The break even analysis is something most small business owners and entrepreneurs have heard of. It is a formula used to determine the sales a business must generate to pay off their total expenses. A thorough break even analysis should always be done before entering into a venture.
There are two types of expenses:
- Fixed Expenses – These are expenses that don’t regularly change each month, even if there is an increase or decrease in production. Rent, utilities, insurance, janitorial fees, interest on debt, permit fees and salaries of full time workers are typical examples of fixed costs. So if production were to slow or even stop, these costs would generally stay the same.
- Variable Expenses – These are expenses which are tied directly to production and can fluctuate depending on the volume produced. For restaurant owners, raw food costs, hourly labor, paper products and waste are good examples of variable costs.
Fixed costs are much easier to determine than variable costs, so start there. Be thorough, be realistic and be objective. Wishful thinking while doing this important calculation can lead to large losses. Variable costs require careful calculation as they are related directly to production. The raw ingredients, the labor required to combine those ingredients and the costs involved in selling the completed product, in any business, are the most important factors in determining whether a worth while profit can be attained.
So here is the actual equation:
Breakeven Point = Fixed Costs / (Selling price of unit – Variable costs per unit)
That’s it in a nutshell. This simple calculation with help you determine how many units you will have to sell in order to pay your monthly expenses. If you sell multiple products, like in a restaurant, simply calculate the average price and average cost of your menu items.
- Joe’s Pub – It costs Joe $10,000 per month in rent, utilities, insurance and fees to run his pub. The average price of a drink is $5. Joe spends $1 in alcohol, mixers and labor costs to make that drink. Breakeven -> $10,000 / ($5 – $1) = 2500 drinks. So Joe needs to sell 2500 drinks per month to pay his expenses. If Joe has an average of 50 customers per day who buy 2 drinks each, then he’s obviously in good shape.
- Ipodsforsale.com – It costs $6000 per month in hosting, programming, salaries and fees to run the website. They are selling Ipods for $250. They purchase the Ipods from Apple for $200. Most of their customers are generated from Google Adwords, and since Ipod is a competitive keyword, it costs an average of $5 in marketing for every sale. Breakeven -> $6000 / ($250 – ($200 + $5)) = 133 Ipods. So Ipodsforsale.com must sell 133 Ipods per month to stay in business.
But that’s so simple you say. Exactly! But a high percentage of rookie entrepreneurs (and veterans) will not give this analysis the attention it deserves. As a result, they will squander their money and valuable time on a poor business model. This analysis should be on the top of every entrepreneurs list when considering a new venture.