Tough, calculated business decisions have to be made every day to guide a company to financial success. Without adequate accounting information, how would you determine what actions were necessary to ensure profitability?
A good place to start controlling your company’s financial health is with understanding how to use break-even analysis.
What is a break-even point? It is simply the point where your costs equal your income and profit is zero.
The goal of break-even analysis is to determine:
1) The quantity of items that need to be sold to breakeven
2) How increases in quantity of items sold equates to profit.
3) How changes to the financial variables (increases and decreases in costs of goods sold and variable sales related expenses) affect profit.
What are the financial variables that go into computing a break-even analysis?
1) The quantity of items sold
2) The average price of a sale
3) Fixed costs. Fixed costs are expenses that do not change. They are basically the same month in and out regardless of the quantity of items sold. For example, rent, utilities, administration labor costs.
4) Variable costs. Variable costs change directly with the number of items sold. For example, your delivery costs will increase proportionately with increases in the number of items sold. If your salespeople are paid on a commission of sales, your sales costs will increase proportionately with the number of items sold. The cost of raw materials and labor to manufacture a product represent your cost of goods sold and are variable costs.
How to calculate the break-even point.
First you will need to compute from your financial records your:
1) Average variable costs per unit (AVC)
2) Total fixed costs (TFC)
3) Average sale price per unit(ASP)
For our example let’s assume:
AVC equals $500.00
TFC equals $100,000.00
ASP equals $1,000.00
Total revenue (TR) = $1,000.00 (ASP) x quantity of units sold (Q)
Total Cost (TC) = $100,000.00 (TC) + ($500.00 (AVC) x quantity (Q)
The goal is to determine the quantity (Q) to breakeven. The equation is:
ASP x Q = TFC + (AVC x Q)
$1,000.00 x Q = $100,000.00 + ($500.00x Q)
To find Q subtract $500.00 from each side of the equation leaving:
$500.00 x Q = $100,000.00
Q = $100,000.00 divided by $500.00
Q = 200
In this example you need to sell 200 units to breakeven.
If you sold 300 units what would be the profit? Use the formula to do the math. Your answers are:
TR = $300,000.00
TC = $250,000.00
Profit = $50,000.00
To manage the financials of a business responsibly requires knowing the companies breakeven. You must know how many items you need to sell in order to breakeven. You must know how changes in selling prices and/or any of your costs affect profit so you can make informed decisions about how to maintain or improve profit performance.
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