Episode 43: Break Even Analysis

March 2, 2022

This is a short but important episode where Sarah and Trudi take you through what is break even analysis and how it should be used when pricing your products or services. Download the free example spreadsheet here and follow along with two examples of break even calculations and then have a go at calculating the break even point in your own business. Understanding your break even point is a really important aspect of your business finances, as if you get it wrong it will flow through to pricing that may not be earning a profit!

Podcast Transcript Available Here

Duration: 27:34

Trudi Cowan: Welcome to season three of the Financial FOFU podcast where we talk all things finance, money and mindset. To find out more about us or to listen to some old episodes, you can visit us on our Instagram or Facebook pages or check out our website. So let's get into it today. Sarah Eifermann: Hello everyone and welcome to today's episode. We are going to continue our education of your books. Trudi Cowan: Yes. Sarah Eifermann: Specifically chatting about some break-even analysis. Trudi Cowan: I love it. It's exciting. Trudi Cowan: So those new listeners, I am Trudi Cowan. I am an Accountant. Sarah Eifermann: And I'm Sarah Eifermann and I am a Business Advisor and a Finance Broker. Trudi Cowan: And so today with our break-even analysis, I would love to use an example of a widget but Sarah vetoed that. Sarah Eifermann: I wonder why. Trudi Cowan: Instead, I have two examples for you that we're going to have a bit of a run-through. One, is if you are a product business, we're going to use the example of selling a phone cover and we've also done, we're going to talk through an example of someone in the construction business and I'm just going to keep it very generic in terms of construction. But to start with, Sarah, tell me what is break-even analysis to you or what is the break-even point? Sarah Eifermann: So a break-even analysis helps you calculate how much you either depending on which way you run the formula, calculate how much you need to turn over to break-even and therefore it helps you calculate whether your business is even viable, worthwhile and have you priced things correctly. On the flip side, how much do you have to price things to turn over a set amount to break even. So it's kind of the same outcome depending on how you view it. Trudi Cowan: Yes, so if I go in my accounting speak, it's how many units do I need to sell at a certain price to cover all my costs. Sarah Eifermann: Very accounting speak. Trudi Cowan: At your break-even point, you're neither losing any money nor making any money. Sarah Eifermann: Correct, you're breaking even, zero. So you're not losing. So as per our last episode, it's not a loss and it's not a profit. It's a break-even. Trudi Cowan: Yes and so a couple of terms that I just want to run through before we sort of jump into the example that we're going to go through today. So we talk about fixed costs and variable costs. The variable costs are those that are specific to selling each unit of your product. Whereas the fixed costs are those that don't change, regardless of how many sales we make. So you're still going to have to pay your insurance and you're still going to have to pay your rent, you're still going to have some website costs, even if you make zero sales. They are your fixed. yes. The variable costs however, will go up and down depending on the volume of your sales. Trudi Cowan: Correct? Sarah Eifermann: Yes, because they are directly related to the product or service that you're offering. Not like writing a business. Trudi Cowan: yes. That's right, so when we have a look at our break-even analysis, the first thing we need to do is list down all of our fixed costs and all of our variable costs. Sarah Eifermann: Do you take them annually? Monthly? What do you do is true. Trudi Cowan: Okay so for fixed costs annually and your variable costs per unit of product. Sarah Eifermann: If you're a new business and you don't necessarily have 12 months of trading, you would guess what your fixed costs would be for 12 months. Trudi Cowan: No, we don't guess, we estimate. Sarah Eifermann: Sorry, accountants speak. Estimate, what your costs would be for 12 months so that this example or this template would be viable for you if you're trying to work out how to be profitable from the start. Trudi Cowan: Yes, that's right and what we would then do is have a look at what is our average sale price. Let's jump into our example, so for our phone cover, our variable costs in this case would be the manufacturer of the phone cover. Sarah Eifermann: Yes. Trudi Cowan: They would be shipping from the manufacturer to us and they would also be shipping out to the customer. Sarah Eifermann: Yes. Trudi Cowan: All of those things are going to vary depending on the volume of our product. Okay, so in our case, we've got $17 of variable costs and we're going to sell our product per item, we're going to sell each phone cover for $40. Okay, so that's how. These are sort of some of the numbers that we need to start having a look at. Then we would add up all our fixed costs, so in this example, which we're going to upload for you so that you can have a look at our fixed costs, your accounting fees, your bank fees, marketing, insurance, rent, motor vehicle, website, office supplies and then paying the owner of the business some wages and superannuation. All those things are included in our fixed costs for a total of $30,570. The next thing we then need to calculate is what we call the contribution margin. Now, this margin is how much of that $40 sale price goes towards covering those fixed costs. Sarah Eifermann: Yes so it's not talking about the variable costs, it's specifically talking about the fixed costs of running your business. Trudi Cowan: Yes Sarah Eifermann: I mean, when we upload the example, you can have a look. But in this business, the wages and the superannuation that they're paying account for nearly 52% of their fixed costs. Trudi Cowan: That's right, we're doing $25,000 wages, total fixed costs of 30,570. So really, the wages are a big chunk of that fixed costs and the contribution margin is just your selling price plus your variable costs so in this case, the $40 selling price, less $17 of variable costs, gets to your contribution margin of $23. Sarah Eifermann: Yes, that's a simple a minus b equals c, right? Trudi Cowan: Yes. Sarah Eifermann: Your average sale price minus your variable costs, equals the contribution margin. Trudi Cowan: Yep, so for each time we sell one phone cover, that covers $23 of their fixed costs. Sarah Eifermann: How many break-even units do we then need to sell to cover our fixed costs versus make a profit? Trudi Cowan: Okay, so to get to our break-even units, now this formula, we will again put in the example, but if anyone can follow this formula verbally, it is our fixed costs divided by the sale price less your contribution margin. Sarah Eifermann: So say that again, it's your fixed costs Trudi Cowan: Divided by the average sale price less the contribution margin. Sarah Eifermann: Our example has fixed costs of 30,570, an average sale price of $40, 40,000 is a very expensive phone cover [cross talk 7:40] and variable costs of $17. Trudi Cowan: Yes and that then gets to our break-even units of 1,329. Sarah Eifermann: They sell 1329 phone covers to break-even because that includes all of our operating expenses or our fixed costs. Trudi Cowan: You can then say why it's really important to do this break-even analysis because as a business owner you might go 1300 units, that's easy to do. I can sell that. I can sell that easily, at $40. Not a problem, so I'm going to make this business profitable. On the flip side, you might go Oh I could struggle to sell 1300. I reckon I'm only going to be able to sell 1000 in which case you can then decide on this product. Well if I put the price up, what will the analysis look like? Sarah Eifermann: Yes and is it marketable, that you can sell it. Trudi Cowan: Can I achieve that or if I'm only going to be able to sell 1000 and I really can't put the price up? Well, then it's probably not worth investing in making this phone cover. Sarah Eifermann: Yes because it's 25, nearly 26 a week that you have to sell to make 1329 per year to keep your fixed costs. Trudi Cowan: Yes, that's right and look, we're doing this in isolation is one product, I'm sure there are not many businesses around that sell a single phone cover with these numbers, but it then starts to inform you that, is this product worthwhile me developing? Or do I not bother anymore? Or if you've already got this product out there, and you're developing it, you can play around with your sale price. Yes and what is the perfect price that I can put it at? You know, I think I can make this many units. Trudi Cowan: Well, what price then makes me a nice little profit on that. Right, so that's why this analysis then becomes important for any business. yes. Replace the phone cover with any product that you want. Replace the fixed and variable costs with what's relevant for you and it could be that you've got multiple products. You can run this on an average basis so you could put your various products in here and just do an average sale price. To again, come out with what's the average break-even units that I would need to sell, you probably wouldn't want to do it if you had one product that was $5 and one that was 100. But if you had a bunch that was all sort of between 30 and 50, you know pretty close to each other, you could still do it on a total basis, to come up with some helpful information around your pricing. Sarah Eifermann: I mean, the other way that you can then do it is to categorize each one and split it out, in our scenario, it's the manufacturer cost and the shipping from the manufacturer to you, and then the shipping from you to the customer. So you have to do that for each item. Yes, to work out what your variable costs were as a business. There are a couple of different ways to do it and sometimes it is valuable to do it that way and other times, it's valuable to do it as the average instead. Trudi Cowan: Just really depends on the nature of your business Sarah Eifermann: Because it's what you're trying to calculate too, right? Trudi Cowan: The other number that's helpful that comes out of this is that we can work out what's their break-even revenue. Sarah Eifermann: Yes. Trudi Cowan: That's just so we had a break-even unit of 1329, multiply that by your sale price of $40, so your break-even revenue is 53,165. yes, go back to earlier we said, we're going to do wages of about 25,000. What we're saying is of revenue of 53,000 25,000 of that is coming back to this business owner. yes, plus the super [cross talk 11:33] as their wages. So again, starts to give you a little bit of information around that maybe you go well for the amount of effort I've got to put in to sell that many units, I'm willing to only earn 20,000. So again, you can readjust your calculations by putting your wages down and seeing what that does to the units you need to sell. Sarah Eifermann: On top of that if you change the price by $2. What then comes back is profit, because wages are not profit, wages is replacement income for the work that you would have earned elsewhere and this is a common thing in the business where they think they're making or depending on your accounting method on your account, you may just draw drawings and not pay yourself wages and then at the end of the year, you think well, I paid myself $100,000 so that was my profit. No, that was your wages. Trudi Cowan: Yes, which is different from your profits. Sarah Eifermann: Different to profits, so there are lots of cool things that you can do with this analysis. Once you've got it there. That opens your eyes. It's game-changing. Trudi Cowan: It is. I guess the any, here's another aspect, how break-even units is 1329. But if you go well, I can sell to 2000s of them easily. Well, the difference is then gravy, that's all profit. There are additional 671 units. That's all profit on those, right? Sarah Eifermann: And in this scenario, the extra 671 is how much extra cash. Trudi Cowan: How much extra cash? Quick calculation 26,834, okay. Sarah Eifermann: Right, so now you've made $27,000 of wages plus how much in profit, did you say? Trudi Cowan: 26,834 Sarah Eifermann: Yes, just over 50k in the income of some kind, profit and wages. It's game-changing, guys. Game-changing and it's not well known. and accountants, you guys learn it as part of your degree but I don't think it gets promoted. It's not given the justice it deserves. Trudi Cowan: It's not given the justice that it deserves and I'm having a lot of fun playing around with these spreadsheets. Anyone that's handy, you don't even need a lot of Excel skills, but just a little bit of handy, play around with these numbers and see what happens. Just by changing things, a couple of dollars here and a couple of dollars there. It might even be helpful for you in your budgeting process to go well what happens if I decide that I don't need as big a warehouse anymore. Sarah Eifermann: Yes. Trudi Cowan: I'm going to get a smaller one, which has cheaper rent, what does that then do to how many units I have to sell? Okay, it can then start to help you play around with some of those questions. Sarah Eifermann: Game-changing. Trudi Cowan: Game-changing. Sarah Eifermann: Absolutely. Let's then jump to the service. Trudi Cowan: So I've done construction, which is trading Sarah Eifermann: Trading Trudi Cowan: Still kind of service-based. But I guess that's the key point. You could do this with any type of business. Sarah Eifermann: Yes. Trudi Cowan: It just comes down to understanding what are your fixed and what are your variable costs. Sarah Eifermann: So trading would have higher variable costs potentially than a professional service? Trudi Cowan: Yes. Trudi Cowan: If I looked at myself, my variable costs would be some of my software which I would pay depending on the number of clients I have on it. I would have some contractor fees that I use for a few jobs. Sarah Eifermann: Yes. Trudi Cowan: That's my variable costs. Everything else is very fixed in my type of business and a lot of service providers would probably be very similar in that sense. Sarah Eifermann: Whereas a trade based business or construction or anything that requires you to purchase real materials to complete said job and provide the service of labor to that job.They will have a higher variable cost as a result of the cost of actually, and this is important at the moment because the variable cost is going through the roof. Trudi Cowan: Yes, with materials. Definitely at the moment,so what I've included for the variable costs are materials, contractors. I've included wages for the guy, not the business owners, but not your team, Sarah Eifermann: For the actual job though, the time they spent outside. Trudi Cowan: The superannuation for those guys as well, and rubbish removal is another big one that I see in these types of jobs. So I've included a lot of those things in the variable costs. Sarah Eifermann: Yes Trudi Cowan: Then for the fixed costs, very similar to what they were for the phone cover product because those things don't change. Most businesses would have these types of expenses around accounting fees, marketing, insurance, rent, all those sorts of things, which don't change a lot. Sarah Eifermann: Not really. Trudi Cowan: Especially not in the smaller business space. Sarah Eifermann: In this scenario, you are paying wages of 80,000 plus $8,000 in super so because it is more of a labor-intensive job, we are replacing a full-time income or full-time earnings. Trudi Cowan: That's right. Trudi Cowan: So numbers in this situation are a little bit bigger. So our fixed costs are 101,620 our variable costs per job are 6400. You can already see that we're going to have to one, sell the product for a lot more money and two, get a lot more money in before we reach our break-even points. Just because we're talking about much bigger numbers than what we were in the phone cover example. Sarah Eifermann: Yes, exactly. Trudi Cowan: So in this situation, we're going to say that the average sale price or the average job revenue is $10,000, variable costs are 6400, which means the contribution margin is 3,600. So just to remind you, the contribution margin is the portion of the sale price that goes to covering your fixed costs. Okay and so in this set of numbers, our break-even unit is 28. So this guy only needs to do 28 jobs per year, to reach their break-even point. So, a little over two jobs a year get them to their break-even point. Sarah Eifermann: A month Trudi Cowan: I said month in my head. A little over two jobs a month gets us to our break even. Sarah Eifermann: It's about 2.4 jobs a month. Trudi Cowan: Then every other job that you do that month is your gravy and just contributing to your profit. Sarah Eifermann: So just switch the numbers from 2.4 jobs, if the average price per job is 10,000, they need to do jobs to the equivalent of 25k per month. Trudi Cowan: Yes and that's another great way of looking at it so that you can then be budgeting. Sarah Eifermann: Yes, that's how we explain it for my trainees because it's really good for them to have a goal they need to chase work through the value of 25k per month. Their target, I give them a target which is 25k per month. Trudi Cowan: So really, what you're doing is generating a revenue budget. Sarah Eifermann: Yes Trudi Cowan: So in this instance, this business is needing revenue of 282,000, just to break-even. Sarah Eifermann: That's important because if you're a trade-based business, and you're trying to pay yourself a wage, the idea of you turning over $282,000 can be very scary [cross talk 19:11] It's mind-boggling, if you try and work out how the hell you are going to get work worth $282,000 just to break even. Sarah Eifermann: That's why 25k a month is a better mindset goal target to have Trudi Cowan: Definitely worth breaking that down to a monthly point. Sarah Eifermann: I mean, I think it's fair to say here that we have done replacement income of $88,000 in total inclusive of super and the thing is, a lot of trade-based businesses wouldn't pay themselves $80,000. They don't. They pay themselves closer to 50 to 60 Max. Trudi Cowan: I think it's really important to include your wage. Sarah Eifermann: living wage Trudi Cowan: In this analysis and look, I put 80,000 but most traders would probably be wanting to earn more than that. Sarah Eifermann: Correct,so this comes back then to the analysis of do you work for yourself? Or do you work for somebody else? yes Trudi Cowan: So you might do this analysis and go now I'm going to put the wages in, that I want to earn and then work out the break-even point that gets you to earn the wages that you want to earn. Rather than the other one is,[cross talk 20:26] living wage to get[unintelligible 20:27] and then everything on top of that is gravy. Sarah Eifermann: The other thing that you can look at this as, Okay, I want to make more money off the jobs that I'm doing. Therefore, I need to be more efficient in the jobs that I'm doing, we need to try where possible to reduce our materials bill, reduce our contractor's price, reduce our direct wages for the job. So you need to get faster and more efficient on-site or you to need to find a way to lower your rubbish removal costs. Sarah Eifermann: We did have a client Trudi Cowan: We did, a few days ago, Trudi Cowan: I was thinking the same example that their rubbish removal costs were going through the roof because they were having to pay for skips,so they changed the narrative and went and bought a truck that do the removal themselves,and then they only just had to pay for the landfill feature. Sarah Eifermann: Yes and their truck payments Trudi Cowan: But on a long term basis, it was worth it. Sarah Eifermann: I think they more than half and got an asset Trudi Cowan: Got an asset. Exactly. Right. Sarah Eifermann: So their job was more efficient because they weren't stuck waiting for the skip, to be dropped and collected. They could do their jobs as needed, so that in itself meant at the end of the day, more profit. Trudi Cowan: Yes and this analysis can put focus on that as well and make it nice. Am I spending that much money on contractors per job? Why am I spending that much money on contractors per job? Maybe I'm better off just hiring another guy. Sarah Eifermann: Yes on wages. Trudi Cowan: Who I've then got available to me all the time. Or it might be the flip? Why am I paying so many wages to these guys, when they sit around a bit? Maybe I don't need them all and I'm better off just getting in a contractor as I need to fill in the gaps. Sarah Eifermann: Correct. We all know the staff is a really hard thing. Trudi Cowan: It's a very hard thing and it's hard to get the balance, right? Sarah Eifermann: I don't even think it matters at the moment, whether you're in construction, or whether you're in hospitality, like whether you're looking for an admin assistant, or whether you're looking for someone who works labor-intensive. Staffing is a big problem right now and it needs to be front of mind for everybody to stay on top of these costs because the costs are blowing out. I had an example the other day where the client employed somebody, set their price, they started work, they decided they wanted to be paid more. Trudi Cowan: It's changing so quickly. Sarah Eifermann: It's changing so quickly because getting the staff is hard. So he had to come to me to ask whether or not they could afford to do it. I was like, we're working on him being able to look at this and go, that's what that's going to do to my job. Yes, I can afford it because of the long-term benefits or no, I can't afford it and I need to let him go and find somebody to replace him. So many things, this break-even analysis gives you real clarity on, I think that's perhaps what I love about it the most, is the clarity that comes from that contribution margin because it then means that your profit, your net profit is a true net profit, because it's included all the other expenses in your calculations, and you know where you stand and again we say it a lot business owners don't pay themselves wages, because they don't have the money to pay themselves the wages. Trudi Cowan: Yes. Sarah Eifermann: But if you're like, there's an element that you sacrifice a lot to be a business owner and it's so true. Trudi Cowan: If you are paying yourself wages, What are you doing it for? Sarah Eifermann: Exactly. Have you got any other comments to make on contribution margin or your prices or break even? Trudi Cowan: If your contribution margin comes out as negative then you need to either consider, is the sale price high enough or why my fixed costs so high? Sarah Eifermann: Okay, so remembering that contribution margin again, is the total cost per unit of your fixed costs. Trudi Cowan: Yes so if it's negative, you're saying your sale price is not covering any of your fixed costs. I would be willing to bet there would be some businesses around that is either negative or very close to, such that the sale price is not right. Sarah Eifermann: Which means you're also trading in sovereignly. We've talked about this before, which means should you even be trading at all? And then can you increase your prices? Will the market allow it? If you haven't done In your research upfront to price your product or service correctly in the first place, you may not have any room to move to charge more to cover those fixed costs and if you can't reduce the fixed costs, you're screwed. Trudi Cowan: So again, a really good analysis to do whether you're starting your business, Sarah Eifermann: As projections Trudi Cowan: Growing your business or in a well-established portion of your business, I can provide some various insights around both your expenses and your pricing of all your products and services. Sarah Eifermann: Yes, I'm sure all your minds have been blown today, because the first time I learned about break-even analysis, it blew my mind. I was doing this innately. But I couldn't tell you how I was doing it. The break-even analysis gives you the statistical figures that cement your ability to then make decisions and that's so important as well. So if you go to our website under this episode, if you're listening on your phone, on the podcast, Apple podcasts, or on Spotify, jumped to www.financialfofu.com or scroll to the latest episode and our example will be up there as a spreadsheet that you can play with to plug your figures into it and see how you go, I'd love to hear back from you as to whether it is what you thought it was going to be and what needs to either stay the same or change. Trudi Cowan: Even this has been a catalyst for change.[inaudible 26:33] Sarah Eifermann: Yes, amazing right? Next week, we're talking about how to price your product or service, so if you are following along with us each week, go and do the break-even analysis. Trudi Cowan: Definitely. Sarah Eifermann: We head straight into next week's episode. So we will see you then. Trudi Cowan: Bye. Sarah Eifermann: Bye. Announcer: Thanks for listening to this week's episode of Financial FOFU. We appreciate you tuning in and hope that you have subscribed to our channel. I just wanted to let you all know that the information and material in our podcast, any supplementary and associated information available is for general purposes only. It should not be taken as constituting professional advice from us, the podcast owners, and our special guests and we recommend that you seek independent suitable advice that is specific for your unique circumstances. Thanks for tuning in. Hope to see you next week. Please use our link and send us any requests or feedback. We'd appreciate it. Cheers

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DISCLAIMER- The information and material in this podcast, and supplementary and associated information available, is for general information only. It should not be taken as constituting professional advice from the podcast owners, and we recommend you seek independent suitable advice that is specific to your unique circumstances.