by Laurie Owen 

“Can I afford to hire that new salesperson?”  
“How much more do I need to sell if I lower my prices?”
“What amount of sales should my new advertising campaign create to pay for itself?”  

What do these questions have in common?  Each relates to how changes in costs, volume, and pricing affect your bottom line.  By the end of this article, I’ll have given you a single formula to help you answer these questions more accurately than ever before.

It all starts with the concept of break-even analysis.  Many of you may remember break-even from some long ago undergrad accounting course. Your professor went through various mathematical gyrations, then finished by drawing two intersecting lines with a downward arrow pointing at a number that indicated break-even – the amount of sales at which a company nether made nor lost money. 

“So what,” you thought then (and I bet you say now).  “Who wants to just break even?”  And you’re right. Calculating your break-even point is just the beginning.  break-even analysis is a financial tool that illustrates the relationship between COST-VOLUME-PROFIT, and as such can help you answer all the questions above and more. 

We first need to define two broad classes of costs - based on how they behave in the business.  First, fixed costs.  Within a reasonable sales range, fixed costs do not vary with sales or production volume.  Examples would include administrative salaries, rent, interest, insurance, utilities, depreciation. 

Next, variable costs.  Variable costs are those which are directly proportional to the sales volume (i.e., no sales, no variable costs).  Examples would include direct materials (cost of goods sold), commissions, and bad debts.  Think of variable costs this way:  sales cause variable costs.  If sales don't cause them, consider them fixed costs.

Now to calculate break-even.  From your existing profit and loss statement, you total all your current fixed costs.  Let's say your total comes to $100,000.  Next, you calculate your total variable costs as a percent of your total sales.  Let's say your "variable cost percent" turns out to be 75%.

This means that for every $1.00 of sales, 75 cents goes to variable costs.  What's left?  Yes, 25 cents.  To cover what - fixed costs.  So now we have to answer the question "What amount of sales do I need to cover $100,000 of fixed costs?”  The answer, of course, is $400,000 – this is your break-even point.  I've diagrammed it below, using the term "contribution margin" to replace the term "what's left?"  

But, as we said earlier, the key issue is not so much how to calculate break-even – it’s how to use it.  For example, our employees once lobbied to pay for an outside coffee service. Our annual cost for this coffee service was going to be $1,000.  How much in additional sales did we need to cover this increase?

                                
Yes, sales had to increase $4,000 just to pay for the coffee service.  Knowing this, we were inspired to take turns buying the beans and brewing the coffee ourselves. And it's these "creepers" you must watch every day, because with a contribution margin of 25% for every $1.00 increase in "fixed costs" (as they "creep" on you), you have to achieve a $4.00 sales increase just to stay even. Every business owner and every employee should know how much in sales is needed to be able to fill in the blanks in this sentence, “For every $1 in fixed costs, I need to make $______ in sales to cover it.”

Steps to Calculate break-even

1. Divide costs into fixed and variable (don’t forget to include cost of goods sold).  

2. Total fixed costs in dollars.  

3. Calculate variable cost as a percent of sales to get your Contribution Margin or “what’s left”.  

4. Use the formula:

Let’s use break-even analysis to determine how much in sales a new salesperson needs to make in order to cover their costs. Here are your assumptions:

Base Salary and employment taxes: $35,000
Extras: Lunches/Training Approx $2,500 Annual
Commission: 2% gross sales

Based on earlier analysis, you determine your total cost structure of your company to be:

Total variable costs: $661,000
Total fixed costs: $413,000
Total Sales: $1,080,000  

Contribution Margin = 100% - 61.2% = 38.8% or .388

Fixed Cost increase = 35,000 + 2,500 = 37,500

Commission impact on Contribution Margin = 38.8% - 2% = 36.8%

$37,500
   .368        =   $101,902

That’s the minimum in sales this new person needs to make in order to cover the additional costs of base salary, extras and commission.  Now you (and your new sales associate should you decide to hire him or her) have a specific target when you sit down to set sales goals and evaluate performance.

And you’ve got a new tool to help you reevaluate every dollar your company spends.

Laurie Owen is senior vice president and business coach at Business Resource Services.