Fact – even if you don’t, others (customers, suppliers, funders, shareholders) will be looking at your business and, especially in this period of uncertainty, gauging how robust it is. If they are advised properly, one of the things they will look at is Breakeven.
This Tectona “In 3” peels back the layers of the concept of Breakeven.
Writing this at a time when we are in Week 8 of the 2020 Coronavirus lockdown; and with murmurings of relaxing the lockdown, I have been speaking to a huge number of business owners and funders – and none of them can clearly see the way forward.
In normal-times (and these certainly are not normal times) you can assess the extent of the damage with some certainty. For example, when you lose a major customer or experience a bad debt, you know the worst case and can plan accordingly. The insidious thing about this virus is that no-one has the faintest idea how much longer it is going to go on for, and so estimating the financial damage is very difficult to do.
There are any number of things to look at in a business to gauge its financial strength. A review of working capital is a great place to start – have a look at our take on this here.
We suggest that the next thing to look at is profitability, both historic and current. A great way of doing this is to look at Breakeven (or B/E).
So, In 3:
1. What is Breakeven?
In short, it is the amount of units – be that widgets, time (hours/days), occupancy (tables/rooms) that need to be sold to generate a net income of zero. Or, put another way:
All Income minus All Expenditure = Zero.
2. How do I calculate it for my business?
You will need to know the gross profit of each item or unit you are selling. This is the selling price less the variable cost of producing that unit.
An example: a business assembles and sells a gear mechanism for bicycles for £200 each. The cost of the materials are £50 and the labour involved to assemble each unit is £20. The variable cost is therefore £70 (£50 + £20) and the gross profit is £130 per unit (being £200 less £70).
So far so good.
Now, you need to consider the fixed cost base of your business. These are costs that will not vary whether you produce 1,000 units or 5,000 units; these fixed costs will typically be premises costs, non-productive labour costs, marketing, professional fees, insurance etc. In our example, let’s say that these total £100,000.
To calculate the number of units you must sell to breakeven you would use the following formula:
Breakeven units = Fixed Cost/(Gross Profit per unit)
So in our example this would be:
= £100,000/£130 = 769 units
Whilst breakeven is usually framed as a volume (number of units, number of hours, number of rooms sold) there is another way of looking at it called –
The Breakeven Percentage
We calculate this by converting the units calculated above into £’s by multiplying by the selling price(s) and showing this as a percentage of the existing turnover.
In profitable businesses the Breakeven Percentage will always be less than 100%.
Armed with this we can now look at the ‘headroom’ that a business has – the difference between the Breakeven Percentage and 100%. The greater the gap, or the discount, the more operationally robust the business is likely to be.
Conversely, if the Breakeven Percentage is greater than 100% then the business will be loss making.
Tectona tip: we use a very handy tool called Profit Booster that will quickly help us to help you calculate breakeven (and so much more) for your business.
3. Why is Breakeven useful?
- As noted above, it gives an idea of the resilience of a business
- It helps hugely in the planning and budgeting process
- It emphasises that discounting prices is, of itself, not a great strategy
- It shows that the correct pricing strategy, properly implemented, is a faster way to profitability than simply selling more
The Headroom concept is hugely powerful
It is quick and easy to calculate
It helps determine how much you should sell for
It is quite a crude instrument
Variable costs vary (eg. you may be able to negotiate volume discounts; or staff costs will change due to furlough)
Output does not always equal sales
Assumptions can be unrealistic, if you sell a wide range of products then it is more difficult to calculate.
The Tectona Profit Booster process enables you to really explore the financial effects of various strategies in an entirely safe environment; and it takes the hard work out of scenario planning.
If you are at all unclear as to how to scenario plan, or how to manage your working capital properly, then the Tectona Profit Booster process is just what you need.
It will automatically generate robust and accurate forecasts for your business – meaning not only a profit and loss account, but also a cashflow forecast and balance sheets which all link together.
Tectona can quickly provide this for you by running you through our Profit Booster process which not only calculates your existing breakeven point, but also how your Breakeven Percentage will change with any combination of different strategies.
Tectona tip: if after your scenario planning the revised Breakeven Percentage is greater than the original or baseline value then the changes you have introduced will reduce the available headroom; occasionally this may be inevitable – but it’s seldom desirable.
These cash flow forecasts are critical right now as they will show when and how much of a hole you might have in your cash.
Having identified that you will need to work out how to plug that hole. You will probably need funding and Tectona can help you review the funding options available to you, including helping you through the maze of government coronavirus support.
Contact the Tectona team so that we can help you work through your options.
Tectona Partnership helps business owners sleep at night by embedding one of our 15 commercial finance directors in your management team. Very often, a part time solution is the most effective solution for small businesses.
We make sure you have the necessary management information and strategic insight to make informed decisions and we will tell you what you need to know, when you need to know it.