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How to Define and Calculate a Break-Even Analysis

General Business News

July, 2019

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How to Define and Calculate a Break-Even Analysis

Break-Even AnalysisAccording to data from a U.S. Small Business Administration Office of Advocacy report from August 2018, businesses have varied longevity.

Nearly 80 percent (79.8 percent) of business startups in 2016 lasted until 2017. Between 2005 and 2017, the SBA mentions that 78.6 of new businesses lasted 12 months. Similarly, nearly 50 percent lasted at least five years.  

While there are many reasons why a company goes out of business – one is profitability. Knowing when the business is breaking even and will start making a profit can be accomplished with a break-even analysis.

Defining a Break-Even Analysis

As the SBA explains, a Break-Even Analysis is a useful way to measure the level of sales necessary to determine how many products or the amount of services that must be sold in order to pay for fixed and variable costs, otherwise known as “breaking even.” It refers to the time at which cost and revenue reach an equilibrium.

In order to get the Break-Even Quantity (BEQ), as the SBA uses, businesses must take their fixed costs per month and divide this figure by what's left over after subtracting the variable cost per unit from the price per unit – or the product’s selling price.

Fixed Costs

These types of costs can include things such as rent or lease payments, property taxes, insurance, interest payments or monthly machine rental costs.

Variable Costs

In contrast to fixed costs, such as taxes or interest payments for the next month or year, business owners also must deal with variable costs. Utilities and raw material expenses are two examples of variable costs.

Looking at electricity costs, the amount and price of kilowatts used per month will vary based on the amount and length of usage of lights, climate control equipment, production runs and the rate of kilowatts from the supplier.

Looking at raw materials, such as oil or precious metals, these costs can decrease or increase frequently due to tariff or commodity fluctuations.

Sales Price Per Unit and Further Considerations

When it comes to how much an item is ultimately sold for, there are different considerations for different product sales. If a company is selling a product for $100 on the retail level, and the business' fixed costs are $4,000 and there's $50 in variable costs, the Break-Even Quantity can be calculated like this:

$4,000 / ($100 - $50) = $4,000 / ($50) = 80 products (to break even)

If those products are surfboards priced at $100 each, then sales of the 81st surfboard and onward would represent profits for the company. It’s also important to see how changing either fixed costs or variable costs can make a difference in the break-even point.

Reducing Fixed Costs

If a business owner refinances a loan to a lower, fixed interest rate, or reduces a salary for the next 12 months, the overall fixed costs will go down. Here’s an example with a lower fixed cost for the same scenario:

$3,500 / $50 = 70 products (to break even)

Reducing Variable Costs

If a business owner searches for another supplier, such as one that’s not subject to import tariff costs that get passed on to consumers, variable costs can be reduced for the same scenario. In this example, the variable cost is reduced to $45.

($100 - $45) = 55

$4,000 / $55 = 73 products (to break even)

While each business has its unique costs and industry conditions, a break-even analysis can help business owners determine future moves.

Sources

https://www.sba.gov/sites/default/files/advocacy/Frequently-Asked-Questions-Small-Business-2018.pdf

https://www.sba.gov/sites/default/files/Worksheet_Pricing_Models_for_Successful_Business.pdf

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These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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