During boom times, businesses grow by adding staff, moving into larger premises, expanding into new markets, and so on. When a recession hits and sales drop, many businesses take an ax to their expenses. Typically they use break-even analysis to determine how much to cut.
Break-even analysis centers around the break-even point, which is defined as the dollar amount of sales necessary to break even. When you break even, your net profit is zero. The formula for calculating the break-even point is as follows:
Break-even point = fixed costs / gross margin percentage
Let’s look at the numerator of the break-even formula, which is fixed costs. Fixed costs are costs and expenses that must be paid regardless of sales volume, such as rent, advertising, and salaries. Simply add all your fixed costs together and, voila, you have this part of the formula for a given period. You can summarize fixed costs by month, quarter, or year.
Next let’s look at the formula’s denominator, gross margin percentage. The gross margin percentage is based on your gross margin, which is calculated as follows:
Gross margin = sales – variable costs
Variable costs are those costs that can be directly traced to a sale, for example, the cost you paid your supplier, commissions, merchant fees, and so on. In other words, variable costs are costs that will vary depending on the volume of sales.
Once you know the gross margin, gross margin percentage is calculated as follows:
Gross margin percentage = gross margin / sales x 100%
When deriving your sales and variable costs, you should use the same period (month, quarter, or year) you use when deriving your fixed costs.
Let’s look at a hypothetical business that sells two products, shoes and socks. These products generate $30,000 in sales per month. The variable costs associated with these sales are $12,000. The gross profit is $18,000 and therefore the gross margin percentage is 60 percent.
Gross margin = $30,000 – $12,000
Gross margin percentage = $18,000 / $30,000 x 100%
The fixed cost for this business is $15,000 per month, which is made up of rent, advertising, telephone, utilities, and so on.
Now that we know the inputs to the break-even formula, we can plug them in:
Break-even sales = $15,000 / 60% = $25,000.
Using our example, what would happen if this business were generating sales of $23,000? It would be operating at a loss. You may be able to fund losses in the short term, but not indefinitely. If you can’t change your gross margin by increasing prices or reducing your variable cost, you must decrease your fixed cost so you can operate at break-even or better.
One word of caution before bringing down the ax: Cut the fat but not the bone. In other words, don’t cut expenses that would damage your business in the long term.
Ian Benoliel is the CEO and founder of NumberCruncher.com, a developer of inventory and order management software for entrepreneurial businesses.