The 1% Solution: Knowing Your Break-Even Point - Tire Review Magazine

The 1% Solution: Knowing Your Break-Even Point

Every business wants to make a profit, right? An important key tomaking a profit is understanding your break-even point. Figuring it outis a simple and necessary process for any tire dealer’s success.

Surprisingly, many owners or store managers don’t know their break-evenpoint. Yet, calculating a break-even point is a common tool in mostbusinesses. The variable nature of many business expenses, however,complicates break-even analysis for those in the tire and servicebusiness.

Before continuing, let’s take a look at what break-even is. Thebreak-even point is a sales objective, expressed in either dollar orunit sales, at which a business (or location) will “break even,”earning neither a profit nor incurring a loss. To calculate abreak-even point you’ll need to know your operating expenses includingvariable 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 objectivetarget on which to focus, using some carefully reasoned steps. Butremember, an increase in sales does not always translate into anincrease in profits.

No doubt, more than one tire dealer or manager has gotten into troubleby ignoring the break-even point. Again, this may be especially truefor tire and service operations because variable and semi-fixedexpenses can change with the volume of business and have adisconcerting tendency to get out of hand as sales increase.

In a one-product business, break-even analysis is easy. But for amulti-product or service business, the calculations can get far morecomplex. Despite the complexity, though, the basic technique is thesame.

Depending on the individual circumstances, some of the figures neededfor the calculation will be estimates. In these instances, a good pieceof advice is to make those estimates as conservative as possible. Usesomewhat pessimistic sales and margin figures and slightly overstatethe 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” isoperational or fixed costs in dollars; and “VC” is the variable costsin dollars.

Fixed costs or “fixed expenses” and “occupancy expenses”, as they maybe called on the income statement, will not vary with the level orvolume of sales. Items usually included are rent or its equivalent indepreciation, real estate taxes, utilities and repairs. Salaries arealso included, but not commissions.

Fixed costs are allocated across the entire store. Where departmentsare involved, the fixed costs may be apportioned depending on thedepartment size or according to the benefit derived from thedepartment. Usually there is little or no control over these costs.

Variable costs, which may appear as “other operating expenses” on theincome statement, move up or down in relation to sales volume.Commissions, advertising, telephone, training and expenses related todelivery vehicles are examples of variable costs. Owners and managershave considerable control over these expenses.

Before continuing, it is important to point out that the fixed andvariable costs items mentioned are meant as examples only. The specificinformation needed for break-even analysis can be taken from thebusinesses 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-evenformula to take into account the cost of goods sold. Knowing the totaloperating expenses (from the income statement) and the gross marginexpected (the overall percentage of gross profit anticipated from thestore 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 onsales 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 annualsales number by 12.

$1,029,411/ 12 = $85,784

For further analysis, you might want to develop a graphicrepresentation of the break-even point. It’s a handy way to makeobjectives more tangible than the usual “We need to gross $90,000 amonth” message.

By plotting the results on a graph, everyone can see at a glance howoften sales or gross profit came in above break-even. It can be a veryilluminating, or perhaps intimidating, experience to start postingbreak-even projections.

Another way to use break-even figures is to measure progress towardprofit goals. This calculation will take into account the profitforecast 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 thatgoal? 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 tonet $30,000 or an $88,236 increase over the break-even annual salesamount 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. Thebusiness will benefit any time the staff gets the opportunity tovisualize their progress toward a goal.

Yet another way to use break-even analysis is to illustrate themultiplier 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 salescan produce large increases in net income. Financial analysts refer tothis multiplier effect as operating leverage.

Here’s an example of operating leverage: Using the same figures as theprior example, let’s look at the effect of a 1% increase in annualsales 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 willbe $33,800, an approximate 12.7% increase over the $30,000. The examplealso assumes that the increased sales can be produced without anincrease in semi-fixed or personnel expenses.

It should also be noted that just as operating leverage is affected bychanges in sales volume it is also affected by a change in profitmargins.

Higher profit margins mean that a lower sales volume is needed to breakeven. And slight increases in sales can generate much larger increasesin net profit. We can demonstrate this by using the prior examples butimproving the gross margin to 37%:

$11,176 x .37 = $4,135

The 1% rise in sales with the increase in gross margin to 37% nowresults in an approximate 13.8% improvement in net profit. This is alsoan important reason to understand the difference between profit marginand markup.

As I said, it can be an illuminating experience.

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