Do you know anybody who had a successful business for a couple of years and all of a sudden closed it down?
Have you heard a business owner complaining that after years of reinvesting money back into the business they are earning less money or even running at a loss?
Do you know any business owner who is unhappy because they seem to work more and more but see less and less money left in their personal bank account?
I have not only heard, but also seen myself on that same boat a few times. Although, since I understood the concept of the ‘Break-Even Point’, I have never again found myself in that same situation.
I would like to share this business knowledge with you and in doing so I will create a case study.
First off, let me explain what a Break-Even Point is.
The Break-Even Point (BEP) is the point at which total cost and total revenue are equal: there is no net loss nor profit, and one has “broken even”. Neither a profit nor a loss has been made. In short, all costs that needs to be paid are paid by the firm but the profit is equal to 0.
All businesses have costs and overheads, and all of us entrepreneurs should know how many units of our product or service we are supposed to sell in order to pay all our business costs and overheads.
Business costs is the money spent to buy the products for resale or it could also be raw material and direct labour if your business is manufacturing something.
The total variable cost varies according to the production level or sales level. Overheads do not increase or decrease according to the production or sales level. Now, let’s introduce our case study in order to explain this better.
Let’s look at a butcher’s (called Labaldi in this case study) where they buy and sell sirloin steak per kilo. Let’s assume that the butcher buys the sirloin steak for £18.20/Kg and he is looking to sell it for £24.50/Kg. In this case the total gross profit would be £6.30 per kilo.
The gross profit is a very important figure because it basically gives Labaldi an idea of how much profit he will make per kilo of sirloin steak he sells.
In order to calculate the gross profit margin, Labaldi needs to divide the gross profit per kilo (£6.30) by the total price per kilo (£24.50). The total gross profit margin in this case would be 34.62% (£6.30/£ 24.50).
The Butcher shop also has overheads such as rent and rates, utility bills, marketing and 1 full time employee totalling £6,300. Let us also consider as we explained before that the total overheads will not change no matter how many kilos of sirloin steak Labaldi sells.
I classified the labour as an overhead because in my opinion labour costs in a small business should be treated differently to that of a big business. In a big business labour is almost always classified as being a direct cost, but I would like to simplify my explanation.
*gross profit margin calculation
*Total Overheads table
To calculate the break-even point, we need to divide the total business overheads by the gross profit (£).
Break-even point = Total Overhead/gross profit
Let us calculate the break-even point for Labaldi Butcher Shop:
Break-even point = £ 6.300/£ 6,3 = 1.000 kilos of Sirloin Steak
Labaldi will need to sell 1.000 kilos of Sirloin Steak in order to pay all the business costs and expenses. If Labaldi sells 1,000 plus 1 his business starts making a profit. If Labaldi sells 999 Kilos, his business is running at a loss.
Now, Let us say for instance that Labaldi opens his Butcher shop tomorrow for the first time and see what could happen in his business in the first 18 months of trading.
You can notice that the total overheads represented by the yellow line keep the same value and only increase in the month 10 when Mr Labaldi opens the second shop.
The Red line represents the total business variable costs and the blue line represents the total business costs and overheads. The business total sales is represented by the green line and every time the green line is under the blue line it means the business is making a loss. When the green line is above the blue line the business is making a profit. The point in which the blue line crosses with the green line the business reaches the Break-Even Point.
Now what are the advantages in calculating the Break-Even Point?
- You know how many units of a product needs to be sold to break even. In this way you know how to set sales targets for your sales team;
- You will always try to find ways to increase your business productivity to decrease the business total cost;
- You will know how many more units you need to sell if your business overheads increase;
- You will try to lower your business direct costs (buying cheaper and finding alternative suppliers);
- You can calculate if your business will need extra working capital to hold any temporary losses;
- It will help you to make smarter business decisions;
- You will also calculate for each different product or services how much will be each individual marginal contribution (price – total cost of sales)
Now, follow my case study above and calculate your business break-even point. If you have any questions, please send me an email Rodolfo.firstname.lastname@example.org
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