But Does Your Product Pencil?

cartoon-october18-20111 “I know I lose $500 per house, but I’ll make it up in volume” – Anonymous Subcontractor

You love what you do, right? But even though that business or product may be the fire in your belly that gets you going in the morning and working until the wee hours of the night, it still needs to pay the bills.

In my last post, I discussed how one of the key concepts a business owner must grasp no matter their industry is that of breakeven point. Here we’ll break down the pieces of breakeven so you can understand where your breakeven point is.

Breakeven is a simple formula on the surface. It means basically, that you have reached an amount of sales that covers not just the cost to produce those sales but also your monthly overhead and fixed expenses.

First, let’s look at overhead and fixed expense or for simplicity sake, let’s just call it overhead. Each month there is a list of expenses that rear their ugly heads whether or not you sell a dime. These expenses include rent, insurance, utilities, office supplies, and equipment rentals… anything that really doesn’t change much no matter what volume you produce. Now, granted, there are some fluctuations in utilities and other overhead items if volume changes dramatically but for the most part, you’re not getting out of these expenses.

Let’s use an example of a winery. The monthly overhead is going to include all of the expenses above. It will also include certain amounts of labor that don’t change throughout the year: marketing, information technology, fermentation tanks, maintenance and anything that a winery needs to spend to keep the doors open before they ever make or sell that first bottle of wine. For our example, let’s say that our winery has monthly overhead of $100,000.

Once you know how much your overhead is, the next step is to figure out what your margin is on product you sell. This is where a little algebra comes in. You know, that stuff you swore you’d never use? Well, now that you have your own business, it will come in handy.

There is a difference between margin and markup. Markup means something costs X and the amount you mark it up is a multiple of X. If something costs you 50 cents and you mark it up 10%, this means you are selling it for 55 cents.

Margin means that for every dollar you sell, you keep a certain percentage. So, if you sell a bottle of wine and your margin is 40%, then that means that for every dollar of sales, your margin is 40 cents. It also means that for every dollar you sell you have to spend 60 cents on variable expenses, otherwise known as cost of goods sold. Cost of goods sold for our winery includes grapes, pickers, bottles, barrels and everything that fluctuates based on the amount of wine we are producing. Equally important to this calculation is to determine that your margin is truly what you think it is. I have seen many companies that believe their margins are at one point only to find they are much lower when based on actual expenses.

To bring the pieces of breakeven together, let’s walk through the math. The monthly overhead for our winery is $100,000. In order to cover this or, in other words, to breakeven, you need to have a margin on your wine of $100,000 per month. Because we only keep 40 cents for every dollar we sell, we need to sell $250,000 of wine in order to cover our overhead.

Therefore, our breakeven point is $250,000.

While the formula for breakeven can be relatively straightforward in a text book example such as our winery, it can be difficult to gather the information to calculate it in a real world situation. However, staying focused on this calculation and whether and by how much you are above or below your breakeven point will be a key factor in your and your company’s success.