How to Use Break-Even Analysis to Make Better Business Decisions

The quest for independence exists in so many of us. Many of us aspire to be independent financially, and of bosses. A fraction of us then brave it, and start our own businesses where we mean and hope to assert our value for independence.

Any answer to this question is correct depending on who you are, or what industry you are in. However, when we skew the data to ambitious entrepreneurs, we learn that results tend to confirm that running a start-up is more difficult than keeping a job.

Being an entrepreneur isn't ez. Wearing so many hats just to make it. pic.twitter.com/L0RP8DLrBJ

— Tim (@ATRgod) October 26, 2016

There is stability and a lot of predictability when it comes to a job. The opposite is true when it comes to running a start-up business. So many disruptions to routines, and things coming at you from many directions. One article by Entrepreneur.com once put this in perfect perspective – an entrepreneur has to wear many hats to make sure the business survives. That can be a lot of work.

Michael E. Gerber, in the bestseller, The E-Myth Revisited shows how the general perspective that ‘entrepreneurship is owning a job without a boss, and getting as much money as possible’ is a myth. According to Gerber, this myth is so widespread it’s like a pandemic.

The Problem

One of the major challenges in entrepreneurship is profit maximisation to encourage expansion and growth.

Many start-ups make sales whose revenue is not enough to meet just the recurring expenses to keep the business afloat. We’re talking costs such as rent, salaries, purchases and others like stationery and advertising. Some, of course, manage to meet their expenses however they never seem to realise profits.

All businesses go through these phases.

The issue is predictability and managing the phases. A well-meaning ambitious entrepreneur is going to want to set a period to assess their business and see whether it is achieving its primary goals or not. Some give their business ventures five years, others two, others 10, and others 20 years. I learnt that SpaceX took more than 10 years before it started making profits.

The Value of Break-Even Analysis

Most of us give our ventures two to five years. In that period, you expect your business to start with losses, but soon enough you should break-even, the move over to profitability so that you can start expanding.

It can help if any of these stages are predictable. Like, if you knew what you needed to do to start making profits, or how many units you needed to make to break even.

Once you know how many units you need to break even, you are equipped with decision-making information. Some of the decisions include;

1. Keeping or closing the business.
2. Making or buying the goods you’re selling
3. Subcontracting or producing certain components
4. Subcontracting some of the services or parts of your business.
5. How to make profits much sooner with much fewer units than what your calculations show you?

This article addresses most options but mostly focuses on the last question.

Let me put this into perspective.

How Break-Even Analysis Helps In Identifying The Problem

Once, in one of my prospective business ventures, I learnt that I needed to sell 140 units to break even. This doesn’t sound so bad until you learn what was our full capacity. We could only produce 150 units if we used all our resources efficiently.

That means, if we reached full capacity, revenue from only 10 units out of 150 units would be considered profit. This profit expressed as a percentage of sales would be a mere 6.7%. That is way below the standard margin of at least 25% in the industry we were in.

At this point, you’re faced with the decision of whether to keep or close the business. The first question on our list of common questions entrepreneurs asks themselves.

In my case, I chose to keep the business, so I had to face the question: How do I make profits much sooner with much fewer units than what your calculations show you? This is the last question on our list of common questions entrepreneurs ask themselves in the entrepreneurial journey.

I had 2 answers:

1. Increase selling price, thereby increasing sales revenue, or
2. Streamline costs, especially fixed costs, thereby lowering Total Costs.

Let us evaluate the options;

Solutions

Lower Fixed Costs

By lowering fixed costs, you thus lower total costs. Why don’t we just say ‘Lower total costs then?’ instead of targeting fixed costs.

Fixed costs are those costs that remain constant with changes in output in the short-run, like a year or so. These costs do not change even when your units produced increase. Fixed costs are also known as indirect costs or overheads. They include rent, indirect electricity costs, and supervisors’ salaries among others.

Variable costs, also known as direct costs, are costs that change with output. That means variable costs increase as units produced increase. We’re talking about costs such as direct labour, direct electricity, cost of raw materials and related.

Total costs are the sum of fixed costs and variable costs. To ensure that the quality of goods is not compromised, you don’t ever want to lower variable costs. Rarely can you do that without either compromising quality or the break-even output. You don’t want that.

However it is quite practical to say, cut supervisors’ salaries or lower your indirect electricity. One way of cutting supervisors’ salaries is by laying off some of the supervisors or giving them more rest periods. You can also lower electricity costs by ensuring that appliances are switched off when not in use, especially at night when you leave the office.

In addition, you can lower your rentals. Oftentimes, start-ups want to be as fancy with top-of-the-range office space and equipment which they don’t very much need, but just want. Calculating and evaluating your options you may find you’ll be okay working from your home or a car, or a much smaller facility or, much away from the CBD – city centre, where rentals tend to be much lower.

Lowering your rent can just be all the adjustment you need to start making profits with much less output. That could even mean a higher profit margin. For instance, in my case, I found if we used a partner’s home we could cut our total costs by 40% translating to a break-even output of 100 units. Ultimately making a profit margin of about 50%.

It should be noted that streamlining costs is not a paradox of excellency. It comes with its drawbacks.

For instance, cutting supervisors’ salaries can be detrimental to your main objective of doing it. Salaries, according to American Psychologist and business management expert, Frederick I. Herzberg in his renowned 2 Factor Management Theory, salary is a demotivator factor. Salaries are hygienic factors. The presence of a salary doesn’t necessarily motivate workers, but its absence and wreak havoc in a stable company. That shows that the idea of cutting salaries is not such a great idea.

As if that’s not enough, you’ll find laying off can have the same effect or more. When others are laid off, it threatens job security for those who are remaining. Like salaries, job security is a hygienic factor in management. Therefore, you don’t want to temper with it too. Well, as long as you have other better options anyway.

So, you may be left with only lowering rent. Let’s note how that isn’t as perfect a solution as well, considering how your premises must be accessible, and cater for your needs and all. So, somehow if all this is not attended to, you may find yourself grappling for sales.

I found that the easy and practical one is increasing sales revenue.

Increasing the Price

By increasing your selling price, you can expect to see your sales revenue increase. Ultimately, the units you need to start making profits will be less. This is very good because you get to expand your portion of profits in relation to your sales.

Increasing the selling price comes with quite a number of side benefits, besides bringing your break-even output to a much lower volume.

Benefits of Price Increase

Quality Appeal

We tend to associate high prices with high quality. So, if your products or services are being offered at a much higher price, you tend to be perceived as offering high quality. And, that is great because you attract a niche, a small group of customers who are usually decided about getting your product/service. This group tends to see and get meaningful value from what you’re offering. Their potential for satisfaction tends to be much higher which naturally tends to lead to…

Customer Retention

With high prices, we tend to retain more clients than our low-pricing counterparts.

Have you noticed that oftentimes, when a service is low-priced, more people try it? This, more than they do with the same service when high-priced. This is because, among other things, the buyer can afford more of the same at a lower price, and also the fact that the risk of loss is lower when the price is lower.

This is usually the benefit of selling a product or service at a lower price. In this case, it is a disadvantage. How? Customer retention can be very low. That’s why you need to offer your products/service at a higher price.

At higher prices, customers make sure they know everything they need to know. The risk is higher. So they have to be as informed as possible. When they knock on your door, they’re usually decided. Thus, once the sale is closed, they’re yours. We’re talking recurring revenue. That is good because now, there’s some stability. The chance of them leaving is quite low. Hence you get to keep as many of your customers as possible, than having to lose and get new customers every day.

Why is Customer Retention so Important?

Because the cost of acquiring new customers is much higher than the cost of keeping existing customers. In any business actually. I mean, any business that means to grow, and scale well.

To add, new customers, are more likely to bring with them a lot of strain as they’re not accustomed to how you operate. The cost of converting them to returning customers will be much higher than the cost of keeping already existing clients. I mean, you have to work on educating them, not to mention the cost of the much-needed customer support.

So, to break even with much less output, increase the price as it comes with more benefits than drawbacks.

Cover Promotional & Distribution Expenses

A higher price will mean more revenue which will mean the financial muscles to actually attend to the much-needed-often-neglected aspect of a startup – promotion and distribution.

We’ve found that a startup that mean business spends an average range of $30,000 to $750,000 in promotion and distribution expenses. This includes digital marketing, content marketing, and ad placement on social media, newspapers, radio, TV, etc.

For a startup that is ambitious, which all businesses must; this budget is not a nice-to-have, it is a must-have.

If ever you mean to get funding, especially in the form of investors, which I think all of us do, you’ll need to get and compile data that is proof of growing sales. That speaks to the much-needed potential of your product/service. Growing sales. This is achieved in a practical sense, by a high promotion and distribution budget. This should then explain why a higher price, besides helping to lower break-even output, is good for business sense.

However, like the previous option – lower fixed costs – increasing the selling price is not a paradox of excellence. There’s a downside to increasing your prices. Your prospective clients may not be so eager to consider your services, and the current clients may also exit, eventually causing your profits and revenue to be low.

So, what can you do?

Intensify your marketing effort.

That is the surest way to make price increases practical. If you intensify your marketing, say reaching 100,000 people within your targeted group, you’re likely to generate potential customers from 10% of the people reached, meaning you can get 10,000 people interested.

As you nurture these leads, – potential clients, continuously through your aggressive marketing strategy, you can expect about 10% of the leads to enquire. That is about 1,000. 10% of this may actually buy being 100. That is not so bad.

Some expert in marketing, one that I respect very much, once said, “Life, is a numbers game.” This means, in a case like this, if you need to record 500 sales, you know you need to intensify your marketing so that you reach 500,000 people. And all this is attainable with the right marketing strategy and execution.

Reminder: Influence ZW is a marketing agency, we can help you chart a more sure course in planning and launching an aggressive marketing campaign for your brand. Here is our services page.

Conclusion

Startups are a headache, and entrepreneurship is a whole extreme sport. So many questions, so few practical answers. To get profitable with few units, – break even – you’ll need to consider either lowering fixed costs or increasing the selling price. While each of these two options has its merits, they each have drawbacks. Conclusively, I recommend increasing prices and then launching an aggressive marketing campaign.

Let me know if you have any questions so we can further clarify and discuss.

More: you may have contributions to or against any or all of this, feel free to reach out via email at hello@influencezw.com or join our WhatsApp group.

On another note, as you read and studied through this post you may have come to a point where you thought, “I need to draw my plans so I can have such a clear view of things so I can make informed decisions.”

You’ll need either a detailed business plan, a detailed financial plan or a marketing plan. You may even want a business development coach to help you set up your startup for sustainable growth and profitability. I can help with that. Visit my catalogue /services section on my personal Facebook page. Or contact us.