UNDERSTANDING THE PROFITABILITY of your business is knowing the difference between expenses and revenue. A breakeven analysis is one tool that gives business owners an understanding of when to expect a profit.
Breakeven is normally the point at which your business is generating enough sales to meet all expenses. The business would count the two main types of costs — variable and fixed — over a period of time and then calculate how much they would need to sell to cover these costs.
Fixed costs are those expenses that stay the same regardless of sales, such as rent, insurance, salaries, and some utilities. Fixed costs are generally easier to manage.
Variable costs can increase or decrease based on sales or revenue. Examples of variable costs would be sales commissions, cost of raw materials, credit card fees, taxes, etc.
So why calculate breakeven? There are a number of advantages.
1. It helps determine if your margins are high enough. If your breakeven is approximately 45 percent of your revenue but your gross margin is only 40, then most likely your business is operating at a net loss. Your gross margin dollars need to cover your costs, and if they don’t, you need to push up your gross margin and/or lower your costs to ensure a sustainable and profitable business mode.
2. It helps with planning. New decisions can be made from understanding the business’s financial picture. For example, increasing your marketing spend or budgeting for a new employee and then understanding how many additional sales it will take to cover the cost of the new hire or the increased marketing budget.
3. It will help with new store decisions. This analysis is critical when adding a new location or a startup as it will help determine how much capital you’ll need through a business loan, investors, line of credit, etc., especially since new businesses will often have to be bankrolled for a period of time while sales are slowly ramped up. Breakeven will help you determine what that point is.
4. It will help with new product lines. More established businesses can use the breakeven analysis to determine which product to eliminate or add to their product mix. Does the new product meet the gross margin threshold to cover costs? Will it be a short-term drain on profitability? Will it increase your breakeven point?
Keep in mind that a breakeven analysis does not factor in market demand. Also, if you’re considering lowering your costs, be sure to weigh your options carefully. You don’t want to cut costs to the point that it damages your brand and ultimately costs you business. It’s about understanding what your breakeven point is and then making a profit.