Why Break-Even Calculation is Important
Break-even analysis is a method of calculating what the margin of safety is in a company, using the company’s revenue balanced against its operating costs. It answers the question of whether or not a company is generating sufficient income from a product or service to justify the output from its expenses. At the break-even point, money is neither being earned nor lost. Being above that point signifies profit; below it means loss. This type of analysis allows businesses to make key decisions when it come to such considerations as pricing, frequency of sales, and other projections affecting the launching or continuation of their products. In this way, break-even analysis can be especially useful in a company’s early stages.
(Chart courtesy of CaminoFinancial.com)
In the words of Colleen Egan, of AI Engineers: “When will I break even? It’s one of the biggest questions you need to answer when you’re starting a business. And that’s why it’s so crucial to conduct a break-even analysis, which helps you determine fixed costs (like rent) and variable coast (like materials) so you can set your prices appropriately and forecast when your business will become profitable.” (Square IP (Links to an external site.)). Break-even analysis can also help a company set goals, in terms of the viability of launching new products, and the possibilities for expansion. Setting these types of goals can strengthen a company’s forward-thinking potential and overall motivation.
Applying Break-Even Analysis
As Kevin Kinsella, founder of Avalon Ventures, has said: “You have to look at the fundamental raison d’être of the business—what is it doing? What’s the nature of the business and what are its prospects for success? What are its prospects to break even and then return the sustained profit?” (Avalon Ventures (Links to an external site.)) Break-even analysis can be used to address these questions, by providing an accurate assessment of a company’s profit, total cash flow and general financial situation.
Let’s say that you work for a company that sells computers. You’ve determined that the fixed costs including rent, insurance, property tax, utilities, and salary equal $30,000.00. These amounts do not change as your volume of sales change. You then sum up your company’s variable cost for each computer sold, such as computer parts, accessories, software, and monitors, and come up with a figure of $200 for each computer that sells for $500. Using these numbers, your next step is to calculate your contribution margin, which is the sales price minus the variable cost, or $300. Your breakeven volume would provide the amount of computers you would have to sell in order to avoid a loss on your investment. In this case, the fixed costs of $30,000.00 would be divided by your contribution margin, which is the sales price of $500 minus the variable cost of $200. The resulting amount is a break-even unit amount is 100 computers. Multiplying those 100 units by the cost of $500 would give you a break-even sales amount of $50,000.00.
Applying break-even analysis makes it possible for a company to address any number of specific concerns about optimizing its operations, by projecting profits and losses at different levels of output. It can help determine pricing, determining the minimum level of sales that would avoid loss. It can be instrumental in making projections for new products and for dropping old ones. And it can help a company decide whether or not it would be advisable to invest in such things as the improvement of its facilities. “In business, your ultimate objective is to make money. So, when you launch a new product or purchase a new piece of equipment, how do you know whether a potential investment will at least cover the costs associated with it? You could simply make a wish and hope it all works out—or you can evaluate the project more formally to see if it makes financial sense. One way of doing this is to complete a Break-Even Analysis.” (MindTools.com)