Most businesses need to know much turnover they need to make before they can breakeven. In the most simplistic terms, the breakeven point is where the business makes enough profit from selling goods or services to cover all its fixed costs, which will generally be overheads. All sales made after the breakeven point in this very basic model will theoretically represent pure profit (assuming the sales price is higher than the acquisition cost). Of course, in reality it is a bit more complicated than that, but the model provides a good starting point for calculating how many customers a business needs in order to be viable. It is exactly the sort of calculation you would do in your Business Plan before you even start trading.
In order to calculate your breakeven point you need to know 3 things:
a) The margin on your sales
b) The fixed costs of the business
c) The variable costs of the business
As a very simple example, assume XYZ Limited sells Product A for £5 each and the net rate is £3.50. Fixed costs are £90,000 per annum and variable costs are 30p per unit sold. The profit per item before deducting fixed costs is £1.20. It would therefore take sales of 75,000 units per annum to cover the fixed costs - that is the breakeven point.
For service companies the margin on sales is usually just the sales revenue itself. Generally there are few bought-in costs on services provided by the business itself. For businesses selling goods the margin will usually depend on the standard mark-up. This is likely to change over time and vary between different products. Net rates rarely stay the same for very long in most sectors, and if goods are purchased in foreign currencies the margin can fluctuate wildly when exchange rates are volatile. It is therefore important to update your breakeven point according to changes in selling prices, net rates and exchange rates.
All businesses have a range of overheads which are normally incurred up-front. Examples include rent, rates and service charges on business premises, wages for sales staff and selling costs such as advertising and license fees. All these costs normally have to be incurred before a business can even start trading. Most of these costs are fixed and therefore predictable, so in theory it should be possible to estimate your breakeven point from the projections in your Business Plan. In reality there will always be unforeseen one-off expenses to take into account so it is usually best to add a bit of leeway.
Many fixed costs are actually only fixed at certain levels of trading activity. For example, if your business expands you may need to rent larger premises or take on more staff, so you need to think about how long your current level of fixed costs can be maintained. Expenses of this nature are known as step-costs because they are fixed for a while and then go up suddenly rather than the more gradual increase usually seen with other types of expenses.
Variable costs are those directly influenced by trading activity. Credit card charges and processing fees are a good example. The more sales you make the higher the fees. Commission and bonuses based on sales revenue is another variable cost. Postages, packaging, telephone, printing and stationery also tend to go up with sales activity. These can be fairly easy to predict as they are usually based on known rates. However, you have to anticipate new expenses or rate jumps precipitated by escalating sales revenue or the need to maintain customer services. For instance, you may need to upgrade your IT systems or take on more specialised staff. And if your turnover exceeds £6.5 million you may need to have your annual accounts audited, which can easily add another £10,000 to your administration expenses.
The most important aspect of breakeven analysis is to understand how your costs and revenues behave at different levels of activity. You need to know what your existing capacities are in terms of shop, office and warehouse space, staff resources, plant and machinery and all the other factors that go into servicing your customers. It is particularly important to know how sustainable your sales targets are if you need to expand the business. You need to know how your profit margins are likely to stand up in the face of increased competition or higher net rates. In short, you need to know your business inside-out and always be aware that your breakeven point is a moving target.