Ever wondered how many sales are required to cover your company’s monthly or
annual expenses? What about calculating how much additional revenue would have
to be generated to justify a bigger building or an additional staff member?
These questions and more can be answered with a very important management tool –
breakeven. In addition to being very helpful in assessing a business’ current
situation, breakeven analysis can play an important role in evaluating future
business decisions.
annual expenses? What about calculating how much additional revenue would have
to be generated to justify a bigger building or an additional staff member?
These questions and more can be answered with a very important management tool –
breakeven. In addition to being very helpful in assessing a business’ current
situation, breakeven analysis can play an important role in evaluating future
business decisions.
By Kerry Woodson
Ever wondered how many sales are required to cover your company’s monthly or annual expenses? What about calculating how much additional revenue would have to be generated to justify a bigger building or an additional staff member? These questions and more can be answered with a very important management tool – breakeven. In addition to being very helpful in assessing a business’ current situation, breakeven analysis can play an important role in evaluating future business decisions.
Most business owners are at least somewhat familiar with the breakeven concept – it is the point where enough revenues are generated to cover expenses. There is no profit and no loss. Is there a way to know this number ahead of time? Absolutely – but you must know some information unique to your business. Most companies have some combination of variable and fixed expenses. Fixed expenses are things that must be paid even if there are no sales (rent, utilities, salaries). Variable expenses, just as the name implies, vary directly with sales (materials, sales commission). If there are no sales, these expenses do not exist. The first step is to divide expenses into these two categories. Next, calculate variable costs as a percentage of sales and then use this number to determine the contribution margin. Contribution margin is the amount left after variable expenses are paid and is what is available to pay fixed expenses and provide profit. To arrive at the breakeven number, divide fixed costs by the contribution margin percentage. It’s sounds complicated but let’s look at an example to see how simple it can be:
Company Y has $100,000 (1,000 units @ $100 each) in monthly sales with $60,000 variable expenses and $30,000 fixed expenses.
1. $60,000(variable expenses divided by)$100,000 (sales) = 60% variable cost percentage
2. 100% - 60% = 40% contribution margin percentage
3. $30,000 (fixed expenses) divided by .40 (contribution margin %) = $75,000 breakeven
Under this scenario, Company Y must have $75,000 (750 units) in sales to cover expenses. That’s good information to know but the application can be expanded to evaluate “what if” scenarios. What would happen if prices are reduced or increased? How much sales would be required to cover an additional staff member or a larger building? These areas provide examples of where breakeven can be used as a great management decision tool.
Reducing/Raising prices 5% - Without goingthrough all the calculations here, a 5% price reduction would result in the need to sell about 853 units (almost 14% more units!) to reach breakeven while raising prices 5% would decrease the required unit sales to about 664 units (approx 11.5% reduction).
Increasing fixed costs – What if a manager is considering adding a worker and moving to a larger facility, adding $5,000 to the monthly fixed cost. How would breakeven be affected? A simple calculation would show that an additional $12,500 in monthly sales revenue would be needed to cover the extra expenses. Would the proposed changes result in at least this much more income?
Other applications exist for breakeven. What would happen if variable expenses are reduced? A target profit level can even be included as a fixed expense to calculate a sales goal necessary to reach a desired profitability. Don’t get too bogged down in the math at this point but realize that there is a concept that can be incorporated into your business toolbox that can help you quantify some business decisions instead of relying on subjective feelings. Not every business decision can be reduced to a numeric equation but the more guesswork that is removed from the scenario the better are the odds of making the right choices.
Ever wondered how many sales are required to cover your company’s monthly or annual expenses? What about calculating how much additional revenue would have to be generated to justify a bigger building or an additional staff member? These questions and more can be answered with a very important management tool – breakeven. In addition to being very helpful in assessing a business’ current situation, breakeven analysis can play an important role in evaluating future business decisions.
Most business owners are at least somewhat familiar with the breakeven concept – it is the point where enough revenues are generated to cover expenses. There is no profit and no loss. Is there a way to know this number ahead of time? Absolutely – but you must know some information unique to your business. Most companies have some combination of variable and fixed expenses. Fixed expenses are things that must be paid even if there are no sales (rent, utilities, salaries). Variable expenses, just as the name implies, vary directly with sales (materials, sales commission). If there are no sales, these expenses do not exist. The first step is to divide expenses into these two categories. Next, calculate variable costs as a percentage of sales and then use this number to determine the contribution margin. Contribution margin is the amount left after variable expenses are paid and is what is available to pay fixed expenses and provide profit. To arrive at the breakeven number, divide fixed costs by the contribution margin percentage. It’s sounds complicated but let’s look at an example to see how simple it can be:
Company Y has $100,000 (1,000 units @ $100 each) in monthly sales with $60,000 variable expenses and $30,000 fixed expenses.
1. $60,000(variable expenses divided by)$100,000 (sales) = 60% variable cost percentage
2. 100% - 60% = 40% contribution margin percentage
3. $30,000 (fixed expenses) divided by .40 (contribution margin %) = $75,000 breakeven
Under this scenario, Company Y must have $75,000 (750 units) in sales to cover expenses. That’s good information to know but the application can be expanded to evaluate “what if” scenarios. What would happen if prices are reduced or increased? How much sales would be required to cover an additional staff member or a larger building? These areas provide examples of where breakeven can be used as a great management decision tool.
Reducing/Raising prices 5% - Without goingthrough all the calculations here, a 5% price reduction would result in the need to sell about 853 units (almost 14% more units!) to reach breakeven while raising prices 5% would decrease the required unit sales to about 664 units (approx 11.5% reduction).
Increasing fixed costs – What if a manager is considering adding a worker and moving to a larger facility, adding $5,000 to the monthly fixed cost. How would breakeven be affected? A simple calculation would show that an additional $12,500 in monthly sales revenue would be needed to cover the extra expenses. Would the proposed changes result in at least this much more income?
Other applications exist for breakeven. What would happen if variable expenses are reduced? A target profit level can even be included as a fixed expense to calculate a sales goal necessary to reach a desired profitability. Don’t get too bogged down in the math at this point but realize that there is a concept that can be incorporated into your business toolbox that can help you quantify some business decisions instead of relying on subjective feelings. Not every business decision can be reduced to a numeric equation but the more guesswork that is removed from the scenario the better are the odds of making the right choices.
RSS Feed