In theory, a professional football team has sixteen games in a season to generate revenue to ensure there is enough cash to stay in business during the remaining thirty-six weeks of the off-season. In fact, although perhaps not as extreme, most businesses deal with some degree seasonality, and understanding how to adjust for inevitable fluctuations can keep a business out of a distressed situation.
Break-even is one of the more universally recognized but least effectively utilized key performance indicators (KPI). When understood as a function of management, operational adjustments based on predictive break-even analytics can have more impact on the success and competitiveness of a business than virtually any other managed KPI.
In cost-based accounting, break-even is the point of balance where:
Revenue is equal to costs or expenses
The number of units sold covers all of the expenses incurred to sell the units
The profit threshold has been crossed in a calendar year, month, week, day or hour
Once break-even has been reached, every additional dollar of revenue represents pure profit. Equipped with this understanding, large companies are able to project when to “slash prices” to levels oftentimes lower than the cost paid by their smaller competitor and still yield a significant profit. When there are no more expenses, items can be sold at any price, even below cost, and still remain profitable. Break-even understood and effectively utilized can give management greater control of the both the profitability of individual items as well as the overall profitability of the firm.
Reaching the Profit Threshold
A simple formula to determine a firm’s overall break-even is:
Fixed Costs ÷ Contribution Margin Ratio
Where Contribution Margin Ratio = (Sales Volume-Variable Expenses) ÷ Sales Volume
For example, Company A has sales volume of $2.5m, with variable costs of $2.0m and fixed expenses of $400k. The break-even point for Company A is $2m in sales.
Taken a step further, the break-even period can be represented as a percentage used to determine a measure of time. Using the formula, Break-Even Volume ÷ Sales Volume, the break-even period for Company A is 80%.
Breaking Down Break-Even
If monthly expenses are reconciled, projecting monthly break-even using the formula provided will be more accurate when accounting for adjustments in seasonality. Otherwise, the annual break-even can be broken down into smaller representations to increase management’s understanding of the firm’s profitability, including:
Days to break-even: 365 x Break-Even % = 292 days
Sales to Achieve Profitability:
Per Month: $2m ÷ 12 months = $166,667
Per Week: $2m ÷ 52 weeks = $38,462
Per Day: $2m ÷ 365 = $5,479
Per Hour: $2m ÷ 2,920 = $685
When accurately inputted, additions to the costs associated with break-even can be added into the formula to measure the impact of adjustments. This is particularly effective in determining when a new line of merchandise will become profitable or the impact of increases in labor or capital expenditures on the firm. However deep a firm may choose to go in its use and understanding of break-even, even the simplest initial calculation will lead to a better understanding of the firm’s profitability, and similar to a football team, how to remain profitable through the off-season.