What is a break-even analysis and how to create one?

September 6, 2016 / Reading: 3 minutes

If you’re looking for an accurate and dependable cash flow formula for your business to prevent flushing your money down the drain in a slow and prolonged death, you’re going to need to utilize a break-even analysis.

Investments for a small business can be tricky and often take up hours of your time debating on every decision that requires appropriating funds for a long-term investment. Here is how you can calculate whether or not you have the cash flow to keep up.

The Break-even Formula

To figure out your limits, you must take your fixed costs and divide that by the gross profit margin percentage. You might not know how to reach these numbers immediately, so let’s break each category down to its base.

Related: Free Break-Even Analysis Template

Another name for fixed costs are the fees that you will need to pay, no matter how high or low your sales are at any given time. These are your rental fees, employee salaries, basic advertising budget, and various overhead costs. Once you get a solid number, you can then move onto figuring out your gross profit margin.

To get your gross margin, you need to subtract your variable costs (commission, inventory, materials, etc.) from your total sales. To turn that into a percentage, you will need to divide it by your sales and multiply this by 100%. Make sure all of these figures line up with the exact same dates.

Examples and Real Applications

Here’s how this will look in a real business. We have a business that sells paintings and frames that makes $40,000 in sales per quarter. The variable costs add up to $14,000, making the gross profit total $16,000, or 40 percent. The number for the fixed cost will be at $10,000. This will cover the rent and utilities to store our inventory. With that number, we now have all the data to make our break-even analysis for our business.

This will be $10,000 divided by 40%, which equals $25,000. This means, anything less than $25,000 in sales would put our business in the red. No matter how much money you inject into the business, if you aren’t identifying the underlying cause for your inability to break-even, you will never be able to grow as a business. This may mean increasing product prices slightly, lowering the cost of rent, or reducing the number of SKUs that you have of the shelves. These are all very common decisions that must be made eventually as a small business.

Break-even analysis is not only used when you fall on tough times and start looking for ways to stay afloat, it is also extremely useful for when your business is successful and you are trying to calculate how to squeeze more profit without needing to take big risks.

Learning how to trim inefficient and redundant expenses on your balance sheet is important if you want to make long-term gains. While it is tempting to conduct major surgical audits on your business, you do not want to trade short-term success for a potential loss of infrastructure or supports.