Fixed Costs, Variable Costs, and Contribution Margin
Before we go full throttle though, let’s run through a quick recap of some important accounting concepts. This will help you make sure the numbers on your P&L we’re about to grab are categorized in the right “bucket”.
- Fixed Costs: This is another word for your overhead. Fixed costs are expenses that your business will incur even if you’re not working on any projects. For contractors, this means things like office rent, insurance, and equipment leases to name a few.
- Variable Costs: These costs fluctuate depending on the kind of projects you’ve got going on. Materials, subcontractor payments, and labor all fall under variable costs. Carefully tracking these variable costs along with your fixed costs will help you accurately calculate your profitability later.
- Revenue: The earned income your company makes from projects (this doesn’t include customer deposits).
- Contribution Margin: Your revenue minus your variable costs, or in other words, your gross profit percentage. This represents how much revenue contributes to covering your fixed costs and profit. To calculate this, divide your gross profit by your total income.
How to Find the Numbers You Need
Now it’s time to grab your P&L. Go ahead and put a star by these numbers:
- Total income (earned income)
- Gross profit
- Total expenses (fixed costs)
Heads Up: The “total expenses” line on your P&L will capture 99% of the picture we need for a break-even analysis. The other 1% we need to factor in here comes from the balance sheet. From the balance sheet, add:
- Whatever you’re paying in principal every month (if you’re paying off loans)
- The amount you take out of the business via an owner’s draw or disbursement
How to Calculate Your Break-Even Point
Once you’ve got these numbers on hand, you can figure out your break-even point. The formula for this is: Fixed Costs ÷ Contribution Margin.
So what could this look like for a construction company doing $10 million? Let’s say their gross profit margin is around 15%. This means their gross profit is $1.5 million. In this example, they’re looking at $1 million in expenses, plus $200,000 for principal payments and draws to pay the owner. This puts us at $1.2 million.
To see where they’re breaking even, we need to take $1.2 million divided by their contribution margin (gross profit margin) of 15%. 1.2 million divided by 0.15 = $8M. This is the number the business needs to produce in a given year to break even.
I use the word “produce” here specifically because selling a project doesn’t = income in the bank. Selling a project is just the first step. To actually earn revenue and hit your break-even point, you have to produce and complete the work.
What If I Don’t Know My Gross Profit Margin?
Don’t know your gross profit margin? You can make an educated guess based on the target margins you set on project estimates and use that to calculate your break-even point. Or, if you’re doing cost-plus jobs, you can use that to estimate your gross profit margin.
Just remember that markup isn’t the same as margin. For example, a cost plus 20% doesn’t mean you have a 20% margin. If something costs $100,000 and you’re charging $120,000, you’re looking at a 16% margin ((120,000 - 100,000) / 120,000).
A Practical Way to Use Break-Even Analysis
Once you have the break-even formula, you can use it to guide certain financial decisions you want to make.
Let’s say you’re hiring an admin or estimator: You would add their salary into the fixed costs of the calculation since we’re essentially adding overhead to the business.
If your estimator is making $140K, we’d add that to our $1.2M. Our new calculation is $1.34M / .15 = $8,933,333 to break even.
A position like a project manager is a little different. Because their work is directly related to building specific projects, we’d add their salary under COGS. But, no one shows up on day one and immediately makes your business more money. Before you hire a PM, figure out how long it’s going to take to get them up to speed. In this example, let’s say we think it’ll take them 2 months at a yearly salary of $150k, or 25k for those two months. Just like we added those principal loan payments and owner’s draw to your total fixed costs, you’ll also want to add this $25k to that number, because they’re essentially overhead until they are contributing to revenue at their full capacity.
Based on the example we’ve been using, we now have 1,225,000 in fixed costs ÷ 15% contribution margin to give us a break-even point of ~$8.16M. If you bought a new vehicle or hired a superintendent at the same time, that break-even point would be even higher.
This is what I mean when I tell my clients that the financial decisions they make for their business don’t happen in a vacuum. Everything impacts that break-even point and your bottom line at the end of the day.
Building a Solid Budget with Your Break-Even Analysis
Along with answering important “What if?” questions, you can work backward from your break-even analysis to create a yearly budget for your business.
What do you want your profit to be by the end of the year? You can add that number back into these equations we’ve been playing around with to give you the big number you’ll want your sales team to shoot for over the course of the year. Of course, this isn’t just your sales team’s responsibility - it takes everyone owning their performance to meet that goal. If you’re interested in this concept of encouraging accountability and engagement at every level of your business, I’d recommend checking out any of the books on the Entrepreneurial Operating System (EOS) by Gino Wickman.
Once you’ve got a target profit, you can also break down how much you want to spend on each category of expenses. You want to answer the questions, “What numbers will get us to our break-even point?” and “How can we manage these numbers to ultimately achieve our profit goal?”
Wrapping Up
As they say, you have to spend money to make money. Knowing exactly how much you need to break even means you can make a plan to grow your business while minimizing as much risk as possible. By doing a break-even analysis, you’ll be able to determine the right project volume for your profitability goals.
My challenge to you? Don’t wait till you’re almost underwater to calculate your break-even point. Follow this guide and see where your company needs to be today, or reach out to TruBalance Accounting and let us walk you through it.