Although the goal of any business is to succeed and become profitable, this task cannot be accomplished without verifying reliable data on its financial situation. The accounting break-even point is an effective way to perform this data assessment.
With this methodology, entrepreneurs can find out exactly the amount needed for their enterprise to pay its expenses and become viable. In addition, based on the information it provides, it becomes easier for entrepreneurs to plan their activities and ultimately make a profit.
Would you like to learn more about the accounting break-even point? Keep reading and find out how to calculate it and apply it to your business!
Concept of accounting break-even point
It is no surprise that running a business entails several expenses. Some enterprises go through constant loss periods at the beginning of their operation, a situation that requires capital availability from shareholders and investors for them to remain active.
Break-even point is the moment when the company’s turnover is enough to finance its operation, so that shareholders and investors are no longer obliged to make constant contributions to ensure their operations.
Achieving a balance between revenues and expenses is critical to the financial health of any business. But it is important to emphasize that the ultimate goal of every enterprise is to achieve profit, and this point exists as a parameter to make this goal viable.
Thanks to its simplicity, which makes its calculation and application quick and intuitive, the accounting break-even point is the methodology most used to check the financial situation of a company. It has two variations: as each of them is suitable for a different scenario, it is necessary to know them.
Financial break-even point
There are many companies that include in their annual balance sheets the depreciation of assets and other non-refundable costs. The methodology behind the financial break-even point takes into account only the expenses that are directly discounted from the company’s cash, which automatically leaves the undiscounted expenses out of the calculation.
Therefore, when performing the calculation to verify the financial break-even point of a business, expenses such as devaluation of machines and equipment, which do not represent a real cost, should not be computed.
Economic break-even point
When entrepreneurs invest their resources in a business, they miss out on other forms of investment, which, in a way, can be considered an “opportunity cost”. The goal of the economic break-even point is to measure this cost.
For example, by using $100,000.00 to open a store, the entrepreneur gives up on investing that capital in an investment that would provide him with an annual interest rate.
The economic break-even point of a company is only reached when its turnover is enough to fund its operations and still deliver the same return that a financial investment would have.
Let’s say that the store in question has its accounting break-even point equivalent to $150,000.00. To open the store, the entrepreneur forgoes an investment that would yield 10% per year, that is, $10,000.00. For this store, the economic break-even point would be $160,000.00.
Formula of the method
The break-even point calculation is directly linked to two variables: fixed expenses and contribution margin. Before learning the formula, you should understand what these variables are.
This variable is composed of the various costs that a company has to maintain its operations; among them we can mention:
- office supplies;
Production expenses such as sales taxes, sales commission and raw materials should not be considered. That is because these amounts are already added to the final product cost.
Contribution margin is the gross result obtained from the company’s sales. In addition to being important to verify the break-even point, it is useful for calculating the best price for selling a product.
Its calculation requires that the costs with goods sold are added to sales taxes. This amount should be subtracted from the total number of sales in the period.
For example, let’s say that a company had an $200,000.00 turnover with its product in a given period. During that time, its costs to provide the service were $30,000.00 and taxes were $80,000.00.
Proceeds = $200,000.00
Production costs (PC) = $30,000.00
Taxes (T) = $80,000.00
Contribution margin (CM)
CM = $200,000.00 – ($30,000.00 + $80,000.00)
CM = $200,000.00 – $110,000.00
CM = $90,000.00
CM % = $90,000.00/$200,000.00
CM % = 45%
After performing the calculation, it is easy to verify that the contribution margin is $90,000.00 or 45% of the total amount collected from the services provided.
Application of the formula
Finally, in order to calculate the break-even point (BEP) of a company, just divide its fixed expenses (FE) by its contribution margin (CM).
BEP = FE/CM
It is easier to see how it works using an example. However, it is necessary to consider that the contribution margin must be presented in its percentage form in the formula.
Let’s say that a certain company has annual fixed expenses of $100,000.00. In that same period, its contribution margin is 18%.
BEP = FE/CM
BEP = 100,000/0.18
BEP = 555,555.55
Therefore, to avoid losses, the company in question needs to have a minimum annual turnover of $555,555.55.
The same formula should be used to calculate the financial and economic break-even point. However, for the financial BEP it is necessary to disregard all non-disbursable expenses of the operation. For the economic break-even point, the opportunity cost must be added to the fixed expenses.
For example, if the opportunity cost is equivalent to 10%, in the previous situation it would represent $10,000.00. Therefore, after being added to the fixed expenses, they would reach $110,000.00.
Without knowing for sure the amount needed to pay its fixed expenses, it becomes impossible for entrepreneurs to plan their operation and make profits. For this reason, it is no exaggeration to say that the methodology to find the break-even point is vital for any entrepreneur who wishes to be successful.
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