Tuesday, August 11, 2009

Two Biggest Flaws with Break-Even

Most of the folks who read my blog know I write from the CFO and entrepreneur perspective on start-up, emerging, and medium-sized businesses.  This post will be no different, and its intent will be to clarify the two most significant flaws entrepreneurs, business owners, and CEOs experience when trying to understand their break-even point, both in terms of sales volume and units.

The traditional method for calculating break-even requires us to separate the fixed and variable costs.  These come from the profit & loss statement, or statement of operations.  Often a significant portion of the active owners' compensation, meaning the "wage" for their time and effort working in the business day-to-day and excluding profits and dividends, is pushed through the balance sheet for tax purposes.  Specifically, an S-corp often pays a reasonable salary to the owners to meet IRS requirements and also has a regularly scheduled distribution to make up the difference.

Here is an example.  Let's assume a business that is structured as an S-corp has one owner who requires $150,000/year to pay her bills and do the things she wants and needs to do.  She is advised by her tax advisor to only pay herself $90,000 as a salary.  This flows through the profit & loss and will be included in the break even analysis.  She is additionally advised to take the other $60,000 as a dividend to avoid unnecessary payroll taxes.  So she schedules a $5,000/month dividend to herself and counts on that not as a distribution of profit but as her regular and expected wage.  The challenge is that this $5,000/month flows through the balance sheet and is not part of the break-even calculation, even though it is, for all intents and purposes, just like a fixed cost.

The way to solve this is to add another $5,000 per month to the fixed cost total for running the firm each month.  This will being the break-even calculation to a more correct place.

Another fixed outflow of money that is often missed in the break-even calculation is reduction of the principal balance of outstanding notes and loans.  The interest portion of all debt payments shows up on the profit & loss and should be part of the fixed costs of the break-even calculation.  But the principal only flows through the balance sheet.

In some cases the amount of depreciation being recognized as a fixed cost is about equal to the principal reduction, but often it is not.  For example, a business that is paying an extra $3,000 per month towards one of their equipment loans.  The owner has set this as a requirement that the business must meet every month.  When this owner thinks about break-even, she is hoping that this extra $36,000 of principal reduction is considered.  In addition, she is also hoping the fixed dividend of $6,500 she takes every month from the company is included as well.

Hopefully you picked up on the place where break-even flaws occur - transactions that only hit the balance sheet.  In some ways, start-up, emerging, and medium-sized companies need to look very closely at both their operational break-even and their cash flow break-even to truly understand the minimum level of sales they can experience and still stay at a break-even from a profitability and a cash flow perspective.  Business finance textbooks teach only operational break-even and they fail to mention the inherent flaws to its calculation.

What good is knowing your break-even?  Besides the clarity and peace of mind it will bring, it can become essential in helping you price your products and services and help you refine your business model to its most efficient and effective state.  There is a power in being able to say: "We need to sell 100 units to break-even this month."