Thursday, January 5, 2012

Break Even Analysis: The Easiest Way to Know if Your Business Model Makes Financial Sense


Kat and I recently started working on (what could turn out to be a big) project, and I volunteered to be responsible for the financial stuff. Between this project and my regular dissertation work (for which a conference paper is due at the end of the month), I realize that I will have even less time for Investor Juan and my other "less noble" pursuits (think what you will). So this month at least, I'll try to hit as many birds as I can with the few stones that I have. I worked on our project's break even analysis earlier this morning, so it made sense to to make that the topic of this post.

What is break even analysis?

Break even analysis, if done right, should be able to tell you if your business concept has a good chance of making money. As the name suggests, it shows how much sales you need to generate to break even: if you are confident that your business can easily and consistently beat break even sales, then you're on your way to riches; if, on the other hand, you think only a miracle could make you beat your break even point, then it makes no sense to proceed with the business.

However, since break even analysis only determines the profitability of your planned business and does not consider the investment (in real estate, machinery, or vehicles, for example) that your business would require, your financial analysis should not end there. To determine if your business can actually create additional wealth or value for your investment, then you would have to use your break even analysis results with capital budgeting procedures like net present value analysis and others that I'll discuss in future posts. Still, break even analysis is the most practical starting point of every financial analysis for a business venture.

Variable and fixed costs

Break even analysis is based on how the costs of operating a business behave differently. One set of costs or expenses--variable costs--rise and fall with revenues or sales. Some common examples of variable costs are the cost of raw materials for manufacturing and the cost of merchandise for retail or merchandising firms. Expenses that stay the same regardless of sales (only to a certain degree, which I'll get back to later) are referred to as fixed costs: examples include rent, (usually) wages, and overhead expenses.

A simple example to see how it works

Say, you're thinking of investing in a sandwich cart business. Your only product is ham and cheese sandwich, which consists of bread, ham, cheese, and mayonnaise; you estimate that these materials cost around 20 pesos per sandwich. You've found a suitable location for your business, for which the lessor asks 5,000 pesos per month. Finally, you figure that you would have two get two personnel--one to man the cash register and one to prepare the sandwiches--and you would have to pay each 7,000 pesos per month. If you plan to sell each sandwich for 30 pesos, how many sandwiches would you have to sell to break even? How much would you have to sell to break even?

Break even analysis is based on the simplest business formula there is: PROFIT = SALES - EXPENSES. To perform break even analysis, we just have to break these terms down into their respective components:


where SPU = selling price per unit, Q = quantity sold, VC =  variable costs, and FC = fixed costs. Going further


Where VCU = variable cost per unit. Remember, since VC rises and falls with Q, then VCU = VC/Q should be constant regardless of sales.

By definition, break even is the level of sales at which profit is zero. So at break even,

PROFIT = 0 = (SPU - VCU)*Q - FC
(SPU - VCU)*Q = FC
Q = FC/(SPU - VCU) = BEQ

Where BEQ = break even quantity. The break even point in pesos is just BEQ*SPU. SPU - VCU is referred to as the contribution margin per unit or CMU. It's the amount that each unit sold contributes to the recovery of fixed costs.

Now, back to your sandwich business. The first thing we have to do is identify which are variable and which are fixed costs. Based on how we defined these earlier, I hope that it's (even a bit) clear that the cost of bread, ham, cheese, and mayo represents variable costs and that rent and wages comprise fixed costs. [Speaking of which, one wise economist once mentioned that in the long run (or in continuously increasing sales quantities), all costs are variable: this means that some costs are only fixed at a certain level of sales called the relevant range. For example, as your business grows and you sell more sandwiches, you may eventually realize that two personnel are not enough to manage the demand at that branch and that you would have to hire another one. Soon, you may even decide to expand and open another branch and pay for another location. In both these instances, sales will have grown enough to drive "fixed" costs such as wages and rent past their relative ranges and become somewhat variable. But I digress...]

VCU = 20
FC = 5,000 + 2*7,000 = 19,000
SPU = 30

So now we have everything we need to proceed with our analysis.

BEQ = 19,000/(30 - 20) = 1,900 sandwiches per month
Break even point in pesos = 1,900*30 = 57,000 pesos per month

Based on the analysis, you would need to sell at least 1,900 ham and cheese sandwiches or generate sales of 57,000 pesos to break even. That's around 64 sandwiches or 1,920 pesos of sales per day. The next question that you need to answer is: do you have what it takes to break even?

If at first pass your think your break even point is too high, there are still a few things you can do to get better results. Try increasing the selling price, but not too much that it will result in significantly less demand (an estimate for the price elasticity of demand for your core product or service would be helpful, but that's another story altogether). Or try looking for cheaper supplies or a less expensive place to bring down your fixed costs. Tweaking your model is okay as long as you remain realistic.

Well, that's it. Now to go back to my other pursuits. ;)

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