How to understand break-even sales
Every small business owner should know these numbers
So you think your small business is too small to worry about break-even sales?
Let's start with a simple ratio, and that's gross profit.
I like to explain gross profit as the difference between your sales and your cost of sales. The key, from a management perspective, is determining just what expenses make up the cost of sales. If it's an expense that is going to naturally go up correspondingly with your sales, then it should be considered cost of sales -- your direct costs. (If you're a plumber, the cost of labor used to actually provide the service calls is a direct cost.)
Related to this, would be payroll taxes, workers’ compensation insurance, etc., the cost of materials purchased for the job -- whether the customer is getting billed for them or not -- would also be included. In some cases, the costs of packing and shipping should be included.
Any expense that is not a direct cost of sales is a fixed expense -- an expense that isn't going to vary, regardless of your sales. Keep in mind that there are economies of scale here. For instance, if you're an auto repair shop that has only two bays, the fixed costs of two bays is finite, meaning that your fixed costs could go up substantially when you need to add that third lift.
Every business is going to be different. Once we know our sales and once we've determined our cost of sales, the difference between the two is your gross profit. Correspondingly, your gross profit percentage is your gross profit divided by your sales.
Once we know your gross profit percentage, and once we know your fixed expenses, we can start to understand break-even sales.
Simply take the fixed expenses we just talked about and divide it by your gross profit percentage.
For instance, my gross sales are $400,000, my cost of sales are $240,000 and I have fixed expenses of $170,000. In this example, my gross profit percentage is 40 percent and my break-even sales would be $475,000 ($170,000 divided by 0.4). In other words, I need to get $75,0000 in more sales if I'm going to break even.
But what if we could change the equation and reduce our fixed expenses by $10,000 a month? With $160,000 in fixed costs we could break even with $400,000 in sales. Or we could adjust our overall pricing so our gross sales are higher, and maybe reduce our direct costs.
Do you have a system in place to regularly monitor this? Would your system allow you to compare where your business was a year ago, and thus be able to explain why the numbers would be different?
Every small business owner, regardless of size, should be able to know these numbers.
Steven A Feinberg, CPA, of Appletree Business Services LLC, Londonderry, is a regular blogger at NHBR Network. He can be contacted at 603-434-2775 or firstname.lastname@example.org.