How many units--products or hours of service--do you have to
sell to cover your costs? Don't know? Then it's about time
you found out! Follow these five steps for figuring out your
break-even point. It's the key to determining your pricing and
profitability.
Step 1. Determine the per-unit selling price and direct
costs of the product or service you provide. Direct costs are
classified as the costs that go into creating the product or
service (that is, direct materials and direct labor). So let's
say you have a gift basket business. The direct costs would be the
price of the basket, the items in the basket, the wrap for the
basket, and the labor involved in putting the basket together.
Step 2. Calculate your contribution margin in dollars per
unit. Once you know the selling price and direct costs of each
product or service unit you sell, you can calculate your
contribution margin in dollars per unit. This is the amount of
money you get over and above your direct costs for each unit you
sell. (You can define your unit as either a product or hour of
service.) Again, using the gift basket business as an example, if
your selling price was $50 and your direct costs added up to $40,
then your contribution margin in dollars would be $10 per unit.
This is the amount you can contribute towards your overhead costs
from each sale of your product or service.
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Step 3. Calculate your overhead costs. What are all the
other costs you incur in your business that need to be covered
before you can start earning a profit? Overhead costs include such
things as insurance, indirect labor, rent, taxes, dues and
subscriptions, advertising, office supplies and so on. This is
calculated in total, not on a per-unit basis. You need to know how
much money it takes to run your business because you've got to
cover these costs in addition to your direct costs before you can
start making a profit.
Step 4. Determine your break-even point. Once you know
your overhead costs, take that total number and divide it by your
contribution margin in dollars per unit (the answer from Step 2
above). For example, if your overhead costs were $1,000 and your
contribution margin from each unit you sell is $10, then your
break-even in units would be $1000/$10 or 100 units. So, continuing
with the gift basket business example, you must sell 100 gift
baskets at $50 each to break even.
Remember, there's no profit in your business until
you've covered your direct and indirect (overhead) expenses.
Only after selling 100 units will you break even. Starting with the
51st unit, you'll be earning a profit. If you've determined
that, based upon market predictions, you can only sell 40 items per
month, you'll never earn a profit and you need to reconsider
your business idea or your pricing. Increasing your pricing and
trying to trim costs may just increase your contribution and
profitability margins enough to keep you in business.
Step 5. You need to recalculate your break-even point on a
regular basis. As your selling price, direct costs and indirect
costs change, so will your break-even point. So it's absolutely
imperative that you recalculate it as the other costs of doing
business change. Without knowing your break-even point, you'll
never know just what you have to do to make a profit.
Calculating your break-even point is something you need to
incorporate as part of your pricing policy to ensure that
you're making money on every unit you sell and that you'll
be able to be profitable based on your costs and your sales. If
you're not profitable, you will not stay in business. It's
as simple as that.
Every type of business can incorporate this equation into their
pricing module. No matter whether you own a service- or
product-based business, you've got to have a good understanding
of your direct and indirect costs and how they affect your pricing
and profitability models. It might just mean the difference between
a profitable and nonprofitable year for you.
If you don't know your break-even point, you're running
your business blindly. It's a fact that thousands of companies
go out of business every year. Why? One decisive factor is they
just don't know their numbers. Why not make a difference in
your business this year and get to know your break-even point?
Pam Newman is Entrepreneur.com's "Financial
Management" columnist and president of RPPC Inc., which
helps entrepreneurs succeed in their businesses through
small-business training and consulting services in the areas of
accounting and management. She's also author of Out
of the Red, a management accounting guide for small-business
owners.