This continues our 10-part series of best practices for business owners.
Best Practice 5: Understand your break even point
Many people go into business with a dream to make lots of money. The harsh reality is, in small business, making money is much easier said than done. For this reason it is important for business owners to understand their break even point. Break even analysis is a tool small business owners can use to understand when a business will be able to cover their expenses and begin to make a profit.
Simply stated, your break even point is the point at which the new product or service is paid for. Here are 4 steps to aide small businesses in calculating their break event point:
- Know your fixed costs. Fixed costs are those costs that remain the same regardless of your sales volume. Examples are rent, utilities, or payroll (if not directly related to sales). If you plan to take money out of the business to pay yourself, don’t forget to include it here.
- Understand your direct or variable costs as a percent of your sales. Direct or variable costs are those costs that are directly related to sales. These are typically expressed as a percent of sales. Examples are cost of goods sold, inventory or direct labor.
- Determine average gross profit of the products or services you sell. Gross profit is the money left from each sale after paying direct costs of the sale. Direct costs are what you pay to provide the product or service. For example, a business makes an average of $100 per sale with an average cost of goods sold of $40, giving them a gross profit of $60 or 60%.
- Calculate a monthly break even point. The formula to calculate break even is:
Fixed costs / Gross profit percent
For example, a business has monthly average fixed costs of $2,000, using the above example $2,000/.60=$3,300 is their monthly break even point.
What can you do if your break even point is higher than the projected sales? Determine which metrics can be changed to meet the projected break even point. For example, reduce payroll, work from home rather than renting space or find a less expensive source for direct costs. The goal is for the break even point to be less than or equal to the projected sales producing a realistic financial business plan.