Step 1: Break-Even: Fixed Costs Can Have a Surprising Effect on Your Profits!
In the previous issue, I outlined a seven-step process guaranteed to improve performance. We call this process Profit Mastery. My goal going forward is to give you more detail on each of the steps, a specific action plan for how to apply each to your own business, and how to incorporate the results into your strategic thinking.
Everyone knows their costs, right? This is a concept as old as Methuselah. Well, do you know yours? And do you know how those costs behave in your business? And can you answer the question: Why would anyone in their right mind care?
I firmly maintain that this information ought to be "walkin' around in your head" knowledge. Not only does the behavior of these costs have a significant impact on your profitability, it also impacts your marketing strategy.
And costs are controllable today. Suppose I posed the question: Your costs will go up $1,000; what do you have to make in increased sales just to stay even? You guessed it: far too many times, the answer is $1,000. Bad sign.
So let's talk about costs. I'll give you a tool today to manage costs and a method to analyze your cost decisions. The problem is understanding how costs behave. The tool is break-even analysis. Break-even analysis is a financial tool that illustrates the relationship between cost-volume-profit. By definition, break-even is the exact sales volume at which the business neither makes a profit nor incurs a loss.
To calculate break-even, we first need to define two broad classes of costs, based on how they behave in the business: fixed costs and variable costs.
First, fixed costs. Within a reasonable sales range, fixed costs do not vary with sales or production volume. Examples include administrative salaries, rent, interest, insurance, utilities, and depreciation.
Next, variable costs. Variable costs are those which are directly proportional to sales volume; i.e., no sales, no variable costs. Examples include direct materials (cost of goods sold), commissions, and bad debts. Think of variable costs this way: sales cause variable costs. If sales don't cause them, consider them fixed.
Okay, so now how do you calculate break-even? From your existing profit/loss statement, total all your current fixed costs. Let's say that comes to $100,000. Next, you calculate your total variable costs as a percentage of your total sales. Let's say your "variable cost percentage" is 75 percent.
What does this mean in terms of $1? Well, for every $1 of sales, 75 cents goes to variable costs. What's left? Yes, 25 cents. To cover what? Fixed costs. So now we have to answer the question: How many 25 cents are there in $100,000 of fixed costs? The answer, of course, is 400,000. This means that you will have to do $400,000 in sales to reach break-even. I've diagrammed it here, using the term "contribution margin" to replace the term What's left?
Break-Even Calculation Break-Even Proof Fixed Costs: $100,000 Sales $400,000 Variable Cost % 75% Less: 75% variable cost - 300,000 Contribution margin 100,000 Formula: $100,000/ Less: fixed costs - 100,000 (100% - 75%) Net Profit 0 Break-even sales: $400,000
The key issue is not so much how to calculate break-even as it is how to use it. For example, I once discovered that my company had contracted for a coffee service and our annual costs went up $1,000. How much in additional sales did we need to cover this increase?
Fixed cost increment = 1,000 = $4,000 (100% - 75% .25
Yes, sales had to increase $4,000 just to pay for the coffee. It's these "creepers" you must watch every day--because for every $1 increase in fixed costs (as they creep on you), you must achieve a $4 sales increase just to stay even.
I had an experience some years ago that has stuck with me to this very day. I stopped by a client's shop one day, only to discover him fuming around, mad as a hornet. Seems an employee had just destroyed a $6,000 cement mixer. I said, "I sure understand." He said, "No, LeFever, you don't understand at all. That's not the problem." So I said, "I guess I don't understand."
He stormed over to the trash bin and pulled out three discarded C-clamps. "See this," he fumed. "They'll only break one cement mixer in their life--and it's insured. But they'll throw away three C-clamps every day, forever. Add it up!" I did. And it made a lasting impression.
If you "add it up" for your business, you may find a few new ways to manage your creepers.
Steps to calculate break-even:
- Separate costs into fixed and variable
- Total fixed costs in dollars
- Calculate variable costs as a percentage of sales
- Use the formula:
Break-even = Fixed Costs (100% - variable cost %)
Steve LeFever is the chair of Business Resource Services (BRS). For over 10 years, franchisors and franchisees have improved their financial performance by following the BRS Profit Mastery process: financial training, performance benchmarking, and accountability/bankability modeling. Contact them at 800-488-3520 x14 or firstname.lastname@example.org.
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