BREAK-EVEN ANALYSIS – How It Helps You Judge Risk

This is a tool that is sometimes overlooked, even though it is easy to use and gives you valuable information in a number of different contexts. The break-even tells you in dollars or units what amount of sales you need to achieve in order to recoup all your fixed costs or investment. I am always amazed, when I visit MBA classrooms, at how few students take the time to make these relatively simple calculations. Are you trying to decide whether to proceed with a new product introduction? Are you trying to understand exactly where costs stop and profits start for your company? Are you trying to decide whether to buy a company? In all of these cases, the break-even analysis should be your tool of choice.

To do a break-even calculation on a product:

1.  Determine the cost of the product (let’s say it’s $9).

2.  Determine the average selling cost ($20).

3.  Subtract #1 from #2, which gives you your profit per unit ($11).

4.  Determine the total investment required for that product ($80,000).

5.  Divide #3 into #4. The result is the breakeven (in this case, 7,273 units).

The same analysis applies in calculating the break-even for a company in dollars.

1. Determine your average Gross Margin, say 40%.
2. Determine your Fixed Overhead, say $200,000 for a year.

3.  Divide $200,000 by .40, and your Break-Even is $500,000.

Thus you know in this case that you lose money on yearly sales under $500,000.

Once you know the break-even figure for a given product, you can ask the critical questions. Is it reasonable to attain the break-even sales figure based on

1. The offering
2. Our knowledge of the current market
3. In light of the resources that will be required to bring this product or company to market, how risky is this bet?

If you think it is too risky, then you can consider mitigating it by reducing cost, raising the selling price, or getting a third party to assume all or part of the risk or assure you of higher sales.