| Breakeven analysis answers the question, | | | | loans, or mortgages - it is a good idea to |
| "what do I need in sales in order to break | | | | include the principal payments as part of |
| even?" By breaking even, we mean not losing | | | | your breakeven calculation.Some improvements |
| any money, but also not making any money. The | | | | to the breakeven calculation The examples |
| breakeven sales amount is commonly referred | | | | below are from an Excel spreadsheet built to |
| to as your monthly "nut". If sales are below | | | | take care of these problems. You can download |
| this amount, you feel bad, if they are | | | | the Excel spreadsheet by clicking on this |
| higher, you feel good. Unless you use Enron | | | | link: Breakeven There are four basic inputs |
| type accounting, or are swimming in debt, you | | | | from your Income Statement needed to |
| should be able to work out the cash flow to | | | | calculate breakeven:SalesCost of SalesOther |
| sustain your business if you are consistently | | | | Variable Costs (to catch truly variable costs |
| profitable.Of course, you want to make a | | | | such as commissions that may not be included |
| profit, not just break even month after | | | | in "Cost of Sales")Fixed CostsThe Excel |
| month. So you can use this type of analysis | | | | example shows six months of data for a |
| to set a profit goal, and figure out what | | | | hypothetical company with fixed costs of |
| your sales should be to reach that goal. The | | | | $20,000 per month, the same for all six |
| Breakeven Coverage Ratio is another way of | | | | months. But because the mix of sales varies |
| stating a profit goal.Recently, I had a | | | | from month to month, the gross margin is |
| client ask me to figure out what his | | | | anywhere from 60% in month 1 down to 48.15% |
| Breakeven Sales were for him. I thought to | | | | in month 6. Total variable costs as a |
| myself - "why can't you do that yourself? | | | | percentage of sales range from 50% to 61.48%. |
| It's not exactly rocket science."But maybe it | | | | As a result, "Breakeven Sales" ranges from |
| is not so obvious. There are some nuances for | | | | $40,000 to $51,293.The Breakeven Coverage |
| a small business that can make the | | | | Ratio is simple the "Actual Sales" for the |
| calculation difficult. The key is to separate | | | | month divided by the "Breakeven Sales." This |
| your costs into fixed and variable portions. | | | | is a measure of how well you've got your |
| The variable costs are those incurred only | | | | breakeven covered. Depending on your type of |
| when a sales is made. Then you do a little | | | | business, a coverage ratio of 1.25 or better |
| algebra.If you are a retailer or wholesaler, | | | | is considered good.3 Month Moving Average To |
| your variable costs would be the cost of | | | | answer the question, "what is my breakeven?" |
| goods that you re-sell, plus perhaps some | | | | - a moving average is helpful to smooth out |
| credit card charges, and maybe | | | | the variations in costs and margins from |
| commissions.For a service company, you may | | | | month to month.The owner of this company |
| have no variable costs, or perhaps just | | | | would feel confident saying his breakeven is |
| commissions, or maybe sub-contract labor. | | | | about $45,000 per month. The breakeven |
| When you are small, salaries are not variable | | | | coverage ratio of 1.21 is a little below the |
| over small increments in sales. You make do | | | | target of 1.25 or higher.Breakeven before |
| with the work force you have.Fixed costs are | | | | Owner's CompensationIf the owner is drawing |
| things like rent, utilities, telephone, | | | | $5,000 per month in compensation, you can |
| salaries, and benefits. For a basic breakeven | | | | back that out of fixed costs to calculate |
| analysis, we consider costs as fixed if they | | | | Breakeven before owner's compensation.Notice |
| don't vary with small increments of sales. | | | | how this lowers the breakeven quite a |
| Obviously, if your sales quadruple, you would | | | | bit.Cash Breakeven If you are paying back a |
| need to add staff and incur other costs that | | | | loan, the "Cash Breakeven" may be more |
| are fixed in the short term. But for the | | | | important to you than the "Sales Breakeven." |
| purposes of a breakeven analysis, we consider | | | | Just add back the principal portion of the |
| these costs to be fixed.For a simple | | | | loan to the figure for total fixed costs (the |
| breakeven analysis, we use the | | | | interest will already be included in fixed |
| formula:"Breakeven Sales" = "Fixed Costs" / | | | | costs) before calculating the breakeven. You |
| (1 - "Variable Cost % of Sales")For a profit | | | | can see what this does to the breakeven |
| goal expressed as Return on Sales (ROS), we | | | | coverage ratio below - now the company is |
| use this formula:"Sales" = "Fixed Costs" / (1 | | | | barely breaking even.What if?A key reason to |
| - Variable Cost % of Sales"- "ROS %")(see the | | | | look at breakeven is to understand how much |
| derivations of these formulas at the end of | | | | you have to sell to in order to sustain the |
| this article)Example 1 - a Services | | | | business. You also want to know what that |
| CompanyFixed costs are now $30,000 per month. | | | | figure will be as you hire people, acquire |
| During the last 6 months, variable costs | | | | more space, or buy new equipment. To |
| amounted to $32,000 on sales of $200,000. You | | | | calculate the breakeven for a future month, |
| calculate your "Variable Cost % of Sales" to | | | | you need to make just two assumptions:Fixed |
| be 0.16 ($32,000/ $200,000 or 16%) - which is | | | | costsVariable Costs as a % of SalesYou can |
| for commissions and credit card fees. Your | | | | look at the year to date average, or a 3 |
| breakeven is $30,000 / (1 - 0.16) = $30,000 / | | | | month moving average to decide on what to use |
| 0.84 = $35,714.What will your breakeven be if | | | | for these numbers. Then bump up the fixed |
| you add a salaried sales rep at $5,000 per | | | | costs by the cost of the new person, or the |
| month (including FICA and benefits)? It is | | | | increase in rent, and you have a new |
| $35,000 / 0.84 = $41,667, an increase of | | | | breakeven.In the Excel example, we pick the 3 |
| $5,953.What sales do you need to produce a | | | | month moving average of 55.85% for "variable |
| 10% return on sales after adding this | | | | costs as a % of sales", not too far off from |
| salaried rep? It is $35,000 / (1 - 0.16 - | | | | the year to date average. We increase the |
| 0.1) = $35,000 / 0.74 = $47,297.Example 2 - a | | | | fixed costs by $5,000 to reflect the hiring |
| RetailerFixed costs are now $30,000 per | | | | of a new person, and the resulting breakeven |
| month. You thought that your "Variable Cost % | | | | is $56,625.How the formulas were |
| of Sales" was 50% because your standard | | | | derivedFirst, let's state the fundamental |
| markup is 2 times cost. But, based on the | | | | calculation of profit:"Profit" = "Sales" - |
| last 6 months of actual financial results, | | | | "Fixed Costs" - "Variable Costs".Furthermore: |
| you calculate your "Variable Cost % of Sales" | | | | "Variable Costs" = "Variable Cost % of Sales" |
| to be 0.58 (i.e. 58%) - because of markdowns | | | | * "Sales"So: "Profit" = "Sales" - "Fixed |
| and credit card processing fees. Your | | | | Costs" - "Variable Cost % of Sales" * |
| breakeven is $30,000 / (1 - 0.58) = $30,000 / | | | | "Sales"Now its time to consult with your 12 |
| 0.42 = $71, 429.You figure it will cost you | | | | to 14 year old to solve this equation for |
| $3,000 a month to extend your store hours by | | | | Sales algebraically:Breakeven For breakeven, |
| 10 hours a week. How much additional sales | | | | we want Profit to be zero. So now we have:(1) |
| will you have to generate to cover the | | | | 0 = "Sales" - "Fixed Costs" - "Variable Cost |
| additional costs? It is $3,000 / 0.42 = | | | | % of Sales" * "Sales"To get all the Sales |
| $7,143. Your total breakeven would then be | | | | terms on the same side of the equal sign:(2) |
| $33,000 / 0.42 = $78, 571 per month.What do | | | | "Fixed Costs" = "Sales" - "Variable Cost % of |
| you need now to produce a 10% return on | | | | Sales" * "Sales"Simplifying the Sales |
| sales? You need $33,000 / (1 - 0.58 - 0.10) = | | | | terms:(3) "Fixed Costs" = "Sales" times (1 - |
| $33,000 / 0.32 = $103,125.Calculating | | | | "Variable Cost % of Sales")Divide both sides |
| Breakeven in the Real WorldThere are a few | | | | of the equation by (1- 'Variable Cost % of |
| things you run into when you try to apply | | | | Sales")(4) "Fixed Costs" / (1 - ""Variable |
| this technique in the real world. Keep in | | | | Cost % of Sales") = "Sales"Which is the same |
| mind that the numbers used to calculate | | | | as:(5) "Sales" = "Fixed Costs" / (1 - |
| breakeven are coming from your accounting | | | | "Variable Cost % of Sales")Profit Goal For a |
| system. Here's what you run into:Fixed costs | | | | return on sales (ROS) of 10% (0.1), we want |
| seem to vary from month to monthGross profit | | | | Profit to be 10% of sales. So now we |
| margins and hence variables costs may also | | | | have:"Profit" = 0.1 * "Sales"But |
| vary from month to monthOwner compensation | | | | also:"Profit" = Sales" - "Fixed Costs" - |
| distorts the breakeven calculationThe | | | | "Variable Cost % of Sales" * "Sales"So:(1) |
| existence of debt service makes a cash | | | | 0.1 * "Sales" = "Sales" - "Fixed Costs" - |
| breakeven a better measureThe solution is to | | | | "Variable Cost % of Sales" * "Sales"To get |
| smooth out variations using moving averages, | | | | all the Sales terms on the same side of the |
| and calculate more than one breakeven number | | | | equal sign:(2) "Fixed Costs" = "Sales" - |
| to find one that works best for your | | | | "Variable Cost % of Sales" * "Sales" - 0.1 * |
| situation.Fixed costs seem to vary from month | | | | "Sales"Simplifying the Sales terms:(3) "Fixed |
| to monthThis seems like a ridiculous | | | | Costs" = "Sales" times (1 - "Variable Cost % |
| statement. After all, what is a fixed cost, | | | | of Sales" - 0.1)Divide both sides of the |
| but one that is "fixed." Here are some | | | | equation by (1- 'Variable Cost % of Sales" - |
| reasons these numbers can bounce around:1) | | | | 0.1)(4) "Fixed Costs" / (1 - "Variable Cost % |
| the Bookkeeper may sometimes put an expense | | | | of Sales" - 0.1) = "Sales"Which is the same |
| in the wrong month2) there may be other | | | | as:(5) "Sales" = "Fixed Costs" / (1 - |
| bookkeeping errors, especially if there is | | | | "Variable Cost % of Sales" - 0.1)(6) "Sales" |
| more than one person making entries in the | | | | = "Fixed Costs" / (1 - "Variable Cost % of |
| books. What is booked as a cost of sales one | | | | Sales" - "ROS %")Rusty Luhring has spent the |
| month may be a fixed expense another month.3) | | | | last 27 years as a software entrepreneur. |
| some expenses are quarterly or annual (such | | | | His first startup was Ferox Microsytems, Inc. |
| as business licenses)4) you have unusual | | | | where he developed some of the first PC |
| legal or accounting fees that are not related | | | | based financial modeling software. The |
| to the level of salesGross profit margins may | | | | software was used primarily by large |
| also vary from month to monthThe mix of sales | | | | corporations for financial analysis and |
| may change from one month to the next, | | | | complicated planning models. Ferox grew |
| affecting your overall gross margin. Sales | | | | rapidly in the early years, and then hit a |
| promotions may reduce average prices. Tiered | | | | few bumps and almost went under. The |
| commission plans may cause average commission | | | | experience of surviving some pretty severe |
| rates to fluctuate.Owner compensation | | | | cash flow problems, and learning to focus on |
| distorts the breakeven calculationOwner | | | | the customer at the same time, inspired his |
| compensation consists of owner salary and | | | | second startup, Luhring SurvivalWare, Inc. |
| benefits, and possibly a few other expenses | | | | SurvivalWare ( went online in 2002, |
| such as the company delivery yacht or the | | | | dedicated to helping small business survive |
| European training seminars. Separating out | | | | and thrive. The SurvivalWare line of |
| these expenses and calculating a breakeven on | | | | software is designed to bring big company |
| what is left helps you figure out what the | | | | financial modeling and analysis to the small |
| number is you need to make to keep the | | | | business community by making it affordable, |
| business running. The theory is that in a | | | | and spreading the development costs of a |
| pinch, you can give up the perks and live on | | | | model over a large base of customers. There |
| a mere mortal's salary.The existence of debt | | | | is even a "Lite" version (also known as |
| service makes a cash breakeven a better | | | | Transaction Modeler) for those entrepreneurs |
| measureYou may or may not have a lot of debt | | | | who are in the middle of a cash flow crisis. |
| service. If you do have auto loans, equipment | | | | |