The Break-Even Analysis
The break-even analysis provides you with a crucial piece of data: your company's break-even point. The break-even point occurs when your company's revenues exactly equal its costs and expenses, resulting in neither a profit nor loss. When sales fall below the break-even point, your business incurs a loss; when sales climb higher, you see profits.
To come up with your break-even point, you need three pieces of infor-mation: the total expected fixed costs, projected variable costs, and projected sales. Fixed costs include both administrative expenses (a.k.a. overhead) and interest, all of which must be paid whether or not you make a single sale. Variable costs include cost of goods sold and selling expenses; total variable costs naturally go up as sales volume increases. Your projected sales volume should be based on how much you realistically expect to sell at a particular price. Keep in mind, those projected sales are what you expect to sell, not your break-even point.
To calculate a break-even point for your service business, use service salaries as your cost of goods sold. When employees perform services on behalf of the company, divide up their salaries into units that match your revenue units (whatever basis you use to determine customer prices, such as hours). Don't forget to include a rate for yourself when you perform services.
If your break-even analysis doesn't pan out, which indicates loss potential, you may be inclined to keep working the numbers until you get a favorable outcome. Your energy may be better spent on rethinking this plan or considering a different direction for your company. When you start pulling numbers out of the air to make an analysis come out the way you want, you could be setting yourself up for losses.
Break Down the Break-Even Equation
Once you have those pieces, you have to do some math (you may even have to do a little algebra here). Here's the basic break-even equation:
BE=FC + (VC/S × BE)
BE stands for break-even sales, FC stands for fixed costs, VC stands for your total projected variable costs, and S stands for your total projected sales.
It's easier to look at with numbers. In this example, the fixed costs are $30,000. Total projected variable costs came to $50,000, and total projected sales are $100,000. Here's how to work the break-even equation with these numbers.
BE=$30,000 + ($50,000 / $100,000 × BE)
BE=$30,000 + (0.50 × BE)
BE – (0.50 × BE)=$30,000
In this example, the break-even point came to $60,000, which is less than the projected sales figure of $100,000. That means this analysis is favorable, and implementing this decision is likely to result in profits.
When to Prepare a Break-Even Analysis
Use this analysis every time you plan to make a major change in the business. Major changes include:
Adding a new product
Expanding the business
Taking on significant debt
Entering a long-term contract (with either a supplier or customer)
Setting or changing prices
Prepare a break-even before you definitively decide to make such a major change. This will let you know whether that change can be profitable; if it can't, reconsider your plans.