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One of the trickiest aspects of bringing a new product to market is to estimate the total cost involved in its production. Cost of production effects margin and margin determines how many units must be sold to make a profit. If the number of units sold can't provide sufficient margin at a market acceptable price, then, no matter how good the product is, producing it will result in a loss for the business. The nexus between cost of production, price and units that need to be sold to make a profit, is called the 'break-even point'.

Break-even analysis is one of the most important financial tools you can use to make better business decisions.
 

How break-even analysis works


A break-even analysis is a simple way to determine how much of a product must be sold (at a given price) for it to earn sufficient revenue to cover the costs of producing it.

Here's a much simplified example of how the break-even calculation works. Say the total costs of operating the business each month are $10,000. Each product the company produces can be sold for $1,000. Each product costs an average of $800 per unit to produce, sell and deliver. The profit contribution per unit is therefore $200 each, so the company must sell 50 units per month to cover its operating costs ($10,000 / $200), that is, to break even. Only after the company has sold 50 units in one month does it begin to earn a profit of $200 per unit. If the company figures it can't sell that many, then it needs to rethink its plans for production or marketing.

For startups, performing a break-even analysis is a critical part of the business plan. Establishing the viability of the business depends on having a firm idea of what sales volume needs to be achieved to reach the break-even point, since only after that does the business start to make a profit. For early-stage businesses, the figures that went into the break-even analysis provide the baseline for monitoring actuals against pre-start projections to determine if the business is staying on track to make a profit. For the mature business, break-even analysis can provide insight about product profitability.

Using break-even analysis to determine product profitability


Many businesses produce a range of product but don't assign the costs of production separately among them. They treat the electricity bill, for example, as a monthly cost to be paid without analysing how much of it was incurred producing Product A, Product B or Product C, even though one could be using a substantial portion and another barely any. Analysing costs down to the specific proportion involved in the production of each product allows for a very precise break-even analysis on a product-by-product basis. Some products, as it turns out, could actually be making only insignificant margins or even running at a loss.

That's valuable information to know:
  • It could be a good move to discontinue loss-making products and invest the time and money on the more profitable ones or a new product entirely

  • Alternatively, it could be the prompt to look at improving marketing to sell more, or,

  • Increase the price to improve the margin (it's surprising how just a small increase in price can snowball into a good profit on volume sales), or,

  • Try lowering the break-even point. One way to do this is by lowering the cost of goods sold, for instance by changing to a less expensive supplier, improving production efficiency or managing inventory more effectively.

  • Don't make any changes that could decrease sales, like reducing product quality or the customer service level associated with it
Inevitably in business, expenses tend to creep up and sales decline as a product moves towards the end of its lifecycle so the break-even point may increase beyond what sales are covering. Break-even analysis isn't a report available from most accounting software but it is an important analysis for you to have and understand. Ask your accountant to run one for you on a six monthly or annual basis to keep abreast of just how profitable each of your product lines really is. Knowing the true break-even point for each product provides a clear picture of just how much profit each is contributing to your bottom line.