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Do You Know Your Breaking Point?


9/11/2007
By Gary Naples

Every business wants to make a profit, right? An important key to making a profit is understanding a company’s break-even point. Figuring it out is a simple and necessary process for any store’s success.
 

Surprisingly, many parts store owners, store managers, or department 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 parts business expenses, however, complicates break-even analysis for those in the automotive parts business.

Before continuing with this article 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 a division of a business) will “break even,” earning neither a profit nor incurring a loss. To calculate a break-even point you’ll need to know your department operating expenses including variable costs. You can then create a spreadsheet to chart the figures.

A parts store, for example, breaks even, then, when revenues equal total expenses. Once that point is determined, the store 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 business owner or manager has gotten into trouble by ignoring the break-even point. Again, this may be especially true for parts operations because variable (including most pay plans) 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 line like a parts 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 the businesses fixed costs in dollars; and “VC” is the operational or businesses 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. Store 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.

Let’s continue. 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 parts store expenses) will be $350,000. Also assume that the contribution gross margin on sales is 34 percent.
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 parts store will have to generate $1,117,647 in annual sales to net $30,000 or a $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 five percent increase in sales, for instance, will not increase net profit by five percent.

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 one percent 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 one percent increase in sales, the net income will be $33,800, an approximate 12.7 percent 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 percent:

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

The one percent rise in sales with the increase in gross margin to 37 percent now results in an approximate 13.8 percent improvement in net profit. This is also an important reason to understand the difference between profit margin and markup. Refer to Counterman March 2005 issue, Profit Margin or Markup: Understanding the Difference.
As I said, it can be an illuminating experience.













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