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"Costs" versus "Revenues"

Learn how the process of "breakeven analysis" can help you to minimize costs and maximize profits.

Breakeven Analysis

By: Dr. William R. Osgood

Breakeven analysis is a powerful management tool, and one that is critical in planning, decision-making, and expense control. Breakeven analysis can be invaluable in determining whether to buy or lease, expand into a new area, build a new plant, and many other such considerations. Breakeven analysis can also show the impact on your business of changing your price structure. As the price goes down (and so your gross margin goes down), breakeven shoots up - usually very rapidly. Breakeven analysis will not force a decision, of course, but it will provide you with additional insights into the effects of important business decisions on your bottom line.

Breakeven refers to the level of sales necessary to cover all of the fixed and variable costs.

Fixed costs are those costs or expenses that are expected to remain fairly constant over a reasonable period of time. These costs are relatively unaffected by changes in output or sales up to the point where the level of operation reaches the capacity of the existing facilities. At that point, major changes would have to be made, such as the expansion of existing plant and equipment or the construction of new facilities. Such actions would increase the fixed costs. However, under normal operating conditions, the fixed costs (also referred to as indirect costs, overhead, or burden) will remain constant. Some examples of fixed costs include rent or mortgage payments, interest on loans, executive and office salaries, and general office expenses.

Variable costs are those costs or expenses that vary or change directly with output. These costs are associated with production and/or selling and are frequently identified as "costs of goods sold." As compared with the fixed costs, which continue whether the firm is doing business or not, variable costs do not exist if the firm is not doing business. Thus, by definition, variable costs are zero when no output is being produced. At that time, fixed costs are the only costs that will be incurred. Examples of variable costs include cost of goods sold, factory labor, and sales commissions.

Break-even analysis will provide a sales objective that can be expressed in either dollars or units of production or sales, or whatever else is relevant. If the breakeven point is known, it can be a definite target to be reached and exceeded by carefully reasoned steps.

The basic breakeven equation is B/E = FC + VC, where FC = fixed costs in dollars and VC = variable costs in dollars.

Variations on this basic formula which can be used when different combinations of the basic factors are known, such as: B/E = FC/(1-VC/S), where FC = total fixed costs in dollars, VC = total variable costs in dollars, and S = total sales in dollars.

It is also possible to calculate your breakeven point when you do not know what your total variable cost will be, but you know your gross margin. The gross margin is the percentage of gross profit to sales (gross profit divided by sales). The gross profit is the amount remaining once the variable costs have been subtracted from sales. This equation is B/E = FC/GM, and GM = GP/S, where FC = total fixed costs in dollars, GP = gross profit (or sales minus variable costs), and S = sales in total dollars.

Another way to calculate breakeven sales level is by using a breakeven chart. In constructing a breakeven chart, the vertical axis represents total dollars of activity, and the horizontal axis represents dollar or unit sales or some other measure of activity. Fixed costs are shown as a horizontal line, and variable costs are shown rising from the intersection of the fixed cost line with the vertical axis. As long as the sales price is greater than the variable costs, the sales line will eventually cross the variable cost line. The point of intersection of the sales line and the variable cost line represents the breakeven point. Many people find a breakeven chart more useful than the more accurate number method used above, simply because of the visual aspect. However, either way, the relationships between the elements can be directly examined and experimented with to provide a better understanding of how the business works. Any close decision will probably be affected by other factors in addition to these calculations anyway.

Once you know the level of sales you have to reach before making a profit, you can evaluate the reasonableness of this target. What are the odds of reaching this breakeven sales level? One way to test this is to convert the gross dollar sales needed for breakeven into some other unit which can then be compared against the capacity of the business or the size of the market. If the breakeven occurs at or near the capacity of the business, or if your analysis shows that you must capture all (or more than all) of the available target market, the feasibility of your concept is suspect, and the odds of business success are loaded against you.

Another way to use breakeven analysis is to change the variables in the equation. If fixed or variable expenses can be reduced, the breakeven point will go down. If prices can be increased without hurting sales (and without increasing costs), the breakeven point will go down. This is an excellent way to experiment with different alternatives. Clearly, this is a subjective process - but then, so is the rest of business analysis. The purpose is to make your business decision making as reasonable as possible. Breakeven analysis can be one of the most valuable tools at your disposal for this purpose. To view a breakeven calculation and sales analysis worksheet, click here.

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