Today I will look at why it is a good idea to reduce the 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?
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.
I looked in detail at the break even point concept (BEP) and break even analysis in this article:
and explained how it can be calculated in this one:
Calculating The Break Even Point In An Owner-Managed Business
An owner-manager business has the difficult issue of the owner’s salary to consider.
While other businesses pay approximately the market rate for its management and staff, an owner-managed business has much more discretion.
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.
Since the calculation is easy, you may also want to do it with the salary and benefits that you really want your business to give you.
This is what I call the Ideal Profit Point.
There Are Three Positions Around Break Even
- A business can be trading well above it and making a good profit.
- A business can be trading close to it. In practical terms, this means that in good months the business will make a small profit, in other months a small loss.
- A business can be trading well below it and make a big loss.
Why It Makes Sense For Each Of These Businesses To Think About Reducing The Break Even Level Of Sales
Why A Business Trading Well Below 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. Making changes and increasing sales and marketing can be expensive, increasing fixed costs and the level of sales needed.
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 effective action is taken 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.
At this level of performance, one small effect, like losing a medium-sized customer or even a key employee can destabilise the business and send it sharply into significant losses.
Why A Business Operating Well Above Should Still Monitor And Control Its BEP.
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 fixed cost creep.
This is where both fixed costs and variable costs increase faster than they should because the pressure to operate at low costs has been lost.
This is damaging to the overall strategic health of the business where cost effectiveness will always remain an issue.No business with serious competition can afford for its costs to become much higher than its rivals unless it can charge premium prices through effective differentiation.
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
Think of how well your business is trading compared to its BEP as an indication of business health.
Just as medical practitioners will check blood pressure and temperature regularly, you should be tracking your BEP and margin of safety.
If the trends start to look unhealthy, you can see it as an early warning system and think about what you can do to make sure your business returns to a healthier position.
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