Break-even analysis is a process used to determine when a business will be able to cover all its expenses and begin to make a profit. For the startup business it is extremely important to know your startup costs, which provide you with the information you need to generate enough sales revenue to pay the ongoing expenses related to running your business.
A startup business owner must understand that $5,000 of product sales will not cover $5,000 in monthly overhead expenses. The cost of selling $5,000 in retail goods could easily be $3,000 at the wholesale price, so the $5,000 in sales revenue only provides $2,000 in gross profit available for overhead costs. The break-even point is reached when revenue equals all business costs.
To calculate your break-even point you will need to identify your fixed and variable costs.
Fixed costs are expenses that do not vary with sales volume, such as rent or administrative salaries. These costs have to be paid regardless of sales and are often referred to as overhead costs.
Variable costs vary directly with the sales volume, such as the costs of purchasing inventory, shipping, or manufacturing a product.
The formula for determining your break-even point requires no more than simple arithmetic.
Will Your Business Make Money?
Before you prepare a business plan, you should figure out if your business will break even. Figure out at what point you break even. How many sales until this event occurs?
How can you tell if your business idea will be profitable? The honest answer is, you can’t. But this uncertainty shouldn’t keep you from researching the financial soundness of your idea. Preparing what’s known as a break-even analysis, as well as several other financial projections, can help you determine whether or not your business will succeed.
What a Break-Even Analysis Tells You
Your break-even analysis shows you the amount of revenue you’ll need to bring in to cover your expenses before you make a dime of profit. If you can attain and surpass your break-even point -that is, if you can easily bring in more than the amount of sales revenue you’ll need to meet your expenses — then your business stands a good chance of making money.
Many experienced entrepreneurs use a break-even analysis or forecast as a primary screening tool for new business ventures. They won’t even write a complete business plan unless their break-even forecast shows that their projected sales revenue far exceeds their costs of doing business.
How to Prepare a Break-Even Analysis
To perform a break-even analysis, you’ll have to make educated guesses about your expenses and revenues. Although you don’t have a crystal ball, you should do some serious research -including an analysis of your market – to determine your projected sales volume and your anticipated expenses. Your best bet is to invest in a do-it-yourself business plan product to learn how to make reasonable revenue and cost estimates.
You’ll need to make the following estimates and calculations when you prepare your break-even analysis:
Fixed costs. Fixed costs (sometimes called “overhead”) don’t vary much from month to month. They include rent, insurance, utilities and other set expenses. It’s also a good idea to throw a little extra, say 10%, into your break-even analysis to cover miscellaneous expenses that you can’t predict.
Sales revenue. This is the total dollars from sales activity that you bring into your business each month or year. To perform a valid break-even analysis, you must base your forecast on the volume of business you really expect — not on how much you need to make a good profit.
Average gross profit for each sale. Average gross profit is the money left from each sales dollar after paying the direct costs of a sale. (Direct costs are what you pay to provide your product or service.) For example, if Amy pays an average of $100 for goods to make lingerie that she sells for an average of $300, her average gross profit is $200.
Average gross profit percentage. This percentage tells you how much of each dollar of sales income is gross profit. To calculate your average gross profit percentage, divide your average gross profit figure by the average selling price. For example, if Amy makes an average gross profit of $200 on lingerie that she sells for an average of $300, her gross profit percentage is 66.7% ($200 divided by $300).
Calculating Your Break-Even Point
Once you’ve calculated the numbers above, it’s easy to figure out your break-even point. Simply divide your estimated annual fixed costs by your gross profit percentage to determine the amount of sales revenue you’ll need to bring in just to break even. For example, if Amy has fixed costs of $6,000 per month, and her expected profit margin is 66.7%, her break-even point is $9,000 in sales revenue per month ($6,000 divided by .667).
In other words, Amy must make $9,000 each month just to pay her fixed costs and her direct (product) costs. (This number does not include any profit, or even a salary for Amy.)
Don’t Forgo a Break-Even Analysis
Although creating a break-even forecast might sound complicated, you owe it to yourself to prepare one as one of the first steps in your business planning process. As you can see, a realistically prepared break-even forecast will tell you whether your idea is a sure winner, a sure loser or, like most ideas, it needs modifications to make it work.
If You Can’t Break Even
If your break-even point is higher than your expected revenues, you’ll need to decide whether certain aspects of your plan can be changed to create an achievable break-even point. For instance, perhaps you can:
Find a less expensive source of supplies
Do without an employee
Save rent by working out of your home, or
Sell your product or service at a higher price.
If you tinker with the numbers and your break-even sales revenue still seems like an unattainable number, you may need to scrap your business idea. If that’s the case, take heart in the fact that you found out before you invested your (or someone elses) money in the idea.
Further Financial Analysis
If your break-even forecast shows you will make more revenue than you need to break even, you can consider yourself fortunate. But you still need to figure out how much profit your business will generate, and whether you’ll have enough cash available to pay your bills when they are due. In short, a break-even forecast is a great screening tool, but you need a more complete analysis before you start investing real money in your venture.
The following are additional financial projections that should also be part of your business plan, to round out your business financial picture.
A profit-and-loss forecast. This is a month-by-month projection of your business’s net profit from operations.
A cash flow projection. This shows you how much actual cash you’ll have, month by month, to meet your expenses.
A start-up cost estimate. This is the total of all the expenses you’ll incur before your business opens.
Preparing a break-even forecast will help you decide whether it’s worth drafting a business plan for your idea – but it should never take the place of a complete profit-and-loss forecast and cash flow projection.
It all starts with a dream, then you add a touch of reality and who knows where it goes!
By Graeme Nichol President of Arcturus Advisors. Please visit their website at http://www.arcturusadvisors.com. Arcturus Advisors works with business leaders to close the gap between great strategies and mediocre results.