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This module explains, how to analyse and interpret the figures from the profit and loss statement and how to determine and analyse the breakeven point.
Good decisions are necessary to manage a business successfully. Good decisions are based on the analysis of information about the business itself, the local and national economy, and the market potential for your products. Your books and records provide part of the information about the state of the business, namely, basic financial information. This section tells you how to analyse and interpret financial information about your business.
Module 5, “Profit and Loss Statement”, explained how to calculate profit. But why should you make a profit? And what information can you draw from a profit and loss statement?
After you have analysed the profit and loss statement, you should be able to identify and understand your financial problems.
Even if a business makes a loss every year, it may still live as long as there is cash. But only for a certain time, because all money initially invested for workshop and equipment will be used up and there will be no money left to replace old equipment or to expand the workshop. After a certain time of loss, the business will even cease to exist, namely then, when all the money is used up. But there are also other reasons for making a profit.
· Loan repayments,
· Unexpected costs and emergencies,
· Cash reserve for when business is slack,
· Business expansion,
· Income for you and your family.
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Profit is necessary for the survival of the business |
Generally speaking, profit is the difference between income (= gross profit) and costs (= expenses).
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The higher the income is, compared to the costs, the higher the profit. Normally, income and costs are not stable, they change all the time. If, for example, the income increases and the costs stay stable, the profit will increase. If, on the other hand, the income stays stable and the costs increase, the profit becomes smaller or even turns to a loss.
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Costs should be kept as low as possible. It is important to analyse costs whenever they increase. Income should be as high as possible. Decreasing income should be analysed carefully. |
The Analysis is made in three steps:
Step 1
What trend has profit/loss?
Make an actual profit and loss statement. Is there a profit or a loss? Is it higher or lower compared to earlier profits/losses? Is there a trend over the last periods? If there is an increasing loss, you are in a very bad situation. If there is a loss, but losses becoming smaller every period, you still are in a bad, but improving situation. If there is a profit, but profits are becoming smaller every period, you should carefully analyse your situation. Only if there is an increasing or at least stable profit, you are in a good position.
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In the last quarter Mr. Garcia made a profit of LU 63’000. He is satisfied with this profit. But he recognizes with sorrow that the profit is becoming smaller from period to period. |
Step 2
What trend has sales income?
Use the last three to five profit and loss statements and compare the figures for sales income. What general trends do you see? Are sales increasing or decreasing? What types of good had increasing or decreasing sales? Did customer preferences change? Were your prices too high? Was a certain type of good of poor quality?
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Income from tile sales was as follows: The turnover of gray tiles steadily decreased because in Mr. Garcia’s town they are too expensive for low cost housing. The turnover of red and traditional tiles, however, was increasing as a result of NGOs and wealthier people buying these types of tiles. Mr. Garcia could sell much more red tiles if he could produce enough of them. But in the past, he could never produce enough tiles, because his untrained workers had a low productivity and wasted raw material. |
Step 3
What trends have costs?
Use the last three to five profit and loss statements and compare the figures for costs. What general trends do you see? Are costs increasing or decreasing? Which prices and costs are increasing faster than others? Was there a loss or waste of raw materials? Did you need more raw material because of poor quality?
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The raw material prices increased. This can be explained by increases in the price of cement. An analysis of cement prices from several suppliers shows that although the cement price rose generally, Mr. Garcia’s supplier’s price was always 15% higher than that of other suppliers. |
If there is a loss or a decreasing profit, the question arises, how the profit could be improved.
Step 4
How do you improve the situation?
There are four basic ways to improve the situation:
1. Decrease costsCosts should be as low as possible. You should use every chance to cut your costs. In Module 4, “Costing and Pricing”, you may find some ideas, how to do so.
2. Increase sales
When you increase your sales through a marketing effort, you must also increase your production. With higher production levels, fixed costs such as administration, management, marketing, depreciation and interest normally remain stable, resulting in a decrease in the fixed costs per piece and an increase in the profit per piece (see Module 4, “Costing and Pricing”).
3. Increase the price
If you increase your prices while your costs remain stable, your profits will increase. However, before increasing your prices, you must make sure that your prices remain competitive in the market and that you are still able to sell all the tiles you produce.
4. Change the product
Another product or changes in the actual product, such as new colours, unique shapes and original designs may make the product more attractive to customers and they may be willing to pay more for it. Moreover, there may be less competition for other or changed products. You may sell more products at a higher price.
It depends on the situation which strategy is the best. In some cases, even a combination of two or more strategies may be required.
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Mr. Garcia thinks about his possibilities to improve the situation. · Mr. Garcia decides to stop the production of gray tiles for a moment and to increase the production of red tiles. · Mr. Garcia decides to look for a cheaper supplier for cement to decrease his raw material costs. |
The profit not only depends on the price but also on the quantity of goods sold. If you are able to produce and sell much more goods than before, the profit may be higher even if you sell your goods at a much lower price. But what quantity of goods do you have to produce and to sell at a given price to be profitable? How is the relation between quantity, price and profit?
The key to understand the relation between quantity, price and profit are the fixed costs. They stay stable when you produce more goods, but the fixed costs per good will decrease.
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Suppose your fixed costs (consumables, administration, maintenance, depreciation, interest, etc.) per year are LU 10’000 and the variable costs (workers, raw material) are LU 1 per tile. When you produce 1’000 tiles per year, each tile has to cover LU 10 of the fixed costs (LU 10 × 1’000 tiles = LU 10’000). Thus, the production of each tile costs you LU 11 (fixed costs per tile + variable costs per tile). Now suppose, your customers are prepared to pay LU 2 per tile. HOW many tiles do you have to produce and sell each year, at a selling price of LU 2, just to cover all your costs? The variable costs per tile still are LU 1. So another LU 1 is left to pay for the fixed costs. Therefore, you have to sell 10’000 tiles to cover the LU 10’000 fixed costs. When you sell 10’000 tiles, your costs and your Income will be LU 20’000. |
At the break-even-point, the total income is the same as your total costs - you make neither a loss nor a profit. In other words, you ‘breakeven’.
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The break-even-point is the level of sales at a given price where you make neither a profit nor a loss |
If you sell more goods, you will make a profit. If you sell less goods, you will make a loss. Before you decide how many goods to produce it is always good to know the breakeven point at the current market price.
The breakeven point is calculated as follows:
Step 1
Determine the variable costs per piece. The total variable costs for a specific period is divided by the amount of pieces sold in that period.
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In the period from the 1st of January to the 31st of December, Mr. Garcia has variable costs of LU 550’000 (B) and sells 50’000 tiles (C). The variable costs per piece is: |
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Step 2
Determine that part of the selling price which can be used to cover the fixed costs. This is the difference between the selling price (D) and variable costs per piece (B/C).
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The selling price per tile is LU 18. The variable costs per tile are LU 11. The difference between selling price and variable costs is: |
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Step 3
Determine the number of pieces which have to be sold to reach the breakeven point. This is the total amount of fixed costs (A) divided through the part of the selling price which can be used to cover the fixed costs (D - (B/C)).
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The total fixed costs In this period are LU 280’000. The part of the selling price which can be used to cover the fixed costs is LU 7. Thus the breakeven point is: |
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It is important to know if it is possible to produce the amount of goods needed to reach the breakeven point. For this reason, the capacity utilization at breakeven point should be calculated. If the resulting utilization is about 90% or higher, then the capacity of the workshop is not enough. In such a case either the capacity would have to be increased - perhaps with additional equipment - or the breakeven point can be reduced by lowering costs or increasing the selling price. Keep in mind that all tiles produced have to be sold, and that the selling price cannot be higher than your customers are willing to pay. Capacity utilization at the breakeven point is the relationship between the capacity used at breakeven point and total productive capacity of the business.
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The maximal capacity of Mr. Garcia’s workshop is 60’000 tiles per year. At the break-even-point of 40’000 tiles per year, only (40’000 * 100/60’000) = 67% of the maximal capacity is used. Conclusion: The capacity of Mr. Garcia’s workshop is high enough to be profitable. |
Sometimes it is important to know the lowest price at which a certain number of goods can be sold without making a loss. This is the break-even price. If you sell the goods at a higher price than the break-even price you will make a profit. If you sell them at a lower price, you will make a loss. Remember, the break-even price increases if the number of goods produced and sold decreases. To calculate the breakeven price divide the total costs (fixed + variable costs) by the number of goods sold. The result will be the breakeven price.
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In Mr. Garcia’s workshop, the total (fixed + variable) costs of the 50’000 tiles produced and sold per year are LU 830’000. Thus, every tile has to be sold at least for (830’000/50’000) = LU 16.60 to cover total costs. Conclusion: As long as costs and quantity are unchanged, every price above LU 16.60 will lead to a profit. |
Sometimes it is necessary to take extra costs into account, for example, the repayment of loans. In such a case, you would have to sell additional goods to make a profit. To calculate the breakeven point including loan repayment, calculate the fixed costs plus the repayment amount, then divide this amount by the part of the selling price, you can use to cover the fixed costs. The result of this calculation will be the number of goods you must produce and sell to reach break-even point including loan repayment.
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Mr. Garcia would like to pay back his loan of LU 70’000 The part of the price, which can be used to cover the fixed costs still is LU 7 (see above). To calculate the new breakeven-point, the amount of loan repay (LU 70’000) has to be added to the fixed costs: (280’000 + 70’000)/7 = 50’000 tiles Conclusion: The new break-even-point is within the maximal capacity of the workshop. |
On the following page, you see an example how the calculation of break-even-point, capacity utilization, break-even-price and breakeven-point with loan repayment could look like. The figures needed for the calculations are taken from a profit and loss statement, the manufacturer’s equipment specifications, or are estimated based on actual experiences.
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Attention Please make sure that all amounts used in calculations are from the same period (i.e., year, month, half-year). The calculations will not be accurate if the figures used are from different periods of time. |
Example format to calculate the
break-even-point
Determine the figures for your own business and then calculate the breakeven point, the capacity utilization, the breakeven price and the breakeven point adjusted for loan repayment.
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