Tuesday, October 6, 2009

Throwing in the Towel & Breakeven Analysis

You wake up suddenly one morning and realize that your business is going under, and going under fast. What do you do? In some cases, owners become overwhelmed with current debt and in the end they are left with few if any options other than to throw in the towel. If they are lucky, they get to file for Chapter 11 or reorganization, but that is typically so expensive that only the lawyers win in that situation.

In a few cases, calculating your breakeven and then playing "what if'" games with the key ratios might help shed some light on your current perilous situation and it might suggest specific steps you can take to avoid bankruptcy.

Breakeven calculations are designed to estimate the current monthly (or annual) sales required in order to satisfy all of the company's monthly fixed and variable expenses. If your financial statements are properly organized, you should be able to conduct this analysis quickly.

(To download a sample of the Excel Spreadsheet go to my downloads Page)

Cost of goods (and those items listed beneath this heading) are almost always considered variable and are directly expressed as a percent of sales. You need to know what your current COG ratio is in order to calculate breakeven.

What about Overhead Expenses? Generally speaking, overhead expenses are considered fixed, and are usually expressed in raw dollars each month required to cover advertising, accounting, rent, etc. From a practical standpoint, you would not include depreciation as a monthly expense, BUT you would include all interest and note & loan payments, which would normally be found on your balance sheet.

What about payroll - is payroll treated as a variable (thus a percent) or do we treat it as a fixed expense, and thus as specific dollars required each month? I suggest treating it as a variable expense., because that is what it should be.

You need to know what your total current payroll ratio is, including all related payroll expenses such as taxes, fica, workman's comp, etc. Do you include a basic salary for yourself as well? Well, that depends upon the purpose of preparing this breakeven analysis. If you are trying to calculate the bare minimum montly sales required to pay all the bills but before you take out a salary then leave your salary out of the ratio. If, on the other hand, you require at least $3,000 per month to cover living expenses then make sure that $3,000 is included in your payroll percentage.

Here is a practical example of a real world company facing a crisis. This company is currently averaging $100,000 in monthly sales.

Monthly overhead costs (fixed) are $52,000 which includes $23,000 per month in loan and note payments. Monthly COG is running 25% which is excellent.

Monthly payroll, however, is terrible at 38%. So let's figure the breakeven sales for this company required to meet all of its fixed and variable expenses.

The basic formula is: Fixed Costs ($) + (Variable Costs * BE) = Breakeven (BE)

To solve the above, divide total Fixed Costs by (1-variable costs) to calculate Breakeven.

Note Payroll is 38% and COG is 25% for a total of 63%. Using our formula, we have the following:

$52,000/(1-.63) = $140,540

Note the breakeven is well above current sales level, and the company is losing buckets of money each month.

What happens if overhead $$$ remains the same, and COG remains at 25%, but we trim payroll costs from 38% to 28%? Let's re-figure:

$52,000/(1-.53) = $110,638

With that single change (not a painless one, but possible) this company only has to increase sales by $10,000 a month to meet all of its monthly obligations.

Now, recalculate again, and find a place to trim just $4,000 from overhead costs and the breakeven drops to $102,000.

Raise prices by 5% across the board and that automatically lowers the monthly COG by 1.2%, and a new breakeven for this company becomes $99,585.... In fact, the company might actually start producing a very modest profit with these new ratios.

Yes, I've thrown a lot of numbers around above, but a breakeven spreadsheet is easy to prepare and can be very useful for calculating the impact on future profits and sales when various changes are made to certain fixed and variable expenses. I will try, in the next day or two, to post a simple spreadsheet where you can plug-in your own numbers to see the impact of various changes on your overall profitability.
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