Ideas & Stories

Smart Owner Part 2: Break-Even Point on a Napkin

Chris AlpDon’t be embarrassed. You are not the only business owner who does not know how to work out their Break-Even Point. Right now, it might be pretty handy to know what it is.

If your sales are less than that magic break-even point, you will be creating losses.

We will show you how to calculate this in your head. It’s a quick and easy mental calculation (well it is for us accountant types) but it might be easier to write on that napkin that came with the takeaway coffee and muffin.

We presume that you only have one napkin. So, we will keep it simple.

1. Fixed Costs

Okay, in the short run, what does it cost to open the doors of your business? Whether you sell a little or a lot. Add up those monthly overheads (rent, administration, actual or nominal owner’s salary, depreciation, subscriptions and so on) and finance costs for the business. You should be able to remember them.

These are the fixed costs that you need to cover every month. For example:

Rent 20
Admin 16
Finance 8
Owner Salary (see below) 6
Total Fixed Costs 50

2. Cost of Goods or Services Sold

Okay, now think about the variable costs to produce those goods or services.

For example, if you have a factory, you would include the cost of all the materials and consumables directly used in production, the cost of factory wages (even though they are not overly variable in the real world) and the cost to get the goods into the factory. You leave out rent, allocated overheads and other fixed costs (already counted above) because they don’t vary with the amount of output.

This is your Cost of Goods Sold. It also works for service industries the same way except that most of this cost would be labour.

Raw Materials 150
Factory Wages 130
Freight Inwards 20
Cost of Goods Sold 300

3. Gross Profit

So, your Sales less this Cost of Goods Sold is your Gross Profit. Easy.

Sales 400
less: Cost of Goods Sold 300
Gross Profit 100

Does your Gross Profit exactly cover your overheads and finance costs? If it does, you would be exactly Break-Even. But that would be a fluke.

4. Your Break-Even Point

To know your actual break-even point, we need to do one further calculation. Still plenty of napkin left. Divide Gross Profit by the Sales (x 100) to get your Gross Margin Percentage. It will vary from maybe a low 10% (better check our Magic Profit Levers article) to a healthy 40%. Here …

Gross Profit 100
Sales 400
GP Percentage 25%

Nearly there.

Now get the Total Fixed Costs (above) and divide (not multiply) by that ratio.

Indirect Overheads 50
Divide by GP % 25%
Break-even point 200

Therefore, in this example, at $200 of sales, the business is exactly at break-even. At this level of sales, you are neither making money nor losing money. Less sales will mean loss; more is profit.

Now the important part

Having worked this out on a napkin, it is time to compare the results with last month’s (and YTD & last year’s) actual accounts. What does the Gross Profit percentage look like in the accounts? I bet they differ.

Why? Maybe it is your memory of all of those costs, or they put vodka in your coffee.

Maybe. But I wouldn’t mind betting that your accounts differ to your napkin in how the accounts calculate Gross Profit. All too often, key variable costs (like direct labour) are simply classified as fixed, giving owners a misleading understanding of their business margins.

Or worse, overheads (such as office salaries) are allocated into the Cost of Goods Sold.

What we have inadvertently done here with your napkin (you didn’t know where this was all heading) is to double check the methodology (as originally set up in your accounting system by some IT boffin) as to how to measure, control and run your business.

Yeah, your business.

Don’t be shocked. We see it in so many other businesses. Really big ones too. The accounts mismeasure the business’s most important indicator … the Gross Profit Ratio. It’s like driving a car with a blindfold on.

Once you are confident that you are calculating this (for your business) correctly, you are now equipped to be able to double check your pricing and realised margins, every month (or even more frequently).

Finally, remember that mark up and margin are not the same. That catches a few business owners out.

For example. A 25% mark up on something that cost $100 means a selling price of $125. But that is only a 20% margin, not 25%. That’s because the Margin of $25 is measured against the $125 selling price not the $100 cost.

By the way, if you happen to be in a loss situation, you might stop putting your salary through as wages. You don’t need the deduction and you probably cannot afford to pay tax on that salary that is contributing to the loss.

You can drink your coffee now.  Hope it’s not too cold.

Chris Alp
Business Specialist Partner

In case you missed any of our post-C19 articles: