In my opinion, break even point analysis an essential concept for monitoring the health of an owner-managed business. When it’s done properly, it provides an effective early warning system that a business owner should pay attention to.
Practical Problems With Break Even Point Analysis
There are practical problems that make it difficult to transfer the simple classroom idea to the real world.
Financial Accounts And Even Management Accounts Rarely Show A Contribution Margin
Break even analysis requires the contribution margin to be identified per unit of sale or as a percentage of sales value.
The accounts will rarely show a pure contribution margin.
>>> Contribution Margin Is Your Real Income – Don’t Be Fooled By Sales
Any margin or gross profit number shown can contaminated with fixed costs deducted from sales or variable costs included in the overheads.
What Costs Are Variable And Based On What?
While the cost volume profit relationship is simple in theory, it is more complicated in practice.
Activity Based Costing shows that the way many accountants had allocated overheads to products is wrong and this produces misleading information.
This is because classifying a group of overheads together and allocating it to products on the arbitrary basis of direct labour hours or direct machine hours produces some big anomalies.
Instead, activity based cost analysis shows that costs tend to vary on different bases:
- on volume – the higher the volume, the higher the cost – this is the traditional assumed relationship
- on batches – the more batches and changeovers there are, the higher the costs.
- on products – the more different products there are in the range, the higher costs
- on transaction numbers – a lot of administration work is driven by the number of transactions
- on complexity of transactions – simple transactions and quick, easy and cheap to process but some transactions are much more complicated
- by sales value – the higher the value, the higher the cost
- by number of customers – some marketing costs are driven by the number of customers that need to be contacted
- by contribution value (e.g. sales commissions are best calculated this way and business interruption insurance is usually based on a variety of this measure.)
- by combination measures e.g. transport cost may vary based on tonne-mile or tonne-hour. The lorry is limited for what it can carry by weight but the time (and much of the cost) is driven by distance travelled or time spent travelling to allow for congestion.
and many other different drivers of actual cost.
What Costs Are Fixed?
Throughput accounting stressed that in the short term few costs are variable beyond materials and components, preferring to treat direct labour often as a fixed cost.
Over the longer term even many overheads will vary based on a big change in volume.
Fixed Costs Aren’t Fixed Over A Large Output Range
Instead they increase in a series of incremental steps as activity increases.
Extra employees are hired one at a time.
Existing employees are given pay rises to reward success and extra responsibility.
Even property costs have to increase when the need for space increases.
One Off Expenses Confuse The Analysis
The analysis can be confused by expenses driven by a deliberate management decision which won’t repeat.
For example, compensation paid to a senior manager who’s contract is terminated (e.g. 12 months salary) and the recruitment costs for a replacement (head-hunters fees can be 30 to 40% of salary).
These blips don’t belong to the regular operating rate of the business but if you take them out, there is a nasty habit to have some irregular costs every month.
The Break Even Point Will Vary Widely From Month To Month
The break even point is very sensitive to minor changes in fixed costs and contribution rates.
In my experience, these often seem to vary the same way causing a monthly BEP to swing up and down.
This makes it impossible to see any trend and takes away much of the value of the early warning system.
It’s better to track the calculation of a YTD basis to help smooth it and show a trend. However this sudden stop and start can be confusing in setting normal levels. With many December year ends, both December and January can be non-typical trading months because of the Christmas holidays and difficulties with the weather.
Moving annual totals can make even more sense of it although it means that the impact of any permanent change is slow to filter through.
Perhaps moving quarterly totals is a fair compromise although this will depend on the business.
It Assumes That Average Selling Prices And Variable Costs Are The Same As Marginal Prices And Costs
This is a bit complicated but it assumes that the next set of sales will be at the same prices and variable costs as the average of the existing sales.
In real life, to get extra volume, you may have to go to a customer who will demand a lower price.
Costs will also vary. Extra volume may trigger purchase discounts that reduce the average price or, if the business is already working close to capacity, extra production may require overtime and shift pattern payments.
The Mix Of Products May Play Havoc With The Contribution Rates
If you sell products with different contribution rates, a change in the mix can cause the calculation based on the average contribution rate to switch around sharply.
If the change in mix is permanent, then the business needs to adjust its expectations but it will send misleading signals if the mix is expected to return to normal.
There Are Practical Problems To Interpreting Break Even Point Calculations
In the real world, a simple break even point calculation can send misleading signals.
Like many accounting numbers, absolute accuracy needs to be replaced by a “true and fair” measure.
This isn’t a plea to get the break even point audited but to acknowledge that there are practical issues.
Do it right, and it can provide an early warning system that things are happening in the business that threaten the long term financial viability of it.
A low contribution margin rate can be dismissed as a blip in one month that doesn’t warrant serious investigation. If the problem continues for one or two more months, a detailed explanation is needed and the implications of this change need to be understood by all management – general, financial, sales and operations. Their combined decisions have created the problem.
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