To make a business come into existence is often a venture that stirs some mixed reactions. There’s so much workflow to execute, more precisely if you're a newbie. On the ground, things are a little more hands-on. A break-even point helps you draft a feasible business plan.
For that to happen, the idea of breaking even might casually cross your mind while operating your normal business transactions.
Calculating a break-even point is just but one bit of running a thriving business. It’s as cardinal as handling your inventory, marketing campaigns and, taxes. It's also used to assess recurring production expenses.
A break-even analysis allows you to assess the margin of safety. This, in turn, gives you a chance to estimate the risk before venturing into a business.
So why is the break-even formula of intrinsic value? For the most part, making such an analysis allows you to work with practical projections. That’s just a rough draft of what it’s all about.
Most of the e-commerce entrepreneurs, to be precise, tend to freak out when a compound math problem hits their business’s priorities. Consequently, if a merchant leaves this unattended to, chances are, their business is, unfortunately, doomed to fail.
If, for instance, a retailer is unsure about the business’ total variable costs, this could heavily disrupt the entire cash flow. It’s no wonder that the e-commerce failure rate, according to data-driven stats, is about 80%.
That number is sickening, you might agree with me.
As scary as it sounds, there’s still enough space for better results. Before you even spend a penny, a break-even calculator allows you to consolidate your estimations, concisely.
This guide unwinds the full particulars that are closely connected to the break-even formula. It takes into account, all the perks this analysis calculator brings on board, and breaks down any strange jargon.
So let’s tie the facts together.
What is a break-even point?
Quite remarkably, a break-even formula allows a merchant to set their business goals on safer and high-yielding grounds. It’s a spot-on approach to equate the amount of revenue with the total expenses.
To put it differently, it’s a point where your business’ costs, both recurring(fixed) and variable expenses are steadily less than your sales volumes. In that context, the revenue is equal to all the apparent cost implications.
A break-even analysis is, therefore, a forecast plan to help an entrepreneur realize their profit margins. With that at hand, one can set a clear sales price per unit, marketing, and variable expenses plans.
The sooner a business breaks even, the better for long-term profitability projections. On the flip-side, there are imminent dynamics that affect your profit’s margin of safety.
One big culprit is the variable cost. It seasonally changes depending on your production levels and the scalability potential.
But that's not all.
Your profit margins are highly tied to recurring expenses such as rent, labor, marketing, taxes, and so forth. These are some of the common variable costs a potential entrepreneur should include in their business’ blueprint.
An in-depth break-even analysis lets you work with a precise pricing structure. One which leads to a staggering revenue progression. The whole idea here is to be cognizant of whether the total variable expenses are high or low.
This helps a merchant catch sight of the most probable time to break-even. A single calculation is just never enough. Since inflation is somewhat inevitable in an economy, that would justify why it needs to be a seasonal exercise.
Why is the break-even point formula so cardinal?
There are pragmatic reasons why an entrepreneur needs to run such an analysis for their business.
First things first, a break-even point shows when the total amount of revenue derived from actual sales equals the total costs of running the business. In simple terms, you’ve neither made a profit nor a loss.
To put in plain words, a break-even point is a thrilling sort of phase while running a business that indicates a prospective point where your revenue will match up to all the expenses.
If you hit the break-even point, you’ll be able to determine when exactly to anticipate your profit projections. Closely related to that is the pricing strategy. The sale price of your products will, for sure, affect your cash flow, as noted earlier.
One thing that eats ups your profit is production. There’s absolutely no doubt about that.
Back to the drawing board.
So if let’s say, you buy an item from a supplier at $20, and sell it for $30, the superficial quick math will lead you to $10 in profit. But that’s not the way it works. The worst-case scenario you wouldn’t wish to happen is to run into losses. Let me explain how. You can just alight at a perfect profit figure only if you clock in when each expense occurs.
To faultlessly do that, you must know when exactly the actual profit sprouts. There are two most salient metrics to use for that to materialize. The first pertinent factor being the number of products you need to sell to break-even.
By all means, that’s highly contingent on the price per product sold. Second, to that is the profit markup space you’re going to leverage on. If you lessen the shipping costs, for instance, you can adjust the prices to make better revenue strides.
A break-even analysis excellently gives you a quick estimate of how much in profit prospects, you should be looking at, either quarterly or even annually, whichever periodic formula suits your business best.
As a merchant, you don't need to wait for the end of the financial year to calculate the unit sales in your inventory of a particular period. The market fluctuates at times. As such, getting hold of the profit-margin for a particular period in a year is a well-thought-out idea while running a break-down of all the production costs.
How to calculate your break-even point.
Before we even put all the facts together, you need to draw a clear line between fixed and variable costs. We’ll look into detail how both expenses are distinct from each other just shortly.
Below is a descriptive break-even point formula;
Break-even point = Fixed expenses ÷ (Total revenue per product unit – Variable cost per product unit)
What’s more illustrious is that one needs to identify the contribution margin. Think of it as a bookkeeping drill. In a nutshell, a contribution margin is more like the amount of revenue made out of one unit sold.
Let’s use a practical example.
If the cost to make a single product amounts to $100, then you sell it at $150, the contribution margin, in this context, is $50. That easy. At this point, it’s only the variable costs that are put into consideration. The equation excludes all the fixed expenses.
And why is that the rule of the game?
The contribution margin which is also referred to as the dollar contribution per unit is exclusively meant to allow the business owner to be conscious of what the actual profit per product is, minus all the operational costs. Having a deep analysis of what your profits are, gives you an indicator of whether or not, you’re competing fairly in the market.
Secondly, it gives you a roadmap to calculate your break-even point. And to do that, you need to pile up all the fixed costs and add them up. The next step is to divide that number with the contribution margin.
Here’s a brief recap.
Always take note that your business’ contribution margin is the difference between the total amount of revenue it generates and the variable costs. Figuratively, if you spend $100 to assemble or rather, manufacture a single product, and sell it at $150, the contribution margin will be $50.
The contribution margin and profit margin are two business-related jargons that are, without a doubt, confusingly similar.
Keep in mind, the fact that your profit equation is equal to zero (0). Also, it’s worth noting that your contribution margin ratio gets you inches closer to your revenue. The contribution margin statement helps a retailer to use the historical data of previous sales to sort of predict the business's break-even future.
Let’s sink into this part a little deeper.
Contribution margin ratio
If you have a large catalog of products in your enterprise, being privy to the contribution margin is just but a scratch on the surface. This ratio indicates, in percentage, the amount( preferably in dollars) that a product yields in profit and the surplus left to sort out a business’ fixed expenses.
As your business considerably scales further, so is the need to unfold the level of revenue each product generates per sale, in the long run.
One simple way to calculate the contribution margin ratio is to subtract the fixed expenses from the contribution margin. So long as you have the numbers in order, you're good to go.
Contribution margin ratio formula = contribution margin/ total sales revenue
Aside from the manufacturer’s suggested retail price (MSRP), a margin ratio allows you to monitor how each product you sell compares to your competitor’s pricing structure. It’s more of a handy way to have a thorough analysis of the profit potential your product has.
A related term you need to understand while solving the BEP formula is the cost-volume-profit analysis. It’s also referred to as the break-even analysis in most instances. The better part about this accounting method is that it looks at how the variable costs and production levels affect the end profit.
The CVP formula is often used to calculate the potential sales volume your business is sitting on. You can also bank on this information to get an exact number of sales you need to sort the fixed expenses and know when exactly your business is most likely going to break even.
Calculating the fixed costs
Well, you need to carefully consider this while running your break-even analysis. The deal with fixed costs is that they have nothing to do with the total number of sales you make.
In other terms, the fixed costs are the kind of expenses that sort of, recur, regardless of whether you sell or not. They always remain constant. Needless to say that the products’ catalog isn’t part of your fixed expenses.
Most of these costs are usually paid periodically. Common ones include;
- The storefront’s rent/lease payment.
- Business loan repayment
- Business licenses
- Applicable property taxes
- Marketing costs
- Vehicle and equipment leases
- Labor expenses/ employees’ salaries
- Utility bills(electricity, internet)
For an already existing business, calculating the fixed costs isn’t that much of a mind-numbing exercise. A start-up will, however, need to do some extra digging and learn all the looming curves.
Calculating the variable costs
As you may know, a variable cost is that expense which is closely connected to your business’ production priorities. When the volume of production increases, so are the variable costs and vice versa.
With variable costs, you need to assess the production levels in your business. This way, it’s pretty hard to fall short of the variable unit cost.
Some of the common pointers to look at while calculating the variable expenses include the cost of buying a product or raw materials, shipping rates, and taxes to be paid.
From a practical standpoint, if the cost per unit of producing a backpack is $5, and the company decides to produce 100 units, the variable cost, in this case, would be $500.
So let’s have a quick rundown of some of the mainstream variable costs.
If you’re looking to sell products online, you must have in place, a secure payment channel that shoppers can trust. Most commonly, you might need to accept credit card transactions.
You should treat a credit card transaction fee as a variable cost since it’s based on a percentage per sale amount. The figure changes depending on the price of an item.
Cost of production
There are two major ways to look at this variable expense. A seller can either buy a finished product from a supplier or purchase raw materials and custom-make an item as per the customers’ specifications.
Whichever the case may be, what matters most is the cost per unit. If you’re making a product from scratch, you need to know how much you’re paying for raw materials to avoid any mishaps while adding up all the variable costs.
This is pretty much inevitable while operating a business. You might need to set a provision for repairs once your machinery or equipment wears out to maintain the production capacity.
At some point in time, you’ll have to upgrade your computers or even software.
If you’re source products from another country, it goes without saying that the import duty and taxes are variables to consider and be accustomed to.
Shipping and fulfillment rates
The fun fact about shipping is that most carrier companies use the weight-based approach to calculate the costs. Therefore, it ordinarily depends on how many products you intend to ship.
The same goes for order fulfillment, where picking, packing, labeling, and dispatching fees vary from one item to another.
Break-even point in a nutshell….
To wind everything up, it’s of great significance to highlight the top-notch reasons as to why a break-even analysis is somewhat, an ideal approach to use while running a business.
This part has some final pointers as to why you need to use the break-even calculations.
So who needs to run a BEP analysis?
Making BEP calculations is not limited to enterprise-level businesses. An SMB retailer can make the break-even calculation to weigh options when it comes to setting realistic price levels.
A BEP analysis works perfectly for any merchant who needs to identify the number of sales that would cover the fixed expenses. In so doing, the business owner gets to create a sound financial plan by setting a workable budget.
It allows you to adjust the selling price. To the casual eye, that might sound a little far fetched. By use of the contribution margin ratio, you get to assess the value each product sale brings to the table.
If you add a few bucks to the selling price on each product, it’s quite certain that you need to sell fewer items to break-even. In an industry that has aggressive competition, you’d need to adjust your prices pretty carefully. And that’s where the calculations come in.
You can be able to lower the fixed and variable costs- This helps you set sensible and realistic goals for the business’ long-term objectives. If you reduce a fixed cost such as rent and operate in a place with lenient taxes, you get to break-even way sooner than you can ever imagine.
Most retailers use the BEP formula to catch sight of the overheads and production expenses in the most painstaking and unfussy way. This guide should lead you to the right figures, notwithstanding the size of your business.
Most of all, you can make use of a BEP calculator to work with error-free numbers.