Every business is run with one intention – to earn profit. Many startups fail because they run out of cash before they can see profits. Even the most profitable businesses can eventually run out of cash due to poor decisions, a challenging economy, and unexpected setbacks. How can you, as a business owner, turn your business profitable and sustain it in different scenarios? The answer is Break-Even Analysis.
At any given point, you should know the break-even point (BEP) of your business and act on improving its constituent elements before it’s too late.
Calculating Break-Even Point (BEP)
Any business earns profits by selling goods and services at a certain price, which is higher than the cost it incurred to make and deliver them. The BEP is the point where your revenue = cost. It tells you how many units of a product you have to sell to cover both fixed and variable costs.
Contribution margin = Selling Price – Variable Cost
Contribution margin tells you how much of the selling price can be contributed towards fixed costs. For instance, you sell a product at $100, which has a variable cost of $40. The contribution margin for the product is $60, which means every unit sold can contribute $60 towards fixed costs.
Break-Even Point = Fixed Cost / Contribution Margin
Suppose your fixed cost is $50,000, you will have to sell 834 units to reach a point of no profit, no loss.
BEP = $50,000 / $60 = 834 units
Any units sold above 834 units will earn a profit.
Businesses strive to reach and maintain the BEP, and their business decisions are often centred around this point.
Using Break-Even Analysis in Business Operations
Business owners can use the four elements of BEP to set revenue targets, manage costs, and reduce risk. How they use it is what break-even analysis is about.
Before Starting or Divesting a New Venture
The break-even point is the minimum revenue a business must achieve to sustain itself; otherwise, it will only burn cash.
You should do some prepping before starting a business. Create a financial model that lists down cost estimates. Analyze the competition and market to determine if the product or service has demand and what price potential consumers are willing to pay.
Once you have all three elements, you can determine the BEP and make an educated estimate of how much time it will take for your business to reach break-even sales. Here you have a measurable and time-bound target. If the numbers don’t add up or look risky, you’ll know the business is not feasible. The same logic can be used for deciding whether to discontinue a non-performing product or branch.
Determine Capital Spending (Fixed Cost)
Fixed cost, an essential element of BEP, is incurred even if you don’t sell a single piece. This includes rent, equipment purchased, debt, and more, and is divided equally between all units sold. The more units you sell, the bigger the base to absorb the fixed cost, reducing your production cost. On the contrary, a business with a higher fixed cost and not enough sales could face losses and run into a cash crunch.
Break-even analysis can help you keep the fixed costs in check with the help of the contribution margin. Suppose you run taxi services, and want to add two more cars to your fleet. You can work out the numbers to see if you have enough sales to meet the increased fixed cost.
Optimize Capacity and Improve Efficiency
You can use BEP to determine if you are optimizing the asset to its full potential. If not, you can outsource that work and pay on a use-basis, thereby reducing the fixed cost of owning excess capacity. For instance, if you don’t need a full-time salesperson, you can outsource that work and reduce the fixed payroll cost, without affecting your business operations. Other areas where business owners can look for cost savings include rented office space, unused subscriptions, electricity, and stationery costs.
Technology Adoption to Improve Business Efficiency
Many businesses use technology and digitization to automate mundane tasks and reduce fixed costs, which, in turn, help reduce the BEP and improve profitability.
Business owners can measure all their business efficiency efforts against the BEP number. Initially, the BEP may rise as you incur fixed costs. However, it should gradually decrease to below the level it was before undertaking the capital expenditure.
Apart from long-term decisions, break-even analysis can also help business owners navigate short-term challenges on a real-time basis.
Manage Inflationary Pressure (Variable Cost)
Variable cost changes depending on the units produced, inflation, and the supply and demand situation. This includes raw material cost, utility bills, labour cost, inventory, and more. Tariffs, supply shortages, excess inventory, inflation, oil prices, and taxes can all change the variable costs. While you can look for more suppliers, negotiate terms, or look for alternatives, break-even analysis can tell you at what point the business should pass the variable costs to customers by changing the selling price.
Competitive Prices (Sale Price)
Business owners cannot determine the selling price purely based on BEP. Competition, market demand and supply, customer acquisition, and marketing strategy all play a role in determining the sale price. BEP will indicate whether you are offering too many promotional deals that are negatively impacting profits or if competitive pricing is generating the necessary sales volumes. While price cuts may seem like the only option, your business should be able to sustain them.
Instead of cutting prices of all products, consider segmenting your offerings into a basic and a premium range, offering some value-added services that do not add to your cost. Where price cuts can significantly hurt your margins, you can encourage consumers to buy more by offering discounts on bundled packages that contain a mix of low and high-margin products.
You do not need to wait for a crisis to reduce BEP. An annual review of business operations and finances can help you reduce your BEP and improve profitability. You can perform BEP scenario analysis to determine a margin of safety, indicating how much of the unexpected costs your business can handle and still make a profit.
Contact Black and Gill LLP in Etobicoke to Help You with Data-Driven Business Planning
Being prepared or monitoring profitability in real-time, break-even analysis is a handy tool for business owners in most business decisions. A business consultant can help you crunch those numbers, prepare scenario analysis, and improve your break-even point, to give you a cost advantage over competitors. At Black and Gill LLP in the west end of Toronto, our accountants and business consultants can provide services such as financial statement analysis and cost management. To learn more about how Black and Gill LLP can provide you with the best accounting and business consulting expertise, contact us online or by telephone at 416-477-7681.