Any business that wants to stay in business needs to conduct a break-even analysis before the doors even open, and again periodically throughout the life of the business. What is a break-even analysis? It's the calculation that gives the company's so called "break-even point". Why is it important? Because once a company hits the break-even point, all other income is profit. A company that can't meet its break-even point has to close its doors.
What is the equation formula and how does the calculation work? Plug the company's expenses and average price into the break-even equation, then use that number to create a full break-even analysis. It's not as complicated as it may sound, and it'll save a lot of guesswork in the long run.
First add up the company's fixed costs (also known as "overhead expenses"). This includes everything from rent and utilities to payroll, taxes and insurance premiums. Any expense that must be paid whether you have a sale or not must be included in the fixed costs. Remember to include annual membership or certification fees, if applicable.
For example, let's say a home crafter starts a small business selling handbags. The crafter has low overhead and discovers she has $10,000 in fixed costs per year.
Next, find the average price charged for all products and services. To continue the crafter example, if she prices all her handbags at $100 then her average price is $100. If she charges several different prices, she'll add up all her price points and divide by the number of price points she established. To keep the example simple, let's say she offers a small bag for $50 and a large bag for $150. Added together her prices total $200. Divide by the number of price points, two, and we end up with an average product price of $100.
Finally, add up how much it costs to produce each product. How much does it cost in materials, labor and advertising? What about travel costs and storage fees? If the company provides a service rather than a product, include long distance fees, milage and any other costs associated with each job. To keep our example very simple, let's say our home crafter only spends $10 in material costs for each bag.
The major leg work is done, now just plug these three numbers into the break-even equation:
Fixed costs / [1 - (Average cost of product / Average price of product)]
Here's how it looks with our example numbers plugged in:
10,000 / [1 - (10/100)]
From here it's basic algebra. In this example, the next step would be
10,000 / 0.90 = $11,111
So, the break-even point for our home crafter is $11,111. This means she must make at least that amount just to meet her basic expenses and stay in business.
What's the next step in the analysis? Figure out how many products or hours are required to get to that number. Take the break-even point and divide it by the average product price. This gives exactly how many products must be sold to stay in business.
Once this analysis is done, use the information to set sales goals and track the company's progress through the year. As the business changes, re-calculate to see if any adjustments should be made to the sales and marketing plans. A little time spent with these calculations can prevent a good business from going under.
Read more: Break-Even Analysis (Wikipedia)