Whether you have a fledgling startup or an established business, one of your obvious goals is to make a profit. Usually, making a profit doesn’t happen overnight or by accident. Business owners typically spend time analyzing their financials and making deliberate tweaks in their operations in order to increase their profit.
Calculating the breakeven point is one way to determine which levers to pull in order to increase the profitability of a business. We love to help clients with this, because we believe that “the best way to succeed is to help others succeed!”
We’ll explain the basics of breakeven analysis, but first spend time on two key components of the breakeven point: fixed and variable expenses.
Determining Fixed and Variable Expenses
To calculate the breakeven point accurately, you must include all costs, both variable (directly tied to production) and fixed (overhead).
Start by creating a comprehensive list of all your business expenses. This should include everything, from the most significant costs like rent and salaries to smaller expenditures like office supplies and utility bills.
If your financials are up to date, you can easily access most of the information you need by pulling a Profit & Loss Statement. You may also wish to have several years worth of expenses in order to see which costs stay fairly constant and which ones vary over time.
Once you have your list of expenses, categorize them into two main groups – fixed and variable. Here’s how to distinguish between the two:
Fixed Expenses, aka Overhead
Fixed expenses are costs that remain constant regardless of your business’s level of production or sales. They occur regularly and don’t fluctuate with changes in revenue. They usually make up a significant part of a business’s total expenses. If you omit overhead costs, your breakeven analysis will be incomplete and may lead to incorrect conclusions about when your business will start generating a profit.
Examples of fixed expenses include rent or lease payments, salaries of permanent staff, insurance premiums, and equipment depreciation.
Variable expenses are costs that fluctuate in direct proportion to changes in your business’s activity or sales volume. As your production or sales increase or decrease, variable expenses also go up or down.
Examples of variable expenses include direct labor wages, raw materials or inventory costs, sales commissions, and shipping/packaging expenses.
Some expenses may appear to fit into both categories. A business owner who still does direct work on customer projects, for instance, may designate a percentage of their salary as variable expenses and put the rest into overhead.
You may have other semi-variable costs that are not a significant amount of your overall expenses. We suggest keeping it simple – just throw it in either the fixed or variable bucket and don’t overthink it! But be consistent in how you allocate that expense from month to month.
A company’s business structure will likely dictate whether owner’s compensation is fixed or variable.
In a corporation, owners typically receive wages through payroll. Decide whether you feel that is variable, semi-variable, or fixed, and stick with that. In sole proprietorships and partnerships, the compensation to the owner doesn’t typically appear on the Profit & Loss because it’s taken as an owner’s draw which is reflected on the Balance Sheet instead. This can make your net income look artificially good. You will want to factor in what portion of the owner’s draws are for “wages” and what portion is for “profits”. You’ll add in the wages component as an expense in your analysis.
Be sure that the owner’s salary is “reasonable,” so you’re not skewing your financials one way or the other. For example, let’s say a dentist takes $100,000 of draws and pays herself a salary of $75,000 for a total compensation of $175,000. The draws won’t show as an expense and you likely couldn’t hire many dentists for $75,000/yr. This means your profit will look abnormally good because you’ve manipulated the net income by artificially lowering the owner salary. The reverse may also be true if the owner takes a large salary, which would make the net income look abnormally low.
Calculating the breakeven point is a crucial financial analysis for businesses to determine the level of sales or revenue needed to cover all costs and reach a point of zero profit (neither profit nor loss).
The formula for calculating the breakeven point involves two main components: fixed costs and contribution margin.
Breakeven Point (in units) = Fixed Costs / Contribution Margin per Unit
Breakeven Point (in sales dollars) = Fixed Costs / Contribution Margin Ratio
Let’s break down the components of the formula:
Fixed Costs: Use the total of fixed expenses that you determined above.
Contribution Margin per Unit: The contribution margin is the difference between the selling price per unit and the variable cost per unit. It represents the amount of revenue that contributes to covering fixed costs and generating profit.
Contribution Margin per Unit = Selling Price per Unit – Variable Cost per Unit
Contribution Margin Ratio: This is the contribution margin per unit expressed as a percentage of the selling price. It’s useful when you want to calculate the breakeven point in sales dollars.
Contribution Margin Ratio = (Contribution Margin per Unit / Selling Price per Unit) x 100
Example of Breakeven Point
Calculating the breakeven point is a critical financial analysis that provides insights into the financial health and profitability of your business. It guides pricing strategies, financial planning, and resource allocation.
We’d love to help your business get to a higher level of profitability with a personalized, in-depth breakeven analysis. Contact us today!