Using breakeven analysis.

HI I’m Rob Lockhart from Westpac’s Davidson Institute here to talk to you about ‘Using breakeven analysis’ and how you can use that analysis to help with day to day financial decisions in your business. Breaking even doesn’t sound like much fun though! I mean, aren’t you in business to make a profit?! That’s why I think of breakeven analysis as being all about profits and it helps us to understand the relationship between price, volume, and costs.

Price of course is how much you sell your goods or services for; volume is how much of it you sell; Price multiplied by volume is your sales. Take away your costs. Whatever is left over is your profit. So, understanding how changes to any one of these elements impacts the others, helps you to make more informed decisions aimed at maximising your profits.

Think of it this way. Costs in your business or organisation are constantly increasing so if you want to continue to make the same amount of profit or continue to breakeven then, as costs increase, you are either going to need to sell more, that is increase your volume, or put your price up. But, by how much? Or, if you decide to have a sale and put your price down, how much more do you need to sell to continue to be as profitable as you are now?

Breakeven analysis, by exploring this relationship between price, volume, and costs, helps to answer these and many many other questions, which is why I think it’s one of the most useful financial tools that a business owner can have in their toolkit.

So today we are going to work through the process of how to calculate your breakeven point, then how you can use that information, but the starting point is looking at your costs and understanding how they behave as this is the driver of understanding that relationship between price volume and costs.

Let’s start by looking at how costs are classified in breakeven analysis. You need to look at them a little bit differently and think about what causes a cost to be incurred or in other words how those costs behave.

One way of measuring whether a business is profitable is to put together a Profit and Loss Statement, which for general accounting purposes looks like this. Sales less Cost of Sales equals Gross Profit. Then Gross Profit less Expenses leaves you with a Net Profit. And of course, if you are breaking even then this is zero.

In breakeven analysis you are going to look at this in a slightly different way. You are going to start in exactly the same place with Sales, however then you are going to take away your Variable Costs. So, let’s have a look at your costs and see what is classified as a variable cost.

When classifying costs in breakeven analysis you classify them according to how they behave. I want you to think about variable costs as those costs that are caused by making a sale. If you make the sale the costs are incurred however if you don’t make a sale they’re not incurred.

The most common examples are the direct labour and materials that go into providing your goods and services, however there are other expenses that are incurred because you make a sale, such as packaging, merchant fees, perhaps commissions and the like. These costs will rise and fall directly in proportion to your sales – the more sales you make the higher the costs; if sales decrease so too will your variable costs.

Coming back to your Breakeven Profit &Loss, after you have taken away the Variable Costs you are left with the Contribution Margin. The Contribution Margin is what is left over to cover your fixed costs and profits. So, what are fixed costs?

Fixed costs are those that will be incurred whether you make a sale or not. It is all those things like rent, advertising, wages and salaries etc. All the things that you need to pay for the business to be operational. The ones you need to pay regardless of whether you are making sales or not.

As your sales increase, then fixed costs will increase in a step like fashion. The fixed costs will provide you with the capacity to make a certain level of sales but to go beyond that you may need more resources such as people, equipment, space or marketing which then increases your fixed costs to the next level. The diagram on the screen shows how differently variable costs and fixed costs behave as your sales increase.

So breakeven analysis is based on classifying your costs as variable or fixed, and we have identified that your Cost of Sales are variable costs but that your expenses may be either fixed or variable depending on whether they are caused by making a sale.

This step, classifying your costs and determining whether they’re fixed, or variable is the hardest part of breakeven analysis … which means that the rest of it is pretty easy. If in doubt about a particular cost, be conservative and class it as fixed.

Classifying costs and understanding how they behave is the basis for breakeven analysis. Let’s look now at how you use this information to calculate your breakeven point. To calculate breakeven, there are only 4 simple steps. The first one is classifying your costs, which is what we have just looked at. Is the cost incurred by making a sale? In which case it is variable, or would you have incurred it anyway, in which case it is fixed.

The next step is to then calculate your Variable Cost Percentage … or what percentage of every $ of sales goes to covering those variable costs. It is calculated by dividing your total variable costs by total sales. Let’s have a look at a simple example.

Let’s say you are in the business of selling pens. Each pen sells for $1.00. Your costs to manufacture or purchase that pen and sell it are 60c. To calculate your variable cost percentage, you divide your variable costs by your price (or sales). In this example 60c divided by $1 means you have a variable cost percentage of 60%. From every $ of sales, 60c is used to cover variable costs.

The next step, step 3, is to calculate the Contribution Margin; that is, how much you have left over from each dollar of sales to cover your fixed costs and generate a profit. Start with your total sales percentage, which is always 100%. Take away your variable cost percentage, calculated in step 2, and you will be left with your contribution margin. In the example we just looked at, the variable costs percentage is 60%, therefore the amount left over, or the Contribution Margin, is 40%.

This means from every $ of sales made, there is 40 cents left over to pay for fixed costs and profit.

The final step, step 4, to calculate your breakeven point is to divide your fixed costs by your contribution margin percentage. Continuing with our example … we said you sell each pen for $1, it costs 60c to produce and sell, so you have 40c left over from each sale to cover your fixed costs. Let’s say your fixed costs at the moment are $12. How many of those ‘40 cents’ do you need to cover your fixed costs and breakeven?

To calculate your breakeven point, you divide your fixed costs of $12 by your Contribution Margin of 40%. To breakeven, you need to make $30 in sales, or sell 30 pens. And if you sell 31? You’ve made a profit … of 40c.

So, there you have it, four very simple steps to calculating your breakeven point. But again, all that’s really telling you is the point at which you are breaking even … not making a profit and not making a loss. I think it’s more exciting to think of it as the point where you start making a profit. But this point is going to change as things change in your business. Let’s have a look at some of those changes and how they impact your breakeven point.

If your variable costs per sale are now 70%, your new contribution margin is 30%. Using your new contribution margin of 30% or 30c, and assuming your fixed costs are still $12, your new breakeven sales point is now $40 or 40 pens. It stands to reason, an increase in variable cost percentage means a decrease in your contribution margin, which means you need to make more sales to stay in the same place.

Let’s have a look now at a change in fixed costs. As you saw when you had a look at fixed costs earlier, these go up in a stepped fashion. Let’s say to take your pen business to the next level you need to purchase a warehouse, hire a couple of sales people and purchase some plant and equipment and that your fixed costs have now increased to $900,000. Now how much do you need to make in sales to cover your fixed costs and breakeven?

You use exactly the same formula to arrive at your new breakeven point of $3,000,000. Put aside the size of that number for the moment, because that will be different for everyone, and revel in the knowledge that you now have a fairly concrete figure to work towards instead of a stab in the dark. Now you know that if you decide to go down the expansion route what sales you will need to be making to make it profitable.

So far today we have classified your costs and had a look at the theory behind breakeven analysis. But the real beauty of this analysis is how it can be applied in different situations to help with making decisions that impact your price, volume, and costs. Let’s now look at how you can put that to use in your business.

The first use of breakeven that I’d like to look into is the most common scenario of increasing costs, in particular fixed costs. Now this increase may be caused by taking on a new employee, purchasing some new equipment, rent increases or even general things like the increasing price of fuel or electricity. We’ll continue to use the same example but assuming that this is now an established business.

. Let’s say you are going to move into larger premises that will increase your rent by $35,000 a year.

To calculate the new breakeven sales, you simply add the increased cost to your existing fixed costs and divide the total by your contribution margin. You can see in this case that your breakeven point increases to $3,116,666 … an increase in required sales of $116,666 to cover a $35,000 increase in cost.

Another way you could have calculated the increase is to simply use the formula on the new cost and add that to the current breakeven point. Take $35,000 divide it by 30% to give you $116,666. Then add it to your current break even, in this case $3,000,000 and we come up with the same answer. Use the way that works best for you.

Another use of breakeven analysis is profit planning … because profit shouldn’t be optional. By calculating the sales necessary to achieve a desired profit this can then be built into your sales plan.

In the example on the screen, in addition to covering your fixed costs of $900,000 you are planning to make a profit of $60,000. By adding the two together and using the breakeven formula you can see that to achieve this level of profits you’d need to make $3,200,000 in sales and maintain your current level of fixed costs. This of course is very useful in planning sales targets for your team.

Another use for breakeven analysis is to see the impact of pricing changes on your volume. One example of that might be if you’re going to have a sale and put your prices down, how much do you need to increase your volume by, so you are not worse off?

Starting with the current example, where your price is $1.00, your contribution margin is 30 cents per pen, and you want to make a $60,000 profit. You need to sell 3.2 million pens. But say your gun salesperson says they need to discount to win the next big deal, or your competitors are discounting, and you want to match them. What volume of sales do you need to do to continue to make your $60,000 in profit?

Let’s apply a discount of 10% and drop your price to 90cents. The variable costs do not change, as we have only adjusted prices. This means your contribution margin drops to 20 cents per pen. Divide your $960,000, of fixed costs and profit plan, by your 20 cents Contribution Margin and you now need to sell 4.8 million pens. An increase of 50% in volume or work, and if you do not get 50% more volume you will make less profit.

Discounting inevitably means you need to sell more, or in other words work harder. Using breakeven analysis, you can now calculate the potential impact of various scenarios and make a more informed decision.

On the other hand, what if you put your price up by 10%? What would be the impact? The new selling price would be $1.10; again, the variable costs do not change, so your new contribution margin will be 40 cents per pen. Divide your $960,000 by 40 cents and you now need to sell 2.4 million pens to make your $60,000 profit. That is a decrease in volume of 25%.

So, if you were to increase prices by 10% you could afford to lose 25% of your volume and you would still make the same profit. If you don’t lose 25% of your volume, you would make more profit. The magnitude of this impact will change depending on your own cost structure and contribution margin. The question you need to ask yourself is, if you put your prices up a little bit, how many customers would you lose?

If your answer is none or only a small number, then perhaps you might consider putting your prices up and improving your profitability.

As we’ve seen, breakeven is one of the most powerful tools you can use in your business. Fortunately, it is also one of the simplest. Classify your costs, use the four steps to calculate breakeven and find out what your contribution margin is. Then use it, to discover your breakeven level of sales. Use it to understand the impact of changing costs, use it to understand the level of sales needed to justify expansion and use it to understand the impact of price changes in your business.

Using breakeven analysis and understanding the relationship between your price, volume, and costs can be one of the most useful tools you can use in your business.

Thank you for watching our video on ‘Using breakeven analysis’. I trust you found the information helpful and I encourage you to check out the other financial education resources on the Davidson Institute website to help build your financial confidence. Bye for now.