As a business owner, you’ve probably heard the break-even equation countless times. Revenues = Costs, Profit = 0, you get the picture. Break-even is often used at the beginning of the business to calculate how long it will take for all your hard work and effort to pay off and when you can start making a profit. But even after that initial break-even point, it’s important to check in as your business grows to make sure you’re still gaining a positive profit. Today, we break down break-even!
Steps to Conducting a Break-Even Analysis
1. Note Your Costs
Your costs will include both fixed and variable costs.
Fixed Costs: Costs that exist regardless of output (how many products you produce) These can include rent, subscriptions, property taxes, insurance, utility bills, etc.
Variable Costs: Costs that are dependent on how many outputs you produce. These can include direct labor, direct materials, sales commissions, etc.
2. Note Unit Selling Price
Next, note you much you charge per unit. If you sell outputs at different prices, note all of these, too!
3. Calculate Sales Volume
Based on your unit selling price, note your sales volume, or total revenues. Read on for an easy equation on calculating a sales forecast!
4. Compare your costs to your revenues and see where you are.
Getting The Pieces Right
In order to get the most accurate results possible, you’ll need to do a deep dive into your costs. For a new company, you may have estimates that need to be adjusted as time goes on; in addition, your administrative overhead and expenses may lessen once the business is more established.
For the most part, it’s pretty simple to get an understanding of where your costs lie. Break your costs up into fixed costs and variable costs. Fixed costs are perhaps the easiest, as they will always remain the same. Variable costs depend on output, and if you don’t know yet how many units you’re selling, it can be more difficult to calculate. If you do not know how many outputs you’re producing, make a conservative estimate based on your sales forecast or understand where your possible output capacity is and adjust from there.
Forecasting your revenues may be a bigger challenge, but there’s a simple equation you can use, too! This equation is called the chain ratio method, and it’s simple to manipulate your numbers as they change over time. See the equation below:
Forecasted Sales Equation
Total Estimated Prospective Buyers
x Target Market (% of total buyers)
x Distribution/Communication Coverage (% or target market)
x Annual Purchase Rate (# units per year)
x Average Offering Unit Price ($/Unit)
= Forecasted Sales
Based on this, you can also begin to understand where your margin contribution lies. While this may change as your business evolves, this is an excellent starting point to grasp where your business finances lie.
In addition, your sales forecast will also help you understand your most profitable products or services are and capitalize upon them. This could mean readjusting your marketing methods, finding a new target market to position within your current target market, or where you dedicate your resources!
Break-Even analysis is an important aspect of understanding your financial standing over time. Once you conduct your analysis, you'll understand where you need to cut costs, increase revenues, or reinvest your profit. Need help? Contact us at Practical Accounting Solutions today, and we can conduct your analysis and much more!
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Disclaimer: The views presented in this post are meant as educational resources and should not be taken as direct advice for your personal finances or small business. Should you have questions regarding a post relating to your specific finances, please contact us at firstname.lastname@example.org.