How to Do a Break-Even Analysis before Starting your Business
A break-even analysis is the essential first step of a business plan. A break-even analysis will tell you if your business will make money by showing you your break-even point. A lot of small business entrepreneurs grow overwhelmed by the idea of doing a break-even analysis, but doing one is in the best interests of your business plan. Now is the time to make a habit of calculating your costs and potential profits, if you plan to succeed.
Experienced entrepreneurs won't even start a business plan until they are sure, from their break-even analysis, that their predicted revenue is greater than their costs. Once this is established, entrepreneurs can continue creating their business plan. A break-even analysis is the best way to determine whether your business idea is a winner.
How to Start Your Break-Even Analysis
The first part of calculating your break-even point is making estimates about certain expenses and revenue streams. In order to arrive at an accurate estimate, research the current market of your business. There are plenty of how-to resources to teach you how to make these estimates. The estimates that are needed for a realistic break-even analysis include the following:
- Overhead includes your month to month expenses that are pretty constant, such as rent, insurance, utilities, etc.
- Sales Revenue refers to the total money from all sales activities that your business will make monthly and annually. Be sure to found your estimate on the volume of business that you realistically expect, rather than on how much revenue is needed for a profit.
- Average Gross Profits are the amounts that are left over from each sale, after deducting the direct cost for each particular sale. If a toy costs you $4.00 to sell, and you are selling it for $8.00, your average gross profit is $4.00.
- Average Gross Profit Percentages tell what portion of each dollar of your sales income is gross profit. Gross profit percentages are calculated by dividing the average gross profit amount by the average sales price. If your toy gives you an average profit of $4.00 on each toy that you sell for $8.00, you average gross profit percentage is 50%.
Finding Your Break-Even Point
After you have recorded the estimates listed above, you are ready to find your break-even point. Divide your estimated annual overhead by your gross profit percentage. This quotient is the amount of sales revenue you need to break even.
For example, if your annual overhead is $5,000, and your gross profit percentage is 50%, your break-even point is $10,000 per month ($5,000 divided by 50%). So, you would need to make $10,000 a month to pay your overhead and direct sales costs. Remember that this amount does not include a salary for you or any profit at all. It is merely how to break even between your overhead and revenue.
If Your Break-Even Point is too High
If your break-even point is higher than you expected, don't fret. It may not be a total loss. There may be parts of your business that can be manipulated to yield a desirable break-even point. Consider:
- shopping around for less expensive supplies,
- reducing the number of, or eliminating employees altogether,
- working from home, and
- raising your sales prices.
If after changing some of these factors, your break-even point is still too high, your business idea may not be attainable. This realization is what makes break-even analyses so important. If you end up scratching the business plan, you have saved yourself a lot of time and money. If you reach a desirable break-even point, you know you can continue on with your business plan, and you have an idea of your budget.
The Next Steps in Financial Analysis
If your break-even analysis tells you that your revenue far exceeds your break-even point, you can continue to the next steps in your financial analysis. Now, calculate the following to conclude your business's financial analysis:
- the profit you will generate;
- whether you have enough liquid funds to pay your expenses and bills on time;
- your business's monthly net profit, or "profit-and-loss forecast;" and
- your start-up cost estimate of all the expenses, before your business even opens.
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