How to Make More Money by Knowing When You Start Losing Money, Part OneRead Now
I’m going to do a series of posts on breakeven analysis. This is an underutilized tool you can use in a variety of ways. This first post will be an introduction to breakeven analysis. Future posts will discuss how to calculate it and different ways it can be used.
Breakeven analysis involves finding the point where the net profit for something is zero. So, when there’s no profit you’re just breaking even. It is an easy concept to explain to non-financial people. They can understand the concept of it even if they don’t understand the actual calculation. I’ve been in meetings where I’ve presented a breakeven analysis to a group of non-financial people and you would have thought I had just invented sliced bread from their reactions.
The calculation looks at what items are variable, that is they fluctuate based on the number of units involved, and items that are fixed, they stay the same regardless of volume.
For example, let’s say a company was considering purchasing some equipment but was unsure if the investment would be worthwhile. You know that the cost of the equipment is $25,000. That is a fixed cost; it won’t change based on the number of parts sold. The equipment will allow the company to manufacture parts that will cost $5 less than with the old equipment. That is a variable cost; it changes as the number of parts sold changes.
So, the breakeven number of parts the company needs to sell would be 5,000. This is calculated by dividing the fixed costs of $25,000 by the variable component of $5 per unit. (25,000 divided by 5 equals 5,000.) Then you can compare that to the actual number of the parts sold in the past to see if 5,000 is a reasonable number.
Think of what the reaction would be if instead of a discussing payback periods and return on investments with non-financial managers, you say we need to sell 5,000 parts to cover the cost of the equipment and in the past year we sold 12,000 parts.
That was just a simplified breakeven analysis, but you can see that this can be a powerful tool for communicating the financial picture.