Understanding your financials (Part 1) – What is your business’ break-even point?

Money is better than poverty, if only for financial reasons.
- Woody Allen -

Poor Mr. Joe, he really tried very hard to make a living. Mr. Joe opened his pizzeria few years ago, he was excited and enthusiastic, people told him opening a pizzeria is a sure thing, Joe thought of all the money he is going to make. He rented a nice place a few blocks away from my store. He bought (on credit) a great brick oven. He bought (on credit) Italian silverware. Mr. Joe contracted a few suppliers for dough, cheese and a tomato sauce distributor and paid them upfront. And one Friday evening, he hung a big sign in front of his store – “Grand Opening”.

That night, he got his first few customers and then a few more, and at the end of the month his business made money, yea! Real money, but for some reason, after paying his rent, his vendors and the various credit cards and loans, he needed more money. So he took another business loan.

Customers kept on coming, not a lot but a steady flow. Another month past, Mr. Joe went to his bookkeeper with his financial information, and after entering all the information into the accounting system, the bookkeeper told Mr. Joe – “you made money!” Mr. Joe was happy but then the bookkeeper told him “but you are still short in paying your vendors, loans, credit cards, rent and your utilities. You will need to put a bit more money into your business”.

So, Mr. Joe went to a few friends who gave him money, “hey, a pizzeria is a sure thing, right? Seriously, right?”

But, the same thing happened again month after month. Mr. Joe grew desperate, and he went to see a young friend of his who was a business consultant (and not a great one if I may add). His friend told him “ah, this is an easy problem, all you need is more revenue, you need more clients, and I have a great solution for you”. At that point Mr. Joe should have run away, but he was excited, you know, pizzeria is a sure thing. So he did as the young man recommended. The infamous “all you can eat for $3.99” sign went up in front of his store the same night.

Mr. Joe got his wish! A lot more customers showed up. Mr. Joe served so many pizza slices, garlic knots, and pastas. He was so busy he skipped his monthly meeting with his bookkeeper. And one day the bank called, now he owed a lot of money, his checks bounced, Mr. Joe did not understand. The bank took his business away from him. Mr. Joe’s next sign said “Out of Business”.

Charlie looked very sad when he first heard me sharing Mr. Joe’s story. He shook his head and mumbled, “Without knowing your break-even point, the only thing that will be broken will be your business”.

I remember asking Charlie, “What do you mean by knowing your break-even point?” For business owners and people who know the meaning of the Break-Even point, the question may sound silly. For me on the other hand, this is one of the most important questions I have asked Charlie. Understanding the answer to this question is a key to ensure your business success.

Let me try to explain in simple terms what Charlie said in his more academic way. You know Charlie; he always loves using those big words :-)

A Break-Even point is the point at which the money you pay out (your business expenses) equal to the amount of money which your business received from its clients. So your business costs and revenue are equal, or it is the point your business “broke even”.

If you consistently do not meet your break-even point, your business will end up like Mr. Joe’s pizzeria. Understanding your break-even point is very important if you want to be successful, and who does not want to be successful…

Let me give you a simple example. Assume you and your friend Jenny (everyone should have a friend name Jenny!) decided to start a Lemonade Stand empire. You & Jenny borrow $10 from your mom, and use it to buy a nice Lemonade Stand (it is really just an old table).

You and Jenny then each take $5 from your allowances and use the combined $10 to buy:
• 40 lemons for $4
• 100 plastic cups for $5
• A pound of sugar for $1

Your mom is very nice to let you use the juicer and the tap water for free. As you know, nothing is free in life, you (and Jenny) promised to keep your rooms clean for the next 6 months.

You and Jenny are smart kids, of course you are, and you decided to calculate your cost of making one cup of lemonade. You know that in order to make a jug of lemonade, you need 20 lemons and a cup of sugar. Each jug of lemonade can fill 10 cups of tasty lemonade.

You and Jenny are excited, and slowly write in your yellow notepad the cost of making one lemonade jug:
• 20 lemons cost $2
• 10 plastic cups cost $0.50
• A cup of sugar cost $0.10 (assuming one pound of sugar can fill 10 cups)

So the cost of making a lemonade jug is $2.60, and if each lemonade jug can serve 10 cups, the cost of each cup of lemonade is $0.26.

You and Jenny smile, it is great, you are both yelling together “our break-even point is $0.26”. I told you that you both are smart kids. You think out loud, “if we sell one cup for any amount greater than $0.26 we will be profitable (you really did not use this word, but you still were very happy).”

This happiness lasted exactly 2 minutes. Your mom, who owns a fancy accounting firm, came up hearing your cheers. Excitedly you showed all your calculation to your mom, who was very impressed. Jenny was beaming with happiness, and you said “mom, we are going to be rich, all we need to do is to sell our lemonade cups for more than $0.26 and we will have money left after paying off the cost of making the lemonade. $0.26 is our break-even point!”

What do you think? Are you missing anything?

Mom smiled and said, it is all good but what about the $10 you still owe me? You and Jenny look at each other, smiles are gone…

Mom is right, aren’t they always? You and Jenny calculated the cost to make a cup of lemonade. However, every business incurs costs which must be paid for regardless if a customer bought a single product or service. Such costs are called “fixed costs” and they can be your monthly rent, insurance policy or even your lemonade stand.

Break-even point should include all the costs your business incurs, both the fixed costs (your lemonade stand) and your variable costs (cost of making your product, your lemonade).

I have to go and prepare for my next profitable day at the store. I will explain more about fixed and variable costs in the next blog (end of the month), But before I’ll start my day, let me ask you two very important questions:

Question: How do you calculate your break-even point? What information do you need in order to calculate your break-even point?

I would love to hear back from you. You can leave a comment by clicking here.

Liz (A lover of Lemonade)

About the Author: Liz
SWEETNESS COMES FROM THE HEART

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