What is Break-even
As the name suggests, Break even is the point of no profit or loss. It is a situation when the business is just able to generate sufficient income to meet its expense obligations. Break-even is calculated as follows:
Break-even (Rs.) = Fixed Costs (Rs.) / Variable Margin in %
Break-even can be best explained with a practical scenario.
Mr. X is into the business of manufacturing and selling calculators. For example, the market competitive selling price of the calculator is Rs. 100. Mr. X has a manufacturing facility on rent for Rs. 1,50,000 / month. Further, he has to spend Rs. 2,50,000 / month for fixed salaries and other committed overheads. So, Mr. X will spend Rs. 4,00,000 irrespective of any production / sales achieved. This is our fixed cost.
The variable cost of producing one calculator at optimum labor efficiency and within machine capabilities is, hypothetically, Rs. 80 / calculator. This includes material, labor, machine maintenance, and other conversion costs. Thus, the Variable Margin % is 20% (100 SP 80 Variable cost).
Break-even sales value = Rs. 4,00,000 / 20% = Rs. 20,00,000 i.e. 20,000 calculators.
|Selling price (Rs. / unit)||100||110||90|
|Variable cost (Rs. / unit)||80||80||80|
|Fixed costs (Rs.)||4,00,000||4,00,000||4,00,000|
|Break-even units Nos||20,000||13,333||40,000|
At a market price of Rs. 100, Mr. X needs to sell 20,000 calculators to survive. Assuming Mr. X is currently selling 35,000 units, if the prices go up to Rs. 110 / calculator due to higher demand, Mr. X can take this opportunity of gaining market share since he is already earning handsome margins on existing sales units. Assuming that Mr. X sells at 105 instead of 110, and gains market share of additional 5,000 units [new sales is 40,000 units].
Assuming that prices later down to Rs. 90/calculator, since Mr. X now has a market share of 40,000 calculators, he is still breaking-even in a challenging market.
If Mr. X had not adjusted his pricing when prices were high, he would’ve now reported negative profits at Rs. 90 / calculator. This makes the business vulnerable to market forces, and bankers / lenders’ confidence in such businesses may get dented.
Benefits of knowing your break-even
Following are key benefits for a Company:
- Focused Sales targets, budgetary planning and sales targets hold no meaning if the Company does not know when it will break-even and start earning profits
- Pricing strategies Penetration pricing, cash discounts, volume discounts, premium pricing, etc. can be planned based on the situation the Company is in
- Fixed cost control redundancies can be avoided, and costs can be optimized. Let’s understand that fixed cost is only fixed in mind and that there should always be a motive to keep it under control and bring it down
- Variable cost control efficiencies of variable costs can be more closely monitored once its impact on profitability is clear. One can employ various tools like lean production, Six Sigma, etc. to bring the variable cost also under control
- Better visibility of P&L, better credit rating for a business, confidence of lenders, better interest rates
Challenges SMEs face in identifying their break-even
SMEs generally face the following difficulties in identifying their break-even:
- Books are not in order accounting systems at SMEs are generally observed as less robust due to sub-optimal People-Process-Systems. Even if any of them is sub-optimal, this will result in less reliable and not so timely reporting of numbers. It is more of passive reflection than active decision-making
- No clue about variable margin. Labor costs for manufacturing are not monitored and keep varying at different levels; hence variable margin is not well understood
- Incorrect inventories and valuation
- Clarity on fixed / variable costs is lacking. SMEs face difficulty in understanding the underlying nature of costs and hence identifying and separating fixed and variable costs
- Market price strategy SMEs tend to follow market prices irrespective of their capability and, in the process, deteriorate their P&L. Break-even can give a perspective to promoters to position the brand differently to earn profits.