This is an excerpt from a presentation I give to entrepreneurs about breakeven analysis and managing cash flow.
What is breakeven analysis? Here’s how I define it:
Break-even analysis is determining the point at which you are selling enough of your product or service to cover your production costs and overhead.
In other words, the point at which you’ll be selling enough to stay in business!
Much of this discussion will focus on businesses that sell products, but I’ll address service providers and not-for-profits later on.
Know Your Costs
You need to know your costs before you can do a break-even analysis. For this analysis, there are two types of costs:
- Variable costs: costs that “vary” depending on the level of production (for a business that “makes something”). Examples: materials and supplies.
- Fixed costs: costs that do not vary depending on the level of production. Examples: rent, salaries. Often called “overhead.” Note that salaries and wages are usually a fixed cost unless you tie wages to production (as in a commission).
What about utilities? For your typical small business, utilities will usually be a fixed cost. If you have some means of effectively monitoring the electricity used by machines in production, then it could be a variable cost.
The Basic Break-Even Formula
The formula is a two-step process:
ONE: Calculate your contribution margin. Contribution margin is the amount of money each unit of sales will “contribute” to covering fixed costs.
The calculation is:
Sales Price – Variable Costs = Contribution Margin
TWO: Determine the breakeven point with the following calculation:
Fixed Costs / Contribution Margin = Number of units of sales needed to break even
Company X sells widgets for $15 each. It costs them $10 to make each widget.
Their fixed costs are $50,000.
Step 1: Calculate contribution margin
$15 sale price per unit – $10 variable costs per unit = $5 contribution margin per unit
Step 2: Calculate breakeven
$50,000 fixed costs / $5 contribution margin = 10,000 units.
Company X needs to sell 10,000 widgets at $15/each in order to breakeven. They’ll start turning a profit at 10,001 units of sales.
At this point, the typical small business owner has many questions, in particular about how to determine costs, sales price and units of sales. Hang in there, we’ll get to those things.
Image courtesy of Sandid on Pixabay.com