Part Two: Determining Your True Break-Even Point
As discussed in Part One of this series, successful bidding comes down to a clear understanding of a few important elements – costs (both fixed and variable), overhead and a company’s true break-even point.
We began by examining the concept of “mixed costs” and their role in producing more accurate bids. Now let’s delve into the importance of accurately determining break-even, setting a realistic gross profit margin, and then factoring these numbers into bids that will win future business.
It’s interesting to see that even though the construction industry is in the midst of a prolonged downturn, some contractors seem to be holding their own, and a few are even prospering. Cynical observers might say that it is merely a race to the bottom – that those chasing low-margin jobs will eventually be out of business. Yet, we see companies that do the work at lower margins and are doing fairly well.
One factor could be that the struggling businesses don’t really know their break-even point (“BEP”). Nor have they done the analysis to determine what their true fixed, variable and mixed costs are. (Perhaps after reading my earlier article, such cost analysis has been done).
Owners already know intuitively that if they are not making a profit, they must either (a) get more business, (b) make more money on the jobs they already have, or (c), do a combination of both. Yet too many of them fail to challenge the underlying math they used to formulate the bids that ultimately proved unsuccessful.
So what options does the owner have?
- Keep doing the same and hope for the best (not recommended in this economy)
- Fold up the tent and retire, or do something else
- Hire a better sales team
- Merge with a competitor
- Expand into a new or related market
- Focus on a niche that promises better margins
- Understand and apply the principles of achieving break-even, if only to make a more informed decision about the other options
To understand a company’s true BEP, we must first understand what its real “Fixed Overhead” is. Once that has been established, we need a plan that will provide the company with enough “Contribution to Overhead” to cover the Fixed Overhead nut.
Below is a table that illustrates a business that has already segregated its mixed costs and eliminated what management found to be non-essential overhead. If you missed the earlier article on mixed costs, it is important to know that break-even analysis requires that you are clear about the concepts of Variable Costs and Fixed Overhead to the point where you can segregate any mixed costs into the two components. The first column and its related percentages represent such Adjusted P&L.
Once all mixed costs are appropriately apportioned, the formula is very simple: Fixed Overhead divided by Contribution to Overhead. Here, we have $400,000 of total Fixed Overhead. With a Contribution to Overhead of 35%, Break-Even Sales becomes $1,142,857, which is calculated by dividing the $400,000 of overhead by the 35% Contribution to Overhead.
Ah, but if it were only that simple to put into practice. In reality, it may be very difficult today to obtain enough additional work at a 35% contribution margin to increase volume by 43% ($342,857 divided by $800,000). If you cannot reduce your overhead to achieve break-even, you may have to reduce your pricing to get the extra work.
To keep things simple in the illustration above, let’s assume that the $800,000 is already signed on, and represents your company’s backlog of work. If you were to reduce your pricing by 10% on only the new bids, you would divide the $120,000 of remaining overhead (the “Loss” not covered by the $800,000 backlog) by the Contribution to Overhead to be realized on such additional new work. Be aware that when dropping pricing by 10% to win the additional work, the variable cost percentage increases: what was a 35% contribution would become a 27.8% contribution with a 10% cut in fees. So your break-even volume would have to be $1,231,655 (a scenario not illustrated in the table).
[If you do not follow this increase in variable cost percentage, try this. Simply calculate what it would be on the in-house $800,000 if you dropped pricing by 10% to $720,000. You would have the same $520,000 in variable costs, but yield only $200,000 in Contribution to Overhead which, when divided by $720,000 is 27.8%, rather than the 35% contribution you would derive from the $800,000 in sales secured at normal pricing].
You’ll notice that the new break-even volume of $1,231,655 is even more than the $1,142,857. Now, instead of a 43% increase in volume, this example calls for a 54% increase. At least with a 10% cut in fees, you can reasonably expect to get a lot more work and hopefully achieve profitability. For any work you get over and above the $1,231,655 BEP, 27.8% of it is pure profit. The real key is to operate above your true BEP. For those who aren’t sure what that is, achieving profitability is an ever-elusive goal, especially in difficult times.
While the old adage “we’ll make up for it in volume” is often used as a punch line, the underlying business calculations are quite sound. The trick is to know your true BEP, and to ensure that your contribution to overhead is significant enough to haul in the additional work without totally disrupting your business model and cost structure.
This is also a good time to address an item that may be buried in company overhead – discretionary expenses. If you are accruing “overhead” of, say, $20,000 in personal benefits, extras or niceties, and you have a 20% Contribution to Overhead rate, it means that your BEP is $100,000 more than it should be. The same holds true for someone you treat as overhead who is overpaid (as difficult as that might be to accept).
This doesn’t mean that you cannot continue to carry such discretionary expenses. But to the extent that they exceed your competitors, you need to be careful not to lose bids because you are trying to cover overhead that may be excessive in the new world order.
Remember, as stated above, you are looking for your “true” and “real” overhead costs. As shown in the table’s last column, if you were to eliminate $30,000 from each of your two fixed overhead line items, it’s amazing to see how significantly your BEP drops.
Every business has its own unique circumstances, sensitivities and margins. I have used hypothetical margins here for illustration. While I expect your breakdown to be different, the concepts will not change.
Many of you have multiple divisions or cost centers, which means that you are juggling more than one set of numbers. But the analysis is the same. You do not have to possess all the answers internally, but you do need to come to grips with these relatively simple concepts, even if it means shaking-up your controller or getting outside support.
Sal Falzone, CPA, is a partner in the Boston area accounting and business advisory firm Rucci, Bardaro & Falzone PC, whose Construction Business Services Group offers business, financial and strategic planning advice to companies in transition. For specific questions about the variables that go into successful project bidding, contact Mr. Falzone at (781) 321-6065 or firstname.lastname@example.org.