I guess if you work in the finance side of business, numbers are important. So are formulas. So here’s one:
In words: What I spend divided by what I make equals what I need to sell.
In short hand: $ out/margin = breakeven.
This is the breakeven formula that every small business owner needs to understand.
The numerator is the fixed expenses. They include rent, loan payments, utilities, repairs, and salaries. Note the fixed expenses include salaries, at least they would in my formula. Owners and finance people believe that by definition salaries are not a fixed expense, they are variable and can be reduced if business slows. But, that turns out not to really be true. Unless business volumes fall off a cliff, owners are very slow and reluctant to cut staff, reduce hours, or cut wages. Economists call that sticky. Wages are sticky and don’t go down. Even in this last worst recession, owners held off cutting staff until they had to. So, I include salaries in the fixed expenses, at least for short term (4 – 6 months) planning purposes.
The denominator is a percentage. It is the gross margin percentage. Example: If for every $100 in sales, material costs are $60 (60%), and sales commissions are $20 (20%), then the margin is $20, or in percentage 20%. True variable costs are also sticky; the % moves slowly. It is hard to cut commission percentages to the sales force, it is hard to reduce material costs a lot. So, I treat variable costs as sticky, again in the short term.
So, here is the example: If monthly overhead (salaries included) is $100,000, and the margin is 20%, then the monthly sales breakeven point is $500,000 ($100,000 divided by .2 = $500,000). You need to sell $500,000 a month to meet the monthly expenses.
Move the margin up by 5% to 25%. That is a 25% improvement in the margin (5% divided by 20% = 25% relative improvement). The breakeven sales level moves down 20% to $400,000 ($100,000 divided by the new margin of .25).
Move the expenses down by 25% (the same improvement I assumed in the margin) and the breakeven sales level falls to $375,000 ($100,000 original expense level reduced by 25% becomes $75,000 divided by 20% [original margin]). So, you get more bang for the buck by moving the fixed expenses down. So, focus on the expenses first.
A little of both: move the margin up by 2% (relative improvement = 10% [.02/.2] and drop the expenses by $10,000 (10%) to $90,000. The breakeven sales level is now $409,000. Pretty close to the $400,000 in the formulas where I only moved either the expenses or the margin, but I had to move them 25%, not just the 10% when I move both a little.
Both moves are hard to do (cutting expenses or improving margins) especially in slowing economic times. But, in these examples, which is more achievable? Moving the margin or the expenses by 25%, or moving each by 10%?
Owners and their accountants pretty quickly figure out, life is better if we deal with both sides of the formula at the same time. It is hard to move sticky numbers, so it is easier to move each a little.