Breakeven analysis, one of the most popular business tools, is used by companies to evaluate business performance and determine the level of profitability. John Edwards, left, Chief Executive and Group Executive International of The Institute of Financial Accountants (IFA) looks at the top five rules of thumb every SME should adopt to ensure they gain full benefit.
- Breakeven analysis is integral to a business plan.
It’s good practice for every business to complete a breakeven analysis and it’s an important aspect of a good business plan. That said, there is merit in more frequent evaluation at the moment. Considering current raging levels of inflation and rising costs, it is essential to understand how these are changing a company’s breakeven point. Breakeven analysis helps to ensure business viability, so that when it comes to costs, SMEs – whether a start-up or established – are realistic, understand the sales required to remain profitable, and have a fair degree of accuracy with their pricing strategy. In a nutshell, breakeven point can be determined by calculating the point at which revenue received equals the total costs associated with the production of the goods or services – an essential prerequisite for any business.
- Breakeven analysis provides invaluable insights and benefits.
A breakeven analysis, when completed and fully grasped, offers many advantages. For business owners, it demonstrates how their targets are set, how their products and services are costed, and how the business is funded. It enables smarter decision-making and better choices, providing invaluable data insights including gross margin on a venture. What this in turn can do is encourage companies to price smarter in the knowledge that fixed and variable costs will be covered, and crucially, make a profit. It also affords SMEs the opportunity to help set sales and revenue targets so the business remains firmly on track, and it can minimise financial strain by highlighting products or services that will always be unprofitable. When businesses have put in the effort and have meaningful data in front of them, decision-making will be much easier.
- Breakeven analysis has its limitations.
Analysis is extremely helpful in supporting decisions, yet there are one or two caveats. First, it is only as good as the data quality, and doesn’t account for businesses underestimating or omitting relevant costs, or overlooking market factors such as competition when determining prices. Second, the analysis is based on assumptions, such as reaching maximum output, selling 100% of stock, or using 100% of resources, when in actual fact an SME’s market predictions of demand could be unrealistic, competitor activity hasn’t been considered, and neither have changes over time to the business. Finally, creating breakdown analysis is not a two-minute exercise. It is a comprehensive report which requires a significant chunk of time, particularly initially, with periodic tweaking and improvement. This means that they often get put to one side and forgotten about as business operations and other matters take precedence.
- Breakeven analysis can predict the effect of sales price changes.
By using the straightforward formula below, breakeven analysis can be calculated by taking the average product price and deducting the variable costs i.e. the costs associated with making the product, to give net profit. The business’ fixed costs are then divided by the net profit figure, to get the breakeven point:
Fixed costs / (Average price – variable costs)
Breakeven analysis is usually done using a spreadsheet, where all the fixed costs of a business are listed, as well as all the variable costs, and proposed or average sale price. A quick online search will provide an abundance of free templates which can then be used to simply populate with accurate data which has been collated from company accounts. Not only does this enable SMEs to see their breakeven point, but it enables them to play around with the numbers which is just one of the many advantages as it gives the ability to predict both the effect of changes in sales price, and the effect of cost and efficiency changes on profitability.
- Breakeven analysis should be carried out at specific times.
In the past, businesses have tended to use breakeven analysis at the point of making a major business decision: establishing a new business, launching a new product or service, breaking into a new market, or introducing a new sales channel. It’s an extremely efficient and useful tool to have when beginning a new business as it allows owners to see if their strategy is working. It also supplies data that can be utilised to develop a cost structure.
It may be that over time, as sales rise, more can be produced without increasing inputs, boosting efficiency. Net profits will therefore rise, which is a good time to re-evaluate breakeven analysis. Conversely, if sales exceed capacity while investment in additional equipment is needed to meet demand, net profit may drop temporarily; this is when re-assessment of breakdown analysis may also be needed.