Breakeven and burn rate have historically been used to gauge the viability of start-ups and high-tech companies that have yet to turn a profit. But these analytical tools can also be used by established businesses that are struggling to survive today’s challenging market conditions.
Breakeven analysis calculates the volume of sales at which a company (or investment) starts earning a profit. It’s also the point at which revenue equals total costs. To calculate breakeven, first categorize all costs as either fixed (such as rent and administrative payroll) or variable (such as materials and direct labor).
Next, calculate contribution margin per unit by subtracting variable costs per unit from the price per unit. Companies that sell multiple products or offer services may substitute $1 for the cost per unit and then estimate variable costs as a percentage of sales. For example, if a company’s variable costs run about 40% of annual revenue, its average contribution margin would be 60%.
Finally, sum up fixed costs and divide by the unit (or percent) contribution margin. In the previous example, if fixed costs were $600,000, the breakeven sales volume would be $1 million ($600,000 divided by 60%). For each $1 in sales over $1 million, the hypothetical business would earn 60 cents. So, if the company sold $1.5 million, its profit before taxes and interest would be $300,000 ($500,000 times $0.60).
When calculating breakeven, it’s important to highlight some subtle nuances. First, depreciation is normally included as a fixed expense, but taxes and interest are usually excluded. Also, fixed costs should include all normal operating expenses (such as payroll and maintenance) — not just those that would continue if the business went broke. The more items included in fixed costs, the more realistic your breakeven estimate will be.
Breakeven analysis can help you judge whether projected sales will sustain the company through a downturn. The exercise of analyzing costs also helps management re-evaluate spending habits. Based on this analysis, you may decide to cut (or postpone) discretionary costs.
How Fast Are You Consuming Cash?
Burn rate was popularized in the dot-com era, but it’s still helpful to many businesses today. For instance, seasonal and distressed companies can use it to evaluate how quickly they’re consuming their cash. In general, the slower a company’s burn rate, the better. High burn rates may be a precursor to bankruptcy.
Burn rate typically is estimated monthly. But businesses facing a crisis (or seasonal peak) may need to calculate burn rate daily or weekly to prevent excessive spending.
The calculation is fairly straightforward. Simply estimate monthly spending for operating expenses, such as:
- Marketing and advertising,
- Licenses and royalties,
- Legal and accounting fees,
- Taxes, and
- Research and development.
How long a business can stay afloat is a function of cash on hand, expected monthly receipts and current burn rate. For example, suppose a start-up has raised $20,000 of capital. It expects $10,000 of cash receipts each month, but its monthly operating expenses are $15,000. So, the company is consuming $5,000 more than it takes in each month ($15,000 minus $10,000). Unless sales improve or costs are reduced, the company will consume its cash reserves in just four months ($20,000 divided by $5,000).
As you can see, burn rate provides a deadline for when a company will become self-sustaining or need another round of financing. It’s important to recalculate burn rate regularly because unforeseen circumstances — such as equipment breakdowns, supply chain shortages, pricing volatility and sluggish consumer demand — can affect the rate of cash consumption.
Fiscal discipline is the key to surviving in today’s uncertain marketplace. Breakeven and burn rate help management stay focused. Contact your financial advisor for more information on how to apply these metrics to your business.