By Sandra Taylor-Sawyer: Business columnist
Managing a business’s finances can be a huge undertaking. It can be a daunting task to connect how an increase in advertisement will impact sales, and most importantly, how the increase will affect the balance sheet. There are financial tools available when deciding to raise wages or lowering the sell price and still maintain the current net profit. One such tool is the break even analysis.
The break even analysis determines the point when sales cover costs, which means there is not a loss or profit. By using the tool the business owner will know their cost of doing business. This means pertinent questions can be answered prior to hiring a new employee or knowing what sales must be generated if rent increases by $3,000.
All businesses have costs, which are distinguished in two categories: variable and fixed. Variable costs are directly created by the generation of sales. On the other hand, fixed costs will occur regardless of how much product is sold or services rendered. The types of variable and fixed costs can vary from industry to industry and business to business. Inventory, labor, commission, and utilities are typical variable costs. These costs will increase as sales increase. Fixed costs remain constant regardless of increases or decreases in sales. Advertising, accountant fees, insurance, and salaries are typical fixed cost.
To determine break even, costs must first be identified as variable or fixed. If costs are not easily identified, the role of thumb is to be conservative and define the cost as fixed. The second step is to compute the Variable Cost Percentage (VC), which is total variable costs divided by sales. If the VC percent equals 65 percent, it means for every $100 in sales generated, $65 is spent on variable cost.
Once sales dollars are generated to cover variable costs, the Contribution Margin percentage comes into play. The CM percent is computed by subtracting the VC percent from 100 percent (100-65=35). This means $35 is available for fixed costs per $100 in sales. So what sale amount is needed to break even? If fixed costs total $75,000, then sales of $214,286 are needed to break even. The computation is to divide Total Fixed Costs by the CM percent ($75,000/35 percent) and express it as a decimal.
Why is this important to a business owner? Computing break even is not as important as knowing how the results can influence day-to-day business decisions. For example, if utility cost increases by $500, sales must increase by $1,429to pay for it ($75,500/0.35=$215,714-$214,285) .
A thorough knowledge of the impact of variable and fixed costs should be clear prior to increasing or decreasing cost or changing sale prices for any business to grow successfully.
Sandra Taylor-Sawyer is director of the Clovis Community College Small Business Development Center. Visit at www.clovis.edu/sbdc or contact the center at 769-4136.