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. The breakeven point is reached when revenue equals all business costs.
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. You should do some serious research -- including an analysis of your market -- to determine your projected sales volume and your anticipated expenses. Business plan books and software can teach you how to make reasonable revenue and cost estimates.
You'll need to make the following estimates and calculations:
Fixed costs (sometimes called "overhead") don't vary much from month to month. They include rent, insurance, utilities, and other set expenses. It's also a good idea to throw a little extra, say 10%, into your break-even analysis to cover miscellaneous expenses that you can't predict.
This is the total dollars from sales activity that you bring into your business each month or year. To perform a valid break-even analysis, you must base your forecast on the volume of business you really expect -- not on how much you need to make a good profit.
Average gross profit for each sale
Average gross profit is the money left from each sales dollar after paying the direct costs of a sale. (Direct costs are what you pay to provide your product or service.) For example, if Antoinette pays an average of $100 for goods to make dresses that she sells for an average of $300, her average gross profit is $200.
Average gross profit percentage
This percentage tells you how much of each dollar of sales income is gross profit. To calculate your average gross profit percentage, divide your average gross profit figure by the average selling price. For example, if Antoinette makes an average gross profit of $200 on dresses that she sells for an average of $300, her gross profit percentage is 66.7% ($200 divided by $300).
Calculating Your Break-Even Point
Once you've calculated the numbers above, it's easy to figure out your break-even point. The formula for determining your breakeven point requires no more than simple arithmetic. 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. (Note that this number does not include any profit, or even a salary for Antoinette.)
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:
find a less expensive source of supplies
do without an employee
save rent by working out of your home, or
sell your product or service at a higher price.
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.