Why You Should Perform a Break Even Analysis before Starting Your Business

Running a small business is not for the faint-hearted. It requires a lot of stamina, determination, and knowledge. One of the vital skills you need is to know how to perform a break even analysis. Not sure how to perform one? Don't worry; we'll take you through the process step-by-step.

What Does Break Even Point Mean?

This is the point in your business where your costs and revenue are equal. When you discover what that figure is, it's time to evaluate all elements of your business. This includes the cost of labor and materials and possibly rent, if you don't own your own building.

This is also a good time to examine your pricing structure to determine if your prices are too low. If your prices are too low or your costs too high to reach a break-even point in a reasonable amount of time, then your business is in danger of being unsustainable.

The Formula for the Break Even Analysis

There is no one formula for this—in fact, there are a few basic ones, and which one to use depends upon how you want to measure. You can craft your formula using products sold or based upon sales in dollars.

We'll look at each formula, and then you can decide which one would be most appropriate in your business.

To Calculate Based Upon Units

Simply take the fixed costs by the revue per unit and then subtract the variable cost per unit. Remember, the fixed costs are those that do not change, no matter how many units are sold.

The revenue would be the price you're selling the product for, minus costs like labor and materials.
In other words:

Break-Even Point (in Units) = Fixed Costs divided by (Revenue Per Unit minus Variable Cost per Unit)

When Calculating a Break-Even Point in Dollars

Here, you simply divide the fixed costs by the contribution margin. This is determined by subtracting the variable costs from the price of a product.

The formula is:
Break-Even Point (in dollars) = Fixed Costs divided by Contribution Margin.

If some of the terminology above was confusing, don't worry. We'll take a closer look at the definitions for these important business terms.

Fixed Costs

These are expenses that are not affected by how many items are sold. An example would be the rent you pay on a building or computers and software.

Contribution Margin

All you have to do to get the contribution margin is to subtract the items variable costs from the selling price. For example, if you're selling a product for $20 and the cost of materials and labor is $10, then the contribution margin is $10.

That $10 would be used to cover any fixed costs. Whatever is left after that is your net profit.

After the Analysis

The analysis is a tool, and it doesn't mean that your job is complete. The figures might have some big revelations, and you may realize that you have to sell more products or raise prices in order to break even.

Just remember that there are also a lot of variables you must also take into account when trying to determine the break even point with your business.
For example, just because you have the product priced correctly doesn't mean that the product is going to sell. Your business can also be affected by the local economy or job market.

This is one reason why it's a good idea to do a break even study before you start a business because then you're preparing yourself for the task and giving yourself the tools you need to succeed.