If you are own an existing business or looking to start a new one, but do not have enough resources, you would need investors. One of the key aspects that investors look for in a new business is their break-even analysis, a financial tool that helps you assess the future of your company. Simply put, a break-even analysis tells you at what stage your company will start making a profit.
This is determined by the break-even point, which is the situation where the company is not making or losing any money, and no extra cost is being incurred. In other words, break-even analysis tells you the stage or point in time at which the net profit (or loss) of your company is exactly zero.
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The Importance of Break-Even Analysis
Break-even analysis is used for a number of reasons. If you are aiming to start a new business, performing a break-even analysis allows you to determine whether your idea is realistic and feasible. It helps you determine how long it would take before you can cover your costs, and guides you about your pricing strategy.
If you are an existing entrepreneur, break-even analysis can be important for you too. If you’re planning to launch a new product, you need to research how good the product might perform in the market, and at what price should you sell it. Also, if you’re planning to switch to a new business model, such as from wholesale to retail or vice versa, break-even analysis can give you significant data about your expenditure. It will also help you fix prices that would ensure that you are not making any loss by changing your business model.
The break-even analysis has some other uses as well. For a production model, it tells you the unused capacity or stock remaining when the breakeven is reached. It can also help you determine the maximum profit that you can make at a particular price, and the changes in profit when the price is changed. Therefore, break-even analysis can also help you to make your pricing policies and set the optimum price to earning the most profit in the shortest time.
The Components of Break-Even Analysis
Generally, break-even analysis is performed by making a break-even chart. Which is a graphical representation of costs and sales due to various activities Generally, the break-even point or the quantity at which the company breaks even is calculated by the formula:
Break-even point = Fixed costs (Revenue per unit-Variable costs per unit)
Therefore, it is clear that the break-even point depends on three components: fixed costs, variable costs, and revenue.
Fixed costs, also known as indirect costs or overheads are those expenses that do not change with the change in production. By definition, they are either fixed or dependent upon a time such as rent, stationery expenses, or interest. Fixed costs can change over time, but the takeaway is that instead of products, they change due to changes in the company policies. For example, the rent for office space may increase after a year, but it stays the same from month to month. Thus, fixed costs stay constant in the short run, although they may change in the long run.
Variable costs are those costs whose change is directly dependent on the goods or services produced. In other, it is the sum of the marginal costs of all the products. This includes costs such as raw material, labor and other resources that you need to pay for to produce a unit of your product. Variable costs change in the short run and from month to month due to changes in production.
Some costs, although generally fixed, can change due to production. These costs are called semi-variable costs. For example, although utility bills have a fixed based amount, using more electricity or water for production will drive up costs. Similarly, although employee salaries are fixed, you may have to pay them extra if they work overtime. Utility bills and employee overtime fall under the category of semi-variable costs.
Revenue refers to the income that the business gains from its activities, especially due to sales of goods and services. However, revenue includes all sorts of monetary gains that are made by the business. For example, for manufacturing or retail stores, most of the income is earned through the sale of goods. On the other hand, more service-oriented industries such as computer repair shops or hairdressers earn their revenue through the sale of their services. Revenue also includes fees received from its customers such as through the lending of assets by car rentals or the interest generated in banks.
Once you know your total revenue and total expenses, you can calculate profit. Profit is the monetary gain by the business after all the expenses have been deducted from all the revenue earned by the business. Some businesses are concerned with profit earned only after business expenses are covered. Whereas other businesses take into account extra expenses such as taxes before finalizing their profit.
In break-even analysis, profit refers to the income earned after reaching the break-even point. Any income that is earned after the break-even point generates a profit, as at that point the total revenue earned is greater than the total costs.
In conclusion, although breaking even may not be a primary business goal, it can definitely help you to plan your strategies. In addition, your break-even point provides valuable information to your finance, sales and production department. And allows your investors to make wise decisions regarding your business. Thus, whether your business is a new one or an existing one, it is important to conduct a break-even analysis. In the long run, break-even analysis helps you to determine the approach you will regarding your prices, and the marketing strategy you will follow to maximize your profit in the shortest period of time.