Understanding the breakeven point of a business is critical if you want to run a profitable business. Once a business gets past this point income drops to the bottom line at an increased rate. This concept will be explained in greater detail later. First let’s review the definition of the following two different types of expenses:
Fixed Costs
Business expenses that are constant for a company no matter what the production level is. In a nutshell it is all of the expenses a business would incur regardless of sales.
Examples of Fixed Costs are:
- Rent
- Insurance premiums
- Lease payments
- Office payroll
- Basic phone service
- Internet cost
- Website hosting
Variable Costs
Business expenses that vary in direct proportion to the quantity of output. Variable costs are a direct function of production volume, rising whenever production expands and falling whenever it contracts.
Examples of variable costs are:
- Materials for production of product
- Labor
- Delivery costs
- Cost of product for resale
- Outside contractors for production of product or for service sold
The first step in determining the breakeven point of a business is to identify and quantify the fixed expenses. Once this is done – determine how much revenue is needed in order to cover all of your fixed costs at a predetermined gross profit margin. This would be best illustrated by example. In order to make this point clear we are going to go through an example of a restaurant breakeven and analyze what happens as we get past this point.
In order to keep the example simple let’s assume the following:
Fixed Costs
- Rent
- Utilities
- Telephone
- Insurance
- Labor – our labor cost includes the cook, the manager and two servers who also double to prep the food and also to clean up and get ready for the next day. As a result there is not any variable labor.
Variable Costs
- Food Costs and related paper products for take out – This cost is 30% of our sales. For example if we have $100 in sales, our direct cost is $30 (30% of $100 in sales)
Example of Break Even for Tasty Food Restaurant
| Sales | $15,571 | |
| Variable Costs | ||
| Cost of Goods Sold 30% of Sales | $4,671 | |
| Gross Profit | $10,900 | $10,900 |
| Fixed Costs | $2,500 | |
| Rent | 500 | |
| Utilities | 100 | |
| Telephone | 300 | |
| Insurance | 7,500 | |
| Labor | ||
Total Fixed Costs | $10,900 |
|
| Net Profit | $0 |
Now comes the big news …… once you reach your breakeven point $.70 (or 70%) of every dollar in sales comes right to your bottom line. Let’s look at the example – if sales increase by $3,000 our bottom line increases by 70% of that or $2,100.
Example of $3,000 Increase in Sales for Tasty Food Restaurant
| Breakeven Point | $3,000 Sales Increase | ||||
|---|---|---|---|---|---|
| Sales | $15,571 | $18,571 | |||
| Variable Costs | |||||
| Cost of Goods Sold 30% of Sales | $ 4,671 | $5,571 | |||
| Gross Profit | $10,900 | $10,900 | $13,000 | $13,000 | |
| Fixed Costs | |||||
| Rent | $2,500 | $2,500 | |||
| Utilities | 500 | 500 | |||
| Telephone | 100 | 100 | |||
| Insurance | 300 | 300 | |||
| Labor | 7,500 | 7,500 | |||
| Total Fixed Costs | $10,900 | $10,900 |
|||
| Net Profit | $0 | $2,100 |
Now for the even bigger news …. Drum roll please ….. In order to double the bottom line of $2,100 you only need to increase your sales by an additional $3,000!!!!! Some business owners incorrectly feel that in order to double their bottom line they have to double their sales. In this case they only have to increase sales by 16% or $3,000 to double their bottom line to $4,200.
Example of an Additional $3,000 Increase in Sales for Tasty Food Restaurant
| $3,000 Sales Increase | Additional $3,000 Sales Increase | ||||
|---|---|---|---|---|---|
| Sales | $18,571 | $21,571 | |||
| Variable Costs | |||||
| Cost of Goods Sold 30% of Sales | $5,571 | $6,471 | |||
| Gross Profit | $13,000 | $10,900 | $15,100 | $15,100 | |
| Fixed Costs | |||||
| Rent | $2,500 | $2,500 | |||
| Utilities | 500 | 500 | |||
| Telephone | 100 | 100 | |||
| Insurance | 300 | 300 | |||
| Labor | 7,500 | 7,500 | |||
| Total Fixed Costs | $10,900 | $10,900 | |||
| Net Profit | $2,100 | $4,200 |
Once the breakeven point is reached all of your gross profit goes right to your bottom line. THIS IS REALLY AN IMPORTANT CONCEPT BECAUSE A BUSINESS CAN DOUBLE OR TRIPLE THEIR BOTTOM LINE BY HAVING SMALL ADDITIONAL INCREASES IN THEIR REVENUE.
A lot of businesses want to always focus on lowering costs, but after a certain point there is very little you can reduce without sacrificing the quality of product or service you are offering. At this point it is better to focus on ways to increase revenue instead of cutting more costs since this will yield a much more positive outcome.
The gross profit of any incremental sale past the breakeven point goes directly to the bottom line.
Many businesses have turned the corner to profitability or have quickly doubled or tripled their bottom line once they understood and harnessed the power of the breakeven point.
