According to the American Bankruptcy Institute, 50,000 business bankruptcy filings are registered in the U.S. per year. It is believed that this could be prevented if businesses steadily forecasted and controlled their costs and sales. If a company is already in debt and does not know how to solve this problem, it is recommended to make use of the services of business debt advisers (e.g. Business-Debt-Management.co.uk). Small businesses with a small product range can utilise simple calculations such as the Break-Even-Point Analysis to determine their profitability.
How to conduct a Break Even Point Analysis
The break-even-point of a business marks a milestone from which a business begins to be profitable. More precisely, it marks the point of how many units/products must be sold, or how much money must be made to cover all costs and to gain a zero profit. Consequently, it can be calculated in terms of units sold or sales achieved. Generally, the units approach is recommended to businesses which sell countable products such as bags or chairs. In contrast, the break-even point of business which offer services or difficult to define units (e.g. Consultancies or restaurants) is determined using the sales calculation method.
For the two calculation methods, the following variables are needed:
S……Selling Price per Unit
V……Variable Cost per Unit
F……Total Fixed Cost
Q……Quantity of Units produced and sold
Contribution margin per unit…… (S – V)
Contribution margin ratio …… ((S – V) / S)
For the calculation of units needed to reach the break-even point, which is widely seen as easier, the following formula can be used.
Profit = (S x Q) – (V x Q) – F
Having filled in the data and setting the profit zero, the result of the equation determines the break-even-point. Sales numbers below that point mean loss, and above that point profit. If the management assumes it cannot sell exactly or more units than assessed by the break-even-point, it must changes its strategy. Here, either fixes or variable cost should be reduced, or the product selling price increased. The below shown, inverted version of the same formula can be utilised to assess how many unit needs selling in order to reach a specific targeted profit. Here, the profit cannot be set zero anymore, but rather the targeted profit should be filled in instead, and the equation solved.
Q = (F + Target profit) / (S – V)
Let’s assume a book seller who has fixed costs of $200 wants to earn a profit of $ 500 per month, as opposed to only covering its expenses. The question is how many books he needs to sell to reach that aim. In the calculation, the targeted profit is treated as another fixed cost, thus it is added to F. As a result, the book seller should sell 70 books per month to cover its cost and to gain that set target profit.
Q= ($200 + $500) / ($20 – 10)
Q = 70
The formula for the sales approach is making use of the two further variables ‘contribution margin per unit’ and ‘contribution margin ratio’. The first variable states to which extend each unit sold helps both covering fixed cost and increasing profit. In contrast, the latter variable shows how much of each Dollar in sales contributes to paying fixed costs and increasing profit.
Break Even Point in Sales = F / Contribution margin ratio
Let’s illustrate this calculation in an example. Assuming a company has sales of $100,000, fixed expenses of $ 50,000 per year, and $ 25,000 variable expenses. This would mean that the contribution margin ratio is 75% as ($100,000 – $25,000) / $100,000 = 75%. Consequently, having subtracted the variable costs, 75 % of every sales dollar remains to cover fixed expenses and to contribute to profits. In turn, the break-even point in sales is $66,666 per year as 50,000 / 75% = 66,666. This tells a company that if it produces sales of $66,666 per year, it has covered all of its costs at a zero profit.
Disadvantages of the Break-Even Analysis
The simplicity of the calculation methods unfortunately bears some disadvantages. For example, the analysis does not consider that in reality the amount of production is not equal to the amount of units sold. Although, the analysis presupposes that variable costs are directly corresponding to sales numbers, they correspond to production numbers in reality. Furthermore, it may have become clear in the book seller example, that the calculation requires equal sales prices of all products at all times. Consequently, each calculation can be solely applied to one product category which is available at the same price. Unfortunately, books and products in other categories are priced differently. Moreover, considering seasonal price fluctuations, which are in particular common in the tourism or airline industry, it becomes clear that more sophisticated revenue management systems are additionally needed. Fortunately, business can get help from experts which are specialised in different fields such as debt or revenue management. For more information click here.