One useful tool in tracking your business’s cash flow is abreak-even analysis. It’s a fairly simple calculation and can provevery helpful in deciding whether to make an equipment purchase orin knowing how close you are to your break-even level. Here are thevariables needed to compute a break-even sales analysis:
- Gross profit margin
- Operating expenses (less depreciation)
- Annual debt service (total monthly debt paymentsfor the year)
Since we’re dealing with cash flow, and depreciation is anoncash expense, it’s subtracted from the operating expenses. Thebreak-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’sbreak-even sales for years one and two. In Year 1, the company’ssales were $1 million and their gross profit was $250,000,resulting in a gross profit margin of 25 percent ($250,000/$1million). In Year 2, sales were $1.5 million and gross profits were$450,000, resulting in a gross profit margin of 30 percent(($450,000/$1.5 million). Now let’s use calculate their break-evensales figure:
Break-Even Sales for Year 1:
(Operating Expenses of $170,000 + Annual Debt Service of$30,000)/
Gross Profit Margin of 25 percent (.25) = $800,000 break-even salesfigure
Break-Even Sales for Year 2:
(Operating Expenses of $245,000 + Annual Debt Service of$30,000)/
Gross Profit Margin of 30 percent (.30) = $916,667 break-even salesfigure
It’s apparent from these calculations that ABC Clothing was wellahead of break-even sales both in Year 1 ($1 million sales) andYear 2 ($1.5 million sales).
Break-even analysis also can be used to calculate break-evensales needed for the other variables in the equation. Let’s say theowner of ABC Clothing was confident he or she could generate salesof $750,000, and the company’s operating expenses are $170,000 with$30,000 in annual current maturities of long-term debt. Thebreak-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 operatingexpenses. If we know the gross 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
