Calculating your break-even point
Before you start a business, and perhaps leave a job, try working out if your idea will be worth the risk.
If you’re confident there’s a genuine demand for your potential product or service (and at the price you want), the next step is to work out how much you need to sell each month to make a profit.
Will your business venture be worth it?
It’s unlikely your business will be profitable from day one. Sales are likely to be slow at first, but you’ll be hoping they gain momentum.
Meanwhile, you have certain fixed costs (business overheads) that you must pay each month to keep your operation running. These include:
- Rent or mortgage payments.
- Interest on debt.
- Communication costs.
You also have other expenses that will vary with sales levels. These variable costs include supplies to make a product or to stock shelves (if you sell more, you’ll need more), freight, commissions, and extra labor to produce your goods.
When sales equal costs
All of this means that a typical business in its early stages will run at a loss until the point where sales match costs. This is known as the break-even point.
If sales continue to climb, you start making a profit each month.
Below are two quick and ready ways to test the feasibility of your business. They presume you know both the fixed costs of running your business and the variable costs of producing a product or selling a service.
How a manufacturing business breaks even
Here’s an example for a business making garden benches out of wood.
First, work out the gross profit on each bench. This is the difference between the selling price of the product and its variable production costs.
The cost of each bench
|Your research shows a realistic market price for each bench is:||$120|
|Labor cost ($40) and materials ($25) for each chair come to:||$65|
|The difference between $120 and $65 is your gross profit:||$55|
What you want from your business
|To justify the risk, you want a salary each year of:||$80,000|
|The overhead costs of running your business are:||$20,000|
|Therefore, the annual gross profit you need on sales is:||$100,000|
How many sales do you need?
To find out how many benches you must sell each year to meet your salary goal, divide the required $100,000 gross profit by the gross profit per bench of $55. The result shows you need to sell 1,818 benches a year.
How does that average out per week? If you decide you want at least a four-week break every year, divide 1,818 by 48 weeks and your break-even sales target is 38 benches a week.
Do you think you can sell an average of 38 benches a week? Remember, this is a break-even point only. It will pay your required salary, but there’s no extra profit margin in there to grow your business.
Try your own figures.
How a service business breaks even
In a service business, you’re selling time, so you take a slightly different angle. Let’s presume the goals remain similar and you’re working alone, except for one part-time person doing office tasks so you can spend more time with customers. This salary adds $20,000 to your overheads.
What you want from your business
To justify the risk, you want a salary each year of: $80,000
|The overhead costs of running your business are:||$40,000|
|Therefore, you’ll need to bill out:||$120,000|
What time do you have available?
You decide to work 5 days a week, for 48 weeks, or 240 days a year. Subtract another 15 days for sickness and holidays, leaving a total of 225 working days.
You plan to put in at least 8 hours a day but allow 3 hours for travelling and work such as marketing and quotations. This leaves 5 billable hours a day.
Your hourly charge-out rate
Now you’re ready to calculate your charge-out rate.
Divide your goal of $120,000 by 1,125 billable hours and your minimum charge-out rate per hour must be $107. Remember this is just the break-even figure to cover your costs and salary. There’s no extra profit to expand the business.
Some questions to ask include:
- How does an hourly rate of $107 compare with the industry average? Is it competitive?
- Can you really bill out $535 a day (107 x 5 billable hours), or $2,675 each 5-day working week?
Try your own figures to see what hourly rate you come up with and decide if the rate is both competitive and feasible. Will you be able to meet that goal of 25 billable hours each week?
Use a cash flow forecast
Use a cash flow forecast to check your break-even calculations. This will force you to think more carefully about both variable costs and fixed costs. Get advice if necessary from an accountant because a portion of some costs, such as extra power use, may properly belong in variable costs of production rather than fixed costs.
Completing the sales side of your cash flow forecast will also help you identify how long it might take for your venture to break even.
For example, in the manufacturing example, the business needs to sell 1,818 garden benches over the course of the year. However, demand would likely be slow in the winter months before picking up in the spring. Meanwhile, the business’s running costs still need to be paid.
The bottom-line figure for each month will show you both when your business is likely to break even and how much funding you’ll need to keep your business going until then.