Margins and break-even: how pricing and costs drive your profit

Two businesses can have the same sales and very different profits. The difference usually comes down to margins: how much of each sales dollar is left after costs. Once you know your margins, you can work out your break-even point and see how a change in price or cost would affect your profit.

What the numbers are

• Gross profit is, in business.gov.au’s words, the difference between sales and the direct cost of making the sales. The direct cost is often called cost of goods sold or cost of sales.
• Net profit is what is left after all business expenses. business.gov.au calls it your bottom line.
• Variable costs change with how much you sell, such as ingredients, materials, packaging and sales commissions.
• Fixed costs stay much the same whatever you sell in a month, such as rent, insurance, salaried wages and software subscriptions.
• Contribution is what each sale leaves after its variable costs. It goes first towards paying fixed costs, then towards profit.
• Break-even point is, as business.gov.au puts it, the point when a business’s income equals its expenses.

How they are calculated

• Gross margin (%) = (gross profit / sales) x 100
• Net margin (%) = (net profit / sales) x 100
• Contribution = sales - variable costs
• Contribution margin (%) = (contribution / sales) x 100
• Break-even sales = fixed costs / contribution margin (with the margin written as a decimal, so 60% is 0.6)
• Margin of safety = actual sales - break-even sales

Gross margin and contribution margin are often close, but not always the same. Gross margin uses cost of goods sold as your accounts record it. Contribution margin uses every cost that rises and falls with sales, which can include things like card fees, freight or commissions that sit lower in the profit and loss.

Margin is not markup

Margin is profit as a share of the selling price. Markup is profit as a share of the cost. An item that costs $4 and sells for $10 has a $6 profit, which is a 60% margin but a 150% markup. Mixing the two up is a common reason prices end up too low.

Worked example

Riverbend Bakery is a fictional bakery in Ballarat. For simplicity, its only variable costs are ingredients and packaging, and it treats its wages as fixed because its team works the same rostered hours each week.

Item	Amount
Yearly sales	$600,000
Ingredients and packaging (variable)	$240,000
Gross profit and contribution	$360,000
Rent	$60,000
Wages and super	$200,000
Other overheads	$40,000
Total fixed costs	$300,000
Net profit before tax	$60,000

• Gross margin = ($360,000 / $600,000) x 100 = 60%
• Net margin = ($60,000 / $600,000) x 100 = 10%
• Break-even sales = $300,000 / 0.6 = $500,000 a year
• Margin of safety = $600,000 - $500,000 = $100,000

So sales could fall by $100,000 a year before the bakery stopped making a profit.

If prices rise 5% and customers buy the same amount, sales rise to $630,000 while ingredient costs stay at $240,000. Contribution becomes $390,000 and net profit becomes $90,000. A 5% price rise lifts profit by 50%.

If ingredient costs rise 10% and prices stay the same, variable costs rise to $264,000. Contribution falls to $336,000 and net profit falls to $36,000, a drop of 40%. The contribution margin is now 56%, so break-even sales rise to about $536,000 ($300,000 / 0.56).

Real life is less tidy. A price rise can lose some customers, and costs rarely move one at a time. But the example shows why small changes in price and cost matter so much.

What the numbers may tell you

• A falling gross margin may mean supplier prices have risen and you haven’t passed them on, discounting has crept in, or there is waste or theft.
• A steady gross margin with a falling net margin usually points to overheads growing faster than sales.
• Break-even close to your actual sales means a small drop in sales could tip you into a loss.
• Different margins across products or services can show which ones earn their keep and which ones only add work.

Budgeting and forecasting

business.gov.au describes a budget as a plan for what you want to earn and spend for the financial year, and a forecast as an estimate of what is likely to happen next based on your current data and recent trends. It suggests writing your budget each year with a mid-year review, updating forecasts monthly or quarterly, and setting time each month to compare your spending with your budget.

Margins and break-even make both more useful. Once you know your contribution margin, you can test how many sales you need to cover a new hire or a rent increase before you commit.

Valuation basics

If you ever sell the business, buyers usually focus on its earnings: how much profit it makes and how reliably it can keep making it. Buyers often look at profit adjusted for one-off or owner-specific items, check how steady margins have been over several years, and compare that with the risk involved. Better records and steady margins generally make a business easier to assess. Valuation methods vary by industry and buyer, so talk to your accountant or a qualified business valuer if you are thinking about selling or buying.

Where these numbers appear

• Profit and loss statement. Sales, cost of goods sold, gross profit, expenses and net profit. business.gov.au notes you can use it to help develop sales targets and an appropriate price for your goods or services. See the lesson on the profit and loss statement.
• Budget and forecast. Where you plan margins and test changes.
• Product or job reports. Many accounting and point-of-sale systems show margins by product, job or customer.

When to get professional help

A bookkeeper can make sure costs are coded to the right accounts, which your margins depend on. An accountant can help you split fixed and variable costs properly, set prices, build a budget and forecast, and explain what your margins mean for tax and for the value of the business.

Where this becomes relevant to finance

Lenders often look at profitability when assessing an application, and margins show how much room a business has to absorb higher costs, including repayments. See what lenders may look at in your numbers. If the business is below break-even, borrowing can add to the problem rather than solve it. Read when borrowing is not the answer.

Important things to know

• Profit margins don’t show cash. A business with healthy margins can still run short of cash if customers pay slowly.
• Costs aren’t always neatly fixed or variable. Wages, power and delivery costs can be a mix. Your accountant can help you draw the line sensibly.
• Check margins regularly. Supplier prices change. A margin that was right last year may not be right now.
• Don’t compete on price without knowing your numbers. A discount comes straight off your contribution.
• Break-even is a guide, not a guarantee. It depends on your estimates of costs and sales mix.