Written by John Hojnar, a CPA with Hojnar, Leuck & Associates, Ltd., a full-service financial services firm. With over twenty five years of experience in acounting and taxes, they also consult on investments, retirement plans, strategic planning, buy-sell agreements, estate planning and trusts. They can be contacted by calling 630-887-8181 or write to Financially $peaking c/o The Plastics Distributor and Fabricator Magazine.
ARE YOU BREAKING-EVEN OR BREAKING-UP?
Do you know how much business you must generate just to break-even? If you would like to make a $50,000. profit, do you know how much revenue you will need to do so? Does it seem as though your profits are lower even though your sales are higher than they were several years ago?
For most small to medium size businesses these are some of the questions you can answer just by knowing the basics of computing the break-even point.
To be effective, the process requires that you be on the accrual method of accounting. In other words, you record revenues when earned and record expenses when incurred irrespective of when cash is received or paid out. While the accrual method may not be the best method for preparing your tax return it generally provides better financial reporting. If you're on the cash method, preparing accrual financial statements requires that you include your receivables and payables for the period as well as the corresponding revenue, expense or other accounts related to the receivables and payables.
Then to determine your break-even point, segregate all expenses as to either variable and fixed for an accounting period. A variable expense is an expense which changes with your activity or volume. A typical variable expense is the cost of the goods you sell. With every sale there is a corresponding cost. A fixed expense remains the same irrespective of changes in volume. Typical fixed expenses would be rent, real estate taxes or depreciation because these expenses are not affected by changes in the level of your sales or services.
While it could happen that your volume increase was so large that you had to rent more production space, the distinction of fixed and variable expenses is made within a relevant range of business activity. As long as a fixed expense will not change within a certain level of sales or services, the level of business is considered to be in the relevant range of activity and the break- even concepts can apply.
Next, divide your variable expenses by your revenues and subtract the result from 1 which we will call the contribution margin. Divide your contribution margin into your fixed expenses to determine your break-even point.
Let's take an example: Your revenue is $950,000, variable expenses are $665,000 and fixed expenses are $190,000. Dividing variable expenses by revenues equals .70. Subtracting .70 from 1 equals .30. Dividing your fixed expenses by .30 indicates that your break-even point is $633,333 of annual revenue. ($190.000/ .30 = $633,333)Now let's prove our answer. If your revenue is $633,333 then your variable expenses would be $443,333 ($633,333 X 70%) Subtracting $443,333 from $633,333 equals your fixed expenses of $190,000. At this level of fixed expenses and the relationship of your variable expenses to revenue, you will have to generate $633,333 of revenue to break even.
Using these relationships, let's say you would like to earn $150,000, of profit before taxes. You would determine the required level of revenue to break-even and provide $150,000 of profit as follows: Compute your contribution margin as before but this time, add your targeted level of profit, $150,000 to your fixed expenses then divide by the same contribution margin determined before. For example, fixed expenses of $190,000 plus $150,000, of targeted profit equals $340,000. Divide the $340,000., by the same .30 equals $1,133,333. To generate $190,000, of profit would require revenues of $1,133,333.To prove our answer, multiply $1,133,333 times .70 would result in variable expenses of $793,333. Subtracting $793,333 from revenues of $1,133,333 equals $340,000. This amount will cover your fixed expenses of $190,000 and a provide your targeted profit of $150,000.Now that we've covered the complicated parts of determining a break-even point, several other factors should be considered.
- These concepts apply to both manufacturing and service businesses. The key is being able to distinguish variable and fixed expenses. Contact your accountant for help if necessary.
- Be sure to compute the break even point for several successive prior years in addition to the current year. This will show you how your fixed expenses have changed in relationships of your product costs. Also consider significant changes made in manufacturing processes or the nature of fixed expenses over the years. These changes can distort the comparability of your analysis.
- Use the computations to estimate profits and losses at various levels of revenues. As long as your computations are in the relevant range, the break-even computations can be quite effective in projecting profitability. Also, several years of analysis can yield some interesting results. In particular, you will find that profits will increase at a greater rate as revenues increase. Similarly, losses will increase at a greater rate if you are below the break-even point and revenues decline.
- Break-even concepts work best when you have a single product or services or limited to a few types or where cost relationships are similar for a larger variety products or services. If there is a large variety of products or services with dissimilar cost relationships, changes in revenue categories will prevent comparisons to prior years. Remember, accounting is more than numbers, it's knowing what the numbers mean.
For more information, Hojnar, Leuck & Associates, Ltd., a full-service financial services firm. With over twenty five years of experience in acounting and taxes, they also consult on investments, retirement plans, strategic planning, buy-sell agreements, estate planning and trusts. They can be contacted by calling 630-887-8181 or write to Financially $peaking c/o The Plastics Distributor and Fabricator Magazine.