The determination of the Balance Point (BP) is one of the central elements in any type of business as it allows us to determine the level of sales necessary to cover total costs or, in other words, the level of income that covers fixed and variable costs. This balance point (or zero leverage) is a key strategic tool in determining the solvency of a business and its level of profitability. Aaron Rodriguez, an expert in the implementation of business optimization plans, explains the true importance of having a balance point for an adequate business. To begin with, some basic aspects must be defined.
Fixed Cost (FC) makes reference to all those costs that are independent of the operation or running of the business. “Those costs that must be incurred regardless of whether the business is operating, e.g., rents, fixed costs for water, energy, and telephony, secretary, salesmen, etc. Whether or not there are sales, there is always an associated cost,” Rodriguez explains.
Variable Costs (VC) refers to everything involved in the live operation of the business, for example, merchandise or raw materials. Unlike fixed costs, variable costs change in direct proportion to production and sales volumes. For the business to make sense, the selling price must be higher than the purchase price. This difference is what is known as the contribution margin.
Based on several examples, fixed costs have a constant amount over time, since the factors involved are fixed by contract: leases, salaries, depreciation, amortization, etc. The variable cost, on the other hand, increases according to the activity of the business. The sum of both costs corresponds to the Total Costs.
Rodriguez indicates, “It is interesting to make this distinction because once the business starts operating, the race to cover the fixed costs begins first (rents, salaries) and then the variable costs (merchandise, raw materials).” When revenues reach the point where all costs (fixed and variable) are covered, it is said to be at the balance point. This point is also known as the balance point since when we cross it, we leave the deficit area and move to the profit area. To obtain this, some formulas could be used.
In the first hypothetical case, the balance point can be obtained in Value, while in the second, it can be obtained in Sales Volume. It should be clear that this second equation presents in the denominator the Contribution Margin (the difference between the Sales Price and the Cost of the product). This second equation can offer a simple way to know the balance point for any company or business that applies a standardized contribution margin.
Here the formula reduces to BP=FC/CM, where CM is the contribution margin. If the contribution margin of the product is 30% of its value (purchased at $70 and sold at $100), and the fixed costs are $5,000, the balance point is obtained in this simple way: BP=5,000/0.3: that is when the sale of $16,667 (or 167 units) is reached, the balance point has been reached.
According to this example, and to how we consider the information, we can calculate the balance point in sales volume, or the balance point in terms of value, or the balance point for long-term projects. However, beyond these considerations, there is one aspect that, as in any economic activity, is particularly relevant: the time factor. If we consider the Time factor, we can see that the reality of a business is very different depending on when it reaches the balance point. In this case, the point is reached when 167 units are sold.
“Determining the balance point allows us to check the viability of the business. If there is consistency in the rate of revenue, there will also be consistency in the range or timing at which the balance point will be reached,” says Rodriguez. If economic activity destabilizes and becomes more volatile, the balance point will also be volatile, moving out of the usual range and causing liquidity problems that will force postponement or refinancing of credit or raw material payments.
To conclude, the balance point allows you to know the level of profit. In the case of the example, once the balance point is reached, not everything sold is net profit. From each new unit sold (from unit number 168 onwards, continuing with the example), the net profit is only the contribution margin, the 30% that is already determined. This contribution margin is so-called because it contributes to the financing of fixed costs. Once the fixed costs are covered, this contribution margin becomes net profit. In other words, if an additional 100 units are sold per month, the net profit is $3,000.