Most business owners are familiar with the concept of the break-even point. In simplest terms it is the sales or revenue level at which a business does not make any money, but does not lose any either. It is a useful metric to know if you run a business, because it assists with planning, expense control, and other important business goals. However, each business is different and scale may even impact where the break-even point falls. With that said, how do we calculate our break-even point.
The first and most important step is to identify your expenses as either fixed or variable. Depending upon how your financial records have been organized, you may assume that all costs of sales are variable. (While this is a bit of a lazy approach, it does allow you to get a feel for your break-even more rapidly.) How can you determine if an expense is fixed or variable? You should look at the expense category historically over multiple periods of time. So, I would select a period (month or year) with a high sales volume and compare it to a period with low sales volume. If the expense category or line item remains at the same level, it is safe to identify the expense as fixed. Examples of fixed expense might be rent, liability insurance, interest, etc. On the other hand, if an expense moves up with sales volume and down with a decline in sales, it should be labeled as variable. Examples of these types of costs are sales commissions, product transportation costs, manufacturing or service labor, etc. There might also be some non-repeating or non-operating costs such as legal expense or gain/loss on sale of assets. These should be ignored and not used in our break-even calculation.
Now that we have identified our fixed and variable costs, how do we make the break-even calculation? Add all the fixed costs together for your business. Then add up the variable costs for your high sales period. Calculate a ratio = Variable Expense/Sales. Do the same for the low sales period. Your ratio should be close to the same. If it is not, you may wish to review the expenses you have labeled as variable, or you may wish to take the average of the two ratios. Then subtract your variable expense ratio from one. This is your CONTRIBUTION MARGIN, or how much of each sales dollar can be used to cover fixed expenses. Then divide the contribution margin into the total fixed cost. This is your BREAK-EVEN POINT = FIXED COST/(ONE-VARIABLE EXPENSE RATIO).
An example: Assume your total fixed costs are = $1 million
Assume your variable expense ratio is = 65%
Your contribution margin = 1 – 65% = 35%
BREAK-EVEN = $1 million/0.35 = $2,857,143.
This tells you that above $2.857 million in sales, you should start making profit. Below that number, you will probably produce a loss. Now you can use this target for planning purposes, sales commissions, and expense control. You can also talk more intelligently with your banker, your staff, and other interested parties.