Breakeven analysis is a conceptually simple but practically a little difficult tool that is used to examine the implications of profitability. An example of breakeven analysis is the best way to understand how to use this tool.
This page comes under the section Small Business Management.
Breakeven analysis is a high value tool that enables you set targets for achieving profitability and positive cash flows. We will learn about this technique by looking at a few examples. We review some major examples of breakeven analysis, including how breakeven analysis could be used as a planning tool at your small business start. We also look at the limitations of breakeven analysis so that you won't use it inappropriately.
Before we look at the examples, let us review the concept of breakeven analysis, in case you are unfamiliar with the term.
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If you are a businessperson, you will have observed that certain costs, such as rent, insurance, license fees, part of payroll and maintenance costs, among others, tend to remain constant month after month. These costs are not related to the level of production operations. We can call them FIXED establishment costs.
You would also have observed that certain other costs, such as raw materials, shipping costs, sales commissions and other direct production or sales related costs tend to vary with levels of production and sales. We call these VARIABLE costs.
If your sales revenue exceeds your variable costs during a period, you get a surplus that goes firstly to recover your fixed costs, and then to generate surplus profits. This surplus is called the CONTRIBUTION made by sales. It is this contribution that determines your profitability.
The contribution depends on two things. Firstly, it depends on SELLING PRICE. The higher your selling price, the greater the contribution per unit sold. Secondly, contribution depends on the VOLUME of sales. The more units you sell, the more total contribution you generate.
| Total revenues for a small business | = 50000 |
| Total direct expenses incurred | = 35000 |
| Revenues minus Direct Expenses, i.e., Contribution | = 15000 |
| Rate of contribution per unit of revenue | = 15000/50000, i.e., 30 cents |
| Total 'fixed' establishment expenses | = 24000 |
| No of units that must be sold to recover fixed expenses | = 24000/0.30 = 80000 |
The breakeven level of sales for this business is 80,000 units. Only 50,000 units are being sold now. That means this business is incurring losses. The amount of losses would be the contribution that would have been generated by the shortfall in units sold, i.e, 30,000x0.30 = 9,000. You can check this as follows:
| Total revenues for the small business | = 50000 |
| ===== | |
| Total direct expenses incurred | = 35000 |
| Total 'fixed' establishment expenses | = 24000 |
| Total expenses | = 35000+24000, = 59000 |
| ===== | |
| Excess of expenses over revenue | = 59000 - 50000 = 9000 |
| ===== |
Developing a business plan is a basic requisite at small business start. And business plans start with an estimate of the sales levels. Estimating this level is extremely difficult for a new start up business. Breakeven analysis comes to your help in this situation.
It could go something like this:
| Estimated establishment expenses total | = 30,000 |
| Direct costs per unit, as estimated by technical people | = 24 |
| Prevailing market price per unit for this product | = 30 |
| Rate of contribution per unit of revenue | = 30 - 24 = 6 |
| Level of sales at which establishment costs will be recovered in full | = 30000 / 6 = 5000 units |
Now that we know at what level we could recover our fixed establishment costs, we could look at the market and decide whether we would be able to sell more than 5000 units at a selling price of 30 to operate profitably.
Pricing DecisionsIn our last example, we decided to price our product at 30 per unit, i.e., the prevailing market price. And found that we need to sell 5000 units to break even. Suppose we decided that it wouldn't be possible to achieve that level with that price.
So we think about pricing at a lower level to attract business. We fix a new price and check the volume required to become profitable. And check whether we could sell the required volumes.
| New price per unit | = 28 |
| Rate of contribution per unit of revenue | = 28 - 24 = 4 |
| Level of sales at which establishment costs will be recovered in full | = 30000 / 4 = 7500 units |
If we could sell 7500 units at the significantly lower price, the lower pricing could be justified.
This is a common example of breakeven analysis, but one that is more practicable after we have gained some experience in the market and have become aware of price sensitivity and customer response.
Breakeven analysis can thus provide decision support information in different situations.
All the examples of breakeven analysis given above reveal one thing. Break even analysis analyzes the situation as at a particular time, and within a particular environment, i.e., breakeven analysis is a static tool.
Fixed costs are fixed only within a certain range of activity, and during a particular period. So, you have to be careful that your projections do not extend beyond these activity and time limits.
Breakeven analysis does not consider the possibility of alternative uses for the existing facilities. For example, you might be able to earn a higher return by leasing out your facilities, or using them to produce some other product. You would notice from the examples of breakeven analysis that none of them consider such alternative uses of existing facilities.
Breakeven analysis also does not factor in interest costs. Cash received after a year (or later) has to be discounted to a present value using current interest rates. Otherwise, the apparent returns might be fictitious. You might be paying interest higher than this return, or you could get higher returns by lending the money (to a bank, for example).
Breakeven analysis is a simple tool, and also cheap. An alternative, a full-fledged discounted cash flow analysis, could prove far more expensive. So do a breakeven analysis first, and then decide whether further analysis is worthwhile.
In the examples of breakeven analysis, we assumed that it would be a simple matter to segregate fixed and variable costs. In practice, you might find that some costs are a mix of both - part fixed and part variable.
In such cases, you have two options.
For a small business, the second option might be the practicable option.
Return to Section Main Page Managing a Small Business
This chapter explains breakeven analysis--how much (or how much more) you need to sell to pay for a fixed investment--another financial tool that many managers find useful in making decisions. The chapter elucidates this and several other concepts that that every manager should understand (fixed costs, variable costs, contribution margin, and operating leverage) to determine at what point you will break even on your cash flow and when you will exceed it.
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