Break-Even Analysis

A break-even analysis shows you when you've started to make a profit.
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One useful tool in tracking your business's cash flow will be break-even analysis. It is a fairly simple calculation and can prove very helpful in deciding whether to make an equipment purchase or just to know 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)
  • Total of monthly debt payments for the year (annual debt service)
    Since we are dealing with cash flow and depreciation is a noncash expense, it is 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 1 and 2:

Break-even Sales for Year 1: ($170,000 + $30,000)/.25 = $800,000
Break-even Sales for Year 2: ($245,000 + $30,000)/.30 = $916,667

It is 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).

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 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 that the gross profit 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

Excerpted from Start Your Own Business: The Only Start-Up Book You'll Ever Need, by Rieva Lesonsky and the Staff of Entrepreneur Magazine, © 1998 Entrepreneur Press

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