When planning to start a new business, one of the first questions you ask yourself (and hopefully your accountant) is at what point are you going to start making money. One simple way to determine this is to calculate the breakeven point, which is the point at which your sales (revenues) equal your expenses.
How is it calculated?
The formula for the breakeven point is:
Fixed Costs/(Price per unit - Variable cost per unit)
Let's make the following assumptions for a company that sells pickles:
Price per pickle = $1 (they are special pickles)
Cost of cucumbers, vinegar and other ingredients, per pickle = $0.50
Cost of labour and pickle making machine, per pickle = $0.10 (assume they are at full capacity)
Total fixed costs including rent, insurance, salaries, dues for pickle association and utilties, per month = $10,000
Breakeven Point = $10,000/($1-$0.50-0.10) = 25,000
Based on these (very simple) assumptions you would need to sell 25,000 pickles, per month, to cover your costs.
For every pickle sold in excess of 25,000 units you would make a profit of $0.40 per pickle ($1-$0.50-0.10). So 30,000 pickles would bring in a net profit of $2,000 ia.e.(30,000-25,000)X$0.40.
Why calculate it?
It is important to perform a breakeven analysis, particularly when you are a startup, so that you can set your sales goals, ensure that they are realistic and estimate what your financing requirements are going to be until you meet your sales goals.
Ultimately, a breakeven analysis is only as strong as the underlying assumptions. As such, it is important to ensure that a) you try, to the extent possible, to include ALL costs that relate to your business, and b) to estimate the actual costs and sales prices as accurately as possible. If you think you might have to sell your pickles at a discount to bring in customers, ensure that these are reflected. Also, it is important to update the analysis as the underlying assumptions change . Since breakeven analysis is based on assumptions, some of which can be difficult to determine, the actual breakeven point might be different from the calculation.
Like many forecasting metrics, breakeven point can is subject to it's limitations; however it can be a powerful and simple tool to provide a small business owner with an idea of what their sales need to be in order to start making money.
This post was included in Personal Dividends carnival-of-wealth-8-entrepreneurship-edition