Study tips: Break-even analysis series
In part one we looked at the underpinning theories and principles behind break-even analysis which are crucial to understanding this tricky subject.
If you haven’t read it then it would be a good idea to do so before continuing as we are going to re-visit the idea of the four components of break-even analysis: sales, variable costs, fixed costs and profit.
Now I would like you to put yourself in the shoes of a business owner and think about what you would want to know about your business’s performance. Probably first on the list is whether it’s profitable. In order to answer that, you need to know how much is left of your sales income after you have covered all your costs.
Contribution is always the first calculation in any break-even analysis
By calculating the contribution we are removing the variable costs from the sales income thereby dealing with two of the four components.
Let’s say we manufacture beds. Each bed sells for £700 and has variable production costs of £450. The business has fixed costs of £500,000.
In theory, the variable costs can be avoided, so for break-even analysis we assume that they will be covered by the selling price and therefore deduct them to see what’s ‘left over’. In other words, the contribution. £700 less £450 means that we have a contribution of £250 per bed.
Break-even point is when we have enough contribution to exactly cover the fixed costs
As sales and variable costs have now been dealt with we can concentrate on component three, fixed costs.
By dividing the fixed costs by the contribution we can calculate how many beds we need to sell in order to have enough money to pay our bills. In this case, £500,000 ÷ £250 = 2,000 beds.
Note: be really careful about whether the figures you calculate represent monetary values or quantities as it is easy to get confused.
Break-even point can be described in a number of ways
The basic calculation we’ve just done tells us the number of units we need to sell in order to break-even. However, it may be more useful for us to know the value of the sales turnover required to break-even instead. They are fundamentally the same thing, just presented differently.
The simplest way to convert quantity to value, is to multiply the number of units by the unit value. In this case we know we need to sell 2,000 beds to break-even and that each one sells for £700. Therefore, we need sales turnover of £1,400,000 (2,000 x £700) in order to generate enough sales income to cover our variable costs and have exactly £500,000 left to pay the fixed costs thereby breaking even.
Profits are generated by the contributions made by sales after the fixed costs have been paid.
Sales less variable costs equal contribution and fixed costs divided by contribution tells us the break-even point. So the only component left unaccounted for is profit.
Let’s say we sell 3,000 beds. We know that we need to sell 2,000 beds to break-even and that each one makes a contribution of £250 (£500,000). Therefore, the 1,000 beds sold after we’ve reached the break-even point will generate £250 of profit each (£250,000 in total) as the fixed costs will have already been covered.
Break-even point is used as the basis of further analysis – target profit
There’s not much point being in business if you only break-even. However, knowing the break-even point is fundamental to being able to plan for profitable business growth. Let’s say that as the owner of our bed company we want to make £70,000 profit this year. That’s all well and good but now we need to back it up with information that is meaningful for our production and sales teams. In other words, how many beds do we need to sell to achieve it?
We already know we have to sell enough beds to cover our £500,000 fixed costs and at that point we are no longer making a loss. But we’re not making any profit either, so now we’re adding the target profit of £70,000. Therefore, we need to sell enough beds to cover both.
The fixed costs of £500,000 plus the £70,000 target profit equal £570,000.
£570,000 divided by the contribution of £250 tells us we now need to sell 2280 beds.
The first 2000 will provide enough money to pay the fixed costs and the remaining 280 will generate the desired profit (280 x £250 = £70,000)
Margin of safety
Sales targets can also be set in terms of value as well as quantity. In combination with the break-even point these forecasts can be used to provide useful management information.
If the break-even point is where we must be in order to exactly cover our fixed costs then we’re making a loss until we reach it, and that’s a dangerous place for a business to be. However, as soon as we sell one unit more than the break-even we are making a profit and that’s much safer for our business’s future.
If we have a sales forecast of 3,500 beds, that indicates where we’d like to be. The difference between where we must be and where we’d like to be is called the margin of safety (MofS).
Ideally this difference should be as big as possible, as the further we move away from the break-even point and towards our forecast, then the safer and more profitable we become.
The difference between our forecast of selling 3,500 beds and our break-even point of 2,000 beds is a margin of safety of 1,500 beds.
That’s the same as £1,050,000 worth of sales (the MofS in units x selling price). We needed £1,400,000 to break-even and if we sell all 3,500 beds that’s £2,450,000 but anywhere in the middle would be profitable and safe.
Finally, it’s often useful to know how safe we are as a percentage of our forecast. In this case it is 43%, which is calculated as the MofS divided by the forecast multiplied by 100 (1,500 ÷ 3,500 x 100 = 43). This means that 43% of the forecasted sales are on the safe side of the break-even point.
At the beginning of article one, we questioned why break-even analysis is such a tricky topic. I hope you now have a better understanding of what it actually means and how it is used. I also hope you’ll be able to work calculations out logically and will therefore forgive me for the lack of formulae.
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Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.