When embarking on your new business venture, one of the first and most important concepts that you will be introduced to is a Break-even Analysis which, very simply, is the amount of revenues you need to generate to cover your expenses. A good grasp of this is essential since even businesses with significant sales revenues can incur losses.
The starting point of any breakeven analysis is to determine your businesses variable costs which are effectively costs that vary with each product made. These include the materials, packaging, labels, shipping etc. Next is to determine fixed costs which can include rent of the premises, salaries paid to employees, office/computer expenses, subscriptions, bank fees, professional fees (paid to accountants and lawyers etc), supplies, telephone and utilities and anything else that is specific to the business for which a fixed amount is paid. Note that this can also include direct costs like labour and machinery since the inputs of these cost do not vary with the output i.e. volume of product sold.
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 (organic handpicked vegan cucumber) pickle = $1
Cost of cucumbers, vinegar and other ingredients, per pickle = $0.50
Cost of packaging, labels and shipping per pickle = $0.10
Total fixed costs including factory labour, rent, insurance, admin 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 basically 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 calculated as (30,000-25,000)X$0.40.
Why calculate it?
The importance of a breakeven analysis, particularly when you are a startup, is to establish the baseline of sales revenue and/or volume that has to be generated to cover costs, ensure that they are realistic and estimate what your monthly cash flow requirements are going to be so that you can meet, and exceed, your sales goals. For example if you only sell 10,000 pickles in the first month, at $0.40 gross margin before fixed costs, you would have $4,000 to cover $10,000 of fixed costs. This leaves you with a $6k deficit which you need to ensure can pay for either through your own funds or via a bank loan or line of credit.
Ultimately, a breakeven analysis is only as strong as its 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 in the calculation. Also, it is important to update the analysis as the underlying assumptions change . Since breakeven analysis is an estimate at best these should be refined and honed over time to ensure as much precision as possible. If you have a good accounting system which is updated regularly, a review of the profit-loss (income statement) can give you excellent insights into how your business is doing.
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 without necessary having a sophisticated accounting system in place.