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When starting and growing a business, there are many critical numbers: your revenue, your profit margin, and how much cash you have in the bank are three figures that immediately come to mind!
And when I talk to existing business owners, they are usually clear about those pieces of financial information. A number that they’re less clear about – but which is just as important – is their Break-Even Point on a monthly basis.
In other words, do you know how much money your business needs to generate this month in order to Break Even (i.e., cover all of your expenses, so neither losing money nor making a profit)?
Knowing this figure gives you a specific target when planning any of your revenue or growth plans. If you know how much the business costs to run each month, then you have the first monthly sales goal for example.
If you’re not yet in business, you might think this is an easy figure to calculate, but the reality is that some of your monthly expenses are fixed and some are variable – they are linked to how much revenue you bring in. In this chapter, I combine that information to share with you the formula to help a business understand where that Break Even Point is and therefore what your formula is for profit.
Break even = Fixed Costs / Gross Profit Margin %
Step 1) First, you need to understand your business’s Fixed Costs. These are the expenses you have to pay no matter what – things like your rent, most of your staff, a lot of overheads, leases, software and so on. These are going to be the same each month same regardless of whether you sell a dime’s worth of actual business services or you sell a million bucks’ worth!
(This figure is sometimes called “the cost of opening the doors”. Just by opening the doors to your business each month, you are committing to this amount of expenses.)
Step 2) Once you understand those Fixed Costs, you then need to separate out the Variable Costs within your business. These are costs that you will only incur when you sell your product or service – almost by definition they are a percentage of your revenue.
As a side note, I say almost by definition because if you find that your Variable Costs in and of themselves exceed the actual revenue that you generate from that product then you’ve got a dog of a business! That means it costs you more to sell your product than you bring in in revenue, which means you’re going out of business backwards.
I’m not a believer in “Loss Leaders”. I can certainly understand that some products or services may have a lower margin, but you don’t want to create a business where for every dollar of revenue you generate your Variable Costs are more than a dollar. Partly, this is because the Variable Costs are going to sit on top of the Fixed Costs, those overheads that you can’t get out of and have to pay every month regardless.
While there are exceptions for well-funded venture capital companies, again this is risky for the average start-up business founder. Eventually, you want your business to turn a profit.
Once you know your Fixed Costs and Variable Costs, you can project your revenue and profit forecasts much more accurately. Your Variable Costs are a percentage of revenue, so you can start to calculate what extra Variable Costs you will incur for every extra dollar of Revenue.
Some businesses may have a Variable Costs of just one or two cents on the dollar – they’re heavy on fixed overheads like professional staff who are paid a salary no matter what. Some business have Variable Costs that are much higher – they’re selling a product at a low margin like retailers.
If your financial reports, especially your Profit and Loss Statement does not separate out Fixed and Variable Costs then you will struggle to discover (which is the point of this chapter) where exactly your Break-Even Point is.
Step 3) This is the easiest step! To calculate your ‘Gross Profit Margin’, just subtract your Variable Cost Percentage from 100%.
If your Variable Costs are 60% of your Revenue … then your Gross Profit Margin is 40% (100% – 60%).
Step 4) Because your Break-Even Point is calculated by adding the Variable Costs on top of the Fixed Costs, and working out where Revenue crosses the line.
Revenue starts at $0. Fixed Costs starts somewhere higher – say $10,000. Variable Costs also start at $0 (if you have $0 revenue), but they get added on top of the Fixed Costs.
So say your Variable Costs are 60% and you generate $10,000 worth of Revenue. This means your total costs for the month are $24,000 – $10,000 in Fixed Costs and $4,000 (40% of the $10,000 Revenue) in Variable Costs. Your Revenue is climbing, but so is the total amount of your expenses.
Your Break-Even Point is where the Revenue line would cross those Expenses. In this example:
Break even = Fixed Costs / Gross Profit Margin %
|Break Even = $10||000 divided by 40%|
|Break Even = $25||000|
You need to generate $25,000 each month in order to break even.
(And you can double check this math. If you did $25,000 in revenue then your Variable Costs would be $15,000 (60% of $25,000). That would leave you with $10,000 left, which is used to cover your Fixed Costs.)
Everything that your business generates over and above that Break-Even Point is profit. This is the situation where all of the Fixed Costs have been met, where you have exceeded the runway on those Variable Costs and moving forward you continue to grow the margin as a percentage over the top.
As you can see, understanding where your break-even point is gives you a specific target each month. You ideally want to hit that target as early as possible in the month, so that you can exceed and build out that profit. For every $1 of revenue above Break Even Point, you are creating a Net Profit (i.e., the money you get to ‘keep’) equal to the Gross Profit – it goes ‘straight to the bottom line’.
As a final caveat, there are other ways of calculating this, and there are other more complicated elements like knowing your ‘Cash Break-Even Point’. As we will see in a later chapter, a good accountant will always pay for themselves when it comes to helping you to grow your business and may be useful in calculating a more complicated model that provides you with more accurate data.
Hopefully, however, you’ve seen how just using those three simple elements (Fixed Costs, Variable Costs, and Revenue) can help you calculate this number for yourself and ensure you consistently have that desirable fourth element: Net Profit!