Maybe you are considering starting a firm. Well you should start with a business plan that includes a look at your expected marketing approach, strengths, weakness, opportunities, threats (SWOT) and financials. Financials include determining what you will you need to break even or profit. Let’s take a look at breaking even. Something you should think about before you create your firm.
I will be describing this from a manufacturing perspective, but these basics can be applied to a service company. Be patient and read through and I will tie it together in the end.
There are two types of costs, variable and fixed. Variable costs include direct materials, direct labor and manufacturing overhead. If the material is a part of the end product it is a direct material. For example the heating element in your toaster would be a direct material. Direct labor can be determined by the “touch test.” If the labor touched the final product it is direct labor. The person who soldered the heating element into the toaster is an example of direct labor. The person who cleaned all of the soldering guns is not. The plant supervisor’s salary is manufacturing overhead. He doesn’t touch the product, but he supervises the labor. Essentially all the other costs necessary to operate the factory are manufacturing overhead. Lastly there are administrative and selling costs that may be variable and/or fixed.
Architecture is a service industry. For now let’s use a simple example of creating a set of construction documents. Now the architect working on the drawings and putting together the specifications would be the direct labor. We could include the billable time of any other staff member that works on the project. What about direct materials? Direct materials would be the cost of paper. This is a negligable, so we would include it in manufacturing overhead. If this was a large set of drawings a 100 sheet set that needs to be printed and duplicated in house, that is a noticeable cost that can be quantified. But the remaining costs will primarily be overhead (or manufacturing overhead).
Let’s look at one job to determine what it would take to break even. (Let’s say we have done some research and determined as an architect in our location the average job is $200,000 with a 5% fee. So each job is $10,000.)
Sales (one unit) $ 10,000
Variable Costs (one unit) - $ 3,200
Unit Contribution Margin $ 6,800
Fixed Costs - $ 129,200
Net Operation Income/Loss $(122,400)
Unit Contribution Margin = Sale of 1 Unit – Variable Cost of 1 Unit
$10,000/unit – $3,200/unit = $6800/unit
Fixed Costs/Unit Contribution Margin = Break even units
$129,200 / $6800 per unit = 19 units
So it would take 19 units (jobs) to break even. Let’s look at what it would take to break even:
Sales (19 units) $ 190,000
Variable Costs (19 units) - $ 60,800
Contribution Margin $ 129,200
Fixed Costs - $ 129,200
Net Operating Income/Loss $ 0
Any more than 19 jobs and the company will provide a profit.
Here are the assumptions I have made about the variable and fixed costs and some flaws in this analysis as a result.
The variable costs are 40 hours/week x $20/hour x 4 weeks =$3200. (1 job takes 1 person, 1 month.) That’s one person working on a job for 4 weeks. Now that means to break even you will need another person to do the other 7 jobs, but this analysis does not take into consideration that employee’s salary beyond 7 months! Another way to look at it is the principal will be covering some of this extra work, but this analysis is not exactly correct. Also we are looking at an average job cost and actual jobs will be priced differently. (This is a two person firm, the owner (principal) and one employee.)
The fixed costs are monthly $1,200 rent and $900 insurance and utilities, so that’s $2,100 times 12 for $25,200. The principal’s salary is 40 hours/week x $50/hour x 52 weeks equals $104,000. $25,200 and $104,000 equals $129,200. Now the principal’s salary can be billed partially to certain jobs as a variable cost. In this case, I am assuming all of the principal’s salary is a fixed cost, which is not actually the case.
Here are some other links to help understand the break even analysis:
Break-Even Calculator
Breakeven Analysis
Break Even Analysis
PPI