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A person starting a new business often asks, "At what level of sales will my company make a profit?" Established companies that have suffered through some rough years might have a similar question. Others ask, "At what point will I be able to draw a fair salary from my company?" Our discussion of breakeven point and break-even analysis will provide a thought process that may help to answer those questions and to provide some insight as to how profits change as sales increase or decrease. Frankly, predicting a precise amount of sales or profits is nearly impossible due to a company's many products (with varying degrees of profitability), the company's many customers (with varying demands for service), and the interaction between price, promotion and the number of units sold. These and other factors will complicate the break-even analysis. In spite of these real-world complexities, we will present a simple model or technique referred to by several names: break-even point, break-even analysis, break-even formula, break-even point formula, break-even model, cost-volume-profit (CVP) analysis, or expense-volume-profit (EVP) analysis. The latter two names are appealing because the break-even technique can be adapted to determine the sales needed to attain a specified amount of profits. However, we will use the terms break-even point and break-even analysis. To assist with our explanations, we will use a fictional company Oil Change Co. (a company that provides oil changes for automobiles). The amounts and assumptions used in Oil Change Co. are also fictional.
Expense Behavior
At the heart of break-even point or break-even analysis is the relationship between expenses andrevenues. It is critical to know how expenses will change as sales increase or decrease. Some expenses will increase as sales increase, whereas some expenses will not change as sales increase or decrease. Variable Expenses Variable expenses increase when sales increase. They also decrease when sales decrease. At Oil Change Co. the following items have been identified as variable expenses. Next to each item is the variable expense per car or per oil change:
Motor oil Oil filter Grease, washer fluid Supplies Disposal service Total variable expenses per car
The other expenses at Oil Change Co. (rent, heat, etc.) will not increase when an additional car is serviced. For the reasons shown in the above list, Oil Change Co.'s variable expenses will be $9 if it services one car, $18 if it services two cars, $90 if it services 10 cars, $900 if it services 100 cars, etc. Fixed Expenses Fixed expenses do not increase when sales increase. Fixed expenses do not decrease when sales decrease. In other words, fixed expenses such as rent will not change when sales increase or decrease. At Oil Change Co. the following items have been identified as fixed expenses. The amount shown is the fixed expense per week: Labor including payroll taxes and benefits Rent and utilities for the building it uses Depreciation, office and professional, training, other Total fixed expenses per week $1,200 700 500 $2,400
Mixed Expenses Some expenses are part variable and part fixed. These are often referred to as mixed or semi-variable expenses. An example would be a salesperson's compensation that is composed of a salary portion (fixed expense) and a commission portion (variable expense). Mixed expenses could be split into two parts. The variable portion can be listed with other variable expenses and the fixed portion can be included with the other fixed expenses.
Revenues or Sales
Revenues (or sales) at Oil Change Co. are the amounts earned from servicing cars. Oil Change Co. charges one flat fee of $24 for performing the oil change service. For $24 the company changes the oil and filter, adds needed fluids, adds air to the tires, and inspects engine belts. At the present time no other service is provided and the $24 fee is the same for all automobiles regardless of engine size. As the result of its pricing, if Oil Change Co. services 10 cars its revenues (or sales) are $240. If it services 100 cars, its revenues will be $2,400.
Contribution Margin
An important term used with break-even point or break-even analysis is contribution margin. In equation format it is defined as follows: Contribution Margin = Revenues Variable Expenses
The contribution margin for one unit of product or one unit of service is defined as: Contribution Margin per Unit = Revenues per Unit Variable Expenses per Unit
At Oil Change Co. the contribution margin per car (or per oil change) is computed as follows: Contribution Margin per car = Contribution Margin per car = Revenues per car $24 Variable Expenses per car $9
The contribution margin per car lets you know that after the variable expenses are covered, each car serviced will provide or contribute $15 toward the Oil Change Co.'s fixed expenses of $2,400 per week. After the $2,400 of weekly fixed expenses has been covered the company's profit will increase by $15 per car serviced.
It's always a good idea to check your calculations. The following schedule confirms that the break-even point is 160 cars per week:
Oil Change Co. Projected Net Income For a Week Sales (160 cars serviced at $24 per car) Variable Expenses (160 cars at $9 per car) Contribution Margin Fixed Expenses Net Income $ $ 3,840 1,440 2,400 2,400 0
Always check your calculations: Oil Change Co. Projected Net Income For a Week Sales (240 cars serviced at $24 per car) Variable Expenses (240 cars at $9 per car) Contribution Margin Fixed Expenses Net Income $ 5,760 2,160 3,600 2,400 $ 1,200
The above schedule confirms that servicing 240 cars during a week will result in the required $1,200 profit for the week.
The break-even point in sales dollars for Oil Change Co. is: Break-even Point in Sales $ = Total Fixed Expenses Contribution Margin Ratio Break-even Point in Sales $ = $2,400 per week 62.5% Break-even Point in Sales $ = $3,840 per week
The break-even point of $3,840 of sales per week can be verified by referring back to the break-even point in units. Recall there were 160 units necessary to break-even. At $24 per unit the necessary sales in dollars would be $3,840.
Sales $100,000
The amount of sales necessary to give the owner a profit of $1,200 per week is determined by this breakeven point formula: Break-even Point in Sales $ per week = Fixed Expenses per week Contribution Margin Ratio Break-even Point in Sales $ per week = $3,600 per week 62.5% Break-even Point in Sales $ per week = $5,760 per week
To verify that this answer is reasonable, we prepared the following schedule: Per Week 52 Weeks
As you can see, for the owner to have a profit of $1,200 per week or $62,400 per year, the company's annual sales must triple. Presently the annual sales are $100,000 but the sales need to be $299,520 per year in order for the annual profit to be $62,400.