Understanding How to Calculate Break-Even and Set Profit Targets
Achieving profitability is the goal of any business. It is also one of the things that you are likely to be working with your clients to achieve, particularly if you work with business clients in an advisory capacity. As an accountant, it is likely that you will be responsible for providing expert advice and guidance on ways in which businesses can streamline their operations and minimise their expenses, whilst maximising their income and therefore their profit. Therefore, it is important that you are familiar with the different formulas that can be used to calculate profitability, and how break even calculations and other formulas come into play in this.
In this article, we will start by looking at what profitability is and why it is important, before moving on to some of the key calculations and formulas are that you will use to determine the current profitability of your clients’ businesses. We will also be looking at the role of break even calculations in assessing profitability, before finishing up by looking at setting profit targets in more depth. This is likely to be something that you will be assisting your clients with regularly in your day-to-day work as an accountant, so it is important that you understand how to support your clients in setting realistic targets that put them on the right track to achieving their business goals.
What is profitability?
When we talk about profitability, we are talking about the ability of a business to generate a profit. The term profit is used to refer to the financial gain that a business achieves by carrying out its business activities, once all expenses have been deducted. Usually, businesses generate profit by providing goods and services to their customers.
Profit can also be considered as being the difference between the business’s income and expenses. Where this is positive (meaning the business’s income is greater than its expenses), this is referred to as profit, however if this is negative (meaning the business’s expenses are greater than its income), it then becomes a loss.
Profit is calculated by subtracting the business’s expenses from its income. As a formula, it can be expressed as:
Profit = Income - Expenses
For example, let’s say Company A generates $560,000 in income per year and has $340,000 in expenses. If we plug this into the above formula, this gives us:
Profit = 560,000 - 340,000 = $220,000
This means that Company A earns $220,000 in profit per year. You will notice that this basically represents the amount of income that is left after all of Company A’s expenses have been deducted. Because Company A’s income is greater than its expenses, this means that their business is profitable.
As another example, let’s say Company B generate $57,000 in income per year, however their expenses are $72,000. If we plug this into the above formula, this gives us:
Profit = 57,000 - 72,000 = ($15,000)
You will notice that in this situation, Company B’s expenses are greater than its income. This means that Company B is actually running at a loss, meaning it is not profitable.
Common calculations used to assess profit
There are a number of other calculations that are commonly used to determine how much profit a business is making. These include:
- Expenses and costs: To be able to calculate how much profit a business is making, it is necessary to first calculate what their total expenses and costs are. This means adding up all of the expenses that the business incurs (including both fixed expenses and variable expenses, which will also cover overheads and the cost of goods sold, along with any other costs). This could be expressed as:
Total Costs = Fixed Expenses + Variable Expenses + Other Costs
For example, if Company C incurs $20,000 in fixed expenses and $12,000 in variable expenses per year, when you add these two together that gives you $32,000 in total expenses.
- Income: This is calculated by adding together all of the revenue (or money) that the business has made within a particular period of time. Most commonly, this revenue will come from the sale of goods and services. However, some businesses may also generate revenue through other sources. This could be expressed as:
Total Income = Sales + Other Income
Using Company C again as an example, they might make $8,000 in sales for Product A, $4,000 in sales for Product B, $13,000 in sales for Product C, and $7,000 in sales for Product D. Assuming they don’t receive any other income, when you add these together, you will arrive at the total income for Company C which is $32,000.
- Turnover: Turnover refers to the total amount of money that a business generates through the sale of goods and services. This can be calculated in two ways.
The first is to multiply the number of customers by the average number of transactions per customer by the average value of each transaction. This can be expressed as:
Turnover = Number of customers x Average number of transactions per customer x Average value of each transaction
For example, if Company D has 100 customers who each perform one transaction each at an average value of $25 each, you would multiply 100 x 1 x 25. This will give you a total turnover of $2,500.
It can also be calculated by multiplying your volume of sales by the price the business sells its products or services for. This can be expressed as:
Turnover = Volume of Sales x Price of Goods and Services
For example, if Company D sells 1,000 products for $10 each, the total turnover will be $10,000.
- Net and gross profit: The net profit is the amount of money that the business will have left after deducting its operating expenses. It can be calculated by subtracting the total operating expenses from the total revenue. This can be expressed as:
Net Profit = Total Revenue - Total Operating Expenses
For example, if Company E makes $700,000 in revenue per year but its total operating expenses is $570,000, this would mean that it makes a net profit of $130,000 once all of its costs have been deducted.
The net profit can also be expressed as a net profit margin, which provides an indicator of the business’s overall financial health. This is calculated by dividing the net profit by the total revenue, then multiplying it by 100. This can be expressed as:
(Net Profit / Total Revenue) x 100
Using our previous example with Company C, this would mean that if you divide their net profit of $130,000 by their total revenue of $700,000 then multiply that by 100, that gives you a net profit margin of 18%.
Generally speaking, 5% is a low net profit margin, 10% is a healthy profit margin, and 20% is a high profit margin. This margin represents the business’s profit as a proportion of the total amount of money earned by the business. This means that, for example, for a business that has a net profit margin of 20%, 80% of the money they earn will be expenses and 20% will be profit.
Gross profit is calculated in the same way, only it is calculated by subtracting the total cost of goods sold from the total revenue. This can be expressed as:
Gross Profit = Total Revenue - Total Cost of Goods Sold
Using our previous example of Company E, let’s say their total cost of goods sold is $200,000. If we subtract this from their total revenue of $700,000, that gives us a gross profit of $500,000.
Likewise, the gross profit margin is calculated by dividing the gross profit by the total revenue, then multiplying it by 100.
For many types of businesses, a gross profit margin of 50 - 70% would be considered good. However, for other types of businesses, what is considered to be a good gross profit margin could be much higher or much lower. This is something that can vary significantly depending on the types of products or services that the business sells, as well as the industry or sector in which it operates.
Other calculations used to assess profitability
There are a number of other calculations that can be used by businesses to measure their profitability. These include:
- The accounting rate of return (ARR), which is used to compare the future net revenue (or earnings) of a particular project or asset to its initial capital cost (that is, the cost of the initial investment). It is calculated by taking the average net income that a particular project or asset is expected to generate for the business, and dividing this by the average capital cost. This will give you a percentage, which represents the expected annual rate of return.
- The required rate of return (RRR), which you may also hear referred to as the hurdle rate. This identifies the minimum return that an investor would accept for a particular investment. This minimum rate of return represents a certain amount of compensation that the investor would expect to receive in return for a certain level of risk being involved in the investment. This minimum required rate of return can be calculated using two models: the dividend discount model or the capital assets pricing model.
- The average annual profit, which is the total amount of profit that the business expects to earn per year. It is calculated by dividing the total profit over the investment period by the number of years.
- The payback period, which looks at how long it takes for a particular capital investment to generate enough revenue to recoup the initial cost of the investment. It is calculated by dividing the cost of the investment by the annual cash flow. The shorter the payback period is, the faster investors will be able to recover the cost of their investment.
- The return on investment (ROI), which is calculated by subtracting the cost of an investment from its final value, and then dividing this by the cost of the investment and multiplying it by 100. When the return on investment is positive, this means that the returns being received will be greater than the initial cost of the investment, meaning the investment will be a profitable one.
- The profitability index (PI), which compares the present value of the cash inflows and outflows associated with a particular capital investment. It is calculated by dividing the present value of the inflows by the present value of the outflows. The greater the profitability index is, the more profitable the investment will be.
- The net present value (NPV), which looks at the difference between the present value of cash inflows and cash outflows over a period of time. It is calculated by first determining the cash inflows and outflows for the relevant time period, and discounting them to determine the present value. The cost of the initial investment will then be deducted from the total discounted cash flows to arrive at the net present value.
- The internal rate of return (IRR), which is calculated using the same formula that you would use to determine the net present value. However, with the internal rate of return, the net present value of all cash flows is set as equal to zero. This shows the annual rate of growth that is expected to be generated by a particular investment, which plays a role in how profitable that investment will ultimately end up being.
- The return on capital employed (ROCE), which looks at how efficiently and effectively a business is generating profits from its available capital. It is calculated by dividing the net operating profit by the total capital employed.
Although it would be impossible to cover all of these within the scope of these article, it is likely that you will be exposed to all of these in your professional practice as an accountant when supporting clients to improve the profitability of their businesses.
Together, these measures and metrics can be used to provide businesses with a comprehensive picture of their overall financial health and financial position, as well as their profitability (i.e. whether their current business activities are profitable).
By assessing the profitability of a business, it is also possible to highlight opportunities for improvement. For example, should the business stop offering certain products and services because they are not profitable, or is there a way for them to cut their costs in some way to increase their profit margin? All of these are questions that an accountant who is experienced in helping businesses to increase their profitability will be able to answer. They will also be able to assist with things like setting profit goals and targets, which we will be looking at in more detail later in this article.
For this reason, it is recommended that businesses work with an accountant who is experienced in profitability to ensure they are doing all that they can to maximise their profitability, and therefore their overall success as a business.
Break even calculations
There is one other important profitability calculation that we have not looked at yet, and that is the break even point. The break even point is reached when a business’s total revenue is equal to its total costs - that is, its income is equal to its expenses. In other words, the business is just “breaking even”, without any kind of profit or loss.
The break even point can be calculated in two different ways. The first calculates the break even point as a dollar value, and is calculated as follows:
Break Even = Overheads / (1 - (Cost of Goods Sold / Total Sales))
Let’s say Company F produces a particular product. To produce this product, they might incur overheads of $10,000 and the cost of goods sold might be $45,000. They might sell 50,000 of this product per year.
If we input these numbers into the above formula:
Break Even = 10,000 / (1 - (45,000 / 50,000) = $100,000
As a dollar value, this means that Company F must sell $100,000 worth of products to break even. This means that they will be covering all of their costs, but will not be making any kind of additional profit on top of this.
The second way to calculate the break even point is as the number of units of product that need to be sold. This is calculated as:
Break Even = Overheads / (Unit Selling Price - Unit Cost to Produce)
Let’s say that we have Company G, who produce a particular product for $4.50 per unit. They might sell 10,000 units per year for $12 each, and also incur $12,000 in overheads in addition to the cost to produce the products themselves. If we input these figures into our formula:
Break Even = 12,000 / (12 - 4.50) = 1,600
This gives us our break even point as a number of units. Again, this means Company G must sell 1,600 units in order to break even. If they sell more units than this, they will then be making a profit. However, if they make less than this, they will not be breaking even.
In order for a business to become profitable, it is important that it first has the ability to break even, or to recoup all of its operating expenses within the amount of revenue generated. For this reason, it is important that businesses are able to identify the number of units or dollar value in sales they need to make in order to break even.
Helpful Resources
For a practical explanation of break-even analysis and how it applies to real businesses, this Investopedia guide on break-even analysis offers a solid foundation.
Setting Profit Goals and Targets to Achieve Business Objectives
For businesses to become profitable, it is essential that they have proper, clearly-defined profit targets in place that are backed up with realistic financial strategies to help them get there. By working with an experienced business accountant, businesses can develop clear strategies that will keep them on the right track to achieving their profit goals, and ensuring the success of their business overall.
There are a few different ways that businesses can go about setting profit targets. As a general rule though, they will need to:
- Consider the business’s current income and expenses. This will assist them in arriving at a profit target that is realistic and achievable for the business and its current level of financial performance.
- Start off by setting a target net profit (or net income). This will basically be the amount of revenue that the business is aiming to generate in profit once all of its expenses have been deducted.
- Set targets for the gross profit margin and minimum number of sales that will be needed to achieve the target net profit goal that they have in mind.
- Prepare sales forecasts to estimate the amount of sales that are expected compared to the number of sales that will need to be generated in order to meet the set profit targets.
- Develop a clear strategy for the products and services or business activities to focus on to drive maximum profits.
- Start implementing this plan across the different teams within the business. This step might include taking specific actions to boost sales or promote certain products, along with streamlining operations, cutting costs, and adjusting pricing.
- Over the coming months, the business will need to continue monitoring their progress as they work towards achieving their profit targets. Along the way, it may be necessary to make adjustments if the business finds that the initially planned strategies are not bringing them as close to achieving their profit goals as they had hoped.
Accountants with experience in supporting businesses to maximise their profitability are well-placed to assist their clients with setting profit goals and targets. For this reason, it is important that, as an accountant, you are familiar with the many different kinds of profit calculations. You should also be well versed in profit goal setting, as well as the different strategies that can be used by businesses who are wanting to increase their overall profitability.
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