Concept of Breakeven

Concept of Breakeven 

A company's breakeven point is the amount of sales that it must generate in order to cover the costs of running the business. In other words, it is the point at which the company neither makes a profit nor suffers a loss.

In its simplest form, breakeven analysis provides an insight into whether revenue from a product or service is able to cover the relevant costs of production of that product or service. Business owners can use this information in making a wide range of business decisions that include price negotiation, costs control and if it should invest in new ventures.

Understand the nature of your business costs

In computing the breakeven sales, the fundamental principles underlying the breakeven concept are that costs can be classified into:  

(a)     Variable costs
These are expenses that change with the level of sales (e.g. direct materials, freight costs, sales commission, etc). Variable costs would not be incurred if there is no sale; and

(b)    Fixed costs
These are expenses that generally do not vary in accordance to the level of activities and are incurred whether or not a sale is made (e.g. administration staff salaries, office or factory rental and facilities insurance charges). 

Estimate the contribution margin ratio

Contribution margin is the amount that in excess of sales after deducting direct variable costs. The contribution margin would be available to pay for the fixed costs and contribute to net profits. We normally express the contribution margin as a percentage to sales to see the contribution margin ratio.
  

Compute the breakeven sales

To compute the breakeven sales of your business, take the total fixed costs and divide it by the contribution margin ratio. Assuming the total fixed costs of your business amount to S$150,000, the breakeven sales would be $375,000 ($150,000 ÷ 40%), based on the illustration above. If the unit price of your products is $300, you would need to sell at least 1,250 units ($375,000 ÷ $300) of products so that you will not incur a loss. This level of sale is call the breakeven point.

After you have sold 1,250 units, for every unit of products that you sell in excess of the breakeven point, you will make a net profit of $120 per unit ($300 x 40%).

Using breakeven sales analysis for decision making

Understanding the breakeven concept and how it applies to your business will give you an intimate knowledge of the cost, volume, and profit relationships of your business.

It enables you to make important business decisions supported by facts and figures.

(a)     To hire or not to hire?

For example, your business is blooming and you are considering to hire a new sales person to help clinch more sales. The annual salary costs of the sales person is $30,000. If the contribution margin ratio of the business is 40%, the incremental sales that the business would need to generate in order to cover the incremental costs of hiring the new sales person would be $75,000 ($30,000 ÷ 40%). The sales person would need to sell at least 250 units of products in order to cover the incremental fixed costs. Hence, hire only when it is probable that the sales person can bring in incremental sales of more than 250 units.

If you are aiming to make incremental profits of $20,000 from the hiring of a new sales person, the sales target that the new sales person would need to achieve would be $125,000, computed in the illustration below:
 

(b)     Reduce price and to sell more?

Here is another typical situation - should the business drop prices to sell more? In this example below, you are of the view that you can sell about 300 more units if you were to reduce your price by 10%. Is this justifiable?
 

In the above illustration, the overall contribution margin will reduce by $18,000 ($180,000 - $162,000). Hence, it does not add value to reduce price for the higher volume of sales. By reducing the selling price by 10%, the breakeven sales increase to $450,000. Other than the difference in contribution margin, there are other considerations, such as the working capital needed to support the higher level of sales as well as the logistics of handling higher volume of business.

Improving the viability of the business

If the business is unable to generate a level of sales that is higher than the breakeven point, the business owner will have to review the business model critically and the possible reasons are:
•   The business model is not competitive
•   There is insufficient volume of business
•   There is excess capacity
•   The operating cost structure is too high.

Below are some ways to improve the viability of the business:

 

1.    Improve margins

This will result in an increase in the contribution margin. Direct costs can be reduced by sourcing for less expensive supplies; reducing wastages or pilferages; implementing a more efficient inventory management system to reduce inventory holding cost; using a more cost effective production scheduling system  to increase labour productivity or deploying  technology to automate processes.

2.    Control expenses

Renegotiate for better rental rates with the landlord or, use energy-saving devices to save utilities charges. However, extra care has to be taken in any cost-cutting exercise. You may not want to cut too deep to cause distress among employees or scaling back marketing efforts and sending wrong signals to your customers.

3.    Raise the selling price

Consider raising the prices of your products and services, especially if you have a competitive edge of providing better services or better quality products. Most business owners find it difficult to increase the selling price of its products and services as they fear that this may drive their customers away, especially if the competitors are always undercutting prices to win business.

Limitations of breakeven analysis

While understanding the concepts of breakeven can help business owners make wiser decisions, it is important to be aware of its limitations.

1.    The breakeven analysis is usually based on the businesses' projected sales, fixed and variable costs. The current cost structure is probably relevant and can only support up to a limited scale of business volume. Moving beyond the scale would require additional capital expenditure like more production floor, more equipment etc or increasing the level of sales and logistical support. This will change the variable and fixed costs proportions significantly.

2.    The breakeven analysis assumes production and sales have a linear relationship. However this assumption may not necessarily be correct. A business may be able to reduce the overall unit variable costs if it optimises its production capacity efficiently and hence, enjoys economies of scale. However, if there is no corresponding demand for its products, the business may be laden with slow moving inventories caused by over-production. The business owner will have to find a balance in the activities and estimate the costs accordingly.

3.    The analysis assumes that selling prices are consistent at all level of outputs and contribution margin is constant, which may not be the case. A business may vary the selling price based on customers' requirements, the volume of orders as well as the credit risks associated with the trade. The change in sales mix will result in variation of the contribution margin ratio and distort the breakeven analysis.

Conclusion: The ultimate goal is to make profits

Remember that you are doing business to make profit and not to just breakeven. As a business owner, you need to build up the business volume to be able to generate a comfortable margin of safety so that your business is able to weather any setbacks due to unexpected economy slow down.

Only when you have that margin of safety built-up, you can then consider committing resources into expansions or diversifications.

Once you understand this, you are on your way to success.