Lucinda has taught business and information technology and has a PhD in Education.
Performing a break-even analysis can help you make decisions regarding how much of your product or service you need to sell to make a profit. In this lesson, you'll learn what a break-even analysis is and how it is calculated.
How Much Is Enough?
We know the fundamental reason to be in business is to make a profit - right? Of course! We want to be able to sell a product or service that meets the needs of a consumer and that will net us an income. How do we know when we start making an income? How do we know when we start making that profit? We can't just look at sales. Say we make $5,000 in sales; that sounds terrific, right? Well, yes, until you realize that to make that $5,000, you had to spend $4,500; now that $5,000 turns out to be only $500 in profit, which may not be enough to be a decent income for you.
So, what can you do to find out if it is profitable for you to be in business? What you can do is perform a break-even analysis. Basically, what you want to do is to find out how much of your product you have to sell to break even - meaning pay your bills or expenses. This is our break-even point, and anything you sell over that amount is what you can count as profit.
How Much Is Just Enough?
Let's say we want to start a lemonade stand. Before we even get started, we're going to want to know how many glasses of lemonade we'll need to sell in order to make a profit - because, remember, it's not all profit (unless your parents are paying for the lemons, sugar, (disposable) glasses, and supplying the table, chairs, and pitcher). Let's assume your parents are not footing the bill for production. What do you need to know in order to perform a break-even analysis?
First, you need to know what your fixed costs are. In other words, what are the costs to you to sell that first glass of lemonade? For our lemonade stand, fixed costs would include the cost for the table, the chairs, and the pitcher. In the case of our lemonade stand, let's say those costs are $2 (we're renting the table and chairs from our parents). For more advanced businesses, this would also include rent or mortgage on property, any loans on machinery, and the raw materials to produce one unit.
Next, you will need to know what your variable costs are. Variable costs are the expenses you incur to produce every unit. For our lemonade stand, let's say the variable costs are $0.10 for each glass of lemonade, which includes the sugar, water, lemon, and (disposable) glass. A more advanced business may also need to include costs for their human resources and electricity.
The third thing we need to know is how much we are going to charge for a glass of lemonade. Let's say we think we should charge $0.25. We can start out with that amount and then adjust it once we do our break-even analysis.
The basic formula we use is this:
Note that we have to subtract the variable costs from the sale price before we do our division. This is because fixed costs aren't going to change no matter how many units are sold, so those costs are spread across all the units that are sold.
Let's look at the math for our lemonade stand:
Once we do the math, we see that in order to make enough money to pay our expenses, we need to sell 13.33 glasses of lemonade. Realistically, we need to sell 14 glasses because we can't sell 33% of one glass, but that means part of glass number 14 will be profit.
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What if we thought we could get $0.50 per glass of lemonade? What would our break-even analysis look like then?
The only thing that changes in our equation is the sell price. After some calculations, we see that our break-even point at that price would be 5 glasses of lemonade. So, we will start earning a profit after we sell 5 glasses of lemonade.
Making It Work
Often, business owners use break-even analysis to help them decide where to set the price of a good or service. They can also use it to decide or whether or how much it would benefit them to negotiate better deals for the variable and fixed costs. The bottom line is a break-even analysis can help a business determine if it is viable. Can it support its fixed and variable costs with the number of products it can sell?
Let's look at another example for the production and sale of widgets:
Our fixed costs for manufacturing widgets is $500, and the variable costs, or the cost to produce one widget, is $50. If we set the sell price of one widget at $100, then we would need to sell 10 units in order to break even. We could, however, increase the price like we did with our lemonade stand. If we change the sell price per widget to $200, we find that we would only need to sell 4 widgets in order to break even.
So, which way do we go? A higher price gives us an earlier break-even point; however, it may be easier to sell 10 units at $100 than 4 units at $200. It then becomes necessary to do a demand analysis. How much demand is there for the product, and how much would people be willing to pay for the product. In other words, at what point will the customer say, 'No, I'm not willing to pay that much?'
A break-even analysis is one way that businesses use to determine a price point for their product. The break-even analysis uses three pieces of information: the fixed costs, such as rent; the variable costs, such as for raw materials; and the expected sales price. With these pieces of information, a business can calculate their break-even point - how many units must they sell to pay their bills. The formula is:
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