Breakeven Sales: A Tool for Decision Making
Many value added firms may be heavy in fixed assets. A firm is using operating leverage if it chooses to emphasize the use of fixed assets in their venture. To the extent a firm uses debt to finance their operation, they are using financial leverage.
What issues or questions can a simple breakeven analysis help you address or answer? Questions such as how many sales are required to break even? How many sales are required to generate a profit? What is the effect on volume or breakeven from a change in cost of materials? Breakeven helps to evaluate the impact of high fixed costs. What does the breakeven sales formula tell you? It indicates how much you must have in sales to pay the cost of the sales and still have money left over to pay operating expenses, but have no profit. That is, total revenue equals total expense and, therefore, operating expense is zero. The formula tells you the amount that sales must increase if you are going to add a fixed expense or asset, but you do not want that cost to reduce profit.
Here is a simple breakeven formula:
Breakeven sales dollars = fixed expenses/gross profit margin.
Gross profit margin percent = gross profit margin dollars/sales *100%
Gross profit = sales – cost of goods sold.
Breakeven sales units = fixed costs/price – variable cost per unit.
For instance, how much sales revenue must a new salesperson generate every year if the person is to return to the company their salary and expenses, so the bottom line is not reduced? Here, divide the person’s salary and expenses (a fixed expense) by the gross profit margin of the company. What else does the formula tell you? It relates how much the firm needs to generate in sales dollars to pay for each dollar increase in fixed expense.
What if the firm is a new venture and does not know what the gross profit margin is or will be? A way to start assessing the impact of your decisions in this situation is to use the source for financial ratios, Robert Morris Annual Statement Studies. The studies are published yearly by Robert Morris Associates, an association of bank loan and credit officers. The financial information is a compilation of raw financial data submitted by member banks, then categorized by both sales volume and asset size. The information provides only general guidelines but does represent a starting point for decision makers.
Many libraries and most banks have copies of the latest studies available for use.
Example
$ %
Sales .............................................................................................................. 1000 ........................ 100
Cost of goods sold ......................................................................................... 600 .......................... 60
Gross margin ................................................................................................... 400 .......................... 40
Operating expense, fixed ............................................................................... 300 .......................... 30
Profit before tax ............................................................................................... 100 .......................... 10
Breakeven sales dollars = fixed expense ($300)/gross profit margin % (40%) = $750.
Proof
Sales ........................................................................................................................................ $750.00
Cost of sales ............................................................................................................................. 450.00
Gross margin ............................................................................................................................. 300.00
Expenses ...................................................................................................................................... 300.0
Profit .................................................................................................................................................. 0.00
Example
A group of beef producers decides to start its own slaughter plant. To do so will require a continuing marketing effort that will cost $30,000 per year. The question is, should the executive steering committee approve such an ongoing expenditure? How much will the sales effort need to generate in sales, just to pay for it? Checking Robert Morris Associates ratios, manufacturers – meat packing, $500,000-$2,000,000 in assets, the gross profit margin is 17.3 percent.
The breakeven sales for the marketing effort:
Breakeven sales $ - $30,000/.173 - $173,410.00
Can the sales effort generate enough sales to pay for itself? It is possible.
Example
Sales to Attain a Certain Sales Volume
If the group decides it would like to generate $50,000 in profit the first year, on an investment of fixed assets of $2,000,000, what is the sales volume required?
Breakeven sales $ - $2,000,000 + $50,000/.173 = $11,850,711.
Two questions surface for consideration. One, does the plant have the capacity to produce that much sales? And secondly, will the firm be able to sell that much product?
Cash Flow Analysis
A cash flow forecast will be required for all business plans, but more importantly is required for a new operation to determine if the operating capital available is sufficient to provide capital until the business generates a positive cash flow.
A cash flow forecast is comprised of two cash budgets. The cash receipts budget and the cash payments budget. The key to both is to determine the timing, the timing of receipts or payments.
Cash Receipt Budget
In the cash budget, the first step to developing the cash receipt budget is to spread the projected sales for one year over 12 months. For a start-up business, the sales would be expected to be smaller at the start of the year, allowing for growth in the business. The second step of the process is to time the receipt of the collections by use of the account receivable collection period. A simple example will illustrate.
Example
Sales receivables are collected 30 days after the sale.
Month 1 ..................................................................................................................................... $1,000
Month 2 ..................................................................................................................................... $1,000
Month 3 ..................................................................................................................................... $1,000
Month 4 ..................................................................................................................................... $1,000
Month 1 Month 2 Month 3 Month 4
Sales .................................................................. $1,000 ........... $1,000 ........... $1,000 ........... $1,000
Collections ................................................................. 0 ............ $1,000 ............ $1,000 ........... $1,000
Total receipts ............................................................................. $1,000 ............ $1,000 ........... $1,000
Cash Payments
The focus of the cash payment schedule is to account for the timing of payments for material, labor and overhead expense related to the manufacture of product; and the payments for general and administrative expense, interest payments, taxes, dividends and new plant equipment.
To continue the simple example, assume material is paid 30 days after receipt; labor expense and factory overhead are paid when incurred. Taxes are paid every quarter, interest once a month, and new equipment is paid for in month four.
Item $ Amount
Material ........................................................................................................................ 100 per month
Labor ............................................................................................................................... 50 per month
Interest ........................................................................................................................... 10 per month
Taxes................................................................................................................................................. 10
New equipment ............................................................................................................................. 500
Factory overhead ......................................................................................................... 25 per month
Summary of All Monthly Payments
Month 1 Month 2 Month 3 Month 4
Material .........................................................................................$100 .............. $100 .............. $100
Labor ......................................................................... 50 ...................50 .................. 50 .................. 50
Factory O/H .............................................................. 25 ...................25 .................. 25 .................. 25
Interest ..................................................................... 10 ...................10 .................. 10 .................. 10
Taxes.......................................................................................................................... 10 ......................
Equipment ...................................................................................................................................... 500
Total payments ...................................................... $85 ...............$185 .............. $195 .............. $685
Monthly Cash Flow
Month 1 Month 2 Month 3 Month 4
Cash receipts .......................................................... $0 .............$1000 ............ $1000 ............ $1000
Cash payments ....................................................... 85 .................185 ................ 195 ................ 685
New cash flow .................................................... $(85) ...............$815 .............. $805 .............. $315
Small Business Administration (SBA) Cash Flow Format
The SBA cash flow format is designed in an easy to use manner with detailed explanations on its use. This format will show the cumulative effect of purchases and receipts along with loan receipts and disbursements. The net effect will be to show the cumulative cash positive or negative cash balance. This forecast can not be completed until key operating decisions related to sales, labor force size, purchases, loan receipts and collection and payment cycles are made.
A cash flow format based on an SBA document is shown in the following document.