How much money do you need? Break even Analysis 101
How much money do you need?
As a new business owner, a big part of my ongoing experience and planning center around money. Admittedly money isn’t the reason I got into this (I’ll save that for another topic…) but it’s always going to be a factor.
However, and I think this applies to everybody, money definitely plays a large part in determining the amount of success my business will have. Which brings us back to the starting point:
How much money do you need? How much money do you want?
Now there’s a philosophical aspect to this question that ties into living within your means and that kind of stuff, but right now I’m thinking of the more tactical and practical viewpoint of how to use break even analysis to drive all sorts of strategic planning.
Note – this is an extremely basic set of calculations. Those of you that have done some accounting will likely find this not very interesting, but I bet you do some variation of this in your head or on a napkin somewhere when you’re thinking about your business.
Simplistically, a break even analysis is a way of calculating how much of my product or service I need to sell to cover all of my fixed and variable costs.
Although there’s potentially a lot of details and difficulties in getting to this information, the break even calculation is simply your fixed costs divided by your Gross Profit margin (as a percentage). *Note – Gross Profit margin is your gross income (Total sales – Variable Costs/cost of sales) over your total Sales. Here’s a quick example.
Assume you sell $100 of widgets (it’s gotta be widgets…!) and it costs you $70 for every widget you make (variable cost). That gives you a gross income of $30 which means you have a Gross Profit Margin of 30% or $0.30 on every dollar is profit (before you factor in fixed costs).
|Variable Costs||$ 70|
|Gross Income||$ 30|
|Gross Profit Margin||30%|
So back to the break even analysis.
Fixed Costs _____________ (A)
Your Gross Profit Margin _____________ (B)
Break even Sales (A/B)
If we use the example above and assume our fixed costs are $100, our break even sales would be $100/.30 = $333.33 meaning that we would need to sell $333.33 dollars worth of goods just to break even.
Anything under that is a loss…!
Anything over that is profit…!
Now that’s an interesting piece of information to know – but what’s even more interesting is to use this process to figure out what you would need to sell in order to reach your desired income/profit.
So let’s say as a small business owner you would like to make $100,000 for the year (before taxes and assume that all net profits would flow to you as the owner).
Let’s also assume that your Gross Profit Margin on your widgets is 30% (same as the example above). Finally, let’s assume that your fixed costs are $50,000 for office space, equipment costs, whatever it is that you are spending whether you make any widgets or not.
The sales you would need to meet your desired income goals is simply your Desired Income plus your Fixed costs / Gross Profit Margin. Here it is with the numbers from our example:
($100,000 + $50,000)/.3 = $500,000
In other words, given this scenario, Sales of $500,000 would net you as the owner, $100,000 in profit.
Now that’s a pretty cool thing to know. If you want to make $200,000… ($200,000 + $50,000)/.3 = $833,333 in Sales.
More importantly this gives you an easy and simplistic (quick) model you can use to think about your business in different ways.
What do I mean? Maybe you think $500,000 in sales is a bit optimistic this year – what else could you do to tweak your process and still hit your target of $100,000 in profit?
You could make changes to your Gross Margin (reduce your variable costs or increase your price). Going back to the $100,000 in desired profit, a Gross Profit Margin of 40% instead of 30% means you would only need to sell $375,000 instead of $500,000 ($150,000/.4). (Note – that would be the equivalent of a 16.7% price increase using the example at the top of the page.)
Alternatively you could reduce your fixed costs. Fixed costs of $25,000 instead of $50,000 would lower your required sales to $416,667 instead of $500,000 ($125,000/.3).
Obviously this is too high level to use for accurate and precise planning, but it does give you a quick and easy way to visualize and brainstorm what you need to do to get the money you need.
In a future post, I’ll break down you can use this information as a basis for calculating the number of sales leads you need to be tracking down every week to hit your desired income.
If you’re interested, I can send you a simple spreadsheet that lets you play around with these numbers (note -very simple). Just drop me an email via the Contact Page with a note about this topic.
As a business owner, do you know what your break even point is?
How often do you step back and think about what you’d like to make…and what it would take in real terms in order for that to happen?
I’d love to hear your thoughts on this.
Shawn Kinkade www.aspirekc.com