and selling promotional items. She made items such as T-shirts, water bottles, bumper stickers, and anything with a company logo that would help promote a company’s product or service.
Barb knew the company’s total fixed costs. In fact, she could recite the cost of her lease, insurance, and loan interest off the top of her head. She also knew the variable cost she would incur for every item she produced. Finally, she had a sales amount in mind every month that she hoped to achieve. Barb knew how much profit she would generate if she hit that sales number.
Barb’s problem was that all these facts and numbers were swimming around in her head and not organized on paper. She needed a simple tool to analyze costs, sales (volume), and profit in one place. That’s the value of cost-volume-profit analysis. An owner or manager can have all three calculations in one formula and understand how they affect one another. So when you understand cost-volume-profit, you’ve added a powerful analytical tool to your arsenal.
Calculating the breakeven point
Cost-volume-profit analysis starts with the breakeven point. Breakeven answers this question: “What’s the amount I need to sell to cover all my costs?” When you open the front door of your business on the first day of a new month, your first concern is likely to be how much you have to sell to at least cover all costs for that month. At a minimum, you don’t want to lose money.
It doesn’t matter whether you’re selling a few glasses of lemonade or manufacturing automobiles. Either way, the breakeven point has three simple elements:
It includes fixed costs and variable costs.
It includes sales, either units of product sold, or the total dollar amount of sales (revenue). The term volume refers to the level of sales.
It assumes profit of zero.
Examine the elements required to find the breakeven point: Fixed costs remain constant, regardless of the volume of products or services you provide. Variable costs increase or decrease proportionately with the number of products you sell or services you deliver. The total variable costs, of course, increase as you produce more products or provide more services, and vice versa if fewer items, products, or services are provided. Sales is the total dollar amount received for your product or service. Finally, profit represents sales less all your costs.
Okay, if you want to split hairs, there’s an exception about fixed costs that is important in analyzing cost-volume-profit: relevant range (see Chapter 1). But in most cases, the level of activity stays within the relevant range for fixed costs.
What makes the breakeven point so important is that every sale above your breakeven point generates a profit. If your breakeven point is 100 units, you make a small profit when you sell the 101st unit. That’s good! After you know your breakeven point, you can plan the level of sales you need to generate a specific amount of profit.
What goes up can come down. If you sell only 99 units, you have a small loss. That’s not good! The fewer units you sell, the larger your loss.
The breakpoint formula
Before you start selling a product, you need to know the fixed costs, the variable costs, and the sale price. See Chapter 2 for more on cost terms. You can use the cost and price information to determine how many units you need to sell to recover all your costs — your breakeven point. The formula is
Profit ($0) = sales – variable costs – fixed costs
Failing to get a grip on profit, loss, and breakeven point can be funny, at least on TV. Saturday Night Live did a skit years ago about “The Change Bank.” Its only business was to make change, and its tag line was “We can meet all of your change needs.” The owner was asked: “How do you make money just making change?” “Volume!” says the owner.
The joke in the Change Bank skit is that regardless of how much business you do, there’s no profit in making change for people.
A case in point (breakeven point, that is)
You own a software company, and you’re thinking about buying a booth at a technology trade show. You hope to sell your product to trade-show visitors. Before deciding to attend, you benefit from a little breakeven analysis.
You might say to yourself, “I’m not getting on a plane unless I can at least cover all my expenses. How many units do I need to sell to cover all expenses?”
That number is the unit sales needed to reach your goal. Say your application sells for $40 per unit, and you have variable costs of $20 per unit. Fixed costs amount to $1,000. Plug those numbers into the formula:
Profit ($0) = sales – variable costs – fixed costs
Profit ($0) = (units × $40) – (units × $20) – $1,000
Profit ($0) = units × ($40 – $20) – $1,000
Profit ($0) = units × $20 – $1,000
To finish this little piece of algebra, add $1,000 to both sides of the equation. Then divide both sides by 20: X = 50, or 50 units.
$1,000 = units × $20
$1,000 / $20 = units
50 = units
You need to sell 50 units at $40 per unit. If you don’t think you can sell at least 50 units of software, don’t get on the plane for the trade show.
Financial losses: The crash of your cash
When your unit sales are less than breakeven, you’re operating at a loss. And that could affect the cash you need to operate each month. You likely will need cash to pay expenses (such as rent, utilities, and salaries) before you collect cash from sales.
Every time you incur a loss, it’s likely your available cash balance will decline. Generally, losses reduce your cash balance; conversely, profits increase them. Assume your loss for the month is $1,000. After you collect cash on all your sales and pay cash for all the bills, your ending cash balance will be $1,000 lower than where you started.
Losses are the curse of business. After all, the business exists to generate profits. Maybe the only good news about a loss is that it gets you analyzing and fixing problems.
Contribution margin: Covering fixed costs
Variable costs probably won’t keep you up at night. It’s the fixed costs that may cause insomnia, whether you’re talking about trade-show cost, the monthly rent, or salaries you need to pay your employees each month.
You focus on covering fixed costs using the contribution margin (that is, sales less variable costs):
Contribution margin = sales – variable costs
Profit = contribution margin – fixed costs
You also can use contribution margin to compute your breakeven point in terms of units.