How to Maximise Business Profitability
I’m going to take a stab in the dark and guess that you’d like to make more money in your business. Assuming I’m right, I’m going to share with you the starting point on that journey that I’d estimate 80% of small business owners don’t understand. And that is their break-even point.
What is the Break-Even Point?
The break-even point is simply the point in sales volume where you’ve covered all your overhead costs and can now make a profit. Knowing this number enables you to:
- Make decisions on costs and pricing
- Understand how you are doing throughout the year, week or month just by looking at sales
- Set sales targets that will give you your desired level of profitability, and understand the feasibility of achieving it.
There is one other great thing about knowing and understanding your break-even point. It’s not overly complicated, in fact you don’t even need to be a financial whiz to work it out!
When most people want to make more money, they go out and make more sales or they reduce their costs. While they are both great things to do, they are largely done without understanding the underlying numbers.
And if you don’t understand the numbers, you don’t know
- If you are actually doing the right thing; or
- How much of it you should do.
So that approach most commonly turns into ‘busyness’ or a ‘head in the sand’ type approach. Definitely not the best way to run your business.
To work out your break-even, you first need to understand your gross margin. Gross margin is simply, how much money is left over after you make a sale and have paid for the direct costs associated with that sale.
Direct Costs
So what are direct costs you ask?
All costs in a business can be divided into ‘Direct’ (also called Cost of Goods Sold or COGS for short) and ‘Indirect'(or sometimes called ‘fixed costs or overhead’).
Direct costs are directly-related to making a sale and are only incurred when you make a sale. Indirect or fixed costs are there regardless of how many sales you make.
Some examples of indirect or fixed costs:
- Rent
- Insurance
- Car payments
- Utilities
- Software
Some examples of direct costs:
- Materials
- Royalties
- Labour
Labour can be a tricky one depending on your business, as it’s usually not just incurred when you make a sale (unless you are using sub-contractors). So, you’ll need to use some discretion whether you put labour in Direct or Indirect. You can also spit it up – meaning you may put your front-line labour costs into Direct and your management and admin in Indirect.
Once you understand and have separated out your Direct vs. Indirect costs, you can calculate your Gross Margin. Gross Margin is simply how much money is left over after you make a sale and have paid for your Direct Costs. It’s expressed as a percentage. Let’s look at an example.
A Gross Margin Example
Over a year, Sally’s cake business sells $300,000 worth of cakes. She needs to pay $60,000 in labour costs to her kitchen staff who make the cakes and approximately $50,000 is ingredients. Assuming they are the only direct costs, we’d work out the Gross Margin like this:
Sales | $300,000 | |
Direct Costs | ||
Materials | $50,000 | |
Labour | $70,000 | |
Total Direct Costs | $120,000 | |
Gross Profit | $180,000 | (Sales minus Total Direct Costs – $300k – $120k) |
Gross Margin | 60% | (Gross Profit / Sales)*100 |
From this calculation, Sally now knows that for each $1 of cakes she sells, she gets to keep $0.60 after she pays for overhead and profit.
(Side note: the higher your gross margin, the better. It means you don’t need to sell as much to cover your overhead and generate profit.)
The next step is to determine your overhead (Indirect Costs), which are all the other costs you didn’t allow for in your Direct costs.
Taking Costs Into Consideration
Continuing with our example, Sally’s overhead totals $160,000 per year. That includes rent, her wage, other wages, utilities, marketing, professional fees, insurance and all the rest. Meaning Sally has a profit of $20,000 at the end of the year.
Sales | $300,000 | |
Direct Costs | $120,000 | |
Gross Profit | $180,000 | Sales minus Direct costs |
Indirect Costs | $160,000 | |
Profit | $20,000 | Gross Profit minus Indirect costs |
Now back to our break-even point. Sally can find that out (as can you) by using the following formula
Fixed Costs/Gross Margin
So break-even for Sally, would be $160,000 / 60% = $266,666.67.
This means that Sally needs sales of $266,666.67 to cover all her costs (including her salary).
Where this formula becomes more powerful is in scenarios like these:
- Sally gets offered a great new space – it’s her dream kitchen setup, and the rent will be an extra $30,000 per year. How will this affect her break-even?
- Sally wants to make $100,000 per year in profit; how much does she need to do in sales Will she need to increase overhead to achieve this? If yes, how does that now affect the required sales target?
- Sally decides she needs to give wage rises to her staff or her ingredient costs go up by 5%; what impact will this have?
- She is getting some price push back by some customers. Should she consider lowering her price to ‘meet the market’? (side note: my default response to this is No. There are usually many other ways to manage price objections before you consider lowering your prices. Reducing prices erodes margin and profitability.)
- What would be the impact on break-even if she raised prices by 10%
This is a small list of some of the real-life situations you as business owners face. And if you don’t have the financial framework to view these decisions, you are flying blind. While certainly not the only consideration in these types of decisions, your break-even calculation is a great starting point to understand the impacts of different choices.
You are now armed to build a beautiful, financially sustainable business. Go forth and create