Break even Analysis enables you to know if you made any profit in the month.
Sometimes you may feel your business is still too small to warrant spending on accounting software. Some businesses have software but still don’t trust the figures they are seeing every month.
Using Your Sales Figures
For me, the best way to quickly assess if you have made profit is firstly to know what Sales you have made for the current month. Luckily for most businesses, this is the key figure. If there will be one figure you are tracking it should be your sales made in the month.
Sale made being firstly the sales you have invoiced for and secondly the Sales cash received into the bank. Depending on the nature of your business and how quickly your customers pay you, these two figures can be quite different.
Understanding the Difference between Cash and Profit
See my Video Tutorial here for further explanation on the difference between cash and profit and to decide which measure of Sales you should use for your business.
For our purposes, we will use the sales invoiced in the month figure. Knowing the Sales figure in isolation however is not enough.
Using Your Costs Figures
You should, as a business owner, sit down and do a one off exercise to quantify what you believe is the size of your cost base. Your cost base relates to all of those fixed costs often referred to as overheads. You know those costs? The ones where you have to pay out, every month, even when your sales are low or even zero. Rent, rates. stationery admin staff, Insurances, Entertainment. Office Costs like Telephones and Electricity and Travel are good examples of these costs. It is important to be able to identify all the current costs that you are incurring on Overheads and total these up to see how much this costs you per year.
Now simply divide by 12 to get the monthly cost.
Calculating Your Break Even Point
When you have established what it costs you on a monthly basis to keep your business going, you need to the work out, for every £1 of revenue how much is automatically spent on directly producing the item or service. These types of costs are called Costs of Sales. They vary directly and in proportion to your sales. Examples of these would be raw materials, sales commissions, packaging and direct labour who only work exclusively on the product.
For these types of cost, we will try to see what is the relationship between the Cost of Sales and the Sales figure. We want to obtain a ratio that can be applied to any level of sales.
A Worked Example
Cost of Sales £2,160
Gross Profit £1,840
Gross Profit/Sales = 1840/4000 X 100 = 46%
This means that for every £1 of sales sold, 46p is Gross Profit.
Using Your Gross Profit Figure
Gross Profit is the profit that is directly made every time your product is sold and if you have worked out you Gross Profit margin correctly, it is a great indicator of how profitable your product is when compared against different products that you are selling.
Of course, after you have made gross profit, your overheads still need to be paid. Therefore, we need to use this Gross Margin to calculate how much sales we need to make, in order to cover all of our overheads.
Going back to the example above:
Cost of Sales £2,160
Gross Profit £1,840
Gross Profit/Sales 46%
Net Loss -£160
In order to cover all our overheads and Breakeven, we need to generate £2,000 worth of Gross Profit.
Given our Gross profit % is 46%, this means we need to generate £4,348 of Sales.
If you would prefer to see this calculation explained more visually, check out my short video which explains how to calculate your Break Even Sales figure.
Once you have worked out the Key figures which are:
- Total Overheads per year and monthly Overheads per year
- Gross Profit/Sales %
Remember to check these two figures whenever you make changes to your business. If you have brought in a new product line, increased your overhead spend by employing more resources, increased marketing and so on. This will change your breakeven point. Often as the business grows, this is one of the main ways a business falls into cash flow issues; the additional expenditure around growth resources does not generate sufficient additional Sales and gross margin to cover the higher cost of the overheads.
Likewise, if your Cost of Sales have increased due to say raw material price increases or additional direct headcount, check again to make sure you understand the impact on your break even sales figure.