I applaud those who have the intestinal fortitude to take a leap of faith and start their own business. Unfortunately many are inexperienced in financial techniques, such as braak-even point analysis, that help guide them to financial success. My observation is that in their enthusiasm to launch their business and their intense focus on the future opportunities, they neglect or maybe forget the present realities of business. For most business owners, that’s not a surprise, their focus is on the future not the present or the past. There are others that can perform in those arenas. This article is about Intelligence – financial intelligence – the kind of intelligence that will result in successful growth of the business. In this article we will address the analysis tool of “Break-even”.
The power of break-even analysis is in its simplicity. Obviously businesses need to have sufficient revenue to cover a variety of costs and to make a profit. Several costs incurred by businesses include “Cost of Goods Sold,” “Selling and Marketing expenses”, “General and Administrative expense” and a reasonable level of Net Profit. It is important for the business owner to recognize the point of breaking-even – that point at which all the fixed and variable expenses incurred by the business are covered by the revenues received from the business. There is nothing left over for the owner to apply to current or future bills; nothing left over for profit. Revenues equal expenses.
There are several ways to compute the point of break-even – graphic, equation or formula. This article will present the formula method to demonstrate break-even in dollars. The steps are as follows:
- Sales less variable cost equals Contribution Margin.
- Contribution Margin divided by Sales equals the Contribution Margin Ratio.
- Fixed Costs divided by the Contribution Margin Ration yields break-even point in dollars.
Three simple steps. Unfortunately, few businesses can readily separate variable and fixed expenses. Not to worry. One can associate variable costs with Cost of Goods Sold and Fixed costs with all expenses below the gross profit line. While not precise, it is close enough. The revised formula is as follows:
- Sales less Cost of Goods Sold equals Gross Profit.
- Gross Profit divided by by Sales equals Gross Profit Ratio.
- Selling and Administrative expenses (expenses below Gross Profit) divided by the Gross Profit Ratio equals the break-even point in dollars.
For example: A business has been in operation for several years. Sales equals $5,400,000; Cost of Goods sold (Material, Labor and overhead) equals $3,240,000; and Sales and Administrative Expenses equals $2,000,000. Now simply apply the three steps presented above.
- Sales ($5,400,000) less Cost of Goods Sold ($3,240,000) equals Gross Profit of ($2,160,000)
- Gross Profit ($2,160,000) divided by Sales ($5,400,000) equals 40%.
- Selling and Administrative Expenses ($1,800,000) divided by Gross Profit Ratio (40%) equals a break-even point of $4,500,000
The power of break-even is that it can be used to determine the amount sales would have to be increased simply to break-even should a particular decision such as adding a new employee or purchasing a particular piece of equipment be made. For example suppose you were considering hiring a new sales person and expected to pay that person $60,000 per year. How much additional sales would he have to generate just to recover his salary.
- Simply divide the additional cost ($60,000) by the Gross Profit Margin Percent (40%)
- $60,000 / .40 = $150,000.
Thus the new sales person would have to generate $150,000 in new sales just to recover the cost of his salary.
Break-even analysis is a great tool for analyzing the impact of any decision which results in added costs to a business for which the business owner desires to know how much additional sales revenue must be generated in order to just cover the cost of the decision.