No business sets out to break even or lose money, but one that operates without the knowledge of the sales volume required to cover cash flow requirements can run into trouble. While Pointguard recommends accrual basis accounting to evaluate profitability, you will need to know a few other items to ensure you have enough cash to operate.

How to Calculate Break Even

While there are several variables to consider, the most critical are the amount of your general and administrative expenses, your anticipated gross profit margin percentage, your non-cash expenses including depreciation and amortization, and your monthly debt principal due.  To calculate break even sales volume, take the sum of your total general and administrative expenses and your monthly debt principal and subtract the monthly recorded depreciation and amortization expense.  Divide the sum by the anticipated gross profit percentage.  The result is the amount of gross sales volume you need to generate to break even for the month. 

How To Use Break Even in Planning

Develop your yearly forecast broken down into months so that you anticipate which months based on history you may have trouble reaching break even sales volume.  If your business is cyclical, work to fill in the slow months with additional work or plan to reduce your costs to minimal levels to avoid unnecessary losses simply because you failed to plan ahead.  If necessary, build working capital in profitable months to help cover the months you anticipate not achieving break even volume.   

Other Considerations Generating break even volume will not cover your additional working capital needs for inventory, slower than anticipated collections of accounts receivable, or one-time expenses.  It could mean that you will need short or long term lending options for seasonal shortages.  A business can’t live on break even volume, but you can survive in the short term if you plan ahead.

Business owners require a net return on their investment to motivate them to continue to invest.  While there are several measurements used in evaluating performance, Pointguard relies on two primary measurements of return. 

Return on Sales (Net Income)

This measurement evaluates the financial return on every dollar of sales revenue earned during the period after deducting all costs of providing for or manufacturing of the product or service; and the costs of infrastructure – also known as general and administrative expenses or overhead.  Pointguard refers to these as infrastructure costs, which are dependent on what is required to support the level of sales volume the Company is able to generate.   In our experience, a company will require a 5% return on sales in order to survive.  This 5% return on sales will pay for minimum debt service, minimal fixed asset purchases, and income taxes, but will not provide a cash return to the equity owner.  A company that does not earn above a 5% return will require outside debt or equity to fund its working capital needs in order to operate.

Companies producing or reselling a product can achieve a return of 8-12% depending on whether the product is a commodity or unique to the market, while companies that primarily sell services can achieve a return on sales of up to 30% based on maximizing the return on their labor.  If your company is on the lower end of the scale, you can expect to leave more of your return in your company for operating capital and growth.  Removing capital from the business will slow your growth and cause a heavy reliance on debt.

Return on Equity

This measurement evaluates the financial return on every dollar of equity the owner continues to invest in the business.  This return has nothing to do with the owner’s compensation for working in the business, but rather, the return on the investment of the owner’s capital in the company.  It is measured as the net income earned on the beginning of year equity.

This return should be evaluated based on the comparison of relative risk of an investment of money in the equity markets.  Investments in small closely held businesses are higher in risk due to several factors including dependence on key personnel, higher concentration of sales with one or a few customers, and regional economic or industry limitations.  For this reason, we have observed a minimum return of 20-25% on owner’s equity to be required to pay for this level of risk. 

Every business owner must evaluate the return they expect to achieve each year by forecasting the Company’s operations in advance.  The result of the forecast should determine if the plan will achieve the desired results, and if not, changes to the plan are necessary.  Make sure you have a plan that pays you for your risk.

Starting a new year is stimulating for business owners and managers because you wipe the slate clean and start over.  Whatever the struggles were in the prior year, you have learned from them.  A new year provides an opportunity to make required changes to maximize performance.  If you sell services to your customers, you have an opportunity to impact profits this year by charging appropriately for your time and your quality.  If you have more than one product you sell, or if you sell a mix of service and products, you have an opportunity to impact profits this year by adjusting your sales mix. 

Selling Services

The market purchases services based on the value of your time and expertise.  If your company provides a service that gives your customer a high return or is unique to the market with little competition, you can achieve a higher price for your time.  Customers will pay for value – even though they may first fight for the lower price.  Hold your ground, and don’t undervalue your services.  If your services are a commodity, then consider what you can offer to increase the value – something that is tangible that your competition doesn’t offer.

Selling Products

The market purchases products based on competitive pricing.  If your products are deemed to be commodities, it will lower your price.  Most companies we work with have multiple product lines or services they provide, each one providing various levels of profit margin.  If they change the focus of their sales efforts toward higher margin products or services and can achieve similar sales volume, their bottom line increases with the same level of effort.  This doesn’t mean giving up on your legacy products or services, but it does mean you may need to change your mind set on what you focus on selling.  My first advisory client over 25 years ago was able to turn his company around financially by acknowledging that the high end product he was most proud of was providing the lowest profit margin and highest effort.  When he accepted that he was more interested in profit than sales volume, he changed his focus and his results.  Within one year, he turned his losses into profits. 

Don’t settle this year for what you have always done.  Use your skill to evaluate and then embrace the opportunities you have in valuing your services, and changing your sales mix to positively impact profitability.

Making decisions in the heat of battle is the most difficult position for a leader, yet great leaders are able to evaluate and courageously commit in spite of the challenge.  As I work with business owners and leaders, I find that they struggle most with the timeliness of key decisions.  There are many reasons for this including compassion for people in personnel decisions, and fear of making the wrong choice that may have a detrimental financial impact.

As I reflect back on decisions I have made, the one common theme is delayed timing.  Most all personnel decisions I have made were delayed, most often because of hope that things would change for the better.  While I believe compassion for people overrules a quick trigger, when it is clear that it isn’t working, it is best to move on quickly and professionally.  I have also delayed hiring key positions because of the fear of being overstaffed as we grow.  My attitude now is find key talent – these people will cause growth to happen.  Don’t delay on personnel decisions – if you’ve done your homework, you need to trust your instincts and courageously move forward.

Finally, every business owner has had the experience of a bad decision that made a negative financial impact.  Whether it was a bad customer relationship, or an incorrect bid, or even circumstances beyond your control –these happen.  Don’t let that paralyze you when approached with another opportunity.  An effective business owner evaluates the risks, but then steps out in faith with the decision.  The one common mistake I have made is delaying the decision.  Do your homework, including obtaining wise counsel – then trust your instincts and move forward in confidence.