When you have what you think is a good idea, the first step is to analyze whether your business will succeed. The first financial tool you should use is a break-even analysis. A break-even analysis will calculate what your revenues must be for your business to produce a profit.
The key to using this tool is to be realistic in your expected revenues and conservative (high) in your expected costs. The break-even analysis will force you to do the research that will allow you to know whether you should pursue your business idea further.
You will need to do a break-even analysis for your business plan anyway, but it’s a good idea to do it now to determine whether it is even realistic to pursue your business idea and whether it is worth writing a complete business plan.
Revenues above the break-even point result in profits whereas revenues below the break-even point result in losses. You can do a break-even analysis whether you are selling a product or a service. If you have a rough idea of what your expected revenues will be, you can tell after doing a break even analysis whether you can expect a profitable business. If not, you either have to make some changes or give up your business idea. It is crucial to understand some basic concepts before doing a break-even analysis.
- Sales revenue 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.
- Fixed costs (sometimes called “overhead”) don’t vary much from month to month. They include rent, insurance, utilities, and other set expenses. It’s a good idea to add a cushion to your projected fixed costs because there will always be miscellaneous expenses that you can’t predict.
- Variable costs are expenses that change in proportion to the activity of a business. Variable costs vary with the number of units produced. Variable costs are made up of direct costs which are costs that are attributable to preparing each unit for sale, and indirect costs like certain overhead which can vary with the number of units prepared for sale. Together, variable costs and fixed costs make up the two components of total cost.
- The break-even point for a product is the number of units you need to sell for total revenue received to equal the total costs, both fixed and variable.
To prepare your break-even analysis for your potential startup business you have to make an educated guess as to the number of units you can sell, the expected sales price per unit, fixed costs and variable costs. This educated guess is made on the basis of research.
Once you’ve estimated the four numbers above, it’s easy to calculate your break-even point by using the following formula:
Break-even Point = Fixed Costs / (Unit Selling Price – Variable Costs)
Let’s see how that works in an example where we estimate we can sell 1,200 widgets per month at $10 each, resulting in sales revenue of $12,000. We estimate that our fixed costs for rent, utilities, and so on are $5,000 per month. We also estimate that it will cost us $5 per widget to buy raw materials and prepare the widgets for sale (our variable cost).
Plugging our numbers (except the number of widgets we expect to sell) into the formula, we get the following:
Break-Even Point = $5,000/ ($10 – $5)
or, Break-Even Point = $5,000/$5
or, Break-Even Point = 1,000 widgets per month
At the Break-Even Point, then, we would sell 1,000 widgets at $10, for sales revenues of $10,000. Our costs would be $5,000 fixed costs + $5 x 1,000 widgets, or $10,000. If we sell more than 1,000 units per month we make a profit. If we sell fewer than 1,000 widgets per month, we lose money.
Based on our break-even analysis, we calculate that if we sell the number of widgets projected, 1,200, we would make a profit of $1,000 per month, as follows, using the numbers we already know:
Profit = Sales Revenues – Fixed Costs – (Variable Costs x Units Sold)
or, Profit = 1,200 units x $10 – $5,000 – ($5 x 1,200)
or, Profit = $12,000 – $5,000 – $6,000
or, Profit = $1,000 per month
Are you satisfied with $1,000 profit per month? If not, you must have a plan to increase sales or lower costs. Maybe you can start by selling 1,200 widgets per month, knowing you will earn $1,000 per month and then have a plan to expand your product line. Many such issues can be addressed once you have determined your break-even point and your expected profit given your expected sales.
If your Estimates Fail to Break Even
If your estimate doesn’t at least show sales at the break-even point you can make adjustments before you start your business. Consider the following:
- Find a less expensive way to make your product.
- Reduce your fixed costs. Maybe you can save on rent. Maybe you can do with fewer employees.
- See if you can sell your product or service at a higher price.
- Find a larger market niche to increase unit sales.
If you can do none of those things, maybe your idea is not economically feasible. It’s better you know it now than later.
Break-even analysis is a powerful tool you can use to determine whether your business idea will be profitable. Consider your break-even analysis to be only one tool in your arsenal. Even if this analysis shows that you can make a profit given your expected sales and costs, there are other tools you will use in your business plan to give you a fuller picture of your financial forecasts. Among them are:
- A profit and loss statement
- A cash flow projection
- A start-up cost estimate