Do you have a good understanding of how profitable different products or services might be? Do you know how much product must be sold to cover costs or what happens if costs or prices change? These are important considerations in today’s feed and grain business. Understanding break-even points and break-even analysis can be important to making solid business decisions. You want to be sure you can sell enough product or service to make a profit. In this column, we focus on reviewing the details of break-even analysis since this is an important tool for business decisions.
What is break-even?
Break-even is the point at which total income from sales equals total expenses. Break-even analysis helps you determine the amount of sales needed to break even. Break-even is used to answer questions such as: What is the minimum level of sales needed to ensure there is not a financial loss and how sensitive is break-even sales volume to changes in costs or price? There are several elements that you need to understand in order to determine your break-even point. These include fixed costs, variable costs, sales revenues, contribution margin and profit goals. Let’s get started looking at these.
Understanding your costs
Categorizing your operating costs between fixed and variable costs is essential for break-even analysis. Fixed costs are those which are not directly related to the volume of production. They are often referred to as “overhead” costs and do not change as sales volume or production changes. You still have these costs — even if production or sales stop. Fixed costs generally include administrative costs and salaried personnel costs, rents, interest, depreciation, insurance and property taxes. Variable costs, on the other hand, are those that change when your production output or sales volume changes. Variable costs generally include wages for labor, raw materials, sellers’ commissions, packaging, freight and energy costs. Classifying your costs is very important to conducting a good break-even analysis, so it is important that you as the manager have a good handle on all of your costs and whether they do or do not change with output or sales. If you have this understanding, then you can properly classify each cost.
Revenue, contribution margin
Revenues are the sales dollars you receive for selling your product or service. You will need to forecast your expected sales by multiplying the number of units of product (for example — tons of dairy feed) or service that you expect to sell by the price you will charge your customers.
Contribution margin is another important element to understand in break-even analysis. Once you know your variable costs and have a forecast for your expected sales, the contribution margin is easy to determine. Contribution margin is just revenues minus variable costs. Why is this important? This margin is used to contribute or help cover fixed costs. Once you cover all your fixed costs, then this contribution margin goes directly to the “bottom line” — as profit.
Break-even sales can be determined using the following formula:
Break-even Sales ($) = Fixed Costs/(Contribution Margin/Total Sales)
Once you have determined your break-even sales in dollars, you can convert this to number of units sold in order to breakeven — simply divide break-even sales dollars by the per unit selling price. If units are sold at differentiated prices, then divide by the average selling price per unit.