Every business wants to make a profit, right? An important key to
making a profit is understanding your break-even point. Figuring it out
is a simple and necessary process for any tire dealer’s success.
Surprisingly, many owners or store managers don’t know their break-even
point. Yet, calculating a break-even point is a common tool in most
businesses. The variable nature of many business expenses, however,
complicates break-even analysis for those in the tire and service
business.
Before continuing, let’s take a look at what break-even is. The
break-even point is a sales objective, expressed in either dollar or
unit sales, at which a business (or location) will “break even,”
earning neither a profit nor incurring a loss. To calculate a
break-even point you’ll need to know your operating expenses including
variable costs. You can then create a spreadsheet to chart the figures.
A store, for example, breaks even, then, when revenues equal total expenses.
Once that point is determined, the owner or manager has an objective
target on which to focus, using some carefully reasoned steps. But
remember, an increase in sales does not always translate into an
increase in profits.
No doubt, more than one tire dealer or manager has gotten into trouble
by ignoring the break-even point. Again, this may be especially true
for tire and service operations because variable and semi-fixed
expenses can change with the volume of business and have a
disconcerting tendency to get out of hand as sales increase.
In a one-product business, break-even analysis is easy. But for a
multi-product or service business, the calculations can get far more
complex. Despite the complexity, though, the basic technique is the
same.
Depending on the individual circumstances, some of the figures needed
for the calculation will be estimates. In these instances, a good piece
of advice is to make those estimates as conservative as possible. Use
somewhat pessimistic sales and margin figures and slightly overstate
the anticipated expenses.
For calculation purposes, the break-even formula is as follows:
S = FC + VC
“S” is the break-even sales volume expressed in dollars; “FC” is
operational or fixed costs in dollars; and “VC” is the variable costs
in dollars.
Fixed costs or “fixed expenses” and “occupancy expenses”, as they may
be called on the income statement, will not vary with the level or
volume of sales. Items usually included are rent or its equivalent in
depreciation, real estate taxes, utilities and repairs. Salaries are
also included, but not commissions.
Fixed costs are allocated across the entire store. Where departments
are involved, the fixed costs may be apportioned depending on the
department size or according to the benefit derived from the
department. Usually there is little or no control over these costs.
Variable costs, which may appear as “other operating expenses” on the
income statement, move up or down in relation to sales volume.
Commissions, advertising, telephone, training and expenses related to
delivery vehicles are examples of variable costs. Owners and managers
have considerable control over these expenses.
Before continuing, it is important to point out that the fixed and
variable costs items mentioned are meant as examples only. The specific
information needed for break-even analysis can be taken from the
businesses income statement. These financials can vary in format,
however, depending on the particular business.
For our calculations, we have to use a variation of the break-even
formula to take into account the cost of goods sold. Knowing the total
operating expenses (from the income statement) and the gross margin
expected (the overall percentage of gross profit anticipated from the
store operations), use the following formula:
Sales = Operating Costs / Gross Margin
Assume that total operating expenses (the total of all store expenses)
will be $350,000. Also assume that the contribution gross margin on
sales is 34%.
Then the break-even point can be calculated as follows:
$350,000/.34 = $1,029,411
Annual sales of $1,029,411 are needed just to break even – no profit,
no loss. To calculate a monthly break-even point, divide the annual
sales number by 12.
$1,029,411/ 12 = $85,784
For further analysis, you might want to develop a graphic
representation of the break-even point. It’s a handy way to make
objectives more tangible than the usual “We need to gross $90,000 a
month” message.
By plotting the results on a graph, everyone can see at a glance how
often sales or gross profit came in above break-even. It can be a very
illuminating, or perhaps intimidating, experience to start posting
break-even projections.
Another way to use break-even figures is to measure progress toward
profit goals. This calculation will take into account the profit
forecast for a month or year. For example, say the goal for the year is
$30,000 net profit. What level of sales will be required to reach that
goal? The formula to use is:
Sales = (Operating Costs + Projected Profit) ÷ Gross Profit Margin
Calculated, it looks like this:
$350,000 + $30,000/.34 = $1,117,647
So the tirestore will have to generate $1,117,647 in annual sales to
net $30,000 or an $88,236 increase over the break-even annual sales
amount of $1,029,411.
This of course assumes no unusual or additional expenses above the projected norm.
As before, it is a good idea to chart the results on a graph. The
business will benefit any time the staff gets the opportunity to
visualize their progress toward a goal.
Yet another way to use break-even analysis is to illustrate the
multiplier effect that a change in sales can have on net income. A 5%
increase in sales, for instance, will not increase net profit by 5%.
Once the break-even point has been reached, small increases in sales
can produce large increases in net income. Financial analysts refer to
this multiplier effect as operating leverage.
Here’s an example of operating leverage: Using the same figures as the
prior example, let’s look at the effect of a 1% increase in annual
sales will have on a projected profit:
$1,117,647 x .01 = $11,176
$11,176 x .34 = $3,800
By this example, with just a 1% increase in sales, the net income will
be $33,800, an approximate 12.7% increase over the $30,000. The example
also assumes that the increased sales can be produced without an
increase in semi-fixed or personnel expenses.
It should also be noted that just as operating leverage is affected by
changes in sales volume it is also affected by a change in profit
margins.
Higher profit margins mean that a lower sales volume is needed to break
even. And slight increases in sales can generate much larger increases
in net profit. We can demonstrate this by using the prior examples but
improving the gross margin to 37%:
$11,176 x .37 = $4,135
The 1% rise in sales with the increase in gross margin to 37% now
results in an approximate 13.8% improvement in net profit. This is also
an important reason to understand the difference between profit margin
and markup.
As I said, it can be an illuminating experience.