Breakeven Analysis
Breakeven analysis
answers the question, "what do I need in sales in order to break
even?" By breaking even, we mean not losing any money, but also not
making any money. The breakeven sales amount is commonly referred to
as your monthly "nut". If sales are below this amount, you feel bad,
if they are higher, you feel good. Unless you use Enron type
accounting, or are swimming in debt, you should be able to work out
the cash flow to sustain your business if you are consistently
profitable.
Of course, you want to
make a profit, not just break even month after month. So you can use
this type of analysis to set a profit goal, and figure out what your
sales should be to reach that goal. The Breakeven Coverage Ratio is
another way of stating a profit goal.
Recently, I had a client
ask me to figure out what his Breakeven Sales were for him. I thought
to myself - "why can't you do that yourself? It's not exactly rocket
science."
But maybe it is not so
obvious. There are some nuances for a small business that can make the
calculation difficult. The key is to separate your costs into fixed and
variable portions. The variable costs are those incurred only when a
sales is made. Then you do a little algebra.
If you are a retailer or
wholesaler, your variable costs would be the cost of goods that you
re-sell, plus perhaps some credit card charges, and maybe commissions.
For a service company,
you may have no variable costs, or perhaps just commissions, or maybe
sub-contract labor. When you are small, salaries are not variable over
small increments in sales. You make do with the work force you have.
Fixed costs are things
like rent, utilities, telephone, salaries, and benefits. For a basic
breakeven analysis, we consider costs as fixed if they don't vary with
small increments of sales. Obviously, if your sales quadruple, you
would need to add staff and incur other costs that are fixed in the
short term. But for the purposes of a breakeven analysis, we consider
these costs to be fixed.
For a simple breakeven
analysis, we use the formula:
"Breakeven Sales" =
"Fixed Costs" / (1 - "Variable Cost % of Sales”)
For a profit goal
expressed as Return on Sales (ROS), we use this formula:
"Sales" = "Fixed
Costs" / (1 - Variable Cost % of Sales”- "ROS %")
(see the derivations of
these formulas at the end of this article)
Example 1 - a Services Company
Fixed costs are now
$30,000 per month. During the last 6 months, variable costs amounted to
$32,000 on sales of $200,000. You calculate your "Variable Cost % of
Sales" to be 0.16 ($32,000/ $200,000 or 16%) - which is for commissions
and credit card fees. Your breakeven is $30,000 / (1 - 0.16) = $30,000
/ 0.84 = $35,714.
What will your breakeven
be if you add a salaried sales rep at $5,000 per month (including FICA
and benefits)? It is $35,000 / 0.84 = $41,667, an increase of
$5,953.
What sales do you need to
produce a 10% return on sales after adding this salaried rep? It
is $35,000 / (1 - 0.16 - 0.1) = $35,000 / 0.74 = $47,297.
Example 2 - a Retailer
Fixed costs are now
$30,000 per month. You thought that your "Variable Cost % of Sales” was
50% because your standard markup is 2 times cost. But, based on the
last 6 months of actual financial results, you calculate your "Variable
Cost % of Sales” to be 0.58 (i.e. 58%) - because of markdowns and credit
card processing fees. Your breakeven is $30,000 / (1 - 0.58) = $30,000
/ 0.42 = $71, 429.
You figure it will cost
you $3,000 a month to extend your store hours by 10 hours a week. How
much additional sales will you have to generate to cover the additional
costs? It is $3,000 / 0.42 = $7,143. Your total breakeven would
then be $33,000 / 0.42 = $78, 571 per month.
What do you need now to
produce a 10% return on sales? You need $33,000 / (1 - 0.58 -
0.10) = $33,000 / 0.32 = $103,125.
Calculating Breakeven in the Real World
There are a few things
you run into when you try to apply this technique in the real world.
Keep in mind that the numbers used to calculate breakeven are coming
from your accounting system. Here’s what you run into:
- Fixed costs seem to vary
from month to month
- Gross profit margins and
hence variables costs may also vary from month to month
- Owner compensation distorts
the breakeven calculation
- The existence of debt
service makes a cash breakeven a better measure
The solution is to smooth
out variations using moving averages, and calculate more than one
breakeven number to find one that works best for your situation.
Fixed costs seem to
vary from month to month
This seems like a
ridiculous statement. After all, what is a fixed cost, but one that is
“fixed.” Here are some reasons these numbers can bounce around:
1)
the Bookkeeper may sometimes put an expense in the wrong month
2)
there may be other bookkeeping errors, especially if there is
more than one person making entries in the books. What is booked as a
cost of sales one month may be a fixed expense another month.
3)
some expenses are quarterly or annual (such as business licenses)
4)
you have unusual legal or accounting fees that are not related to
the level of sales
Gross profit margins
may also vary from month to month
The mix of sales may
change from one month to the next, affecting your overall gross margin.
Sales promotions may reduce average prices. Tiered commission plans may
cause average commission rates to fluctuate.
Owner compensation
distorts the breakeven calculation
Owner compensation
consists of owner salary and benefits, and possibly a few other expenses
such as the company delivery yacht or the European training seminars.
Separating out these expenses and calculating a breakeven on what is
left helps you figure out what the number is you need to make to keep
the business running. The theory is that in a pinch, you can give up
the perks and live on a mere mortal’s salary.
The existence of debt
service makes a cash breakeven a better measure
You may or may not have a
lot of debt service. If you do have auto loans, equipment loans, or
mortgages – it is a good idea to include the principal payments as part
of your breakeven calculation.
Some improvements to the breakeven calculation
The examples below are
from an Excel spreadsheet built to take care of these problems. You
can download the Excel spreadsheet by clicking on this link:
www.survivalware.com/download/breakeven_analysis.xls
Simple Breakeven
There are four basic
inputs from your Income Statement needed to calculate breakeven:
- Sales
- Cost of Sales
- Other Variable Costs (to
catch truly variable costs such as commissions that may not be
included in “Cost of Sales”)
- Fixed Costs
This example shows six
months of data for a hypothetical company with fixed costs of $20,000
per month, the same for all six months. But because the mix of sales
varies from month to month, the gross margin is anywhere from 60% in
month 1 down to 48.15% in month 6. Total variable costs as a percentage
of sales range from 50% to 61.48%. As a result, “Breakeven Sales”
ranges from $40,000 to $51,293.
The Breakeven Coverage
Ratio is simple the “Actual Sales” for the month divided by the
“Breakeven Sales.” This is a measure of how well you’ve got your
breakeven covered. Depending on your type of business, a coverage ratio
of 1.25 or better is considered good.
3 Month Moving Average
To answer the question,
“what is my breakeven?” – a moving average is helpful to smooth out the
variations in costs and margins from month to month.
The owner of this company
would feel confident saying his breakeven is about $45,000 per month.
The breakeven coverage ratio of 1.21 is a little below the target of
1.25 or higher.
Breakeven before Owner’s Compensation
If the owner is drawing
$5,000 per month in compensation, you can back that out of fixed costs
to calculate Breakeven before owner’s compensation.
Notice how this lowers
the breakeven quite a bit.
Cash Breakeven
If you are paying back a
loan, the “Cash Breakeven” may be more important to you than the “Sales
Breakeven.” Just add back the principal portion of the loan to the
figure for total fixed costs (the interest will already be included in
fixed costs) before calculating the breakeven. You can see what this
does to the breakeven coverage ratio below – now the company is barely
breaking even.
What
if?
A key reason to look at
breakeven is to understand how much you have to sell to in order to
sustain the business. You also want to know what that figure will be as
you hire people, acquire more space, or buy new equipment. To calculate
the breakeven for a future month, you need to make just two
assumptions:
- Fixed costs
- Variable Costs as a % of
Sales
You can look at the year
to date average, or a 3 month moving average to decide on what to use
for these numbers. Then bump up the fixed costs by the cost of the new
person, or the increase in rent, and you have a new breakeven.
In the example below, we
pick the 3 month moving average of 55.85% for “variable costs as a % of
sales”, not too far off from the year to date average. We increase the
fixed costs by $5,000 to reflect the hiring of a new person, and the
resulting breakeven is $56,625.
How the formulas were derived
First, let's state the
fundamental calculation of profit:
"Profit"
= "Sales" - "Fixed Costs" - "Variable Costs".
Furthermore: "Variable
Costs" = "Variable Cost % of Sales" * "Sales"
So: "Profit" =
"Sales" - "Fixed Costs" - "Variable Cost % of Sales" * "Sales"
Now its time to consult
with your 12 to 14 year old to solve this equation for Sales
algebraically:
Breakeven
For breakeven, we want
Profit to be zero. So now we have:
(1) 0 = "Sales" - "Fixed
Costs" - "Variable Cost % of Sales" * "Sales"
To get all the Sales
terms on the same side of the equal sign:
(2) "Fixed Costs" =
"Sales" - "Variable Cost % of Sales" * "Sales"
Simplifying the Sales
terms:
(3) "Fixed Costs" =
"Sales" times (1 - "Variable Cost % of Sales")
Divide both sides of
the equation by (1- ‘Variable Cost % of Sales”)
(4) "Fixed Costs" / (1 -
""Variable Cost % of Sales") = "Sales"
Which is the same as:
(5) "Sales" = "Fixed
Costs" / (1 - "Variable Cost % of Sales")
Profit Goal
For a return on sales (ROS)
of 10% (0.1), we want Profit to be 10% of sales. So now we have:
“Profit” = 0.1 * “Sales”
But also:
“Profit” = Sales" -
"Fixed Costs" - "Variable Cost % of Sales" * "Sales"
So:
(1) 0.1 * "Sales" =
"Sales" - "Fixed Costs" - "Variable Cost % of Sales" * "Sales"
To get all the Sales
terms on the same side of the equal sign:
(2) "Fixed Costs" =
"Sales" - "Variable Cost % of Sales" * "Sales" - 0.1 * "Sales"
Simplifying the Sales
terms:
(3) "Fixed Costs" =
"Sales" times (1 - "Variable Cost % of Sales" - 0.1)
Divide both sides of
the equation by (1- ‘Variable Cost % of Sales” – 0.1)
(4) "Fixed Costs" / (1 -
"Variable Cost % of Sales" - 0.1) = "Sales"
Which is the same as:
(5) "Sales" = "Fixed
Costs" / (1 - "Variable Cost % of Sales" - 0.1)
(6) "Sales" = "Fixed
Costs" / (1 - "Variable Cost % of Sales" - "ROS %")
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