Do you know how much your products cost you? Do you know how many products you have to sell in order to be profitable each month? Do you have the necessary data to make important decisions about pricing to help improve sales?
These questions are frequently asked by small business owners, but the answers are not always apparent. The reason is that a simple break even analysis is not performed to help provide the answers to make these important business decisions.
A break even analysis is a simple formula that helps determine the actual number of products needed to sell in order earn exactly the amount spent on the products, or the "break even" point.
While the formula is simple, the data necessary to plug into the formula does require some research and collection.
Fixed Costs - Your fixed costs are the expenses that are the same month after month, no matter how many units you sell. Fixed costs include:
Variable Costs per Unit - This figure may require some math. You must be able to track all the costs directly associated with the manufacture or assembly of a product and break it down into a per unit figure. For instance, if you buy 10 pounds of ham for $50 and it is enough to make 30 sandwiches, the ham breaks down to $1.66 per sandwich ($50 / 30 = $1.66). Similarly, if a worker is able to make 25 sandwiches per hour and the worker earns $10 per hour, the payroll cost associated with that each sandwich is $0.40 ($10 / 25 = $0.40).
Average Price per Unit - This is simply the price of the product you charge to the customer. If you charge different prices at different times or locations, you may need to figure an average price for break even analysis.
The formula for a break even quantity is BEQ = Fixed Costs / (Ave price per unit - Variable cost per unit).
Let's plug in the numbers of our sandwich example. If you figured that your total fixed costs per month equal $2,000, variable costs per sandwich is $2.50, and you sell sandwiches for $5.99, your break even quantity is 537 sandwiches (2000 / ($5.99 - $2.50). That means you will need to sell at least 538 sandwiches each month to even make a profit.
What if you wanted to sell your sandwiches for $6.99? What if you did not want to change the price of your sandwiches but you are not earning enough profit, or worse, not breaking even each month? Or what if you had a notion to see how many sandwiches you would need to sell in order to make a $1,000 profit each month?
These are the types of important business decisions that can be answered with the data provided by the break even analysis formula. For instance, for the $1,000 questions, the answer is 824. First, we already know the breakeven point is 537 sandwiches. Knowing that each sandwich earns $3.49 above the cost of the product ($5.99 - $2.50 = $3.49), we know that 287 sandwiches will reach the $1,000 profit goal ($1,000 / 3.49 = 287).
What break even analysis cannot do is tell you what strategies to implement in order to reach your goals. You still need to do additional homework, but it gives you a starting point.
Another example may be pricing your sandwiches differently. You will still need to check against your competition to ensure that you are not pricing yourself out of the market. Also, if you determine that you need to reduce fixed costs, you will need to make the tough choices in the areas of staffing, equipment, and even changes in rent or location in order to make your financial goals.
Numbers don't lie. Don't be like most small business owners who are afraid of financial formulas. Use break even analysis to get your business on the right financial track.