Management

Breakeven Analysis - A Practical Guide for the Busy Entrepreneur

Breakeven analysis answers the question, "what do I need in sales in order to break even?" By breaking even, we mean not losing any money, but also not making any money. The breakeven sales amount is commonly referred to as your monthly "nut". If sales are below this amount, you feel bad, if they are higher, you feel good. Unless you use Enron type accounting, or are swimming in debt, you should be able to work out the cash flow to sustain your business if you are consistently profitable.

Of course, you want to make a profit, not just break even month after month. So you can use this type of analysis to set a profit goal, and figure out what your sales should be to reach that goal. The Breakeven Coverage Ratio is another way of stating a profit goal.

Recently, I had a client ask me to figure out what his Breakeven Sales were for him. I thought to myself - "why can't you do that yourself? It's not exactly rocket science."

But maybe it is not so obvious. There are some nuances for a small business that can make the calculation difficult. The key is to separate your costs into fixed and variable portions. The variable costs are those incurred only when a sales is made. Then you do a little algebra.

If you are a retailer or wholesaler, your variable costs would be the cost of goods that you re-sell, plus perhaps some credit card charges, and maybe commissions.

For a service company, you may have no variable costs, or perhaps just commissions, or maybe sub-contract labor. When you are small, salaries are not variable over small increments in sales. You make do with the work force you have.

Fixed costs are things like rent, utilities, telephone, salaries, and benefits. For a basic breakeven analysis, we consider costs as fixed if they don't vary with small increments of sales. Obviously, if your sales quadruple, you would need to add staff and incur other costs that are fixed in the short term. But for the purposes of a breakeven analysis, we consider these costs to be fixed.

For a simple breakeven analysis, we use the formula:

"Breakeven Sales" = "Fixed Costs" / (1 - "Variable Cost % of Sales")

For a profit goal expressed as Return on Sales (ROS), we use this formula:

"Sales" = "Fixed Costs" / (1 - Variable Cost % of Sales"- "ROS %")

(see the derivations of these formulas at the end of this article)

Example 1 - a Services Company

Fixed costs are now $30,000 per month. During the last 6 months, variable costs amounted to $32,000 on sales of $200,000. You calculate your "Variable Cost % of Sales" to be 0.16 ($32,000/ $200,000 or 16%) - which is for commissions and credit card fees. Your breakeven is $30,000 / (1 - 0.16) = $30,000 / 0.84 = $35,714.

What will your breakeven be if you add a salaried sales rep at $5,000 per month (including FICA and benefits)? It is $35,000 / 0.84 = $41,667, an increase of $5,953.

What sales do you need to produce a 10% return on sales after adding this salaried rep? It is $35,000 / (1 - 0.16 - 0.1) = $35,000 / 0.74 = $47,297.

Example 2 - a Retailer

Fixed costs are now $30,000 per month. You thought that your "Variable Cost % of Sales" was 50% because your standard markup is 2 times cost. But, based on the last 6 months of actual financial results, you calculate your "Variable Cost % of Sales" to be 0.58 (i.e. 58%) - because of markdowns and credit card processing fees. Your breakeven is $30,000 / (1 - 0.58) = $30,000 / 0.42 = $71, 429.

You figure it will cost you $3,000 a month to extend your store hours by 10 hours a week. How much additional sales will you have to generate to cover the additional costs? It is $3,000 / 0.42 = $7,143. Your total breakeven would then be $33,000 / 0.42 = $78, 571 per month.

What do you need now to produce a 10% return on sales? You need $33,000 / (1 - 0.58 - 0.10) = $33,000 / 0.32 = $103,125.

Calculating Breakeven in the Real World

There are a few things you run into when you try to apply this technique in the real world. Keep in mind that the numbers used to calculate breakeven are coming from your accounting system. Here's what you run into:

Fixed costs seem to vary from month to month
Gross profit margins and hence variables costs may also vary from month to month
Owner compensation distorts the breakeven calculation
The existence of debt service makes a cash breakeven a better measure

The solution is to smooth out variations using moving averages, and calculate more than one breakeven number to find one that works best for your situation.

Fixed costs seem to vary from month to month

This seems like a ridiculous statement. After all, what is a fixed cost, but one that is "fixed." Here are some reasons these numbers can bounce around:

1) the Bookkeeper may sometimes put an expense in the wrong month
2) there may be other bookkeeping errors, especially if there is more than one person making entries in the books. What is booked as a cost of sales one month may be a fixed expense another month.
3) some expenses are quarterly or annual (such as business licenses)
4) you have unusual legal or accounting fees that are not related to the level of sales

Gross profit margins may also vary from month to month

The mix of sales may change from one month to the next, affecting your overall gross margin. Sales promotions may reduce average prices. Tiered commission plans may cause average commission rates to fluctuate.

Owner compensation distorts the breakeven calculation

Owner compensation consists of owner salary and benefits, and possibly a few other expenses such as the company delivery yacht or the European training seminars. Separating out these expenses and calculating a breakeven on what is left helps you figure out what the number is you need to make to keep the business running. The theory is that in a pinch, you can give up the perks and live on a mere mortal's salary.

The existence of debt service makes a cash breakeven a better measure

You may or may not have a lot of debt service. If you do have auto loans, equipment loans, or mortgages - it is a good idea to include the principal payments as part of your breakeven calculation.

Some improvements to the breakeven calculation The examples below are from an Excel spreadsheet built to take care of these problems. You can download the Excel spreadsheet by clicking on this link: www.survivalware.com/download/breakeven_analysis.xls

Simple Breakeven There are four basic inputs from your Income Statement needed to calculate breakeven:

Sales
Cost of Sales
Other Variable Costs (to catch truly variable costs such as commissions that may not be included in "Cost of Sales")
Fixed Costs

The Excel example shows six months of data for a hypothetical company with fixed costs of $20,000 per month, the same for all six months. But because the mix of sales varies from month to month, the gross margin is anywhere from 60% in month 1 down to 48.15% in month 6. Total variable costs as a percentage of sales range from 50% to 61.48%. As a result, "Breakeven Sales" ranges from $40,000 to $51,293.

The Breakeven Coverage Ratio is simple the "Actual Sales" for the month divided by the "Breakeven Sales." This is a measure of how well you've got your breakeven covered. Depending on your type of business, a coverage ratio of 1.25 or better is considered good.

3 Month Moving Average To answer the question, "what is my breakeven?" - a moving average is helpful to smooth out the variations in costs and margins from month to month.

The owner of this company would feel confident saying his breakeven is about $45,000 per month. The breakeven coverage ratio of 1.21 is a little below the target of 1.25 or higher.

Breakeven before Owner's Compensation

If the owner is drawing $5,000 per month in compensation, you can back that out of fixed costs to calculate Breakeven before owner's compensation.

Notice how this lowers the breakeven quite a bit.

Cash Breakeven If you are paying back a loan, the "Cash Breakeven" may be more important to you than the "Sales Breakeven." Just add back the principal portion of the loan to the figure for total fixed costs (the interest will already be included in fixed costs) before calculating the breakeven. You can see what this does to the breakeven coverage ratio below - now the company is barely breaking even.

What if?

A key reason to look at breakeven is to understand how much you have to sell to in order to sustain the business. You also want to know what that figure will be as you hire people, acquire more space, or buy new equipment. To calculate the breakeven for a future month, you need to make just two assumptions:

Fixed costs
Variable Costs as a % of Sales

You can look at the year to date average, or a 3 month moving average to decide on what to use for these numbers. Then bump up the fixed costs by the cost of the new person, or the increase in rent, and you have a new breakeven.

In the Excel example, we pick the 3 month moving average of 55.85% for "variable costs as a % of sales", not too far off from the year to date average. We increase the fixed costs by $5,000 to reflect the hiring of a new person, and the resulting breakeven is $56,625.

How the formulas were derived

First, let's state the fundamental calculation of profit:

"Profit" = "Sales" - "Fixed Costs" - "Variable Costs".

Furthermore: "Variable Costs" = "Variable Cost % of Sales" * "Sales"

So: "Profit" = "Sales" - "Fixed Costs" - "Variable Cost % of Sales" * "Sales"

Now its time to consult with your 12 to 14 year old to solve this equation for Sales algebraically:

Breakeven

For breakeven, we want Profit to be zero. So now we have:

(1) 0 = "Sales" - "Fixed Costs" - "Variable Cost % of Sales" * "Sales"

To get all the Sales terms on the same side of the equal sign:

(2) "Fixed Costs" = "Sales" - "Variable Cost % of Sales" * "Sales"

Simplifying the Sales terms:

(3) "Fixed Costs" = "Sales" times (1 - "Variable Cost % of Sales")

Divide both sides of the equation by (1- ?Variable Cost % of Sales")

(4) "Fixed Costs" / (1 - ""Variable Cost % of Sales") = "Sales"

Which is the same as:

(5) "Sales" = "Fixed Costs" / (1 - "Variable Cost % of Sales")

Profit Goal

For a return on sales (ROS) of 10% (0.1), we want Profit to be 10% of sales. So now we have:

"Profit" = 0.1 * "Sales"

But also:

"Profit" = Sales" - "Fixed Costs" - "Variable Cost % of Sales" * "Sales"

So:

(1) 0.1 * "Sales" = "Sales" - "Fixed Costs" - "Variable Cost % of Sales" * "Sales"

To get all the Sales terms on the same side of the equal sign:

(2) "Fixed Costs" = "Sales" - "Variable Cost % of Sales" * "Sales" - 0.1 * "Sales"

Simplifying the Sales terms:

(3) "Fixed Costs" = "Sales" times (1 - "Variable Cost % of Sales" - 0.1)

Divide both sides of the equation by (1- ?Variable Cost % of Sales" - 0.1)

(4) "Fixed Costs" / (1 - "Variable Cost % of Sales" - 0.1) = "Sales"

Which is the same as:

(5) "Sales" = "Fixed Costs" / (1 - "Variable Cost % of Sales" - 0.1)

(6) "Sales" = "Fixed Costs" / (1 - "Variable Cost % of Sales" - "ROS %")

Rusty Luhring has spent the last 27 years as a software entrepreneur. His first startup was Ferox Microsytems, Inc. where he developed some of the first PC based financial modeling software. The software was used primarily by large corporations for financial analysis and complicated planning models. Ferox grew rapidly in the early years, and then hit a few bumps and almost went under. The experience of surviving some pretty severe cash flow problems, and learning to focus on the customer at the same time, inspired his second startup, Luhring SurvivalWare, Inc. SurvivalWare (http://www.survivalware.com) went online in 2002, dedicated to helping small business survive and thrive. The SurvivalWare line of software is designed to bring big company financial modeling and analysis to the small business community by making it affordable, and spreading the development costs of a model over a large base of customers. There is even a ?Lite? version (also known as Transaction Modeler) for those entrepreneurs who are in the middle of a cash flow crisis.

Rusty Luhring

Tags: Breakeven, Financial Analysis, Entrepreneur, Small Business Finance

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Management

Breakeven Analysis - A Practical Guide for the Busy Entrepreneur

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