Business may be booming. You could have more orders than you can handle. And your customers might tell you that they love what you do. But the truth is that a busy SME isn’t necessarily a profitable one. How do you know when your company is really making money?
It’s a simple question that too few business owners ask themselves. The ‘break-even’ point in a business is when a company’s revenue equals its total costs or expenses. Beyond that, the income an enterprise brings in is that longed-for thing – profit. Yet, many small business owners simply rely on gut feeling about the state of their finances. And because they don’t undertake regular financial analysis of their operation, a surprising number fail to recognise when its costs are greater than the money it’s making.
- About one in two small firms doesn’t know what their break-even point is, according to past Government research.
This shocking fact matters for several reasons. Without knowing how much money an SME really has in profit makes business planning near impossible. Being aware of the point at which a firm breaks even can inform how much you produce of a given item, what services you provide, and how you set pricing. Without this hard data, costing is little more than luck or a stab in the dark.
The risks of ignorance
A business owner who can’t demonstrate that he or she is on top of the company’s numbers is also unlikely to impress would-be lenders or investors. Perhaps most importantly, if you aren’t aware when the company is in the black and by how much – or worse, in the red – then, your enterprise could be in danger of collapse without you realising it. More than 14,600 companies in England and Wales went bust in the 12 months to June this year, according to the Insolvency Service. A good proportion of these will not have been in command of their basic numbers, and wouldn’t have seen disaster looming early enough to prevent it.
Ideally, a business wants to keep its break-even point as low as possible in order to maximise its potential to make profit. But how can someone running an SME begin to calculate when their costs and income are equal to start with?
The numbers you need to know – and what they say
There are some key figures that you need to hand in order to figure out where the business’s break-even point lies:
- Level of sales. This means the number of units sold in a year, and the selling price. This will tell you your sales revenue.
- Fixed costs. These are the expenses that exist regardless of how much you sell or not, and will include such things as rent, rates, utilities, and cost of staff salaries.
- Variable costs. This may involve the cost of production of goods, and could vary depending on the price of raw materials, for example.
Accountants use a variety of methods to assess the point when a business breaks even, but there are crude calculations that business owners can make themselves to get an idea of how their company is performing. First, you must determine your gross profit. Your gross profit figure is your total sales revenue minus the variable cost of the goods or services sold. Then, you need to know your gross profit margin (GPM) – gross profit expressed as a percentage of sales. The calculation for this would be:
- GPM = gross profit divided by sales revenue.
Next, comes the calculation to determine when your business is breaking even:
- Break-even point = fixed costs divided by GPM.
For example, if a business has sales turnover of £500,000, fixed costs of £100,000 and variable costs of £200,000, its break-even point will be just short of £167,000. Past that point any income for the company qualifies as profit.
To get a true picture of how your business is performing it’s always sensible to talk to your accountant. He or she should be familiar with crunching these numbers, can identify your exact break-even point, and will be able to help you interpret the figures.
What your break-even point tells you
As well as allowing businesses to make informed decisions about pricing and inventory levels, knowing where your SME’s break-even point lies can act as an early warning system. If you’re starting to lose money, you’ll know about it in time to take action, be that by chasing late payers, cutting costs, or even, in the worst scenario, letting staff go. The reality is that ignoring what the key financials are telling you is a recipe for disaster, and things won’t get better just by waiting for conditions to improve.
There are simple and practical checks and balances that business owners can put in place to keep on top of their figures on an ongoing basis:
- Create systems to monitor orders and sales, overheads, margins, and net profit. Do this monthly or even weekly. The process could be as simple as creating a profitability spreadsheet in Excel. A more sophisticated technology infrastructure may be necessary if the business’s structure and range of products and services warrants it.
- Once you can chart the business’s progress accurately, compare the current position of your operation with the same point last year. This will give you a good sense of how well – or badly – the company is faring overall.
And be aware that it’s not enough to do your sums just once. Selling prices, costs, and trading conditions change, so you should recalculate your break-even point on a regular basis. It’s likely to affect your pricing policy and your decision-making, so be vigilant and get to know what’s really happening in your business. Don’t be one of the fools who just relies on what their gut tells them. Use your head, rather than putting it in the sand.
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