Spotting the Break-Even
Here's how to figure out this crucial piece of information
that shows when you're making a profit
by David Carnahan
I’m sure you’ve heard the saying: Lose a little bit on each sale and make it up in volume.
Whoever coined this phrase obviously didn’t understand the concept of break-even analysis. Many business principles transcend specific industries. As business owners we can, and should, learn from other businesses whether they are in our industry or not. We should recognize their successes and see if we can borrow any of their habits and apply them to our own businesses.
Wal-Mart is such a company. It was started in 1962 and went public in 1970. At that time, it had some 38 stores and sales of $44 million. By 1979, it had 276 stores and had racked up sales of $1.2 billion. This magnitude of success didn’t happen by accident. It happened by following a clear and thoughtful plan. Wal-Mart has a reputation for relentlessly crunching and refining its financial numbers.
An informal survey I took of glass shop owners indicated that fewer than 20 percent sit down annually and develop a formal financial plan for their business. Chances are good that if you’re not doing much in the way of financial planning, you’re probably not doing much financial analysis either.
I have been privileged to help automate companies of all sizes and levels of technology for almost 25 years. Moreover, I have observed that the most successful, enduring companies are not necessarily run by the smartest, best-educated or most charismatic leaders.
Successful and enduring companies are proactive. On the financial side, that means having a financial plan. Here’s what I’ve found about these successful companies.
• They have a financial plan;
• They manage their plans, continually reviewing them and making necessary adjustments to them;
• They know their sales mixes;
• They know what their biggest movers are;
• They know their costs;
• They track critical information; and
• They know their industry.
A useful tool in analyzing your company is to compare it to the averages in the industry. A number of organizations, both fee-based and free, offer data on the auto glass industry. The SIC (Standard Industrial Classification) for the auto glass industry is 7536. If you look up SIC 7536 on the Internet, you’ll see many options for gathering data on the industry.
Comparing yourself to industry averages can be a very useful guide in recognizing areas that need improvement as well as seeing where you are operating efficiently.
Calculating and planning your break-even point is a key element of financial planning and management. The break-even point of sales volume can be defined as the dollar amount of sales at which a business generates neither profit nor loss. Annual sales that exceed this break-even point earn profit for the business and sales that fall short of the break-even point result in losses. Break-even is the gateway through which you must pass in order to achieve profitability.
Common terms associated with break-even analysis are:
• Fixed costs: also referred to as overhead costs, these costs don’t change as a direct result of changes in sales. They are a set amount whether you sell anything or not. Examples of fixed costs are rent, utilities, property taxes and salaries (not installer wages).
• Variable costs: these are also referred to as costs of goods sold (COGS) or direct costs. Variable costs, as the name implies, vary based on the jobs you do. They are the costs directly associated with performing jobs and include the cost of glass and kit costs, installer labor, etc.
• Sales revenue: this is the (net) revenue you receive for selling your product. It is the sum total of your invoices excluding discounts and taxes.
• Gross profit: this is the sales revenue minus the variable costs (Sales Revenue – Variable Costs = Gross Profit).
• Gross profit margin: this (GPM) is your gross profit as a percent of sales revenue (Gross Profit ÷ Sales Revenue).
Break-even sales volume for a company is equal to its fixed costs divided by the gross profit margin. If we put this formula into the context of a typical auto glass shop, Fig. 1 is what we get.
In this example, the shop achieves a break-even point when it reaches $470,211 in net sales. An average of 46.4 percent of every sales dollar after the break-even point contributes directly to net profit.
Let’s examine the powerful relationship between gross profit and break-even. In our example, cost of sales (variable costs) is, on average, 53.6 percent of our sales. If we could save $1.63 on every $100 in direct costs, this is how it would look:
Break-Even = Total Fixed Cost ÷ Gross Profit Margin
$470,211 = $218,037 ÷ 46.37%
After reducing our variable costs by 1.63 percent, our net profit would increase from $12,215 to $19,829, an increase of more than 62 percent.
You can look at these numbers on a monthly basis by simply dividing every number by 12.
You can even calculate your daily break-even volume by dividing the monthly number by the number of working days in the month.
Another way to examine your break-even is to look at an invoice profit report (most software programs offer a report like this) and look at the average profit for each invoice. Divide your average profit per invoice by your break-even sales volume and now you have the number of invoices per year, month or day that you need to break-even.
Estimating your break-even sales and conducting a sensitivity analysis relative to break-even sales gives you a tangible framework in which to operate. It helps answer questions such as:
• What is the minimum revenue needed to cover costs?
• How low must variable costs be to break even based on price and sales forecasts?
• How low must fixed costs be in order to break even?
• How do changes in price levels affect the break-even sales volume?
• How many invoices (at my average profit margin) must I do to break even?
This article barely scratches the surface of break-even analysis. If your software includes (as most do) a report that shows invoice gross profit, you can find your average gross profit per invoice, then use that number to determine the number of invoices per year, month, week or day needed to break even.
You might not arrive at a perfect number on your first attempt at break-even analysis. Keep reviewing your data to see if it matches your assumptions. If it doesn’t, change your assumptions. As you continue this review and revise process, your analysis will improve and eventually you will really know what it takes to break even. Remember, break-even is the gateway to profitability.
David Carnahan is the president and founder of Mainstreet Computers, Belleville, Mich. The company has been in business since 1982 and offers software to the auto and flat glass industry.
© Copyright 2006 Key Communications Inc. All rights reserved. No reproduction of any type without expressed written permission.