Every small business owner knows the critical importance of making sure that revenues are higher than expenses – i.e. that a business is profitable. It’s a fundamental tenet of business that a private company must be able to do two things at once: First, it must be able to maintain effective cash flow. And second, it must be able to generate a profit.

Certainly, no business owner intends to break these rules. Protecting cash flow is essential to the day-to-day survival of the company, and profitability is what ensures the future success of the business. And yet, it’s surprisingly easy for a business owner to find herself making decisions that don’t protect cash flow or fail to lead to profitability – and not even realize it.

Lack of visibility into the profitability potential of the business and/or any one operation or product the business offers, is a critical blind spot for many business owners. One tool that can be used to overcome this weakness and provide clarity to the CEO is break-even analysis.

In its simplest form, break-even analysis is a process used to identify the point at which revenues the company receives will equal the costs related to generating that revenue. In addition, break-even analysis can enable you to calculate the ‘margin of safety’, which is the amount that revenues may surpass the break-even point. This margin of safety also represents the level to which revenues can fall without violating the break-even point.

Break-even analysis seems very simple to determine, and sometimes it is. But often, CEOs forget to include or consider key factors that can impact the results, including the three key items necessary to calculate it effectively: the fixed costs, variable costs and average price per unit of the product or service being sold.

For example, your company may provide residential real-estate brokerage services, and you want to determine the break-even point if you launch a new commercial real estate arm focused specifically on the office and industrial space market. Obvious costs to consider would be those associated with operating the new division – such as expanded office space, new hiring and a dedicated advertising budget.

On the other hand, if your new division secures 30% of its leads from existing residential clients, two things might be easy to miss: First, the portion of the residential operation’s costs that are relevant to the break-even analysis for the commercial division; and second, the revenue risk associated with any cuts to the residential operation’s budget (especially if those cuts are employed to make room for new investments in the commercial division).

The key role of break-even analysis is to help the business owner analyze how revenue, expenses and profit will vary with different expectations of sales volume or other factors. It is not only useful for the business as a whole. It is also essential for decision-making relating to new equipment purchases, product launches or other major investments in growth.

Should your dental practice really lease an additional suite and add two new exam rooms? Is it time for your professional services firm to expand from two markets to three? Are you going to see the intended returns if your retail business opens a location in an additional city? Answering these questions effectively often begins with a break-even analysis.

One limitation of break-even analysis is that it is a ‘supply-side’ analysis, in that it only examines the cost of sales and does not consider variations in demand at different price points.

For example, would it make more sense to sell 100 units of an item priced at a higher price, or 200 units of the same product priced at a lower price? The break-even analysis serves as an essential first step, since it will tell you where your break-even point will vary between the two scenarios. Pairing the break-even analysis with a demand-side analysis looking at the market’s likely response to the two different price points will then fill out the other half of the picture.

Whether yours is a consumer-facing business or a business-to-business company, and regardless of whether your firm makes products or sells services, an effective break-even analysis can be of enormous benefit as you make critical decisions about the growth and future direction of your business.

Selected Sources:

Breakeven Analysis: How to Know When You Can Expect a Profit
https://www.sba.gov/content/breakeven-analysis

Break-Even Analysis
http://www.investopedia.com/terms/b/breakevenanalysis.asp

Break-Even Analysis Defined
http://www.entrepreneur.com/encyclopedia/break-even-analysis

How to Perform a Break-Even Analysis http://www.inc.com/guides/2010/12/how-to-perform-a-break-even-analysis.html

Image Credit: Got Credit (Flickr @ Creative Commons)