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	Steven D. Strauss Author of The Small Business Bible
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Break-Even Analysis

Break-Even Analysis is a mathematical technique for analyzing the relationship between sales and fixed and variable costs. Break-even analysis is also a profit-planning tool for calculating the point at which sales will equal total costs. The break-even point is the intersection of the total sales and the total cost lines. This point determines the number of units produced to achieve breakeven. The analysis generally assumes linearity (100% variable or 100% fixed) of costs. If a firm’s costs were all variable, the firm could be profitable from the start. If the firm is to avoid losses, its sales must cover all costs that vary directly with production and all costs that do not change with production levels.

Fixed costs are those expenses associated with the project that you would have to pay whether you sold one unit or 10,000 units. Examples include general office expenses, rent, depreciation, interest, salaries, research and development, and utilities. Variable costs vary directly with the number of units that you sell. Examples include materials, direct labor, postage, packaging, and advertising. Some costs are difficult to classify. As a general guideline, if there is a direct relationship between cost and number of units sold, consider the cost variable. If there is no relationship, then consider the cost fixed.

You construct a break-even chart with a horizontal axis representing units produced and a vertical axis representing sales and costs. Represent fixed costs by a horizontal line since they do not change with the number of units produced. Represent variable costs and sales by upward sloping lines since they vary with the number of units produced and sold. The break-even point is the intersection of the total sales and the total cost lines. Above that point, the firm begins to make a profit, but below that point, it suffers a loss. Here is a sample break-even chart:

The algebraic equation for break-even analysis consists of four factors. If you know any three of the four, you can solve for the fourth factor. You calculate the break-even amount with the following equation:

Sales Price per Unit * Quantity Sold = Fixed Costs + [Variable Costs per Unit * Quantity Sold]

For example, assume you have total fixed monthly costs of $1200 and total variable costs of $6 per unit. If you could sell the units for $10 each, the equation indicates that you need to sell 300 units to break even. If you knew you could sell 400 units, the equation would indicate that the sales price would need to be $9 per unit to break even.

When managing inventory, you should aim for the Economic Order Quantity (EOQ). This is the level of inventory that balances two kinds of inventory costs: holding (or carrying) costs, which increase with the amount of inventory ordered, and order costs, which decrease with the amount ordered.

The largest components of holding costs for most companies are the cost of space to store the inventory and the cost of tying up capital in inventory. Other components include the labor costs associated with inventory maintenance and insurance costs. Also include deterioration, spoilage, and obsolescence costs. The costs of more frequent orders include lost discounts for larger quantity purchases and labor and supply costs of writing the orders. Additional costs include paying the bills and processing the paperwork, associated telephone and mail costs, and the labor costs of processing and inspecting incoming inventory.

EOQ is the size of order that minimizes the total of holding and ordering costs. The algebraic expression of EOQ is as follows:

EOQ = square root of [2*U*O divided by H] where U is the number of units used annually, O is the order cost per order, and H is the holding cost per unit.

For example, assume you use 40,000 units annually, it costs $50 to place an order, and it costs $20 to hold the raw materials for one unit. The equation yields an amount of 447, which is the number of units you need to order at one time to minimize total costs.

The reorder point, or Economic Order Point (EOP), tells you when to place an order. Calculating the reorder point requires you to know the lead time from placing to receiving an order. You compute it as follows:

EOP = Lead time * Average usage per unit of time

For example, assume you need 6400 units evenly throughout the year, there is a lead time of one week, and there are 50 working weeks in the year. You calculate the reorder point to be 128 units as follows.

1 week * [6400 units / 50 weeks] = 128 units

You might also consider “Just In Time” inventory management, if available and appropriate. “Just In Time” allows you to keep minimal inventory in stock. You only order when you make a sale. Carefully analyze the time lag. You must be able to satisfy the customer as well as keep your inventory investment minimized.

Ratio Analysis is useful in showing relationships between items on the financial statements. You can use ratio analysis in many ways. You can compare your projections with actual results. You can also compare last year with this year, and last quarter or last month with this quarter or this month. Additional comparisons include same quarters or months of last year with same quarters or months of this year, and your business with other similar businesses, or with industry averages.

There are several excellent sources for obtaining pertinent data on similar businesses to use for comparison. Here are several of the most useful sources:

Dun & Bradstreet’s Industry Norms and Key Business Ratios, 99 Church Street, New York, NY 10007
Robert Morris Associates’ Annual Statement Studies, Philadelphia National Bank Building, Philadelphia, PA 19107
Accounting Corporation of America’s Barometer of Small Business, 1929 First Avenue, San Diego, CA 92101
National Cash Register Company’s Expenses in Retail Businesses, Marketing Services Department, Dayton, OH 45409
Small Business Administration (SBA)
Trade Associations