Breakeven analysis is a cost accounting technique that helps potential business owners decide whether it is prudent to go into a particular line of business. The idea is to give the prospective business owner some reasonable idea of how much sales activity will be needed to breakeven.
Example. Eric Jong is currently the VP of operations at the Ping Pong Bong company. Having been passed over for a promotion he thinks he richly deserved, he is considering setting up his own wholesale bong distributorship. He needs to know how many bongs he would have to sell in order to breakeven.
The breakeven approach tackles this problem by distinguishing between fixed and variable costs. Variable costs are costs that vary with the volume of units sold. Direct unit manufacturing costs and sales commissions are examples of variable costs. Fixed costs, as the name implies, are costs that do not vary with sales volume. Insurance, office rent, and clerical salary are typical examples of fixed costs.
Example. Jong estimates that he can purchase quality bongs from manufacturers for $4 per unit. He expects the average sales price to be $20 per unit and that he will pay a 10% commission for each unit sold, or $2 per units. So his total variable unit costs are expected to be $6 per unit. He estimates his fixed costs in rent, insurance, and other overhead to be $28,000 per year.
To compute the breakeven point, the amount of sales volume needed to breakeven, the following formula is used:
X= Units needed to breakeven
SP= Unit selling price
VC = Unit variable costs
FC= Total annual fixed costs
Often the difference between the unit sales price and unit sales costs (SP-VC) is called the contribution margin (CM). Now the breakeven point in dollars is literally the point where total revenue less total expenses equals 0. So we can restate the above equation as follows:
Replacing (SP-VC) with CM yields:
Rearranging the terms in the above formula gives a new formula for the breakeven point in units:
In words this says that the units that must be sold to breakeven equals the total fixed costs divided by the contribution margin.
Example. Since Jong’s unit sale price is $20 and his unit costs is $6, his contribution margin, CM, equals $14. Dividing this into his expected fixed costs of $28,000 yields a breakeven volume of 2,000 units. You can check this formula by constructing an income statement.
So what does this tell Jong? It tells him that he has to be able to sell 2,000 bongs to just breakeven. But Jong, like most other business owners, needs to do better than just breakeven. He needs to pay himself for his time and effort and get a reasonable profit on his investments. So the above formulas need to be modified to accommodate a required salary and/or profit for the owner. Now this required return for the owner is really just another fixed cost. So the revised formula is:
Example. Let’s say that Jong’s current salary is $84,000 and he feels that he needs at least this much to justify going into business for himself. So taking (28,000+84,000)/14 yields 8,000 units. This means that if his projected unit revenue, unit costs and fixed costs are accurate, selling 8,000 bongs will yield him a profit or salary of $84,000. Now Jong has to decide whether he thinks that selling 8,000 bongs is really feasible or is just a pipe dream.
Precise numbers and formulas can lull us into thinking that we have greater knowledge than we actually have. In applying breakeven analysis or other cost accounting techniques simplifying assumptions and guesstimates almost always have to be made. Reality will almost always be messier than our formula answers would lead us to believe.
For example in most wholesale or retail businesses more than one type of product is sold. Each different product is likely to have different unit revenue and unit variable cost characteristics. The above breakeven model assumes only one product. To apply the model to a multi product firm requires taking average unit prices and average unit costs. Or perhaps averages weighted by the popularity of products sold. These simplifying assumptions can and will create distortions.
Another important factor in applying breakeven analysis is the fact that the distinction between fixed and variable costs is not always easy to make. Much depends upon the time frame involved. It is often said that in the very short run all costs are fixed and in the long run all costs are variable. How you slice costs between fixed and variable will have a great effect on the results obtained.
In most cases the results of the breakeven analysis should be considered a rough approximation of the kinds of volume needed to achieve desired results.