Analyze your break-even point (B/E Point) to make better business choices. Sounds simple enough right? Read on for a little basic guidance on this fundamental business tool.
Break-even analyses are an important and useful tool in business financial management. You can use break-even analysis to help evaluate:
- Starting a new business,
- Expanding current operations,
- Developing a new product line or service offering,
- Contemplating an acquisition,
- Downsizing operations, or
- Approaching banks and other potential lenders,
Why calculate break-even?
- The break-even point an excellent starting point for finding out where the business is and where it can go.
- It’s the first step in planning future growth.
- It shows how much sales volume is needed to cover fixed and variable expenses so it’s an excellent budget tool.
- Once a company has reached break-even, all gross profit beyond that point goes directly to improving the bottom line, growing and prospering.
Break-even is relatively easy to understand and use. First, review the annual financial statement in order to figure out fixed and variable expenses. Variable expenses are the cost of goods or services sold and other costs of sales, such as direct labor and sales commissions. They are called variable expenses because the quantity of products (produced/ordered/sold or – in the case of services – hours worked) causes the expenses to either decrease or increase with volume. You must know your unit selling price and the variable costs associated with each unit sold (production or acquisition costs) to be able to compute the gross profit percentage. You will also need to know your fixed costs. Fixed costs are those expenses that are not affected by production such as rents, insurance, telecommunications, and fixed salaries. Once you know all the variables (unit selling price, variable and fixed costs) the rest is just plain-old arithmetic. You will divide your fixed costs by your gross profit percentage to arrive at the break-even point. For example, if you have fixed costs of $10,000 and your gross profit percentage is 25%, your breakeven point is sales of $40,000 ($10,000 ÷ 25% = $40,000). You would have to sell $40,000 worth of products or services in order to cover all of your costs and not be in the red or black.
There are, of course, some costs that are, or seem to be, part fixed and part variable. Management will have to use good business judgment to split these items into reasonable proportions.
There are certain limitations for the use of break-even analysis. It ignores the importance of cash flow and makes the assumption that fixed and variable expenses will stay within the parameters used to calculate the break-even. Again, sound business assessment will overcome these shortcomings.
Call us – we would be happy to assist you with calculating your business’s break-even point to help you with budgeting and evaluating your profit structure.