Calculation of the Profitability Threshold

Welcome to this chapter on calculating the break-even point!

There are different ways to calculate the cost of a product within a business unit. For example, the full cost method is used to calculate the cost price of a product. But the partial cost method is more favorable for calculating the break-even point.

In this BTS MCO Operational Management course, you will learn everything you need to know for the calculation of the break-even point in order to properly prepare for your E5 test.

Within the business unit, the manager needs to know how to calculate the break-even point because it determines the turnover at which the company reaches equilibrium.

The manager therefore has an objective to achieve because he knows that the profits will only see the light of day when this turnover resulting from the break-even point calculation is achieved.

Here's what you'll learn in this break-even management course:

• Variable and fixed charges
• How to establish a differential income statement?
• Definition of the break-even point
• Calculation of the break-even point
• How to calculate the breakeven point?
• What is the point of using the break-even point?
• Margin of Safety and Safety Index: How to Calculate Them?
• Conclusion

 

Before talking about calculating the break-even point, it is necessary to understand the different categories of expenses that allow us to get there.

There are different ways to distinguish costs within the business unit. Partial cost analysis is the most relevant for calculating the break-even point. This method consists of distinguishing between fixed costs on the one hand and variable costs on the other.

 

Variable and fixed charges

Variable expenses

Variable costs vary depending on the activity. They are also called operating expenses. They are assumed to be proportional to the company's activity.

Variable costs are mainly:

• purchases of goods
• purchases of raw materials
• purchasing supplies
• sales commissions
• shipping charges
• charges related to product packaging
• packaging costs
• transportation costs

 

Example of variable charges

The Milatra company sells mobile phones in the Lot department. Patricia, a versatile saleswoman, spends 3/4 of her time selling mobile phones.

A phone bought for 120 euros excluding VAT is resold for 270 euros excluding VAT. For this task, she is paid 1 €. She also receives a 500% bonus on each sale. During the period, Patricia sold 20 phones.

These sales also generate fixed costs of around €2. Salary contributions are 000%.

Variable costs correspond to the purchase of telephones, Patricia's bonus accompanied by the contribution.

The total variable charges correspond to the following calculation:

(900 x €120) + (€270 x 900 x 0,2) + (€1 x 500) = €0,45

The total variable charges therefore amount to €157.

 

Fixed charges

Fixed costs do not vary depending on the activity, they are incompressible.

They generally correspond to the following headings:

• fixed assets
• charges related to the structure of the company
• rent
• amortization
• personnel costs,
• heating
• provident insurance
• the subscriptions

A structure corresponds to a level of activity. Moreover, fixed costs are also called structural costs.

 

Example of fixed charges

Fixed costs correspond to Patricia's salary, expenses incurred and the contribution on the salary.

The total fixed charges correspond to the following calculation:

€1 + (€500 x 1) + 500 = €0,45

The total fixed charges therefore amount to €4.

If you would like to see a practical exercise on the allocation of variable and fixed costs, I suggest this video:

 

How to establish a differential income statement?

The differential income statement is a table which highlights the variable cost portion and the fixed cost portion of the operation considered.

In addition, the differential analysis table also specifies the margin achieved with regard to variable costs, i.e. the margin on variable costs. It also allows us to see whether the company is achieving a perte or a profit.

In some cases, it can highlight several types of margins such as:

1. the margin on variable purchasing costs
2. the margin on variable production costs

The amounts are also evaluated as a percentage of the turnover, except for the amount of fixed costs. The differential income statement allows to determine whether the company has made a profit or a loss.

I also specify that the sum of several charges corresponds to a cost.

Here is a concrete example of a differential income statement:

For the calculation of the margin on variable costs, I suggest you read my article Business Calculations: 36 Formulas to Master Them.

After seeing the fixed and variable costs as well as the differential income statement, we can move on to the break-even point calculation part.

But first, you need to know what exactly we are talking about, that is to say, know the definition of break-even point.

 

Definition of the break-even point

The break-even point is the revenue at which the business unit begins to make a profit on a service, product, or commercial operation. (eg: a mailing or a trade fair organization). This is a particular turnover also called " critical turnover ».

It’s a minimum turnover to be exceeded if the company wants its activity or even a commercial operation to be profitable.

Le calculation of the break-even point allows you to target a number of services to sell or a number of products to manufacture since it is expressed both in value and in volume.

 

Calculation of the break-even point

The break-even point can be calculated in different ways based on the following elements:

• the turnover excluding tax
• the selling price excluding VAT
• the amount of variable charges
• the amount of fixed charges
• the margin rate on variable costs

 

Break-even formulas

Break-even point in value = Fixed costs / Margin rate on variable costs

Profitability only in value = Fixed costs / [(Turnover – Variable costs) / Turnover]

Break-even point in quantity = Break-even point in value / Unit selling price excluding tax

The break-even point in quantity corresponds to the number of products or services to be sold for the business unit to achieve zero profit. Beyond this minimum volume, the company begins to make a profit.

 

How to calculate the break-even point?

The break-even point corresponds to the date on which the profitability threshold is reached. It is from this point that the operation in question begins to become profitable. At the break-even point, the company makes neither loss nor gain: its result is zero.

The break-even point formula is:

Break-even point = (Break-even point ÷ Revenue) x 360 days

 

What is the point of using the break-even point?

The break-even point can be very useful in the following cases:

• During a business creation at the time of writing the forecast
• If you have a business takeover to know if the latter is profitable or not

 

Margin of Safety and Safety Index: How to Calculate Them?

 

What is the margin of safety?

The safety margin is the difference between the turnover achieved and the break-even point.The company can withstand this drop in turnover before recording an accounting loss.

 

How to calculate the safety margin?

To calculate the safety margin, you must apply the following formula:

Margin of safety = Turnover – Break-even point

 

What is the safety index?

The safety margin expressed as a percentage of turnover corresponds to what is called the safety index..

The company can withstand this percentage drop in turnover before recognizing an accounting loss.

 

How to calculate the safety index?

To calculate the safety index, you must apply the following formula:

Safety Index = Safety Margin / Turnover

 

Conclusion on the calculation of the break-even point

The break-even point can also be determined using a graph by integrating the fixed costs line and that of the variable cost margin.

This possibility of “calculating” the break-even point makes it possible to highlight the loss zone and the gain zone.

If you want to apply what you have just read, I strongly invite you to consult my article on corrected management exercises entitled Profitability Threshold: 13 Corrected Financial Years.

There you go, now you know how to do it calculation of the break-even point. You no longer have any excuse not to achieve your goal: Get an excellent grade in the Operational Management test!