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ACCOUNTING

How to Perform a Break-Even Analysis
 

How many units of stuff—say, how many ham sandwiches, iPhone apps, or hours of consulting services—must you sell in order to cover your costs?

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A break-even analysis is a key part of any good business plan. It can also be helpful even before you decide to write a business plan, when you're trying to figure out if an idea is worth pursuing. Long after your company is up and running, it can remain helpful as a way to figure out the best pricing structure for your products.

It sounds complicated, but it's not. Basically, a break-even analysis lets you know how many units of stuff—say, how many ham sandwiches, iPhone apps, or hours of consulting services—you must sell in order to cover your costs.

You'll need several basic pieces of information:
•    Fixed costs per month
•    Variable costs per unit
•    Average price per unit

Performing a Break-Even Analysis: Fixed Costs

Fixed costs are ones like rent and administrative payroll that don't change much from month to month, regardless of how many units you sell. SCORE lists many common fixed costs.

"Be sure to include everything," says Jerry Chautin, a volunteer SCORE business mentor in Atlanta and Sarasota, Florida. "People forget about things like deposits or contingency funds, which can add up to a sizable amount."

If you're creating a business from scratch, don't rely on guesswork to estimate your costs. Chautin suggests asking the utility company for the past year of bills for your location. Call an insurance broker for a real quote for your particular business. Check with trade associations or web sites such as www.bizstats.com for information on average costs in your particular industry.

Dig Deeper: Exploring the Break-even Analysis


Performing a Break-Even Analysis: Variable Costs


Variable costs are ones like inventory, shipping and sales commissions that rise or fall with your sales volume. As with fixed costs, talk to trade associations, vendors and even other business owners in your field to come up with the most accurate estimate.

"Look up the financials of public companies in your industry: 10-Ks, which are annual disclosures, or 10-Qs, which are quarterly," Chautin says. "Even though those companies are much larger, you can size it down. The ratios are not going to be that far off."

Dig Deeper: Break-Even Analysis Chart


Performing a Break-Even Analysis: Pricing


This is the trickiest of your three pieces of data, since you're able to choose exactly where to set your prices. Start by looking at your competition, and how they price their products. You can also do informal focus groups to see what people might be willing to pay for your wares or services.

"You can look at pricing many different ways," says Gwendolyn Wright, a small business coach with The Wright Consultants in San Francisco. "How's your competition pricing it? Do you want to be at the midpoint, higher end, or lower end? I see people pricing earrings at three times what their competitors are charging. Why would anyone buy that?"

You'll also need to consider your costs when setting prices. If you spend $2 on meat and condiments to produce a hamburger, you'll obviously need to price it at more than $2. But how much more—$4? $5? $7?  That's where a break-even analysis can come in handy.

Dig Deeper: Break-Even Analysis in Inc. Tools


Performing a Break-Even Analysis: The Formula


Once you've got your cost data and a target price, plug them in to this formula:

BEQ = Fixed costs / (Average price per unit – average cost per unit)

This will tell you your break-even quantity (BEQ), the number of units you need to sell to cover your costs. Any sales above that are pure profit. Anything below means you're losing money.

Here's an example. Suppose you're turning a jewelry-making hobby into a business. You have $1,000 per month of fixed costs (studio rent, utilities, equipment, etc.). Your variable costs for each necklace are $50 for materials and labor. You'd like to charge $70 per necklace, since that's what similar pieces are selling for.

BEQ = $1000 / ($70 – $50) = $1000 / $20 = 50

That means you'd need to sell 50 necklaces a month at $70 each in order to break even.

Use your break-even formula to compare different pricing strategies. For instance, if you raised the price to $80, you'd only need to sell 33 necklaces—but it might be harder to attract buyers.

On the other hand, if you lowered the price to $60, you'd attract bargain shoppers—but would need to sell 100 necklaces to break even.

The break-even formula can help you compare different cost structures as well as prices. For instance, suppose you used less expensive materials in your necklaces and pared the unit cost down to $45. The formula tells you that you'd have to sell just 66 necklaces at $60 to break even.

You can use a basic Excel spreadsheet to run different break-even scenarios, or download one of many break-even templates available online.

Dig Deeper: Break-Even Analysis, a Basic Calculation

IMAGE: Getty
Last updated: Dec 15, 2010




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