Today's Finance for Non Financial Managers training lesson concerns break even analysis and the calculation of the break even point.
This is particularly suitable at the moment because another series of articles featuring in the blog concerns the issue of business turnaround where moving the business back above the break even point is such an important issue.
What Is The Break Even Point?
The Break Even Point for a business is the sales volume or sales value where the business neither makes a profit or a loss but is said to break even.
While arithmetically, the break even point is very precise, in general if a business is trading at a small profit or loss is will be said to be breaking even.
In previous financial training lessons (e.g. Matching Costs To Time), I have tried to make you understand that financial performance is not precise since it depends on interpretations, judgements and estimates.
So one accountant may prepare a set of accounts for a business which shows a £4,000 profit for the year while another accountant will make a different set of decisions and report a £3,000 loss. In both situations, the business is operating at around the break even point and the differences will be evened out over time.
Cost Volume Profit Analysis
An understanding of break even analysis is based on the cost - volume - profit relationship within a business.
There are three fundamental relationships:
- Revenue varies directly with the number of units sold and the price the sales units are sold at.
- Some costs vary directly with the number of units sold
- Some costs in the business are fixed for a period and do not vary directly with sales levels. These costs do not automatically increase if sales increase and do not reduce if sales are lower than expected.
This creates a cost volume profit relationship which can be seen by the graph below:
As you can see the blue Revenue line starts from zero (if you don't sell anything, you don't generate any revenue) while the red Cost line starts from a point on the £000 axis which represents the fixed costs of the business.
Where the Revenue line and the cost line meet, the business does not make a profit or loss and is said to be at the break even point.
To the left of the break even point, the business is making a loss because costs are greater than revenue. While the angle of the revenue line is steeper than the cost line, it takes single sales to pay for the fixed costs.
To the right of the break even point, the business is making a profit because revenue is greater than costs.
An alternative way to think about your break even analysis and cost volume profit relationship is to your sales as contributing to meeting and then exceeding your fixed costs.
In this approach you don't look at total revenue and costs but instead focus on the contribution of every sale, which is the difference between your sales price and the variable cost of that sale.
So for example, a book shop may have an average selling price per book of £10 with an average cost price of £7. This means that the contribution (margin) per book is on average £3.
This changes the break even graph to look like the one below:
This is the approach that I prefer since it helps focus on the three basic profit generating tactics more clearly:
- Can you increase your sales volumes?
- Can you increase the contribution per sales unit (either by having a higher selling price or a lower variable cost)?
- Can you reduce your fixed costs?
These three questions are the very essence of working with the break even analysis / cost - volume - profit relationship to improve the results of a business.
Calculating The Break Even Point Of A Business
The standard calculation uses the simplifying logic of the second graph and therefore if you want to calculate the break even point for a business you need to know:
- The value of fixed costs
- The contribution margin either as per unit or as a percentage of sales.
The Break Even Point Formula
The formula is simple
The Break Even Point = Fixed Costs / Contribution Margin
Let's work through a couple of examples starting with the book shop mentioned above.
If the fixed costs are £6,000 per month for the shop and wages for staff and the average contribution per book is £3 then the break even point is £6,000 divided by £3 per book which means that the shop needs to sell 2,000 books per month to break even.
If we assume that on average the shop is open on average five days per week and four weeks per month, that means that the break even target per day is 100 books and per week 500 books.
With this knowledge, the book owner has a general indication of how well the business is performing each day before any accounts are prepared.
If one day, they sell 200 books then the book shop owner knows that they have had a very good day and should make a profit but if only 50 books were sold, then the business is likely to have lost money.
This calculation assumes that the £3 contribution per book sold remains true but in practice the margin on books will vary significantly with a much lower profit on the latest paperback bestsellers and much higher prices and profit on the expensive hardback textbooks.
One way around this problem is to use a contribution margin as a percentage of sales in the break even point calculation and this is the method used where it is not practical to work with sales units.
Break even point in sales value equals fixed costs divided by the contribution margin as a percentage of sales value.
So in the book shop example, there were fixed costs of £6,000 per month and with a 30% contribution margin it means that the break even point in sales value equals 6000 divided by 30% which equals £20,000 sales per month.
So the book shop owner now has a slightly different daily measure as the minimum sales target becomes £1,000 per day.
Using The Break Even Analysis
The break even analysis or cost volume profit analysis can be used in many different ways:
- Before you start a business, it is very difficult to know how much you are likely to sell but your fixed costs can often be estimated with reasonable accuracy and then it is up to you to live within the budget.
So the break even point can be calculated based on your estimated margins and a "worst case margin" to give you a range of estimated break even points. This then acts as a sense check or feasibility check. Do you really think that your business can sell at above the break even point level and if so, how quickly?
- If you are considering major changes in your business you can calculate what effect it will have on your business. For example, you may have a salesman who comes to you and says that your prices are not competitive but if you allow him to reduce prices by 10%, he can increase your sales by 50%.
To see whether this is a good idea, you would do a quick calculation. For example suppose your business has fixed costs of £100,000 per month and you have a 35% margin. This gives you a current break even point of £286,000 (100,000/35%) which you comfortably exceed with average monthly sales of £350,000.
With a 35% margin, sales are 100% and variable costs of sale are 65%. If sales prices reduce by 10%, this comes straight off the margin so sales are 90% of the old level, margins are 25% of the old level and the new margin as a percentage of sales is 27.8% (25/90).
This will mean that the new break even level is £360,000 (100,000/27.8%) which is higher than the current sales level so the salesman must be right in his assertions that he can increase sales. If he can't the salesman has taken a profitable business and turned it into a business that is losing money and therefore you would see this sales price reduction as a very risky move.
[It is not relevant to this discussion on break even points but the salesman's idea may work if he can increase sales by 50% because the contribution would be higher than the existing business generates.]
- As a method to target business improvement and creative thinking. The cost volume profit analysis provides the framework to help you brainstorm ideas for increasing values, increasing contribution rates and for reduced fixed costs.
Conclusion on Break Even Analysis
The break even analysis is a simple but powerful method for understanding the profitability of your business. In a future article I will look at some of the weaknesses and problems that exist in the simplifying assumptions but I am a stronger believer in businesses calculating their break even points and monitoring trends.
Fixed costs have a nasty habit of creeping up with time and margins often reduce as customers negotiate special discounts, purchase prices increase and the business is worried about increasing its own prices.
The trend of the break even point puts these changes into perspective and shows that the business must take action to improve its performance.
Other Articles About Break Even Point AnalysisWhat Is Fixed Cost Creep?
Why It's A Good Idea To Reduce Your Break Even Point
How To Reduce The Break Even Point In A Business
How To Move From The Financial Logic Of Making Money to Taking The Right Actions In Your Marketing
You are invited to take a 30 day trial in my business growth system at www.ProfitableGrowthStrategies.org for $1 or £1. You will discover many ways you can increase your profits by selling more, more often to more customers.