Breakeven Analysis

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It is absolutely essential that each business owner do a breakeven analysis of his current or proposed business. A breakeven analysis examines the interaction among fixed costs, variable costs, prices, and unit volume to determine that combination of elements in which revenues and total costs are equal.

Fixed costs are those dollars which must be spent to be in business and are not impacted by sales. They will include such things as rent, basic telephone expenses and utilities, wages for core employees, loan or lease payments, and other necessary expenditures. An entrepreneur should also include a living wage for himself/herself as a fixed cost.

Variable costs include those expenses which change as a result of sales volume. In a manufacturing business, the material cost of sales will be variable. Often utility expenses above some base rates increase sales, including gas or electricity charges in the factory or telephone expenses in the office.

The labor component of production may be variable or fixed, depending upon the obligations to its employees. In some cases employees need only be paid for hours worked (variable expense), while in others, some minimum number of paid hours is required regardless of the number of actually worked (fixed expense).

Now let's take a look at how the breakeven analysis can be helpful to the entrepreneur. For this example, let's assume the entrepreneur has determined that $10,000 of fixed costs are necessary to run the business on a monthly basis. In addition, he/she has determined that the variable costs of the product will be $15 per unit. Further, he/she has estimated that at a price of $25 per unit he/she can sell 1,500 units per month.

At 1,500 units per month, this business will generate sales of $37,500 and operating profit of $5,000.  It is possible to identify the breakeven point at 1,000 units.

By plotting the company's revenues and costs in the manner discussed, it is also possible to determine what the impact might be if the company were to sell only 800 units rather than the projected 1,500. It would experience a loss of $2,000.  Under those circumstances, the challenge to the entrepreneur is to determine a cost and revenue structure which could create profitability at only 800 units. 

Assuming that the variable cost per unit is fixed at $15, then the two remaining ways to lower the breakeven point to below 800 units are to reduce the fixed costs or raise the price. If the $10,000 fixed cost figure were cut to $5,000, then the breakeven point has been reduced to 500 units, and at an 800 unit volume, this company would generate a $3,000 profit.  In addition, if the original forecast of 1,500 units is achieved, the resulting profit would be $10,000.

Conversely, if the costs cannot be changed, then the only remaining variable is price. Through similar analysis, increasing the price from $25 to $30 would lower the breakeven point to 667 units. At an 800 unit volume, this company would produce a $2,000 profit, and if the original plan of 1,500 units is achieved, the profits from this scenario would be $12,500.

The preceding is a very brief overview of how breakeven analysis can be used for the entrepreneur to better understand the relationship of price, cost and volume and the dynamic impact they can have on the company's operation. By reducing the company to these three factors for preliminary analysis, the entrepreneur can avoid making serious mistakes and may discover significant opportunities. The management challenge will be to design and implement the programs necessary to achieve the desired results.



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