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Understanding Your Breakeven Point
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An excerpt from the book The Playbook To Managing Your Business By The Numbers
The breakeven point is a critical number to know in managing a business, particularly for any business that is not abundant in profit. A company's breakeven point refers to the exact amount of revenue needed to generate zero net income - no profit and no loss. The breakeven point is a function of contribution margin (which is gross profit minus all other variable expenses) and fixed expenses. A low breakeven point is preferred over a higher breakeven point, because a lower breakeven point means the minimum revenue needed to cover expenses is lower, and therefore easier to earn. A company's breakeven point lowers when fixed expenses decrease or when contribution margin as a percentage of revenue increases.
A breakeven point is usually stated in dollars, such as “our breakeven point is $50,000 in monthly revenue” but can also be calculated in units, such as “our breakeven point is 1,850 billable hours in a month.”
To illustrate the breakeven point, let’s assume in a particular month a company has fixed expenses of $250,000, gross profit margin of 55% and variable operating costs (in this case sales commissions) of 10% of revenue.
That means for every dollar in revenue generated, 45% goes to cost of goods sold, leaving a 55% gross profit margin, and then another 10% goes to sales commissions. So, 55% of all revenue dollars are variable. In this situation, we would say that the contribution margin is 100% - (45% for COGS + 10% for other variable costs = total of 55% variable costs) = 45%. In this example, 45 cents out of each dollar in revenue “contributes” towards fixed costs and profit – hence the term “contribution” margin.
To calculate the breakeven point in dollars, divide the fixed costs by the contribution margin. $250,000 / 45% contribution margin = $555,555 in revenue ended to break even, producing no revenue and no loss.
To work the calculation backwards and prove the math:
• Revenue: $555,555
• COGS: $250,000, or 45% of revenue
• Gross Profit: $305,555
• Variable Costs: $55,555, or 10% of revenue for sales commissions
• Contribution Margin: $250,000
• Fixed Expenses: $250,000
• Net Income: $0. That’s called “breaking even”.
If our business provides hourly services and our average bill rate is $150/hr, the breakeven point can be calculated in hours as $555,555 / $150 = 3,704 billable hours needed to break even.
If a company sells products at a sales price of $125 per unit, the breakeven point can be calculated in units as $555,555 / $125 = 4,444 units needed to break even.
A business might want to calculate the cash-basis breakeven, because the revenue needed in order to report zero net income on the income statement might be different than the revenue needed in order to be cash-neutral. Differences between cash and net income might include regular loan payments or planned distributions for the owner based on profits earned in a prior period, or to back out of the calculation that one of the costs impacting net income is depreciation, a non-cash expense. In this case, adjust the fixed expenses number higher for additional cash outflows that need to be covered by the revenue earned, and reduce the fixed expenses by any non-cash costs, such as depreciation.
A business that is performing better than the breakeven point has a margin of safety. The margin of safety refers to the sales above the breakeven point. For example, if a company is currently selling 4,000 units and it has calculated that the breakeven point is 3,600 units per month, the margin of safety is 400 units, the difference between those numbers.
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