What is your break-even?
It is important that business owners understand the details of their profitability. Analytical approaches that help include cash flow, sales projections, profit and loss analysis, and return on investment. Another common technique is the break-even analysis.
A business breaks even when its total revenue equals its total cost. It is the point at which your product or service stops costing you money to produce, and begins to generate profit for your company.
However because costs are both fixed and variable, projections change, and revenue per unit is not constant, it needs study.
Let’s look at the fundamentals. The variable cost of a product is that cost that it takes to produce one more unit. If we are making shovels, the variable cost would include the material for the handle (wood) and the blade (steel), the coatings, and the labor to make these parts, assemble them, and coat them. The fixed costs are costs that don’t change if you produce more or less shovels. These would include the interest and depreciation on the machine that stamps the blade, rent, insurance, most utilities and administrative costs. If your fixed cost was $90,000 per year, your variable cost was $20 per shovel, and the price of your shovel was $30 (high quality shovel), then you can calculate the number of shovel you need to sell in order to break even.
Intuitively you can see that every shovel contributes $30-$20 or $10 to cover your $90,000 fixed cost. So you would have to sell 9,000 shovels (90,000/10) to break-even. For those of you who like formulas (probably not many), BE = Fixed Cost/(Unit Price-Unit Variable Cost)
The purpose of a break-even analysis is to check for reasonableness. Can you sell 9000 shovels?
You must continually monitor your break-even point. Your variable costs (cost/unit) might change. If you buy in larger quantities your variable cost could go down. But maybe your fixed cost goes up somewhat, since you need more storage space. Also costs, in general, tend to creep up.
Perhaps if you sell in large quantity, your price per unit is less (but you sell more). Does your BE go up or down?
You can use this analysis to help in specific decisions. Perhaps you could buy a new machine to stamp out shovel blades, lowering the cost of each blade by $4. If the machine cost you $4,000 your break-even would be 1000 shovels. (How is your shovel demand?)
There are three ways to lower your break-even point. First you can lower your variable cost. Perhaps you can use advanced technology, more efficient scheduling, increased productivity, or cheaper materials (but check your quality).
Secondly you can reduce your fixed cost. Watch out for a cost reduction in one area resulting in a cost increase in another. Make sure your plan considers all of your business functions.
Finally, you can raise prices. However, you must do this with a complete understanding of the market and your competition. If you are in a price-sensitive market (and who isn’t these days), this may be difficult. Sometimes a small increase (4-5%) won’t matter.
Businesses need to perform a break-even analysis on their entire business by looking at every product or service they offer. This can help you determine which part of your business is doing well and which is not. Start-up businesses typically break-even in 6-12 months.
Try a break-even analysis. It will help you understand your business economics and maximize your profitability.
This article was written by Seattle SCORE Chapter member Fred Parkinson for the Kitsap Sun in Bremerton.