Breakeven Analysis – The Key

Breakeven Analysis

How many units/service jobs do you need to do on a daily basis to breakeven? To begin to predict where you begin making a profit in your business, you need to know the Breakeven Point…that moment of sales and expenses when you can breath your first sigh of relief. Most businesses spend their first 3-5 years trying to hit that breakeven mark regularly, so it’s especially critical for a new business just starting out to track and record expenses meticulously and to price based on your actual costs rather than a guess. For cleaning service businesses, you need to know, week to week, exactly how many houses you need to clean to keep the bank account in the black so that you can keep on cleaning houses for another month. As your business grows, as you gain more clients and hire more technicians, your break even point changes. That’s what makes the Breakeven point a critical metric to follow almost daily during major growth periods.

To determine breakeven, take your fixed costs divided by your price minus your variable costs. As an equation, it’s defined as: Breakeven Point = Fixed Costs / (Unit Selling Price – Variable Costs). Fixed costs (FC) are costs that are the same regardless of how many items you sell. All startup costs, like rent, insurance, and computers, are considered fixed costs because you have to make these expenditures before you sell your first item. Variable costs (VC) are recurring costs that you must absorb with each unit you sell. If you’re operating a greeting card store where you must buy greeting cards from a stationery company for $1 each, that dollar represents a variable cost. As your business and sales grow, you can begin allocating labor and other items as variable costs if it makes sense for your industry.

This calculation and its resultant graph will clearly show you how many units of a product you must sell in order to break even. You’ve recovered all costs associated with producing your product, both variable and fixed when you’ve reached this point.

Every additional unit sold after this increases profit by the amount of the unit contribution margin, which is defined as the amount each unit contributes to covering fixed costs and increasing profits. This equation is: Unit Contribution Margin = Sales Price – Variable Costs.

Costs change over time, so it’s recommended to record this information in a spreadsheet where you can easily make adjustments. It also lets you play with different pricing options and easily calculate the resulting breakeven point. If you want to give yourself a goal of a certain profit, say $1 million, then work backward to see how many units you would have to sell to hit that number.

Setting a Price to Get to Breakeven

Setting the right price (SP) is crucial to your breakeven analysis and eventually turning a profit with your startup. You can’t calculate expected revenue if you don’t know what your unit price will be. Unit price is the amount you plan to charge customers to buy a single unit of your product or service.

Pricing can involve a complicated decision-making process on the part of the consumer, and plenty of research has gone into the marketing and psychology of how consumers perceive price. Take a little time to review the pricing strategy and the psychology of pricing before choosing how to price your product or service.

  • Pricing Methods — There are several schools of thought on how to treat price when you’re conducting a breakeven analysis. It’s a mix of quantitative and qualitative factors. You should be able to charge a premium price if you’ve created a brand new unique product, but you’ll have to keep the price in line with the going rate or perhaps even offer a discount to get customers to switch to your company if you’re entering into a competitive industry.
  • Cost-Based Pricing — The cost-based pricing method calls for figuring out how much it will cost to produce one unit of an item and setting the price to that amount plus a predetermined profit margin. It’s often frowned upon because competitors can make the product for less and easily undercut you on price.
  • Price-Based Costing — According to David Bakken, Founder and Managing Director at Foreseeable Futures Group, price-based costing encourages business owners to “start with the price that consumers are willing to pay when they have competitive alternatives, and whittle down your costs to meet that price.” This allows you to lower your price and still turn a profit if you encounter new competition. Different pricing methods can be used.

Limitations of the Breakeven Analysis

It’s important to understand what the results of your breakeven analysis are telling you. If the calculation reports that you’ll breakeven when you sell 500 units, your next step is to decide whether this seems feasible.

If you don’t think you can sell 500 units within a reasonable period of time as dictated by your financial situation, patience, and personal expectations, then this may not be the right business for you. It may not turn a profit quickly enough to stay alive. If you think 500 units is possible but would take a bit of time, try lowering your price and calculating a new breakeven point. You might also take a look at your costs, both fixed and variable, to identify areas where you might be able to make some cuts.

Lastly, understand that breakeven analysis is not a predictor of demand. If you go to market with the wrong product or the wrong price, it may be tough to ever hit the breakeven point.

Service Business Product Unit Definition

Both retailers and manufacturers have a well defined product which they buy or manufacture and then sell. As we have seen above, when using the breakeven formula the business defines a unit as the product itself. The complication in calculating a service business breakeven is that the business does not tend to have a physical product to sell, and first needs to identify what it means buy a unit. For example, a consultancy business might bill customers by the hour, a salon might charge by the treatment, an educational business sells courses, and other businesses might have a set price per customer or client. In each case the service business is seeking to find out how many units (hours, treatments, courses, customers, clients etc.) it needs to reach break even.

In addition, having defined what is meant by a unit, in any service business breakeven analysis it is necessary to distinguish between variable costs and fixed costs. For a retailer, the predominant variable cost is the purchase cost of the product, for a manufacturer it is the materials and direct labor costs which go into manufacturing the product. The nature of a service based business however, means that the largest portion of its total costs normally relates to the wages and salaries of its employees and staff leading to difficulties in defining what is a variable and what is a fixed cost. Think in terms of the entire process from beginning to end that you have to utilize to deliver the service to your client. It includes the first consultation, the review of the clients needs, the process of making a a recommendation and suggestions, the quoting of rates and terms for your service and after than securing the order and delivering the service to your client.

Service Business Breakeven Examples

Set out below are examples of service business breakeven analysis for three different business each of which uses a different definition of what a unit is.

  • Example 1: Unit = Clients
    • Consider a consultancy business which defines a unit as a client, and wants to calculate how many clients it needs to break even.
      • Fixed Costs — The total fixed costs of the business are 260,000 including the cost of two full time consultants amounting to 182,000, and other fixed costs of 78,000 for rent, utilities, insurance etc. The salary costs of the consultants are regarded as fixed costs as they are paid irrespective of the number of clients.
      • Selling Price per Unit — The business estimates that an average client will need 100 hours of time spent on it each year, and that the revenue earned from each client will be on average 12,500 a year.
      • Variable Cost per Unit — It is estimated that for the average client, the variable costs for items such as printing, room hire, brochures, and computer costs will amount to 2,100 each year.
    • Based on this information the consultancy service business break even position is calculated as follows:
      • Unit = Client
      • FC = Total Fixed costs = 260,000
      • SP = Selling price per client = 12,500
      • VC = Variable cost per client = 2,100
    • Service business breakeven clients = FC / (SP – VC)
      • Service business breakeven clients = 260,000 / (12,500 – 2,100) = 25
      • The business needs 25 clients each year to break even.
      • Quick Feasibility Check — While the service business break even calculation shows that 25 clients are needed, it does not necessarily mean that the business has the capacity to cope with this level of clients. If a client needs 100 hours of time each year, the business must have at least 100 x 25 = 2,500 labor hours available to deal with these clients. Based on a 35 hr week operating 46 weeks of the year, the two consultants are able to provide 3,220 (35 x 46 x 2) hours. At break even the business operates at 78% (2,500/3,220) capacity, which is more than adequate to make reaching this break even point feasible.
  • Example 2: Unit = Hours
    • Consider a service business which wants to calculate how many chargeable hours it needs to break even. In this case the unit has been defined as an hour.
      • Fixed Costs — The total fixed costs of the business are 85,000 for items such as rent, telephone, insurance, utilities, and office staff. In this example it is assumed that the labor cost of providing the service is variable in that it can be called on as required.
      • Selling Price per Unit — The business intends to bill customers on the basis of time spent at the rate of 125 per hour.
      • Variable Cost per Unit — The labor cost to the business amounts to 50 per hour. As the labor can be increased or decreased dependent on the requirements of the business, it is regarded as a variable cost. In addition the business estimates additional variable costs will be incurred for each hour spent on a customer of 7 per hour.
    • Based on this information the service business break even position is calculated as follows:
      • Unit = Hour
      • FC = Total Fixed costs = 85,000
      • SP = Selling price per hour = 125
      • VC = Variable cost per hour = 57
    • Service business breakeven hour = FC / (SP – VC)
      • Service business breakeven hours = 85,000 / (125 – 57) = 1,250
      • The business needs 1,250 chargeable hours each year to break even.
      • Quick Feasibility Check — The service business break even calculation shows that 1,250 chargeable hours are needed. Assuming the business can call on only one person to provide the service and that they can be available if needed for 46 weeks of the year for 40 hours each week, the available capacity is 1,840 (46 x 40) hours. At break even the business operates at 68% (1,250/1,840) capacity, which is more than adequate to make reaching this break even point feasible.
  • Example 3: Unit = Courses
    • The final service business break even example relates to an operation running educational courses for students. The business has decided to define a unit as a course and needs to establish the number of courses it needs to run in order to break even.
      • Fixed Costs — The total fixed costs of the business are 51,000 for items such as rent, telephone, insurance, utilities, and office staff. In this example it is assumed that the labor cost of providing the service is variable in that it can be called on as required.
      • Selling Price per Unit — The business plans to have 20 students on each course and to price the course at 50 per student. The total sales value of course is therefore 1,000 (20 x 50).
      • Variable Cost per Unit — It is anticipated that each course will require 8 hours of labor at the rate of 50 per hour, giving a total labor cost of 400 per course. In addition, each student on the course will be provided with lunch at a cost of 10 per student giving a total food cost of 200 (20 x 10) per course. Finally the cost to rent a room for is expected to be 100 per course. The total variable costs of operating a course are therefore expected to be 700 (400 + 200 + 100) per course.
    • Based on this information the service business break even position is calculated as follows.
      • Unit = Course
      • FC = Total Fixed costs = 51,000
      • SP = Selling price per course = 1,000
      • VC = Variable cost per course = 700
    • Service business breakeven courses = FC / (SP – VC)
      • Service business breakeven courses = 51,000 / (1,000 – 700) = 170
      • The business needs to run 170 courses each year to break even. Since each course requires 20 students, the business requires 3,400 (170 x 20) students to break even.
      • Quick Feasibility Check — The service business break even calculation shows that the business needs to run 170 courses, requiring 1,360 (8 x 170) labor hours. Assuming the business utilizes the services of one person to provide the service and that they can be available if needed for 46 weeks of the year for 40 hours each week, the available capacity is 1,840 (46 x 40) hours. At break even the business operates at 74% (1,360/1,840) capacity, which is more than adequate to make reaching this break even point feasible.

Summary Service Business

Breakeven point analysis can be applied to a service based business in the same manner in which it is applied to any other type of business, but requires the business to first define the units on which it wants to perform the calculations. The units can be any appropriate measure such as client numbers, labor hours, courses, jobs, projects etc. but the analysis still requires the separation of costs into fixed and variable costs per unit.

It should also be noted that the service business breakeven analysis is only valid over a given limited range of unit sales volume. The break even calculations assume that fixed costs are indeed fixed, outside the limited range the fixed costs may need to be stepped up or down to accommodate the changing volumes. For example, larger offices may be required if the business expands resulting in a step increase in rent and other fixed costs. At this point the break even position needs to be recalculated.

If you liked this thought, you may enjoy viewing the free video The Financials – Managing Your Business Session 2 Financial Concept Uses.

Copyright ©John Trenary 2017

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