If you are starting out with your first small business, you might face some funding issues. Let us review the concept of breakeven analysis, in case you are unfamiliar with the term.
A break-even analysis is a major aspect of any solid business plan. It can also be helpful prior to writing a business plan, when you’re trying to work out whether an idea is worth your time. Long after you have setup and run your business, it can remain helpful as a way to figure out the best pricing structure for your products.
An example of breakeven analysis is the best way to understand this simple but highly useful tool. We review some important examples of breakeven analysis, and also look at the limitations of breakeven analysis. In particular, we look at how breakeven analysis could be used as a planning tool at your small business start.
Lets take a look at costs that are typically incurred by small businesses.
Businesses incur two types of costs, Fixed and Variable. Examples of fixed costs are Rent, Insurance, Plant Maintenance, License Fees, Pay of permanent employees and such establishment expenses. These expenses are termed fixed because they tend to be incurred even when there is no revenue generating activity.
Examples of variable costs are direct materials, direct wages, shipping costs, sales commissions and other costs which vary in proportion to the level of sales or other revenue generating activity. To earn revenue, you have to incur these costs.
From the revenue (i.e. sales or other income), deduct these variable expenses to arrive at ‘contribution’. Contribution is the surplus of revenue over direct costs, and goes to meet fixed costs (and generate a final surplus).
Breakeven point is that level of revenues where this contribution just equals the total fixed costs. At this level of revenue, there is neither a profit or loss.
Any additional revenue would bring in contributions greater than the fixed costs. It is this excess that we call profits.
Break even analysis seeks to segregate fixed and variable costs, and compute at what level of revenue full recovery of fixed costs occurs. This analysis helps us make a number of different kinds of business decisions, as illustrated in the examples of breakeven analysis given later.
Examples of breakeven analysis decisions include
- decision to go ahead with our small business start,
- pricing decisions,
- buy or lease decisions, and
- decisions to expand existing operations by adding a new plant.
We will now look at a generic example of breakeven analysis and then at the above specific examples. Towards the end, we will also look at some limitations of breakeven analysis.
A Generic Example Of Breakeven Analysis
|Total revenues for our small business||= 50000|
|Total direct expenses incurred||= 35000|
|Revenues minus Direct Expenses i.e. Contribution||= 15000|
|Rate of contribution per unit of revenue||= 15000/50000 i.e. 30 cents|
|Total ‘fixed’ establishment expenses||= 24000|
At 30 cents per unit, 80,000 units must be sold to recover the fixed costs of 24000 in full. Only 50,000 are being sold now. So the business would be incurring a net loss of 9000 now i.e. Fixed costs of 24000 minus contribution from 50000 units [50000×30 cents].
Example Of Breakeven Analysis: Small Business Start
Developing a business plan is a basic requisite at small business start. And business plans start with an estimate of the sales levels. Estimating this level is extremely difficult for a new start up business. Breakeven analysis comes to your help in this situation.
It could go something like this:
|Estimated establishment expenses total||= 30,000|
|Direct costs per unit, as estimated by technical people||= 24|
|Prevailing market price per unit for this product||= 30|
|Rate of contribution per unit of revenue||= 30 – 24 = 6|
|Level of sales at which establishment costs will be recovered in full||= 30000 / 6|
= 5000 units
Now that we know at what level we could recover our fixed establishment costs, we could look at the market and decide whether we would be able to sell more than 5000 units to operate profitably.
Example Of Breakeven Analysis: Pricing Decision
In our last example, we decided to price our product at 30 per unit i.e. the prevailing market price. And found that we need to sell 5000 units to break even. Suppose we decided that it wouldn’t be possible to achieve that level with that price.
The next question would be about pricing at a lower level to attract business. We fix a new price and check the volume required to become profitable. And check whether we could sell the required volumes.
|New price per unit||= 28|
|Rate of contribution per unit of revenue||= 28 – 24 = 4|
|Level of sales at which establishment costs will be recovered in full||= 30000 / 4|
= 7500 units
If we could sell 7500 units at the significantly lower price, the lower pricing could be justified.
This is a common example of breakeven analysis, but one that is more practicable after we have gained some experience in the market and have become aware of price sensitivity and customer response.
Other Examples Of Breakeven Analysis
While lease or buy decisions might primarily be made on other considerations, such as finance availability and likelihood of obsolescense, breakeven anlaysis could provide a perspective.
If you are facing a high demand and thinking of expanding your capacity by adding a new plant, breakeven analysis could help you. You could check whether the contribution from additional sales would recover the additional fixed costs of the new plant.
Other examples of breakeven analysis include:
- using idle plant capacity (how low can you quote?)
- planning advertising (what prices would recover the costs?)
Limitations Of Breakeven Analysis
All the examples of breakeven analysis given above reveal one thing. These are useful to analyse the situation as at a particular time, and within a particular environment. Breakeven analysis is a static tool.
Fixed costs are fixed only within a certain range of activity, and during a particular period. So, you have to be careful that your projections do not extend beyond these actitivity and time limits.
Breakeven analysis does not consider the possibility of alternative uses for the existing facilities. For example, you might be able to earn a higher return by leasing out your facilities, or using them to produce some other product. You would notice from the examples of breakeven analysis that none of them consider this aspect.
Breakeven analysis also do not factor in interest costs. Cash received after a year (or later) has to be discounted to a present value using current interest rates. Otherwise, the apparent returns might be fictitious. You might be paying interest higher than this return, or you could get higher returns by lending the money (to a bank, for example).
Breakeven analysis is a simple tool, and also cheap. Collecting data to do a full-fledged discounted cash flow analysis could prove far more expensive. So do a breakeven analysis first, and then decide whether further analysis is worthwhile.
A Point About Variable Costs
In the examples of breakeven analysis, we assumed that it would be a simple matter to segregate fixed and variable costs. In practice, you might find that some costs are a mix of both – part fixed and part variable.
In such cases, you have two options.
- Develop a formula to separate the fixed and variable parts; or
- Identify the dominant characteristic of the cost, whether mainly fixed or mainly variable, and classify it under that dominant class.
For a small business, the second option might be better.