Breakeven analysis

Breakeven analysis is used to locate the sales volume at which a business earns exactly no money, where all contribution margin earned is needed to pay for the company’s fixed costs. Contribution margin is the margin that results when all variable expenses are subtracted from revenue.

In essence, once the contribution margin on each sale cumulatively matches the total amount of fixed costs incurred for a period, the breakeven point has been reached. All sales above that level directly contribute to profits.

Breakeven analysis is useful for the following reasons:

  • Determining the amount of remaining capacity after the breakeven point is reached, which reveals the maximum amount of profit that can be generated.
  • Determining the impact on profit if automation (a fixed cost) replaces labor (a variable cost).
  • Determining the change in profits if product prices are altered.
  • Determining the amount of losses that could be sustained if the business suffers a sales downturn.

In addition, breakeven analysis is useful for establishing the overall ability of a company to generate a profit. When the breakeven point is near the maximum sales level of a business, this means it is nearly impossible for the company to earn a profit even under the best of circumstances.

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, thereby reducing 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 they increase the breakeven point.
  • Technologies. Implement any technologies that can improve the efficiency of the business, thereby increasing capacity with no increase in cost.

To calculate the breakeven point, divide total fixed expenses by the contribution margin. The formula is:

Total fixed expenses ÷ Contribution margin percentage

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. The formula is:

(Total fixed expenses – Depreciation – Amortization) ÷ Contribution margin percentage

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 formula is:

Total fixed expenses ÷ Average contribution margin per unit

A potential problem with the breakeven concept is that it assumes the contribution margin in the future will remain the same as the current level, which may not be the case. You can model the breakeven analysis using a range of contribution margins to gain a better understanding of possible future profits and losses at different unit sales levels.