When you are preparing for a meeting with a lender or investor, one of the key numbers you need to have at your fingertips is the break-even point. This is the level of sales expressed, either in £s, or number of units sold, at which point sales = total costs ie: zero profit and zero losses. For a new business, this is the first major financial milestone – the start of profits. It’s a psychological seachange for the business, which is now no longer dependent on shareholder support.
So break-even is an important reasonableness test on the viability of your business plan: Is your break-even point realistically achievable
It also helps identify the margin of safety (as it is known): How far above break-even are you trading or projecting to trade (In other words, how much could sales fall before you start making a loss?)
It is at the heart of your business model because your break-even point is driven by your pricing and cost decisions. Before we look at how it’s calculated, a bit of theory:
Break-even is based on recognizing that some costs vary with sales and some are fixed. In a sandwich shop, rent and marketing are fixed, while ingredients (boiled eggs, anchovies etc) vary with the level of sales.
In general, variable costs are direct, which basically means you can see them in the product, while fixed costs are generally indirect – what you and I would consider the overhead of the business.
As far as the calculation is concerned, there are two methods: the contribution/unit sold, or the gross profit margin method. Let’s start with the latter. Print off your profit and loss, and you will have your expenses in the following order:
SalesLess Cost of Goods Sold (direct costs)= Gross profitLess overheads (indirect costs)= Operating profit
Gross profit represents the value you have added – but you may have included some fixed costs in here eg: production overhead such as factory rent. You need to exclude these to leave just variable direct costs.
Take the revised gross profit and divide it by sales and you have your variable gross profit MARGIN as a percentage. (I like to think of this as your trading margin.) In a food business, this is typically around 70 per cent. In other words, for every £1 turnover, 30p goes on food costs.
Now total all the other costs (including the production overhead taken out of direct costs). The question you want to answer is: What level of sales is required at 70 per cent gross profit margin to cover your fixed costs” If your overhead (fixed costs) came to, say, £14,000, and you divide £14,000 by 70 per cent, the answer is that the business would break-even at £20,000 turnover.
What can be really helpful is to express this in units – for a software business, the number of installations required to reach break-even. It gives everyone something tangible to focus on.
Alternatively, you can calculate break-even on a per-unit contribution basis. To do this, take your selling price and deduct the variable costs per unit, giving you contribution/unit. Then, divide your fixed costs by this figure to arrive at the number of units required to break-even.
Check out this link to a break-even calculator, where you can see the effect of pricing, margin and fixed costs on your break-even. http://connection.cwru.edu/mbac424/breakeven/BreakEven.html
Remember: you can express break-even over any time period – weekly, monthly or annual break-even.
To really ace your meeting, make sure you understand how sensitive your break-even is to changes in sales volumes – both up and down. This exercise will highlight how important it is to keep fixed costs as low as possible in the early days – rent rather than buy, even though it may be more expensive, because it gives you more flexibility. Or can you borrow office space rather than renting?
Johnny Martin started his colourful career running a bar in the French Alps with ASOS founder Nick Robertson. Since then, he’s used his “business numbers brain” to see through major trade sales and prepare business plans that have raised over £25m.When he’s not running his farm storage business in Somerset, he passionately promotes financial understanding for business startups and has helped thousands of entrepreneurs overcome their fear of the f-word (finance) and bridge the often enormous gap between them and the financiers, bankers and business angels.
Johnny is an adviser to the Creative Capital Fund; runs “Beginners Guide to Finance” for the British Library and is a visiting finance speaker at the University of the Arts. His fast-paced workshops will help you get past the financial gobbledygook and get your hands on the cash you need to drive your business.
For more information, visit www.johnnymartin.co.uk or post a comment below with your question.