Often when thinking about starting a business, entrepreneurs are excited about their idea, new product, valuable service, and how they can make a difference or “change the world.” Big picture thinkers, excited to get going, small details like break-even analysis, margin, or variable cost analysis can go by the wayside.
As with any investment, it is important to do your due diligence. You might be excited to have your first sale or someone tells you, “ya, I’d buy that!” but do you know how many sales will be needed to reach your goals?
As you consider your business, since you don’t have any previous data to reference, you can do some basic math “guestimates” to determine your fixed annual costs. Fixed costs are those costs that remain the same and are generally unchanged with volume sold, such as rent, salaries, advertising, professional licenses, administrative fees, etc.
For example, let’s say you want to make $50,000 making pickles. You work out of your house so you have no rent as of now, $1500 in business license fees, $3000 for your telephone and internet, $2400 for canning to make your pickles, $1000 for accounting help and you think you need to spend at least $12000 on advertising. Adding these together, your total fixed costs are estimated at $69,900
Now let’s consider variable costs. These are the costs of your product or service and change depending on the volume you sell. Variable costs can be things like product costs and commissions.
For example, let’s say that you are hoping to sell your pickles for $5.99. Each jar of pickles includes the jar $.75 cents, ingredients $1.25, and packaging $.25. Your total cost for your pickles is $2.25. Therefore, your variable costs are $2.25 per jar of pickles sold.
Now we can pull together your break-even point to understand how many jars of pickles you need to sell in order to break-even and hit your goal of making $50,000 using the formula below.
Breakeven (units) = Fixed Costs / (Selling Price – Variable Cost)
Breakeven (# of pickle jars) = $69,900 / ($5.99 – $2.25)
That is 18,689 jars of pickles!
So now we know that you need to sell 18,689 jars of pickles. This equates to total revenue of $111,952. That is your number of pickle jars to sell, 18,689 multiplied by your selling price, $5.99.
When you perform a break-even analysis, you can see how small changes in your pricing or reducing certain fixed or variable costs can help you reach profitability quicker. For example, if you increased your pickle jars to $6.99, you would only need to sell 14,746 pickles. (69,900/($6.99 – $2.25) = 14,746.
Understanding break-even in units and revenues can help you to run different scenarios for your new business venture. It can help you determine how long you have to sustain until you can reach break-even, because very few if any businesses start making a profit initially and typically take 3 – 5 years. Break-even analysis highlights the importance of keeping track of your product costs and the costs to run your business. Prior to starting your new venture, run a break-even analysis to determine how much product you need to sell. This can also help you determine ramp-up time, marketing costs, and create your path to profitability.