How to Calculate Break Even Point, Gross Profit and Net Profit
The thing that scares me the most about the idea of starting a business — I mean wake-up-sweating-with-visions-of-the-zombie-apocalypse terrified — is managing the financial side of things.
A lot of business owners run into issues keeping track of the numbers. It takes a lot of work, it’s complex, and we’d all rather focus on what our business does instead of the minutia of running it.
Even if you’re a numbers whiz, keeping track of the accounting can be a daunting task. And if you want to sell your business one day, you need to have your financial house in order so that you have the proof you need to support your asking price.
You need to be able to show your costs, your profits, and if your business has reached the break-even point.
Buyers are going to ask questions; if you don’t have good information to show them, you’re not going to get the offers you expect or need.
Let’s talk about how you can stay on top of all the number stuff so you can get the best offer on your business if you decide to sell.
What Do You Need to Know?
The most important numbers for your business are how much you’re spending and how much you’re making.
It’s important to know these numbers when you get ready to sell because these are two key data points your potential buyer will be interested in, but knowing them is also critical to operating your business at peak efficiency.
For instance, if you want to hire new employees or expand your offerings, you need to know how much you can afford in new overhead or at what level you need to price your new product or service.
But since nothing is ever quite that easy (and with apologies to those who are about to have Econ for Poets flashbacks), let’s get a little Business Financials 101 here.
Here are a few terms you need to know to manage your financials.
Costs: this one is pretty self-explanatory. These are what you spend to make your product or provide your service. It’s anything that goes out of the business.
Costs include things like equipment, salaries, rent, other overhead, and the resources you need to make that specific product or provide that specific service.
For example, if you own a drop-shipping business, your costs will include the development and maintenance of a website and maybe customer service staff. If you’re going to start a business as a virtual assistant, you’ll have costs associated with marketing your service and the equipment you’ll need to provide the service (which could vary depending on who your clients are).
Gross profit: your total revenue (equivalent to total sales) minus the cost of goods sold.
If you take your profit and subtract the costs of making your goods or providing your service, what you have left over is the gross profit.
If your dropshipping business costs $500 a month to run, and you take in $1000, you’ve made $500.
But because it can’t be that easy (again, right?) there’s your gross profit, and then there’s your actual profit.
Net profit: the actual profit after paying all other expenses not included in the calculation of gross profit.
In other words, Susan spends $100 to make a widget that she sells for $150. Her gross profit on that one widget is $50. But… she also has expenses for things that aren’t directly used to make that widget, like marketing and budget-tracking software. So if she adds up all the widget expenses and subtracts them from the amount she made selling all the widgets, then subtracts from that all these other expenses, that’s her net profit.
Your net profit is important because it helps you calculate the break-even point.
Break-even: the point where the profits are equal to the costs.
This concept is pretty easy to grok. It’s the point where the money you’re putting into the business equals the money coming out of the business. It’s a good point to be at because this is where you stop losing money.
It’s also the point where you have to work harder to actually turn a profit.
So to figure out the true break-even point, you have to consider both your gross profit and your net profit.
No wonder Susan is looking for free budget-tracking software.
What are Some Apps That Can Help You Track These Things?
Yes, there is an app for that.
Look, keeping track of your books is like keeping track of your time. If you don’t know where you’re spending, you probably don’t have a good handle on your business. And that means you’re probably losing money.
No one wants that.
Keeping your books isn’t hard, even if you’re math-challenged and number-shy. Here’s a good, recent round-up of some of the tools you can use to help track your financials.
Some of these work better for freelancers, some are designed for any type of small business, and some of them can scale up.
Some of them, like Zipbooks and Wave, offer free accounting software for tasks like basic bookkeeping and invoicing, and let you then step up to paying for services like handling payroll and more advanced accounting.
Find a financial app that works for you and put the time into keeping things in order. It’s worth it; your business will run better, and when you’re ready to sell it, you’ll be ahead of the game.
When You’re Ready to Sell
Keeping your books in order is a good rule of thumb for your business regardless of whether you’re going to sell it or not. But when you get ready to sell, it is absolutely, positively critical.
Your main goal in selling your business is to get the best deal possible for you, which generally means the best price. To do that, you need to have accurate numbers that show how your business is doing.
If your books aren’t in a state where potential buyers can tell what they’re getting, you’re not going to have an actual buyer. You want to make sure that what potential buyers see on the books is the real value of the business — the real costs and the real profits.
One way to do that is to make sure that you’ve considered add-backs.
An add-back, according to the Oxford Dictionary, is defined as the “adjustment of net income through addition or deduction of items not affecting working capital; an item thus added or deducted.”
Yeah, that clears it up.
Okay, let’s try this explanation. When you are calculating your break-even point and you look at your gross profit and net profit, your net profit is a more accurate representation of what you are actually making from the business.
But you may also choose to deduct other expenses from your net profit. For example, you may have one-time expenses that aren’t figured in your normal calculations, like a business trip where your family accompanied you and the business paid for it.
If you are the sole owner of your business, you may choose to pay yourself a salary or cover other personal expenses, like travel, with your profit.
If you consider these kinds of expenses in your gross profit calculations, your books might look like you have a lower income (or profit) each year than you actually do, because you’re basically using your business as a source of funding for things that you would pay for with a salary if you worked for someone else.
Because it’s your business and your profit — as long as you’re covering all other necessary business expenses and correctly reporting your taxes — you can do that.
But it also means it will look like your business has a lower net profit than what it is actually earning.
When you get ready to sell, you want that profit/income line to be as high as possible in order to get a better price for your business.
So you add back these expenses to your accounting in order to show the business’s real net profit. Otherwise, the potential buyer looks at the reported net income as the value of the business and sees a lower figure than what you actually made running the business.
For example, Susan figures that her gross profit for 100 widgets is $5000, but her net profit is $4000. She then decides to pay herself a salary of $1000 and cover $1000 in travel to a trade show where she networks but also takes vacation. Because those costs are accounted for in the financial reporting, since the money is taken out of the business, it looks like the net profit is $2000. So she creates an accounting column for add-backs and shows those numbers in that space.
A note of caution: don’t add things back that aren’t legit expenses. Here’s a good description of how to sort your add-backs, but, as always, consult an expert if you’re not sure.
Math is Good for the Soul… and the Bottom Line
Taking the time to keep your financial house in order is good for you and good for your business.
When you know exactly what your costs and profits are and what your break-even point is, you are in a better place to both run your business and to sell it.
It doesn’t have to be scary — there are tools to help you — but if you want the best price for your business, it’s something you have to do.
Photo credit: galdzer