Why Break-Even and Contribution Margin Matter for Your Retail Business
To prepare for next week’s live webinar session on succession planning, I am discussing how to better understand and manage your business’s finances.
If you are running a retail business, you probably want to know how much profit you are making and how to increase it. One way to do that is to understand the concepts of break-even and contribution margin. These concepts can help you measure your business performance, plan your budget, and make strategic decisions.
What is Break-Even?
Break-even is the point where your total revenue equals your total cost. At this point, you are not making any profit or loss. You are just covering your expenses. To calculate your break-even point, you need to know two things: your fixed cost and your variable cost.
Fixed cost is the cost that does not change with the level of output or sales. For example, rent, salaries, insurance, interest, and even balance sheet expenses like principal on debt.,etc.
Variable cost is the cost that changes with the level of output or sales. For example, merchandise purchases (cost of goods sold or cost of purchases), selling salaries, commissions, credit card fees, and marketing costs.
What is Contribution Margin?
Contribution margin is the money left over from revenue after covering all your variable costs. That money is used to pay your fixed expenses. Once you have covered your fixed expenses and variable expenses you are at break even. Here’s an example at break-even:
Revenue = 100 %
Cost of purchases 52%
Selling payroll 12%
Marketing 5%
Credit card fees 3%
Other variable expenses 1.5%
Total Variable expenses = 73.5% of revenue
That leaves 27.5% of revenue to cover fixed expenses. In other words, for every dollar, 73.5 cents goes to variable expenses and 26.5 cents goes to fixed expenses.
Your contribution margin is 100-variable expenses= 26.5%
If your volume is $1,000,000, then you have $265,000 to cover fixed expenses. (.265*1,000,000). If your fixed expenses are greater than $265, 000, you are not generating enough margin dollars to make money.
Let’s say through better managing expenses you can cut purchases and marketing by 1% each. That lowers your variable expenses to 71.5% and increases your contribution margin to 28.5%. You now have $285,000 to pay for your fixed expenses. (Rent, Insurance, interest, etc. as well as principal on debt.) If your fixed expenses are $285,000, then you are at break-even in this example.
How to Use Break-Even and Contribution Margin
Break-even and contribution margin can help you answer some important questions about your business, such as:
How much revenue do you need to generate to break even or make a certain profit?
Once you hit your break-even volume, you are covering your fixed costs and all revenue beyond the break-even volume, less your variable costs, becomes your profit. (Said differently, the profit contribution from your sales in this case is sufficient to pay for your fixed costs – that’s why we call it contribution margin. It’s the margin you generate that contributes to paying for your fixed costs.)
If your contribution margin is 28.5%, then you make 28.5 cents on every dollar of revenue over your breakeven.
The sooner in the year you hit break-even the earlier you can build cash profit.
Managing initial markup, understanding your variable expenses, and uncovering ways to lower your fixed expenses are all strategies to achieve break-even earlier rather than later.
The quick formula for break-even is fixed costs as a dollar amount divided by your contribution margin.
Fixed costs = $260,000
Contribution margin = 28.5%
Break-even = 260,000/.285= $912,280
After you reach $912,280 in revenue you make 28.5 cents on every dollar and at a million dollars in revenue, your profit is:
· $1,000,000 - $912,280 = $87,720
· $87,720*.285 = $25,000 in profit.
Let’s say your contribution margin was 33% and you had the same fixed expenses.
$260,000/.33 = $787,878 is the new break-even, substantially lower as you can see.
At a million dollars in revenue, your profit is:
· $1,000,000 - $787,878 = $212,121
· $212,121*.33 = $70,000 in profit
In the above example on the same revenue, the profit potential is 179% greater just by increasing your contribution margin by 4.5 points.
Conclusion
Break-even and contribution margin are useful concepts that can help you understand your business performance and make better decisions. By knowing your break-even point, you can set your sales target and monitor your progress. By knowing your contribution margin, you can optimize your purchases, and manage your costs to maximize your profit. By using these concepts, you can improve your business efficiency and profitability. A good floor for a contribution margin for Indie Retailers is 33%.
If you have any questions or feedback, please let me know in the comments section below. Please contact Management One for a free break-even analysis.We are always happy to discuss your results and share solutions for you and your indie retail business.
Onwards, and Upwards,
Marc Weiss - Co-founder, Management One