Calculating Your Break-Even Point
Profitability is the goal of every business owner. But before you can turn a profit, you first have to break even. Spending more money than you are taking in to produce a product or provide a service can quickly bleed a company of its capital. Even if your business has a financial cushion large enough to allow it to operate in the red for a period of time, you should at least be aware of the areas in which losses are occurring and have in place a plan for steering your company into the black.
The break-even point is the number that must be reached before an investment starts to generate a positive return. To run your business successfully, it is crucial that you have identified the point at which revenues cover expenditures on each of the products and services you offer, as well as on your overall operations. Because these break-even points shift as conditions change, break-even analyses should be performed regularly, preferably on a quarterly basis.
While there are a number of methods for determining a business’s break-even point, one relatively simple approach is to calculate how large the company’s gross profit margin must be to cover its fixed costs.
To get started, add up all the fixed costs your business has to cover regardless of sales volume, such as rent, payroll (including your own salary), debt payments, insurance, and similar overhead expenses.
The next step is to calculate the gross profit margin on the products or services you sell. The gross profit margin is a financial metric used to determine the percentage of funds left over from revenues after accounting for the cost of purchasing or producing the goods sold. The gross margin can be calculated on a per-unit basis or by subtracting variable costs from the sales price. The break-even point can then be calculated by dividing your fixed costs by your gross profit margin.
For a very simple example, imagine you have added up your expenses and determined that your monthly fixed costs amount to $50,000. Then, assume your business consists of purchasing gadgets at $3 per unit and selling them at $10 per unit, giving you a gross profit margin of $7 per unit, or 70%. When your fixed costs of $50,000 are divided by your gross profit margin of 70%, the resulting figure is approximately $71,429. This means you would have to sell 7,143 gadgets in a given month to break even. If sales dip below 7,143 units per month, your business is losing money, while any sales above this threshold represent profit.
The calculations become more complex, of course, when multiple product lines are involved, or when expenses change frequently. There are many other factors that affect the financial health of the business over time, such as projected changes in market conditions. A break-even analysis should, therefore, be seen as a basic tool that can provide a snapshot of where a business stands at a given point in time, which should be used in conjunction with other financial measures.
A break-even analysis can, however, provide you with important preliminary information about the status of your business. If the results of the analysis reveal that your sales are not sufficient to cover expenses, or that your profit margin is smaller than you would like it to be, there may be action you can take to lower your break-even point.
Start by investigating ways to reduce the cost of purchasing or producing the products or services you sell. Is there another supplier who would sell you the same or a similar gadget for $2.75, instead of $3? If you make the product yourself, are there options for manufacturing it less expensively?
Next, think about whether there are steps you can take to trim overhead expenses without harming your operations. Finally, consider raising prices. Implementing small changes in one or more of these areas could enable you to reset your business’s break-even point, and move your company in the direction of greater profitability.
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