For startup businesses, the biggest and most important question to ask is: “will it be profitable?” A breakeven analysis will help you determine the exact point when your business is making profit.
If you are still embracing the principle of “spend more money to make more money”, maybe it’s time to change that.
For one, it may not always be true. Second, there is a way we can help you lower that risk with a breakeven analysis that helps you make important business decisions when you understand what you need to do to cover your initial investment.
And that means, learning to calculate the breakeven point for your business.
For many small business owners, the term breakeven point is unfamiliar. But that’s okay. You can call your financial advisor to discuss about it; or, you can read on this article to understand how it helps you in the return of investment. Later, you can get some professional bookkeeping help if you feel you need it.
Let’s begin with the question what is a breakeven analysis?
It’s a fancy term used in bookkeeping and economics to describe a financial tool that helps business owners estimate the quantity of units of a product they need to sell in order to hit a point where they have covered their costs for initial investment. It’s called the breakeven point.
Once you hit your breakeven point, you are assured that you have sold enough to cover your fixed costs. That means, every incremental sales thereafter will generate profit for you.
Moving forward, let us find out the different costs you will need to calculate when we discuss later how to find the breakeven point.
Keep in mind that how you are spending your money makes a lot of difference in making your company successful or not. But it begins with understanding the difference between direct variable costs and fixed costs. But there are other costs, too, that you need to know.
Let’s take a look at the different types of costs.
1. Direct Variable Costs. When you need to spend money on items that are directly related to creating your product or providing your service, it’s called direct variable cost. For example, your laundry shop needs water, soap, and fabric conditioner to provide the laundry service; and even laundry bags used to store laundry. These are direct variable costs.
It’s important that you identify what are your direct variable costs or what is sometimes called as your costs of goods sold. That’s because it helps you determine the correct pricing for your product or service.
2. Fixed costs. When you spend for shop rental and wage, these are costs that remain the same whether you generate revenue or not. And so, they are fixed costs.
3. Indirect Costs. When you need to spend money on items that are indirectly related to creating your product or providing your service such as electricity and office salary, it’s called indirect costs.
4. Variable costs. When you need to spend for items that vary based on the quantity of products you create, they are called variable costs. Your variable costs may increase based on the demand to produce more of the products you will sell. Or, it may decrease if you will produce less. For example, the costs that incur to buy the detergent you will use increases or decreases based on the quantity of laundry you need to deliver.
5. Mixed costs. If the cost is both fixed and variable, it’s called mixed cost. If you are paying your employee a basic salary, it’s a fixed cost. The overtime pay is a variable cost. Since your employee’s wage is both fixed and variable, it is now classified as a mixed cost.
Finding your breakeven point
Let’s move ahead to help you calculate when you will make profit in your business.
When you hit your breakeven point, it means you have earned enough to cover your total fixed costs and you can move ahead to making profit.
Here’s the simple breakeven formula:
If you determined your fixed cost to be $1500 and you earn $10 for a kilo of clean laundry you produce with your variable cost at $3, which gets you the following equation:
This means that you should be able to produce 214 kilos of clean laundry to hit breakeven. Once you’ve hit your breakeven point, you’re moving forward into making a profit with more clean laundry you produce because you have covered your fixed costs.
In this problem, the assumption is that the company wants to sell new hand-held pliers at a price of $15 per unit and targeting a profit of $100,000 in the first fiscal year assuming they can sell 1,200 units monthly. The questions we want to answer are:
At a price of $15 per unit, how many pliers needs to be sold to breakeven? and how many needs to be sold to achieve the target profit?
Assuming sales of 1,200 units per month, how many months will it take to breakeven? and how many needs to be sold to achieve the target profit? The data below shows the company’s fixed cost and variable costs per unit.
The data below shows the company’s fixed costs and variable costs per unit.
We are using the automated tool provided by the Harvard Business School that generates the breakeven point when we enter the data provided in the sample problem above.
CalcXML is another online tool that you can use to generate your breakeven point.
All you have to do is to input the following data: total fixed costs ($), variable costs per unit ($), sales price per unit ($), and anticipated unit sales then hit calculate.
You will see your breakeven point graph as shown below.
Going back to our sample problem, the breakeven point graph below shows that the company needs to sell 10,833 units to breakeven. If they are selling 1,200 units per month, they will hit their breakeven point on the ninth month. To make a profit targeting $100,000 in the first fiscal year, the company will have to sell 6,666 units more or a total of 17,499 units to hit their target. That means they will have to sell 1,458 units monthly.
Source: Harvard Business School
But there’s a problem. The forecasted monthly sales is only 1,200 units, which means they are short by $46,440 in profit based on their target.
What can the company do if they are not hitting their target profit margin? There are three things:
Reduce the fixed cost
Reduce the variable cost
Raise the price
If at this point, you are still asking why you need to perform a breakeven analysis, here are seven reasons to consider calculating for your breakeven point:
To help you set smart pricing strategy
To make sure you get the return of investment
To identify missing expenses
To set profit margins
To make sound business decisions
To mitigate financial risks
To get your business funded
Watch this video presentation on finding your breakeven point if you need a step-by-step guide on the formula you can use to determine the units you will need to sell to cover your costs.
Remember that a breakeven analysis helps you lead a better financial plan for your business.
Do you know when your business is making profit?
We help you plan, forecast and analyze your financial data
so you can get on top of your finances today to grow your small business big tomorrow.
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