Breakeven analysis is a tool 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 breakeven point is reached when revenue equals all business costs.
To calculate your breakeven point you will need to identify your fixed and variable costs. Fixed costs are expenses that do not vary with salesย 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.
Will Your Business Make Money?
Before you prepare a business plan, you should figure out if your business will break even. How can you tell if your business idea will be profitable? The honest answer is, you canโt. But this uncertainty shouldnโt keep you from researching the financial soundness of your idea. Preparing whatโs known as a โbreak-even analysis,โ 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 youโll 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 โ that is, if you can easily bring in more thanย the amount ofย sales revenue youโll need to meet your expenses โ 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 wonโt 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, youโll have to make educated guesses about your expenses and revenues. Although you donโt have a crystal ball, you should do some serious research โ including an analysis of your market โ 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.
Youโll need to make the following estimates and calculations when you prepare your break-even analysis:
-
- Fixed costs.ย Fixed costs (sometimes called โoverheadโ) donโt vary much from month to month. They include rent, insurance, utilities and other set expenses. Itโs also a good idea to throw a little extra, say 10%, into your break-even analysis to cover miscellaneous expenses that you canโt predict.
-
- Sales revenue.ย 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 โ not on how much you need to make a good profit.
-
- Average gross profit for each sale.ย 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 Antoinette pays an average of $100 for goods to make dresses that she sells for an average of $300, her average gross profit is $200.
-
- Average gross profit percentage.ย 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 Antoinette makes an average gross profit of $200 on dresses 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 youโve calculated the numbers above, itโs easy to figure out your break-even point. Simply divide your estimated annual fixed costs by your gross profit percentage to determineย the amount ofย sales revenue youโll need to bring in just to break even. For example, if Antoinetteโs fixed costs are $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, Antoinette must make $9,000 each month just to pay her fixed costs and her direct (product) costs. (This number does not include anyย profit,ย or even a salary for Antoinette.)
Donโt Forego 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 loser or, like most ideas, it needs modifications to make it work.
If You Canโt Break Even
If your break-even point is higher than your expected revenues, youโll 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 thatโs the case, take heart in the fact that you found out before you invested your (or someone elseโs) money in the idea.
Further Financial Analysis
If your break-even forecast shows youโll 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 youโll 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 needย a more completeย 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 businessโs financial picture.
-
- A profit-and-loss forecast.ย This is a month-by-month projection of your businessโs net profit from operations.
- A cash flow projection.ย This shows you how much actual cash youโll have, month by month, to meet your expenses.
A start-up cost estimate.ย This is the total of all the expenses youโll incur before your business opens.
Preparing a break-even forecast will help you decide whether itโs worth drafting a business plan for your idea โ but it should never take the place of a complete profit-and-loss forecast and cash flow projection. For instructions on how to create a profit-and-loss forecast and a cash flow projection, see How to Write a Business Plan, by Mike McKeever (Nolo).
Call us atย 1300 282 026ย or email us atย info@ebs.org
You May Also Read โย The Power of Your Subconscious Mind