The importance of break-even analysis

Break-even is a term that is part of the lexicon of everyday life; applied to fields widely different from finance. However, it is in the world of business that it has its greater application, and where its importance as a concept is most relevant.

Simply put, a firm has reached break-even when the money it makes from its sales is sufficient to cover all of its costs, both variable and fixed. From that point forward, provided that sales are maintained and expenses and costs not increased disproportionately, then the business will be in profit.

In most cases, a business will require some form of financial investment before beginning operations – in stock or machinery, for example. And, even once a business has started, it can take some time before its sales are such that it is no longer operating at a loss. When the business is no longer loss-making but has yet to be profitable, it can be said to have reached the break-even point.

The break-even point is not only important for the business as a whole but is relevant for calculating the viability of any new business or product line, or potential source of revenue. If that new business or product has a break-even point far-off in the future, or requires substantial additional investment before it can be reached, then small business owners should consider deferring or cancelling the project altogether, because it will dilute the profitability of the existing business.

In determining the break-even point, it is important to distinguish between the different types of cost for a business. Fixed costs are expenses that stay the same, irrespective of the level of sales. These might include the rent on a building, management or administrative salaries, or subscription costs. Regardless of the level of activity, these costs will remain constant, at least in the short-term.

Fixed costs are difficult to reduce, except in the longer-run. An office cannot just be vacated; rent will need to be paid for several months whilst a notice period is served and new premises located. Salaries can normally only be radically reduced if there is a headcount reduction programme which many have legal and other ramifications, as well as additional cost implications, such as compensation and redundancy payments.

Variable costs, on the other hand, are dependent on the level of sales. These might include materials, shipping or production labour costs in a business which produces goods, or travel and advertising costs in a service industry.

When calculating the break-even point both the variable and fixed costs need to be taken into account (a fact sometimes forgotten by the unwary!).

The calculation of break-even itself is quite simple.

First of all, deduct your variable costs from your revenue to determine your gross profit (or gross margin). Then deduct your fixed costs. If the net result is positive, then you have broken-even and are profitable. If the net figure is negative, you have not broken-even and are trading at a loss.

Based on this formula, you can also determine what level of sales you need to achieve – assuming that your variable and fixed cost assumptions are right – in order to achieve break-even.

This can be very important in determining price and marketing initiatives – for example, offering promotions or price discounts to increase sales – without endangering the longer-term profitability of your business.

There is more than one way of achieving break-even – for instance, raising prices to increase the gross margin. or reducing expenses. By knowing what your break-even point is, you can judge the relative impacts these various strategies will have on your business.

From the viewpoint of an investor in a business, the break-even point is a key indicator. When they invest they want to know not only what the return on their investment is likely to be, but also when it will be realised. The further the break-even point is in the future, the greater the risk that a business will fail to achieve it, and the less likelihood there is of somebody being willing to invest in it. And, if they do invest, they will demand a greater return on their investment as a risk premium.

Break-even then is an important metric for a business; for the operation as a whole, as well as for any new product or service which it intends to introduce. Business owners should know how to calculate their break-even point, and what strategies to adopt in order to achieve this benchmark as quickly as possible. Furthermore, for those looking for outside investment, it is crucial to be able to tell would-be financiers what the break-even position is, and to keep them regularly informed as to progress in reaching that level.