The Path to Survival!
Break-Even – The Threshold for Success!
Every company should have an understanding of its financial numbers that are required for survival. The first two Laws of Management Physics explain this clearly.
Law#1 – “The Goesinnas Need to Exceed the Goesouttas.”
Law#2 – “Profit Is Muscle, Cash Is Blood.”
When operating at pre-revenue revenue it is important to define the burn rate; cash that is being spent on a monthly basis divided into total available. The answer will provide a number for understanding how many months can be covered by the cash available before running out.
After revenue is available, the financial analysis to find the survival numbers and that is called the break-even point. Break-even is the minimal sales required to cover all the costs to reach that sales number. There are typically two break-even sales numbers. One relates to profit and it defines the necessary sales needed with the margin that results from the sales of product or services, to cover all the costs in place to end up with zero profit. It sounds like a circular nightmare, but it is easily determined.
First it is necessary to know the fixed costs in place at any sales level. Second is necessary to know the variable costs to manufacture the product or the labor to perform the service. There is a simplification example below to illustrate the break-even analysis. Start with the fixed costs in dollars, and then determine the gross margin by subtracting the variable costs in percent from the sales at 100 percent. The variable costs are normally a fixed percentage of sales over a wide range of sales values. In this example we will use material as the only total variable costs. Subtract the variable costs percentage from 100 percent to get the gross margin, which is equivalent to the added value percentage. This yields the percentage of sales revenue that will be left over to cover all the other costs, including fixed costs, and profit. Considering that the break-even point is at no profit, divide the fixed costs by the added margin percentage to get the break-even sales number.
Example: Fixed costs equal $60,000. The margin, sales minus material cost is 60%. The break-even sales number is $60,000/.6 = $100,000
The $100,000 is the sales that would be needed to cover the fixed costs and variable cost to manufacture the product at zero profit The target to break-even then can be called the sales needed to cover all the costs of the company, which includes the fixed costs and the material costs and there is no money left over for profit. Theoretically a company can survive with zero profit.
If the company did $110,000 in sales, the margin at 60% would be $66,000 and for the fixed costs at $60,000, there would be a profit of $6,000. However if the company only did $90,000 in sales and the margin at 60% would only yield $54,000, not enough to cover the fixed costs, resulting in a loss of $6,000.
For startups and small companies with no reserves and little money in the bank it is best to consider two, the cash break-even. It is hard to imagine by some business owners how a big company reporting a loss of $1 billion can survive. This is where profit and cash separate. The bigger you get the more non-cash items start to occur including depreciation, reserves and accruals.
It must be expected that in a growing company with a high growth rate most likely the profit will be insufficient and cannot support the growth because of the necessity of putting costs in place before the sales revenue can cover them. In doing cash break-even the fixed costs need to be recalculated by removing non-cash items including depreciation, amortization, reserves and accruals. Assume as result the fixed cash costs are $56000. The math occurs in a similar fashion to the profit breakeven number using the adjusted fixed cost numbers without non-cash items. By using the same margin (0.6), and with the fixed cash costs at $56,000, the break-even cash sales number would be $93,333, which is $6,667 less than the profit break-even number.
In the early years of a startup or the early growth period of a company, it is extremely important to eventually get to the break-even point before the cash available expires, or there will be no future.