USING THE HIGH-LOW METHOD TO ESTIMATE BREAK EVEN SALES

In order to use this equation, S=(FC+TP) /CM to calculate the level of sales needed to obtain the desired amount of profit, the FC (total fix costs) and CM (contribution margin per sales dollar) is required.  In an existing business we can use the high-low method to divide the total expenses into FC and VC (total variable costs and expenses).  Remember this is only a means of estimating.  Results are not precise by any means.  The least squares method is more precise but is more difficult to apply. Let's see how the high-low method works.

Assume that in the year 2008, the low and high months for sales were January and October, respectively.

 January October Difference Sales \$50,000 \$75,000 \$25,000 Expenses \$35,000 \$45,000 \$10,000

VC/sales dollar = difference in total expenses/difference in total sales  = \$10,000/\$25,000 = .40

Lowest level:  TC = VC + FC

\$35,000 = .40 x \$50,000 + FC

\$35,000 = \$20,000 + FC

\$15,000 = FC

Highest level: TC = VC + FC

\$45,000 = .40 x \$75,000 + FC

\$45,000 = \$30,000 + FC

\$15,000 = FC

As you can see from the calculations presented, the FC is \$15,000.  The CM is 1- VC/sales dollar or 1-.40 = .60.  The break even point in sales for this example is (\$15,000 + \$0)/.60 or \$25,000.

Proof: S = FC + VC + TP

\$25,000 = \$15,000 + (.40 x \$25,000) + \$0

\$25,000 = \$15,000 + \$10,000 = \$25,000

If we desired \$3,000 in profits, our calculation would be (\$15,000 + \$3,000)/.60 or \$30,000

Proof: S = FC + VC + TP

\$30,000 = \$15,000 + (.40 x \$30,000) + \$3,000

\$30,000 = \$15,000 + \$12,000 + \$3,000 = \$30,000

Break even analysis also known as cost-volume-profit analysis is very useful for setting prices of products and services, making decisions about adding product lines, expanding capacity and many other day to day financial challenges.  The skillful use of this tool will significantly improve the management of  your business.