I am a big believer in using break even point analysis in helping a business to improve its financial performance.
In this article I will explain how a business can reduce the break even point so that it makes a profit at a lower level of sales value or sales volume.
It does not look at ways to increase the sales volume or value so that it moves from the bad side of the break even point to the good side.
You will find help on increasing sales in three other sections of my blog:
Do You Understand The Break Even Concept?
I’ve written these other articles you may need to read first:
In this article I’m going to assume that you’re now familiar with the concepts of contribution, fixed costs and variable costs and the cost-volume-profit relationship.
How To Reduce The Break Even Point In A Business
The break even point formula is simple and it makes it clear that the only ways to reduce the level of sales needed to avoid making a loss are:
- To reduce fixed costs per period.
- To increase the contribution margin, either per unit or as a percentage of the sales value.
To increase the contribution margin per unit or percentage, you need to:
- Increase the sales price
- Reduce the variable costs
Sometimes it is a little more complicated by involving a trade-off but the net result is that the contribution margin still improves:
- Increase the sales price by more than the increase in variable costs
- Reduce the sales price by less than the reduction in variable costs
Lets keep things simple and conclude that to reduce the break even point, you need to do one or more of these three things:
- Reduce fixed costs
- Increase selling prices
- Reduce variable costs
If you can do all three, the break even point will reduce quickly but often there are compensatory effects in one of the other factors in the BEP equation.
How To Reduce Fixed Costs
First a reminder of definitions.
Fixed costs are fixed in relation to volume over a normal level of business. These costs will include items like property rent and many salaries.
These costs are not fixed over time but you normally have to make a deliberate decision to make cutbacks.
Sometimes the decisions will be tough.
If you decide to reduce salaries, you will need to:
- Reduce the number of people who are employed (either by making someone redundant, dismissing them or not filling a vacancy when an employee leaves).
- Replace people who leave by recruiting at a lower level of experience.
- Negotiate a reduction in pay levels. This is what some businesses have done in the recession to avoid redundancies.
To reduce rent, it is likely that you will have to wait until there is a break clause in the lease or the lease finally expires.
- Negotiate a lower rent. Landlords are becoming more flexible because they earn nothing if the property is empty for a period.
- Give back some of the space you rent or, if allowed, sub-lease it to another tenant who will pay rent.
- Move to a different property where there is less space or where the price per square metre is lower.
Other times, the cost is much easier to control. You just decide to stop buying.
A technique I like very much is zero based thinking.
Look down the list of your costs – and it’s better to to with individual transactions than account analysis totals – and ask yourself the zero based question.
“Knowing what I know now, would I still buy this?”
If your answer is No, stop it as soon as you can.
If your answer is a firm Yes, you know that you’re committed to that cost.
Many will be in the middle and you can take some time to think about each.
Some business turnaround experts believe it is better to cut hard, get the costs right down and then build them back up if you cut too far.
In general, you’ve got three factors to look at with every significant cost:
- the quantity you buy
- the price you pay for the quantity
- the amount that is wasted and not used as well as it can be. If you can make better use of what you buy, the quantity you need will reduce.
If you’re not fully using a resource, you have some choices:
- to reduce the quantity you buy (this might mean a full time employee reduce their working hours to part time).
- to find other valuable uses for the resource (perhaps the employee can be given work responsibilities that take up your time)
- to sell the spare capacity to a third party (this might mean, for example, offering your book-keeper’s services to your wife for her business as well as yours).
If you want guidance on prioritising the cost reviews, look for quick wins along two dimensions:
- High value
- Easy and quick to stop
The first to focus on are the big costs that can be stopped quickly and with little difficulty. The last are the small costs which are difficult to stop.
Try to base your decisions on what your business needs now and in its foreseeable future. While X% across the board savings can appear to be fair on the basis that “we’re all in this together”, reducing some costs will damage your business.
How To Reduce Variable Costs
The volume you buy of these items will automatically change with the volume you sell, although there may be timing differences as stock (inventory) increases or decreases.
Here the issue is more about price, quality and wastage although it will depend on whether you buy and sell “as is” or if you “buy and transform”.
I’ve chosen the word transform because we wouldn’t think of a restaurant as a manufacturing business, but the business will buy the ingredients for items on the menu and sell the completed meals.
It is a good example to highlight the issues.
Imagine a menu item that is usually made out of fillet steak.
If the restaurant wants to improve it’s margin per meal, it can:
- Negotiate a lower price for the fillet steak from its existing supplier or from a new one.
- Switch from using fillet steak to rump steak and hope that the quality of the final meal is still high. Obviously it would test it first.
- Reduce the wastage, either by specifying more lean meat and less trimmings when it buys or by making sure that any spare steak is used and not thrown out after the eat-by-date.
In this example, it could also change the mix of ingredients slightly and reduce the amount of steak, perhaps from 8oz to 7oz, perhaps increasing the quantity of cheaper items to make sure the meal doesn’t look smaller.
How To Increase Selling Prices
I will be writing more about this in other articles but businesses are often very nervous about increasing prices because they fear they will lose large volumes of sale.
Customers will be very sensitive to price increases if you sell a commodity item without any service differentiation and if you already match the price charged by competitors.
However it is rare that there isn’t some kind of leeway, through supplier ignorance of prices, service differentials and customer inertia.
For example, there are few products that are more of a commodity than petrol (gasoline) for your car but how sensitive are you to changes in price? I will buy from a supermarket, which is often the cheapest, if it is convenient (in location and time) but otherwise, I will buy from anyone. I certainly won’t drive around looking for the lowest price per litre.
Customers fall into a number of categories when it comes to price:
- They buy regularly, they know and check the prices and are very price sensitive. They give little value to any kind of differentiation and they will switch suppliers if there is a lower price on offer.
- They buy regularly but they value the service differentiators. They will stay loyal provided the price gap isn’t too big.
- They buy rarely or occasionally and don’t know the price. If it is a big purchase value, they will shop around but otherwise, they will convenience buy.
Increasing prices for Business-To-Business customers (B2B) can be much harder than if selling to Business-To-Consumer (B2C). They may have negotiated a special price deal and therefore changes in price may also need to be negotiated. Obviously they will have some reluctance to increase the price they pay and the increase will need to be justified, either in terms of your own cost increases or your unwillingness to continue to supply at very low prices.
It’s different if you sell to B2C customers. Again use your own experience as a shopper to realise how few prices you actually know to the penny. Often you have broad ballpark numbers in mind or you accept the prices on offer and look for what you believe is the best value.
If you rarely buy something, either B2B or B2C, your judgement is not the price in absolute terms for each product for your perception of the relative value per money.
Because you don’t know what the price was last year, or last month, you have a much reduced sensitivity to the price charged provided you believe you’re getting the best deal.
This means that suppliers of occasionally purchased products have more freedom to increase the price without it forcing down sales volumes.
Reducing The Break Even Point
If you can take the steps to work on all three of the levers:
- Reduce fixed costs
- Reduce variable costs
- Increase selling prices
your break even point can move very quickly downwards. A struggling business can become viable or a business that has traded around the break even level can become consistently profitable.
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