Description: This measure should be in the core group of performance measures that any accountant uses. It measures the sales level at which a company exactly breaks even. This figure is quite useful for a number of operating decisions, such as determining how much extra productive capacity is available after breakeven sales have been manufactured, which tells the management team how much profit can theoretically be generated at maximum capacity levels. It is also good for determining changes in the breakeven point resulting from decisions to add fixed costs (especially when replacing variable production costs with fixed automation costs). It can also be used to determine changes in profits when the sales staff is contemplating making changes in product prices.
Formula: Divide the average gross margin percentage into total operating costs. Be sure to include all operating costs outside of the cost of goods sold in this calculation – only extraordinary items that are in no way related to ongoing operations should be excluded from this formula, which is as follows:
Total Operating Expenses
Average Gross Margin Percentage
A variation on the formula is to remove all non-cash expenses, such as depreciation, from the calculation. This approach is useful for companies that are more interested in determining the point at which they break even on a cash flow basis, rather than on an accrual reporting basis. This formula is as follows:
Total Operating Expenses – (Depreciation + Amortization + Other Non-Cash Expenses)
Average Gross Margin Percentage
Cautions: This measurement should be tracked on a trend line, because it usually requires substantial changes by the management team to alter it, which may require a number of reporting periods to accomplish. To calculate it on a spot basis, it is useful to create a multi-period measurement, so that an average gross margin percentage and operating cost can be used that smooths out expense irregularities over the short term.