Using the Break-Even Analysis Formula to Assist With Making Financial Decisions
Making business decisions is an everyday part of being a small business owner. There is a method available that helps a small business owner gauge whether or not they should invest in a particular project, such as expanding their business or starting a new product line. This method is called the “break-even analysis”. It is simply a formula you plug some financial information into and it will let you know how long it will take for you to “break-even” on your project. In other words, if you invest $100,000 this formula can let you know how long it would most likely take for you to make $100,000 in sales which would recoup your investment, or “break-even”.
Let’s say that you are a toy manufacturing company and are looking to expand your business by starting a new line of products. Before deciding on making the investment you want to know how many units of the new products you must sell before you break-even. Then, knowing how many units you must sell you can then decide if the investment is worth it.
You can also use the break-even analysis to determine if you should invest in a large capital project such as building another manufacturing plant. Based on all of the added costs of building another plant you can use the break-even analysis to determine how many sales you must generate to break-even on the new plant. Even though there will be added costs associated with the build, you might be able to save on product manufacturing costs with the expansion because you will be able to produce at such a larger volume. In this case the break-even analysis might prove that the expansion would be more prudent financially.
In order to calculate the break-even point you would need to know three things: Fixed Costs, Variable Costs, and the Price of the Product.
Fixed Costs: These are costs that the business has to pay regardless of how many products it sells. An example would be rent; the rent is the same amount each month regardless of how much revenue you bring in.
Variable Costs: These are costs that the business pays when it actually sells something. These costs are tied directly to your sales. For example, a product that you sell for $10 has a variable cost of $3. This means that if you sell 5 products then your variable costs total $15 ($3 x 5). If you sell 20 products then your variable costs total $60 ($3 x 20).
Price of the Product : This is the price you are selling the product for to the customer based on your company’s pricing strategy.
Once you have the three data inputs above you can plug them into the break-even analysis formula:
Fixed Costs / (Price - Variable Costs) = Break-Even Point in Units
Let’s look at a couple of examples. Let’s say that the ABC Company manufacturers toys for kids and wants to start a new product line selling toys for pets. They want to know if this is a wise decision financially and so they decide to conduct a break-even analysis.
They know that:
Fixed Costs: $100,000
Variable Costs: $2 per unit
Price of the Product: $6
Using the formula, we can find out how long it would take for the company to break-even.
$100,000 / ($6 - $2) = 25,000
This means that it would take the company producing and selling 25,000 units for it to break-even.
The company can then take this number and determine, based on its forecasts, how long it will take them to sell 25,000. Let’s say they estimate it will take 3 years to sell 25,000 units and so now the company can make an informed decision on whether or not the investment is worth it.
The nice thing about Break-Even analysis is that you can create unique scenarios to see what would happen if some of the data changed. For example, you may want to see what the break-even point is if you changed your price from $6 to $8 or from $6 to $10. Using our example from above, let’s change the price from $6 to $10 to see what happens.
$100,000 / ($10 - $2) = 12,500
By increasing the price, the company now only needs to sell 12,500 units to break-even.
Now, let’s use the break-even analysis to help the ABC Company decide if a particular large capital project makes sense. Let’s say that the ABC Company is in a current warehouse that costs $50,000 a year in rent and it wants to see if it would make sense to rent the space next door for an additional $25,000 a year in rent. Using the break-even analysis and the same data as above we can determine how many units they would need to sell in order to break-even with the additional space.
Fixed Costs: $125,000 (We added the additional $25,000 in fixed costs to their current fixed costs of $100,000)
Variable Costs: $2 per unit
Price of the Product: $6
Using the formula, we can find out how long it would take for the company to break-even with the additional rent.
$125,000 / ($6 - $2) = 31,250
The company now knows it will need to sell 31,250 units in order for this to make financial sense.
Let’s say, now, that based on the additional space the ABC Company now has the ability to produce a higher volume of products and they were able to get their variable costs down from $2 to $1 per unit. Let’s see how this changes our break even formula:
$125,000 / ($6 - $1) = 25,000
As you can see, by changing the data points you can determine what would happen to the break-even point. You can change one or more of the data points to help you see various “what if” type scenarios. By simply changing the variable cost, we can see how many less units would need to be sold in order for the project to break-even.
The break-even analysis formula is a simple but effective way for you to gauge whether or not a major financial decision is worth it. You can create multiple “what if” scenarios by simply changing the fixed costs, variable costs, and/or the price of the product.