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Definition: A technique for analyzing how revenue, expenses and profit vary with changes in sales volume .
One useful tool in tracking your business's cash flow is a break-even analysis. It's a fairly simple calculation and can prove very helpful in deciding whether to make an equipment purchase or in knowing how close you are to your break-even level. Here are the variables needed to compute a break-even sales analysis:
- Gross profit margin
- Operating expenses (less depreciation)
- Annual debt service (total monthly debt payments for the year)
Since we're dealing with cash flow, and depreciation is a noncash expense, it's subtracted from the operating expenses. The break-even calculation for sales is:
(Operating Expenses + Annual Debt Service)/Gross Profit Margin = Break-Even Sales
Let's use ABC Clothing as an example and compute this company's break-even sales for years one and two. In Year 1, the company's sales were $1 million and their gross profit was $250,000, resulting in a gross profit margin of 25 percent ($250,000/$1 million). In Year 2, sales were $1.5 million and gross profits were $450,000, resulting in a gross profit margin of 30 percent (($450,000/$1.5 million). Now let's use calculate their break-even sales figure:
Break-Even Sales for Year 1:
(Operating Expenses of $170,000 + Annual Debt Service of $30,000)/
Gross Profit Margin of 25 percent (.25) = $800,000 break-even sales figure
Break-Even Sales for Year 2:
(Operating Expenses of $245,000 + Annual Debt Service of $30,000)/
Gross Profit Margin of 30 percent (.30) = $916,667 break-even sales figure
It's apparent from these calculations that ABC Clothing was well ahead of break-even sales both in Year 1 ($1 million sales) and Year 2 ($1.5 million sales).
Break-even analysis also can be used to calculate break-even sales needed for the other variables in the equation. Let's say the owner of ABC Clothing was confident he or she could generate sales of $750,000, and the company's operating expenses are $170,000 with $30,000 in annual current maturities of long-term debt. The break-even gross margin needed would be calculated as follows:
($170,000 + $30,000)/$750,000 = 26.7%
Now let's use ABC Clothing to determine the break-even operating expenses. If we know the gross margin is 25 percent, the sales are $750,000 and the current maturities of long-term debt are $30,000, we can calculate the break-even operating expenses as follows:
(.25 x $750,000) - $30,000 = $157,500
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