What is break-even analysis, why is it important, and what are its limitations?
Let’s keep this simple.
What is break even analysis?
A “break-even analysis” is a calculation used to establish the “break-even point” (BEP) for a product or service. The analysis weighs the cost of a new business, product, or service against its unit sale price.
It’s used to determine the point at which a new offering breaks even – or, in other words, the number of units you’ll have to sell to cover the costs of building, marketing, and operating a new venture.
Break even analysis: how it works
Break-even analysis is an internal management tool commonly used when assessing the viability of a new offering. It might be shared with investors, regulators, or financial institutions when seeking loan financing.
The formula for break-even analyses takes into account both fixed (e.g., facility rent, mortgages, equipment costs, salaries, interest, taxes, insurance premiums) and variable costs (e.g., direct hourly labor costs, sales commissions, costs for raw materials and utilities per unit, and shipping) relative to both individual unit sale price and projected unit profits.
Total variable costs per unit are subtracted from the sales price of each individual unit to give a “unit contribution margin” (UCM) – the amount each unit sold contributes to reaching the break-even point by offsetting fixed costs.
UCM = Unit sale price – variable costs per unit
What is the break-even point?
The “break-even point” or BEP is the point at which sales of a product or service cover costs – the point at which your initial investment is returned dollar for dollar, and you have neither made nor lost money on your new venture.
BEP = Fixed costs/ UCM
The significance of the break-even point in financial calculations lies in its utility as a risk assessment tool. Knowing the number of units you’ll need to sell to cover both the initial fixed costs of a new operation and the variable operating costs incurred as you do business.
Break even analysis: importance and application
When might your organization need to perform break-even analyses? In the main, they’re a critical element of financial projections for startups and new or expanding product and service lines. It’s an important part of determining how quickly and how affordably you can recoup the initial capital expenditure incurred in establishing your new offering and the best way in which to finance it.
A management consulting firm, for instance, might conduct a break-even analysis to determine the viability of a new service offering. A public sector organization might use one to determine the most economical and efficient way to consolidate or streamline multiple different service offerings in a new way.
More mature organizations might also use them to evaluate risks in everything from innovating their workflows to the hiring of new employees. (Break-even analyses can be used, with some modification, to calculate the break-even point on a new hire considering their hiring and onboarding costs and training period.)
They can also be used more generally at any point your organization is considering adding or changing its costs as part of your scenario planning process. Additional costs can arise from many areas - mergers and acquisitions, expanding to new locations, moving employees between departments, or radically shaking up the way you handle your operations, including through the lowering of prices as part of your competitive strategy. Break-even analysis can account for the likely cost-effectiveness of these actions over time and help your leadership teams streamline their decision-making.
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Break even analysis: limitations and considerations
The biggest limitation of a break-even analysis is that it doesn’t take market demand into account. Knowing how many hours you’ll need to bill, for instance, to make your new service hit the break-even point doesn’t tell you how quickly you’ll be able to bill those hours. This part of the equation will require you to conduct at least some market research before you can confidently assess your actual break-even time.
The break-even analysis also doesn’t take into account the time and effort necessary to reach the break-even point. It might require several weeks of working time from your sales team – time that might be better spent selling something more profitable.
When considering these questions, you should also think carefully about how you can optimize your break-even point. Generally, lowering your break-even point on a given endeavor means either raising prices or lowering costs. Obviously, such major changes can’t occur in a vacuum but need to be considered in line with market conditions and a full appraisal of all elements of costs – including quality control and delivery – to keep your reputation and operations in a good state of repair.
How can Unit4 help you?
Unit4’s ERP, FP&A, and HCM solutions routinely incorporate methodologies like break-even analysis into forecasting, planning, and other accounting and operational management calculations as part of our full suite of people experience focused solutions. To discover more about how our products help you create a smoother operational environment and user experience, you can learn about our people experience suite here.
