Break-even analysis allows you to determine the business revenue necessary to pay all your expenses. Break-even analysis is a simple and powerful financial-management technique related to business profits. At the break-even point, a business doesn’t make any money, but it also doesn’t lose any money. In general, you want to know a business’s break-even point because it represents a sales level you must surpass to make money.
The Trick to Calculating Break-Even Points
To calculate a business’s break-even point, you need to determine the total fixed costs of a business and its gross profit margin as a percentage. A business’s fixed costs are those expenses a business must pay regardless of the sales volume.
In a retailing business, for example, fixed costs probably include rent, salaries of sales clerks, and other overhead expenses such as utilities and insurance. If a business’s fixed costs include $20,000 in monthly rent (which also includes utilities and property insurance) and $40,000 in salaries, the business’s fixed costs equal $60,000 a month.
A business’s gross profit margin percentage is the difference between sales and its variable costs expressed as percentage of sales. You can calculate the gross margin percentage either on a per-unit basis or by using total sales and total variable costs.
Suppose you want to calculate the gross profit margin on a per-unit basis. If you own a retailing business that sells T-shirts for $20 and the T-shirts cost you $10, your gross profit margin per unit is $10 or, restated as a percentage, your gross profit margin is 50 percent, calculated as $10 divided by $20.
To calculate a break-even point, you figure out how much gross profit margin needs to be generated in order to pay for the business’s fixed costs. In the case of the T-shirt retailing business with $60,000 of fixed costs and an 50 percent gross profit margin, the retailer must sell enough T-shirts so that the gross profit earned on the T-shirts pays the fixed costs.
To calculate the T-shirts that must be sold to break even, use the following formula:
Break-even point = (fixed costs/gross profit margin)
In the case of the T-shirt retailing business, for example, you can calculate the number of T-shirts that must be sold to break even like this:
Break-even in units = ($60,000 fixed costs/50 percent)
When you divide the $60,000 by 50 percent, you calculate the sales necessary to break even: $120,000. At $20 a T-shirt, this works out to 6,000 T-shirts.
You can test this number by creating a worksheet that describes the income and expenses expected if the retailer sells 6,000 T-shirts, as shown here:
|Income (6,000 $20 t-shirts)||$120,000|
|Var. Exp. (6,000 $10 t-shirts||$60,000|
|Profit (or Loss)||$0|
Using Quicken or QuickBooks to Make Break-Even Calculations Easier
The preceding discussion described how you can determine your business’s break-even point if you know your fixed costs and your gross profit margin. As a practical matter, however, you probably don’t know these two figures—at least not right off the bat. Does not knowing them mean you can’t calculate your break-even point? No, you can easily use Quicken or QuickBooks to develop the raw data you need.
To collect the raw data you need for your break-even analysis, you set up a couple of classes: one named Fixed, for tracking your fixed costs, and one named Variable, for tracking your variable costs.
To set up classes for segregating your fixed and variable costs, follow these steps, choose the Lists → Class command to display the Class List window. In Quicken, you then click the New command button to display the Set Up Class dialog box, which you use to name and describe the class. In QuickBooks, you click the Class button and then choose the New command to display the New Class dialog box, which you use to name and describe the class.
Note that you need to set up two classes: one for the fixed costs and one for the variable costs. Once you set up the Fixed and Variable cost classes, classify each cost you incur as either fixed or variable. Things such as rent, utilities, insurance, and salaries are probably fixed; items such as sales commissions, costs of products or services you sell, and delivery or freight charges are probably variable. To classify an expense as either fixed or variable in Quicken, follow the expense category with a forward slash and the class name. To classify an expense as either fixed or variable in QuickBooks, enter the class name when you record a check or bill.
To see what fixed and variable costs you’ve incurred in a year or month, produce a Profit and Loss statement that summarizes costs by both category and class. This will give you the total fixed costs—one of the pieces of data you need.
To calculate your gross profit margin, you can use the total sales and total variable costs figures and the following formula:
Gross profit margin = (sales – variable costs)/sales
If you need help performing break-even analysis, please contact us to set up an appointment. If you’ve got good financial records, we can probably come up with a rough break-even point quite quickly.
You should also know that once you begin breaking down your cost costs into its fixed and variable components that you can rather easily perform what’s known as profit-volume-cost analysis. Profit-volume-cost analysis lets you forecast how your profits change as sales volumes change. Profit-volume-cost analysis usually produces wonderful data for the business owner to use in planning and managing his or her business.