Managing a business’ 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.
Break even 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. Meaning, 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. Advertising, accountant fees, insurance, and salaries are typical fixed costs.
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, which is total variable costs divided by sales. If the VC percentage equals 65 percent, it means for every $1 in sales generated, 65 cents is spent on variable cost.
Once sales dollars are generated to cover variable costs, the contribution margin percentage is calculated. The CM percentage is computed by subtracting the VC percentage from 100 percent (100 minus 65 equals 35). This means 35 cents is available for fixed costs out of every $1 generated in sales.
So what sale amount is needed to break even? If fixed costs total $75,000 sales of $214,286 is needed to break even.
The computation is to divide total fixed costs by the CM percentage ($75,000 divided by 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 the cost to raise wages increases by $500, sales must increase by what amount to maintain the current level of net profit?
The answer: $1,429 in additional sales.
The computation: $75,500 divided by 35 cents equals $215,714 minus $214,285.
A thorough knowledge of the impact of variable and fixed costs should be clear prior to increasing or decreasing costs or changing sale prices for any business to grow.