A breakeven study helps you to establish key targets for your business so that it operates profitably. Make it realistic and you would have benchmarks for:
1. The selling price you must get per unit of product or per standard service assignment,
2. The number of products or assignments you have to sell during a month or year,
3. The level of establishment, i.e., recurring and fixed, costs that you are allowed to incur, and
4. The input and other direct costs allowed for producing a unit or completing an assignment on an average.
Breakeven analysis is simple in concept but a little difficult in practice. Let us now look at how it is done.
1. Determine the level of recurring fixed costs that your establishment must incur. Examples of such costs include:
==> The rent you pay for accommodation,
==> The lease rent you pay for equipment,
==> The depreciation on your own equipment,
==> The portion of interest on borrowings that would have to be paid even if business operations are temporarily stopped, and
==> The portion of payroll that cannot be reduced by laying-off workers during a shutdown
Look at each expense item and determine the “fixed” component that would be incurred even if business operations were temporarily at a standstill. (If you are permanently shutting down the business, you can eliminate all expenses by selling your facilities and getting out of all contracts.)
2. Estimate the “direct” and variable costs of making a unit of product or rendering a typical service. assignment. Examples include:
==> Costs of raw materials and incidental supplies,
==> Payroll costs of production workers and staff, and
==> Other costs that can be identified with the production activity and vary with the level of the activity.
In practice, for several cost items it is difficult to segregate the fixed and variable components. Depending on factors such as the level of competition in your industry and the costs of doing the analysis, you have two options. You could go ahead and carry out an elaborate statistical analysis to identify the variable component of each cost item. Or you could just classify a cost item fully as either variable or fixed, depending on its dominant characteristic.
3. Estimate the selling prices you would be able to obtain under applicable business conditions. Would you be able to sell at the prices you set? Or would you have to sell at prevailing market prices?
Next, estimate the selling expenses you would have to incur, like sales commissions, advertising campaigns, marketing department expenses (not included earlier under “fixed” costs) and any other. Compute the average selling expenses per unit of sale (after you have estimated the volumes of units or service assignments you would be able to sell).
Now, compute the net sales proceeds per unit of sale after deducting selling expenses per unit from the selling price.
4. Estimate the number of production units or service assignments that you would be able to sell in your particular market. This is determined by the total demand in the market, number and strength of competitors and your own marketing strategy and set up. Segment the total market into meaningful sectors and consider your strengths in each sector and make realistic estimates accordingly.
If you continuously monitor your marketing results and improve your marketing efforts, your sales would be growing month by month. So, do month-by-month computations for direct costs, selling prices & expenses, and sales volumes.
5. With all the required information assembled, you are now ready to do the breakeven analysis.
==> Compute the margin per unit, i.e., Net Sales proceeds per unit minus Direct Production Costs per unit. This margin is known as “contribution”, as it is a contribution by your marketing efforts to recover the establishment costs and generate a profit.
==> Divide the total Fixed Expenses for each month by the contribution per unit. What you get is the number of units you must sell to recover your full costs. This is known as the Breakeven Point.
==> At the breakeven point, you make no loss and no profit. You just recover your establishment costs. Any units you sell over this breakeven point generate a surplus of profit.
What Is the Significance of Breakeven Study?
With the breakeven analysis completed, you now know
==> How much you must sell,
==> At what prices, and
==> The establishment expense and direct cost allowances you must adhere to.
You now have clear goals for your business. Discuss with your marketing department or person how to achieve the desired levels of sales, at the desired prices.
Confer with each department manager or person in charge how to keep the expenses at the desired levels.
Ask your accountant to monitor the actual performance of sales, selling prices, establishment expenses and production costs against the benchmarks. If there are deviations from the benchmarks, they should be analyzed for reasons and reported to you.
And you would be in control of your business.