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[kcjenkins]

Art of Accounting: Break-even Analysis

August 8, 2014
By Edward Mendlowitz

One of the best tools to evaluate a business and get a quick handle on the knowledge of the owner or manager is the break-even analysis.

Break-even analysis is a simple calculation that tells how much sales are needed to break-even, and how much will be lost or earned when sales fall short of that amount or exceed it. A key part of this is to determine the “product lines” a business has and its direct cost structure.

 

A simple explanation is to imagine a bar and restaurant. There are two basic product lines—liquor and food. Generally the direct costs for the bar are around 20 percent and the food around 35% percent. If bar sales are 40 percent of the total and food 60 percent, we can then get a weighted average of sales. This information can be applied to almost any business.

 

Now, how I get this information is very insightful to me. I get it over lunch with my client—primarily new clients—and write it on a napkin. I believe most owners or managers should understand and have a handle on the product lines and the approximate direct costs. Most do, but some do not.

I am appalled when clients do not have a clue about this information. This tells me a lot about them and how the business is being managed—it isn’t. I then draw up a proposal to provide a methodology for helping them get a better grasp and establish controls.

 

For those that know, I test what they told me and then complete the B/E analysis for them. It then becomes one of their management tools.

 

The more knowledgeable the client, the better it is to work with them.

 

 

Edward Mendlowitz, CPA, is a partner in WithumSmith+Brown, PC, CPAs. He has authored 20 books and has written hundreds of articles for business and professional journals and newsletters plus a Tax Loophole article for every issue of TaxHotline for 27 years. Ed also writes a blog twice a week that addresses issues his clients have at www.partners-network.com. He is the winner of the Lawler Award for the best article published during 2001 in the Journal of Accountancy. He has also taught in the MBA graduate program at Fairleigh Dickinson University, and is admitted to practice before the U.S. Tax Court. Ed welcomes practice management questions and he can be reached at WithumSmith+Brown, One Spring Street, New Brunswick, NJ 08901, (732) 964-9329, [email protected].

[JohnH]

Very good article.

I can see how a service-type business can squeak by without an understanding of break-even analysis. Not because a break-even point doesn't exist, but because the break-even point for many service businesses is the sum of all their fixed costs plus a few other simple adjustments & tweaks. The owners often carry this figure around in their heads even if they don't know what to call it.

But for a manufacturer, fabricator, or any business for which COGS is an important consideration, failure to understand B/E analysis is a surefire route to bankruptcy. They can get by without it when times are good, but when business slows down they will tend to make very bad decisions. Or as Warren Buffett says, "You never know who's swimming naked until the tide goes out."