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 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.
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 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:
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 Antoinette’s 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 any profit, or even a salary for Antoinette.)
Don’t 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 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:
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 else’s) money in the idea.
Further Financial Analysis
If your break-even forecast shows you’ll 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’s financial picture.
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. 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).
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Where’s My Cash Gone?