Break Even Analysis - an essential exercise for any startup or existing business
Use a break even analysis when any significant or sizable project or expenditure is being undertaken. What is it?
A break even analysis examines the relationship between the costs and revenue in your business. The break-even "point" of a business is the level of total revenue which is equivalent to its total costs. The calculation can be applied to the business entity as whole, or some logical part of it, such as a product, business unit, asset grouping or sales segment. Why is it so important to know break even point?
For a developing business, the break-even point is the point at which the business starts paying for itself, and becomes self-sustaining. Therefore from a business planning perspective, when looking into the future, a business must have sufficient cash reserves to stay afloat until the break even revenue point is exceeded. "Total Costs" - at a point in time
Business expenses can be categorised as fixed, variable or semi-variable. Therefore the calculation of "Total Costs" in a business will not be precise, because expenses will vary and even change their nature according to a range of influences on the business' activity level - influences such as seasonal demand factors, and a variety of real-world factors which fluctuate over time. Exercise Caution
Because a break even calculation is an arithmetic calculation taken at a single point in time, caution should be exercised in relying too heavily on a single calculation when taking big decisions. Nevertheless, despite the limitations, a break even calculation or graph is an essential inclusion in any business plan,
because it, together with the
cash flow forecast
gives the reader a prediction of how soon a business venture will become self-funding, and of course by implication, how much money it will require to get to there. The Margin of Safety
An established business (whether new or long-standing) which has successfully traded beyond its break even point, will be interested in its "margin of safety", that is to say, how much total revenue could fall before the business starts making a loss, i.e. expenditures are greater than revenue. A business with a large margin of safety, is clearly in a much stronger position. Let's look at a simple example, to illustrate the arithmetic:
In this example, when the business has sold the break even number of 1429 units of its product, the profit made will be just zero - as shown. At these prices and cost levels,
Sales above the break even level of 1,429 units would yield a profit.
Sales below the break even level of 1,429 units would result in a loss.
If you download the spreadsheet (click on the picture above), you can use the yellow cells to manipulate costs and price to give different break even sales volumes, or to target a specific profit level. The break even analysis is a useful shorthand calculation which can be applied across an entire enterprise, or at the level of a specific product, sales segment or business unit.
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