Business management: planning for profit.
Follow this simple formula to help your business thrive.
"Break-even point." Does the term ring a bell? It should. That's the magic number that tells you when your revenue will cover your expenses. Although entrepreneurs often fail to realize the significance of recognizing and reaching the break-even point in the financial cycle, understanding what it takes to break even is critical to making any business profitable.
Unfortunately, most small business owners fail to keep close tabs on their business. For many, financial reports are viewed as a necessary evil required only for tax purposes or assessing profits and losses. But unless you have an unlimited supply of operating capital, these reports could - and should - be used to monitor your company's fiscal health.
If your business is like most of the emerging companies that fill the pages of BLACK ENTERPRISE, then now is the time to understand how to make your business profitable. And the first step is to determine just how many units you must sell or the amount of sales you need to generate to reach that crucial break-even point.
"About 70% of the business owners I work with see me after they're in trouble," says Louis G. Hutt Jr., managing partner of Bennett, Hutt & Co., a Columbia, Md., accounting firm. Hutt, who has been using break-even analysis with small business owners for 12 years, laments that many entrepreneurs plan for their business in a vacuum.
Hutt, a certified public accountant, attorney and featured speaker at several BLACK ENTERPRISE Entrepreneurial Conferences, explains: "They look at their performance at the end of the year and then make judgments on what should be done the next year."
Failing to calculate your break-even point early in your business life is a grave mistake that could lead to an entrepreneurial nightmare. The Dun & Bradstreet Corp., a New York City business information marketer, reports that U.S. business failures increased 14.3% in the first nine months of 1992 to 74,715, from 65,368 in the same period in 1991. Poor financial planning is certainly a major culprit in the untimely demise of many of these businesses.
In fact, the National Federation of independent Business Foundation, a Washington, D.C., small business research group, reports that in 1991, managing cash flow ranked third in the top five problems small business owners faced. Thirty percent called the problem "critical," compared with only 9% who didn't think it was a problem.
Incorporating accurate and thorough break-even analysis as a routine part of your financial planning will keep you abreast of how your business is really faring. Determining how much business is needed to keep the door open will help improve your cash-flow management and your bottom line. Bob and Armentha Cruise-Mills would definitely agree.
The Mills own and run Aspen Temporary Services Inc. (ATS), a 5-year-old Takoma Park, Md., temp agency, which grossed $1.2 million in revenue and posted a 6% profit margin in 1992. The couple's motto: Never spend more than you have to.
Says Armentha, ATS' president: "We've always been very cost-conscious. We've never had to borrow money, and about 75% of our sales go back into the business. We look+ at our expenses very closely to decide which projects we can take on."
The Mills credit Hutt, whom they met at a business finance seminar last October, with helping them identify company profit centers and unnecessary expenses.
"Break-even analysis made us realize that placing data entry operators is more profitable to the business than placing word processors," Bob Mills, ATS' vice president, explains. "We were paying word processors $12 an hour and billing the customer $17 an hour (for a profit of $5 an hour). But with data entry operators, we paid them $8 an hour and billed $14 an hour (for a profit of $6 an hour)."
If break-even projections can help pump out more profits, then why don't more entrepreneurs do it? A major reason, say several small business consultants, is that many business owners don't buy into the necessity of keeping an accountant on retainer or using standard accounting practices. Despite the proliferation of easy-to-use computer and manual accounting systems, small business owners are famous for stuffing receipts and financial data in shoe boxes. But without carefully maintained balance sheets, calculating what it will take to make your business profitable is virtually impossible. Too often, entrepreneurs don't find out that they've been paying out more than they've been taking in until they are out of business.
How Break-Even Analysis Works
Break-even analysis isn't a novel concept. In fact, accountants have been using the formula for over 25 years. The analysis works best when you're selling one product or offering a single service. It gets messy, however, for multiservice or product line businesses.
To use Hutt's analysis, the break-even point can be determined by calculating your fixed costs (unvarying expenses), variable costs (fluctuating expenses) and your contribution margin (selling price per unit minus variable expenses per unit). (See worksheet, "How To Determine Your Break-Even Point," for a step-by-step guide.)
After making your calculations, divide the total fixed costs by your average contribution margin per unit to determine your break-even point. Example: Let's say you own a small factory that manufactures belt buckles. You've estimated that your total fixed expenses for the year will be $200,000 (including rent, insurance and administrative salaries). Your variable costs (i.e., advertising or sales commission) on a per unit basis is $1, and your selling price to wholesalers will be $3. By subtracting your variable costs from your selling price you will make a contribution of $2 toward your fixed expenses. In this example, you would divide $200,000 (fixed expenses) by $2 (contribution margin). By this formula, you would need to sell 100,000 units to break even.
To determine the volume of sales you will need to break even, multiply the number of units you must sell by the selling price. Under this scenario, the needed sales volume is $300+,000 (100,000 units x $3).
Doing an in-depth break-even analysis is critical for African-American small business owners. Because most black businesses remain severely undercapitalized, African-American entrepreneurs have little or no margin for error. If they don't plan for profit early on, their chances of surviving three years are almost nil. After you've determined your break-even point, adds Hutt, "the profit factor can be built into your business."
Strategic financial planning can also help you answer such perplexing questions as: If my unit prices are reduced 5% and sales unit volume increases 15%, how is my operating profit affected? How will a reduction in my fixed costs affect my estimated net income and break-even point?
Measuring progress against a plan is paramount if you are to make your forecasted financial goals by your target dates. "Your analysis should be reexamined on a quarterly basis," suggests Hutt. "Be sure to compare actual to projected performance and adjust your plan if it is unrealistic."
While analyzing your progress, take a hard look at your operating expenses to identify where cost-cutting measures can be taken. For instance, if business is slow, you might consider cutting back on staffing, inventory or overhead. You may also have to restructure existing debt to lower monthly loan payments.
Becoming A Proactive Entrepreneur
Paulette J. Robinson, the self-employed president of PJ's Pen Inc., a 5-year-old McClean, Va., public relations consulting firm, says she probably wouldn't be in business today without break-even analysis. Every November, Robinson sits down with one of Hutt's tax planners to examine her firm's fiscal health. "Louis makes me do two spread-sheets, a receipts journal and a disbursements journal."
The former Cable News Network (CNN) producer and writer notes that break-even analysis also helped her make some tough decisions. In 1992, Robinson was running herself into the ground, working 20-hour days, seven days a week. She had two choices: Give up one of her contracts or drop from sheer exhaustion.
She explains: "I examined two of my contracts: CNN and Big Brothers of the National Capital Area and realized I couldn't handle both of them. I compared the $40,000 that I made from Big Brothers with the $50,000 from CNN. I also evaluated some of my outside contracts. I decided to cut Big Brothers and stick with the for-profit business where I made more money," explains Robinson, who broke even last year on $58,000 in revenues.
Adds Hutt: "We looked at each of those contracts as separate profit centers and calculated the break-even point for both. Based on the fees and expenses, we determined that the CNN contract would break even sooner than the Big Brother project."
Katherine G. Collier, owner of an 8-year-old dental practice is another entrepreneur who profited from break-even analysis. Collier, whose Baltimore-based practice grossed $1.3 million last year, admits that when she started out she didn't know the difference between a debt and debenture.
When Collier wanted to purchase an additional office seven years after launching her business, she consulted Hutt. "We calculated the minimum volume of business that Katherine needed to break even,+" Hutt recalls. "In the end, she decided that it wouldn't be a wise financial move because the necessary volume of business wasn't there."
By using break-even analysis, Collier was able to make an objective decision based on hard numbers. Without it, she asserts, "I'd be so much less aware of how to run my business."
In The Final Analysis
The bottom line is that, especially for small businesses, the margins for error are much too narrow to make business decisions on gut instinct alone. Every idea, whether it is the introduction of a new product line, the opening of branch offices or the hiring of additional staff, must be tested through basic business analysis. If you don't have a business plan, or you haven't being reviewing it periodically, you're not likely to know how well your business is doing.
Crunching the numbers now - understanding basic financial statements, projecting future cash flow and determining your break-even point - could save you a lot of grief later. It's this kind of analysis, Hutt says, that separates the entreproneurial contenders from the also-rans. He adds: "Successful business owners must establish goals, develop a plan and invest the time and resources the business needs to thrive."
Remember,the formula for break-even analysis is not designed to be 100% accurate. It's only one planning tool in an arsenal of financial help available to small business owners. But it can help you establish some parameters for operating performance.
"Business owners that do break-even analysis are searching for a methodology to produce and sustain profits for the long term," Hutt says. "Without a doubt, these entrepreneurs are often my most successful clients."
HOW TO DETERMINE YOUR BREAK-EVEN POINT
To calculate the sales you must generate and the number of units you need to sell for your company to break even, do the following analysis. First, here are three terms you must know:
* Fixed expenses: Costs that remain constant regardless of sales. Examples include rent, insurance, taxes on property, general equipment maintenance, administrative salaries and interest on borrowed money.
* Variable expenses: Costs that vary as sales volume increases or decreases. Examples include direct labor costs and related payroll taxes, costs of goods sold, sales commissions and delivery expenses.
* Contribution margin: Your profit on sales.
Here's how the formula works:
Step 1: Subtract your variable expenses per unit from the selling price per unit. Example: If your selling price per unit is $30 and your variable cost per unit is $20, your contribution margin is $10
Step 2: Divide your annual fixed costs per unit by your contribution margin. Example: If your annual fixed costs is $50,000, divide that by $10. Your break-even point in number of units is 5,000.
Step 3: To determine how much revenue you must make to break even, multiply your total break-even point in number of units (in this case it's 5,000) by your average selling price per unit ($30). Under this scenario, your total break-even point in sales dollars is $150,000.
BELOW IS A WORKING EXERCISE:
Company A sells standard computer chips used for manufacturing personal computers. Company A's annual fixed operating costs, including administrative salaries, office rent, utilities, travel, professional and other fixed expenses, are $425,000. Company A's normal selling price per chip is $30, and its estimated average cost of production per unit is $20.
CALCULATE COMPANY A'S
1. Break-even point in units
2. Break-even point in sales dollars
Remember, doing this kind of analysis doesn't guarantee that your company will make a profit. However, it does serve as an excellent planning tool. Once you determine the minimum level of sales needed to carry the business, you're better equipped to plan how your firm can operate in the black. Keep in mind that this formula works best with businesses that sell one product or offer one service. For businesses that offer multiple products or services, this formula would have to be modified to calculate the average cost and selling price.
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|Author:||Thompson, Kevin D.|
|Date:||Apr 1, 1993|
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