Breakeven Point

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Description: The breakeven point measures the sales level at which a company exactly breaks even. This figure is quite useful for a number of operating decisions, such as determining how much extra productive capacity is available after breakeven sales have been manufactured, which tells the management team how much profit can theoretically be generated at maximum capacity levels. It is also good for determining changes in the breakeven point resulting from decisions to add fixed costs (especially when replacing variable production costs with fixed automation costs). Breakeven point analysis can also be used to determine changes in profits when the sales staff is contemplating making changes in product prices.

Formula: To calculate the breakeven point, divide the average contribution margin (sales minus variable expenses, divided by sales) into total fixed expenses. Extraordinary items that are in no way related to ongoing operations should be excluded from this formula, which is:

Total Fixed Expenses
Contribution Margin Percentage

A variation on the formula is to remove all non-cash expenses, such as depreciation, from the calculation. This approach is useful for companies that are more interested in determining the point at which they break even on a cash flow basis, rather than on an accrual reporting basis. This formula is:

Total Fixed Expenses – (Depreciation + Amortization + Other Non-Cash Expenses)
Contribution Margin Percentage

Yet another variation is to measure the breakeven point in terms of the number of units that must be sold in order to achieve the breakeven point. This formula is:

Total Fixed Expenses
Contribution Margin per Unit

Example: The Reef Shark Acquisition Company, which is a holding company that acquires all types of distressed businesses, is looking into the purchase of a sewing thread company. Its two key concerns are the breakeven point of the acquiree and the presence of any overhead costs that it can eliminate by centralizing functions at its corporate headquarters. Its due diligence team constructs the following table of information:

	Before Acquisition
Maximum sales capacity	$10,000,000
Current average sales	9,500,000
Gross margin percentage	35%
Total operating expenses	3,500,000
Breakeven point	$10,000,000
Operating expense reductions	750,000
Revised breakeven level	$7,857,000
Maximum profits with revised breakeven point	$750,050

The table clearly shows that the acquiree currently has a breakeven point so high that it is essentially incapable of ever turning a profit, since the breakeven level is the same as its maximum productive capacity. However, the removal of some key overhead costs reduces the breakeven point to such an extent that the acquirer will be able to generate a significant return from the existing sales level. The revised breakeven level is determined by subtracting the operating expense reductions of $750,000 from the existing operating expenses of $3,500,000, and then dividing the remaining $2,750,000 in operating expenses by the gross margin of 35% to arrive at a new breakeven point of $7,857,000. The maximum potential profit figure of $750,050 is derived by subtracting the revised breakeven point from the maximum possible sales capacity level of $10,000,000 and then multiplying the result by the gross profit percentage.

Cautions: You should track the breakeven point on a trend line, because it usually requires substantial changes by the management team to alter it, which may require a number of reporting periods to accomplish. To calculate the breakeven point on a spot basis, it is useful to create a multi-period measurement, so that an average gross margin percentage and operating cost can be used that smooths out expense irregularities over the short term.