business’s break-even point is the point where your revenues are sufficient to cover your expenses. Remember, even if you don’t sell anything, you still have fixed costs to cover.
Consider the following example:
Revenue per unit — $10
Cost per unit — $7
Gross margin — $3
So, for every unit you sell, you net $3. Now, what if your fixed expenses looked like this:
Rent — $7,500
Utilities — $1,250
Wages — $9,470
Office supplies — $595
Total fixed expenses — $18,815
How many units would you have to sell to cover your fixed expenses?
$18,815 ÷ $3 = 6,272 units
You would need to sell 6,272 units to keep the doors open. If you sell more, you make a profit. If you sell fewer, you will lose money.
Instead of looking at the number of units you need to sell to break even, you can also calculate the total sales you need to make. Using the above example, we would start by calculating a gross margin percentage (gm%).
GM% = GM per unit ÷ Revenue per unit = $3/$10 = 30%
Break-even sales would then be —
Overhead/GM% = $18,815 ÷ 0.30 = $62,717
You would therefore need to have revenues of $62,717 to be able to keep the doors open.
Most small businesses never take the time to calculate their break-even point. Most feel that their revenues will be whatever they are and that they can’t do anything about them. You can see from the above example why it would be important to know how much your sales have to be in order to survive.
Capacity
Not only is it important to know how much you need to sell in order to keep the doors open, you need to know how much you can do in sales with your current fixed cost structure. This is called capacity. If you’re a manufacturer, your plant and equipment will only physically handle so many units before you need to move to a larger premises and purchase new equipment. If you’re in a service business, as your revenue levels start to increase, you will need to hire more staff and have larger offices.
Think of the break-even point as the minimum you need to do and capacity as the most you can do.
For example, let’s look at a business that manufactures dolls. The business has a combined plant/warehouse and employs 35 manufacturing staff. The owner has analyzed the equipment, space, and staff, and has determined the following:
Maximum units manufacturing equipment can produce — 12,500
Maximum units warehouse can store — 10,475
Maximum production of manufacturing staff — 14,675
This analysis tells us that the warehouse space is the limiting factor, or the bottleneck, in the business. No matter how hard the staff work or how hard the equipment is run, the warehouse can only handle 10,475 units. This is the capacity of the current cost structure.
Why is this important information? If the owner is budgeting and forecasting for the upcoming year and budgets any more than 10,475 units to be produced, she must also plan for more space — which increases her fixed costs. She would then have to determine whether the profit from the additional units offsets the new cost of larger warehousing space.
This concept is also valid for service businesses. Let’s assume your business provides consulting services. You are the owner and chief consultant and you have two other consultants working with you.
Case Study
“So, based on my calculations,” Becky said, “we would need to make sure that the new employee has at least 20 hours of billable work a week in order to pay for his salary.”
“That’s right,” said Vivian. “And you were telling me that, with your expected increase in commercial construction work, you should easily be able to get the 20 hours. So it makes sense to hire an employee.”
“I’ll get the ad in the paper today,” said Becky.
You want to calculate your capacity. Look at the following figures:
Number of hours in a work year (per person) — 1,950
Average number of hours spent on admin. activities — 250
Number of hours available to charge to clients — 1,700
Average charge-out rate — $75
Each of the three consultants should be able to charge out 1,700 times $75 annually to clients. This is then multiplied by the number of consultants:
1,700 X $75 X 3 = $382,500
This means that the maximum revenue with your current cost structure is $382,500. It would be ridiculous to budget for revenue of $500,000 without planning for a new staff member.
Chapter Summary
• Fixed costs are costs that do not change with volume of sales.
• Variable costs are costs that do change with changes to the sales volumes.
• The break-even calculation tells you how much of your product or service you have to sell in order to cover your fixed costs.
• The capacity calculation tells you the maximum number of units of your product or service you can produce or provide with your current operating facilities.
4
Ratio Analysis for Fun and Profit
In this chapter, you will learn —
• Why ratio analysis is critical to successful businesses
• The basic ratios and what they tell you
• How to pick the ratios that best foretell your business’s success
• What to do when ratios indicate a problem
• How to integrate ratios into your management reporting system
The subject of ratios is one that makes most small business owners’ heads hurt. Financial analysts and stockbrokers regularly assess the ratios of large, publicly traded companies, but many small businesses do not even consider ratios when they prepare their financial information. Why should you care about ratios? Consider the following reasons:
• Your bank will certainly care about monitoring ratios. They want to see how you’re doing in comparison with other businesses that they are lending to, and in comparison to the standards they have set for lending.
• Ratios are excellent indicators of financial health. Much like a high blood pressure or cholesterol reading at your doctor’s office would signal impending physical trouble, out-of-kilter ratios signal financial trouble for your business.
• Ratios are a useful tool for comparing your business activities year over year. For example, is your working capital ratio steadily improving or not? (We will discuss this and other ratios later in the chapter.)
• Ratios are a useful tool for comparing your business activities with those of other businesses. Without using ratios, it can be difficult to compare businesses of different sizes.
Case