Break Even Analysis
If you can accurately forecast your costs and sales, conducting a break even analysis is a matter of simple math. A company has broken even when its total sales or revenues equal its total expenses. At the break even point, no profit has been made, nor have any losses been incurred. This calculation is critical for any business owner, because the break even point is the lower limit of profit when determining margins.
Defining Costs: - There are several types of costs to consider when conducting a break even analysis, so here’s a refresher on the most relevant.
· Fixed costs: These are costs that are the same regardless of how many items you sell. All start-up costs, such as rent, insurance and computers, are considered fixed costs since you have to make these outlays before you sell your first item.
· Variable costs: These are recurring costs that you absorb with each unit you sell. For example, if you were operating a greeting card store where you had to buy greeting cards from a stationary company for $1 each, then that dollar represents a variable cost. As your business and sales grow, you can begin appropriating labor and other items as variable costs if it makes sense for your industry.
Setting a Price: - This is critical to your break even analysis; you can’t calculate likely revenues if you don’t know what the unit price will be. Unit price refers to the amount you plan to charge customers to buy a single unit of your product.
Psychology of Pricing: Pricing can involve a complicated decision-making process on the part of the consumer, and there is plenty of research on the marketing and psychology of how consumers perceive price. Take the time to review articles on pricing strategy and the psychology of pricing before choosing how to price your product or service.
Pricing Methods: There are several different schools of thought on how to treat price when conducting a break even analysis. It is a mix of quantitative and qualitative factors. If you’ve created a brand new, unique product, you should be able to charge a premium price, but if you’re entering a competitive industry, you’ll have to keep the price in line with the going rate or perhaps even offer a discount to get customers to switch to your company.
One common strategy is "cost-based pricing", which calls for figuring out how much it will cost to produce one unit of an item and setting the price to that amount plus a predetermined profit margin. This approach is frowned upon since it allows competitors who can make the product for less than you to easily undercut you on price. Another method, referred to by David G. Bakken of Harris Interactive as "price-based costing" encourages business owners to "start with the price that consumers are willing to pay (when they have competitive alternatives) and whittle down costs to meet that price." That way if you encounter new competition, you can lower your price and still turn a profit. This presentation from Harris Interactive offers a further explanation of these methods, and About.com offers an overview of common pricing methods.
The formula: To conduct breakeven analysis, take your fixed costs, divided by your price, minus your variable costs. As an equation, this is defined as:
Breakeven Point = Fixed Costs / (Unit Selling Price - Variable Costs)
This calculation will let you know how many units of a product you’ll need to sell to break even. Once you’ve reached that point, you’ve recovered all costs associated with producing your product (both variable and fixed). Above the break even point, every additional unit sold increases profit by the amount of the unit contribution margin, which is defined as the amount each unit contributes to covering fixed costs and increasing profits. As an equation, this is defined as:
Unit Contribution Margin = Sales Price - Variable Costs
Recording this information in a spreadsheet will allow you to easily make adjustments as costs change over time, as well as play with different price options and easily calculate the resulting break even point. You could use a program such as Excel’s Goal Seek, if you wanted to give yourself a goal of a certain profit, say $1 million, and then work backwards to see how many units you would need to sell to hit that number.
Limitations: - It is important to understand what the results of your break even analysis are telling you. If, for example, the calculation reports that you would break even when you sold your 500th unit, decide whether this seems feasible. If you don’t think you can sell 500 units within a reasonable period of time (dictated by your financial situation, patience and personal expectations), then this may not be the right business for you to go into. If you think 500 units is possible but would take a while, try lowering your price and calculating and analyzing the new break even point.