Break Even Analysis
A break-even analysis explores the relationship between expenses and revenues. Revenues are the amounts you earn for selling your product or service. Expenses are your operating and production costs. But before we start figuring at what point we can break even, let’s go back over some accounting terminology:
- Variable expenses are tied to your revenues. Revenues go up, variable expenses go up. Revenues go down, variable expenses go down. Materials are variable expenses that fluctuate with revenues. The more products you sell, the more money you must spend on materials to make your product. Shipping and delivery are other variable costs that increase or decrease with your revenue numbers.
- Fixed expenses consist of costs that remain the same regardless of how much are generated from monthly sales, such as rent expense, salaries, insurance, and other ongoing, general office and administrative expenses.
- Contribution Margin is the amount generated after the variable expenses have been covered which then will contribute toward the fixed expenses.
- Breakeven Point = Fixed Costs / (Unit Selling Price – Variable Costs)
- # of units to produce the Expected Profit = (Expected Profit in Dollars / Contribution Margin per unit) + Breakeven Point in # of units
Using this formula, you can determine how much of your product you will need to sell to break even. Once you have reached that point you have recouped all your cost that you have generated producing your product both fixed and variable.
Let’s take a look at an example of each of these formulas. Amy is the Financial Manager of a manufacturing factory. She is not sure the current year’s lighting models are going to turn a profit and what to measure the number of units they will have to produce and sell in order to cover their expenses and make at $500,000 in profit. Here are the production stats.
Total fixed costs: $500,000
Variable costs per unit: $300 ($250 for materials plus $50 for shipping)
Sale price per unit: $500
Expected profits: $200,000
First we need to calculate the break-even point per unit, so we will divide the $500,000 of fixed costs by the $200 contribution margin per unit ($500 – $300).
2,500 units = $500,000 / $200
As you can see, the Amy’s factory will have to sell at least 2,500 units in order to cover its fixed and variable costs. Anything it sells after the 2,500 mark will go straight to the Contribution Margin since the fixed costs are already covered.
Next, Amy can translate the number of units into total sales dollars by multiplying the 2,500 units by the total sales price for each unit of $500.
$1,250,000 = 2,500 units x $500 per unit
Now Amy can go back to the upper management and say that the company must sell at least 2,500 units or $1,250,000 in sales before any profits are realized. She can also take it a step further and use a break-even point calculator to compute the total number of units that must be produced in order to meet her $200,000 profitability goal by dividing the $200,000 expected profit by the contribution margin then adding the total number of break-even point units.
3,500 units = ($200,000 / ($500 – $300)) + 2,500 units
Now that you know how to do the break-even analysis, you can play with various scenarios to forecast profitability. And keep in mind, break-even analysis is a living thing; it’s never final. What if you found a cheaper material? Or maybe new equipment would decrease your labor costs? Or maybe your rent’s about to go up. There are countless factors that will impact profit per product unit, but break-even analysis allows you to quickly run the numbers and get a snapshot.
In a service business, you’re selling time, so you take a slightly different angle than to retail or manufacturing business. As a general rule, a service business should calculate to bill an average of four to five hours a day. This does not look much, but it is better to be conservative in your calculations than to over-project your income and not able to meet commitments.
Service companies may know the exact amount of material and labor hours required to do a project, however, many do not understand how to price to cover their overheads — their cost of doing business. No two companies will have the same overhead. A proper strategy for pricing requires you find your cost of doing business, so you can establish your break-even point per person hour, per service and per project.
A standard formula for determining an hourly rate requires you to add together your labor and overhead costs, add the profit you want to earn, then divide the total by your hours worked.
|Number of hours required to break-even =||Overheads + Project Cost + Desired Income|
|Average charge per hour|
|Number of services carried out to break-even =||Overheads + Project Cost + Desired Income|
|Average charge per service|
Overhead includes all the costs you incur to do business, such as those for:
- rent and utilities
- business insurance
- website expenses
- office supplies
- postage and delivery
- office equipment and furniture
- clerical help
- travel expenses
- legal and accounting fees
- telephone expenses
- meals and entertainment
- advertising and marketing
- medical and disablity insurance
Service businesses usually generate most of their income through billable hours. There are some misunderstanding with these businesses is that you can bill eight hours a day – which you cannot. Simply put, you have to consider your travel time, preparing proposals and invoices for each project – all of these examples are not billable.
In a year, there are 52 weeks and assuming a 40 hour work week, 2,080 possible hours. We are also assuming that you will take two weeks (80 hours) of vacation during the year and have six major holidays off (48 hours) so now we are down to a possible 1,952 hours of possible work. Every day there is travel time, training, and other “non-billable” time. You will also spend at least 25% of your time on administrative tasks such as bookkeeping, billing, and marketing your services. This means you will likely have about 1,464 billable hours.
A self-employed Graphics Designer, Karl wants to receive $60,500 salary. He estimates that his annual overhead amounts to $35,000 per year. He wants to earn a 15% profit and estimates he will have 1,464 billable hours each year. To determine his hourly rate:
Salary and overhead = 60,500 + 35,000 = 95,500
Plus 15 % profit = 109,825 (95,500 * 1.15)
Hourly rate = 109,825 / 1,464 = 75.02 (rounds to $75.00)
So Karl determines that his hourly rate should be $75.00. However, depending on market conditions, Karl might end up charging more or less.
Janitorial Service Company contracts to various building firms at a charge of $20.00 per labor/hour. Its overheads per year are $30,000 and the payroll bill is $70,000. How many billable labor hours would it have to contract for to break-even? The business expects to work 46 weeks in a year.
Break-even is 5,000 billable hours per year = (30,000 + 70,000) / 20
109 billable labor/hours per working week to break-even = 5,000 / 46
An electric technician has an average charge per client of $75.00. Its overheads are $25,000 and his assistant takes $25 from every charge. How many clients does the electrician need to serve in a year to break-even? The business expects to work 46 weeks in a year.
Break-even is 500 clients served per year = 25,900 / (75 – 25)
10.87 clients per week to break-even = 500 / 46
Break-even analysis is a very useful tool with which to approach a variety of decision problems. Such questions as the costs of expansion, evaluation of sales or profit performance, estimation of the impact of various expenses on profit, setting prices, and financial analysis in general are appropriately addressed using break-even analysis. It is best used in conjunction with other financial analysis techniques or as a screening device to determine whether more study is needed. In any case, familiarity with break-even analysis is a must for any business person.