Break Even Point Analysis is a very simple to understand financial model of a business which I believe every business owner should understand.
It can be quickly used to help guide business decisions that will impact on the financial performance of the business.
When I have taught this idea to business owners and managers in Finance For Non-Financial Managers courses, the people have been amazed at how the financial fog lifts and things start to make sense.
A Quick Summary Of Break Even Point Analysis
A business is said to break even when it operates at a sales level that neither makes a profit or loss.
The two big issues to focus on are:
- Costs can be split into two categories – those that vary directly with sales volumes and those that are fixed over a short time period.
- Contribution margin rather than sales revenue is the real income of a business.
The Break Even Point Formula which calculates the break even point is:
Fixed Costs
Contribution % or Contribution per unit
For a deeper understanding on the topic of break even point analysis please read the following articles:
>>> Why Break Even Point Analysis Is Important
>>> The Cost Volume Profit Relationship
>>> How To Calculate The Break Even Point Of A Business
>>> Contribution Margin Is Your Real Income – Don’t Be Fooled By Sales Revenue
>>> Practical Problems With Break Even Point Analysis
>>> What Is The Margin Of Safety In Break Even Analysis And Why Is It Important?
>>> The Dangers Of Fixed Cost Creep
How Break Even Analysis Can Guide Financial Decisions
Let’s take a look at a few decisions a business owner has to make and you’ll see how easy it is to use Break Even Analysis to see if the idea makes financial sense and to make an assessment of how risky the decision could be.
The Business Details
It is a commercial stationery wholesaler which sells office products it buys in to businesses within a 15 mile radius of its location.
The simple Profit & Loss Account look like this:
Sales Revenue = £1,200,000
Cost of Sales = £864,000
Carriage Costs = £36,000
Contribution Margin = £300,000
Overheads / Fixed Costs = £260,000 (including a salary for the owner of £35,000)
Operating Profit = £40,000
Interest Payable = £10,000 (on a bank overdraft used to finance working capital)
Profit before Tax = £30,000
Corporation Tax = £6,000
Profit After Tax = £24,000
The contribution margin as a % of sales = 25%
The Break Even Point Of The Business
Break even point is normally calculated on profit before interest and tax.
That would make it (Fixed Costs/Contribution%) = £260,000/25% = £1,040,000
It could be calculated to include the interest payable by adding that cost to fixed costs.
Break even point (after interest) = (260,000+10,000)/25% = £1,080,000
Decision 1 – Should The Business Reduce Prices By 5%?
The business employees one salesperson who is regularly moaning that prices are too high. he says that if they cut prices by 5%, he could sell an extra £200,000.
Let’s put to one side whether the salesman’s estimate is at the old 100% price or a proposed 95% and see what the sales revenue would be needed to maintain the contribution margin at £300,000.
Effectively this is making sure that the proposal breaks even compared to the current situation.
If prices are reduced by 5% for all sales, the margin changes from
(sales revenue – cost of sales & carriage)/sales revenue
(100-75)/100 = 25%
to
(95-75)/95 = 20/95 = 21.05%
Note that although prices are reducing by 5%, the margin is reducing from 25% to 21.05%. This makes it hard to estimate the impact of price changes on margins percentages and you should always calculate rather than take a guess).
We can now use the Break Even Point Formula but our objective is not to break even and cover fixed costs but to make sure that contribution stays at £300,000.
We therefore put £300,000 into the equation and divide it by the new contribution margin to find the new sales revenue needed to generate £300,000.
300,000/21.05% = £1,425,178
The original sales revenue was £1,200,000 so the increase needed to maintain the total contribution margin is £225,178.
The sales person’s estimate of an extra £200,000 isn’t enough.
Even if he had estimated a potential increase of £300,000 and he was talking about revenue based on the new prices, any price reduction would still have been risky.
The contribution on (£1,200,000 + £300,000) at 21.05% is £315,750, a potential gain of £15,750.
That doesn’t sound enough to me to justify:
- Needing extra working capital to support the increase in sales. As the company has an overdraft, this money will have to be borrowed and, assuming the bank will lend it, interest payable will increase.
- Since the proposal is based on increasing sales by taking business away from competitors, there is a high chance that competitors will react and reduce their prices by 5% as well. that will leave the business with its existing sales but at a lower margin.
Decision 2 – Should The Business Employ Another Sales Person?
The business owner doesn’t accept that price is the problem and thinks that the salesperson doesn’t make enough sales calls. His solution is to hire another sales person and keep prices the same.
The second sales person will add £40,000 to fixed costs, what is the minimum level of extra sales needed to keep Operating Profit the same?
This time there is no fiddly calculation for the contribution margin. It is a straight application of the standard break even point formula with the increase in fixed costs inserted.
£40,000 extra fixed costs/ 25% margin = £160,000
The new sales person will need to generate an extra £160,000 of sales to cover his or her costs.
The business owner believes a good, committed sales person should generate £500,000 of extra sales.
This would:
- Increase contribution by £125,000 (£500,000 * 25%)
- Increase Operating Profit by £85,000 (£125,000 extra contribution minus the costs of the new sales person of £40,000).
These extra sales will make need significant financing because customers are slow to pay. The business will have to borrow more money from the bank but the business owner believes the bank will support the proposal.
With such a big increase in Operating Profit and just £160,000 of extra sales needed to cover the costs, there is plenty of allowance for the risk that the new salesperson may not work out as well as expected or may take time to build up a presence in the area.
Decision 3 – Should The Business Increase Prices By 5%?
The accountant is concerned at how close the business is its overdraft limit and doesn’t believe the bank will increase the facility. In fact she thinks that if the business asks for an increase, the review might cause the bank to want to reduce the overdraft limit.
She believes the salesman is lazy and discounts the price at the first sign of any resistance from the buying up to his maximum allowed discount. She believes the business should increase prices and be prepared to let some of the most price conscious customers take their purchases elsewhere.
Can we calculate how much sales would need to reduce to keep the contribution margin at £300,000.
The new margin will be (105-75)/105 = 28.57%
Note the price has increased by 5% but the contribution margin % has only increased by 3.57%.
Using the £300,000 minimum contribution in the Break Even Formula,:
300,000/28.57% = £1,050,053
i.e. sales can fall by £149,947 (from £1,200,000) to keep the same contribution.
Will a 5% price increase cause sales revenue to fall by 15%?
Possibly but perhaps not.
It might be worth testing a smaller increase of averaging 2% to see what happens.
Few people do a lot of checking on the prices of stationery although some headline items may be monitored e.g. photocopier & computer printer paper. The price of these very competitive items could be held constant and the other items increased by more than 2% to make up.
Simple Financial Analysis Helps You Make Decisions
Can you see how some simple financial analysis helps you to work out the financial impact of a decision.
You can normally have two numbers to compare:
- What you think will happen; and
- What needs to happen for the decision to break even.
Contribution Margin Calculations
When you are working in monetary units and you look at pricing decisions, the impact on margins are hard to estimate.
You need to calculate them using this formula:
The new margin is
(old selling price + price change) – cost of sales
(old selling price + price change)
This makes it hard to see the volume effect and the price effect because they are bundled in together.
If you calculate break even point in terms of sales volumes using the Contribution Margin Per Unit, what is happening is brought better into focus.
The new contribution per unit = the old contribution per unit plus the price increase per unit.
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