Importance of Break-even analysis for SMEs

Importance of Break-even analysis for SMEs

What is Break-even

Break-even???, as the name suggests, 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.

Practical scenario

Mr. X is into the business of manufacturing and selling calculators. The market competitive selling price of the calculator is say 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 1 calculator at optimum labor efficiency and within machine capabilities is say Rs. 80 / calculator. This includes the material costs, labor costs, machine maintenance, 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.

In a highly competitive environment where prices are determined by market forces, a Company can decide how far it can go in terms of competitive pricing, based on its break-even assessment. Let us look at situations of changing prices.

Selling price (Rs. / unit) 100 110 90
Variable cost (Rs. / unit) 80 80 80
Margin % 20% 27% 11%
Fixed costs (Rs.) 4,00,000 4,00,000 4,00,000
Break-even (Rs.) 20,00,000 14,66,667 36,00,000
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 the 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 difficult 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 confidence of bankers / lenders on such businesses may get dented.

Benefits of knowing your break-even

Following are key benefits for a Company:

  1. 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;
  2. Pricing strategies Penetration pricing, cash discounts, volume discounts, premium pricing etc. can be planned based on the situation the Company is in;
  3. Fixed cost control redundancies can be avoided, and costs can be optimized. Lets understand that Fixed cost is only fixed in mind and that it should always be challenged to keep it under control and bring it down;
  4. 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;
  5. Better visibility of P&L, better credit rating for 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:

  1. Books are not in order accounting systems at SMEs are generally observed as less robust often due to sub optimal People-Process-Systems even if any one 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;
  2. 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;
  3. Incorrect inventories and valuation;
  4. 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;
  5. 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.

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