Break-Even analysis is a very powerful decision model which you must have in your management arsenal.
Do not let the name of this model mislead you into thinking it just answers the question of break-even sales level. This model goes way beyond that, enabling you to play "What-If?" on a very sophisticated level.
Below, we answer a number of important financial management questions, all starting with "What-If".
The questions address giving yourself a raise, hiring a supervisor, becoming more efficient in your operations and making investments in equipment.
The range of financial questions that can be answered with Break-Even Analysis is amazing.
With break-even analysis it is possible to get a very quick idea of the impact of financial decisions you make relating to your business.
Even if you think you know how to use the Break-Even decision model, look at the examples below to make sure you really appreciate how useful this model can be.
The decision model is really very intuitive to understand. In any business, you have
The money to pay for the fixed costs comes from what is left over after the variable costs have been paid. A simple example will illustrate --
You have a job that will pay you $2,500 when completed. In finishing the job, you have accrued $1479 in material costs and $203 in labor costs. You also have a rent payment of $100, a truck payment of $50, and you want to pay yourself $500 for this week.
When you receive the $2,500 payment, you will pay the $1429 in materials and the $203 in labor that are directly related to the job. That leaves you with $868 to pay expenses that are not directly related to the job. With the $868, you pay the rent ($100), the truck payment ($50) and yourself ($500), leaving you with $218. If no other expenses remain to be paid, the $218 represents your profit on the job.
Break-Even is the sales figure at which we make no profit and also experience no loss.
We can back into the break-even number by deducting the profit in this example. If the total job revenue was $2,500 and the profit was $218, the break-even amount would be $2,500-$218, or $2,282. You can prove this by using $2,282 as the job revenue, and deducting the variable and fixed expenses.
Break-Even = $2,282 - $1,429 - $203 = $650 - $100 - $50 - $500 = $0
However, we want to be able to use the information to look forward in time, not backward. We want to be able to make a decision based on what we believe will happen. To do that, we require a decision model for calculating our break-even point on a job.
We can get all the information we need to calculate Break-Even from the Income Statement.
The first number we need is the Fixed Costs. That number is usually called Expenses on your Income Statement and comes after the Cost of Goods Sold section. We will assume that Fixed Costs = $340,000, and includes $50,000 for your compensation.
Then we need the Variable Expenses number. That is generally your Cost of Goods Sold, or job-related expenses. We will assume that Variable Expenses = $748,000.
Then we need the Total Revenue number. That is easy to find on the Income Statement. It is just your Total Sales. We will assume that Total Sales = $1,100,000.
The first step is to calculate the ratio of Variable Costs to Total Sales. If the Variable Costs (VC) for your construction company is $748,000 and Total Sales (TS) is $1,100,000, then
Job-related Costs as a percent of Total Sales = VC/TS = 748,000/1,100,000 = 68%
This result would indicate that for every $1.00 that comes into your company, $0.68 goes to pay expenses directly related to the individual project and $0.32 (or 32%) is available to pay the overhead costs. That 32% which we calculated is also know as the "Contribution Margin", because it is the amount that is "contributed" to overhead by the actual work which is done by your company.
To find the break-even point, we are looking for sufficient "Contribution Margin" to pay for all of your fixed (non-job-related) costs. The question you are asking is "How much money do I have to bring in to cover my basic operating expenses?".
Using the numbers from the above example,
Break-even sales were $1,062,500. Total Sales was $1,100,000. The difference was $37,500.
What was the profit for the year? No, not $37,500.
Recall that from every dollar earned, 68% is spent to cover job-related costs. The remainder of the $1.00, or $0.32, is "contributed" to cover fixed costs. In our example, all fixed costs were covered at Total Sales = $1,062,500. Therefore, $0.32 of every dollar earned above $1,062,500 is profit, and
Which can be proved from the Income Statement, which would show
The above information is useful to develop and understand the Break-Even decision model. However, we did all that work, and calculated the number we could have gotten just by looking at the bottom of the income statement.
How much more valuable would the decision model be if we could use it to predict the future.
Using the same numbers as above, here is how you do that...
You could pay yourself an additional $12,000 if you decided to forego any profit in the company. Probably not a wise decision.
Try these, using numbers from your own company.
What is your Break-Even point?
If you could reduce material costs by only 2%, what would be the impact on your Break-Even point.
If you could reduce direct labor costs by 5% by instituting the Subcontractor Management program, how would that effect your Break-Even point?
This simple-seeming tool can provide a huge amount of valuable information to help you make the right financial decisions regarding expenditures and investments in your company.