I woke up recently to a wise tweet from an amazing entrepreneur, Norm Brodsky:
When you are starting your #business the most important questions are 1. what’s (yo)ur break even point 2. how will you get there
Great point. Unfortunately, entrepreneurs who can answer this question are few and far between. That’s because there are few accounting teams that understand its importance – so they opt to deliver the same old boring profit and loss statement (P&L) instead.
Here’s an example of a break even point report for, let’s say, the month of May 2012. It is generated from the same set of data as your profit and loss statement, so some numbers on here should look familiar.
Revenue equals total revenue on your P&L (your top line.) On this graph, the revenue is represented by the green line going from $0 (sad) to $a lot (yay!) The green dot is where the actual revenue for the month is, at $71,005.
What’s different here is that all of the expenses are gathered to one of two numbers:
- Fixed Costs: Money that you will spend even if you sold $0 in services. Typical fixed costs are things like office rent, loan payments, software subscriptions, salaries, etc. See the horizontal grey line on the bottom of the chart? That’s the fixed costs line at $26,682.
- Variable Costs: Money that you spend when you sell services. Things like sub-contractor payments, purchases on behalf of the clients, data/software subscriptions used for clients, etc. See the red line? That’s the projected (assumed) variable expenses at different level of revenue. Unlike the fixed costs that stay, well, fixed. The variable costs increases as you sell more. The red dot is where it actually is for this month – at $16,868 + fixed costs of $26,682 = total expense of $45,550.
Finally, the third dot (and most important for the purpose of this post) is the grey dot where the green (revenue) and red (variable costs) lines meet. That’s our break-even point, or the minimum dollar amount you have to sell to not lose money for the month. In this case, that number is $37,619.
The green triangle formed from the three dots is the “margin of safety.” It is basically where we can be and still be okay (profitable). In this example, the safety zone is $33,386, which means I could theoretically sell that amount less than what I actually sold and still be profitable. But, as an entrepreneur, I am much more interested in moving towards the right side of that triangle.
There you have it – the most important number in your business. I hope this post had been helpful to all of the entrepreneurs who read it. Post any comments and questions below, and let’s get a dialogue going.
W. Michael Hsu is the founder and CEO of DeepSky, a company that acts as the in-house accounting department for one to ten million-dollar service companies. With knowledgeable accountants, best practice processes, and carefully selected technology, DeepSky helps entrepreneurs obtain, understand, and then internalize critical business numbers to help move the needle.