Learn How A Simple Break Even Analysis Can Uncover Hidden Truths About Your Business Economics.
A break even analysis shows you where total revenue equals total cost. Extremely important to know. It is easy to do. Yet it is not regularly done. As you set out to sell your business, you need to do this kind of analysis. And you need to do it right. Because a prospective buyer exhibiting any sophistication will do one on your business. You will want to know what it will uncover, before he does. You may even want to take steps to improve the outcome.
Many years ago I did a very revealing break even analysis on a new venture about to be launched by a large international company. Management had engaged me as a consultant to validate their decision to start it. It was really a classic application of this type of analysis. So you can get a firmer grasp of the process, and the results, I will use it go through it for you.
It took very little time to do the analysis. The cost structure was quite easy to determine. The
was relatively high. It was mainly made up of the ownership cost, and the related costs that had to be covered regardless of whether revenue was $100, or $100 million. They were easy to identify. Your business may have a lower proportion of fixed cost to total cost than this business. But you will have some level of fixed cost.
Next another critical component of the break even analysis had to be identified. The
had to be determined. A relatively easy analysis determined that it formed a relatively small proportion of total cost. This is frequently highly desireable. Many highly profitable businesses have low variable costs as a proportion of total cost.
Fortunately, unit revenue was easily determined, as it was dictated by the market. Unfortunately it was a commodity like business. So knowing unit revenue, fixed cost, and variable cost, it was a simple mathematical calculation to determine the
. It can also be done in the form of a simple graph. And a graph conforms to the adage that a picture is worth a thousand words.
Since unit revenue was known, it was an even simpler calculation to determine the unit volume necessary for break even. Another simple calculation stated the volume necessary for break even as a percentage of total capacity. And that was when the atmosphere took a turn for the worse. It turned decidedly gloomy.
A simple break even analysis, that took only a couple of days to do, gave management some really bad news. Break even was about 85% of theoretical capacity. This meant that it impossible for this business venture to make money, as theoretical capacity is almost never reached. And management had committed millions of dollars of capital to an unprofitable venture, where the capital equipment had only modest salvage value.
The variables that I used to do this analysis of the venture were all known to management well in advance. I was no smarter than members of management. In fact more than one member of the management team knew more about the important information provided by this type of analysis than I did. They had frequently used them in the past. Heads rolled because a simple analysis like this wasn't used before capital was committed. No member of management would have knowingly gone into a business venture that required 85% of capacity to break even.
It doesn't matter what kind of business you are in. A break even analysis can be done on it. And the results will give you important information, whether the news is good or bad. If it is good, it will form another part of your sales presentation and argument. If it is bad, you will know before a prospective buyer tells you. And you will have time to take remedial action.
This is a tool that is frequently used in economics. It is often overlooked in business for reasons I cannot understand. It is also less used today than it was 30 years ago. Perhaps the ability of computers to calculate to three or four places of decimal provides the illusion of greater accuracy and meaning. But it is only an illusion.
For another perspective have a look at a Business Planning site.
You will learn more about how to do a break even analysis. The example described previously was done before computers were easy to use. It included a break even graph on graph paper, drawn with the aid of a ruler. The graph made a powerful statement about the economics of that business.
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Break Even Analysis
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