One of the most common sources of business ideas is turning a hobby into a business. But the big question is always going to be – will the business make enough money to support you and cover all the costs?
Intuit’s Three Year Glitch report highlights how most businesses which fail in their first three years do so because of poor financial management. Checking how viable your business is in the very early days, as well as using accounting software to keep a close eye on your finances from the start, are the best ways to help your business succeed and protect yourself against becoming a statistic.
Calculating the break-even point
In this jargon buster I am going to explain a really useful financial management term that will help you see whether your business is workable by calculating just how much you are going to have to sell to cover your costs and pay the rent on time.
This is called finding your “break-even point”. It’s really useful because the break-even calculation shows you the moment when your total sales cover your total costs, i.e. the point at which the business starts to make money or at least stops losing money.
So, how do you calculate the break-even point?
There are, as with most financial things, a number of ways of doing it and I am going to pick the one I think you will find the easiest. We will learn to calculate the break-even point using a sandwich shop as an example and we will cover it in six steps.
Step 1: First we need to cover some theory – costs in accounting terms can either be variable or fixed.
Variable costs vary with the level of sales – like the ingredients in a sandwich. The more sandwiches you sell, so the cost of the ingredients goes up in total.
Fixed costs by contrast are relatively fixed irrespective of the level of sales, e.g. the rent of the premises or the marketing costs. These kick in as soon as you are open for business.
Step 2: A bit more theory – you can express the break-even point over any time period, i.e. how much you have to sell in a week or month, or over a year. Also, you can express the break-even point either in terms of the number of units you have to sell – e.g. sandwiches if you run a sandwich bar or hours if you have a consultancy business – or you can express it in terms of sales value (e.g. £x per month).
Personally, I prefer units as it gives a tangible feel as to how much you have to sell – and/or make!
Step 3: To calculate the break-even point on an annual basis, work out your annual fixed costs including your salary, e.g.:
Step 4: Work out the variable costs per unit, e.g. for the sandwich shop:
Step 5: Work out the profit per sandwich. To do this, take the selling price and deduct the variable costs per unit.
Let’s say the sandwich is selling for £2.10, then the profit per sandwich in this example is £2.00 (£2.10-£0.10).
Step 6: Divide the fixed costs (£40,000) by the profit per sandwich (£2.00) and the answer is 20,000 sandwiches. This is your break-even point and you can also express it in terms of sales value – in this case £40,000. You can check it as follows: 20,000 sandwiches x £2.00= £40,000 – the fixed costs which we calculated.
Varying levels of profitability
Before talking about how to use the break-even point, a quick caveat. So far we have calculated the break-even point with one product. If you are selling products with varying levels of profitability, then your break-even point will be affected by the mix of products that you sell.
You will have to estimate your average profit per unit based on your expected sales mix. A two-product business might look like this:
|Sandwich A||Sandwich B|
|Estimate % sales||50%||50%|
So half your sales make £2.00 and half £1.80 – to calculate the average:
50%x £2.00 + 50%x £1.80 = £1.00+£0.90 = £1.90
And the break-even point would now be:
£40,000/£1.90 = 21,052 sandwiches, i.e. it has gone up from 20,000 when the profit per sandwich was £2.00.
How to use the break-even point
So now you know one way to calculate break even, how can you use it?
Starting a new business
If you are starting a new business, the break-even point is your first financial milestone and it helps you to assess whether the business is viable – you can see whether, from a specific location, with a particular marketing budget, it is realistic to expect to sell 20,000 sandwiches. And if not, you can then go and revisit your pricing, costs per unit and fixed costs to come up with a different “recipe” or business model that feels more realistic.
This break-even calculation will also show you if it’s not viable to turn something into a full-time business, either because you can’t charge enough or realistically expect to sell enough to cover your overheads. However, it’s so much better to know that at the start than further down the line when you can’t pay bills.
Running a business
If you are running an existing business, it is still useful to know your break-even point because it shows you how much sales could fall before the business started to make a loss. This is known as the “margin of comfort”.
If you are looking to raise money from investors, then without a doubt one of their questions will be “what’s the break-even point?” – if you can confidently walk them through your calculations, you will be off to a good start.