We are pleased to share this article by guest author, Rod Bristol.
OKAY! You went to your annual conference and heard the highly paid, highly profane keynote speaker rail at you for 90 minutes about how you need to run Facebook ads! You got convicted! You then went through the process of creating the ad, measuring the ad for reach, amplification, content, and engagement trends; figuring out if anyone likes it, comments on it, or actually shares it with others. But how do you know if you’re actually MAKING ANY MONEY from the ad?
To answer that question, I’m going to introduce you to the single most important financial number that every business owner needs to know in order to successfully drive up the profitability of their operation and know if the money that they’re spending on anything is actually helping them make a profit, or just digging them deeper in the hole.
It’s Your Contribution Margin %.
This amazing number helps you answer questions like:
“What amount of sales should my new Facebook ad campaign create to pay for itself?”
“Can I afford to hire that new salesperson?”
What do these questions have in common? Each relates to how changes in costs, volume, and pricing affect your bottom line. By the end of this article, I’ll have given you a single, simple formula to help you answer these questions more accurately than ever before.
It all starts with the concept of break-even analysis. Many of you may remember break-even from some boring, long ago undergrad accounting course. Your professor went through various mathematical gyrations, then finished by drawing two intersecting lines with a downward arrow pointing at a number that indicated Break-even – the amount of sales at which a company neither makes nor loses money.
“So what,” you thought then (and I bet you say now). “Who wants to just break even?”
When is the only time you want to be at break-even when you own a company? When you’re losing money and writing a check every month for the pleasure of owning your ‘hobby.’ A business is supposed to PAY for the hobby, not BE the hobby!
Calculating your break-even point is just the beginning. Break-even analysis is a financial tool that illustrates the relationship between COST-VOLUME-PROFIT, and as such can help you answer all of the questions above and more.
We first need to define two broad classes of costs – based on how they behave in the business. First, FIXED COSTS. Within a reasonable sales range, fixed costs do not vary with sales or production volume. Examples would include administrative salaries, rent, interest, insurance, utilities, depreciation.
Next, VARIABLE COSTS. Variable costs are those which are directly proportional to the sales volume (i.e., no sales, no variable costs). Examples would include direct materials (cost of goods sold), commissions, and bad debts. Think of variable costs this way: sales cause variable costs. If sales don’t cause them, consider them fixed costs.
Now to calculate break-even. From your existing profit-and-loss statement, you total all your current fixed costs. Let’s say your total comes to $100,000. Next, you calculate your total variable costs as a percent of your total sales. Let’s say your “variable cost percent” turns out to be 75%.
This means that for every $1.00 of sales, 75 cents goes to variable costs. What’s left? Yes, 25 cents. To cover what? Fixed costs. So now we have to answer the question, “What amount of sales do I need to cover $100,000 of fixed costs?” The answer, of course, is $400,000 – this is your break-even point. I’ve diagrammed it below, using the term “contribution margin” to replace the term “what’s left?”
|Break-Even Calculation||Break-Even Proof|
|Variable Cost %||75%||Less: 75% variable cost||300,000|
100% – 75%
|Break-Even Sales||$400,000||Less: fixed costs||100,000|
|Fixed Cost Increment||= 12,000|
|100% – 75%||.25|
|= $ 48,000|
Yes, sales would have to increase $48,000 just to pay for the ad campaign. And it’s these “creepers” you must watch every day, because, with a contribution margin of 25% for every $1.00 increase in “fixed costs” (as they “creep” on you), you have to achieve a $4.00 sales increase just to stay even. Every business owner and every employee should know how much in sales is needed to be able to fill in the blanks in this sentence, “For every $1 in fixed costs, I need to make $______ in sales to cover it.”
Steps to Calculate Break-even:
Divide costs into fixed and variable (don’t forget to include cost of goods sold).
Total fixed costs in dollars.
Calculate variable cost as a percent of sales to get your Contribution Margin or “what’s left”.
Use the formula:
100% – Variable Cost %
And what about that $40,000 for your sales person you would love to hire? How much will they need to sell before they will begin to pay for themselves? It’s a very simple calculation:
$40,000 / .25 =
$160,000 in new revenue needed to pay for your new salesperson
And now you’ve got a terrific new financial tool to help you reevaluate every dollar your company spends to be sure that it’s driving up profitability in your operation.
Rod Bristol, CFE is the Executive Vice President of Profit Mastery. He guides business networks from “Profit Mystery” to “Profit Mastery®.” For over 30 years, business networks have improved their financial performance and unit profitability by following the Profit Mastery process: financial training, benchmarking, and accountability/bankability modeling.
Contact Rod at: 800.488.3520 x13 — or Bristol@brs-seattle.com.