The Break Even (BE) number is not just another percentage and doesn’t fall into the category of “88% of statistics are made up on the spot”. It’s an actual calculation that is used in business to understand how it is performing. It allows the Business Leader to adjust their business plan and either keep going in their current direction or maybe try a different tact and explore new avenues.
The Break Even answers the question of how many sales does a business need to sell in order to cover the total number of fixed costs and variable costs over a given period of time.
Fixed costs1 can be anything from insurances, property taxes, rent, salaries, utilities to amortising/depreciating tangible assets such as patents or equipment.
Variable costs2 are those items that can fluctuate in cost such as raw materials, production supplies (e.g. machinery inputs that are consumed based on usage like welding wire or even ink cartridges), billable hours of staff wages, commissions, credit card fees, and freight. As these costs are unknowns until the end of a period of time that has passed we can use the Gross Profit Margin (GPM) instead of guessing the variable cost.
Gross Profit Margin is the proportion of profit made after a product or service has been sold. This takes into account the variable costs for manufacturing the item and it can be averaged out to give a more than fair accurate forecast. The GPM can be been used in lieu of the variable cost when calculating Break Even points.
Why Break Even is important to know
Break Even (BE) can be used in different areas of a business, from financial forecasting, pricing strategy, budgeting and setting targets.
Sales is a great focal area to use BE. For example the sales team may be provided with an incentive or bonus for hitting the BE plus 10% over. This way the team have a realistic target they can achieve.
It is important to use the BE when determining sales targets. It’s used when a business is looking to introduce a new product and it needs to determine at what price and how many units it needs to sell in order to produce a profit. The break even gives a mark in the sand that indicates, from that point onward, the product will become profitable. Finding out how many sales are required before a business starts seeing profit means it can make better business decisions.
Apart from setting sales incentives the BE can also show the period of time that a product needs to be in the market (excluding the elasticity of demand1, timing and other market forces).
Additionally, after the initial investment is paid off for a product (when BE is reached) then the business can turn its the attention on the price point. Is the demand steady enough to sustain the same price point? Can the market bear a price increase? Has demand petered off and is it time to bundle the product with another product?
In the earlier discussions regarding Star Products, it was evident that a business with a Star Product has a natural propensity toward its delivery and the added bonus of a level of demand being present. Therefore determining the BE for a Star Product will allow the business to know when the profits will roll in, and enable it to make a sound business forecast for enjoying an ongoing gross profits off that Star Product.
A cornerstone for planning and forecasting is often found with the determination of the Break Even points in a business.
Calculating Break Even
We can now revisit the following - Break Even (BE) is the number of sales that are needed to cover all fixed costs (C) and variable costs (v) over a given period of time. In this section we will estimate our BE over a 6 month period using the following equation:
BE = Fixed Costs (C)
(Gross Profit Margin % ÷ 100)
As discussed above, the actual variable costs aren’t known until the end of the month, therefore in this version of the equation we will use the Gross Profit Margin (%) in place of the variable costs.
Finding the Fixed Costs and Gross Profit Margins is easily located on a business’ Profit and Loss Statement. Each figure should be represented as both a number and as a percentage (ensure the statement has both representations).
Take the total of the last 6 months from the Profit and Loss Statement for the Fixed Costs (number version) and Gross Profit Margin (percentage version). Divide each figure by 6 to provide an average monthly total.
Working example 1
Let’s find out how many sales need to be made to break even when the business has a GPM of 10% and $100,000 worth of fixed costs.
BE = 100,000
(GPM 10% ÷ 100) 0.1
BE = 1,000,000 (1 million)
To cover the fixed business costs of $100,000 when the price point provides a Gross Profit Margin of 10% per sale, the business will need to sell 1 million units of product. That means that at the million sales mark the profit is ZERO.
Remember that the business still needs to manufacture the product. Therefore, the sales are 1 million dollars, the fixed costs are $100,000 and the remaining $900,000 is what it directly costs to manufacture the product itself. The break even is still zero at this point. The first sale after the millionth sale, will be when the business will start to see profits.
Example 2
To understand how Gross Profit Margins work let’s explore the following.
If a product is sold at $1,000 per unit with a 10% Gross Profit Margin, how much profit (P) is made on each product?
P = $1,000 price per unit x (GPM 10% ÷ 100) 0.1
P = $100 profit per unit
This shows that for every unit sold $100 is made on each sale on top of the base costs (which can vary) for manufacturing that product.
Using Break Even with GPM
If a product is sold at a price point of $1,000 per unit and has a 10% Gross Profit Margin, how many products need to be sold to break even?
BE = 1,000
(GPM 10% ÷ 100) 0.1
BE = 10,000
As daunting as it may seem to go back to the drawing board and re-visit a break even figure, working it out is actually good business practice. A solid understanding of where a business is heading with accurate assessment of inputs and outputs using Break Even points, will enable the Business Leader to be confident that the business has long term sustainability.
Online References
1 http://www.accountingtools.com/questions-and-answers/what-are-examples-of-fixed-costs.html
2 http://www.accountingtools.com/questions-and-answers/what-are-examples-of-variable-costs.html
3 http://www.economicsonline.co.uk/Competitive_markets/Price_elasticity_of_demand.html
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