Understanding the break even point in a business is a crucial but often overlooked piece of the financial puzzle.
It is particularly important in a manufacturing business where there are both overheads to just keep the doors open, and the marginal costs of production.
In order to make informed and sensible cost and pricing decisions, and effectively manage the business, you need to understand both.
This is the cost of making and selling another widget. The materials consumed, packaging, and direct labour necessary. The difference between your sales price of a widget and the marginal cost of that widget is usually referred to as the ‘Gross margin’
For example, if a widget costs .80 cents to manufacture, (materials + packaging + direct labour) and you sell it for $2.00, the gross margin is $1.20/unit.
These are the costs necessary to keep the business going, and not tied to the cost of production. Rent, insurance, staff labour costs, marketing and sales expenses, travel, and many others. These costs keep on coming irrespective of sales.
Let’s assume your business has fixed costs of $600,000/year, it is a small business, so you as the owner pay yourself a modest wage, there is one sales person, an office manager, rent and insurance, as well as the general costs of running a business. In the factory there are three people, a factory manager, and 2 people who work on the production line. The factory manager would normally be included in overheads, but if he works on the line part time, then a portion of his salary would reasonably be included in the costs of production.
There are always questions about where a cost should be allocated, marginal cost or fixed cost, For example, sales commissions would usually be considered a marginal cost, but sales salaries would be considered a fixed cost. Similarly with freight costs, the cost of keeping trucks on the road would be considered a fixed cost, but the cost of an outsourced courier service would be a marginal cost, as without a sale, it will not be incurred. The key is to be consistent in the treatment of costs.
Break even is the point at which all costs are covered, but there is no profit.
How to calculate the break even.
The formula is fixed costs divided by the unit gross margin.
In our case above, the break even point would be $600,000/1.20 = 500,000 units.
In a situation where there are several different widgets, with different selling processes and differing costs of production, the calculation can be done either by taking averages, of both the sales revenue and costs of production based on average sales mix, or it can be done separately, for each of the products and added together.
In any event, understanding the structure of your break even will assist enormously in making sensible pricing and cost management decisions. It will also make the choices that impact future cash flows, such where to concentrate your limited sales and marketing resources, much clearer.
This will be the last StrategyAudit post of 2017. I am very grateful to those who have commented, shared and generally engaged with the sometimes random stuff that pops out of my brain, and I am enormously gratified that you see the value in the ideas. Have a safe and merry Christmas, and I will be back early in 2018, refreshed and eager to go another mile.