How to tell what the profit should be.
By Ed Mendlowitz
77 Ways to Wow!
Break-even analysis is a budgetary process designed to tell you how much sales are needed to break even, and how much you will make or lose if you exceed or fall short of this “break-even” sales amount. Properly used, it can become a very potent tool.
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In a break-even analysis, all costs and expenses must be separated into “fixed” and “variable” categories. Designations such as “Costs of Goods Sold,” “Selling” or “General and Administrative” are irrelevant.
Fixed costs are those that will occur, whether or not there are sales, or no matter what the sales volume. Rent, office administrative and telephone are examples of items that are generally considered fixed.
Variable costs are costs incurred because a sale was made. Materials purchased and commissions are considered variable costs.
Fixed items should be stated in dollars and variable costs as a percentage of sales. If a product sells for $100 and has a variable cost of $60, then the variable percent is 60 percent. On the same token, $40 is available to recover fixed costs and earn a profit. This is referred to as the profit contribution percent. The amount represented by that percent determines what is available to recover fixed costs and provide a profit. Arithmetically it is done by subtracting the variable percent from 100 percent. In the example in this paragraph, the profit contribution percent (“PCP”) is 100% – 60% or 40%. To determine the break-even point, the fixed-cost dollar amount is divided by the PCP.
Multiplying sales amounts over the break-even point by the PCP will tell what the profit should be. Multiplying sales under the break-even point by the PCP will tell the dollars lost.
This calculation assumes that the fixed costs will not change from period to period. If they do, then adjustments must be made in the formula. For example, if there is a major repair, the break-even analysis can tell how much additional sales are needed to recover that cost. Just divide the additional cost by the PCP.
Generally, the break-even point should stay about the same from month to month. However, users should be aware and sensitive to extraordinary items and changing conditions and adjust the formula accordingly. In reality, the fixed costs are fixed for a range of sales. For instance, a 20 percent upward or downward shift in sales should not cause any change in the fixed costs. However, a 50 percent shift would, either requiring greater expenditures for increases or contracting of costs for decreases. An example could be shown with rent. An upward change that appears to become the norm would cause expanding into additional or larger facilities.
A confusing cost is most advertising costs because advertising is usually described as a percentage of sales. However, it is always committed to before the sales are made, making its expenditure independent of the sales volume. Therefore, it is a fixed expense.
However, as with a lot of things there are exceptions. If advertising fees or commissions are paid based on search engine sales, then they become a variable cost because the amount paid is solely based on sales volume.
So, the lesson here is that nothing should be assumed, and the underlying activity needs to be thought out and understood thoroughly before classification decisions are made or acted upon.
Three Forms of Break-Even Analysis Compared
Note that some items have fixed and variable elements and these should be broken into components and classified accordingly. An example could be direct labor, where a base of the labor force would never be reduced.
For example: A direct labor force of 100 people might include 20 people as the rock-bottom minimum that would always be retained, as long as the operation is in effect. Therefore, the costs of those 20 people would be considered as fixed (and those dollars would be recorded as fixed) and anything over that, i.e., the 80 people would be variable and shown as a percentage of sales. Accordingly, if sales increase then the variable labor would be added to, and if sales drop, the variable portion would decrease, but the fixed portion would not change.
Following is a comparison between a conventional form of financial statement and break-even form.
Break-Even Analysis – Illustration 1 |
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| Manufacturing Co., Inc. | ||||||
| Break-even analysis – monthly amounts | ||||||
| Conventional format | Break-even format | |||||
| $ | % | $ | % | |||
| Sales | 1,000,000 | 100.00% | ||||
| Cost of goods sold | ||||||
| Inventory – beginning* | ||||||
| Purchases | 230,000 | 23.00% | 23.00% | |||
| Direct labor ** | 250,000 | 25.00% | 70,000 | 18.00% | ||
| Indirect labor | 34,000 | 3.40% | 34,000 | |||
| Rent | 40,000 | 4.00% | 40,000 | |||
| Utilities | 18,000 | 1.80% | 18,000 | |||
| Insurance | 7,000 | 0.70% | 7,000 | |||
| Factory maintenance and supplies | 14,000 | 1.40% | 14,000 | |||
| Depreciation | 30,000 | 3.00% | 30,000 | |||
| Less inventory – end* | ||||||
| Total cost of goods sold | 623,000 | 62.30% | ||||
| Gross profit | 377,000 | 37.70% | ||||
| Selling, general and administrative | ||||||
| Sales manager | 25,000 | 2.50% | 25,000 | |||
| Sales commissions | 80,000 | 8.00% | 8.00% | |||
| Shipping salaries | 40,000 | 4.00% | 16,000 | 2.40% | ||
| Other selling costs | 25,000 | 2.50% | 25,000 | |||
| Officers’ payroll | 80,000 | 8.00% | 80,000 | |||
| Office payroll | 40,000 | 4.00% | 40,000 | |||
| Rent and utilities | 7,500 | 0.75% | 7,500 | |||
| Telephone | 9,000 | 0.90% | 9,000 | |||
| Other general and administrative | 11,000 | 1.10% | 11,000 | |||
| Depreciation | 7,500 | 0.75% | 7,500 | |||
| Total SG&A | 325,000 | 32.50% | ||||
| Net income before interest and taxes | 52,000 | 5.20% | ||||
| Totals | 434,000 | 51.40% | ||||
| * Inventory is not calculated for this simplified illustration | ||||||
| ** All labor costs above include taxes and fringes | ||||||
| Proof of break-even analysis | ||||||
| Profit contribution percent (100% – variable percent) | 48.60% | |||||
| Fixed costs | 434,000 | |||||
| Break-even sales (fixed costs ÷ profit contribution percent) | 893,004 | |||||
| Sales for month | 1,000,000 | |||||
| Excess over break-even sales | 106,996 | |||||
| Multiplied by profit contribution percent (monthly profit) | 52,000 | |||||
| Profit per conventional format | 52,000 | |||||
| Difference or proof | 0 | |||||
Break-Even Analysis – Illustration 2 |
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| Jan | Feb | Mar | Apr | May | Fixed | Variable | |
| Sales | 1,000,000 | 1,000,000 | 1,200,000 | 800,000 | 1,000,000 | ||
| Cost of sales | |||||||
| Inventory – beginning | 1,000,000 | 1,000,000 | 1,000,000 | 928,800 | 1,000,000 | ||
| Purchases | 250,000 | 250,000 | 300,000 | 200,000 | 250,000 | 25.0% | |
| Direct labor | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 | |
| Indirect labor | 30,000 | 30,000 | 30,000 | 30,000 | 30,000 | 30,000 | |
| Payroll taxes and benefits | 69,000 | 69,000 | 69,000 | 69,000 | 69,000 | 69,000 | |
| Rent | 30,000 | 30,000 | 30,000 | 30,000 | 30,000 | 30,000 | |
| Utilities | 20,000 | 20,000 | 24,000 | 16,000 | 20,000 | 2.0% | |
| Insurance | 3,000 | 3,000 | 3,000 | 3,000 | 3,000 | 3,000 | |
| Factory costs | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 | |
| Depreciation | 4,000 | 4,000 | 4,000 | 4,000 | 4,000 | 4,000 | |
| Less inventory – end | -1,000,000 | -1,000,000 | -928,800 | -1,000,000 | -1,000,000 | ||
| Total cost of sales | 626,000 | 626,000 | 751,200 | 500,800 | 626,000 | ||
| Gross profit | 374,000 | 374,000 | 448,800 | 299,200 | 374,000 | ||
| GP% | 37.4% | 37.4% | 37.4% | 37.4% | 37.4% | ||
| Selling and shipping | |||||||
| Sales manager | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 | |
| Sales commissions | 60,000 | 60,000 | 72,000 | 48,000 | 60,000 | 6.0% | |
| Shipping salaries | 10,000 | 10,000 | 10,000 | 10,000 | 10,000 | 10,000 | |
| Payroll taxes and benefits | 27,000 | 27,000 | 30,600 | 23,400 | 27,000 | 9,000 | 1.8% |
| Advertising | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 | |
| Other selling costs | 15,000 | 15,000 | 15,000 | 15,000 | 15,000 | 15,000 | |
| Total selling and shipping | 152,000 | 152,000 | 167,600 | 136,400 | 152,000 | ||
| General and administrative | 40,000 | 40,000 | 40,000 | 40,000 | 40,000 | 40,000 | |
| Total selling, shipping, G&A | 192,000 | 192,000 | 207,600 | 176,400 | 192,000 | ||
| Net income before taxes | 182,000 | 182,000 | 241,200 | 122,800 | 182,000 | ||
| 470,000 | 34.8% | ||||||
| BE sales | 720,859 | ||||||
| Monthly sales | 1,000,000 | ||||||
| Sales over break-even sales | 279,141 | ||||||
| Profit | 182,000 | ||||||
Break-Even Analysis – Illustration 3 |
|||||
| 2016 | 2017 | 2018 (6 months) |
Fixed (based on 2018) | Variable % | |
| Sales | 20,000,000 | 21,000,000 | 15,000,000 | ||
| Cost of sales: | |||||
| Inventory – beginning (did not include) | |||||
| Purchases | 5,000,000 | 5,250,000 | 3,750,000 | 25% | |
| Direct labor and taxes and benefits | 4,000,000 | 4,200,000 | 3,000,000 | 20% | |
| Indirect labor and taxes and benefits | 800,000 | 840,000 | 441,000 | 441,000 | |
| Factory costs and other overhead | 3,000,000 | 3,150,000 | 1,653,750 | 1,653,750 | |
| Depreciation | 280,000 | 280,000 | 140,000 | 140,000 | |
| Less inventory – end (did not include) | |||||
| Total cost of sales | 13,080,000 | 13,720,000 | 8,984,750 | ||
| Gross profit | 6,920,000 | 6,280,000 | 6,015,250 | ||
| GP% | 34.6% | 29.9% | 40.1% | ||
| Selling, shipping, general and admin: | |||||
| Independent sales representatives | 1,200,000 | 1,260,000 | 900,000 | 6% | |
| Sales salaries, taxes and benefits | 900,000 | 945,000 | 496,125 | 496,125 | |
| Shipping salaries, taxes and benefits | 500,000 | 525,000 | 275,625 | 275,625 | |
| Advertising | 800,000 | 1,200,000 | 600,000 | 600,000 | |
| Other sales and shipping costs | 700,000 | 735,000 | 385,875 | 385,875 | |
| General and administrative | 1,000,000 | 1,050,000 | 551,250 | 551,250 | |
| Total selling, shipping, gen and admin | 5,100,000 | 5,715,000 | 3,208,875 | ||
| Net income before interest and taxes | 1,820,000 | 565,000 | 2,806,375 | ||
| Total fixed costs | 4,543,625 | ||||
| Total variable costs | 51% | ||||
Proof: Calculate the break-even sales (show your calculation)
1 – 51% = 49%
4,543,625 / 49% = 9,272,704 for 6 months = 18,545,408 for a year
Proof: For above 6 months:
15,000,000 – 9,272,794 = 5,727,206 x 49% = 2,806,331 for 6 months
Per above P&L = 806,375
Diff.: 44 (OK per EM)
