In my opinion, break even point analysis an essential concept for monitoring the health of an owner-managed business. When it’s done properly, it provides an effective early warning system that a business owner should pay attention to.
There are practical problems that make it difficult to transfer the simple classroom idea to the real world.
If you’ve looked at any kind of accounts or forecasts for a business, you may have noticed that there is a cash flow statement that is in a different format to the one that you’re used to and you feel confused.
This can be a problem because cash and cash flow are vital concepts for every business owner to master.
>>> Why Cash And Cash Flow Are Important
That’s because there are two very different types of cash flow reporting, with distinct advantages and disadvantages.
As we have a deep look at break even point analysis and why it’s essential for business owners to understand if they intend to navigate their businesses to profitability, the focus so far has been on the difference between variable costs and fixed costs.
>>> Why Break Even Point Analysis Is Important
>>> The Cost Volume Profit Relationship
We also need to understand contribution margin and here is why.
The basic way to calculate the break even point as a sales value is:
Fixed Costs
Contribution margin %
If you know the contribution margin per unit, you can use that instead to calculate the sales volume needed in units of sale.
Contribution (margin) is the difference between the sales price received from the customer and the variable costs of buying, making and delivering the product or service. [continue reading…]
In this article I’m going to explain why cash and cash flow are very important.
When businessmen and bankers talk about cash they are generally referring to your bank balance rather than what’s in your petty cash tin.
Cash (and bank) balance is a snapshot picture at a moment in time that you will see on your Balance Sheet.
Cash flow is the movement between two balances during a period of time. A cash inflow means that you get more in than you pay out, an outflow means that you’ve paid out more than you’ve received.
There are only three ways to grow any business.
Using one method will help your business grow steadily but using all three methods will cause your business to grow exponentially.
This makes it much easier to achieve 100% plus sales growth in a short space of time, often with an even bigger increase in bottom line profit.
A lot of people mention the three ways to grow model or have created derivations from it (e.g. splitting customers into lead generation and lead conversion) but the first person I’m aware of to teach it was American marketing superstar Jay Abraham. [continue reading…]
The break even point ( BEP ) is a fundamental concept in the financial management of a business.
I believe that business owners and entrepreneurs need to have a great understanding of break even point analysis and the associated cost-volume-profit relationship and cash flow management if they are going to create a long term successful business.
It’s not difficult to calculate and understand and it will give you a much deeper understanding of the dynamics of your business and how you make money in it.
>>> See Why Break Even Point Analysis is Important
Break Even Point Analysis is based on the cost volume profit relationship in a business.
Profit is the difference between sales revenue and the total costs incurred in the business.
If sales revenue is greater than costs, the business makes a profit.
If sales revenue is less than costs, the business makes a loss.
The point where sales revenue equals costs is known as the Break Even Point.
That’s all fairly straightforward and obvious but you may have missed an important point.
Although the objective of a business is to make a profit, you can’t act on profit directly.
Instead your actions will influence revenue and costs and depending on how they change, your profit will change.
That’s why it’s important that you understand how your costs change or don’t change for different levels of sales volume.
I don’t expect business owners and entrepreneurs to turn themselves into accountants and finance experts but I do believe that there are two financial concepts that they must understand to be consistently successful.
These will make sure that the owner is managing for profit and cash. [continue reading…]
I introduced the idea of the Ideal Profit Formula in How To Target Your Ideal Profit based on the formula for calculating break even points.
This calculates a sales revenue value or volume that, based on the accuracy of the underlying assumptions, gives you an idea of what’s needed to give you the profit you want.
In this article, we’ll dig deeper into what the sales revenue value means in practical terms.
The Three Ways To Grow A Business
One of the best known ways to look at business growth is the Three Ways To Grow A Business Model.
This gave us the insight that sales revenue is made of three factors that multiply together:
The big revelation is that when most business owners think about increasing sales revenue, they think about ways to attract and convert more customers (factor 1) and ignore the other two, often much easier to improve, factors.
Targeting Your Ideal Sales Value
The Ideal Profit Formula gave us an idea of the value of sales revenue, this next stage breaks down that total across the three elements of the ways to grow a business model.
Comparing what’s happening in your current business with how you’d like to reach your ideal sales revenue identifies the gap in each factor and lets you focus on how the gap can be closed.
What’s Happening In Your Current Business
The easiest number to calculate is often the average sales value per transaction.
This is
total sales revenue
total sales transactions
Obviously you use the same period of time for both.
The next easiest number to get to is the number of different customers who bought in a period.
If you’re good with a spreadsheet, you can download the sales transactions into a worksheet and then use pivot tables to count the number of different customers.
Otherwise, you may have to go through and count up who has been buying. If you have a lot of customers, this can be time-consuming. Try to find a quick way to do this because I’m going to want you to do this regularly.
Try not to use the number of open accounts on your sales ledger / accounts receivable computer program.
This is because you’ll realise that you have many customers registered who have not bought. They are lapsed customers and are useful names to know if you want to try to reactivate them.
If you get into the habit of looking at active customer numbers, you’ll realise that there is valuable information looking from period to period.
The number of customers in the last period
Plus new customers acquired
Minus customers who have stopped buying
Equals number of customers in the current period.
The length of the time period used for this customer reconciliation should be based around the number of times customers buy. If your customers buy on average every two months, then you can use a period of two to three months. If you use too short a period, you will have many lapsed customers but it won’t be valuable information because it’s part of your customers’ natural cycles.
You can calculate the average number of times customers by with this formula:
Total number of sales transactions
Number of customers who bought
You will now have the three numbers for the period:
Because these numbers are important, check that they are right by multiplying them together.
You should finish up with the total sales revenue or close to it if you have rounded some numbers.
Using The Three Ways To Look At Your Ideal Sales Revenue
You can look at the sales revenue you want to give you your ideal profit in terms of what’s happening in your business.
In the future, you can:
If you focus on one measure, your growth is linear and it’s easy to calculate how much your targeted factor needs to improve.
E.g. Current sales revenue
Ideal Sales Revenue based on your Ideal Profit Formula calculation is £1,400,000
Then if you target new customers with the others staying the same, the number of customers you need is 1400000/(250*3) = 1,866.7
This is an increase of 86.67% which is the same increase as jumping from £750,000 to £1,400,000.
If you plan to change all three growth factors by the same amount, things get more complicated because of the exponential growth – a 10% growth in each gives a 33% growth in total sales revenue.
To give you an idea of how this works:
Increasing all three by 10% gives you 33% growth.
Increasing all three by 20% gives you 73% growth.
Increasing all three by 30% gives you 120% growth.
Or to put it another way:
If you want to increase sales revenue by 50%, you need to increase each growth factor by 14.5%
If you want to double sales revenue, each growth factor will need to increase by 26%.
You’ll have to do your own arithmetic if each growth factor is changing by a different number but remember you’ll only have to decide targets for two of them to reach your targeted sales revenue total.
Target 3 = Ideal Sales Total / (Target 1 * Target 2)
Moving Forward Into Your Marketing And Customer Strategies
If you know how many customers you need to reach the sales total you want, you can start looking at:
When you start thinking through your strategies and tactics for new customers, you’ll recognise that again, this breaks down into two numbers.
Number of leads generated * % of leads converted
If you decide that you need to increase your new customer acquisition from 2 customers per week to 8 customers as part of your move towards your ideal sales and profits, you start to see insights into what you can do.
So if you get those 2 customers from 8 enquiries, you have a 25% conversion rate.
If you want to get to eight new customers:
The issue then becomes how do you do it?
Why don’t your leads convert at the moment (see Win Loss Analysis).
This isn’t the article to go into details.
My point is that by drilling into the numbers and understanding what it all means to set a financial goal, you start making the improvements you need to make much more specific and tangible.
It’s terribly vague to think in broad terms like “we want to get our sales revenue up to $1 million” or “we want to double the business”.
It doesn’t move you into action.
Specific numbers linked to action plans (with completion dates and allocated responsibilities) and firm intentions are needed.
This way you start managing your business intentionally as it moves towards set goals and targets.
You get clear feedback.
X is working, congratulations but can it be improved more?
Y isn’t working as well as expected. Why not? What can be done to make it work in the way you expected?
A Different Type Of Business Planning
This is intentional business planning and management.
I’ll talk more about that soon.
The best way to look at business in terms of likely potential for extra sales, profit and growth would be to be able to compare your key performance measures to your main competitors.
This is a process called competitive benchmarking.
It is a systematic comparison of your business with competitors and businesses like yours from other parts of the country (world) in particular critical success factors and key performance indicators.
Imagine learning that an average competitor makes £100k profit per year before owners remuneration but your business only makes £30k.
Imagine the power of knowing that the best competitors have sales of £150k per employee while your business generates £65k per employee.
That would make you think hard about your business and the methods you use in your business, wouldn’t it?
Unfortunately this information isn’t publicly available in the UK which I regard as a disgrace.
I don’t agree with the abbreviated accounts that can be put on public record because it means that one business can’t find out how another business is performing. Some people regard this confidentiality as a benefit but I see it as a curse.
Are There Other Ways To Access Competitive Benchmarking Information?
Sometimes a trade association will carry out a benchmarking study.
If you’re offered the chance, I urge you to take part.
The DTI in UK tried to create a very valuable service called the Benchmark Index. It has since passed into private hands.
I was very keen on this idea and trained to be an advisor/facilitator but unfortunately the scheme has rarely hit critical mass in enough different industries.
Still I couldn’t let a good idea stop me, so I held my own private benchmarking study into marketing practices for business coaches, executive coaches and life coaches. In total, I got 262 coaches to share details with me.
There is no reason why you couldn’t do something similar, either yourself or by paying a professional like myself to create the survey and write the final report.
If you get invited to take part by someone else, it is well worth paying some money to help fund it. The information you get will bring considerable insight into what is happening in the market.
I was a consultant, small business coach and advisor based in Birmingham, with over 35 years business experience, including more than 20 years as self employed.
My main business qualifications are:
– Chartered Accountant
– MBA
– Certified Guerilla Marketing Coach
My main interests are in helping business owners who are stuck get unstuck by thinking more clearly about their issues and possible solutions.
I no longer provide professional business coaching but I will be sharing more ideas on my blog and will continue my popular business book reviews.
I can be contacted by email at Paul@BusinessDevelopmentAdvice.com
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