Whether you are just starting out in business or you’ve been in
business for awhile, break-even analysis can help you make
important business decisions.
Whether you are just starting out in business or you’ve been in business for awhile, break-even analysis can help you make important business decisions. Before any company can earn a profit, it must pass the “break-even point” – the level where total sales equal total costs.
The first step is to identify your fixed and variable costs. Fixed costs are those that do not change with the level of sales (rent, insurance, etc.). Variable costs change depending on the level of business activity (inventory, commissions, etc.). Some costs have both fixed and variable components which should be separated.
Next, determine your gross profit margin (sales minus variable costs) and convert it to a percentage. The break-even point in dollars is calculated by dividing total fixed costs by the gross profit percentage.
Example: Say a company sells pencils for 10 cents each with total fixed costs of $100. If each pencil costs six cents (the variable cost), then four cents from each pencil sold is the profit margin (40 percent gross profit). Given these facts, how many pencils must be sold to break even?
Fixed costs of $100 divided by the 40 percent profit equals $250 of sales is needed to break even. The pencil company must sell at least 2,500 pencils just to break even. They must sell more than that to make a profit.
Before starting a new business, you can use break-even analysis to find out what it will take to turn a profit and whether expectations for the business are realistic.
For an existing business, break-even analysis can help determine the number of sales needed to make a new product profitable. It can show the effect of different price structures and sales levels. It can reveal how cutting fixed or variable expenses will change the company’s net profit picture.
Call us for details on how break-even analysis can help you make better business decisions.
Doug Herring is a CPA with the accounting and business consulting firm of Bianchi, Lorincz & Co. in downtown Hollister and in Morgan Hill.