BREAKEVEN ANALYSIS

Breakeven analysis involves estimating the level of sales necessary to operate a business on a breakeven basis. Generally, the sale price for a product or service will more than cover the variable costs of producing that product or service, but the margin from sales must be enough to cover fixed costs as well. By performing a breakeven analysis and then varying the assumptions regarding sales levels and variable and fixed costs, the real factors behind the profit potential (or lack thereof) of a business become more clear. This process will highlight the most significant factors and assumptions (particularly assumptions about the ability to set prices) in the buyer's business plan.

Key Breakeven Terms

Fixed Costs

These costs remain constant (or nearly so) within the projected range of sales levels. These can include facilities costs, certain general and administrative costs, and interest and depreciation expense.

Variable Costs

These costs vary in proportion to sales levels. They can include direct material and labor costs, the variable part of manufacturing overhead, and transportation and sales commission expenses.

Contribution Margin

This is equal to sales revenues less variable costs. This amount is available to offset fixed expenses and (hopefully) produce an operating profit for the business.

Calculating the Breakeven Point

The following steps are involved in calculating the breakeven point for a business.

  1. Identify the total fixed and variable costs of the business based on actual results during a relevant time period.
  2. Calculate the contribution margin, as a percent of sales as follows:

    Contribution margin = (Total sales - Variable costs)/Total sales

  3. Calculate the breakeven point in dollars of sales revenue as follows:

    Breakeven sales revenue = Total fixed costs/Contribution margin

  4. If contribution margin is expressed in dollars per unit, calculate the breakeven sales volume in units as follows:

    Breakeven unit volume = Total fixed costs/Contribution margin per unit

Break-Even Analysis

Break-even analysis pinpoints where revenue equals total costs. To calculate your break-even point, take your most current income statement and identify each cost as either fixed or variable. Fixed costs are independent of sales level, while variable costs rise and fall with sales. Mixed costs involve elements of both. Most costs will fall readily into fixed or variable. For those that don't, allocate 50% to fixed costs, and 50% to variable. 

Fixed Expenses:                     Variable Expenses: 
________________________________________________________________
Salaries                            Sales commissions 
Office expenses                     Taxes 
Payroll tax                         Sales tax 
Benefits                            Utilities 
Utilities                           Travel and entertainment 
Rent                                Freight 
Licenses and fees                   Overtime 
Operating supplies                  Bad debts 
Insurance                           Cost of goods sold 
Advertising                         Truck 
Legal and accounting                Postage
Depreciation
Interest
Maintenance and cleaning
Dues and publications

 

Calculating Production Needs

It can be most important to small manufacturers to know the quantity of production units they must produce in order to cover the firm's fixed expenses. 

This formula is:
                                          Fixed Expenses
Break-even point in units = _____________________________________________
                                    Contribution margin per unit 
                            (unit sale price - variable expenses per unit) 
 

Calculating the Break-Even Point in Sales

Where the immediate objective is to find only the sales volume that is necessary to reach the break-even point, this formula should be used. 

 
                                          Fixed Expenses
Break-even point in units = _____________________________________________
                                    Contribution margin per unit 
                            _____________________________________________
                                      Selling price per unit
 

This break-even formula determines how many units the firm must produce and sell to pay for fixed expenses. It subtracts the variable expense per unit from the sales income for each unit. The difference per unit is then applied to fixed expenses. The break-even quantity is the number of units that must be sold to cover expenses.

Example:

The Successful Company sells decal-decorated T-shirts to its customers for $10.00 each. The shirts cost $4.00 each, and the decal costs $.40. The store pays a $.60 commission to the salesperson. The total variable cost is $5.00. The total of the fixed costs is $1,500 a month.

Using the Formula for Computing Production Needs we find that, dividing the monthly fixed cost of $1,500 by $5 gives a break-even point of 300 shirts per month. If we sell 300 shirts at $10 each we generate $3,000. Our variable costs total $5 per shirt or $1,500. Add the fixed cost of $1,500 to variable costs of $1,500 equals $3,000. 

                              Breakeven Point =           $1,500
                                                 _________________________
                                                 $10 - $5 = $5 = 300 units

Assumptions and Special Remarks

Describe and give reasons for any assumptions you have made in assembling your business plan, such as assumptions concerning the economy or your competitors, document the source of information on which you based your assumptions.

Also, list any special remarks you wish to be known about your business. In the body of your business plan you should footnote where you have made an assumption or have special remarks about a subject in this section.