By: Alvin A. Rhoney CPA, CMC
Breakeven analysis is one of the most powerful management tools available to business managers today, yet I am continually surprised to see how few managers understand the concept. Even those who understand the concept do not know how to apply it to their business. Part of the difficulty is the traditional belief that breakeven points should be calculated with annual financial data to smooth out seasonal fluctuations in sales, expenses and profits. Some think that you must be a mathematician to harness its power. Others believe that it is only good for theoretical time lines like “...you must work until May 21st to pay your income taxes, only then do you begin to work for yourself...”
· Using daily breakeven analyses allowed us to help a one-chair barbershop owner to increase her annual revenue by 21% and drop 15% of that to the bottom line!
· Using weekly breakeven analysis allowed a hotel chain to maximize their profits by attracting local patrons to weekend getaways. Their competitors laughed and said that they would go broke selling their rooms for half price but they got the last laugh at the bank and now they all do it!
· Using breakeven analysis by route, American Airlines drove People’s Express out of business!
Breakeven concepts are simple. The key is to understand the elements of breakeven and then perform the analyses on your company’s natural business operating cycle(s), not necessarily one year.
Once you know what your breakeven point is (in dollars, hours, units, pieces or other delineation’s), you can then calculate how much flexibility and negotiating power you have in your cost structure so you can price your product or service for the highest profit during your operating cycle.
The elements of break-even analysis are:
· Fixed Costs - fairly stable over a wide range of sales volume. These are almost always independent of the sales volume, such as rent, building insurance and office salaries. If your sales volume doubles, your rent or mortgage payment will not double. (Although it should be recognized that a fixed cost might gradually change over a period of time.)
· Variable Costs - vary directly with the amount of sales and are normally related to what is being sold, such as sales commissions. Variable cost fluctuations are not always the same with both narrow and wide swings in sales. For example, some businesses can achieve a volume discount on larger purchases of products or raw materials, thus yielding a different cost per item.
· Semi-Variable Costs - contain both fixed and variable components. It is usually possible to identify or estimate the approximate fixed component. The balance will vary as a percentage of sales volume. It is often not possible to be precise when projecting this type of expense but an educated estimate is usually preferred over not even trying to separate them. Repair and maintenance costs, auto expense, telephone expense and overtime for office personnel are examples of expenses in this category. While recognizing that these costs exist, it is sometimes more practical to treat them as either wholly variable or wholly fixed. The key is consistency, not precision in the allocation of the fixed vs. the variable portion of the expense.
· Revenues - Total sales dollars for the operating cycle
If you understand that your revenues must pay for fixed costs, variable costs and profit, then it’s a small step to understanding that, at some point, all of your fixed costs are “covered”. Once the fixed costs are covered, then the only costs associated with the next sale are the variable costs. The portion that was being applied to your fixed costs is now going straight to profit.
Sales Price $50.00
Variable Costs (20.00)
Contribution Margin 30.00 (funds available for fixed costs and profit)
Fixed Costs 0.00
Using this concept, we know that at some point in our operating cycle, we will have “covered” all of our fixed costs because we have “broken even” in terms of profit. From that point on, the entire contribution margin will be applied to profit. Therefor, we also know that we can if we wish, or if business conditions mandate, reduce our price by as much as the amount, or percentage, that previously had been applied to fixed costs.
That is exactly what the hotel executive did. He calculated his breakeven for one week because he figured one week was his natural operating cycle. Businessmen check in on Sunday evening and leave Friday morning. He calculated, that by Friday afternoon he had “broken even” for the week. But he still had to pay all the people to run the hotel over the weekend as well as all the related utilities, rent, and so forth. He believed that he could attract local patrons for a get away weekend at a reduced price. He was able to reduce his room prices by as much as 40% and still make a profit on a room that he would not have otherwise rented! All because he understood both the concept of breakeven and how to apply it to his specific circumstances.
In the case of the one-chair barbershop, the owner had a terrible overflow on Saturdays. All of her customers had long waits and she lost a lot of business and goodwill from those who simply left or could not get their hair cut. She also noticed that certain days during the week were very slow and on those days she lost money. So her natural business cycle was one day! Armed with this knowledge, we advised her to give a discount to those who came for their haircut during the week, thereby increasing the revenue to “cover” more of her fixed costs for that day. At the same time, since she had an overflow on Saturday, we increased her prices for Saturday haircuts, knowing that some of those who had a choice anyway would gladly move to a weekday in return for a discount. The happy result was more satisfied customers and a higher profit for her. (This combines breakeven with revenue management techniques)
It doesn’t take a lot to apply the concept once it is clearly understood.
What it does take is a manager that has the time to think. If you are a manager who seems to be constantly putting out fires, then you are simply reacting to your business demands and you will never have the time to think.
The hardest and most important change in your business begins with you.
If you’re ready to increase your efficiency and profits by using customized business tools, call me today.
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