There is an old joke “We didn’t plan on being a non-profit, but we are.”
The Break Even Analysis is an extremely important business tool to learn and use for planning and running your business. The result of this calculation determines the sales necessary to pay all your business expenses. However, it can be used in a number of other helpful ways.
The formula is simple Fixed Expenses / Gross Profit Percentage.
So what are fixed expenses? Generally speaking they are your operating expenses. They are the expenses you have each month regardless and unrelated to your sales. They are things such as rent, utilities, insurance, etc.
How do you determine your gross profit percentage? By subtracting your Cost of Goods Sold (COGS) [for more on COGS vs. Expenses see my September 2011 blog] from your Sales, you arrive at your gross profit. By dividing your Gross Profit by your Sales you determine your Gross Profit Percentage.
Let’s look at an example. If your annual Sales for $100,000 and your COGS were $45,000; then your Gross Profit would be $55,000. That means your Gross Profit Percentage ($55,000/$100,000) would be 55%.
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Let’s assume your fixed (operating expenses) costs were $30,000 per year. To calculate your break even you would divide $30,000 by 55% and you would find your break even figure to be $54,545. To test this, take $54,545 times 45% (COGS %) you will have determined your COGS to be $24,545. Subtract your COGS of $24,545 from your sales of $54,545 and you will have a Gross Profit of $30,000. From the $30,000 Gross Profit subtract your Operating Expenses of $30,000 and you have no profit (or loss).
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May be you have some personal expenses and thus need to make a profit. Let’s assume you need to have a monthly income of $3000 or $36,000 per year. Add the $36,000 to your fixed costs ($36,000+$30,000= $56,000), divide by the Gross Profit Percentage of 55%. Your Sales must now be increased to $120,000 or an average of $10,000 per month.
| Sales |
$120,000 |
100% |
| COGS |
$54,000 |
45% |
| ======== | ||
| Gross Profit |
$66,000 |
55% |
| Op Expenses |
$30,000 |
25% |
| ======== | ||
| Net Profit |
$36,000 |
30% |
Assuming your business operates 5 days a week with 4 weeks per month, then you will have 20 sales days per month. That means you have to make sale of $500 per day ($10,000/20 days). Also assuming your average sale is $100, then you need to make 5 sales a day. Ask yourself this question “Is this realistic?”
This is just one example of how the Break Even Analysis can be used to determine what sales you need to generate to obtain any given profit.