Breaking even is top of mind for many retailers grappling with the business effects of COVID-19.
So it’s good to get a grasp on what breaking even means, how to calculate it, and some actionable steps that retailers and finance teams can take to actually break even.
Doing a break-even analysis can also help inform those tough decisions about any stores to open, reopen or even close. Here’s what we’ll cover:
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What is a break-even analysis?
“A break-even analysis calculates how much income you need to cover your expenses,” explains Rob Stephens (CPA), founder of CFO Perspective. “Break-even analysis provides a reality check for any investment you make in your business. These investments might be a new product or location.”
Retailers have to make many guesses when deciding whether to add a product line or open a location. But retailers rarely know how much new product they will sell or what sales will be at a new location. Thankfully, estimates of expenses are often more accurate than sales estimates.
Think expenses, not sales
In 2020, it has become much more difficult to put a reliable forecast on sales, with COVID-19 shifting consumer behavior in new ways each week and month. Put simply, people are buying differently.
“I’ve built many projections,” says Rob. “When I ask someone how much they’ll sell, they usually answer, ‘I don’t know’. That’s very true, but it’s not useful for making a decision.
“Break-even analysis simplifies the question, by figuring out the least sales needed to cover your expenses. It’s much easier to answer whether you can exceed the sales needed to break even, than it is to guess your future sales,” says Rob.
Why is a break-even analysis useful for retailers?
“A break-even analysis is most useful for a new product or changing the price of an existing product,” explains Rob. “For example, how many more units would you need to sell with no decrease in total profit if you cut your price by 10 percent?”
Break-even analyses are also important for managing financial risk, as Brian Cairns, CEO of ProStrategix Consulting, explains.
“Your financial risk goes up the closer you are to your break-even point. If you are less than 10 percent above your break-even point, then it would only take a minor increase in costs to fall below. If you are around 30-40 percent above break even, then you have a lot more room to maneuver.”
Three times retailers might do a break-even analysis
Break-even analyses are helpful when setting your price or evaluating a fixed cost change, or purchase equipment. Break-even analyses can also help assess your commercial rent or hiring needs. And they are also useful when you are:
- Starting a business: Performing a break-even analysis can be challenging when starting up, because you don’t yet have a track record of business data. Still, doing a break-even analysis (using industry or public competitor data) can help inform financial planning.
- Launching a new product: A break-even analysis can help you figure out how to price a new product and what impact that price may have on other products in your line.
- Exploring new sales channels: A break-even analysis can also help recalculate changed expenses, especially given many retail businesses are now pivoting to a greater focus on online selling.
Break-even analysis formulas for retailers
Now to the math.
“The formula is very simple,” explains Rob. “Break even sales equal your expenses. Calculating it is a little trickier because you have expenses that vary with your sales (i.e., variable costs) and expenses that don’t, such as fixed costs.”
Here are the commonly used formulas for doing a break-even analysis. The first is based on units, the second on sales dollars.
Here is a quick breakdown of some of the key components in these formulas.
“Fixed costs are costs that don’t change whether you sell one unit or one thousand units. For example, if you’re opening a new location, then the cost of the building is a fixed cost,” says Rob. Other fixed costs include:
- utility bills
- loan repayments
- equipment hire
- and other advisory services.
Variable costs are those that change across different parts of the business year. For example, a retail business might spend more on promotional advertising and casual staffing in the weeks leading up to Black Friday – the point in the year where many retailers aim to break even.
Investopedia explains the contribution margin as the difference between the sale price of a product and the variable costs associated with its production and sales process. As a simple formula, it looks like this:
The limitations of a break-even analysis
But break-even analyses have their drawbacks.
“It can be difficult to estimate marginal costs accurately. For example, utilities can be variable, but how do you appropriately allocate utility use to a given unit? It’s very difficult,” says Brian.
“Therefore, many people use an average across the year, and while that can be a good proxy, it breaks down if you have any significant seasonality. This is why a break-even analysis is helpful for knowing, directionally, where you should be. It’s always wise to err on the side of being significantly above your break-even point.”
“Break-even analysis isn’t as effective when analyzing a mix of products,” adds Rob. “The break-even sales amounts vary, with the variance in the margins between the products.
“The simple break-even formula assumes your sales price and costs remain stable. In real life, your variable costs change as the amount of units changes. For example, you may get a volume discount with larger inventory purchases.”
“The biggest mistake I see people make with break-even analysis is ignoring cannibalization,” says Rob. This is when one product decreases sales of another product. For example, selling a new model will greatly reduce the sales of the old model. Think of the iPhone, for example.
“Price cannibalization is reducing your price to existing customers instead of selling to them at your old price, says Rob. “Let’s say you usually sell your product at $100, but you lower the price to $90 to drive growth. If you normally sell 1,000 units, your profit dropped $10,000 — ($100-$90=$10 X 1,000) — which has to be covered by the profits from selling more units at the reduced price.”
How to lower your break-even point
There are two ways to lower the break-even cost: either lower your fixed costs or increase your margin. “The most effective way to reduce the sales you need to break even is to reduce your fixed costs. For example, you can rent a new location instead of buying it,” says Rob.
To lower break-even points, retailers can also:
- Increase the prices of the goods
- Talk to landlords about lowering rents
- Or work out lease terms linked to sales volumes
- Reassess opening hours and cap employee shifts
- Reduce your fixed costs, by converting them into variable costs.
- For example, buy smaller quantities, to reduce the fixed cost of a large initial order.
from World Pet Association