losing money but all of your costs have been covered. With a break-even analysis, you can determine when your company will generate enough revenue to cover its expenses and earn a profit. The same holds true for a particular product or service. This data is often used for financial projections. 

Examples of break-even analysis

Here are two examples of the break-even-point formula.

Example 1

The price of one of your products is $100. Your fixed costs are $10,000 per month, and the variable cost is $50 per product. The formula to calculate how many products you must sell to break even would look like this:

$10,000 / ($100 – $50) = 200

Based on the formula, you must sell 200 products to cover your costs, effectively breaking even. To be profitable, you would have to sell at least 201 products.

Example 2

If a company has $20,000 in fixed costs and a gross margin of 35 percent, the business would need to make $57,143 to break even. 

$20,000 / 0.35 = $57,143

If revenue greater than $57,143 is achieved, the company can pay for its fixed and variable costs and make a profit.

Why is a break-even analysis important?

A break-even analysis informs you of the bare minimum performance your business must meet to avoid losing money. It also helps you understand at which point you’ll generate profits so you can set production goals accordingly. 

You can use this information when your business is in the planning stages to determine whether your idea is feasible. Then, once your business is established, you can use a break-even analysis to develop direct cost structures and to identify opportunities for promotions and discounts. 

Although there are many reasons to conduct a break-even analysis, let’s focus on the three most common uses.

It helps you identify the point of profitability.

A business that doesn’t turn a profit could take a turn for the worse at any time. This is why every company needs to focus on its point of profitability. Ask yourself these questions: 

• How much revenue do I need to generate to cover all of my expenses?
• Which products or services generate a profit?
• Which products or services are sold at a loss? 

A company’s goal is to become profitable as soon as possible. To ensure you’re on the right track, you need to focus on your numbers upfront. If you don’t calculate the break-even points for your products or services, you risk not generating a profit (or generating a smaller one than you expected).

It ensures that you price products and services correctly.

When most people think about pricing, they primarily consider how much their product costs to create, and they fail to take into account overhead costs. This leads businesses to underprice their products. Finding your break-even point will help you price your products correctly. You will know where to set your margins to generate the right revenue to break even and begin turning a profit. 

Determining your break-even point is simple if you offer only a couple of products or services. It becomes more challenging as your service offerings and production increase. 

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As you determine your break-even point for a product or service, ask yourself the following questions: 

• What is the total cost?
• What are the fixed costs?
• What are the variable costs?
• What is the total variable cost?
• What are the costs of any raw materials?
• What is the cost of labor?

It gives you the information you need to implement the best strategy.

Using your break-even analysis, you can create a strategy for the future. Suppose your business’s profitability is determined by the success of one or more products. In that case, the break-even point for each product provides a timeline for the company, which can help you implement a better overall financial strategy that fits the projected costs and profits. 

This analysis can also help you determine ways to reach your company’s break-even point sooner, such as reducing your overall fixed costs, lowering the variable costs per unit, improving the sales mix by selling more of the products that have larger contribution margins, and increasing the prices (as long as it doesn’t cause the number of units sold to decline significantly). 

When should I use a break-even analysis? 

There are many situations where a break-even analysis comes in handy. According to Rick Vazza, owner of Driven Franchising, you should use a break-even analysis to answer the following questions about your business: 

• How much of my product or service do I need to sell per month?
• How much volume do I expect to sell?
• What price makes those figures match my break-even calculation?
• What price allows me to generate a reasonable profit? 

Your goal is to get an accurate look at your profit, net cash flow and finances. 

“It’s much easier for people to decide whether they can beat that minimum than guessing how many sales they may make,” said Rob Stephens, founder of CFO Perspective. 

Here are three times you should consider performing a break-even analysis. 

You are expanding your business.

Stephens suggested using a break-even analysis to assess how long it will take for any planned investments or changes in your business to become profitable. 

“These investments might be a new product or location,” Stephens said. “I’ve done break-even calculations many times for modeling the minimum sales needed to cover the costs of a new location.” 

You need to lower your pricing.

This analysis is also helpful when you’re lowering your prices to beat a competitor. “You can also use break-even analysis to determine how many more units you need to sell to offset a price decrease,” Stephens said. “The most common use of break-even analysis in my career has been modeling price changes.” 

You want to narrow down your options.

When making changes to your business, you may be bombarded with various scenarios and possibilities, which can be overwhelming when you’re trying to make a decision. Stephens suggested using a break-even analysis to narrow down your choices to scenarios with straightforward yes-or-no questions. For example, “Can we do better than the minimum needed for success?”

What are the limitations of a break-even analysis? 

Although a break-even analysis is a classic tool for predicting business sustainability, it does have some limitations. You should always use multiple tools when analyzing business processes and profitability.

It assumes market conditions are consistent.

Once you open your business, it will quickly become apparent that every day, month and year can be completely different. You might have an increased customer demand, multiple competitors or a change in consumer spending.

It’s not sufficient for long-term planning. 

A break-even analysis is most useful for short-term planning. For example, the analysis can accurately predict how many units must be sold for you to be profitable this month, but it cannot help you analyze business conditions over time, especially if you have busy and slow periods.

The analysis can quickly become obsolete.

Due to the short-term nature of a break-even analysis, it needs to be constantly updated to be accurate. If you fall behind on importing new data, the analysis can quickly become obsolete, leading to uninformed business decisions.

It’s not detailed enough.

If you have only one price point, a break-even analysis can be beneficial. However, most businesses have multiple price levels to encourage and engage a wide variety of consumers.

With multiple product tiers, your costs can fluctuate from supplies, inventory demand and shipping. With all of these factors to consider, you’ll need to use additional tools beyond a break-even analysis to accurately portray the financial health of your business.

It doesn’t account for competition.

Because there is no formula for a fluctuating marketplace, a break-even analysis can’t account for competition. You will need to monitor your competitors separately so you can accurately account for supply and demand, product price changes and promotional offers.

Julie Thompson and Julianna Lopez contributed to this article. Source interviews were conducted for a previous version of this article.