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Break
Even Analysis is perhaps the most useful tool a small business owner should
understand. The reason for its importance is that it shows the exact dollar
in revenue when profit begins to occur. More importantly, it is a tool used
to justify new expenses like a new truck, an employee or an expansion of
space.
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The
Contribution Margin
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Remember that costs can be classified
as being variable or fixed. For example, sales commissions would be variable
since they are not paid unless a sale is made. On the other hand, rent is a
fixed expense and gets paid regardless of whether sales are being made.
By separating all expenses between variable and fixed, we are able to make
some important determinations. Consider the following simplified example:
Sales = $600,000
Variable Costs = $200,000 or 33% of Sales
Fixed Costs = $320,000
To perform a Break-Even Analysis, first understand that as sales go up, so do
the variable expenses. In this example, each sale results in an increase in
variable costs like materials, commissions, and so forth equal to 33% or 33
cents per sales dollar. The fixed costs will remain locked-in at $320,000 or
until a level of sales is reached that forces plant expansion, adding
personnel, etc. Therefore, $320,000 is fixed so long as we stay within our
existing “capacity.”
If variable costs equal 33% of Sales, then approximately 67% of each sale is
available to begin paying for fixed expenses – 67 cents on every sales
dollar. This portion of the sale (67 cents) is called the Contribution
Margin. The rest is easy.
Once the Contribution Margin (67%) has been determined, we need only divide
this number into our fixed costs ($320,000) to find our Break-Even Point.
This means the sales point at which all fixed costs are paid and profit
begins.
$320,000 / 67% =
$477,600
The Break-Even Point is $477,600. For each sale made beyond this point, the
company earns 67 cents in profit. Let’s see how we can use this tool to make
critical decisions.
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Break-Even
Analysis for Critical Decisions
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If the example company does $600,000
in sales this year, how much pre-tax profit should be expected?
Simply deduct the Break-Even Point ($477,600) from the Sales ($600,000) and
multiply the answer by 67%.
$600,000 – Break
Even $477,600 = $122,400 x 67% = $82,000 Profit
If a new manager is added at a salary of $60,000, how much will sales need to
increase to cover this new fixed expense?
$60,000 salary /
Contribution Margin 67% = $89,500 of new sales
What if the assembly work is outsourced and three assemblers are laid off
that cost $80,000 annually? Won’t this turn a fixed expense into a variable
expense?
Assume that outsourcing the assembly work will increase variable costs by 5%,
thus increasing overall Variable Costs to 38%.
$320,000 Fixed Costs
- $80,000 Assembler salaries = $240,000 as the new Fixed Costs
33% Variable Costs + 5% Outsourcing Costs = 38% New Variable Costs
New Contribution Margin of 62% or 62 cents
$240,000 Fixed / 62% = $387,000 new Break-Even Point
Based on this analysis, the decision to outsource is a good one. The
company’s Break-Even Point falls from $477,600 to $387,000, meaning it begins
making profit sooner. Additionally, it has transferred Fixed Cost Risk to
Variable Cost Risk, which is almost always more beneficial.
This is but one of the many types of analytical tools BizMACH Affiliates
utilize to assist their clients build more profitable and valuable
businesses. Maybe we can help your business. Call us for a free consultation.
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Coming In
The Next Issue
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Next time we will answer the
perplexing question, “Why do I show profit but there is no cash in the bank
account?” Don't miss the next issue of Exit for Success.
Profit – Yes; Cash –
No
Use the link below to read previously published issues.
BizMACH is an association of highly skilled consultants, evaluation
experts and merger and acquisition specialists. We take ordinary companies
and create extraordinary value. Best of all, we only work with lower
mid-market companies.
Competitive advantage is the key to revitalizing your company's growth and
profitability. Call us if you'd like a free consultation and to learn how BizMACH
can grow your company and increase its value.
When you work with
BizMACH, you're using the BEST®.
Business Evaluation and Salability Tool
Tom Long
Solid Oak Consulting, LLC
522 South Elmwood Ave
Oak Park, IL 60304
708-524-0886
telong@solidoakconsulting.com
Executive Associate
Accredited by the Institute for Independent Business
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