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A person starting a new business often asks, "At what level of sales will my company make a profit?"
Established companies that have suffered through some rough years might have a similar question.
Others ask, "At what point will I be able to draw a fair salary from my company?" Our discussion of breakeven point and break-even analysis will provide a thought process that may help to answer those
questions and to provide some insight as to how profits change as sales increase or decrease.
Frankly, predicting a precise amount of sales or profits is nearly impossible due to a company's many
products (with varying degrees of profitability), the company's many customers (with varying demands for
service), and the interaction between price, promotion and the number of units sold. These and other
factors will complicate the break-even analysis.
In spite of these real-world complexities, we will present a simple model or technique referred to by
several names: break-even point, break-even analysis, break-even formula, break-even point formula,
break-even model, cost-volume-profit (CVP) analysis, or expense-volume-profit (EVP) analysis. The latter
two names are appealing because the break-even technique can be adapted to determine the sales
needed to attain a specified amount of profits. However, we will use the terms break-even point and
break-even analysis.
To assist with our explanations, we will use a fictional company Oil Change Co. (a company that provides
oil changes for automobiles). The amounts and assumptions used in Oil Change Co. are also fictional.
Expense Behavior
At the heart of break-even point or break-even analysis is the relationship between expenses and
revenues. It is critical to know how expenses will change as sales increase or decrease. Some expenses
will increase as sales increase, whereas some expenses will not change as sales increase or decrease.
Variable
Variable expenses increase when sales increase. They also decrease when sales decrease.
Expenses
At Oil Change Co. the following items have been identified as variable expenses. Next to each item is the
variable expense per car or per oil change:
Motor oil
$ 5.00
Oil filter
3.00
0.50
Supplies
0.20
Disposal service
0.30
$ 9.00
The other expenses at Oil Change Co. (rent, heat, etc.) will not increase when an additional car is
serviced.
For the reasons shown in the above list, Oil Change Co.'s variable expenses will be $9 if it services one
car, $18 if it services two cars, $90 if it services 10 cars, $900 if it services 100 cars, etc.
Fixed Expenses
Fixed expenses do not increase when sales increase. Fixed expenses do not decrease when sales
decrease. In other words, fixed expenses such as rent will not change when sales increase or decrease.
At Oil Change Co. the following items have been identified as fixed expenses. The amount shown is the
fixed expense per week:
Labor including payroll taxes and benefits
$1,200
700
500
$2,400
Mixed Expenses
Some expenses are part variable and part fixed. These are often referred to as mixed or semi-variable
expenses. An example would be a salesperson's compensation that is composed of a salary portion
(fixed expense) and a commission portion (variable expense). Mixed expenses could be split into two
parts. The variable portion can be listed with other variable expenses and the fixed portion can be
included with the other fixed expenses.
Revenues or Sales
Revenues (or sales) at Oil Change Co. are the amounts earned from servicing cars. Oil Change Co.
charges one flat fee of $24 for performing the oil change service. For $24 the company changes the oil
and filter, adds needed fluids, adds air to the tires, and inspects engine belts.
At the present time no other service is provided and the $24 fee is the same for all automobiles
regardless of engine size.
As the result of its pricing, if Oil Change Co. services 10 cars its revenues (or sales) are $240. If it
services 100 cars, its revenues will be $2,400.
Contribution Margin
An important term used with break-even point or break-even analysis is contribution margin. In equation
format it is defined as follows:
Contribution Margin = Revenues Variable Expenses
The contribution margin for one unit of product or one unit of service is defined as:
Contribution Margin per Unit = Revenues per Unit Variable Expenses per Unit
At Oil Change Co. the contribution margin per car (or per oil change) is computed as follows:
The contribution margin per car lets you know that after the variable expenses are covered, each car
serviced will provide or contribute $15 toward the Oil Change Co.'s fixed expenses of $2,400 per week.
After the $2,400 of weekly fixed expenses has been covered the company's profit will increase by $15 per
car serviced.
It's always a good idea to check your calculations. The following schedule confirms that the break-even
point is 160 cars per week:
Oil Change Co.
Projected Net Income
For a Week
Sales (160 cars serviced at $24 per car)
$ 3,840
1,440
Contribution Margin
Fixed Expenses
Net Income
2,400
2,400
$0
Let's say that the owner of Oil Change Co. needs to earn a profit of $1,200 per week rather than merely
breaking even. You can consider the owner's required profit of $1,200 per week as another fixed expense.
In other words the fixed expenses will now be $3,600 per week (the $2,400 listed earlier plus the required
$1,200 for the owner). The new point needed to earn $1,200 per week is shown by the following breakeven formula:
Break-even Point in Cars per Week = Fixed Expenses per week Contribution Margin per car
Break-even Point in Cars per Week = $3,600 per week $15 per Car
Break-even Point in Cars per Week = 240 Cars per Week
$ 5,760
2,160
Contribution Margin
3,600
Fixed Expenses
2,400
Net Income
$ 1,200
The above schedule confirms that servicing 240 cars during a week will result in the required $1,200 profit
for the week.
$24
9
$15
Contribution Margin
$15
Revenues or Sales
$24
The break-even point in sales dollars for Oil Change Co. is:
Break-even Point in Sales $ = Total Fixed Expenses Contribution Margin Ratio
Break-even Point in Sales $ = $2,400 per week 62.5%
Break-even Point in Sales $ = $3,840 per week
The break-even point of $3,840 of sales per week can be verified by referring back to the break-even
point in units. Recall there were 160 units necessary to break-even. At $24 per unit the necessary sales in
dollars would be $3,840
$100,000
37,500
$ 62,500
Contribution Margin
$62,500
Sales
$100,000
The amount of sales necessary to give the owner a profit of $1,200 per week is determined by this breakeven point formula:
Break-even Point in Sales $ per week = Fixed Expenses per week Contribution Margin Ratio
Break-even Point in Sales $ per week = $3,600 per week 62.5%
Break-even Point in Sales $ per week = $5,760 per week
To verify that this answer is reasonable, we prepared the following schedule:
Per Week
52 Weeks
Sales
$ 5,760
$ 299,520
2,160
112,320
3,600
187,200
2,400
124,800
$ 1,200
$ 62,400
Contribution Margin
Fixed Expenses
Profit
As you can see, for the owner to have a profit of $1,200 per week or $62,400 per year, the company's
annual sales must triple. Presently the annual sales are $100,000 but the sales need to be $299,520 per
year in order for the annual profit to be $62,400.