Break-even Analysis A Profitable Tool

August 26, 1985|By Ronald S. Rubin, Special to The Sentinel

How can a small business determine if it's turning a profit or losing money? How long will it take for revenue to offset costs? How many products or services must be sold to break even?

These questions can be answered through break-even analysis, a simple, yet powerful procedure for small-business planning. With a pad, a pencil, a calculator and a few key concepts, you can develop a tool to help you fine- tune your business operations.

The technique studies the relationship between sales, fixed costs and variable costs. In general, the break-even point in business occurs when revenue and expenses are equal. Break-even analysis is most useful when applied to future periods as a planning guide, particularly if a change in business operation is anticipated.

To develop a break-even analysis you must identify all the costs of doing business. If you are a retailer you need to take into consideration the cost of merchandise purchased for sale to customers. Service businesses have to monitor labor and materials costs. In addition to these product -- or service- related -- costs, businesses incur expenses such as sales, administration, office rent and insurance.

Your next step is to classify each cost as being fixed or variable. Fixed costs are those that do not change with sales volume, such as salaries, rental expenses, depreciation expenses and most insurance premiums. Variable expenses are those that change with the sales volume.

Once costs have been classified you are ready to calculate the relationship of costs, volume and profit. The difference between revenue and variable cost is called the contribution margin. This represents each unit's contribution toward covering the fixed costs and, thereby, making a profit.

CM equals revenue minus variable costs.

CM can be expressed as a percent of revenue, found by finding the percentage of variable costs in relation to sales. Subtracting that figure from 100 percent gives you the contribution margin.

For example, if sales were projected to be $100,000, and variable costs are $40,000, then the variable costs represent 40 percent of sales. Therefore, the contribution margin is 60 percent, or 100 percent minus 40 percent. The break-even level then is calculated by dividing the fixed costs by CM. (Remember, CM is expressed as a percentage of revenue.)

This concept is useful in determining the break-even point in terms of profit margin.

Remember, the break-even approach develops the volume needed for producing no profit. How about a little profit, say 10 percent. Let's say the original contribution margin was 40 percent, but that's at zero profit. In effect, your 10 percent profit now acts like a variable cost. You must adjust the CM percentage accordingly: 40 percent minus 10 percent equals 30 percent. Now you can calculate the break-even point using the percentage of revenue approach. This will give you the profit margin built into your business.

Break-even analysis allows you to examine cost-volume-profit relationships under a variety of conditions. This aids in profit planning, advertising allocation, planning for new products, and expansion.

Orlando Sentinel Articles