For most business owners and many accounting practitioners for that matter, the measure of ‘break-even’ mistakenly is a static calculation. By that I mean it is measured at a single point in time e.g. at the end of a financial year and is not re-visited until the anniversary of that measurement in the following year.
This is the first mistake the uninitiated make. The truth is, breakeven is a dynamic number, it changes constantly daily, weekly, monthly etc.
The formula for the calculation of breakeven is a simple one: Fixed Expenses $ / Gross Profit Margin %.
Example: Total fixed expenses for a business is $500,000 per year with a Gross Profit Margin of 50%. Therefore $500,000 / 50% = $1,000,000 breakeven.
Proof: Sales $1,000,000 x 50% GPM = $500,000 GP$ – $500,000 FE = $0 profit/loss.
Nothing too complicated about that but that’s not where the story ends. Let’s take that into the real world.
If a business breaks even at $220,000 sales per month, $10,000 per day (excludes weekends), it is self evident that it must be profitable if it is dispatching sales orders worth more than $10,000 a day and loss making if it is less.
It is equally possible to look forward and see what is going to happen in the future from the present sales order intake level.
If weekly order intake is running at an average of less than $10,000 per day and stays below that level despite all the efforts of management to get it up, the business is clearly in trouble. Comparison of sales order intake against breakeven point is therefore an invaluable early warning system.
Are you getting the picture of how valuable / important the regular measurement of breakeven point is to effective management of a business?
Further, if the business is operating at above breakeven, is the gap between sales and breakeven getting bigger, and therefore is profit getting better? And if so, at what rate?
If it is operating below breakeven, is the gap getting smaller and the loss making therefore reducing?
This immediately gives a vision of the future of when the business should come into profit and how long it will take.
It’s likely you could be asking the question “What is the difference between measuring the weekly/monthly build up of sales (and orders) which all businesses (should) do as a matter of course, and measuring the movement in the gap between such figures and breakeven?”
It is here where the ‘dynamic’ nature of breakeven (correctly applied) can open up a whole new world for a business. If a business is loss making and the management team is focussing just on sales and order intake, it is natural to think the only way to reduce losses is to increase sales.
However, if management focuses instead on the gap between breakeven and sales, two possibilities open up:
- increase sales but now even more powerfully,
- get breakeven point down
In the latter case all that matters is that breakeven point should successfully brought down below sales, whether or not sales themselves move ahead as hoped. Something still more startling follows.
If it is the Gap between sales and breakeven that matters, provided a loss making gap is successfully closed, it cannot matter at what volume in sales this happens. It could just as well happen at half or even quarter of present sales volume, as at increased volume.
Therefore even if measures to reduce breakeven point have the unpalatable consequence of also reducing sales, it cannot matter provided the rate at which breakeven falls outpaces the rate of fall off in sales.
The power of beakeven goes far beyond the scope of this Blog. I will deliver in a future webinar, the full scope of this subject which was delivered in past PD workshops and congress presentations.
If attending this would be a worthwhile use of your time, simply add the words ‘BEP Webinar‘ in the comment section of this Blog.
And, if you would like a copy of my Breakeven Point ‘Ready Reckoner’ table fill out your details below to get access.