by Mark J. O'Donnell and Jim Schmersahl
The break-even point (BEP) is the sales level at which total revenue equals total costs, resulting in (of course) break-even. Understanding and effectively using the BEP can significantly enhance your fiscal management and decision-making processes.
Understanding the Break-Even Point
BEP is a crucial business metric as it helps determine the minimum sales needed to avoid losses. By regularly calculating the BEP, business owners can make informed pricing, cost management, and financial planning decisions. The necessary information is available on your financial statements, but you need to reorganize the classification of costs into two main categories: variable costs and fixed costs.
Variable Costs
Variable costs change with sales volume but are typically a consistent percentage of sales. These costs are primarily found in the cost of goods sold section and include direct labor and materials. Other examples include sales commissions and factory utilities, really any cost directly tied to sales volumes. By understanding your variable costs you can better predict how changes in sales volume may affect your overall expenses.
Fixed Costs
Fixed costs remain relatively unchanged within a ‘reasonable range’ of sales. These costs include office and administrative salaries, rent, utilities, insurance etc. Fixed costs do not fluctuate with sales volume, making them predictable but also a potential risk if sales decline. Knowing your fixed costs helps in planning and ensures you are prepared to cover these expenses even during slower sales periods.
Calculating the Break-Even Point
To calculate the BEP first determine your Contribution Margin Ratio, computed as (Sales - Total Variable Costs) / Sales.
Your sales BEP is computed as Total Fixed Costs / % Contribution Margin Ratio (from above).
Example Calculation
Assume the following data from your financial statement:
• Fixed Costs = $250,000
• Variable Costs = $1,000,000
• Sales = $1,500,000
First, calculate the Contribution Margin Ratio: ($1,500,000 - $1,000,000) / $1,500,000 = 33.3%.
Next, calculate your sales BEP: $250,000 / 33.3% = $757,676.
This means that every dollar of sales over $757,676 contributes $0.33 to profit.
Impact of Contribution Margin on Profitability and Break-Even
Increasing the contribution margin lowers the BEP, improving profitability and resilience to sales fluctuations. This can be achieved by raising prices, reducing variable costs, or shifting to higher-margin products. For instance, negotiate better rates for raw materials or streamline production processes to reduce waste and your variable costs will decrease, thereby increasing your contribution margin.
Conversely, decreasing contribution margins raise the BEP, slowing profit growth and increasing vulnerability to sales changes. If your business faces increased competition and you lower prices to stay competitive, or your variable costs increase, your contribution margin will decrease, requiring higher sales to break even.
Impact of Fixed Costs on Financial Risk
Fixed costs directly affect a company’s BEP, raising it and requiring more sales to cover expenses. This increased sales requirement can pressure your business, especially in challenging financial environments. Companies with high fixed costs are more vulnerable to cash flow issues, as these expenses must be paid regardless of revenue, potentially straining cash reserves during slow periods.
High fixed costs reduce your company’s flexibility to adapt to changing market conditions. Scaling down operations becomes more complicated when substantial costs are fixed. This lack of flexibility amplifies operational risk, as any disruption to revenue streams may severely affect profitability.
Conclusion
Break-even point analysis is an invaluable tool for effective fiscal management. Regularly calculating and analyzing the BEP allows business owners to make more informed pricing, cost management, and planning decisions. Understanding the impact of fixed costs on financial risk allows for better risk assessment and mitigation strategies. Ultimately, mastering break-even analysis empowers businesses to gain better control over their financial health, and navigate business challenges with greater confidence and precision.
Mark O’Donnell, CPA, is Partner at Schmersahl Treloar & Co. He can be reached at 314.966.2727. Jim Schmersahl, CPA, is a Partner at Schmersahl Treloar & Co. He can be reached at 314.966.2727.