Key concept: break-even analysis
One of the key concepts in analysing a profitability of a new venture, product or investment is the break-even analysis, both in the case interview and in your subsequent work as a consultant. Break-even analysis is also useful in setting an appropriate price for a new product, which currently has no competition in the market.
Break-even point (Q) represent the quantity of sales required in order to cover the fixed costs of the business. The basic formula is Revenue = Cost, which can be further rearranged as Break-even point = Fixed Cost / (Price per unit (P) – Variable Cost per unit). Note that if Price per unit – Variable Cost per unit (also called “Contribution Margin”) is lower than zero, the business / product will never break-even.
Don’t forget to identify the qualitative insights of the break-even analysis. For example, a high break-even point suggests (typically) high fixed costs, which imply economies of scale (high production capacity is required to break-even) and potential barriers for entry (high investment is required to be profitable in this business or product).
Let’s demonstrate the concept with a simple example – assume that your client considers launching a new product to the market:
Annual fixed costs: $100k
Expected price per unit: $10
Variable cost per unit: $8
Break-even point = 100k/(10-8) = 50k units
Once the break-even point is calculated, it is crucial to discuss the implications of the result. Can the client sell 50k units of the product in the market? Is there demand for 50k units per year? How does the competitive landscape look like? Do competitors sell 50k units? How long will it take to reach this level of sales? How does the variable cost change with the number of units produced (i.e., are there economies of scale)?
In many cases, a Market Sizing analysis will follow the break-even calculation to support or reject the idea to launch the product.