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If you’re a business owner, you should know how to do a break-even analysis. It’s an important thing for making important business decisions and financial planning.
Break even analysis is a small business accounting process for determining at what point a company, or a new product or service, will be profitable. It’s a financial calculation used to determine the number of products or services you need to sell to at least cover your production costs.
For example, a break-even analysis could help you determine how many cellphone cases you need to sell to cover your warehousing costs. Or how many hours of service you need to sell to pay for your office space. Anything you sell beyond your break-even point will add profit.
There are a few definitions you need to know in order to understand break-even analysis:
The break-even theory is based on the fact that there is a minimum product level at which a venture neither makes profit nor loss.
Your break-even point is equal to your fixed costs, divided by your average selling price, minus variable costs. It is the point at which revenue is equal to costs and anything beyond that makes the business profitable.
Formula: break-even point = fixed cost / (average selling price – variable costs)
Basically, you need to figure out what your net profit per unit sold is and divide your fixed costs by that number. This will tell you how many units you need to sell before you start earning a profit.
As you now know, your product sales need to pay for more than just the costs of producing them. The remaining profit is known as the contribution margin ratio because it contributes sales dollars to the fixed costs.
Now that you know what it is, how it works, and why it matters, let’s break down how to calculate your break-even point.
Before we get started, get your free copy of the break-even analysis template here by Shopify. After you make a copy, you’ll be able to edit the template and do your own calculations. Example of the template as below:
If you’re thinking about starting a new business, a break-even analysis is a must. Not only will it help you decide if your business idea is viable, but it will force you to do research and be realistic about costs, and make you think through your pricing strategy.
If you already have a business, you should still do a break-even analysis before committing to a new product—especially if that product is going to add significant expense. Even if your fixed costs, like an office lease, stay the same, you’ll need to work out the variable costs related to your new product and set prices before you start selling.
Any time you add a new sales channel, your costs will change—even if your prices don’t. For example, if you’ve been selling online and you’re thinking about doing a pop-up shop, you’ll want to make sure you at least break even. Otherwise, the financial strain could put the rest of your business at risk.
This applies equally to adding new online sales channels, like shoppable posts on Instagram. Will you be planning any additional costs to promote the channel, like Instagram ads? Those costs need to be part of your break-even analysis.
If you’re thinking about changing your business model, for example, switching from dropshipping products to carrying inventory, you should do a break-even analysis. Your startup costs could change significantly, and this will help you figure out if your prices need to change too.
It’s important to note that a break-even analysis is not a predictor of demand. It won’t tell you what your sales are going to be or how many people will want what you’re selling. The break-even analysis ignores fluctuations over time. The time frame will be dependent on the period you use to calculate fixed costs (monthly is most common). Although you’ll see how many units you need to sell over the course of the month, you won’t see how things change if your sales fluctuate week to week, or seasonally over the course of a year. For this, you’ll need to rely on good cash flow management, and possibly a solid sales forecast.
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