Determining your business’s break-even point: more than just a drop in the bucket
It all started with an Alberta family-owned trucking company that hauled frozen goods to cities across North America. They were consistently booking jobs and were experiencing success. However, as the business continued to grow, their finances began to slip. One month they would make $50,000 and the next they would lose $100,000. Revenue and profit would swing back and forth and they couldn’t determine where things were going wrong – how were their finances fluctuating this much? With the banks breathing down their necks, they were at a crossroads. They could either close their doors for good or find a way out of their predicament… fast. So, the owner decided to engage financial advisor, Brian McGill.
We sat down with Brian to discuss what his experience was like working with the trucking company and how he helped them stay in business by developing and implementing the “Bucket Method”.
Can you explain what the “Bucket Method” entails?
Financial statements and financial management can be an overwhelming challenge for business owners who don’t have a background in the field. I had to come at things from a different angle, and this is how the “Bucket Method” was born. It’s now my tried and true way of explaining a company’s break-even point, which is the point at which a company is earning enough income to offset all their expenses – there is no profit or loss. I fill up and empty out buckets to better illustrate complicated concepts such as variable and fixed costs, and contribution margins.
Why is knowing your business’s break-even point so important?
You’ve likely wondered what level of sales your company will need to profit. To be profitable, you have to understand how much product or service you need to sell (sales volume) in order to cover all your costs. Once you know your break-even point, any money you make above and beyond that point is pure profit. It’s particularly important for start-ups and small businesses because it helps them determine their initial sales goals. The problem is that it can be a bit more complicated than it seems to accurately figure this out.
What is the first step in determining your business’s break-even point?
At the heart of break-even point analysis is the relationship between revenues and expenses, and that starts with understanding your variable and fixed costs and the differences between them. Many businesses make the mistake of lumping these different expenses into the same category, which will create the wrong results, thus wrong decisions.
For the trucking company, we first determined what costs were ‘Variable’ in nature – costs that vary depending on the level of revenue. These included truck fuel, truck repairs, vehicle insurance, truck drivers’ wages, etc. If we did not drive the trucks, we would not have these variable costs.
Then we determined what costs were ‘Fixed’ in nature – costs that do not change as the level of revenue changes (up or down). These included management and office staff salaries, office supplies, loan payments, rent, etc. We then put all of these fixed costs into a separate “bucket”.
It was critical for us to understand the different variable and fixed costs in the trucking business.
How does determining fixed and variable costs affect your break-even point?
We looked at how much money was coming in from the company’s jobs (revenue), and how much remained once the variable costs were paid. The amount left over is known as the Contribution Margin – what the trucking company has left over to pay off the fixed costs or contribute into the fixed cost bucket.
For example, let’s say the fixed costs for operating the trucking company are $200,000 a month. If the company charges $200,000 for a job, and variable costs for a job are $100,000, they have $100,000 (or 50% of revenue) left over to cover the fixed costs in the bucket. Therefore, the trucking company would need to complete two jobs (earning $400,000 in total at a 50% contribution margin) in order to pay the variable costs on the jobs as well as have exactly enough left over to put into the bucket to cover the fixed costs and “break even”.
The higher the fixed costs for the business (ie: the larger the fixed cost bucket is), the higher the break-even point will be and the more products or services they need to sell. But even this can be managed.
How did all of this identification help the trucking company?
We figured out that their revenue per mile was, say, $1.50, but their variable cost per mile was, say, $2.00. Since their variable costs per mile were more than their revenue per mile, nothing was going into the bucket to cover fixed costs. In fact, things were getting worse.
However, we were looking at the company as a whole and ignoring its parts. Thus, we decided to divide North America into 13 geographical segments or lanes. We broke down each lane’s revenue and cost per mile to determine more specifically where the losses were happening. While it may seem obvious, it turned out the costs of driving throughout the mountains were higher than in the prairies because there were more hills, and jobs around Vancouver cost the company more because drivers were delayed by high traffic volume, and their hourly rate and fuel meant cost per mile was through the roof.
What changes did the company implement with this new information?
We found that some lanes had a positive contribution margin to the fixed cost bucket and others a negative effect. Now that they knew some jobs were costlier than others, the company was able to price jobs accordingly and unprofitable lanes were either priced to contribute margin to the bucket or the jobs declined. Further, it created healthy competition amongst the dispatchers to organize effective pick-up and delivery strategies within lanes. It also allowed the company to create bonus incentives to dispatchers and others based on their job pricing decisions and resulting contributions to the overall bucket. All of a sudden, the entire team was in the know and much more invested in the company’s performance and growth.
In addition, now that the trucking company knew their break-even point, they could look at their annual projections and determine at what point in the year they would theoretically begin earning pure profit.
All of this information allowed the company to make better, smarter decisions. They’re still in business today and continue to run a successful company.
If you want to learn more about how your break-even point is critical to your business, join Stawowski McGill at their upcoming Education Forum on Nov. 3, 2016, for a morning of lively discussions with fellow business owners. The forum will include an in-depth review of practical business examples and provide you with thorough calculations to ensure you leave with a firm grasp on how to apply the important principles that will take your business to the next level. For more information, visit our Education Forum event page.