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Financial Literacy

What is a Break-Even Analysis?

When selling products or services, the business needs to make a profit. To establish a price point that ensures this, the company first needs to understand exactly how much it costs to offer the product or service. What is the minimum amount you need to sell something for to justify the cost of providing it? This is the break-even point. To identify it, businesses perform a break-even analysis. 

A break-even analysis is a comprehensive accounting of the cost to produce a specific good or service, alongside a margin of safety. On a macro level, businesses can also perform a break-even analysis for the business itself. How much revenue do you need to sustain business operations? It’s all about covering fixed costs at different levels of operation. 

Here’s a closer look at what a break-even analysis is, how to account for one and the important role they play at both specific and macro levels. 

Investors use break-even analysis

Justifying the Cost of Doing Business

At a fundamental level, a break-even analysis establishes the minimum threshold for business viability. If it costs you $5 to produce a widget, you need to sell that widget for more than $5 to justify business operations. Selling it for less means you’re not breaking even and therefore, are operating at a loss that will eventually lead to insolvency. 

Most businesses use a break-even analysis to understand the level of revenue needed to cover the cost of doing business. If the business has $500,000 in costs, its sales revenues need to exceed $500,000 for the company to justify operations. A break-even analysis at a high level can inform operational decisions that demand their own break-even analyses. It’s how companies identify profitable revenue streams and opportunities for improvements. 

How to Calculate the Break-Even Point

Charting a break-even analysis involves looking at all the costs involved in producing a product or running a business, then the revenue attributable to it. These factors include:

  • The variable costs associated with goods or services (COGS)
  • Fixed costs for operating the business, such as lease and salaries
  • The price per unit or service charged to customers 

The formula for a break-even analysis is as simple as stacking up the costs vs. the revenues of a product or business segment. It’s calculated in two ways:

  • In dollars: Break-Even Point = Fixed Costs ÷ Contribution Margin
  • In units: Break-Even Point = Fixed Costs / (Price per unit – Variable Costs per unit)

Both calculations provide important data about the threshold needed to reach profitability. From a dollar standpoint, a business can look at how much revenue income it needs to achieve. From a unit standpoint, it’s about how many units the company needs to sell. Often times, businesses will use both: dollars for macro-operations and units for specific products or services. 

What is a Margin of Safety?

There’s also the “margin of safety” to consider. This is the difference between actual sales revenues and the break-even point. Businesses use this margin to price their products or use the margin of safety as a measure of how much negotiation room there is in pricing. For example, if the margin of safety is 5% and the break-even price of a product is $100, the lowest price the company can afford to sell that product at is $105. 

Investors can also use margin of safety in the same way. Value investors may look for a margin of safety percentage that’s below a certain valuation metric. In this way, margin of safety becomes a measure of investor risk tolerance. 

How to Use Break-Even Analysis

There are several important ways businesses can use a break-even point. It depends on whether it’s a one-time or ongoing measure of profitability. Here are three examples:

  • One-time break-even point. ABC Company wants to begin selling Widgets. It will cost the company $20,000 to get its Widget division up and running. Each Widget sells for $50 and costs $10 to produce. The company needs to sell 500 Widgets to break even.
  • Ongoing break-even point. ABC Company is growing. It sells Widgets at $50 and needs to sell a minimum of 100 to cover its $5,000 fixed costs. Next quarter, as fixed costs rise to $6,000, it needs to sell a minimum of 120 Widgets. As its fixed costs increase, it needs to continue to ramp up the number of sales to break even.
  • Evaluative break-even point. ABC Company sells its Widgets for $50 and needs to sell 100 each month to break even. However, it’s struggling to reach this level of sales. The company can use dollar vs. unit calculations to better understand if it should raise its per-unit price or try to sell more units to break even.

Because break-even represents the threshold for profitability and sustainability, companies need to assess it from various angles. It can help inform an approach to growing the company, validate a business decision, provide benchmarks to measure against and shed light on operational decision-making opportunities. 

When you know how much you absolutely need to make, you know the operational floor. If you can’t meet it, the situation isn’t sustainable. A break-even analysis is a good way to look ahead with confidence, instead of back in regret. 

Break-Even Analysis is a Fundamental Business Tool

As businesses look to the future to plan for growth or capital allocation, cost-modeling becomes critical. When offering a product or services, the business needs to understand the cost to produce that deliverable before it can determine how much to sell it for—or how much of it to sell. A break-even analysis provides that information.

Even securities investors can use break-even points to plan for better investment outcomes. Factoring in investment fees, taxes, inflation and other costs sets a point for investors to monitor their real rate of return against. In either case, a break-even analysis provides fundamental context for ROI: the point at which revenue breaks into profitability. 

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