Break-Even Analysis––Making it Work for Your Franchise

July 2009 Franchising World

Break-even analysis provides a quick and easy tool to screen opportunities, glean competitive information and benchmark operations.

By Chris Reilly

Break-even analysis can be a simple yet powerful tool to help franchisors   manage their business. It is also one of the oldest financial analysis techniques with the earliest mention of break-even analysis appearing in accounting journals around 1850. In the late 19th century the Interstate Commerce Commission used break-even analysis in determining the adequacy of railroad-freight rates. The longevity of break-even modeling speaks to its usefulness and versatility in evaluating business decisions.

As its name implies, break-even analysis calculates the unit or dollar sales needed to generate revenues that exactly match fixed and variable costs to produce net profit of zero. There are many variations but the simplest mathematical formula for break-even is expressed as follows:

In order to perform effective breakeven analysis using the formulas illustrated above, you need to be able to identify all of your costs and assign them to fixed or variable “buckets.” This task is often more difficult than it would seem but going through the process results in a thorough understanding of your business’ cost structure. Actually, this process is itself one of the benefits of break-even analysis.

Fixed costs include expenses such as rent, depreciation, utilities, interest and insurance. These costs, also referred to as overhead, generally do not vary with the level of sales. In contrast, variable costs rise or fall in direct relationship with sales. They may include shipping, raw materials, supplies, sales commissions, direct labor and other items associated with manufacturing a product or delivering a service for sale. Another name for variable costs is “cost of goods sold.”

The advantage of break-even is its utility and simplicity. After all, it can be accomplished with just three data elements: Actual or Projected Sales, Total Fixed Costs, and Total Variable Costs. It also allows you to model the effects of various scenarios on the breakeven point. For example you might want to know the impact of a 10 percent increase in selling price or a 5 percent reduction in variable costs. Any number of scenarios can be easily tested using break-even analysis.

There are, however, several potential weaknesses of break-even analysis that should be pointed out:

     • Unlike discounted cash flow techniques such as Internal Rate of Return and Net Present Value that examine cash flow over a period of time, break-even analysis provides a static viewpoint based on a single point in time.

   • It assumes a fixed relationship between price, costs and volume at every level of production. For most businesses, economies of scale lead to a reduction in costs as sales increase. Alternatively, at lower levels of sales, costs may rise proportionally. To mitigate, costs used in the break-even analysis should be adjusted upward or downward as appropriate for the assumed production level.

   • It is not easily applied to a multiproduct business with different prices and costs associated with the various products. The break-even analysis for such a multi-product business could assume a certain product mix and a corresponding weighted average price but it is not as meaningful.

   • The break-even model assumes that every unit produced is sold at the same price without regard to limitations of
   market demand and competition.

Given these weaknesses, break-even analysis is more useful in the analysis of a single product or a business having a small number of similar products. For example, break-even analysis is readily appropriate for a restaurant to determine the number of customers and the average ticket needed for break-even. Although many items may be offered on the menu the ingredients, food and supplies, are in large part the same.

Let’s explore some of the ways that break-even analysis can be used by franchisors.

New Unit Evaluation
Break-even analysis can be especially useful for franchisors considering opening a new location. It relies largely on costs which are much easier to estimate than sales for a start-up entity. Cost data from a comparable franchise location or system-wide averages can be used to estimate costs for the new unit. Using this information in the break-even model the sales volume and price needed to start generating a profit can be estimated. If the breakeven analysis indicates 1,200 units are needed and   comparable franchise locations sell 1,000 items monthly, the project it may not be feasible. Many franchisors already use break-even analysis in the evaluation of new units. The information provided is also valuable the franchisee and potential lenders.

Competitive Analysis
Although detailed cost information is not typically available, many publicly held franchisors disclose Cost of Goods Sold (Variable Costs) and non-operating expenses (Fixed Costs). With this information you can estimate the Contribution Margin and the break-even sales. Coupled within information about their pricing, it’s possible to estimate at what point they would cease to be profitable. Obviously this could inform your own decisions about whether to discount or not.

Benchmarking
Another possible use of break-even analysis for franchisors is to compare existing units using system average break-even as a benchmark. Such a process could identify units that are performing poorly, as well as those that exceed expectations. It would also suggest what is leading to performance. For instance, lower-than-average unit prices reflect a concentration of sales at a discount or an unfavorable product mix.

Although, break-even analysis should not be used in isolation to make important business decisions, it provides a quick and easy tool to screen opportunities, glean competitive information and benchmark operations. It can be used in conjunction with or as a precursor to more complex analysis techniques as needed.

Chris Reilly is president of CIT Small Business Lending. She can be reached at 973-740-5718 or chris.reilly@cit.com .