Do You Know Your Break Even?

Do You Know Your Break Even?

Probably not, most business owners don’t.  Some don’t know what it is, some know what it is but not what their Break Even is, some wish they knew but don’t know how to calculate it, and most don’t understand why it is so important to know in the first place.

When Steve asked me to write a blog on Break Even, by the way is it one word or two?  The dictionary says its two words so we will stick with that, despite my personal preference.  When Steve asked me to write about it, I said; “really… do I have to… aren’t people sick and tired of me talking about Break Even, Contribution Margins, and Burden Rates?”.  To which he reminded me that these are the fundamentals of business and if most Business Owners are not understanding them, then we need to rinse and repeat our message, otherwise these Owners may be walking on the edge of failure.

Well, I couldn’t disagree with his logic nor his poetic way of stating the obvious, so here we go… why is knowing what your Break Even is important and what is Break Even anyway?

Simply put Break Even is the point where your sales will cover all of your expenses.  What makes the calculation slightly more difficult than adding or subtracting is that we have two types of expenses.

The first type is Overhead, also called Fixed Expenses.  These are all the types of expenses you would have even if you sold nothing.  i.e. Rent, insurance, any administrative payroll probably including your own, utilities, etc..

These Overhead expenses make it impossible to be profitable on your first dollar of sales.  You first have to enough sales and gross margin to offset the Overhead.

The second type of expenses are Cost of Goods, COGS for short, but also called Variable Expenses.  These expenses go up each time you sell something.  In retail it is generally the wholesale price that you paid for what you sold.  In manufacturing it is usually the cost of “Direct Labor” plus materials.  In restaurants, construction, and most trades it is mostly labor and materials as well.

These COGS expenses make it impossible to earn a full dollar on a dollars’ worth of sales.  Because of COGS the cost could be 70 cents on the dollar, it could be more or it could be a lot less depending on the industry you are in, but very few industries have zero COGS.

Now that you understand the two types of expenses it should be apparent why it is best to separate them on your P&L or Income Statement.  Remember what The Offspring said in the 1994 song “Come Out and Play” … “you gotta keep ‘em separated”.

If you have these already segregated on your P&L then this next part on how to calculate your Break Even is very easy.  I know this is math, and everyone hates it, but I will hold your hand and make it bizeasy.

Step 1:

You will need to know your Contribution Margin. Simply take your total COGS (or Cost of Goods) and divide that number by your total Sales and subtract that from one dollar.

If your COGS is $70,000 and your Sales are $100,000 your Cost would be 70 cents on every sales dollar…right?

If we subtract 70 cents from a dollar, we are left with 30 cents profit, and that is your Contribution Margin, 30 cents.

Step 2:

Now that we know your Contribution Margin, we need to know how many 30 cents’s does it take you pay for your Overhead.

If your Overhead is $40,000, we simply divide that by 30 cents and learn that our Break Even is $133,333.

We said that we are presently doing $100,000 in sales, so we need another $33,333 in sales to get to the point where instead of spending each 30 cents of gross profit to pay for Overhead it will drop to our Bottom-line Profit which presently is a negative number or loss.

You might think that the negative number is ($33,333) but it is much less than that, approximately ($11,000), which can be deceiving and lead you to believe you only need $11,000 of additional sales to Break Even, and this is why a healthy understanding of Break Even and Contribution Margin are so critical to understanding your business.

If you are not presently profitable, then this exercise will allow you to build a plan to get to profitability and help you understand how much loss you will need to withstand to get to that point.

If you are profitable already, this will allow you to predict cash flow and profitability for as many months out as you wish.

The whole trick is understanding the Contribution Margin and how it affects your company.  Small increases in Contribution Margin can easily double or triple your bottom-line.  Increases can easily be achieved with price increases and/or greater efficiency as well as a dozen other ways.

If I had to say what the most important thing for an Owner to manage is, it would be Contribution Margins.  This is how a good Owner works smarter rather than harder or longer hours.

Not knowing your Contribution Margin and your Break Even are like not knowing the MPG in a car with a broken gas gauge.  Is 2 gallons going to take you 30 miles or 80 miles, without knowing your MPG you will not know if you can make it!