Conducting Break Even Analysis for Improved Success in Evaluating New Business Ideas

Creating a break-even analysis may sound difficult and complicated however it is the responsibility of every businessperson to prepare it as one of the first steps in evaluating a new business idea. It is necessary for any businessperson to get to terms with using cost estimates and profit margins as standard tools of business as it is one of the critical success factors in business. A practically understanding of these factors in the preparation of the analysis is a must.

Once the analysis is prepared using realistic financial data it can be used to forecast whether the new business idea is a definite winner, an absolute loser or, like most business ideas, needs amendments to make it a success. This type of analysis will also be useful once the new idea progresses to a potential business that requires preparation for implementation as it should be included in the business plan.

Uses

The analysis is primarily used to calculate at which sales volume the variable and fixed costs of producing a product will be recovered. This technique is also used to solve managerial problems. This includes the setting of price levels, the establishing of optimal variable and fixed cost combinations and the determining of the financial attractiveness of different product options for the company.

Advantages and Disadvantages

The advantages of using this tool is that it is simple and quick to do, it is easy to understand and interpret, especially when it is used in conjunction with a graphic representation. The analysis can also assist in easily spotting potential problems

The disadvantage of this methodology is that it is based on a forecast and it assumes that all products that are manufactured are also sold. In addition to this the cost used in the analysis may change. The technique is also not very good for analyzing the services because prices vary significantly.

Information Obtained From the Analysis

A break-even analysis provides a clear picture of the financial implications of the business idea. It shows the entrepreneur the revenue required to cover the expenses, before profit can be generated. This information can then be utilized to establish if it will be realistic to expect that the business idea will generate profits under normal market conditions. Profits will be generated once sales surpass the break-even point.

Many experienced entrepreneurs use this type of analysis as a primary screening tool for new business ventures. They won't write a complete business plan unless their break-even forecast shows that their projected sales revenue far exceeds their costs of doing business. The good news is that such an analysis forms part of every business plan, so if you start by doing the analysis now, you'll have already started work on your business plan.

Using It as a Sensitivity Analysis Tool

In business it is important to analyze an opportunity while considering various scenarios. If one dimension is changed at a time it will be obvious which dimension will have the largest impact on the profitability of a business idea. The break-even analysis is ideally suited to do this. For example, by adding an additional laborer to the payroll to increase the production volume it can be calculated what the extra sales volume will have to be to recover the extra salary expense. If a different production material is used that is less expensive but the production units will be reduced for the same number of laborers in the production section the analysis is the ideal tool to establish the impact on the profit.

It will be wise to conduct the analysis before spending time on the drawing up of a comprehensive business plan. As soon as sufficient production costing and market intelligence information is available it is recommended to proceed with the conducting of the break-even analysis to get an insight into the potential success of the new business idea.

How to Prepare the Analysis

To conduct an analysis of this type an informed estimate of the expenses and income related to the new business idea should be made. To obtain reasonably accurate information about this some research needs to be done. This includes a comprehensive analysis of the market segment where the product will be positioned in. in order to determine the estimated sales volume of the product the market share needs to be determined.

It is also necessary to determine the expenses as accurately as possible. There are a number of good articles that provides direction on how to make reasonably accurate income and expense estimates.

Conducting this type of analysis requires a number of input dimension. This includes the fixed cost, sales price and volume and variable cost associated with each product.

The fixed cost includes rental, insurance, water and electrical overheads, and other predetermined expenses. Another way of looking at it is that it is the sum total of all the costs required to produce the first unit of a product. This amount does not change along with production variances within a predefined band of production. In order to go beyond this production level, capital expenditures will be needed. When the fixed cost is not accurately available may be a good idea to increase the amount by around 10% to cover unforeseen fixed cost items.

The expected unit sales are the number of units of the product expected to be sold over the evaluation period. It is important to be realistic in this regard. The biggest source of inaccuracy of a break even analysis is the expected sales units. Sometimes the person conducting the analysis also utilizes a different time frame that will result in inaccuracies. The unit expected sales number should be determined for a specific unit price. To perform a valid analysis, the sales forecast must be based on the volume of business realistically expected and not on how much the company needs to sell to make a good profit.

The unit price of the product is the amount of money received from the customer for a single unit of the product or service. This is also known as the per unit sales price.

Variable unit cost is costs that vary directly with the production of one additional unit. It includes items like raw material, production labor cost and other costs that are directly associated with producing a particular unit.

The total variable cost is the total variable cost value of product unit sales. This is calculated by multiplying the total unit sales with the variable unit cost.

The total cost is the sum of the fixed cost and total variable cost for any given level of production. This is calculated by adding the fixed cost to the total variable cost. Care should be taken when calculating this number for later use to ensure that the production number is equivalent to the expected unit sales.

The total revenue is calculated by multiplying the expected unit sales by the unit price. This is then used to determine the Profit or Loss for the scenario that is being assessed. The profit is defined as the monetary gain remaining of the total revenue after subtracting the total cost associated with the sales.

Calculating the Break-Even Point

In practice managers will use figures from the profit and loss projection and use the expected annual fixed and variable costs.

This type of analysis is a tool that provides insight into the big picture. For this reason it is recommend that expense categories are combined to stay within limits. It is important to remember that different categories of expense may either be fixed or variable, but not both.

Once all these dimensions have been determined the break even point can be calculated. This is the point where the number of units that must be sold in order to produce no profit. In other words the point where the total sales revenue will be sufficient to recover all costs associated with the sales.

The formula used to calculate this is as follows:

Break Even Point = Fixed Cost / (Unit Price - Variable Unit Cost)

This point is a useful value but is only one point on a line. Transferring the information for each of the levels of output for fixed cost, total cost and total revenue onto a graph will reveal a lot of useful business information.

An example of such a graphic can be found here. On the graphic it is clear that the break even point is where the total cost is equal to the total revenue. This point can be expressed as a number of units or a value. On the graphic it is 100 units on the x axis or a value of 4000 on the y axis. The red area represents the losses that will be made at the various output levels and the blue area represents the profit.

Should the projected number of units to be sold falls below the break even point it must be clear that a loss will be made. On the other hand if the number of projected units sold is above this point, a profit will be realized.

The relative inclination of the total cost and total revenue lines will also provide insight into the sensitivity of the business model to changes in volume.

Conclusion

The use of break even analysis in business for the evaluation of new business ideas will improve the potential for success. No model can include a sufficient number of variables to replicate reality. For this reason the use of any model should be limited to the dimensions of the model. Once one knows the limitations of a model it can be used with ease as long as these limitations are remembered.

© Carl Marx 2009