This article provides formulas for working out your break even point with explanations on how to establish fixed and variable costs.
Photo Attribution: learningdslrvideo.com
When you are considering whether or not you should start or buy a business, it is useful to know what your break even point is. This is the volume of sales needed to at least cover all your costs.
To work out your breakeven point you will need to establish your fixed costs and variable costs.
Fixed costs (or overheads) are costs which you will incur regardless of your level of sales. Examples include rent, rates, power, phone, interest on debt, insurance, repairs and maintenance, stationary, licenses, and salary of permanent full-time workers.
Variable costs are costs which increase directly in proportion to the level of sales in dollars or units sold. Typically they include cost of goods sold, sales commissions, sales or production bonuses, freight, and wages of part-time or temporary employees.
Now you'll be thinking that some costs are a combination of fixed and variable - a certain minimum level will be incurred regardless of your sales levels, but the costs rise as your volume increases. For example, on your electricity bill you pay a standard fixed line charge each month and you also pay for each unit of power you use. The busier you are, the higher your power bill. Strictly speaking, these costs should be separated into their fixed and variable components, but that may be more trouble than it's worth for a small business.
To simplify things, decide which type of cost (fixed or variable) is the most important for the particular item, and then classify the whole item according to the more important characteristic. For example, if you use a lot of machinery, your variable charges will be higher than your fixed charges so you would classify power as a variable cost.
To calculate your breakeven point you use the following formulas:
1. Sales Price per Unit - Variable Costs per Unit = Contribution Margin per Unit.
2. Contribution Margin per Unit divided by Sales Price per Unit = Contribution Margin Ratio.
3. Breakeven Sales Volume = Fixed Costs divided by Contribution Margin Ratio.
Here's an example:
Assume you want to set up as a shoe manufacturer. Your budgeted fixed costs are $60,000, and your average cost to make a pair of shoes is $110. The average sales price per pair of shoes is $250. Your contribution margin per pair of shoes is $250 - $110 = $140.
The contribution margin ratio is $140 / $250 = 0.56
Your sales required to breakeven are $60,000 / 0.56 = $107,142 sales of pairs of shoes
So of you sell more than $107,142, you make a profit. If you sell less than $107,142, you make a loss.
If you want to know how many pairs you have to sell to make a $30,000 profit, just add $30,000 to your fixed costs and do the last equation again:
($60,000 + $30,000) / 0.56 = $160,714
$160,714 / $250 = 643 pairs
The key now is to determine what are your chances of selling 643 pairs of shoes. To determine this, you will need to do some market research.
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