Managers often want to know how much they need to sell in order to break even or in order to earn a target level of profit. To get this information, managers derive something called a break-even point (BE) — the amount of sales necessary to earn zero profit.
Why bother? Because knowing the break-even point helps you set sales targets.
To figure out the break-even point when you make and sell more than one product, follow these steps:
Compute the contribution margin ratio for each product.
Contribution margin measures how sales impact net income. As it comes in, contribution margin offsets fixed costs. After the total contribution margin exceeds fixed costs, it begins to increase profits above zero. (Of course, if contribution margin falls short of fixed costs, then the company incurs a net loss.)
To compute a company’s total contribution margin, subtract variable costs from sales:
Contribution margin = Sales – Variable costs
Contribution margin tells you how a company’s sales affects profits. For example, if a given sale creates $50,000 worth of contribution, that money will cover fixed costs and then go straight to the bottom line, net income.
One particular measure of contribution margin is the contribution margin ratio, which you compute by dividing total contribution margin by total sales. For example, a contribution margin of $300, with total sales of $400, works out as a contribution margin ratio of 75 percent.
You can also calculate contribution margin ratio on a per-unit basis, dividing a given product’s contribution margin per unit by its sales price.
Estimate the sales mix.
Sales mix is the relative percentage of sales of each product. To figure out the sales mix, divide the sales of each type of product by total sales. The sales mix percentage of all products should always add up to 100 percent.
Suppose that fictional Acme Company sold $8 million worth of rocket-powered products and $2 million worth of giant rubber bands. To figure out the sales mix, divide the sales of each type of product by total sales. Acme’s sales mix percentage of rocket-powered products is 80 percent, while its sales mix percentage of giant rubber bands is 20 percent.
Calculate the weighted average contribution margin ratio (WACMR).
The weighted average contribution margin ratio (WACMR), affectionately known as Wack ’em ’er, is an average of all products’ contribution margin ratios, weighted by sales. To compute WACMR, multiply each product’s sales mix percentage by its contribution margin ratio. Then add all the products together.
Suppose that rocket-powered products have a contribution margin ratio of 30 percent, while giant rubber bands have a contribution margin ratio of 60 percent. (This scenario means that the rocket-powered products are a loss leader for giant rubber bands. A loss leader attracts customers to the business in order to encourage them to buy more profitable products.)
Even though Acme sells two classes of products with widely different contribution margin ratios, the average contribution margin ratio for all products sold — WACMR — equals 36 percent.
Divide total fixed costs by WACMR to get the break-even point in dollars.
In the preceding step, you discover that Acme has a WACMR of 36 percent. To figure out the break-even point in sales dollars, divide total fixed costs by WACMR. Now suppose that the company also has fixed costs of $3.6 million. Plug this information into the following formula to determine the break-even point.
Acme’s break-even point is therefore $10 million worth of sales. When Acme achieves this level of sales, its contribution margin will have covered its fixed costs, and the company will have earned zero profit. After it earns more sales, the excess of contribution margin over fixed costs results in positive net income.
