When it comes to analyzing the demand vs. pricing of goods or services, doing break-even analysis becomes the first and foremost thing to do. As a startup, you should know the outputs at which your business can make a profit.
I know you are all guessing that, “what is Break-Even Analysis?”, “How is it done?” etc. And it’s obvious to ask these questions at this point.
So, let’s understand it in detail.
What is a Break-Even Point?
According to Wikipedia, the break-even point (BEP) or break-even level is the sales amount—in either unit (quantity) or revenue (sales) terms—that is required to cover total costs, including both fixed and variable costs to the company.
In simple words, it’s the minimum sales amount you require to sell to avoid loss in your business.
For instance, you start a business of tables and invest Rs. 50,000 to set up a carpentry shop.
It cost Rs. 500 to make a finished table. You decide to sell it at Rs. 1000. So, what’s the number of tables you should make and sell to cover total costs? Let’s do some basic mathematics.
Fixed cost = Rs. 50,000
Cost price = Rs. 500
Selling price = Rs. 1,000
No. of tables = N (assume)
Total investment = Fixed cost + Cost price of ‘N’ tables = 50000 + 500 x N
Total revenue = Selling price of ‘N’ tables = 1000 x N
So, to avoid the loss your total cost must be equal to the total revenue generated
Total cost = Total revenue
Or, 50000 + 500 x N = 1000 x N
Or, N = 50000 / (1000 – 500) = 100
Now you know that you need to sell a minimum of 100 tables so that you will not be in loss. To your amusement, this is your Break-Even point. You may not have noticed that genius of yours has just derived a formula for Break-Even Analysis. What are you waiting for? Let’s pen it down.
Break-Even Point (BEP) = Fixed Price / (Selling Price – Variable Price)
You see that the total profit or loss at BEP is Zero. It is only possible for your business to pass the break-even point if the selling price of the goods or services is higher than the variable cost. It means that the selling price of the products/services must be higher than the cost price. Once your business surpasses the break-even point, your startup can start making a profit.
If the demand in the target market is less than BEP, your startup could consider the following options:
- Reduce fixed costs – You can go for several negotiations, such as reductions in rent payments, or better management of bills or other expenses.
- Reduce the variable costs – You can find a new supplier that sells unfinished woods for less.
Either option can reduce the break-even point so your business need not sell as many tables as before, and could still pay fixed costs.
Related Article: 3 key indicators to measure your startup’s performance
What is the purpose of Break-Even Point?
The sole purpose of break-even analysis is to determine the minimum sales that must be achieved for a business to profit. As an entrepreneur, you can analyze ideal output levels based on the number of sales and revenue that would meet and surpass the break-even point. If a startup doesn’t reach this level, it often becomes difficult to continue operation.
The date you obtain from Break-even analysis can be useful to your startup’s marketing department as well, as it tells financial goals that your business can pass on to marketers so they can try to increase sales.
What is the Margin of safety?
It is also essential for an entrepreneur to understand the Margin of safety as it tells about the strength of your business. It lets you know the exact amount your business has gained or lost and whether they are over or below the break-even point. In break-even analysis, the Margin of safety is the difference between the current sales and break-even sales.
The margin of safety = (current sales – break-even sales)
Margin of safety% = (current sales – break even sales)/current sales × 100
You can utilize the Margin of safety to know how much sales can decrease before your startup becomes unprofitable.
Related Article: Working Capital Management: A complete guide
What is the Break-Even Analysis?
Break-even analysis is the calculation and examination of the Margin of safety for different demands to ensure the profitability of a company. By analyzing different price levels related to various levels of demand, you can use break-even analysis to determine what level of sales is necessary to cover the company’s total fixed costs. A demand-side analysis would give you a significant insight regarding the selling capabilities of your venture. Let’s dive deep to understand it better.
In break-even analysis, you obtain many break-even points, one for each possible price charged by inserting different prices into the formula. You can make a graph of all BEPs to have clarity. To do this, draw the total cost curve (TC in the diagram), the fixed cost curve (FC) that doesn’t vary with sales, the various total revenue lines (R1, R2, and R3) for the revenue received at each output level, and the respective selling prices (S1, S2, S3).
The break-even points (A, B, C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break-even quantity (Q1, Q2, Q3) at each selling price (S1, S2, S3 ) is the projection of break-even points to the horizontal axis and the break-even price at each selling price can be read off the vertical axis.
Now you understand how vital is break-even analysis. If your startup is seeking to take off the ground and enter a market, it is advised that you formulate a break-even analysis. It will also help your startup cut costs for optimum results.