Break-even Analysis: Advantages & Disadvantages | How to do Break-even Analysis?

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Roshni Tamta

Feb 3, 2022 — 7 min read

When setting up a new business, one of by far the most significant concepts you'll learn is break-even analysis, which is the amount of revenue you'll need to cover your expenditure. Even businesses with large sales revenues can lose money if their costs aren't covered. While break even analysis is more commonly associated with firms that sell tangible goods, it can also be used to assist establish the price of services.

Break-even analysis is an important financial statistic for every entrepreneur or small business owner to understand since it shows you exactly what you need to accomplish to recoup your initial investment. It's a great tool to have when you're beginning a new business because it allows you to see if your strategy is working. It also supplies you with data that you may utilise to develop your cost structure.

Lets know about the steps to do break-even analysis and its advantages and disadvantages.

Break-even Analysis - Importance
How to do Break-even Analysis?
Break-even Analysis - Advantages
Break-even Analysis - Disadvantages
Conclusion
FAQs

break-even analysis meaning

Break-even Analysis - Importance

The point at which total revenue and total cost are equal is known as the break-even point. Break-even analysis calculates the number of units or revenue required to cover your company's entire costs. You are neither losing or gaining money at the break-even point, but all of your business's expenses will have been paid. The sales earned by your company after striking even are pure profit. Simply put, break-even analysis helps you figure out when your business – or a new product or service – will start making money, and it's also used by investors to figure out when they'll recoup their investment and start making money.

When developing a new product, it's a good idea to run a break-even analysis, especially if it's a high-cost endeavour. Finally, whenever you make a change to your business – such as introducing a new sales channel or switching your distribution plan – your costs can drastically change, so a break-even study is always a smart idea.

How to do Break-even Analysis?

Use the following formula to compute the break-even point in units:

Break-Even point (units) = Fixed Costs (Sales price per unit – Variable costs per unit)

In dollars using the formula: Fixed Costs/Contribution Margin = Break-Even Point (sales dollars)

You'll need some information before you start your break-even analysis. Assume you're conducting research for a potential new product. Make a list of all your expenditures and expenses related to that product, including premises, resources and supply costs, tool or equipment costs, and costs for paying personnel to make the product and prepare it for shipping.

You'll also need to be aware of two other details first, the price range you're considering, which starts at $0.00 and second, start with none and work your way up to the maximum quantity you think you'll be able to sell.

The steps to determining break-even are as follows:

Step 1. Calculate variable unit costs: Calculate the variable costs of making one unit of this product. The costs connected with creating the product or purchasing it wholesale are known as variable costs. If you're manufacturing a product, you'll need to know how much all of the elements are going to cost. If you're printing books, for example, your variable unit costs are the cost of paper, binding, and glue for one book, as well as the cost of putting one book together.

Step 2. Evaluate fixed expenses: Fixed costs are costs that must be met in order for your business to continue to operate, even if no items are produced. Add up the costs of running your factory for a month to determine fixed costs. Rent or mortgage, utilities, security, non-production employee pay, and any other costs would be included. Don't forget about the costs of designing the product and packaging, creating a prototype, and possibly patenting your invention.

Step 3. Establish a unit selling price for your goods: Set a unit selling price for your product. As you determine your break-even threshold, this price may fluctuate.

Step 4. Determine the number of units sold and the price per unit: As the product's total sales and unit price fluctuate, the break-even point will shift.

Step 5. Make a spreadsheet: To perform a break-even analysis, you'll need to create or utilise a spreadsheet, which you'll then convert into a graph. The sheet will draw break-even points for each number of sales and product cost, as well as a graph displaying break-even points for each of these costs and volume of sales.

Break-even Analysis - Advantages

1. Break-even analysis provides you with a far more solid foundation on which to offer your products. Analyze your current financial condition to determine how patient you can be in order to reach your break-even point.

2. Break-even analysis is generally a significant component of business strategies when it comes to obtaining capital. You'll probably need to undertake a break-even analysis if you want to secure finance for your business or start-up. Furthermore, a modest break-even point will likely make you more comfortable with the idea of taking on further debt or funding.

3. Some company concepts aren't meant to be pursued in the first place. Break-even analysis can help you reduce risk by eliminating unprofitable projects or business units.

4. A break-even analysis can also be a useful tool for establishing realistic target sales for your crew. It's always easier to settle on revenue targets if you have a specific amount and a timetable in mind.

Break-even Analysis - Disadvantages

1. Break-even analysis is most useful for businesses with only one price point. Break-even analysis may be too simplistic for your purposes if you have many products with numerous pricing. Furthermore, keep in mind that costs can fluctuate, so your break-even threshold may need to be re-evaluated and altered in the future.

2. However a break-even analysis can tell you when you'll break even, it can't tell you how probable it is to happen. Furthermore, demand is volatile, so even if you believe there is a huge untapped market, your break-even threshold may be much higher than you anticipated.

3. Another drawback of a break-even analysis is that opponents aren't taken into account. New entries to the market may have an impact on demand for your items or force you to adjust your prices, affecting your break-even point.

Conclusion

A break-even analysis isn't created in a bubble, of course. If you're introducing a new product that no one has ever seen before, you have no idea how big the market will be or when competitors will appear. But it does provide a starting point for your quest for the "best" pricing for your purchase. Overall, knowing the advantages and disadvantages of Break-even analysis, it's ideal to combine a break-even analysis with other profitability measures like net profit margin to get the most accurate picture of your company's financial health.

FAQs

What is break-even analysis?

The break-even analysis lets you determine what you need to sell, monthly or annually, to cover your costs of doing business.

Is break-even analysis good or bad?

Break-even analysis is beneficial because it reduces the danger of going out of business due to a financial shortage. Because cash flow problems are the leading cause of business failure, knowing that there would be no negative cash flow makes the investment more safer.

What will cause the break-even point to decrease?

The break-even point can be reduced by increasing the average contribution margin earned on each sale.

Is it better to have a higher or lower break-even point?

A low breakeven point indicates that the company will begin to profit sooner, whereas a high breakeven point indicates that more products or services must be sold to reach that point.

How do you calculate break-even points?