Breakeven Analysis



Breakeven Analysis

Breakeven analysis is a tool used to determine whether a business can cover all of its expenses and begin to make a profit. To calculate your breakeven point you will need to identify your fixed and variable costs. Fixed costs are expenses that do not vary with sales volume, such as rent or administrative salaries. These costs have to be paid regardless of sales and are often referred to as overhead costs. Variable costs vary directly with the sales volume, such as the costs of purchasing inventory, shipping, or manufacturing a product.

The break-even point is defined as the point where sales or revenues equal expenses. There is no profit made or loss incurred at the break-even point. This figure is important for anyone that manages a business since the break-even point is the lower limit of profit when setting prices and determining margins. Obviously the break-even point becomes very important when calculating a strategy for net profit.

The break-even margin is a ratio that shows the gross-margin factor for a break-even condition. The formula is total expenses divided by net revenues multiplied by 100 to get a percentage. This ratio is helpful when setting prices, with competitive bidding and when negotiating contracts with vendors and accounts.

The dynamics of the break-even point and the break-even margin show managers the impact of their decisions. In purchasing, costs can be lowered by bulk purchasing, negotiating price/ terms or finding new suppliers. Revenues can be improved by increasing value to the customer or offering non-price concessions. It must be remembered that increasing profits by simply increasing margins is a risky strategy. Unless the consumer perceives higher value, increased prices may negatively impact sales. The customer ultimately decides benefit, value and sales.

When looking at break-evens it is also helpful to look at fixed and variable costs. Fixed overhead is steady and can be factored in quite accurately. Variable costs are not as simple to calculate but in many industries variable costs follow certain percentages or ratios so they are easier to project.

It is also helpful to look at break-evens on a daily, weekly, monthly and yearly basis. Many construction companies base their bids on when they hit their yearly break-even. Once that point is reached they can make their bidding more competitive to stay busy and profitable.



Breakeven Analysis

Breakeven is the point at which your business neither loses money nor makes a profit - in other words the volume of sales at which your revenues exactly match the cost of operating your business...

Doing an analysis of where your firm's breakeven point lies is a fast and effective way of assessing its level of profitability.

A breakeven analysis is a technique used to work out exactly how many items or units you need to sell in order to cover your total expenditure. Sell more products and you start to make profits: sell fewer and you begin to lose money.

Fixed and variable costs

Your breakeven analysis will have to take into account your fixed costs such as premises and your variable costs – i.e. costs that vary according to your levels of production or activity such as inventory or raw materials.

It will also take into account and the unit price - i.e. the revenue generated from each sale.

A simple example of how to work out your breakeven point is as follows: A shop buys bread from a large bakery and sells it to the public.

The shop sells 200 loaves of bread per day @ $1.50 per loaf

Sales = $300

Each loaf costs the shopkeeper 50p.

Cost of goods sold = $100

The shopkeeper's daily operating costs = $200

Profit/loss = $0

In other words, with the price at $1.50 per loaf, the retailer must sell 200 loaves per day to reach the break even point. These figures are useful because they enable the store owner to weigh up the benefits and drawbacks of changing his prices.

If they were to charge $1.40 per loaf, they might find that they can sell 275 and, presuming his operating costs stay the same, they will make a profit of $20 per day.

If they were to increase his prices, they may sell fewer loaves but make more profit. If they charged $2.00 per loaf and only sold 180, they would still make a profit, this time of $52.

Knowing where your business's breakeven point lies is a must when fixing prices and it enables you to set up "what if" scenarios to see what impact a change in sales or prices will have on your bottom line.

In equation form, the breakeven point is when:

Sales revenue - Variable costs - Fixed costs = 0.

Breakeven analysis is a tool used to determine when a business will be able to cover all its expenses and begin to make a profit. For the startup business it is extremely important to know your startup costs, which provide you with the information you need to generate enough sales revenue to pay the ongoing expenses related to running your business.

A startup business owner must understand that $5,000 of product sales will not cover $5,000 in monthly overhead expenses. The cost of selling $5,000 in retail goods could easily be $3,000 at the wholesale price, so the $5,000 in sales revenue only provides $2,000 in gross profit available for overhead costs. The breakeven point is reached when revenue equals all business costs.

To calculate your breakeven point you will need to identify your fixed and variable costs. Fixed costs are expenses that do not vary with sales volume, such as rent or administrative salaries. These costs have to be paid regardless of sales and are often referred to as overhead costs. Variable costs vary directly with the sales volume, such as the costs of purchasing inventory, shipping, or manufacturing a product.

Forecasting future sales is a crucial part of setting up and running a business as well as an essential part of business planning. The future is always uncertain but you need to be able to make credible, evidence-based projections in order to help you plan your business strategy.

A sales forecast is a month-by-month financial projection of the amount of revenue that a business expects to generate from the sales of its products or services. It is not simply a quantitative calculation, but also involves detailed consideration of various external market issues affecting the business. Forecasting therefore is both an art and a science.



Forecasting sales is necessary for a number of important business purposes:

  • To establish that the business is viable: to demonstrate that the business is likely to generate enough sales to make it a viable proposition, especially in the case of start ups, and to provide reassurance that it will eventually reach profitability even if this takes some time to achieve.
  • To plan and manage cash flow: to use in a business plan to obtain funding, and to avoid unforeseen cash flow problems by establishing whether you will need to inject capital or borrow funds.
  • To plan future resource requirements - for example, the number of staff needed to achieve your planned sales. An accurate sales forecast will also help in ordering the correct amount of stock.
  • To plan production and marketing activities. It should indicate which products are the most successful, identify sales trends and help decide where to direct future investment.
  • To set goals and targets for the business.
  • To allow you to compare your actual sales with your forecast, understand the differences and use this information to produce new forecasts.

Sound market research will always form the foundation of your business plan, and this will be a crucial factor in obtaining funding.

A sales forecast in a business plan should show sales by month for at least the next twelve months, and then by year for the following two years. Three years, in total, is generally enough for most business plans.



The sales forecast should be prepared after consideration of the following issues:

Market awareness

  • Is there an established market for your product?
  • What is the size of the market?
  • Is the market growing or declining, and if so, by what percentage each year?
  • Which factors are currently influencing that market?
  • What may influence it in future?
  • How do seasonal factors affect purchases of your product or service?
  • Which trends or fashions are relevant to the sector?

Customer knowledge

  • Develop a clear picture of your existing and potential customers.
  • Be realistic about how many of these customers will wish to purchase your product.
  • Detailed customer profiling can help determine strategy by enabling you to focus on niche markets, and hence affects pricing policy and sales forecasts.

Capacity

  • Make sure that the sales forecast is within the limits of your production capacity.
  • How will any possible future changes in personnel or the size of marketing budget impact on future capacity to produce or to meet sales targets?

Competition

  • How many competitors do you have? Even if your business appears to be unique, new competitors are likely to enter the market once you have done the groundwork to raise market awareness. If there are already many competitors this will probably indicate that there is an established market for your services.
  • Be clear about how your products and services fit into the marketplace. How can you differentiate your business from your competitors' businesses?
  • You may need to be flexible with regard to pricing and the range of products and services offered.

External factors

  • Political, economic, socio-cultural, technological, environmental and legal (PESTEL) factors, such as energy prices, seasonal trends, interest rates, legislation, political and health issues, may all have an impact on your future plans.
  • How do the economic climate and other external factors impact on your business and on your customers' attitudes and inclination to buy your type of product or service?

For the start-up business it is extremely important to know your start-up costs, which provide you with the information you need to generate enough sales revenue to pay the ongoing expenses related to running your business.



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