Definition of Break-Even:
The Break-Even point in sales volume is defined as:
“That point in sales volume, or revenue, where direct costs have been recovered, fixed overhead expenses have been absorbed and where profit begins”.
We can relate Break-Even Point to the information in our financial statements, particularly the Income Statement. The Income Statement should be organized into the following sections:
The sum of all sales and other income net of returns and sales commissions.
2. Cost of Sales (Cost of Goods Sold)
The cost of purchases that are resold (merchandise) and/or raw materials plus the costs of labor to manufacture the product or convert it or install it or deliver it or construct it on site. These costs are also called direct or variable costs.
3. General & Administrative Costs (Overhead)
These are all the costs not directly, or easily, related to sales volume such as Advertising, Bank Charges, Computer Expenses, Insurance, Office Wages & Salaries, Officer’s Compensation, Telephone, Utilities, Depreciation, Interest, Taxes etc. These costs are also called indirect or fixed costs.
4. 1 minus 2 minus 3 = PROFIT.
Note: If your Income Statement is not organized in this fashion (called managerial accounting format), you need to have a session with your accountant and demand it be put into this format so you can manage the business better.
Once you have your financial statements and data in the right format, you can easily calculate Break-Even using the following formula as:
Break-Even Point = FC/(1-VC/S)
Where: FC = Fixed Costs
VC = Variable Costs
S = Sales
For illustrative purposes, let’s look at an example company, Acme Specialties that has the following data from its Income Statement:
Sales = $1,000,000
Cost of Goods Sold = $710,000
General & Admin = $215,000
Acme’s Break-Even Point (during the period indicated by the income statement) is:
Break-Even Point = FC/(1-VC/S) and
VC/S = 710,000/1,000,000 = .71
1- VC/S = 1 - .71 = .29
FC/(1-VC/S)= 215,000/.29 = $741,379 = BEP
And the company operated at $1,000,000/741,379 = 135% of Break-Even during the period.
Break-Even can be calculated for:
A Product Line
A Year (or any other time period)
This is assuming, of course, that fixed costs can be accurately or, at least, reasonably associated with the organizers above.
Using Break-Even in Modeling:
The Break-Even formula can be used as a model to estimate the effect of major decisions on the financial status of the business such as adding a new location, making a capital investment, dropping or adding a product line. Simply estimate the changes in fixed and variable costs (and sales) that result from the decision and plug them into the Break-Even formula for your company. This can also help you set goals for the new operation.
In fact, ANY significant contemplated change in your cost structure resulting from a proposed decision can be modeled to determine the effect on the company’s financial results before the decision is made. You will know what you face and are required to overcome ahead of time. You will be able to set goals based on financial facts rather than intuition only.
Robert A. Normand is Executive Director of the Institute for Small Business Management (http://www.isbminc.com ) and author of “Entreprenewal!, The Six Step Recovery Program for Small Business" (http://www.entreprenewal.com ). Mr. Normand has served as principal management consultant for more than 100 businesses ranging from $500,000 to $50,000,000 in annual sales and has owned and operated several small businesses of his own in diverse industries. Mr. Normand’s small business philosophy is premised on the belief that small business management skills can be developed by busy entrepreneurs using readily available information, tools and procedures not found in business schools or formal degree programs. He can be reached by telephone at 941-330-0889 or by mail at 3751 Almeria Avenue, Suite A4, Sarasota, Florida 34239.