Understanding your break even number will focus you on what you need to do to get your sales to the minimum level you need and beyond. The first step is to know what the break-even number is and how to calculate it.
Take the case of Sally who has a cake shop. Sally buys the ingredients to bake her cakes, the flour, sugar, butter, eggs and so on. She also buys the boxes and cake boards for packaging. Sally is flying solo doing it all herself and has no employees. But Sally does have overhead costs of rent, electricity, telephone bills, cleaning costs, advertising and marketing costs.
In order to determine Sally’s break even number, she needs to take the following steps.
Step 1. Identify all her overhead costs.
These are the costs that she has to pay whether she sells one cake or one hundred cakes. Sally needs to add up these costs over twelve months and identify an annual total. The reason to use an annual total is some costs like insurance are often paid just once a year and she needs to make sure that she has all her expenses accounted for.
Step 2. Identify all her cost of sales costs.
These are the ingredients for the baking, the packaging and any other costs that will vary with the number of cakes she bakes. Electricity or gas costs may belong in this category as the more she bakes the more power she uses. In order to do this, Sally will need to go back over the past twelve months to capture all the costs she spent.
Step 3. Identify her Gross Margin percentage.
In order to do this, Sally needs to make a note of her total income over the previous twelve months. She will then subtract the total cost of sales she calculated at Step 2 from the total income. This will provide the Gross Profit figure. From this Sally will calculate the gross margin but taking the gross profit and dividing it by the total revenue and multiplying by 100 to get the percentage. Let’s look at some of Sally’s figures.
Sally’s total revenue was $ 200,000
Sally’s total cost of sales was $ 120,000
Sally’s Gross Profit is $ 200,000 – $ 120,000 = $ 80,000
Sally’s Gross Margin is $ 80,000 / $ 200,000 x 100 = 40%
Step 4. Calculate the break-even number.
This is the revenue Sally needs to make to cover all her costs, both cost of sales and overhead costs. Break-even means that she won’t be making any profit though, just covering her costs. Let’s continue with some more of Sally’s numbers.
Sally calculated her overhead costs at Step 1 to be $ 105,000
Sally made a loss in the previous year calculated as $ 80,000 – $ 105,000 = $(25,000)
Sally expects that her overhead costs will continue next year at $ 105,000 and wants to make sure that she is not making any more losses. She needs to make sure that her Gross Profit is $ 105,000 not the $ 80,000 she had last year. This means that she needs to sell more, but her question is how much more.
Sally’s break-even number is $ 105,000 / 40% = $ 262,500 which means she needs to sell a further $ 62,500 more cakes over the next year.
Step 5. Setting targets to achieve the break-even number.
Sally has identified that there are two months in the year when she typically doesn’t have good sales and she tends to take some time off at those times too. Realistically, Sally needs to make her break-even revenue in 10 months of the year. Sally now has a new monthly sales target $ 26,250 ($ 262,500 / 10 months) which will allow her to break even.
Knowing how much revenue you need to have to break-even and cover your costs makes it easy to focus on that one number. As long as you keep the cost of sales and overheads under control too, focusing on meeting the new target revenue number will help you to get your business to break-even.
And then, once you’ve got to break-even, the next step is to start making profits by selling more than the break-even number.
