Breakeven Analysis and the Margin of Safety (#70)
/In this podcast episode, we discuss breakeven analysis and the margin of safety; how they are calculated and when they should be used. Key points made are noted below.
What is Breakeven?
Breakeven is the revenue level at which you earn exactly no profit. The calculation is to add up all of your fixed expenses, and divide by the gross margin. So for example, if you have $10,000 of fixed expenses and your gross margin is 40%, then you need to sell $25,000 in order to break even. The breakeven point will go up if the amount of fixed expenses goes up, or if the gross margin goes down. Conversely, the breakeven point goes down if the amount of fixed expenses goes down or if the gross margin goes up.
How Breakeven is Used
So why do we use it? It’s good for two kinds of financial analysis. The first is when you’re looking at a business unit for the first time, usually as an outsider, like a consultant or bank analyst, and you want to find out how much money it can potentially make – or not make. For example, if a factory can potentially produce $1 million of revenue, and the breakeven point is at $200,000, then there’s lots of upward potential for profits. But where you really see the usefulness of breakeven is in the reverse, where the breakeven point is so high that the company literally can never earn any money. The breakeven point is higher than its ability to produce.
I’ve seen this last one a surprising number of times. It’s amazing how many business owners have no clue that their cost structures don’t allow them to ever earn any money.
The second type of breakeven analysis is for incremental management decisions. Usually, this involves one of two sub-levels of analysis. The first is what happens to the breakeven point if a company accepts a large order that has a relatively small gross margin – if the new gross margin is really small, then breakeven analysis shows that the order may clog up the factory’s entire capacity.
This also brings up a good point with breakeven analysis, which is that a company may have to accept price drops in order to find enough orders to max out its factory capacity. The result is that, sometimes, the highest profit level is somewhere below a facility’s maximum capacity.
The second analysis, and the one I get involved with the most, is whether purchasing new equipment is worthwhile.
I’ve seen a couple of cases where adding a complex new piece of equipment increases the fixed cost base so much that there’s no way the company can break even, or only do so if nearly its entire capacity is used. I don’t want to duplicate what I’ve said before about capital budgeting, so go back to Episode 45 to learn more about that. For the purposes of this discussion, just keep in mind that you can really attract management’s attention when they realize that a large asset purchase can render an entire factory completely uneconomical.
Also, please note that the point when a company usually makes the most profit is at the point just before a company invests in new equipment. Once it makes that new investment – usually to increase capacity – costs go up, there’s not enough product demand to use the new capacity, and therefore profits drop.
What is the Margin of Safety?
A variation on breakeven analysis is called the margin of safety. This is the percentage by which a company’s sales can drop before it reaches its breakeven point. It’s a really useful concept when a company thinks that some of its sales might be at risk of going away, such as when a single customer has a large proportion of its sales. By calculating the margin of safety, a company will know how much revenue it can lose before it’ll begin losing cash.
The calculation for the margin of safety is to subtract the current revenue breakeven level from the current sales level, and dividing by the current sales level. For example, if the current sales level is $1 million and the breakeven point is $600,000, then sales can drop 40% before reaching the breakeven point.
Breakeven and the margin of safety are useful for analyzing management decisions, because they’re so incredibly simple. Managers understand them right away, so you can easily create a before-and-after PowerPoint slide for a pricing or purchase decision, and they can see the relevant outcome.
Problems with Breakeven Analysis
The real problem with breakeven analysis is that people don’t know when to stop using it. The tendency is for someone to first use it for a company-wide or factory-level analysis, and then keep drilling down, to the point where they do a detailed breakeven analysis for a single product. The result is a report that shows a whole range of breakeven points for a company’s products, and which might even lead to some of them being discontinued. I’m sure the person who creates this level of detail thinks he’s doing a good deed, but all he’s really doing is working up the management team over what is actually a large pile of false information.
When you run a breakeven analysis on a single product, you’re probably allocating expenses to the product from a variety of work centers; and you’re also probably including direct labor when you calculate the gross margin. But that’s flawed reasoning, because if management drops a product because of a high breakeven point, it’s just voluntarily dropped a bunch of revenue, while the factory as a whole still has all of the same fixed cost structure.
In short, you can get way too granular with breakeven analysis. It’s best to stop using it at the product line level, because that’s the point at which you can usually assign specific people and equipment to a group of products. And if it’s too difficult to break out costs at the product line level, then don’t use breakeven there, either. Instead, confine the analysis to the factory level.
When to Use Breakeven Analysis
This means that you don’t need to use breakeven all that frequently. A company may have thousands of products, but perhaps only a dozen or so product lines, and quite possibly just a few factories – and only at the higher levels is breakeven appropriate.
Another issue is how frequently you should run a breakeven analysis. The answer is – not frequently at all. Most fixed expenses and gross margins don’t alter very fast, so if you run the calculation once a month, any breakeven changes will be so insignificant from the previous month that everyone will ignore it. So if you calculate it once a year, that’s fine.
Now, these frequency recommendations are based on a steady-state environment, where there aren’t many changes. However, you should run a breakeven and margin of safety for any major changes, like a new price point, or if some new equipment is purchased. So in total, depending on the size and number of changes within a company, you might only dust off a breakeven calculation a half-dozen times a year.