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Break Even Analysis

Module by: Peter Baskerville. E-mail the author

Summary: The majority of people that start a business do not know their break even point. This is because (1) they did not think it was important or (2) they don't know how to calculate it or (3) they think it is something that only accountants need worry about. This module deals with the importance of knowing your break even point when establishing a new venture and gives you the tools and formula to calculate it for yourself.

Break Even Point – What is it?

The breakeven point is the point at which the revenue $ from your sales equals the total costs you needed to pay to achieve those sales. In a simple example, if you made $10,000 for the month in sales and the total costs of your raw materials, wages, rent …etc to make those sales came to $10,000 then $10,000 per month is said to be your break even point.

Other ways a Break Even Point can be expressed.

The example given above is said to be your Revenue Break Even Point and is usually expressed as a $ amount of sales per month. If in the above example your products sold for $10 then you could express the Break Even Point as 1,000 units sold per month or the Unit Break even Point. A Break Even Point could also be expressed as a Customer Break Even Point. If the average customer sale was $50 then the customer break even point in the above example would be 200. The final way that a Break Even Point can be expressed is as a Time to Break Even. (i.e. 15 months after opening)

Break Even Point – Why is it important?

A key reason given by many liquidators as to the reason for a business failure is undercapitalization. This simply means that the new business did not have enough available money to build a business that could be financially sustainable. (i.e. it could not achieve Break Even). The best illustration of this is building an aircraft but not having enough money to build on the tail. It crashes because the project was undercapitalized.

Now most new business ventures calculate correctly the money they need to start the business, otherwise they would be barred from entry. This money to buy/build the structure of the business is often called the CAPEX (Capital Expenditure). These new business venture believe that they will make a profit from day one and so that is all the Capital they will need.

The reality is that the vast majority of businesses take a minimum of 18 months before they reach the point where it starts to turn a profit and they need to find further funds in the form of Working Capital to underwrite the venture until it reaches this point.

So, without knowing your break even point and knowing how long it would take to reach that point we are unable to calculate the working capital that we would need to provide for to make sure this business can get off the ground with the tail securely in place.

Different Break Even Points

When looking to calculate a break even point for a new business venture you may need to calculate three (1) Financial Breakeven (2) Sustainable Breakeven and (3) Equity Breakeven.

For this module we will look at calculating the Financial breakeven which is the revenue volume point where all external financial obligations are met. By external we mean those financial obligations that don’t include those of the equity (owners & investors) internal founders. At this point the new venture is not considered successful but it has at least been saved from being taken out of the game by external players.

But how do you calculate a Break Even Point?

Simple … the breakeven formula for units looks like this:

Unit Breakeven Point per month = (Fixed costs per month) ÷ (Unit $ Contribution Margin)

where

the Unit $ Contribution Margin = (Unit selling price – Unit variable costs) or the excess of the selling price over the variable costs.

It looks simple enough but unless you are an accountant, you probably don’t know what the terms fixed cost and variable cost mean. So let me explain.

Fixed costs per month are those costs you need to spend to maintain your business or product sales each month but which do not change in line with changes in your sales volume. Rent is a good illustration of a fixed cost. Regardless of how much you sell, the rent is still going to be the same. Other fixed costs could include equipment rental or lease arrangements, insurance, interest on debt, plant and equipment expenses, utilities, business licenses and salaries of permanent full-time workers.

Variable costs are those costs that do vary in line with and usually in proportion to changes in sales volume. Usually the largest and most common variable cost is the costs of buying or manufacturing the goods that are sold. This cost is often referred to as Cost of Goods Sold (COGS). Other variable costs might include packaging, and labor directly involved in a company's manufacturing or sales process, vehicle fuel and salesperson’s telephone calls.

If you know these numbers already then you can use the many breakeven calculators offered for free on the internet. One that you could use is from dinkytown.com. Check it out. Breakeven Calculator

If you are still having difficulty in calculating these numbers then it may be best to do the following exercise to calculate the Monthly Revenue Breakeven Point.

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