Breakeven

There is a point in every trading year where the business has finally covered its costs and starts earning. Before that point, every sale is paying for rent, salaries, insurance and software. After it, most of the margin on each sale drops through to profit.

Very few owners know where that point sits. They know turnover and they know last year's profit, both of which arrive months after the decisions that caused them.

What the model is

Split your costs in two. Fixed costs stay broadly the same whether you sell a lot or a little: premises, salaried people, insurance, software, accountancy, vehicles. Variable costs move with each sale: materials, subcontractors, direct labour, delivery, card fees.

Sales minus variable costs is gross profit, and expressed as a percentage it is your gross margin. Then:

Breakeven sales = fixed costs divided by gross margin percentage.

That is the whole model. What makes it useful is not the annual figure. It is dividing it down into a weekly or daily number that somebody can act on before the year is over.

Why it matters to an owner

It converts a vague anxiety about whether the month is going well into a number anyone can check. If the team knows the business needs £2,178 a day and today booked £1,400, that is information. Turnover of £47,000 in a month means nothing to most people in the building.

It also puts a price on every decision before you take it. A hire, a lease, a piece of software, a marketing retainer: each one raises the fixed cost line and therefore raises the sales you must make before you earn anything. Owners tend to weigh a new cost against turnover, which is the wrong comparison and always makes it look affordable.

A worked example

Illustrative. An eight-person agency with fixed costs of £312,000 a year and a gross margin of 55 per cent.

Breakeven is £312,000 divided by 0.55, which is £567,000 of sales a year. That is £47,300 a month, or about £2,178 for each of roughly 217 working days. Current sales are £700,000, so the margin of safety is around 19 per cent: sales could fall by nearly a fifth before the business stopped making money.

Now use it to test three decisions.

The hire. A £40,000 salary costs roughly £46,000 once employer's National Insurance and pension are in. That is £46,000 divided by 0.55, so £83,600 of additional sales needed just to stand still. The right question is not whether you can afford £46,000. It is whether that person will generate £83,600 of extra work, and by when.

The discount. Knock 10 per cent off prices and the arithmetic gets ugly quickly. On £100 of work costing £45, margin was 55 per cent. At £90 the cost is still £45, so margin drops to 50 per cent. Breakeven becomes £312,000 divided by 0.50, which is £624,000 at the new lower prices. In units, that is 6,933 sales at £90 against 5,673 at £100: you need 22 per cent more work to be exactly as badly off as before.

The price rise. Run it the other way. Five per cent on price takes £100 to £105, cost stays at £45, margin becomes 57 per cent. Breakeven falls to £546,000, which is 5,200 units. You could sell 8 per cent less work and be no worse off. That is the trade most owners never model before deciding they cannot possibly raise prices.

Fixed costs creep, and nobody notices

The reason breakeven needs recalculating is that fixed costs almost never arrive as a decision. They arrive as a series of small, reasonable additions: a second software subscription at £180 a month, a leased vehicle at £410, a part-time administrator at £14,000, a bigger unit at £900 more per month. None of those merits a board meeting. Together they add roughly £36,000 to the fixed cost line, which at a 55 per cent margin means £65,000 of extra sales required before you are back where you started.

Nobody experiences it that way. What the owner experiences is a year in which turnover grew and profit did not, and a vague sense that the money is going somewhere. It is going into the fixed cost line, one defensible item at a time.

The discipline is dull and effective: every new recurring cost gets converted into the sales it demands before it is approved, and the whole fixed cost list gets read line by line twice a year. Most owners doing that for the first time cancel something within ten minutes.

The mistake most owners make

They calculate it once, usually with the accountant, and never again. Breakeven moves every time you add a cost, and in a growing business it moves several times a year, always upwards, usually without anybody recalculating it.

The second mistake is leaving the owner's own income out of fixed costs. If you need £70,000 to live on, that is a fixed cost of the business and it belongs in the calculation. A breakeven that assumes you work for nothing tells you the point at which the business survives, not the point at which it is worth owning.

The third is using net margin instead of gross margin in the formula, which produces a much larger and entirely wrong answer. Only the costs that genuinely vary with each sale go into the margin. Everything else is fixed and belongs on the top line of the division.

How to apply it this week

1. Split last year's costs into fixed and variable. If something would still be payable in a month with no sales, it is fixed. Do not agonise over the borderline items.
2. Work out your true gross margin. Sales minus variable costs, divided by sales. Do this by type of work if you sell more than one thing, because the blended figure hides the loss-maker.
3. Calculate breakeven three ways. Annual, monthly and daily. The daily figure is the only one that changes anybody's behaviour.
4. Add your own income into fixed costs and do it again. Note the difference between the two answers. That gap is what you have been quietly funding.
5. Recalculate before your next commitment. Any hire, lease or subscription. Work out the extra sales it demands and decide with that number in front of you.
6. Put the daily number somewhere visible. On the board in the workshop, at the top of the sales report, in the weekly meeting. It only works if people see it.

The questions to sit with

• Out of 10, how confident are you that you could state your breakeven sales figure right now, within ten per cent?
• How far could your sales fall before the business started losing money, and how would you know you were approaching it?
• What did your last hire have to bring in for the business to be no worse off, and did anyone ever say that number out loud?
• If you raised prices five per cent and lost some work, would you actually be worse off, or does it simply feel that way?

This is the first calculation in Know Your Numbers and the foundation of any Annual Budget worth having. A budget is a forecast of what you hope will happen. Breakeven is the line beneath it, and knowing where it sits changes how you price, who you hire and what you are prepared to say no to.