Business Alchemy 101 Lesson 18–Break Even Sales Factor (Application)

Spending money you do not have is very common in our society. Many people every day overextend themselves and then end up chained to a debt that grows and grows with no real hope of breaking free.

The cash flow of a business can be quite similar to this scenario. Quite often, a business owner will be passionate about improving and growing the business and spend money on advertising, equipment or man-power that will indeed grow the business but cannot be afforded by the business.

Though not quite as effective as the Contribution Margin analysis, the Break Even Sales Factor can be used to quickly ascertain a company’s cash position to help make decisions about how, when and how much to spend. Consider it wise to establish a base for spending.

For example, set a Break Even Sales Factor of 110% minimum before any cash can be spent to improve the business. That way, you have a sales goal to push for to budget for those important improvements. In doing this, you will be able to stay out of debt and continue to build your business with fewer stresses.

Your business THRIVES on a solid FOUNDATION!

Business Alchemy 101 Lesson 18–Break Even Sales Factor (Part Two)

The equation for this ratio is quite simple and here it is:

(Gross Profit/Total Expenses) X 100 = Break Even (as a percentage)

So to understand the results, we refer back to the article on Understanding Ratios. We want the Gross Profit to win, but we are viewing the ratio from the Expenses point-of-view.

This means that if we have a number higher than one hundred, then each dollar of expenses has to wipe out more than one dollar of gross profit, which means we are doing well. If the number is below one hundred, then each dollar of expense is wiping out more than one dollar of gross profit and we will not be seeing any net profit at the end of the day.

In more technical terms, if the result is higher than 100%, then we are higher than our break-even and adding profit to the company. The total expenses also gives us an idea on how much we need to sell in order to break even.

In the next installment I will go over briefly some applications of this ratio.

Your business THRIVES on a solid FOUNDATION!!!

Business Alchemy 101 Lesson 18–Break Even Sales Factor (Part One)

The Break Even Sales Factor is a very simplified way to find out how much you need to sell in order to turn a profit. The most accurate way to determine this is to use the method discussed under the Contribution Margin topic, but that way takes a lot more work.

To illustrate how this works, pretend I am back in elementary and I bring lunch to school. I have 10 friends that I eat lunch with and we have all agreed to share our treats with each other every day.

One day I have a bag of Goldfish crackers and there are 20 crackers in my bag. I hand out one little cracker to each friend and then there are ten left for me.

However, the next day I have fruit snacks and there are only 8 fruit snacks in my packet, so only 8 of my friends get fruit snacks and I do not get any.

This is how the Break Even Sales Factor works. My friends are all the expenses of my company. The treat is the gross profit of the company (Revenue minus Cost of Goods Sold), and the number of treats left over is the profit I get to eat.

I will go over the equation in the next post.

Your business THRIVES on a solid FOUNDATION!


Business Alchemy Lesson 11–How Much Pie Do You Get? (Profit)

Okay, so this is the last post on profit.  I want to address in this post the more familiar version of reporting profit, which is the Income Statement.

I have already explained how an Income Statement can be used and what it means.  When you dissect this Statement a little bit more you can find some more useful information.

Going back to the Thanksgiving dinner analogy and my mother’s pies, you remember that some of my siblings come with their families and some don’t depending on what is going on with the in-laws. Continue reading

Business Alchemy Lesson 10–How Much Pie Do You Get? (Contribution Margin)

Once you have put together the total amount of pie that will be eaten for the meal by determining the fixed and variable, you can then get around to the original question of how much pie you get for yourself.

If I determine that there are 15 pieces of pie that will be consumed by my family and there are 20 total pieces of pie, then there are five pieces of pie left for myself, right?  The amount of pie left is my NET PROFIT.

The same is true for your business.  Once you have figured out your fixed and variable expenses, you can subtract them from your total sales (total number of pieces of pie) to determine what is left–your NET PROFIT.

But suppose that my mom wanted to know how much pie to make in order to feed the whole family.  Just like projecting profit, this is when it gets tricky without the correct tools.

In this situation, what I do is begin with what I do know again.  Let us change the scenario a little.  Because the variable eaters eat a percentage of the pie based on the amount made, if my mom makes more pie, then the variable eaters will eat more pie.  Also, let us assume that the percentage consumed is directly related to the total pie produced, in other words, the same percentage of pie is consumed regardless of the amount produced.

We can then take all of the pie (100%) and subtract the amount consumed by the variable eaters (we will say 66%) and come up with the percentage of the total pie that is left for the fixed eaters (33%).  Because you know how much fixed pie will be consumed, you know the minimum amount that has to be left for everyone but me to eat pie.

Stay with me here as I go through some algebra.  I knew my wife, each of my three kids and my mother would each have one piece of pie, these are my fixed numbers, so five pieces.  The amount left after the variables then has to be five pieces.  In other words, five pieces has to be not more than 33% of the total pie available.  So if 5=.33x, then you divide both sides by .33 and the result is fifteen pieces of pie.  5 pieces is 33% of 15 pieces.

You must have 15 pieces of pie for everyone else to get pie.  So now we know that when there are more than 15 pieces of pie made, I get whatever is left.  In the example above, when 20 pieces are made, I get five pieces of pie for myself, right?

Wrong!  Remember that as more pie is made, the variables increase as a percentage.  So this scenario is a little bit different than the scenario given initially, because in that scenario, we said we knew the variable eaters were going to eat 15 pieces of pie.  In this scenario, if five more pieces are produced, 33% of those extra pieces are available for me to eat, or about 1.67 pieces (5 X .33), because we have already served the five pieces that we needed for the fixed eaters as part of the original 15 pieces, which means that once the fixed eaters have been served, the 33% of each additional piece is now available for me (profit).

This is how you can use variable and fixed expenses as a tool.  When you subtract the variable expense percentage from the total sales (which is always 100%), then the resulting percentage is what is known as the contribution margin (33% above).  This percent is the total amount left to cover–or contribute to–your fixed expenses and profit.

The contribution margin percentage can then be used to figure out the bare minimum that you have to sell in order to have zero profit (no pie for me), but still pay all of your bills (fixed eaters).  This is know as your break-even point.  That is one tool you now have from this discussion.

The second tool is profit projection.  Say I want two pieces of pie for myself–which would be a profit of two.  You add the desired profit to the fixed expenses–in this case five pieces, and solve the same way as before to figure out the total pie needed.  7=.33x, so divide 7 by .33 to get 21 pieces of pie.  In other words, there must be 21 pieces of pie for me to get two full pieces of pie for myself.

So there you have it. Contribution Margin, Break-Even and Profit Projection.  These tools are very basic tools to understand profit and of course you already know that…

Without Foundation, your business fails!

Business Alchemy Lesson 9–How Much Pie Do You Get? (The variables)

Our next step toward understanding profit takes us back to our Thanksgiving pie analogy.  If you remember, I am able to figure out ahead of time who would be coming to dinner and how much some of them will eat.

What is left now is the people that are coming that will eat a different amount of pie each year depending on different factors.  The biggest factor is how much food there will be for the dinner.  If there is more food for dinner, they will eat more dinner and less pie and vice versa.

So if I ask my mother ahead of time how much food she will be making, then I can figure out how much pie each of the remaining people will eat.

This little process is how you figure out your variable expenses.  Your variable expenses can depend on several different factors, the most significant of which is the amount of goods or services your business produces each month.

In the analogy, the more food that was produced the less pie each person eats.  However, in business this is just the opposite.  When you make more widgets in a month, your costs increase.  You can figure out just how much each widget increases costs.

The tricky part is figuring out how many widgets your company will produce.  In my analogy, I went to my mom and asked her how much food she was going to be making.  The same concept exists in the business world.  You can go to historical records or ask your team how much product you will be making in a certain period of time, and then estimate the total amount to be produced.

Simple math is then used to multiply the total product by the cost per product to give you the total variable costs for a period of time.

Business Alchemy Lesson 8–How Much Pie Do You Get? (The constants)

I begin this post with two disappointing bits of news.  Number one, I will not be continuing the car analogy with this post and number two is that I think a little more background is important before we dive into the meat of analyzing and improving your business.

This thought came to me as I drove home a couple of evenings ago.  I was listening to Dave Ramsey on the radio (I am not a huge Dave Ramsey fan for reasons I would be happy to discuss with you, but I do think he teaches people to be very responsible citizens when it comes to money).

Anyway, a lady called in that had a business and she didn’t really understand what was going on with her business.  She struggled with understanding profit.  At this point, I realized that it would be beneficial to share an excellent tool you can use for budgeting and for understanding your profit.

For this conversation, I use Thanksgiving and, more specifically, pie.  My family loves my mom’s pies!  And since I am assuming that you love pie as much as me, I will break this conversation up into a couple of posts so as not to overwhelm you and save some pie for tomorrow, if you will.

Here is the problem with my mother’s pies, if I am waiting for everyone else to eat their pie before I serve myself, it varies each year how much I will end up getting to eat.  Some years we have more family there than other years.  Some years there are people that eat more or less than they did the previous year.  This changes the amount of pie left for me, assuming that I wait for everyone else to finish first.

The solution to the problem of how much pie I get begins with the things that are consistent.  Every year, my mother and father will both be at our dinner and eating pie.  My mother will eat one piece of pie.  If I am there, my wife and children will be there also.  My wife and each of my three children will eat one piece of pie.

I have two brothers and two sisters that may or may not be there and each will come with their spouses and children.  I can pretty much go through ahead of time and figure out which of my relatives will be there and which will eat the same amount of pie each year and separate those from the variable eaters.

When all is said and done, I know what my constant, or fixed, amount of pie is that will be consumed and therefore, I am one step closer to knowing how much pie I will get to eat.

I am building this analogy up to a final discussion on profit.  In order to give you all the tools you need to build budgets and understand your profit, it is important to understand the fixed costs of your business.

The constants discussed above are the fixed costs of my pie scenario.  You can look at your costs over the past year or month and pick out the costs that you have every month that are the same amount.  These are your fixed costs.  Now that you have picked these costs out, total them up and set them aside for the next part of our discussion.

Understanding profit takes some basic knowledge first and that is why all of the buildup because as you already know…

Without Foundation, your business fails!