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Crunchers Accountants

Crunchers Accountants

Do you know your Break-even?

Archive for November, 2015

Do you know your Break-even?

Almost certainly the answer to that question is ‘No’.

It could be you don’t know the concept, it could be you have not worked it out, it could be that the calculation is out of date or it could be that you have worked it out wrong.

Whichever is the case, knowing your break-even is one of the quickest ways to give yourself a chance of making money in business.  In this blog we explore why break-even is important, how to calculate it and the missing figure that means almost everyone calculates it wrong in small business.  This last part (please read to the end) is incredibly important.

For the uninitiated, your break-even is the level of sales you need to achieve to pay all your costs.  Let us say you sell clothing from a shop.  How much sales do you need to make to cover the cost of buying the clothes you sell in first place plus all your overheads (rent, staff, advertising, etc)?

The reason it is important is that only once sales go over this level do you start making profit and start clawing back the money you have invested in your business.  One danger of not being clear of your break-even is that you can be living with a false impression that you are making money when in fact you are merely treading water or worse running out of money.

A more serious danger is that you are creating a flow of work to your business that will disappear if you do what is necessary to reach break-even.  For example you may be getting customers to your shop because you have established a reputation for being cheap.  Once you put your prices up, the customers disappear.  In other words you lock yourself into a business model that may be hard to get out of.

Knowing your break-even keeps you trued up with targets you will almost certainly want to manage in your business – the number of sales and your margins.  What we see is that when business owners know their break-even, they understand the importance of meeting sales targets and managing their sales plus they understand the effect of dropping their prices.  Letting sales targets slip and letting prices slip can be extremely tempting.

If reading this is the call to action to work out your break-even, do it now or at least schedule to do it now.  It could make all the difference.

So how do we calculate break-even?

To work out break-even we first need to know something called our Gross Profit Margin.  This the % of a sale income that is left after you deduct the ‘Direct Costs’ of making the product or delivering the service.  If I buy a dress for £60 and sell it for £100 you have a 40% Gross Profit Margin.  Direct Costs include everything you buy in to deliver a particular product or service but exclude your overheads.  Obviously the more you sell the more these ‘Direct Costs’ go up.

Then you need to know the total cost of your overheads for the year – rent, rates, staff, advertising etc.

When your total Sales x Gross Profit Margin = Overheads you are at break-even.

So let us say Gross Profit Margin is 40% and Overheads  are £20k.  Your break-even will be £50k because:

£50k x 40% = £20k

Whilst for many of us this concept is fairly easy to understand, there are two factors that often trip us up in the calculation:

1. Firstly our numbers may be out of date.  When was the last time we checked our Gross Profit Margin?  It is easy to miss that suppliers may have put up their prices.  When was the last time we checked our overheads, it is common to take on extra expenses without realising.

2. Secondly we may have forgotten to include unpaid time.  For many people this is a new concept, so it needs some explanation.  Back to the example of our clothes shop, the owner works 6 days a week in the shop 9 hours a day, but because they are owner they are not paid a salary they are paid out of the profits of the business.  Therefore the value of this time does not show up in any bookkeeping as an expense.  It is invisible.  Without adjusting for the value of this time, you can come to the conclusion that the business is making money when in fact the business is simply drawing on the personal resources of its owner.

Making this adjustment begs the question of how to value the unpaid time.  There are many different ways to view what is in the end a matter of subjective opinion, but our recommendation is to make an estimate of what you would have to pay someone else to do the same work.

Sometimes this adjustment of unpaid time is a rude shock for business owners.  The business they thought was profitable is unprofitable.  But this, of course, is the whole point of the exercise: get trued up on what you need to do to start making money, otherwise you risk living in an illusion.

Finally it is worth saying that break-even is merely base camp in making money.  To make money we need to exceed break-even.  That must be the ultimate goal.