Do you even Break-Even?

• Posted by Entri Admin August 24, 2019 - Filed in Finance - #finance  #accounting  #profit  - 691 views

  Generating sales and turnover is great, but don’t be fooled as this does not equate to profitability. Lest we forget that we have expenses to pay before we can truly enjoy the fruits of our labour, A useful exercise to perform is to assess just how much sales you need to generate to cover your expenses before you reach profitability i.e. at which point do you Break- Even.

  Cost management is a key function of any business and it is often useful for us to consider how costs translate into targeted business performance. Break-even analysis establishes a manner in which to assess the relationship between expenses and revenues. For example, while you may understand that your monthly rental is X or that your staff costs are Y, as what level of sales will your company be able to cover all these costs and ultimately make a profit?

  Break-even point:

  The point of sales (in Rands or units) at which a business is able to pay precisely its variable and fixed costs, such that its operating profit is equal to zero. At this point, the business is said to break even. This is best expressed in the form of an equation.

   

  

  There might be some terminology above that you may not be familiar with, so let us introduce some key concepts within break-even analysis:

  • Widget: The thing that your business sells or a service you provide.
  • Revenue: Income earned on the sale or transfer of a widget to a consumer.
  • Variable expenses: Costs that increase with increasing sales and decrease with decreasing sales. For example, for a printing company, the cost of paper is expected to be largely variable in nature. In this example, fixed expenses will not change per page printed.
  • Fixed expenses: Costs that do not change with a change in sales volumes. For example, regardless of the amount of widgets your business sells, you will owe the landlord rent and the municipality for water and electricity utilised.
  • Mixed expenses: Some expenses are partly variable and partly fixed. These costs should be split into its constituents, with the variable portion included with variable expenses and the fixed portion being included with the other fixed expenses.
  • Contribution margin (CM): The difference between revenue and variable expenses. In equation form:

  -               Contribution margin = revenue – variable expenses or

  -               Contribution margin per widget = revenue per widget – variable expense per unit.

  The CM represents the contribution made from the sale of each widget towards payment of fixed expenses. Once these fixed costs are covered, your company’s operating profit will increase by the CM per widget sold.

  • Contribution margin Ratio: theContribution Margin expressed as a percentage of revenue i.e (Revenue- Variable Expenses)/ Revenue.

   

  Let’s work through an example

  Assuming that a widget sells for R20 and variables costs total R12, the contribution margin per widget is equal to R8. Assuming further than fixed costs total R1000, how many widgets is the company required to sell to derive a zero operating profit?

  

  Thus each additional widget sold after the 125^th results in the operating profit increasing by the contribution margin of R8.

  Break-even Point in Rands

  Oftentimes, besides identifying the number of widgets that will allow your business to break even, it is useful to understand how the break-even point translates into required sales.

  

  As you can see, this ties back to the total revenue earned when the 125 widgets at R20 each are sold. Only sales above this total will result in operating profit for the business.

  Targeted Profit

  You can further use the formula to determine the widgets required to be sold, and the related revenue, in order to generate a desired profit. Using the same example above, but now the business has a target operating profit of, for example R5000, the amount of widgets to be sold to generate this profit can be determined as follows.

  

  You can check the accuracy of the above as follows: 750 widgets results in R15000 in revenue (750 x R20) and R9000 in variable expenses (750 x R12). This produces R6000 in CM, which then covering a further R1000 in fixed expenses, leaves the business with R5000 in operating profit.

  The above examples put graphically:

  

  Source: Entri

  Microsoft Office has many free financial report templates and among this is its Break-Even Analysis Template for Excel with Data-Driven Charts. Here you can input your own figures and see the break-even results.

  Conclusion

  Ultimately, it is important to note that establishing a precise amount of sales or operating profits for a business is nearly impossible where the business has a wide range of products or services, customers and the relationship between price, marketing and amount of widgets sold, as is often the case. All of these factors combine to complicate the break-even analysis.

  Notwithstanding this, the simple formulae presented above provides a high level understanding of its cost structures and the sales necessary to drive profits.