Break-Even Analysis

The Break-Even Analysis helps the business owner determine the success of a business before it begins. It describes the number of units of a product or how many hours of a service must be sold to break even or to make a profit, or the effect that changing a product's price or reducing expenses has on profitability. This simple formula determines the break-even point or the point where the business will begin to show a profit:

Based on her variable expenses, Jean will certainly charge at least $13.50 for a pair of earrings, but how much more should she charge to cover her monthly fixed expenses and make a profit? She must first calculate her gross profit, then determine her break-even point. Her research of the local market showed that comparable earrings sell for $20-30 per pair, so she calculates her gross profit based on three sales prices between $20 and $30 using the following formula: 

Price - Variable Expenses = Gross Profit per Unit

Clearly, by charging more Jean earns more money to meet her projected monthly fixed expenses ($945),  but she must calculate how many pairs of earrings she must sell per month.  Jean is ready to determine her break-even point.

At a selling price of $20, Jean must sell 146 pairs of earrings per month to break even, at $25, she must sell 83, and at $30 she must sell 58. In a month when she sells more than the break-even number for her chosen price, she makes a profit. In a month when she sells fewer pairs, she loses money.

Determining a Sales Goal Based on Desired Profit

In addition to breaking even, Jean wishes to earn $150 profit each month to invest in upgrading her equipment and buying a van. She can calculate how many pairs of earrings over the break-even point she must sell by using this sales goal formula:

If Jean sells her earrings for $20 she has to sell an additional 24 pairs over her break-even point to make a $150 profit, at $25 she must sell an additional 14 pairs, and at $30 she must sell an additional 10 pairs.

Pricing

Once variable costs, fixed costs, gross profit, the break-even point, and sales goals for profits are calculated, the consumer can decide on price. The numbers alone will not dictate the right price. The consumer's previous work on positioning and competition will help set the price. He or she must also consider personal and long-term business goals. For example, how much of a personal draw and/or profit does the business owner need to make a living? 

Pricing a Service

Pricing a service is not always as mathematically clear as pricing a product. For example in a home-based accounting or business management business, materials, labor, and overhead costs may be ill-defined. In such cases, prices are for time and generally the business owner must charge close to the prevailing rate for the area. The potential business owner's research must investigate industry charges for comparable services, method of billing - per hour or per project, and who pays for materials - the customer or the business owner. 

The consumer must still compute a break-even point and profit sales goal for a service business. He or she should select two or three rates and compute the number of billable hours (or jobs) needed to cover fixed costs and profit needs at each rate.

Evaluating the Break-Even Analysis

Although a consultant should have guided the business plan's development, you as the VR counselor must review it to determine whether your agency will provide support. While evaluating the plan's potential, consider:

• Whether the market and consumer research inspire confidence that customers exist who will buy the product at the chosen price? 
• If the price is much higher than competitors' prices, does the consumer substantiate the product's extra value? If the price is much lower, does the consumer explain?
• Does the consumer (and his or her family) seem committed and able to meet the production and promotion goals necessary to support his or her chosen price?
• Can he or she meet the goals without additional personnel? If not, does he or she plan to hire employees?

Chapter 6 Business Plan Study Guide: Break Even Analysis

1. The break even analysis shows:
   a.  How much cash the business will collect each month.
   b.  How many units or the number of hours must be sold each month to break even.
   c.  How many units or the number of hours must be sold each month to make a profit.
   d.  How a change in expenses effects a business's net profit or loss.
   e.  All of the above
   f.  Both items b and c.
   
   
2. If Stan's Variable Expenses for manufacturing a dresser are $175, what is his Gross Profit if the sales price is $200?
   
   
3. How many dressers must Stan sell each month if his Sales Price is $200, his Gross Profit is $25, and his Fixed Expenses are $800/month? 
   
   
4. Stan sells his dressers for $275, his per unit Variable Expenses are $175, and his Fixed Expenses are $800. He wants a $400/month profit. 
   a.  What is his Break-Even Point?
   b.  What is his Profit Sales Goal?
   
   
5. The Break-Even Point and Profit Sales Goal are all that need to be calculated to determine a sales price. T_____ F_____ 
   
   
6. The same calculations are computed for developing a Break-Even Point and Profit Sales Goal for a service business. T_____ F_____ 
   
   
7. Often when determining the price to charge for a service business, many expenses are ill-defined so the business owner charges for his or her time using a prevailing rate for the area. T_____ F_____ 
   
   

Study Guide Answers: Chapter 6 - Break Even Analysis

© July 1998, 1st Revision June 1999, 2nd Revision February 2001