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