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Break-Even Point Analysis

By Louis Frongello

This article deals with a tool that lets you know when you are making money and that suggests ways to make more. I will discuss the break-even point, see how to calculate and chart it, and see its uses in the day-to-day operation of business. First, let's find out what it is.

Break-even analysis is another accounting tool developed by business owners to help plan and control the business operations.

The Break-Even Point

The break-even point is the point at which the income from sales will cover all costs with no profits. The business owner or manager usually considers several factors when studying break-even analysis:

  1. The capital structure of the company.

  2. Fixed expenses such as rent, insurance, heat, and light.

  3. Setup of the organization.

  4. Variable expenses.

  5. The inventory, personnel, and space required to operate properly.

The study of these factors will inform the business owner of the possibilities of lowering the break-even point and increasing the gross profit margins. When attempting to determine the prospect of success for a new operation, the analysis of the break-even point may indicate the advantages or disadvantages in modifying the proposed level of operation.

Break-Even Analysis

The break-even point informs the business owner of the level of sales at which the business wil realize neither a profit nor a loss. It can be expressed in numbers or by the use of graphs. To arrive at the break-even point using either method, we need to calculate the projected and fixed manufacturing, selling, and administrative expenses, and the expected ratios of sales for each category of expenses.

Types of Costs

To fully understand break-even formulas, it is important to know that different types of costs exist.

The total fixed cost is the sum of all costs that do not change regardless of the level of sales. Rent and executive salaries are two examples. The total variable cost, on the other hand, is the sum of all the expenses that flucuate directly with the level of activity or sales. Cost of materials to produce a product or purchases of items for resale are two variable costs.

The average fixed cost is the figure obtained by dividing the total fixed cost by the number of units (covers, meals, etc.) produced. The average variable cost is obtained by dividing the total variable cost by the quantity produced. The average cost is calculated by dividing the total cost by the number of units produced.

Break-Even Point Formulas

To determine the break-even point, we should use the following formula: Sales (S) equals Fixed Expenses (FE) plus Variable Expenses (VE).

It is a usual business policy to evaluate expenses as a percentage of sales. We will use this method when determining the break-even point. For example, if the fixed costs are $100,000 and variable expenses equals 50 percent of the sales of a specific store, the break-even point is computed as follows:

S = $100,000 + .05S
-0.5S + S = $100,000
0.5S = $100,000
S = $200,000

To prove the result, we can substitute the figures for the letters in the equation.

At this point, it is easy to see how the break-even analysis can be used to determine the level of sales required to realize a certain amount of net income. The formula used will be Sales (S) equals Fixed Expenses (FE) plus Variable Expenses plus Net Income (I). Using the formula above, we can easily determine the level of sales that will produce a net income of $40,000.

S = $100,000 + .05S + $40,000
-0.5S + S = $100,000 + $40,000
0.5S = $140,000
S = $280,000

Restaurants and fast-food chains will often want to express their their break-even point by the number of portions sold. This is fairly easy to compute. Here, the break-even point is determined by applying the following formula: break-even point (in units) equals Total Fixed Cost divided by (selling price per unit minus variable cost per unit).

If the selling price of a steak is $1.20, the total fixed cost is $30,000, and the variable cost per unit is 80 cents, how many units must be sold to break-even?

If we apply the formula, the break-even point is

30,000
$1.20 - 0.80
= 30,000
0.40
= 75,000 units

Using this formula, we can compare different sale prices. The break-even point for each price will be calculated and an analysis of the results will determine how reasonable they are and which is to be used when forecasting and budgeting.

Another possibility that the break-even point offers is for a study of the relation between the revenue and cost. A chart can be drawn showing the total revenue and cost at different levels of production when selling a hamburger or a drink at a specified price.

Graphing the Break-Even Point

Break-even point can also be indicated by graphing. Figure 1 below is a sample graph for a business. To draw the graph, we should follow these steps:

  1. Number of units produced is marked along the horizontal axis and the total revenue expressed in dollars is set on the vertical axis.

  2. The sales line is drawn to indicate the sales at each level of production.

  3. A horizontal line is drawn at the $12,000 level of sales to represent the fixed costs for our sample business.

  4. A total cost line is drawn from the point of intersection of the fixed cost line and the vertical axis to the point of total costs as full capacity --$28,000.

  5. The intersection of the total cost line with the sales line represents the break-even point, in this case $20,000. The dotted lines represent the level of production and the total costs at this level of operation.

  6. Areas of net loss and of net profit are marked.

The break-even point graph helps the business owner determine the levels of production that will create profits for every level of sales. The business owner then works to increase profits without investing extra funds. To do this, he/she should study the following important points:

  1. A possible increase in utilization of existing capacity through reduction of idle time.

  2. Better repair and maintenance of equipment to reduce down time --time elapsed from the moment the machine breaks down to the time it gets back in service.

  3. Improved working schedules and inventory levels.

  4. Longer business hours.

  5. Improved production control.

  6. Markup policy.

Let us take a closer look at two of these points.

Markup Policy

Another item to study when considering ways to improve profit without increasing investment is the company's markup policy. Markup is the amount above cost that the business charges for an item. Too many business owners believe that the only way to larger profits is through higher markups. As a result, they tend to use either a fixed percentage of cost markup or some vague and arbitrary "rule of thumb" which multiples costs by some mystical figure in the manager's head to arrive at the selling price.

Actually, markup should be flexible. Break-even analysis allows studies to be made of volumes of sales at various price levels. It is often discovered that a lover markup will produce a higher volume of sales and increased profits.

If a customer feels costs are too high he/she will take their business elsewhere. Reduced turnover means slow sales. It also means that the business owner may have to raise prices to cover its inventory investment. This will drive more customers away.

An appreciation of the meanings of break-even analysis can prevent such a vicious cycle from even starting.

Figure 2 illustrates the point. Assume that a restaurant is presently operating at 6,000 meals per week; present profit is expressed by line P1P1 and is about $2,000. We feel we can increase business to 7,500 meals per week by reducing price 10 percent. A new sales line S2S2 would have to be drawn. Profit would be increased considerably; new profit is represented by line P2P2. We were able to increase our profit because costs rose at a lesser rate than sales rose.

Summary

Break-even analysis and techniques are the tools that finally tell the business owner or manager when he/she is making a profit. Break-even charts and analysis will be part of every budget the business owner put out. They enable he/she to gauge the business' production rate accurately. They will tell whether an increase or a slowdown in production is called for. They are a vital part of the business owner's life.


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