Sin number 6 - Not knowing your break even point
By Greg Carroll
Every business has two types of costs, fixed costs and variable costs.
Fixed costs are those items that must be paid irrespective of what sales you make. Examples include your rent, electricity, telephone, wages etc. These are generally items that appear in your operating expenses on you profit and loss statement. Until your business revenue exceeds these fixed costs you will not make a profit.
Variable costs are those items that vary according to sales, such as raw materials, manufacturing costs or for a retailer this could include stock.
Therefore in simple terms
Sales - variable costs = Gross revenue
Gross revenue - fixed costs = Profit
Therefore one of the first things you need to do is to understand what level of sales you need to make to be able to cover your fixed costs. For every business this will be different. Some businesses will measure this in dollar terms; some will measure it in number of units sold and some in terms of head hours charged. As a business owner you need to have an immediate grasp of this figure as it is one of the most powerful indicators for how your business is traveling.
Let's use the example of ABC Consulting again. Referring to the expenses advertising could be a variable cost unless ABC is locked into a long term contract. Let's assume advertising is variable and the amount the business advertises has a direct effect on the fees the business invoices ($13.3 in head hours is written for every dollar of advertising) It is also possible that part of their wages cost could be variable as some of their staff would be directly linked to chargeable hours. But given that their wages bill is consistent from month to month we will treat it as a fixed cost. Therefore their monthly fixed costs are $32,350.
Let's assume that their chargeable head hour rate for consulting is $200 per hour excluding GST. Their advertising cost per chargeable hour is $15 (200\13.3 = 15) making their gross revenue from each chargeable hour is $185. This means that to cover their fixed costs each month the business will need to write 175 chargeable hours. It also means the business does not start making a profit until this number of hours is exceeded.
So how is this figure powerful? If you were the director of ABC all you would need to know is a single number at any given point in time to know how you're your business was traveling. For example if it was the 25th of the month and this number was 150, straight away you would know that you could be heading for a $4,600 shortfall ((150 x $185) - $32,350 = -$4,600). The fact that you know this information quickly and early even before any end of month figures are prepared means you have time to take action. You might be able to hold off on non-essential expenditure, you might see if there is any work in progress that can be fast tracked so it can be billed in this month. Knowing this figure puts you in a stronger position to manage your cash flow and spot potential disasters before they occur.
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