If you are launching a new product for your business, it could take you as short as 3 months or as long as 3 years to break even. The same is true if you’re just now starting a business.
The break even point is the position where your business enjoys no profit but endures no loss either. You need to identify it in order to better predict your cash inflows and manage your profits.
You no longer have to measure your perseverance, in business, by time alone. It’s not uncommon for a Kenyan entrepreneur to say they will try a line of work for, say, 6 months or 2 years and see how things go. This is smart but it doesn’t reveal details of how you will work. A break even analysis gives you that specific information.
How do you go about it? It’s maths, but you don’t need deep accounting knowledge to understand and compute it.
All you have to do is go to your cash flow and income statements. This means both the ones detailing your past performance and ones you made to forecast and plan about your future performance.
SIMPLE TEMPLATE: CASH FLOW STATEMENT
SIMPLE TEMPLATE: INCOME STATEMENT
You get to decide the time period you want to do a break even analysis about – 3 months? 4 months? It’s your call.
From those statements you need only 3 details. You need the price you charge on a particular product.
You need the cost of producing each of the particular product. This means only the costs that go directly towards the particular product, like raw materials. They are called variable costs and change with the level of your business activity.
Costs that do not change no matter what, like rent and salaries make up fixed costs. This is the last bit of info that you need. Unlike the two above, you need the total fixed cost not amount of money for each product.
In many instances, it is difficult to determine which cost is variable and which is fixed. I know you hate them in equal measure. You could be paying your employees a salary, fixed, but have them work overtime from time to time and pay for that,variable. Or a business vehicle that must pay insurance premiums but the fuel it consumes depends on how much it will transport on the day. How to split the two can end up being your call.
Armed with the information, you can go ahead and do your break even analysis. Take your selling price and subtract the variable cost amount for one product. Divide your total fixed cost by the answer you get.
In summary it’s: Total Fixed Costs/selling price – variable cost per unit
Use of Break even analysis information
Your answer will be the total number of products you have to sell to break even. This can help you target whatever levels of profit you want or reveal to you how much drop in sales you can take. All you need to do is add your desired profit figure to the total fixed cost and proceed with the formula as summarized. You’ll know how many products you must sell to make that profit.
It also aids your decision to drop a product. Since break even analysis is best done on product-by-product basis, you can know which ones are not worth the effort.
Better, you can alter the selling price in the formula to see which is the right price. You don’t want your price to be so low that the average amount of products you sell don’t cover your cash needs. Neither do you want to give discounts that, the math shows, will not pay off. Similarly, you can adjust the variable cost per unit or the total fixed cost to decide the direction your cost control will take.
Can you show this work to a loan officer? Yes, and it can persuade him or her. Proper financial documents are a few of the things that commercial banks in Kenya look at. Your break even analysis can reveal if you’re realistic about meeting interest payments obligations.
This analysis has limitations. It assumes, for example, that only your volume of sales affect revenue and cost or that your amount of stock doesn’t change in a financial period. Even so, it remains a simple tool to figure out a complex task. It’s value in planning for what has been stated makes it a must-know for your business finances.