Most business owners are familiar with the big three financial documents:
- Profit & Loss (Income) Statement
- Cash-Flow Statement (or projection, when used for budget planning)
- Balance Sheet
Those statements are compiled monthly, quarterly and annually and each gives useful insight into the fiscal health of the company. The smart business owner consults these statements each month, teases out the story that is revealed and makes decisions accordingly.
Now suppose that your company plans to launch a new product and you’d like to know when the expenses associated with product development and launch will be recouped by product sales at a given price. For that analysis there is a fourth financial document, the Break-Even Analysis, to provide important forecasting information.
A Break-Even Analysis is conducted when a new product or service will be introduced, or a capital improvement will be made. The Break-Even demonstrates the point in time when sales revenues generated by the new product or service, or the pay-off derived from the operational efficiency that follows the capital improvement, equals the expenses associated with the launch or improvement.
Run a Break-Even Analysis to learn how products and services must be priced to recoup your company’s investment, within a given period of time and learn when the decision to invest will be positioned to earn a profit. The Break-Even allows decision-makers to predict how long losses must be sustained and how to anticipate cash-flow.
Break-Even is achieved when revenues = expenses; the business neither makes nor loses money. Business expenses are of two types, Fixed and Variable. Fixed Expenses are the standard monthly operating costs. These include office space rent, insurance, utilities and payroll. Variable Expenses are largely tied to sales: marketing, sales and advertising expenses chief among them.
When calculating expenses, it is standard to determine the relationship of Variable Expenses to sales revenues. The Variable Expenses amount is divided by the number of product units sold, yielding the Variable Cost per Unit.
In other words, Variable Costs = units sold times variable cost per unit. For the purpose of calculating Break-Even, Total Expenses = Fixed + Variable Expenses (expressed as units sold times variable cost per unit). As always, sales revenues = unit price times number of units sold.
The Break-Even Point is reached when:
Price times Units Sold = (Units Sold times Variable Cost/Unit) + Fixed Costs
The difference between selling price per unit and the variable cost per unit sold reveals the amount that can be applied to Fixed Costs each time a unit is sold. Think of it this way: if monthly Fixed Costs are $2,000 and the average price of your product units sold is $2, with an average Variable Cost of $1 each, when you sell a unit, you earn $1 to apply to Fixed Costs. With monthly Fixed Costs of $2,000, Break-Even is reached when the business sells 2,000 units per month.
Knowing how many units must be sold each month to achieve Break-Even is essential for effective financial management of the venture. One can also calculate Break-Even in terms of dollars that must be generated each month. In this example, Break-Even Revenue is achieved at $4,000 in monthly sales, since the sales price is $2/unit and 2,000 units must be sold each month to cover expenses.
A basic knowledge of the process of business financial calculations and the ability to interpret the data generated are must-have skills for all business owners and Solopreneur consultants. While it is true that one’s bookkeeper or accountant will perform the Break-Even Analysis on Quickbooks by plugging in numbers derived from the P & L Statement, it is always in your best interest to understand how the calculations are made and how to make sense of what the financial documents reveal.
When it is proposed that a new product or service might be sold, which might be the development of a new workshop to propose and teach or some other intangible service, a Break-Even Analysis will indicate how many units must be sold, billable hours generated, or classes must be taught before the production costs will be recouped and the new offering will be positioned to generate ROI.
Thanks for reading,
Kim
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