Embarking on a venture with the idea that just spurred you last night can be more risky. Also, planning to expand your product or service involves lots of risks. Now that you know the risks, you might jump in to do a break-even analysis to find out ‘how’ risky the venture would be.
It’s wise for an entrepreneur or small businessman to do a break-even analysis before starting a business, as it is considered one of the most crucial financial metrics. It will exactly show you if your endeavor is successful and profitable in the coming times.
A break-even analysis will offer clear-cut statistics such as the seed fund needed for the business and the profits you will gain in the future. Now, let us get straight into the topic without wasting much time.
Most businesses have fixed costs such as rent, salaries, as well as raw materials costs. Break-even analysis shows how many sales it takes to pay off the costs of doing business in order to “Break Even.”
It is essential to understand the difference between revenue and profit. Every sale brings revenue. But only after sufficient sales have been made to pay off office costs, and make additional sales, will revenue bring profits.
To do a break-even analysis, you must first know what a business is, fixed costs, price per unit changed to customers, and variable costs to produce each unit. Break-even is equal to fixed costs divided by the retail price per unit, minus the variable cost per unit (Break-even = Fixed Cost/Price-Variable Cost).
Let’s look at an example that will explain a break-even analysis well. For instance, CR7 Sports wants to begin selling a new type of football boots and does a break-even analysis to determine the football’s profitability. To say, it costs $20,000 to prepare the additional retail space to sell the product. Plus $30,000 additional one-time setup costs. These are the total fixed costs.
Each boot costs $100 in materials and labor. Mike, the owner, plans to sell each boot for $250. Break-even calculation goes like this: $50,000/($250 – $100) = $ 333.33 (Break-even). Therefore, Mike must sell 334 football boots before breaking even. Each additional boot sold will make $150 in profit.
THE NEED FOR BREAK-EVEN ANALYSIS
Among the ample benefits, let me showcase the critical reasons behind doing a break-even analysis before venturing into any business. Here are those reasons:
- Smarter Price Management
Effective pricing is one of the crucial parts of any business, and there is a lot of psychology behind it. Break-even analysis helps you to find better pricing for your product or service.
- Fixed Costs Coverage
A lot of importance goes into considering the variable costs as most people are obsessed only with pricing. It would be best if you still cover your fixed costs to make a good profit. A break-even analysis will help you do so.
- Know Missing Expenses
As you advance in your business, you might face many surprises down the road since there are minute expenses that will miss your mind. A break-even analysis helps you figure out those expenses, thus avoiding unnecessary surprises.
- Revenue Targets Setting
Once you complete a break-even analysis, you will clearly understand the sales requirement. It will help you set concrete sales goals, thus making your business profitable. Always be clear with the target; your business may perish soon if you sail without one.
- Smart Decision-making Factor
It’s been found that entrepreneurs often make decisions about their business based on emotion. Decision-making should happen when your mind is still; otherwise, your emotion will ruin decisions. Therefore, make smarter decisions based on facts. In this way, you can be more successful.
Regardless of which stage a business is in, doing a break-even analysis is a requisite metric. It helps the management to monitor the business break-even point constantly and can predict its gross ability to generate profit.
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