All businesses have a break even point, that is a point at which the level of revenue is equal to the total expenses of the business, resulting in a zero profit. A service business break even analysis can be undertaken using the same methods applied to both manufacturers and retailers by applying the break even units formula.
Calculating the Break Even
For a retailer or manufacturer the break even calculation is straight forward. For example, if a retailer operates with fixed costs of 36,000 and sells a product costing 40 to customers at a price of 100, then the business calculates the units needed to break even as follows.
FC = Total Fixed costs = 36,000 SP = Selling price per unit = 100 VC = Variable cost per unit = 40 Breakeven units = FC / (SP - VC) Breakeven units = 36,000 / (100 – 40) = 600
The retailer needs to sell 600 units of its product to break even.
Complications of Service Business Break Even
Both retailers and manufacturers have a well defined product which they buy or manufacture and then sell. As we have seen above, when using the break even formula the business defines a unit as the product itself.
The complication in calculating a service business break even is that the business does not tend to have a physical product to sell, and first needs to identify what it means buy a unit. For example, a consultancy business might bill customers by the hour, a salon might charge by the treatment, an educational business sells courses, and other businesses might have a set price per customer or client. In each case the service business is seeking to find out how many units (hours, treatments, courses, customers, clients etc.) it needs to reach break even.
In addition, having defined what is meant by a unit, in any service business break even analysis it is necessary to distinguish between variable costs and fixed costs. For a retailer, the predominant variable cost is the purchase cost of the product, for a manufacturer it is the materials and direct labor costs which go into manufacturing the product. The nature of a service based business however, means that the largest portion of its total costs normally relates to the wages and salaries of its employees and staff leading to difficulties in defining what is a variable and what is a fixed cost.
Service Business Break Even Examples
To demonstrate we have set out below examples of service business break even analysis for three different business each of which uses a different definition of what a unit is.
Example 1: Unit = Clients
Consider a consultancy business which defines a unit as a client. The business wants to calculate how many clients it needs to break even.
Fixed Costs
The total fixed costs of the business are 260,000 including the cost of two full time consultants amounting to 182,000, and other fixed costs of 78,000 for rent, utilities, insurance etc. The business regards the salaries of the consultants as fixed costs as they are paid irrespective of the number of clients.
Selling Price per Unit
The business estimates that an average client will need 100 hours of time spent on it each year. Additionally it estimates that the revenue earned from each client will be on average 12,500 a year.
Variable Cost per Unit
The business estimates that for the average client, the variable costs for items such as printing, room hire, brochures, and computer costs will amount to 2,100 each year.
Consequently based on this information the consultancy service business calculates its break even position as follows.
Unit = Client FC = Total Fixed costs = 260,000 SP = Selling price per client = 12,500 VC = Variable cost per client = 2,100 Service business breakeven clients = FC / (SP - VC) Service business breakeven clients = 260,000 / (12,500 – 2,100) = 25
The business needs 25 clients each year to break even.
Furthermore at this level of clients the income statement for the business would be as follows.
| Unit | Total | |
|---|---|---|
| Clients | 25 | |
| Revenue | 12,500 | 312,500 |
| Variable costs | 2,100 | 52,500 |
| Gross margin | 260,000 | |
| Fixed costs | 260,000 | |
| Net income | 0 |
Quick Feasibility Check
While the service business break even calculation shows that 25 clients are needed, it does not necessarily mean that the business has the capacity to cope with this level of clients.
If a client needs 100 hours of time each year, the business must have at least 100 x 25 = 2,500 labor hours available to deal with these clients. Based on a 35 hr week operating 46 weeks of the year, the two consultants are able to provide 3,220 (35 x 46 x 2) hours. At break even the business operates at 78% (2,500/3,220) capacity, which is more than adequate to make reaching this break even point feasible.
Example 2: Unit = Hours
Consider a service business which wants to calculate how many chargeable hours it needs to break even. In this case the unit has been defined as an hour.
Fixed Costs
The total fixed costs of the business are 85,000 for items such as rent, telephone, insurance, utilities, and office staff. It is assumed that the labor cost of providing the service is variable and can be called on as required.
Selling Price per Unit
The business intends to bill customers on the basis of time spent at the rate of 125 per hour.
Variable Cost per Unit
The labor cost to the business amounts to 50 per hour. Labor can be increased or decreased dependent on the requirements of the business, and is regarded as a variable cost.
In addition the business estimates additional variable costs for each hour spent on a customer of 7 per hour.
Consequently based on this information the service business calculates the break even position as follows.
Unit = Hour FC = Total Fixed costs = 85,000 SP = Selling price per hour = 125 VC = Variable cost per hour = 57 Service business breakeven hour = FC / (SP - VC) Service business breakeven hours = 85,000 / (125 – 57) = 1,250
The business needs 1,250 chargeable hours each year to break even.
Furthermore at this level of chargeable hours the income statement for the business would be as follows.
| Unit | Total | |
|---|---|---|
| Hours | 1,250 | |
| Revenue | 125 | 156,250 |
| Variable costs | 57 | 71,250 |
| Gross margin | 85,000 | |
| Fixed costs | 85,000 | |
| Net income | 0 |
Quick Feasibility Check
The service business break even calculation shows that the business needs 1,250 chargeable hours.
Assuming the business can call on only one person to provide the service and that they can be available if needed for 46 weeks of the year for 40 hours each week, the available capacity is 1,840 (46 x 40) hours.
At break even the business operates at 68% (1,250/1,840) capacity, which is more than adequate to make reaching this break even point feasible.
Example 3: Unit = Courses
The final service business break even example relates to an operation running educational courses for students. The business has decided to define a unit as a course and needs to establish the number of courses it needs to run in order to break even.
Fixed Costs
The total fixed costs of the business are 51,000 for items such as rent, telephone, insurance, utilities, and office staff. In this example it is assumed that the labor cost of providing the service is variable in that it can be called on as required.
Selling Price per Unit
The business plans to have 20 students on each course and to price the course at 50 per student. The total sales value of course is therefore 1,000 (20 x 50).
Variable Cost per Unit
It is anticipated that each course will require 8 hours of labor at the rate of 50 per hour, giving a total labor cost of 400 per course.
In addition, each student on the course will be provided with lunch at a cost of 10 per student giving a total food cost of 200 (20 x 10) per course. Finally the cost to rent a room for is expected to be 100 per course.
The total variable costs of operating a course are therefore expected to be 700 (400 + 200 + 100) per course.
Consequently based on this information the service business calculates the break even position as follows.
Unit = Course FC = Total Fixed costs = 51,000 SP = Selling price per course = 1,000 VC = Variable cost per course = 700 Service business breakeven courses = FC / (SP - VC) Service business breakeven courses = 51,000 / (1,000 – 700) = 170
The business needs to run 170 courses each year to break even. Since each course requires 20 students, the business requires 3,400 (170 x 20) students to break even.
Furthermore at this level the income statement for the business would be as follows.
| Unit | Total | |
|---|---|---|
| Courses | 170 | |
| Revenue | 1,000 | 170,000 |
| Variable costs | 700 | 119,000 |
| Gross margin | 51,000 | |
| Fixed costs | 51,000 | |
| Net income | 0 |
Quick Feasibility Check
The service business break even calculation shows that the business needs to run 170 courses, requiring 1,360 (8 x 170) labor hours. Assuming the business utilizes the services of one person to provide the service and that they can be available if needed for 46 weeks of the year for 40 hours each week, the available capacity is 1,840 (46 x 40) hours. At break even the business operates at 74% (1,360/1,840) capacity, which is more than adequate to make reaching this break even point feasible.
Summary
Break even point analysis can be applied to a service based business in the same manner in which it is applied to any other type of business, but requires the business to first define the units on which it wants to perform the calculations. The units can be any appropriate measure such as client numbers, labor hours, courses, jobs, projects etc. but the analysis still requires the separation of costs into fixed and variable costs per unit.
It should also be noted that the service business break even analysis is only valid over a given limited range of unit sales volume. The break even calculations assume that fixed costs are indeed fixed, outside the limited range the fixed costs may need to be stepped up or down to accommodate the changing volumes. For example, larger offices may be required if the business expands resulting in a step increase in rent and other fixed costs. At this point the break even position needs to be recalculated.
Service Business Break Even and the Financial Projections Template
The service business break even revenue is an important number to know as once a business has reached this level of revenue it will start to make a profit. After a period of time a business will normally stabilize to a steady break even figure. If the break even position is known then the management of a business can operate on a day to day basis by monitoring actual revenue against break even revenue.
The service business break even point can be calculated for projected figures, and is included in our financial projections template on the financial ratios page.
In addition, our breakeven calculator will calculate the service business break even revenue for up to four different scenarios by inserting values for unit selling price, cost price, and operating expenses.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.