Many entrepreneurs make the mistake of bringing a product or service to the market without fully understanding the total costs involved and the prices they can charge. As a result, they discover they can't sell enough of the product or service to make a profit.
One of the most important tools you can use to make better business decisions is the break-even analysis; it enables you to determine with great accuracy whether or not your idea is a profitable one. Best of all, you can use this tool to evaluate every product or service you offer.
A break-even analysis is a simple way to determine how much of the product must be sold to generate a specific level of profitability. Keep the following in mind:
- Each business has certain fixed costs that must be paid every month, whether or not any sales take place.
- Each product or service has variable costs that are incurred when the product is produced and sold.
- There are semi-variable costs that go up or down depending on the level of business activity.
After all costs attributable to bringing that product to market are deducted, each product or service yields a certain amount of profit. This profit contribution can then be divided into the "fixed costs" to determine how many units must be sold to break even.
Here's a simple example of the break-even model:
The total costs of operating the business each month are $10,000. Each product the company produces can be sold for $1,000. Each product costs an average of $800 per unit to produce, sell and deliver. The profit contribution per unit is therefore $200 each. The amount $200 is divided into $10,000 to determine the break-even point. Next, $10,000 divided by $200 equals 50 units. The company must therefore sell 50 units per month to break even, or approximately two units per business day. Only after the company has sold 50 units in one month does it begin to earn a profit of $200 per unit.
Conducting an accurate break-even analysis requires a careful examination and study of costs and prices in your business. You must know what your product or service costs in total to deliver to the final customer, as well as the price you can charge for the product or service. Include and deduct all miscellaneous expenses involved in operating your business.
To get started, analyze every product or service you produce and sell on a regular basis. Make a list of these products or services, starting from the largest volume seller. Next, calculate the average sales price of each unit, and then calculate the total cost of each unit. Then, calculate the net profit that you earn on the sale of each unit, and calculate the cost of the investment to produce and sell each unit. Determine the percentage of return/profit that you earn from the sale of each unit.
It's important to organize each of your products and services by priority, in terms of their contribution to profitability. The analysis should be done on each of your important products or services. Get started by determining:
- Your single most profitable product or service.
- The volume of sales of each product.
- The total profit per unit of each product sold, after deducting every direct and indirect expense.
- The total profit contribution to the company of each product.
Many entrepreneurs decide to completely discontinue a product or service after conducting this kind of analysis. They immediately see that it would be better for them to invest their time and money in producing and selling something else.
As market conditions change and consumer desires evolve, you may find that a product or service that was once popular and profitable is no longer successful. It will then be time for you to begin offering a product or service that is easier to sell, sells at a higher price and yields a better profit.
Brian Tracy is the founder and chair of Brian Tracy International, a human resource company based in San Diego, and one of America's leading authorities on entrepreneurial development.