Fixed overheads, as the name suggests, are the costs that tend not to vary in line with turnover. These include administrative staff salaries, property costs, insurances, stationery, equipment rental, motor expenses, depreciation, bank charges etc. When calculating the monthly fixed overhead, always remember to allocate a portion of financial costs such as accountant's fees which are billed to you once a year.
To work out your profit Break-Even sales point, you only need two pieces of financial information:
1) Total fixed overhead costs
2) The gross profit percentage (GP% or gross margin)
The gross profit percentage is calculated from the average profit that a business makes on each sale. So if you sell a product or service for £250 and your variable costs are £175, then the gross profit is £75 and the GP% 30%. If you made ten sales, the gross profit would be 10 x £75 = £750 but the GP% would still be 30%.
Now let's assume that total fixed overhead costs each month average £25,000. To calculate the sales required to Break-Even, divide the overhead costs by the GP%. £25,000 divided by 30% = £83,333.You now know that the business has to generate at least £83,333 of sales each month to avoid making a loss.
Note that the Break-Even point is not set in stone. It is a financial information tool for the business owner to use and react to. If the business is struggling to consistently generate more than the £83,333 sales needed to generate a profit, then the business owner aware of Break-Even knows that he is losing money and can immediately take remedial action.
The quickest way to reduce Break-Even is to reduce costs. If you could reduce fixed costs from £25,000 to £20,000 per month, Break-Even sales would fall from £83,333 to £66,666, a significant difference.
Clearly the other way to reduce the Break-Even point is to increase your gross margin. Ways to do this might include putting up your prices, finding cheaper suppliers or introducing higher GP% product or service lines. If the GP% could be increased from 30% to 33%, then Break-Even on fixed costs of £25,000 would be £71,428.
Combining both strategies ie cutting fixed financial overheads to £20,000 and increasing the GP% to 33% would result in a new Break-Even sales of £60,606.
What we have discussed above is PROFIT Break-Even. A variation of this, one which most business directors do not understand or appreciate, is CASH Break-Even. This can literally make the difference between business success or failure.
Break-Even recognises that fixed overhead costs include non cash items such as depreciation. More importantly, it also picks up other cash outlays that do not appear within overheads, indeed they do not appear within the profit and loss account of the business at all!
Take for example a Road Haulier who buys a lorry for £100,000. The lorry has normally has a working life of 10 years so is depreciated in the profit and loss account at £10,000 per year. The haulier can't afford to buy the lorry outright and enters into a finance agreement to pay for the lorry over 4 years.
Ignoring the impact of interest on the loan, cash repayments against the finance agreement are £25,000 per year. In this situation cash outlays of £25,000 exceed the depreciation overhead by £15,000. Based on a GP% of 30%, this means that sales have to be £50,000 per year higher to achieve CASH Break-Even than PROFIT Break-Even. Something worth knowing don't you think?
To conclude, calculating the PROFIT and CASH Break-Even sales points for your business is vital for helping manage cash flow. Making Break-Even as low as possible achieves two great outcomes. It maximises the opportunity to make profit/generate cash and, just as importantly in harder economic time, it considerably reduces the risk of business failure.
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