Guest post by Catherine Flannery
You’ve got the idea, you’ve prototyped your product or maybe you're already selling to the market, but have you remembered the basics? Do the numbers stack up? Are you going to cover your costs?
It’s not the exciting part of being part of a start up, no one wants to be the killjoy saying hang on a minute, have we looked at the numbers?! But whether you think you have the hottest new app, a must have product, or your opening a cafe, break even is key to the viability of your business and ultimately whether it will survive.
The basics of Break even…PROFIT = ZERO
The Break Even Point (BEP) is the point at which your profit equals zero i.e. you are covering all your costs. To work this out you need to know your business well enough to be able to make some estimates, easy if you’re already trading but otherwise requires some time and effort on your part.
We can use this formula for the Break even point:
Break Even Point (BEP)
(BEP) = Total Fixed Costs / Contribution per Unit
Don’t worry about the jargon for now, we’ll work through it with an example but essentially it allows you to work out how many units i.e. products you have to sell to cover your costs. So let’s imagine we are opening that cafe. The key will be how many cups of coffee do we need to sell to break even.
These are costs that you do not change regardless of how many sale you make. So this might be thing like hosting fees for your website or your rent if you have a physical premises. High fixed costs can make for a very risky business, which is partly why so many big retailers saddled with high rental costs are going to administration at the minute. For our example of a coffee shop their monthly fixed costs might be include:
Rent = 1,000
All other bills (e.g. elec, gas, internet) = 500
Staff costs = 1,000
TOTAL Fixed Costs = 2,500
Contribution per Unit
So this is where it starts to sounds like proper accounting jargon but in basic terms this is just how much money does each product you sell give you towards covering your fixed costs. If we carry on with our coffee example, we are trying to find out how much money we make on each cup of coffee sold.
For that we know to know two things: how much we sell each cup for and what it costs us to make each cup (our variable costs).
Sales Price: In the case of our cup of coffee, depending on location and quality there is likely to be a ‘market price’, so let’s say the coffee shop is in London and your expecting to sell your coffee for £2.50 a cup. Your own pricing will require careful research!
Variable costs: As the name suggests these are costs which vary with the amount of sales you make, so if you are send out a physical product it might include the postage and packaging costs i.e. only incurred when an item is sold. Or if you sell via an agent you only pay their commission when a sale is made. So what’s a variable cost in our coffee shop?
Coffee Beans = 15p
Milk = 10p
Paper cup = 25p
Total Variable Cost per cup of coffee sold = 50p
Here our contribution per unit is:
Contribution = Sales Price - Variable costs
£2 = 2.50 - 50p
Each cup of coffee sold contributes £2 towards our fixed costs. And finally we can put these numbers into our BE formula.
Break Even Point (BEP) = Total Fixed Costs / Contribution per Unit
BEP = £2,500 / £2
BEP = £1,250 units (cups of coffee per month)
Translated this means in a month to cover our £2,500 of fixed costs (rent, bills, staff) we need to sell 1,250 cups of coffee. That’s approximately 42 cups a day.
What do you do with your Break Even Point?
The value in doing this is not just in getting to the number, it requires interpretation, is this 42 cups a day viable? You might have a coffee shop outside a mainline rail station and sell 42 cups to commuters before 7am. In another location this might not seem feasible and you might only sell between 40 and 45 cups a day in which case you might be dangerously close to the break even point. The closer you are to the BEP the riskier your business.
Taking your analysis further…
Once you’ve got your head around your basic break even you can also rework the calculation to factor in other costs, for example looking at how many cups of coffee you’d need to sell to give your business a certain level of profit, a salary for yourself or even how many extra cups of coffee you’d need to sell in order cover your childcare costs (this has certainly been a major factor for me when assessing the viability of my business)
If we quickly rework the calculation above, lets say you have childcare costs of £1,000 per month. All you need to do is add these onto your fixed costs to see how many coffee cups you now need to sell in order to break even and also cover your childcare costs too:
Required Output = (Total Fixed Costs + Childcare costs) / Contribution per Unit
Required Output = (£2,500 + £1,000) / 2
Required Output = 1,750 units (approx.58 coffee cups a day)
The BE analysis is just a starting point and becomes more complex the more products you have or when you start to factor in things like semi-variable costs however, a basic break even is certainly a good place to start to make sure that you are on the right track to turn that great idea into a sustainable profitable business.