This statement isn't even remotely controversial, shocking, or insightful, but it's still true:
Businesses sell products and services to make money. Sales — at its core — is the pursuit of profit, so naturally, companies need a pulse on what it takes to get there.
Every product or service has a threshold for profitability — a point where costs are recouped and a business can start reaping some spoils from its investment. That point is known as a break-even point, and every organization needs to know how to find it.
That process is called a break-even analysis. Here, we'll explore the concept a bit further, review the break-even analysis formula, and see how the results of one can be applied.
What is a break-even analysis?
A break-even analysis is an analysis a business runs to determine the point at which total revenue equals total cost (fixed and variable). In other words, a break-even analysis is an analysis that identifies the point at which a company will break even with a specific endeavor.
Break-even analyses are conducted to pin down target levels of production or optimal sales mix. It's typically an internal practice, meaning the process usually isn't leveraged by anyone outside of the company in question — including entities like investors or regulators.
The concept of a break-even analysis rest primarily on a factor known as contribution margin — the difference between the selling price of a product and the variable costs associated with producing it. Fixed costs are left out of that aspect of the equation.
For instance, if a product sells at $5.00 per unit with a variable cost of $1.00, its contribution margin is $4.00. That difference represents the revenue each sale contributes to covering the fixed costs associated with production.
Break-Even Analysis Formula
Break-Even Quantity = Fixed Costs/(Sales Price per Unit - Variable Cost per Unit)
Imagine you're a managerial accountant at a midsize yogurt manufacturer. You've pinned down that your fixed costs — your rent for the factory and main office, property taxes, salaries, machinery purchases, and other costs that don't change with varying output — amount to $50,000.
You've also determined that the variable costs associated with producing a single cup of yogurt add up to $1.00 per unit, and each one retails at $3.50 per unit. To find your break-even quantity, you use the break-even analysis formula like this:
$50,000/($3.50 - $1.00) = 20,000 units
With all those factors in mind, you find your yogurt company needs to sell 20,000 units to break even.
For a walkthrough on using the break-even analysis formula, check out our video here.
Break-Even Analysis Applications
Pinning Down Pricing Strategies
Shooting in the dark when pricing products is never a good call. There are a lot of points to consider, and your company's financial situation is near the top of the list. You have to know what it takes to make a profit before you land on an ideal price for your offering.
Experimenting with your break-even analysis helps you get there. It shows you whether the prices you're considering are financially viable and fundamentally sound. If you don't know what it's going to take to get in the black, you run the risk of selling yourself short with your pricing strategy.
A break-even analysis can help show you whether your fixed or variable costs are excessive to the point of infeasibility. If you conduct your analysis and find that your break-even point could only come at a price that oversteps your product or service's value, you'll know to look for ways you can adjust your budget and balance things out.
Boosting Your Sales Team's Motivation and Morale
Sharing the results of your break-even analysis with your sales reps provides a milestone they can reference when conducting their efforts. It gives them a definitive reference point for how well they're doing and whether they need to pick up some slack. Sales teams often benefit from benchmarks they can track their progress against — a break-even point is an easy one to establish.
A break-even analysis can be essential to multiple facets of a business. Whether it be for accounting, pricing, or motivational purposes, having a picture of what it takes to make a profit is about as key as any other kind of insight.
It might go without saying, but if your business is preparing to sell a product or service, you need to identify your break-even point — plenty of decisions and projections will inevitably rest on it.