Breakeven Analysis

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A basic understanding of breakeven analysis is critical to owning a business. As the name implies; breakeven analysis is simply estimating when you will break even. That is, how many units of a widget do you have to sell before you get your money back.

Here are some examples:
The dollar amounts shown are not real. They are just examples.

Equipment Purchases

You want a new fax machine. Your current machine works fine, but the new machines are faster. You estimate that you will save $0.20 in labor costs for each fax you send. The new fax would cost $200.

The breakeven point is $200 divided by $.20 = 1,000. You would need to send 1,000 faxes to recover the $200 investment.

Breakeven analysis does not make the decision for you. It is just a tool to help you make better decisions. If you send 5 faxes a week, it would take almost 4 years to pay for the fax; the $200 would probably be better invested somewhere else. If you send 50 faxes a week, however, you would pay for the fax in only 20 weeks; a new fax would be an excellent investment.

Comparing Options

Breakeven analysis is helpful when comparing various options. Generally, the lower the breakeven point, the faster you will recover your investment. HOWEVER... breakeven analysis does NOT tell you which option will make the most profit.

Finishing Pillows. Option 1:

You want to start offering customers the finishing service of custom needlework pillows. You estimate that it will cost you $500 for a sewing machine and other equipment, plus $100 for models to show different styles of finishing. You estimate that on average you would make $15 profit on each pillow (after labor and materials).

The breakeven would be $600 divided by $15. You would need to sell the finishing for 40 pillows to repay your initial outlay.

Finishing Pillows. Option 2:

Same as example 2; except instead of buying the equipment, you pay someone to finish the pillows for you. Your initial outlay now is only $100 for models, but you estimate that your profit will only be $5 per pillow. Your breakeven is now $100 divided by $5 = 20 pillows.

Worst Case and Best Case Analysis

You should always looks at the worst case and best case scenarios. Simply, what is the worst that can happen, and what is the best that can happen.

In options 1 and 2 above, the worst case scenario is that no one will want to have a pillow made. If this happens, your loss will be:
Worst case option 1:  $600 loss
Worst case option 2:  $100 loss

You estimate the best case to be that you sell 100 finished pillows a year. If this happens, your profits would be as follows:
Best case option 1: 100x$15 profit each pillow  less $600 invested = $900 profit year 1, and 100x$15 = $1500 in future years
Best case option 2: 100x$5 profit each pillow  less $100 invested = $400 profit year 1, and 100x$5 = $500 in future years.

Looking at the 2 options:

Option 1: $600 initial cost. Worst case $600 loss. Best case $900 profit year 1. $1.500 profit future years.
Option 2: $100 initial cost. Worst case $100 loss. Best case $400 profit year 1. $500 in future years

Breakeven analysis can not tell you what to do, but it does give you valuable information to use in making your decision.  You will also want to read about Monte Carlo Techniques for making business decisions.

Spreadsheet Programs

A lot of the time, calculating the breakeven point is so simple you can figure it on a piece of scratch paper. In cases where the calculations are more involved or the potential investment is large, you may want to use a spreadsheet.

Spreadsheets are perfect for playing 'what if'. Here is more information on spreadsheets.