Calculate Breakeven Points in Your Business - dummies

Calculate Breakeven Points in Your Business

By Stephen L. Nelson

Profit-volume-cost analysis is a powerful tool that estimates how a business’s profits change as the sales volumes change. It can also help estimate the breakeven point. A breakeven point is the sales revenue level that produces zero profits. If your revenue is below the breakeven point, your business is running at a loss.

The formula for performing profit-volume-cost analysis looks like this:

profits = (sales revenue x gross margin percentage) - fixed costs

Rather than calculate profits based on the other three variables (sales revenue, gross margin percentage, and fixed costs), you can calculate a sales revenue amount based on the other three variables (profits, gross margin percentage, and fixed costs).

The formula for making such a breakeven calculation, based on algebraic manipulation of the profit-volume-cost analysis formula, looks like this:

breakeven point (in sales revenue) = fixed costs / gross margin percentage

The gross margin percentage is calculated by subtracting your variable costs from your sales revenue and then dividing that result (which is the gross margin) by the sales revenue. The variable costs include the costs of the items that you sell: inventory, commissions, shipping, and similar costs.

So, for example, suppose that you’re a builder of high-end racing sailboats that sell for $100,000 each. Further suppose that each boat costs you $40,000 in labor and material and that your shop costs $160,000 a year to keep open. also assume that the business’s gross margin percent is 40%. To calculate the breakeven point in sales revenue, you make the following calculation:

$160,000 / 40 percent

which produces the result $266,667. Accordingly, the boat-building business needs $266,667 of revenue to break even.

The breakeven point formula estimates a breakeven point in revenue. However, such a revenue-based breakeven point often doesn’t make complete sense. For example, in the case of the boat-building business in which you sell boats for $100,000 each, there’s no practical way to get $266,667 of revenue. You can’t sell two-thirds of a boat. The correct way to interpret a breakeven point in revenue in this example, then, is to interpret it as a rough breakeven point. As a practical matter in the boat-building business, the breakeven point is slightly less than three boats per year.