Do you sometimes you ask yourself, “Is it all worth it?” If not, maybe you should. It’s an important question for your business.
If you ask yourself, “Is it worth making this product?” or “Is it worth providing this service?”, would you know the answer? If you did, it could make you think about changing your product line or refocusing your business.
One of the tools that can help you get an answer is a break-even analysis. Break-even analysis tells you how much you need to sell to at least cover your costs. It’s pretty crucial to know the break-even point for what you offer and even for your business as a whole. If you fall below it, you’re taking a loss and you may be on the top of a slippery slope.
If you want to calculate a break-even point for a product, you need to consider its sale price and its variable and fixed costs. The variable costs are the ones that increase in direct proportion to sales volume. Say you sell soap, for example. You currently sell it at $1.50 a pack.
Your variable costs might include:
- the price of packaging that you buy from your suppliers;
- the raw materials you use to produce each pack;
- transport costs; and
- sales commissions.
Say your variable costs amount to 50 cents per pack. That leaves you with a margin of $1 on each pack you sell.
To find your break-even point, you then calculate how many packs you need to sell to cover your fixed costs—which are the costs that remain constant regardless of your sales volume.
Your fixed costs could include:
- the rental you pay for your shop;
- insurance costs;
- loan repayments;
- salaries for your core employees; and
- plant costs (provided that you don’t make major purchases).
Say your fixed costs are $50,000 a quarter. Remember that your margin after paying variable costs was $1 per pack. So you’ll have to sell 50,000 packs a quarter just to cover your fixed costs.
If you fall below that point, alarm bells should start to ring. In fact, they should start to ring well before you reach the break-even point, because you’ll be eating into your overall profit margin.
Break-even analysis is also an important part of business planning. Say you’re looking at launching a new product. You’re not sure how to price it so you do some research. You carry out some calculations to estimate how price sensitive it is.
For example, will demand drop off suddenly if there are small price increases? (This commonly happens if you are selling discount goods and you are competing mainly on price.) Or can you price at a range of levels with only a moderate decline in demand and sales? You can estimate a kind of price/demand curve that will tell you how a product might sell at a range of prices. Then you can carry out break-even analysis for a range of points on this curve. This will help you make decisions about pricing, production volumes and profit.
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Christopher Brown
Brown & Company, PLLC
An Important Message
While every effort has been made to provide valuable, useful information in this publication, this firm and any related suppliers accept no responsibility or any form of liability from reliance upon or use of its contents. Consider any suggestions within your own particular circumstances and contact us if you want more help.
Bullseye and RAN-ONE were the original sources for this article.
