Your Income Statement: Break-Even Analysis
To break even in business is to reach that point where your total revenue equals your total costs (cost of goods sold plus fixed expenses). It’s that point of time when you have operating income of zero.
For starting businesses, this is a critical number to figure out because it determines how much units of sales you need in order to cover all of your costs, without having to dip further into your own pocket to keep financing your company. It is also a number that constantly changes, so it’s a great idea to do it once a year so you are always aware of what your break-even point is at any given time, and can plan your marketing and advertising campaigns accordingly.
To calculate break even, you can take one year’s income statement. If this is your first year in business, take the time to project what you think your costs and sales would be in your first year; you can use this projected income statement to base your break even. If you’ve been in business for a while, if possible, use the average of three year’s income statements to calculate your average break even. Alternatively, if you already have a budget for the future, you can also choose to do the same exercise.
With your income statement, you need to identify what are your variable costs and your fixed costs.
Variable costs are called variable because they change depending on the units of sales, and typically, they are costs associated with producing or reselling your products/service. These are things such as cost of goods sold (inventory purchases that has been sold for the period), freight expenses, material costs, labour costs, etc. They are costs that you only incur when you make sales. Fixed costs are fixed because they don’t change, regardless of whether or not you sell anything. These are things such as office rent, utilities, telephone, internet, salaries of administrative staff, etc. Whether your company is selling anything or not, they have to be paid. Identify your costs with highlighters, if necessary. Highlighters are extremely useful in analysis.
Next, you have to calculate your unit contribution margin. This is the difference between the selling price of one unit of product and the variable cost to product that product. Service businesses tend not to have contribution margins because they typically have little to no variable costs. Products businesses have to watch out for this number, because it’s a very useful way of calculating whether more sales will actually help your business.
It could also be called the gross profit divided by total units sold. For example, you sold 40 units at $200/unit, and it costs you $120/unit to buy each item from your supplier. Your unit contribution margin is $80/unit ($200 – $120).
Now, you can calculate break even number of units by dividing fixed costs with the unit contribution margin. For example, if the total fixed costs for the year is $2000, and your unit contribution margin is $80/unit, your break even number of units will be 25 units ($2000 / $80).
In dollars, your break-even is $5,000 (25 units x $200/unit). That means you need to sell 25 units or make $5,000 every year in order to make sure that your company makes enough money to cover all of your expenses and you’re not forced to get a loan or invest more money into the business. It also means that every time you sell over 25 units or go over $5,000, you are making a profit.
For service businesses who have little to no variable costs, your break even dollar amount will be the total of your fixed costs.
You can calculate your break even number of units by dividing your total fixed costs and your selling price per unit of service. For example, if you’re a mechanic with total annual fixed costs of $2,000 and an hourly rate of $50, your break even dollar amount is $2,000 per year and your break even number of units will be 40 hours ($2,000 / $50).
Calculating the break even is a critical step. Don’t neglect it.