Don’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:
- Why is cash more important right now than profit? (8 June 2020)
- Maximising Employee (and Director) Working from Home Expenses Claims (8 June 2020)
- Downturn survival guide (9 June 2020)
- The Razor Gang (23 June 2020)
- In their father’s shadow (23 June 2020)
- Desperate times may require desperate measures (11 July 2020)
- Why Estate Planning is often not enough… (11 July 2020)
- Why should every business be “Investment Ready”? (4 August 2020)
- The Fat Smoker (4 August 2020)
- Our C-19 stocktake for business owners (4 August 2020)
- You Probably know the Next Owner of your Business (3 September 2020)
- The Smart Owner Part 1: Those Magic Profit Levers (3 September 2020)