The Bottom Line: The Breakeven Point

It's widely held in business circles that "what gets measured gets done," which is very unfortunate since most firms tend to measure the wrong things!

In Step 6, I want to focus on one particularly misleading measure, the favorite of bankers everywhere—the breakeven point.

For decades, I've been involved in small businesses in varying capacities and throughout that time, bankers, investors, even company owners, have continuously left the impression that breaking even is a good thing. I suppose the logic behind that belief is that it's better than failing. And, while that may be true, it is also a long way from succeeding. Hanging around the breakeven point month after month, year after year (like so many businesses do) puts an organization in a state of limbo and often encourages bad decisions.

The problem with developing a breakeven point for a small business is that many of the key variables can be adjusted to the detriment of the owners. This is particularly tempting if the breakeven point itself becomes the goal rather than simply one of a variety of measures by which a profitable firm is built.

Let's first take a look at the components of a simple breakeven formula. The breakeven point of any business is where total revenue (sales) equals total costs. That's not exactly rocket science, is it?

However, it does get a bit trickier, particularly when we realize that total costs come in two distinct types—fixed and variable. And, for those of you suddenly nodding off because you think an accounting lecture is about to follow, let me warn you that a basic understanding of the difference between fixed and variable costs is crucial to building a successful small business, including a successful A&D firm.

Variable costs are those that are incurred only if and when the sales that drive them occur. Selling products would be an obvious example where you wouldn't deduct the cost of that product (cost of goods sold) on your income statement until you had also shown the revenue. This gets a bit murkier when, for example, you're trying to decide if the wages of those billing their time are fixed or variable costs, but for now, let's focus on the obvious ones.

The place where breakeven analysis does the most harm is when considering fixed costs—those costs that recur each month regardless of the level of sales. These typically take the form of payroll (that's not commission based), rent, utilities, insurance, etc. These are also commonly referred to as overhead.

Now, let me add one more factor, and then I think I can wrap up the case for when breaking even is bad: Breakeven analysis is almost always used for projections.

Combine these two things—projecting the future, yet wanting to reach or exceed breakeven, and the temptation to cut fixed costs, since lowering fixed costs would also lower total costs, which by definition, lowers the breakeven point. Sure, we could also increase sales, but that form of optimism is often viewed more skeptically by bankers and others while cutting costs means dealing with something that is already in place and something that could affect the bottom line almost immediately.

So what fixed costs get cut? Well, often the owner's wages are held down in lieu of bonuses should everything miraculously work out at the end of the year. Other employees may go without raises. The rent may stay artificially low, perhaps cramming too many people into an old building in lieu of the increased productivity a new one could provide. You may go without insurance that could save your business in the future. You may cut back on travel and entertainment, education and marketing, etc.

In other words, by trying to project a breakeven point, the natural tendency is to starve the business on multiple levels in a way that is certain to harm, not help your growth potential.

The solution is to build your breakeven model from the expense side, but only by projecting the expenses that acquire the image, work environment, and even lifestyle that you truly want. After all, they're just projections!

Add in a fair market wage for yourself and bonuses for your key employees. Adjust the rent to include that office with a view you've been dreaming about as well as the company cars you've considered. Get the right phone and computer systems, the right software … add in everything that you believe would make your company great.

Then, when you begin working the sales side of the equation, you will not only be able to easily calculate how many hours or jobs you need to bill to reach your goal, but you will have much greater incentive to do so.

Lastly, be sure to add a level of retained earnings you want to keep in the business to keep your furniture, fixtures and infrastructure up to date, and a level of "excess cash" you want to take out of the business to build a safety net for yourself.

As described in Step 6 of Your Business or Your Life: 8 Steps For Getting All You Want Out of BOTH, performing the right analysis will give you the ability to not just break even, but to truly break out!

In the next issue of Interiors & Sources, I'll discuss the creation of a management "dashboard" (Step 7) that measures the relatively few key success factors that will help separate you from the pack.