The Purpose and Benefits of a Break-Even Analysis

When starting a business, one of the most basic calculations is the break-even analysis. Wasting no time in explaining how and why this is essential to the projected profit and financial success of a company, Mr. John E. Dustin, CFO of J.E.D. Insurance & Financial Services Agency, Inc., out of Foxborough, Massachusetts, shares his remarks.

“You don’t have to be a CPA. But of all the different sorts of calculations to run a business, one of the requisite skills to having a successful business is understanding financials, having financial acumen,” reassures John. “One of the most basic calculations or ratios is the break-even analysis. It's going to reveal what sort of revenues and what kind of sales will be needed to generate and cover the fixed and variable costs for either the product or service, and generate a profit.”

The purpose of conducting a break-even analysis is to ensure the overall financial health and solvency of the company. John says that such a review outlines a cost structure and a pricing strategy. He points out that some products and services are easier to price because of existing competition in the market or because of knowledge of the industry. Whether the company is a startup or is established, fixed costs are easier to quantify. This list includes rent or mortgage, leased equipment, fixed salaries and non-auditable insurance. These fixed costs help simplify ascertaining the break-even figures. “You’ve got your revenue, which is the income you're going to generate. From that, you get your final revenue by determining the price per unit and how many of X you’re going to need to sell. It’s really just basic math,” John says.

An important caveat, however, is that while fixed costs are easier, that doesn’t necessarily indicate that determining these figures is easy. The pandemic taught us that. Especially for a startup with plans on selling a product that is new to the marketplace, a break-even analysis is more complex. Factoring in the cost of raw materials, labor, commissions, overtime, shipping, and marketing expenses all fluctuate, for example. John says that anticipating those variable costs can be difficult, even for large manufacturing companies. “However, as these businesses grow and become more sophisticated, business owners can look at the history of expenditures for each of these line items – materials, in particular – and keep their costs down by purchasing more inventory at a given point in time. Whether they're food manufacturers or metal, business owners become accustomed to where the fluctuations are going to be and where the economy's going,” John asserts. “Once you know your fixed and variable costs, then you have your total cost, which you take against your revenue. And that's going to tell you at what level of sales you need to break even, to be at zero.”

But who wants to be at zero? No one. So, how does a business owner avoid that, even before conducting a break-even analysis? John says that a business plan is crucial. “I see a lot of business plans. For startup business plans, I’m always surprised when people don’t consider the break-even analysis when they are working up their ideas,” he says incredulously. “This analysis affects pricing decisions. It helps with cost accounting and cost management. It helps identify areas where you must watch your expenses and discipline yourself to be more efficient. It's a preliminary part of your financial forecast. It also can dictate whether to pursue an opportunity.”

Looking at those initial numbers should reassure a business owner and prompt them to ask further questions:

·       What's a realistic goal?

·       From a strategic standpoint, how do we allocate all the resources that are going to be needed for this business?

If the answers are bleak, they should ask themselves if they should be in that business.

While an intangible variable in a break-even analysis, considering the degree of enthusiasm is necessary. Commenting on this, John says that sometimes he doesn’t observe much excitement or passion when someone presents a business plan to him for review or advice. As a rule, he likes to learn why someone wants to start a business, and this becomes more pronounced when zeal appears to be missing. He’s heard many of the same, flat, uninspiring responses: Some people feel forced to because they've done the same thing for years, or they're going to either be downsized or right sized, or there's a change coming so they think they must stay within that industry. The most discouraging answer of all, though, is that the potential business owner isn’t sure. His unequivocal answer to these lackluster statements is, “If you don't have passion, that's a recipe for disaster.”

A break-even analysis for any business is a valuable exercise. For every business owner developing a business plan or conducting a break-even review after a period of being in business, it offers a short-term snapshot of the revenues and profits. Substantiating this, John concludes, “Regardless of what business you’re in, the market is constantly fluctuating, so these numbers aren't static. It's a constant flux. In the beginning, it's essential to make informed decisions about what they need to price their product at and whether they should take the risk and open the business, based on a break-even analysis.” - Copywritten by Boston Edits, LLC.

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