The Balance Point of the business and its strategic importance

The determination of breakeven It is one of the central elements in any type of business as it allows us to determine the level of sales necessary to cover the total costs or, in other words, the level of income that covers fixed costs and variable costs.

This breakeven point (or zero leverage) is a key strategic tool when determining the solvency of a business and its level of profitability. We will explain it in detail below.

Basic concepts

PtoEquilibrio

To begin, we will define some basic aspects. For fixed cost, we will denote all those costs that are independent of the operation or progress of the business. Those costs that must be incurred regardless of whether the business operates, for example rents, fixed expenses in water, energy and telephony; secretary, salespeople, etc. Whether or not there is a sale, there is always an associated cost.

For variable costs, we will denote everything that involves the live operation of the business, for example, merchandise or raw materials. Unlike fixed costs, variable costs change in direct proportion to production and sales volumes. For the business to make sense, the sale price must be greater than the purchase price. This difference is what is known as contribution margin.

Relationship between costs

As the graph shows, fixed costs (CF) have a constant amount over time (horizontal line) since the factors involved in this item have been set by contract: rents, salaries, depreciations, amortizations, etc. The variable cost (CV) increases according to the activity of the business (it starts from the beginning and has a positive slope). The sum of both costs (CF + CV) corresponds to the total costs (TC). Note that at the origin of the Cartesian diagram, both total sales and variable costs are equal to zero. However, for that level of activity equal to zero, we have the existence of fixed costs.

It is interesting to make this distinction because once the business has started, the race begins to cover the fixed costs first (rents, salaries) and then the variable costs (merchandise, raw materials). In the left part of the graph, total costs are higher than total income, hence we call it “Deficit area” (Orange). When income reaches the point where all costs (fixed and variable) are covered, it is said that it is at the equilibrium point.

Breakeven

This point is also known as breaking point, given that when crossing it we leave the deficit area and go to the benefit area (green area). To obtain the Balance Point or breaking point we can use the following formulas:

PtoEquiFormula

In the first case, we obtain the breakeven point in Value (vertical axis), while in the second we obtain the breakeven point in Sales Volume. Note that this second equation presents in the denominator the Contribution margin (the difference between the Sale Price and the Cost of the product). This second equation offers us a simple way to know the breakeven point for any company or business that applies a standardized contribution margin. Here the formula reduces to PE = CF / Mg, where Mg is the contribution margin.

Practical examples

If the contribution margin of the product is 30% of its value (it is bought at 70 euros and sold at 100 euros), and the fixed costs are 5,000 euros, the breakeven point is obtained in this simple way: PE = 5,000 / 0.3: that is, when the sale of 16,667 euros (or 167 units) is reached, the Balance Point has been reached.

According to this example, and as we consider the information, we can calculate the breakeven point in sales volume, or the breakeven point in terms of value, or the breakeven point for long-term projects. However, beyond these considerations, there is an aspect that, as in all economic activity, is of particular relevance: the time factor. If we consider the Time factor on the abscissa axis (Sales volume), we can see that the reality of a business is very different depending on the moment when I break even.

In the case of the example, this point is reached when 167 units are sold. The element to take into account is At what point is breakeven reached?. This data allows us to know the solvency of the business: If the business reaches breakeven in the middle of the month (selling, according to the example, at the rate of 12 units per day), it will make a much higher profit than if it reaches it in the last days of the month. It may also be the case that the month ends and that it does not fully cover the total costs. In this case, you will have to resort to credit to finance yourself and not face liquidity difficulties.

Determining the breakeven point allows checking the viability of the business. If there is constancy in the rate of income, it will also be in the range or moment in which the breakeven point will be reached. If economic activity destabilizes and becomes more volatile, the breakeven point will also have volatility, moving out of the usual range and causing liquidity problems that will force credit or commodity payments to be postponed or refinanced. All these behavioral signals are possible to determine with the analysis of the breakeven.

Finally, the breakeven point allows you to know the level of benefits. In the case of the example, once the breakeven point is reached, not everything that is sold is net profit. Of each new unit sold (from unit number 168 onwards, continuing with the example) the net profit is only the contribution margin, the 30% that is already determined. This contribution margin is so named because contributes to the financing of fixed costs. Once the fixed costs are covered, this contribution margin becomes net profit. In other words, if 100 additional units are sold per month, the net profit is 3,000 euros.

In The Salmon Blog | What is leverage?, What are the expenses of a company?


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