Simple Steps Part 2: The Break-even Analysis

This is the second in a series of posts on how to take simple steps in planning, without holding your business progress up for the complete formal business plan. Get yourself and your business going on planning and you'll see the benefits and keep going with planning. The idea of simple steps also recognizes that there is no particular order; this is the second in a series, and any of them could be your first step. People are different. Do what feels like it's going to work for you, in the order that feels most appropriate. Click here for the first in the series, on strategic focus.

The break-even analysis is relatively simple to do and an easy way to start with planning. Use it to determine the lowest sales level that will cover your costs. It includes both fixed costs, such as rent, utilities, and payroll; and variable costs, meaning costs of buying or making the products you sell, or of delivering the service.

Here's how to do the break-even, step by step:

 

1. Set your thinking to imagine an average or standard month. That can be hard, it can take imagination, but do it.
2. Add up your fixed costs, meaning basically rent and payroll and running costs that you pay every month regardless of sales. These are the costs you'd pay even if you didn't have any sales. Make a simple list. Here's an example:
   
3. Add up the costs for each unit that you sell, of whatever it is that you sell. These are costs of sales, direct costs, also called cost of goods sold, or COGS, all of which are essentially the same thing. Unlike the fixed costs, these are costs that you incur only if you make a sale. If you don't sell, you don't have them
   
4. You need to use your imagination, at this point, and not get lost in the problem of averaging. This analysis doesn't work well if you can't do it over your whole business. If you run a hardware store, don't panic over how many different items you sell and how could you possibly know. Here's an example, for a computer store, of its average cost per computer:
   
   The key is to take an overall average. That's easy for some businesses, and virtually impossible for others, unless you take a deep breath and remind yourself it's an analysis, not a tax report; it doesn't have to be exactly correct, just accurate enough to make the analysis worthwhile. When in doubt, just get the Profit and Loss report from your most recent accounting, and use the same numbers that were used their to calculate the gross margin. Sales less cost of sales is gross margin. So if you don't have a better way to average, just use $1 as the revenue per unit, and as many pennies as your percentage cost of sales as the per-unit cost.
   
5. With those numbers, you can calculate a break-even point. It takes sales of 10 computers in a month to cover your costs. You can see that in the break-even illustration below:
   
   Break-even is how much you have to sell in a month to cover the costs. So in this example, selling 10 computers gives your hypothetical business $9,950, which covers $5,334.90 that it took to buy those computers (that's 10 times $533.49) and $4,540 in fixed costs. Total costs are $9,788. That's often used to draw a line graph, with the sales line crossing the zero at the break-even point, as in  the following:
   
   You can see in that chart how profits (the vertical) start when units (the horizontal) get past 10, in this example.
   

What Does the Break-even Mean? 

The break-even analysis gives you a sense of risk. Knowing how much you have to sell to cover costs, you should get a sense of how likely that is. If you're looking to start a business, then you don't have history to rest on, but at least you get a sense of it. With the computer sales example here, knowing you need to sell 10 systems a month gives you a chance to evaluate how likely that is. It's more than two systems per week. Can you hit that? Do you get enough traffic? Does your marketing generate enough leads.

Break-even is often confused with payback period, meaning how long it takes you to earn back the money that was invested in a start-up business or a project. That's payback, not break-even. Although we talk about "breaking even" on an investment, in this case it's about breaking even on costs in an average month.

As is almost always true with planning, it's important that you like with some level of uncertainty. We're human, we're trying to predict the future, so we aren't always going to be right. Settle for a general sense of it, so you can work with educated guesses and averaging.

A Free Break-even Calculator

There are several break-even calculators available on the web, for free. Just collect your simple assumptions numbers and plug them into the calculator.  I recommend the break-even calculator at bplans.com, but then I'm biased, I'm involved with bplans.com.
For more information on the break-even analysis, including details on the formulas, and calculations, there's also an article on break-even analysis at bplans.com.

-- Tim