Breakeven Analysis: Deciding Whether to Take the Plunge

Michael Sack Elmaleh, C.P.A., C.V.A.

Breakeven analysis is a cost accounting technique that helps potential business owners decide whether it is prudent to go into a particular line of business. The idea is to give the prospective business owner some reasonable idea of how much sales activity will be needed to breakeven.

Example. Ma Jong is currently the VP of operations at the Hong Kong Bong company. Having been passed over for a promotion she thinks she richly deserved, she is considering setting up her own wholesale bong distributorship. She needs to know how many bongs she would have to sell in order to breakeven.

The breakeven approach tackles this problem by distinguishing between fixed and variable costs. Variable costs are costs that vary with the volume of units sold. Direct unit manufacturing costs and sales commissions are examples of variable costs. Fixed costs, as the name implies, are costs that do not vary with sales volume. Insurance, office rent, and clerical salary are typical examples of fixed costs.

Example. Ma Jong estimates that she can purchase quality bongs from manufacturers for $4 per unit. She expects the average sales price to be $20 per unit and that she will pay a 10% commission for each unit sold, or $2 per units. So her total variable unit costs are expected to be $6 per unit. She estimates her fixed costs in rent, insurance, and other overhead to be $28,000 per year.

To compute the breakeven point, the amount of sales volume needed to breakeven, the following formula is used:

X= Units needed to breakeven
SP= Unit selling price
VC = Unit variable costs
FC= Total annual fixed costs

Often the difference between the unit sales price and unit sales costs (SP-VC) is called the contribution margin (CM). Now the breakeven point in dollars is literally the point where total revenue less total expenses equals 0. So we can restate the above equation as follows:

Replacing (SP-VC) with CM yields: Rearranging the terms in the above formula gives a new formula for the breakeven point in units:

In words this says that the units that must be sold to breakeven equals the total fixed costs divided by the contribution margin.

Example. Since Ma Jong?s unit sale price is $20 and her unit costs is $6, her contribution margin, CM, equals $14. Dividing this into her expected fixed costs of $28,000 yields a breakeven volume of 2,000 units. You can check this formula by constructing an income statement.

So what does this tell Ma Jong? It tells her that she has to be able to sell 2,000 bongs to just breakeven. But Ma Jong, like most other business owners, needs to do better than just breakeven. She needs to pay herself for her time and effort and get a reasonable profit on her investments. So the above formulas need to be modified to accommodate a required salary and/or profit for the owner. Now this required return for the owner is really just another fixed cost. So the revised formula is:

Example. Let?s say that Ma Jong?s current salary is $84,000 and she feels that she needs at least this much to justify going into business for herself. So taking (28,000+84,000)/14 yields 8,000 units. This means that if her projected unit revenue, unit costs and fixed costs are accurate, selling 8,000 bongs will yield her a profit or salary of $84,000. Now Ma Jong has to decide whether she thinks that selling 8,000 bongs is really feasible or is just a pipe dream. Precise numbers and formulas can lull us into thinking that we have greater knowledge than we actually have. In applying breakeven analysis or other cost accounting techniques simplifying assumptions and guesstimates almost always have to be made. Reality will almost always be messier than our formula answers would lead us to believe.

For example in most wholesale or retail businesses more than one type of product is sold. Each different product is likely to have different unit revenue and unit variable cost characteristics. The above breakeven model assumes only one product. To apply the model to a multi product firm requires taking average unit prices and average unit costs. Or perhaps averages weighted by the popularity of products sold. These simplifying assumptions can and will create distortions.

Another important factor in applying breakeven analysis is the fact that the distinction between fixed and variable costs is not always easy to make. Much depends upon the time frame involved. It is often said that in the very short run all costs are fixed and in the long run all costs are variable. How you slice costs between fixed and variable will have a great effect on the results obtained.

In most cases the results of the breakeven analysis should be considered a rough approximation of the kinds of volume needed to achieve desired results.

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What are partnerships and limited liability companies?

Some business owners choose to create partnerships or limited liability companies instead of a corporation. A partnership can also be called a firm, and refers to an association of a group of individuals working together in a business or professional practice.

While corporations have rigid rules about how they are structured, partnerships and limited liability companies allow the division of management authority, profit sharing and ownership rights among the owners to be very flexible.

Partnerships fall into two categories. General partners are subject to unlimited liability. If a business can't pay its debts, its creditors can demand payment from the general partners' personal assets. General partners have the authority and responsibility to manage the business. They're analogous to the president and other officers of a corporation.

Limited partners escape the unlimited liability that the general partners have. They are not responsible as individuals, for the liabilities of the partnership. These are junior partners who have ownership rights to the profits of the business, but they don't generally participate in the high-level management of the business. A partnership must have one or more general partners.

A limited liability company (LLC) is becoming more prevalent among smaller businesses. An LLC is like a corporation regarding limited liability and it's like a partnership regarding the flexibility of dividing profit among the owners. Its advantage over other types of ownership is its flexibility in how profit and management authority are determined. This can have a downside. The owners must enter into very detailed agreements about how the profits and management responsibilities are divided. It can get very complicated and generally requires the services of a lawyer to draw up the agreement.

A partnership or LLC agreement specifies how profits will be divided among the owners. While stockholders of a corporation receive a share of profit that's directly related to how many shares they own, a partnership or LLC does not have to divide profit according to how much each partner invested. Invested capital is only of the factors that are used in allocating and distributing profits.

Breakeven Analysis: Deciding Whether to Take the Plunge

Michael Sack Elmaleh, C.P.A., C.V.A.

Breakeven analysis is a cost accounting technique that helps potential business owners decide whether it is prudent to go into a particular line of business. The idea is to give the prospective business owner some reasonable idea of how much sales activity will be needed to breakeven.

Example. Ma Jong is currently the VP of operations at the Hong Kong Bong company. Having been passed over for a promotion she thinks she richly deserved, she is considering setting up her own wholesale bong distributorship. She needs to know how many bongs she would have to sell in order to breakeven.

The breakeven approach tackles this problem by distinguishing between fixed and variable costs. Variable costs are costs that vary with the volume of units sold. Direct unit manufacturing costs and sales commissions are examples of variable costs. Fixed costs, as the name implies, are costs that do not vary with sales volume. Insurance, office rent, and clerical salary are typical examples of fixed costs.

Example. Ma Jong estimates that she can purchase quality bongs from manufacturers for $4 per unit. She expects the average sales price to be $20 per unit and that she will pay a 10% commission for each unit sold, or $2 per units. So her total variable unit costs are expected to be $6 per unit. She estimates her fixed costs in rent, insurance, and other overhead to be $28,000 per year.

To compute the breakeven point, the amount of sales volume needed to breakeven, the following formula is used:

X= Units needed to breakeven
SP= Unit selling price
VC = Unit variable costs
FC= Total annual fixed costs

Often the difference between the unit sales price and unit sales costs (SP-VC) is called the contribution margin (CM). Now the breakeven point in dollars is literally the point where total revenue less total expenses equals 0. So we can restate the above equation as follows:

Replacing (SP-VC) with CM yields: Rearranging the terms in the above formula gives a new formula for the breakeven point in units:

In words this says that the units that must be sold to breakeven equals the total fixed costs divided by the contribution margin.

Example. Since Ma Jong?s unit sale price is $20 and her unit costs is $6, her contribution margin, CM, equals $14. Dividing this into her expected fixed costs of $28,000 yields a breakeven volume of 2,000 units. You can check this formula by constructing an income statement.

So what does this tell Ma Jong? It tells her that she has to be able to sell 2,000 bongs to just breakeven. But Ma Jong, like most other business owners, needs to do better than just breakeven. She needs to pay herself for her time and effort and get a reasonable profit on her investments. So the above formulas need to be modified to accommodate a required salary and/or profit for the owner. Now this required return for the owner is really just another fixed cost. So the revised formula is:

Example. Let?s say that Ma Jong?s current salary is $84,000 and she feels that she needs at least this much to justify going into business for herself. So taking (28,000+84,000)/14 yields 8,000 units. This means that if her projected unit revenue, unit costs and fixed costs are accurate, selling 8,000 bongs will yield her a profit or salary of $84,000. Now Ma Jong has to decide whether she thinks that selling 8,000 bongs is really feasible or is just a pipe dream. Precise numbers and formulas can lull us into thinking that we have greater knowledge than we actually have. In applying breakeven analysis or other cost accounting techniques simplifying assumptions and guesstimates almost always have to be made. Reality will almost always be messier than our formula answers would lead us to believe.

For example in most wholesale or retail businesses more than one type of product is sold. Each different product is likely to have different unit revenue and unit variable cost characteristics. The above breakeven model assumes only one product. To apply the model to a multi product firm requires taking average unit prices and average unit costs. Or perhaps averages weighted by the popularity of products sold. These simplifying assumptions can and will create distortions.

Another important factor in applying breakeven analysis is the fact that the distinction between fixed and variable costs is not always easy to make. Much depends upon the time frame involved. It is often said that in the very short run all costs are fixed and in the long run all costs are variable. How you slice costs between fixed and variable will have a great effect on the results obtained.

In most cases the results of the breakeven analysis should be considered a rough approximation of the kinds of volume needed to achieve desired results.

Return from Breakeven Analysis Page to Home Page

View the original article here

Parts of an Income Statement, part 1

The first and most important part of an income statement is the line reporting sales revenue. Businesses need to be consistent from year to year regarding when they record sales. For some business, the timing of recording sales revenue is a major problem, especially when the final acceptance by the customer depends on performance tests or other conditions that have to be satisfied. For example, when does an ad agency report the sales revenue for a campaign it's prepared for its client? When the work is completed and sent to the client for approval? When the client approves it? When the ads appear in the media? Or when the billing is complete? These are issues a company must decide on for reporting sales revenue, and they must be consistent each year, and the timing of reporting should be noted on the financial statement.

The next line in an income statement is the cost of goods sold expense. There are three methods of reporting cost of goods sold expense. One is called "first in-first out" (FIFO); another is the "last in-last out" (LIFO) method and the last is the average cost method. Cost of goods sold expense is a huge item in an income statement and how it's reported can make a substantial impact on the reported bottom line.

Other items in an income statement include inventory write-downs. A business should regularly inspect its inventory carefully to determine any losses due to theft, damage and deterioration, and to apply the lower of cost or market (LCM) method. Bad debts are also an important component of the income statement. Bad debts are those owed to a business by customers who bought on credit (accounts receivable) but are not going to be paid. Again the timing of when bad debts are reported is crucial. Do you report it before or after any collection efforts are exhausted?

Nonprofit Fraud Prevention

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Relativity of Risk

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Budgeting

Ugh, budgeting is one of those topics we'd rather avoid, but in business, it's an absolute necessity. To prepare a reasoned and thoughtful budget, an accountant must start with a broad-based critical analysis of the most recent actual performance and position of the business by the managers who are responsible for the results. Then the managers decide on specific and concrete goals for the coming year. It demands a fair amount of management time and energy. Budgets should be worth this time and effort. It's one of the key components of a manager's job.

To construct budged financial statements, a manager needs good models of the profit, cash flow and financial condition of your business. Models are blueprints or schematics of how things work. A business budget is, at its core, a financial blueprint of the business. Budgeting relies on financial models that are the foundation for preparing budgeted financial statements. Those statements include:

--Budgeted income statement (or profit report): This statement highlights the critical information that managers need for making decisions and exercising control. Much of the information in an internal profit report is confidential and should not be divulged outside the business.

--Budgeted balance sheet: The connections and ratios between sales revenue and expenses and their corresponding assets and liabilities are the elements of the basic model for the budgeted balance sheet.

--Budgeted statement of cash flows: The changes in assets and liabilities from their balances at the end of the year just concluded to the projected balances at the end of the coming year determine cash flow from profit for the coming year.

Budgeting requires good working models of profit performance, financial condition, and cash flow from profit. Constructing good budgets is a strong incentive for businesses to develop financial models that not only help in the budgeting process but also help managers in making strategic decisions.