How do I calculate my break-even point?
If going into lockdown in March 2020 was a traumatic experience for many businesses, coming out of it will be just as difficult, if not more so.
Unless yours is one of the few businesses like food manufacturing, healthcare or delivery services that have prospered, the chances are that you have suffered a fall in sales and depletion of capital as a result of the pandemic. In a few months your CBILS or Bounce-back loan will have to start being repaid.
Deciding what actions to take to ensure survival of the business may not be something you have had experience of; getting it wrong could be fatal. So what are the metrics that will help you make the best decisions?
Your break-even point is the level of sales you need to cover your costs. You may not have had to worry about this for some time, but with falling sales you may well be trading at below your break-even point and making losses. So you need to measure what it is.
By itself it doesn’t tell you much, but if you measure the gap between breakeven and sales two possible actions open up:
- Increase sales (which may not be that easy); or
- Get your breakeven point down.
Very few business owners think about the second possibility where all that matters is that the breakeven point is brought down to under sales, whether or not sales increase. In fact, provided the loss-making gap is closed it doesn’t matter at what level of sales this happens. So even if the measures to reduce the breakeven point have the undesirable effect of also reducing sales in the short-term or until the recovery starts, it doesn’t matter provided the rate at which breakeven falls outpaces the rate of fall in sales.
So the question is ‘How do you lower your break-even point? To answer this we need to consider another metric and one which is sometimes misunderstood.
There are fundamentally two types of cost in a business: those that happen anyway and are a product of time like salaries, rent, business rates, insurance, office costs etc., and only those that happen when something is sold like material costs, marketing and delivery costs.
The first type is called fixed costs and the second type is called variable costs because they vary in direct proportion to the activity (sales) in the business.
The difference between sales and variable costs constitutes gross profit, which expressed as a percentage of sales is your gross margin.
Do not confuse this with the gross profit shown after cost of sales in your accounts where labour costs, which are more in the nature of fixed costs, are usually included and marketing costs are often excluded. Accountants follow rules to produce your accounts which are not particularly helpful to you in understanding your numbers properly.
So gross profit is what is left after deducting variable costs from sales and represents the real income of the business. As a percentage of say 35%, the gross margin expresses the dynamic that whatever the level of sales in the business its real income is only 35% of it.
For example a business with sales of £100,000 and a gross margin of 35% will have real income of £35,000. If fixed costs are also exactly £35,000 then £100,000 is the breakeven point. Sales above this level mean the business makes a profit and below this level means it makes a loss.
So if you know your gross margin the calculation of your breakeven point is simply:
Fixed costs/Gross margin percentage.
We can now start to see that a number of techniques open up to help businesses survive, even in a recession, by deliberately moving their breakeven point down, and can begin to answer the question: ‘How do you lower your break-even point?’
By using the formula for calculating your breakeven point it is self-evident that you can reduce it by:
- Cutting your fixed costs; and
- Increasing your gross margin percentage (increasing prices or reducing variable costs)
Too often, faced with falling sales, business owners react by cutting prices, increasing costs and trying to sell more even though these tactics, often as not, just hasten the outcome they are trying to avoid. The ‘common sense’ approach to get out of a loss making situation is to increase sales by cutting prices and increasing marketing expenditure. But both these actions combine to push up the breakeven point, and if this is more than the increase in sales the gap between sales and breakeven widens rather than reduces.
Although it may seem counter-intuitive, cutting prices or offering discount is just about the worst strategy a business could employ during a recession.
Those that succeed use techniques for closing the gap by lowering their breakeven point even if it means selling less. As market conditions improve, continuous monitoring of your breakeven point, and not allowing it to rise again, will allow the benefit of the extra sales to flow through to profit.
There is of course no one-size-fits-all approach to financial planning and every business will have different metrics that drive their profitability, but by understanding your breakeven point, gross margin (your real income), fixed costs and the impact of an increase or decrease in your prices you will be better prepared to face the recession caused by the pandemic and more likely to survive to face the recovery.