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Break-Even Analysis

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Break-Even Analysis

This type of report is not one that is automatically generated by most accounting software, nor is it one that is normally produced by your accountant, but it is an important analysis for you to have and understand. For any new business, you should predict what gross sales volume level you will have to achieve before you reach the break-even point and then, of course, build to make a profit. For early-stage businesses, you should be able to assess your early prediction and determine how accurate they were, and monitor whether you are actually on track to make the profits you need. Even the mature business would be wise to look at their current break-even point and perhaps find ways to lower that benchmark to increase profits. The recent massive layoffs at large corporations are directed at this goal, lowering the break-even point and increasing profits.

Break-Even Is the Volume Where All Fixed Expenses Are Covered
You will start a break-even analysis by establishing all the fixed (overhead) expenses of your business. Since most of these are done on a monthly basis, donít forget to include the estimated monthly amount of line items that are normally paid on a quarterly or annual basis such as payroll taxes or insurance. For example, if your annual insurance charge is $9,000, use 1/12 of that, or $750 as part of your monthly budget. With the semivariable expense (such as phone charges, travel, and marketing), use that portion that you expect to spend each and every month.

For the purpose of a model break-even, letís assume that the fixed expenses look as follows:

Administrative salaries$1,500
Rent800
Utilities300
Insurance150
Taxes210
Telephone240
Auto expense400
Supplies100
Sales and marketing300
Interest100
Miscellaneous400
Total$4,500

These are the expenses that must be covered by your gross profit. Assuming that the gross profit margin is 30 percent, what volume must you have to cover this expense? The answer in this case is 15,000ó30 percent of that amount is $4,500, which is your target number.

The two critical numbers in these calculations are the total of the fixed expense and the percentage of gross profit margin. If your fixed expense is $10,000 and your gross profit margin is 25 percent, your break-even volume must be $40,000.

This Is Not a Static Number
You may do a break-even analysis before you even begin your business and determine that your gross margin will come in at a certain percentage and your fixed expense budget will be set at a certain level. You will then be able to establish that your business will break even (and then go on to a profit) at a certain level of sales volume. But your prestart projections and your operating realities may be very different. After three to six months in business, you should compare projections to the real-world results and reassess, if necessary, what volume is required to reach break-even levels.

Along the way, expenses tend to creep up in both the direct and indirect categories, and you may fall below the break-even volume because you think it is lower than it has become. Take your profit and loss statement every six months or so and refigure your break-even target number.

Ways to Lower Break-Even
There are three ways to lower your break-even volume, only two of them involve cost controls (which should always be your goal on an ongoing basis).

1. Lower direct costs, which will raise the gross margin. Be more diligent about purchasing material, controlling inventory, or increasing the productivity of your labor by more cost effective scheduling or adding more efficient technology.

2. Exercise cost controls on your fixed expense, and lower the necessary total dollars. Be careful when cutting expenses that you do so with an overall plan in mind. You can cut too deeply as well as too little and cause distress among workers, or you may pull back marketing efforts at the wrong time, which will give out the wrong signal.

3. Raise prices! Most entrepreneurs are reluctant to raise prices because they think that overall business will fall off. More often than not that doesnít happen unless you are in a very price-sensitive market, and if you are, you really have already become volume driven.

But if you are in the typical niche-type small business, you can raise your prices 4 to 5 percent without much notice of your customers. The effect is startling. For example, the first model we looked at was the following:

Volume$15,000
direct cost10,50070%
gross profit 4,500

Raising the prices 5 percent would result in this change:

Volume$15,750
direct cost10,50067%
gross profit 5,250

You will have increased your margin by 3 percent, so you can lower the total volume you will require to break even.

The Goal Is Profit
You are in business to make a profit not just break even, but by knowing where that number is, you can accomplish a good bit:

  • You can allocate the sales and marketing effort to get you to the point you need to be.
  • Most companies have slow months, so if you project volume below break-even, you can watch expenses to minimize losses. A few really bad months can wipe out a good bit of previous profit.
  • Knowing the elements of break-even allows you to manage the costs to maximize the bottom line.

    Once you have gotten this far in the knowledge of the elements of your business, you are well on your way to success.

    * Source Streetwise finance & Accounting

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