is pretty obvious. It’s the point where you neither make nor lose money. It’s the point where you break even.
Examine the elements required to find the breakeven point: Fixed costs remain constant, regardless of the volume of products or services you provide. Variable costs increase or decrease proportionately with the number of products you sell or services you deliver. The total variable costs, of course, increase as you produce more products or provide more services, and vice versa if fewer items, products, or services are provided. Sales is the total dollar amount received for your product or service. Finally, profit represents sales less all your costs.
Okay, if you want to split hairs, there’s an exception about fixed costs that is important in analyzing cost-volume-profit: relevant range (see Chapter 1). But in most cases, the level of activity stays within the relevant range for fixed costs.
What makes the breakeven point so important is that every sale above your breakeven point generates a profit. If your breakeven point is 100 units, you make a small profit when you sell the 101st unit. That’s good! After you know your breakeven point, you can plan the level of sales you need to generate a specific amount of profit.
What goes up can come down. If you sell only 99 units, you have a small loss. That’s not good! The fewer units you sell, the larger your loss.
The breakpoint formula
Before you start selling a product, you need to know the fixed costs, the variable costs, and the sale price. See Chapter 2 for more on cost terms. You can use the cost and price information to determine how many units you need to sell to recover all your costs — your breakeven point. The formula is
Profit ($0) = sales – variable costs – fixed costs
Failing to get a grip on profit, loss, and breakeven point can be funny, at least on TV. Saturday Night Live did a skit years ago about “The Change Bank.” Its only business was to make change, and its tag line was “We can meet all of your change needs.” The owner was asked: “How do you make money just making change?” “Volume!” says the owner.
The joke in the Change Bank skit is that regardless of how much business you do, there’s no profit in making change for people.
A case in point (breakeven point, that is)
You own a software company, and you’re thinking about buying a booth at a technology trade show. You hope to sell your product to trade-show visitors. Before deciding to attend, you benefit from a little breakeven analysis.
You might say to yourself, “I’m not getting on a plane unless I can at least cover all my expenses. How many units do I need to sell to cover all expenses?”
That number is the unit sales needed to reach your goal. Say your application sells for $40 per unit, and you have variable costs of $20 per unit. Fixed costs amount to $1,000. Plug those numbers into the formula:
Profit ($0) = sales – variable costs – fixed costs
Profit ($0) = (units × $40) – (units × $20) – $1,000
Profit ($0) = units × ($40 – $20) – $1,000
Profit ($0) = units × $20 – $1,000
To finish this little piece of algebra, add $1,000 to both sides of the equation. Then divide both sides by 20: X = 50, or 50 units.
$1,000 = units × $20
$1,000 / $20 = units
50 = units
You need to sell 50 units at $40 per unit. If you don’t think you can sell at least 50 units of software, don’t get on the plane for the trade show.
Financial losses: The crash of your cash
When your unit sales are less than breakeven, you’re operating at a loss. And that could affect the cash you need to operate each month. You likely will need cash to pay expenses (such as rent, utilities, and salaries) before you collect cash from sales.
Every time you incur a loss, it’s likely your available cash balance will decline. Generally, losses reduce your cash balance; conversely, profits increase them. Assume your loss for the month is $1,000. After you collect cash on all your sales and pay cash for all the bills, your ending cash balance will be $1,000 lower than where you started.
Losses are the curse of business. After all, the business exists to generate profits. Maybe the only good news about a loss is that it gets you analyzing and fixing problems.
Contribution margin: Covering fixed costs
Variable costs probably won’t keep you up at night. It’s the fixed costs that may cause insomnia, whether you’re talking about trade-show cost, the monthly rent, or salaries you need to pay your employees each month.
You focus on covering fixed costs using the contribution margin (that is, sales less variable costs):
Contribution margin = sales – variable costs
Profit = contribution margin – fixed costs
You also can use contribution margin to compute your breakeven point in terms of units. Remember that the breakeven point is the sales needed to cover all your costs and to create $0 profit. Consider this formula:
Breakeven point in units = Fixed costs ÷ contribution margin per unit
If you sell a software application for $40, and variable costs are $20 (which just happens to be the same as in the trade-show example), each unit has a contribution margin of $20. If you have $1,000 in fixed costs, the formula looks like this:
Breakeven point in units = $1,000 ÷ $20
Breakeven point in units = 50
If you sell 50 units, you’ve covered your fixed costs. Any sales over 50 units are all gravy and put you in Profit Land.
Lowering the breakeven point to reach profitability sooner
The lower the breakeven point, the easier it is to achieve your sales goal. It takes less effort to break even if you can lower the number of units you need to sell. Would you rather have to sell 100 units or 500 units just to break even? There’s a big difference in time, effort, and financial risk between 100 and 500 units. Think of less effort as taking less risk.
You reduce your breakeven point by changing any one of
