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