The breakeven point is the sales volume at which a business earns exactly no money. The breakeven point is useful in the following situations:
- To determine the amount of remaining capacity after the breakeven point is reached, which tells you the maximum amount of profit that can be generated.
- To determine the impact on profit if automation (a fixed cost) replaces labor (a variable cost)
- To determine the change in profits if product prices are altered
- To determine the amount of losses that could be sustained if the business suffers a sales downturn
Management should constantly monitor the breakeven point, particularly in regard to the last item noted, in order to reduce the breakeven point whenever possible. Ways to do this include:
- Cost analysis. Continually review all fixed costs, to see if any can be eliminated. Also review variable costs to see if they can be eliminated, since doing so increases margins and reduces the breakeven point.
- Margin analysis. Pay close attention to product margins, and push sales of the highest-margin items, to reduce the breakeven point.
- Outsourcing. If an activity involves a fixed cost, consider outsourcing it in order to turn it into a per-unit variable cost, which reduces the breakeven point.
- Pricing. Reduce or eliminate the use of coupons or other price reductions, since it increases the breakeven point. Also, increase price points whenever this is acceptable to customers.
To calculate the breakeven point, divide total fixed expenses by the contribution margin. Contribution margin is sales minus all variable expenses, divided by sales. The formula is:
Total fixed expenses
Contribution margin %
A more refined approach is to eliminate all non-cash expenses (such as depreciation) from the numerator, so that the calculation focuses on the breakeven cash flow level.
Another variation on the formula is to focus instead on the number of units that must be sold in order to break even, rather than the sales level in dollars. This can be useful for setting sales targets. This formula is:
Total fixed expenses
Average contribution margin per unit
Breakeven Point Example
The management of Ninja Cutlery is interested in buying a competitor that makes ceramic knives. The company's due diligence team wants to know if the competitor's breakeven point is too high to allow for a reasonable profit, and if there are any overhead cost opportunities that may reduce the breakeven point. The following information is available:
|Maximum sales capacity||$5,000,000|
|Current average sales||4,750,000|
|Gross margin percentage||35%|
|Total operating expenses||1,750,000|
|Operating expense reductions||375,000|
|Revised breakeven level||$3,929,000|
|Maximum profits with revised breakeven point||$375,000|
The analysis shows that the competitor has an inordinately high breakeven point that allows for little profit, if any. However, there are several operating expense reductions that can trigger a steep decline in the breakeven point. The management of Ninja Cutlery makes an offer to the owners of the competitor, based on the cash flows that can be gained from the reduced breakeven level.