Knowing the break-even point is an important quest for any business. Yet, many companies don’t understand what it is or why it is important. Simply put, the break-even point is the position when the gross margin from sales covers the fixed costs. In other words, it’s when the company stops costing the owner money and begins generating a profit.

The break-even point establishes the lower limit of profit when setting prices and determining margins so the owner knows at what sales volume the company begins making a profit. The degree to which a company goes beyond this point represents increasing profitability. Without knowing the break-even point, it’s difficult for an owner to know if the company is making a profit or, if not, why not?

Increase Profitability
Savvy business owners understand each dollar made by the company is not pure profit. Instead, variable costs such as materials, labor and subcontractor expenses are subtracted from the earnings, ideally leaving something for the company. Accurately estimating and tracking job costs is crucial in determining the break-even point. For example, costs can be reduced by purchasing materials in bulk, negotiating improved prices and/or terms with vendors or finding lower-priced suppliers.

However, increasing profits by simply raising margins is a dangerous policy since increased prices can negatively impact sales. At the very least, owners can use break-even data to decide whether to purchase a piece of equipment, hire a salesperson, determine compensation, prepare more accurate and competitive job estimates and create employee incentives.

Break-even Principles
Break-even concepts have numerous applications for use in every business decision. For instance, contractors love to purchase equipment. Yet, they need to determine how much more in sales the company needs to generate in order to cover the price of the equipment just to get back to where the company was before it had the equipment. It sounds like a mouthful, yet it’s really quite simple.

Here’s an example: Do a break-even calculation on that piece of equipment. If the piece of equipment costs $20,000, when will the company be out of that $20,000 hole? Two months? One year? Five years? This calculation helps the owner determine whether this is the right time to buy that equipment.

Why limit break-even concepts to just equipment? Consider using these concepts when employing new staff. For example, there is an opening for a salesperson and the top candidate states that he wants a salary of $100,000 but he will bring in $2 million worth of business. Is this a good deal for the owner? What if the candidate wants the same salary but will bring in only $1 million worth of business yearly? Is this still a good business deal?

The answers to these questions lie in using a break-even analysis. The salesperson will cost $100,000 in salary plus the fringe amount (benefits and taxes), along with any perks such as a company car. This may mean that the real cost of hiring the salesperson is closer to $150,000. It’s time to ask the break-even question: How much sales does this potential candidate need to generate before the company is back to square one (before bringing the salesperson on board)? Through this calculation the owner may determine the answer is closer to $2 million. Therefore, the owner must ask: Is this salesperson worth the investment?

A more effective payment plan may be to put the salesperson on a sliding sales commission. In that way, his wages are in relation to the break-even point. Once he reaches that point, he earns an incentive.

Calculating the true break-even point allows an owner to lower prices or offer rebates for a period of time to generate additional business. Many contractors have seasonal businesses and must earn the majority of their money during the spring and summer. In winter, the owner may offer employees other opportunities such as snow plowing to keep them busy.

By knowing the company has reached the break-even point, these jobs can be bid at and accepted at the break-even rate or even lower, which will still be profitable for the owner.

This is not something the business owner can continue long-term. Think of a car dealer who offers rebates on the purchase of a new car. These rebates aren’t offered out of the goodness of the owner’s heart. Instead, owners know when a particular model has reached the break-even point, they can offer rebates to move cars off of their lots. The rebates are only valid for a short time, and owners can only capitalize on this marketing tool if they know when that time is appropriate.

It’s advantageous for owners to examine whether or not the company has reached the break-even point on a regular basis – weekly, if possible, but monthly at the very least. Then, when the company does reach this mark, the owner can create a more competitive bidding environment to stay busy and profitable.

‘Sell More for the Same Amount’
Another benefit to calculating the break-even point is using the acquired knowledge to maintain and control costs. This means generating more sales to lower the overhead as a percentage of sales. For example, the company typically has an overhead rate of $20 for every $100 in sales. What if the company can produce $200 in sales for the same overhead? Then the overhead is cut in half, requiring fewer sales to cover the overhead, which results in a higher gross margin for the business. Manufacturers may be limited in what they can do to increase their business capacity because of equipment limitations. Yet, there are no such limits for contractors who can hire more subcontractors to help with the extra work.

Knowing the break-even point assists owners in determining how to sell more for the same amount of overhead. Once the company has reached the break-even point, jobs can be discounted and the company will still make money. If the 20 percent overhead is already covered on a $100 job, then the job can be bid at $80 and the business will still make money – the other $20 is not needed for overhead costs.

Build Your Business
Many think of the break-even point in terms of the total volume needed to break even. Yet, it’s more effective if this point is narrowed down for use in everyday decisions. Think in terms of the unit of measure the company deals with daily. For example, a home-builder might use square feet, while a cement company uses yards. Ask this question in order to make sound business decisions: “At this price, how many yards of concrete must be poured a day/week/month/quarter or year to break even?” Then strive to reach the break-even point earlier every year to increase profitability.

Some companies don’t break even until Dec. 15, which gives them only 10 days to make all their money for the year. Wouldn’t it be useful to know that by mid-October, the company has reached the break-even point? By tracking and using break-even concepts in making decisions, owners can plot this point and take advantage of it to build a more-profitable business.

Richard Fineman is consulting services director for International Profit Associates and Integrated Business Analysis (IPA-IBA). For more information, call 847-495-6786 or visit www.ipa-iba.com.