You’re running a small business, or maybe you’re thinking about starting one. You don’t want to lose money, and you don’t want to go out of business. So, how do you find out how much you need to earn to break even? The answer is simple. You do a break-even analysis.
Don’t worry, a break-even analysis sounds more complicated than it really is. It doesn’t require a lot of math skills. It just requires some thought and a basic equation.
First, what is a break-even analysis? Very simply, a break-even analysis is the process of discovering your break-even point. What’s a break-even point? It’s exactly what it sounds like: it’s the point where your expenses are exactly covered by your income. It’s where you “break even”. Every sale above your break-even point is profit in your pocket.
Once you know your break-even point, you know exactly how much you need to earn to break even. You will also see whether or not you can realistically stay in business.
For example, if your break-even analysis shows you need to sell 1000 widgets every year just to cover your expenses, and historically you’ve only sold 200 widgets a year, then you’re going to have to do a lot of planning to get your sales up to 1000. You might need to dramatically lower your expenses or come up with a better marketing plan to break even.
So, how do you calculate your break-even analysis?
The first thing you do is add up all your fixed costs. This means all the expenses you have to pay whether you make any sales or not. Your fixed costs include your rent, utilities, and any salaries. Your business may have other fixed expenses like membership dues or insurance premiums. As an example, if you made widgets from home you might discover your fixed costs are $10,000.
Next, estimate the average price of your product or service. To continue the widget example, if all your widgets are sold for $100 each, then $100 is the average price of products. But what if your widgets have different prices? Then you find the average price. You find the average by adding up the different prices and dividing that by the number of products.
For example, say you offer 2 different widgets: one is $50 and the other is $150. To find the average price of product, add 50 + 150 and divide by 2. Your average price of products would be $100.
Finally, estimate the average cost of your product. In other words, how much does it cost you to produce each widget? Or, if you provide a service, how much does it cost you to provide that service (travel expenses, phone calls, etc.)? To conclude the widget example, let’s say your widgets cost $10 to produce.
Okay, now you know your fixed costs, the average price of product, and the average cost of product. You’re almost finished. All you have to do is plug these numbers into the break-even equation. This equation will tell you the dollar amount you have to make to break even.
The break-even equation is:
Fixed costs/ [1 – (average cost of product/average price of product)]
So, for the widgets example, take the fixed costs of $10,000 and divide that by 1 – (10/100). Remember, $10 is the cost of product and $100 is the price of product.
$10,000/[1 – (10/100)] = $10,000/.9 = $11,111
The equation shows that you must make $11,111 in order to break even.
Want to know how many widgets you’ll have to sell to get there? Easy. Just divide this number by the average price of product. For the widgets, divide $11,111 by $100 and you get 112 (round up to the next whole number). So, in this example, you must sell 112 widgets every year just to break even.
Calculating a break-even analysis for your small business is the best way to find out how much you need to earn to stay in business. Once you know your break-even point, you can design marketing plans and control your expenses to maximize your earning potential.
Your break-even analysis will tell you exactly at what point you start turning a profit. Every sale above your break-even point will be money in your pocket, so take advantage of the break-even analysis to make better business decisions and increase your profits.