All of us have heard of break even, a sales volume at which a business is operating at zero profit.
But a thoughtful break-even analysis is a critical component in the development of a business strategy around price, production costs and production capacity.
The basic math is simple. The average profit made per billing, unit, whether it's German Dog Beer (yes, it's a thing) or service hours, is divided into your fixed costs, generally recurring bills you can't afford to miss but unrelated to sales volume, to derive a sales unit figure, such as 1,000 doggie six-packs.
But simple math belies complex assumptions.
Loans, rent, administrative salaries, general office or promotional expenses (not sales discounts, however) are basic components of fixed costs. But cast a wider net and include costs not strictly controlled by volume, even if essential to production.
So, in the German Dog Beer example, include the indirect costs, such as the plant bottling supervisor, as fixed.
¦ Include noncash expenses such as depreciation and maintenance in fixed costs. Think of this as saving now to replace your stuff later.
¦ Remember the owner's salary. Salary should be considered distinct from profit. Salary is what an owner earns; profit is what the business earns. But …
¦ Include a minimally acceptable profit as a fixed component. Yes, technically you are no longer breaking even, but a marginal profit should be an embedded business goal and provide cushion for inaccurate estimates.
Invariably, break even highlights the four levers for profitability improvement, arranged in order of both profit impact and risk of implementation. The dollar-for-dollar levers:
¦ Price changes. Price increases can dramatically improve the bottom line but cannibalize volume. Lower volume, though, at higher prices might be more profitable. Essentially, the latter is the premium strategy used by many small businesses.
However, two transactions affect price but not volume: sales discounts and bad debts. Set policies to manage those areas and stick to them. Profits will improve even if nominal prices don't increase.
Conversely, price reductions don't guarantee volume increases, except in economics textbooks.
¦ Be ruthless on fixed costs. Walter White ruthless. Think like a customer, or ask a customer, to identify the tangible features of your product or service that drive the purchasing decision.
Use these impressions to guide you in deciding what is a fixed or hidden cost susceptible to reduction. If some of these costs remain in the gross margin calculation on your financial statement, that's OK.
Break down each cost into components to uncover small savings. An entire function, for example, may not be eliminated, but parts of it can be. A dollar saved might be better than a dollar earned.
¦ Improving per-unit margin. The pursuit of efficiency is a fact of business, but it's the sports equivalent of great defense. Most businesses devote considerable resource to achieving production efficiency. Unfortunately, the benefits can be lost to the customer in the form of reduced prices.
An alternative or complement to greater efficiency might be to upgrade your product with a premium category using improved materials, such as organically grown hops, but a similar production method.
¦ Increasing sales volume. Cross sell and upsell strategies, such as bowls for your dog's beer or canine bottle openers, can produce similar results to price increases, but you still won't get a dollar-for-dollar impact.
However, if you need to hit home runs in sales to achieve break even, get your fixed costs under control and first rethink your pricing. Price decreases to generate volume can backfire as competitors react.
Electronic spreadsheets make it possible to derive multiple break-even strategies, so develop different approaches. Use this flexibility to your advantage and create alternatives, even crazy ones to stimulate creative thinking. When you pick one, assign a priority to dollar-for-dollar strategies.
It's hard to be impartial about your personal business, so have someone take an independent look at your ideas for feasibility. They also should look at the crazy ideas to ignite their creative spark.
Hugh Kelly has held a variety of senior executive positions for publicly held and privately owned companies in financial services, direct marketing and the not-for-profit consulting fields. Formerly a Certified Public Accountant, he is a certified mentor for Lehigh Valley SCORE and can be reached at email@example.com. For more information or free help in building and reviewing a break-even strategy, contact Lehigh Valley SCORE (www.lehighvalley.score.org).