We all know that sales are the backbone of a business, but do you know how much income you need to keep the business going?
When you start out in business the key is to focus on sales, sales and more sales whilst at the same time there are bills, bills and more bills to pay usually requiring you to use some of your savings to pay the bills.
Over time as your business grows, there will come a time when the income is sufficient to pay the bills. Happy days. The next step at this point is to start to pay yourself a salary (or start drawing from the business if you’re a sole trader) and then as the business grows more, you’ll employ staff to support you.
At each phase of your business, it’s important to know what your minimum income is. This is what accountants call break even as it is when your income equals your expenses. However, there is a trap for young players in this definition as it doesn’t take into account repayment of loans and other financial commitments which aren’t classified as expenses.
Let me explain how to calculate break-even income.
Use known figures where you can (e.g. mobile phone, rent, monthly subscriptions like Xero) and estimate the figures where you don’t know, or they may alter from one month to the next (e.g. printing and stationery, advertising, merchant fees).
If you are selling products, you’ll need to factor in the cost of sales and your mark up.
Cost of a product including freight is $ 5 excl GST
If you work on a 50% mark-up, the sale price will be $ 7.50 excl GST
Which means you’ll make $ 2.50 per sale which equates to a gross margin of 33% ($7.50 – $ 5.00)/$ 5.00
If you work on a 100% mark-up, the sale price will be $ 10.00 excl GST
Which means you’ll make $ 5.00 per sale which equates to a gross margin of 50% ($10.00 – $ 5.00)/$ 5.00
Beware the difference between the mark-up percentage and the gross margin percentage.
These include payments for loan repayments, hire purchase payments and payment arrangements where you’re paying off an outstanding debt.
For my example I’m using the following figures:
Business expenses total $ 15,000 per month
Gross margin is 33%
Loan repayments are $ 2,000 per month
Total of the expenses and loan repayments is $ 17,000 ($ 15,000 + $ 2,000)
With a gross margin of 33%, you would need sales of $ 51,515 to cover those expenses ($ 17,000 / 33%)
The profit and loss would look like this:
Sales $ 51,515
Cost of sales $ 34,515
Gross Profit $ 17,000, Gross Margin 33%
Less expenses $ 15,000
Net Profit $ 2,000
Yes, that’s right, you would be making a profit even though from a cash flow perspective you’ve just got enough money to pay all your bills. This is because loan repayments are not expenses in the profit and loss.
Let’s recap with a few key points from the above example.
It’s important to know what your break-even number is. It provides your first goal for income in your business.
Of course, you want to be making sales far greater than your break-even income figure. But in the early days in business, it’s unlikely that you will, so knowing what your goal is, helps you to hustle hard to get the sales up to that level as quickly as you can.
As your business grows, so too will your expenses and by default the break-even income. The key to keeping ahead of your break-even figure is to review it regularly. I recommend every three months if you’re in a growth phase, or each time there is a significant change in costs, for example, you hire a new staff member, or move premises where the rent is higher.
Understand the difference between mark-up and gross margin. The higher the mark-up, the better the gross margin, but don’t be fooled by thinking that you’re making 100% on your sales because you’re marking up the costs by 100%. You’re not. You’re making 50%.
The next step is to do the calculation to work out what your break-even income is and check that against how you’re tracking month by month.
Originally published on www.smallville.com.au