The Ultimate Guide to Break Even Analysis for Startups
- Last Updated December 21, 2023
Suraj Shrivastava
Chief Link Building Strategist
Chief Link Building Strategist
So, you have decided to start a business? That’s great news! But you know what? Running a business isn’t just about solving people’s problems, it’s also about making dollars for yourself.
And this is why you need to know when and how your business will make a profit.
Don’t know how to do it? Well, doing a break even analysis is your solution.
Now it’s time we better understand what break even analysis is, why you should do one, and how to do it.
Let’s go.
See, your break even analysis is all about determining your break even point. So let’s first learn what this thing is.
So, if I try to explain this in simple words, a break even point is the point at which your total revenue is equal to your total cost.
Here, you neither make a profit nor a loss.
Break even point: Total revenue = Total costs
Suppose when you first start your business, your total expenses are $10,000 and your income is $6000. You are currently losing $4000. The break even point is when your company’s revenue reaches $10,000. That is, your total income will equal your total expenses, with neither a profit nor loss. As a result, any further increase in income will be your profit.
Business is more exciting than any game.
Sir Richard Branson, Founder of Virgin Group.
Now that you understand what the break even point is, it’s really easy to understand the break even analysis.
You can guess it by the name – Yes, it is about analyzing when you are going to achieve the break even point.
This tells you what level of output and sales you need to reach the point where your revenue will be as much as your costs (break even point). At the break even point, all the money you make will be all your expenses with no extra profit or loss.
It answers questions like:
Now you might be wondering, is it really that important to conduct a break even analysis for my startup? Well, yes it is.
Let me share some reasons to explain why it is important.
See, when setting up a pricing strategy, you might not always be sure about what is effective and what is not, right? Yes. In such cases, you can take the help of break even analysis to determine your pricing strategy.
As explained earlier, your analysis will tell you exactly when your business is going to achieve the break even point. This tells you how much sales and revenue you need to make to achieve it.
So by learning about how much revenue you need to make, you’ll understand the minimum pricing to cover your expenses.
We all know that setting targets helps businesses grow more effectively than they would without setting one. That is why it is essential to set sales targets for your business.
How can you do that? Well, you guessed it right – break even analysis is the answer.
By conducting a break even analysis, you’ll learn exactly when you’ll be achieving your break even point. By this, you’ll understand the amount of sales you need to make now and in the future, and set clear targets.
One of the best things a break even analysis can do for your business is help in raising funds.
When you conduct one, you get to learn how much money your business spends and when can you cover it all.
This also tells you what your current situation is and whether or not you need more money. You will also understand sales volumes and steps to avoid running out of cash.
It will make proper financial projections and show the future of the business giving it the amount of funding it needs.
With break even analysis, you can also create and set various benchmarks for your startup.
By understanding the amount of revenue you need to cover all your expenses, you can set clear goals toward when and how you will be making profits.
You can set realistic goals for your startups and prepare for profitability in advance.
When you conduct a break even analysis, you learn about all the expenses of your business. This includes everything from rent and bills to production expenses and salaries.
You can analyze exactly how much revenue you need to cover all your expenses and carefully identify unnecessary areas of expenses to cut them out.
Additionally, your break even analysis will also give you hints on what is the most-effective way to produce products at the lowest costs.
Break even analysis can also help your startup manage cash flows.
So by doing a break even analysis, you’ll be clear on how much your business spends and when you can cover everything.
This will tell you what your current situation is and whether or not you need more money. You will also understand sales volumes and steps to avoid running out of cash.
By making a proper projection, you can easily make decisions to manage your cash flow.
So… Now that you know why you must conduct a break even analysis for your startup, it’s time to understand how it works.
A break even analysis is a tool used to figure out the point from when you are going to make a profit. By identifying the point you can easily determine the financial strength of your business, set targets, create pricing strategies, etc.
First, let’s learn what are the components of break even analysis.
See, in a business, there are two kinds of costs – Fixed costs and variable costs.
Among these two, fixed costs are the costs that remain unchanged regardless of how many products you sell. This means that this type of cost will remain the same regardless of whether you sell 1000 products or 5000 products.
This includes rent, interest paid on capital, equipment costs, insurance, etc.
As discussed the two kinds of costs earlier, variable costs are the costs that change with the number of products you sell.
So for example, if the cost of producing a product is $5 and you sell 100 products, your variable costs will be $500. Going further, if you raise the amount of products you sell to 200 products, your variable costs will also rise to $1000.
This includes costs of raw materials, shipping costs, labor costs, sales commissions, etc.
Yeah, you probably know what total revenue is – The total income earned by your business.
You can calculate it by multiplying the selling price per unit by the number of units sold.
Wondering what the contribution margin is? Let me explain. In short, the contribution margin is the money you are left with after you subtract your selling price per unit from the variable cost per unit.
So for example, if you sell a product for $10 and the variable cost per unit is $4, the remaining $6 per unit is the contribution margin.
This contribution margin helps you determine the break even point. Here’s how:
So after subtracting the selling price per unit from the fixed cost per unit, you will next take the fixed cost into the calculation. Taking the previous example, we got our contribution margin as $6, and let’s say our fixed cost is $300. Then we can calculate it by dividing the fixed costs by the contribution margin per unit.
$300/$6 = 50 units.
This means that the break even point is 50 units.
A break even point is the point at which your total revenue is equal to your total cost.
Here, you neither make a profit nor a loss.
Break even point: Total revenue = Total costs
Profit is the amount of money that is left after subtracting your total revenue from your total costs (including both fixed costs and variable costs).
The margin of safety shows the amount by which the sales can fall before the business starts making losses.
It is the difference between the sales and the break even point.
Formula: (Actual sales – Break even point)/ Actual sales × 100
Taking an example, if your break even point is at 1000 units and you sell 1500 units, then the margin of safety would be 33.3%.
500/1500 × 100 = 33.3%
Okay… Now we know about the components of break even analysis. What’s next? Well, now let us learn how to calculate the break even point.
There are two ways to do this.
In this way, you determine the number of units you need to produce to go from making losses to making profits.
Formula:
Break Even Point (Units) = Fixed Costs ÷ (Selling Price per Unit – Variable Cost per Unit)
Example:
For this method, you’ll be calculating the break even point using the contribution margin.
As discussed before, the contribution margin is the amount of money you are left with after subtracting the selling price per unit from the variable costs per unit.
Formula:
Fixed costs ÷ Contribution margin
Example:
To find contribution margin = Selling price per unit – Variable cost per unit
The break even point is 200 units.
Well, you now understand how break even analysis works, that’s great!
In addition, this calculator can help you while calculating break even for your startup.
But when should you use this tool?
There are a few situations when businesses use break even analysis for their startups. Here are some:
It is always a wise choice to conduct a break even analysis when starting a new business. Why? This is simply because the break even analysis will help you check how viable your idea is. It gives you hints on whether the idea is worth pursuing and how quickly it can give you returns.
See, when planning to create a new product, you cannot just launch it and do whatever you think is right. Even for doing this, you need to conduct a break even analysis. This will tell you if the product is worth launching and what must be your pricing strategy to make a profit as quickly as possible.
You see, competition in the commercial market is not child’s play. For doing so, you may sometimes want to lower the prices of your product to attract more customers. In such situations, your break even analysis tells you how many more units you need to sell to compensate for your price reduction.
You must also conduct a break even analysis when you are deciding to expand your business. This tells you how long it takes to get a return on your investment and make a profit.
Bringing changes into your business model like changing your distribution strategy or introducing a new marketing channel can bring big changes to your business. That’s when you need a break even analysis to determine which plan can be the best for your business.
Everything that brings advantages to your business comes with its own disadvantages as well. So you need to be aware of what limitations break even analysis has that can affect your business.
Your break even analysis can only tell you how much you need to sell to make a profit. It can’t tell you how much you will be able to sell.
Further, the demand for your products will not always remain stable in the market. Your analysis will tell you that you need to sell 5000 units but how much you can sell depends entirely on demand.
Your break even analysis won’t give you proper results if you don’t provide accurate data. The effectiveness of your analysis entirely depends upon how accurate the data is.
This can result in a big limitation as sometimes you may not be able to provide proper data which would make calculations complicated.
The formula for the break even point is simplistic. That is, it only considers the basic level of business components.
Some businesses sell more than one product with more than one pricing strategy. In such cases, the analysis may fail to provide the best results.
The break even analysis totally ignores the fact that businesses have competitors who can massively affect their entire business conditions.
For example, a new entrant in the market can bring big changes to your market demand which can affect your entire analysis.
The fact you must know about break even analysis is that it is only useful for a short-run analysis.
This is because, in the long run, your business can have lots of changes that cannot be predicted and taken into consideration in your break even analysis. One example can be the changes in your fixed cost.
One more limitation of break even analysis is that it assumes that your cost can either be fixed or variable. But in reality, it can sometimes be both.
Wondering how it can be both? A good example of this can be when a portion of your factory rent is fixed and another portion varies.
Break even analysis cannot treat both as different costs.
Well, your break-even analysis is all about calculating your break-even point. There are two ways to do it:
1. Break Even Point (Units) = Fixed Costs ÷ (Revenue per Unit – Variable Cost per Unit)
2. Break Even Point (sales dollars) = Fixed Costs ÷ Contribution Margin.
The two types of costs are:
1. Fixed costs
2. Variable costs
Here are a few mistakes you must avoid:
1. Not considering external factors
2. Underestimating costs
3. Overestimating sales volume
4. Relying too heavily on break-even analysis
So there you have it! The complete guide to conducting a break even analysis for your startup.
Now that you’ve learned almost everything about break even analysis, it’s time to conduct one for your startup.
Suraj Shrivastava at ForgeFusion shares simple, effective ways to grow your business using SEO, content marketing, and AI, learned from helping over 50 companies. When he's not working, he loves teaching others or watching documentaries.