We all want our businesses to turn a profit, right? Unfortunately, many companies never do more than barely “break even” and they may not understand why that is. So what’s the difference between a profitable company and one that just barely stays in the black? Often, it comes down to pricing.
You can determine whether or not you are pricing your products or services appropriately by using what’s called a “break even analysis.” It’s not a report that your accounting software will run, and it’s not one that most of your accountants will give you, but just the same, it’s a fundamental tool in helping you understand how to price your product. A break-even analysis is often the key to transforming a business that’s just getting by into one that turns a profit.
In order to create a “break even analysis,” the first thing you’ve got to figure out is what it costs you to produce a unit of whatever it is you sell. This can be a single product, or an hour of a service. Whatever you’re in the business of producing and selling, you need to know what it costs you to produce it.
Let’s say your company produces and sells candy bars. You need to know the price of all the ingredients that go into each bar, as well as the price you pay for the packaging. These are the direct costs that go into each unit. Once you know the direct costs on a per-unit basis, you’ve got the first element you need for your analysis.
So what if you’re a service business? The cost of your product becomes your time, or your employee’s time spent working with the client. It’s easy to account for hard costs to produce products but entrepreneurs are often guilty of not adding in their own time spent on services. Time is a direct cost that must also be accounted for in order to determine profitability.
Once you have your direct costs together, you can then calculate your contribution margin by subtracting the direct costs from the selling price of the product or service. So, to use the earlier example of candy bars, if your company spends $2 producing each candy bar and sells each one for $3, you’ve got a contribution margin of $1 per unit.
Next, you’ll need to take a look at your overhead costs. These include all the expenses that go into running your business, outside of the direct costs associated with making your product (or providing your service). Overhead costs include payroll, utilities, insurance, rent, office supplies, and any other expense that your company incurs.
Once you’ve calculated your overhead costs, you can determine your break-even point. That is, the number of products or services you need to sell in order to pay all of your direct and overhead costs. If you had overhead costs of $1,000 per year, and your contribution margin was $1 per candy bar, you’d need to sell $1,000 candy bars a year just to break even.
And if all you’re doing is breaking even, then your business probably isn’t doing very well for itself. What you really want to do is turn a profit. Fortunately, once you know your break-even point, you can adjust your prices accordingly in order to get things going in the right direction. If your overhead costs are still $1,000 and you can sell each candy bar for even 25 cents more, you’ll turn a profit of $562.50 – even if you still sell the same number of bars each year. Alternatively, if you can’t increase your prices, you can try to trim direct costs or overhead expenses in order to lower your break-even point. Either way, a break-even analysis can be an indispensible tool in your business owner toolbox because your pricing ultimately determines your profitability.
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