Business Tip: Determining break-even point
June 26, 2012 at 1:26 a.m.
By Levi Farias
When working with clients and determining the feasibility of a project the topic of break-even comes up quite often.
So what is break-even?
The break-even point is where cost, both fixed and variable, has been covered and the business is neither making nor losing money. Most business owners would like to stretch beyond this point into the area where profit is made. However, in doing so many can lose sight of the break-even point and all of the information it can provide.
The first step in determining this number is splitting up costs into two categories: fixed or variable.
Fixed cost is an expense that has to be paid every month whether sales are made or not. Examples of this can be rent, insurance, utilities, etc.
Variable costs are expenses incurred that vary with sales. Examples of variable costs can be commissions, direct labor, raw materials, etc.
The next step is to determine the variable cost percentage, which is the amount of variable cost divided by sales in a percent format.
Variable cost percentage equals variable costs / sales
The next step is to figure out the contribution margin, or the amount of money left after variable costs are paid. This money goes toward fixed costs and profit.
Contribution margin equals 100 percent - variable cost percentage
Now that the contribution margin has been determined the break-even level can be calculated by dividing the fixed costs by the contribution margin.
Break-even level equals fixed costs / contribution margin
So how can I use this tool?
The most obvious benefit from all this work is being able to determine the level of sales necessary to cover costs and start making money. Another way to utilize break-even is when you are considering making a purchase.
For example if you are considering buying a new truck but aren't quite sure how it will affect the bottom line, using break-even will help you determine exactly how it will affect profitability.
For this example, the break-even point is determined by dividing the fixed cost by the contribution margin. So in order to get an idea of how that new truck will affect your bottom line, you simply add the projected cost of the new purchase to the current level of fixed cost. This equation will produce a higher break-even level than the original, and the difference between the two is exactly how much the new purchase will lower overall profitability.
Simple tools like these can give you, the small business owner, more information, which turns into better decisions for the company and its employees.
Levi Farias is a business advisor at the University of Houston-Victoria Small Business Development Center.