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Introduction to Break-even Point

A person starting a new business often asks, "At what level of sales will my company make a profit?" Established companies that have suffered through some rough years might have a similar question. Others ask, "At what point will I be able to draw a fair salary from my company?" Our discussion of breakeven point and break-even analysis will provide a thought process that may help to answer those questions and to provide some insight as to how profits change as sales increase or decrease. Frankly, predicting a precise amount of sales or profits is nearly impossible due to a company's many products (with varying degrees of profitability), the company's many customers (with varying demands for service), and the interaction between price, promotion and the number of units sold. These and other factors will complicate the break-even analysis. In spite of these real-world complexities, we will present a simple model or technique referred to by several names: break-even point, break-even analysis, break-even formula, break-even point formula, break-even model, cost-volume-profit (CVP) analysis, or expense-volume-profit (EVP) analysis. The latter two names are appealing because the break-even technique can be adapted to determine the sales needed to attain a specified amount of profits. However, we will use the terms break-even point and break-even analysis. To assist with our explanations, we will use a fictional company Oil Change Co. (a company that provides oil changes for automobiles). The amounts and assumptions used in Oil Change Co. are also fictional.

Expense Behavior
At the heart of break-even point or break-even analysis is the relationship between expenses andrevenues. It is critical to know how expenses will change as sales increase or decrease. Some expenses will increase as sales increase, whereas some expenses will not change as sales increase or decrease. Variable Expenses Variable expenses increase when sales increase. They also decrease when sales decrease. At Oil Change Co. the following items have been identified as variable expenses. Next to each item is the variable expense per car or per oil change:

Motor oil Oil filter Grease, washer fluid Supplies Disposal service Total variable expenses per car

$ 5.00 3.00 0.50 0.20 0.30 $ 9.00

the following items have been identified as fixed expenses. If it services 100 cars. Mixed expenses could be split into two parts. In equation format it is defined as follows: Contribution Margin = Revenues – Variable Expenses . charges one flat fee of $24 for performing the oil change service. At the present time no other service is provided and the $24 fee is the same for all automobiles regardless of engine size.400 Mixed Expenses Some expenses are part variable and part fixed. services 10 cars its revenues (or sales) are $240. The amount shown is the fixed expense per week: Labor including payroll taxes and benefits Rent and utilities for the building it uses Depreciation. $90 if it services 10 cars. $18 if it services two cars. In other words. etc. training. adds air to the tires. For $24 the company changes the oil and filter. Oil Change Co. its revenues will be $2. (rent.'s variable expenses will be $9 if it services one car. and inspects engine belts. if Oil Change Co.The other expenses at Oil Change Co. heat. For the reasons shown in the above list. Fixed expenses do not decrease when sales decrease. At Oil Change Co. other Total fixed expenses per week $1. The variable portion can be listed with other variable expenses and the fixed portion can be included with the other fixed expenses. etc. are the amounts earned from servicing cars. adds needed fluids.400. Revenues or Sales Revenues (or sales) at Oil Change Co. These are often referred to as mixed or semi-variable expenses.200 700 500 $2. As the result of its pricing. Contribution Margin An important term used with break-even point or break-even analysis is contribution margin. fixed expenses such as rent will not change when sales increase or decrease. $900 if it services 100 cars. Oil Change Co. An example would be a salesperson's compensation that is composed of a salary portion (fixed expense) and a commission portion (variable expense). office and professional.) will not increase when an additional car is serviced. Fixed Expenses Fixed expenses do not increase when sales increase.

440 2.840 – 1.400 0 . Break-even Point In Units The break-even point in units for Oil Change Co. Projected Net Income For a Week Sales (160 cars serviced at $24 per car) Variable Expenses (160 cars at $9 per car) Contribution Margin Fixed Expenses Net Income $ $ 3. the contribution margin per car (or per oil change) is computed as follows: Contribution Margin per car = Contribution Margin per car = Revenues per car $24 – – Variable Expenses per car $9 Contribution Margin per car = $15 The contribution margin per car lets you know that after the variable expenses are covered. each car serviced will provide or contribute $15 toward the Oil Change Co.400 of weekly fixed expenses has been covered the company's profit will increase by $15 per car serviced. The break-even point formula is to divide the total amount of fixed costs by the contribution margin per car: Break-even Point in Cars per Week = Fixed Expenses per week ÷ Contribution Margin per car Break-even Point in Cars per Week = $2.The contribution margin for one unit of product or one unit of service is defined as: Contribution Margin per Unit = Revenues per Unit – Variable Expenses per Unit At Oil Change Co.400 per week.400 – 2. After the $2.400 per week ÷ $15 per Car Break-even Point in Cars per Week = 160 Cars per Week It's always a good idea to check your calculations.'s fixed expenses of $2. is the number of cars it needs to service in order to cover the company's fixed and variable expenses. The following schedule confirms that the break-even point is 160 cars per week: Oil Change Co.

200 profit for the week.600 per week ÷ $15 per Car Break-even Point in Cars per Week = 240 Cars per Week Always check your calculations: Oil Change Co. Break-even Point In Sales Dollars One can determine the break-even point in sales dollars (instead of units) by dividing the company's total fixed expenses by the contribution margin ratio.200 The above schedule confirms that servicing 240 cars during a week will result in the required $1. The new point needed to earn $1. The contribution margin ratio is the contribution margin divided by sales (revenues) The ratio can be calculated using company totals or per unit amounts. needs to earn a profit of $1.400 $ 1. We will compute the contribution margin ratio for the Oil Change Co.200 per week as another fixed expense.200 per week is shown by the following break-even formula: Break-even Point in Cars per Week = Fixed Expenses per week ÷ Contribution Margin per car Break-even Point in Cars per Week = $3.600 – 2. You can consider the owner's required profit of $1.200 for the owner).5% . Projected Net Income For a Week Sales (240 cars serviced at $24 per car) Variable Expenses (240 cars at $9 per car) Contribution Margin Fixed Expenses Net Income $ 5.160 3.Desired Profit In Units Let's say that the owner of Oil Change Co. by using its per unit amounts: Revenues or Sales per car Variable Expenses per car Contribution Margin per car $24 – 9 $15 Contribution Margin Ratio = Contribution Margin Ratio = Contribution Margin $15 ÷ Revenues or Sales ÷ $24 Contribution Margin Ratio = 62.760 – 2.600 per week (the $2.400 listed earlier plus the required $1.200 per week rather than merely breaking even. In other words the fixed expenses will now be $3.

400 per week ÷ 62.200 of profit each week.000 Contribution Margin Ratio = 62.500 per year.5%: Sales Variable Expenses Contribution Margin $100. is: Break-even Point in Sales $ = Total Fixed Expenses ÷ Contribution Margin Ratio Break-even Point in Sales $ = $2.600 of fixed expenses each week.500 ÷ ÷ Sales $100. These two facts result in a contribution margin ratio of 62.5% Break-even Point in Sales $ per week = $5.5% The amount of sales necessary to give the owner a profit of $1.840 of sales per week can be verified by referring back to the break-even point in units.The break-even point in sales dollars for Oil Change Co.760 per week To verify that this answer is reasonable.840 per week The break-even point of $3.500 Contribution Margin Ratio = Contribution Margin Ratio = Contribution Margin $62.5% Break-even Point in Sales $ = $3.000 – 37.400 of fixed expenses each week plus earn $1.200 per week is determined by this breakeven point formula: Break-even Point in Sales $ per week = Fixed Expenses per week ÷ Contribution Margin Ratio Break-even Point in Sales $ per week = $3.600 per week ÷ 62.500 $ 62. Recall there were 160 units necessary to break-even.840. In essence the company needs to cover the equivalent of $3.000 and its variable expenses amount to $37. Desired Profit In Sales Dollars Let's assume a company needs to cover $2. At $24 per unit the necessary sales in dollars would be $3. we prepared the following schedule: Per Week 52 Weeks . Presently the company has annual sales of $100.

. Presently the annual sales are $100.600 – 2.5%) Contribution Margin Fixed Expenses Profit $ 5.400 $ 1.000 but the sales need to be $299.760 – 2.400 As you can see.400 per year.800 $ 62.200 $ 299.200 – 124.400.520 – 112.520 per year in order for the annual profit to be $62.200 per week or $62. the company's annual sales must triple.Sales Variable Expenses (37.320 187.160 3. for the owner to have a profit of $1.