Today I will look at why it is a good idea to reduce your break even point in a business and in a couple of days time I will explain how to do it.
What Is The Break Even Point Of A Business?
I looked in details at break even points (BEP) and break even analysis in this article:
and explained how it can be calculated in this one:
The Break Even Point for a business is the sales volume or sales value where the business neither makes a profit or a loss but is said to break even.
An owner-manager business has the issue of the owner's salary to consider. Some owners pay themselves a good salary regardless of how well or badly the business is doing. Others will take little out of the business, even if it is doing very well.
This means that it can be a good idea to do two break even calculations:
- With the existing salary, payroll costs and benefits of the business owner(s)
- With a normalised salary i.e an estimate of what the business would have to pay in the open market for professional management of a similar capability.
There Are Three Positions Around The Break Even Point
- A business can be trading well above it's break even level and making a good profit.
- A business can be trading around break even. In practical terms, that means that in some months it will make a small profit, in other months a small loss.
- A business can be trading well below and make a big loss.
Why A Business Trading Well Below Break Even Should Reduce The BEP
For this business to return to profitability, either:
- Sales volumes need to increase substantially; or
- The break even point needs to be forced down.
Increasing sales quickly can be very difficult for a business losing a lot of money because it's likely that its basic offers are either not competitive in terms of the customers value for money or its sales and marketing practices are poor.
It's usually easier to reduce the level of sales needed to return to profits by forcing down the break even point. This is why turnaround experts often resort to cost-cutting before looking at ways to generate more revenue.
A business losing money fast will have a very short lifespan unless something is done. At this level it is likely to be consuming cash quickly and eating into its financial resources.
Unless something is done quickly, it is likely to go out of business.
Why A Business Close To Break Even Should Reduce Its BEP
A business trading at this level may exist for many years provided the competitive situation doesn't change significantly.
There are two reasons why it should reduce its break even point:
- To make it easier to move into substantial profit.
- To reduce the risk of large losses in the future if the market goes into decline or if it becomes particularly competitive.
If the business is making a good profit, it has few immediate concerns and the owners, managers and employees may justifiably feel entitled to share in the prosperity.
However there is a big danger of cost creep.
This is where both fixed costs and variable costs increase faster than they should because the pressure to be cost conscious has been lost.
This is damaging to the overall strategic health of the business where cost effectiveness will always remain an issue.
Attention can be more focused on top line sales revenue growth than profit growth. The business can start thinking in terms of increasing its market share at the expense of competitors and external status is often generated from publicised revenue and employment statistics than secret profitability.
As a result, both fixed costs can increase and contribution rates reduce, sharply pushing up the break even point.
This makes the business more vulnerable to changes in the external environment.
Even if your business is making an excellent profit, I recommend that you monitor:
- Your break event point
- Your margin of safety - this is a related measure that tracks how much your sales revenue exceeds the break even level of sales
These numbers will provide an early warning system to the health of your business.
Do You Have A Story To Share?
Have you found it helpful to monitor your break even point in the past? Has it guided your decisions?
Do you have a story where you were growing and didn't appreciate the increase in the downside risk in your business?