A significant advantage of some business ideas is that the venture can break even at what seems to be an easily achievable volume. A technique for quantifying that volume, called break-even analysis, examines the interaction among fixed costs, variable costs, prices, and unit volume to determine that combination of elements in which revenues and total costs are equal.
Fixed costs are those expenses necessary to keep the business open, and are not impacted by sales volume. They will include such things as rent, basic telephone expenses and utilities, wages for core employees, loan or lease payments, and other necessary expenditures. An entrepreneur should also include a living wage for himself/herself as a fixed cost.
Variable costs include those expenses that change as a result of sales volume. This can be a relatively simple relationship, as in cost of goods sold, where for example the variable cost of baked goods sold at a coffee shop is what we pay the baker for them, $0.30 each. Variable costs can also be very complex; for example, higher sales in one area of our business may increase long distance charges. Labor costs may be fixed for full-time employees, then, as sales increase, some overtime is incurred until additional personnel can be justified.
Generally, an initial break-even analysis focuses on a relatively narrow range of sales volume in which variable costs are simple to calculate. The variable cost in a coffee shop is simply the cost of goods sold. For a pizza delivery operation, it might be the cost of ingredients, and some cost allocated for operation of the delivery vehicle. A general term often used for the difference between selling price and variable cost is "contribution margin," or the amount that the unit sale contributes to the margin available to pay fixed costs, and generate profit (we hope).
Now let's take a look at how break-even analysis can be helpful to us. For this example, let's assume we have determined that the level of fixed costs (salaries, rent, utilities) necessary to run a coffee shop on a monthly basis is $9,000. In addition, a cup of coffee that we sell for $1 costs us $0.25 for the bulk coffee, filters, and water.
The contribution margin of a cup of coffee is, therefore, $0.75. We can now calculate how many cups of coffee we have to sell to cover our fixed costs:
Break-Even = (Fixed Costs) / (Contribution Margin)
= $9,000/$0.75 = 12,000 cups of coffee per month
Let us say, further, that the fixed cost estimate was based on being open 6 days a week, 8 hours a day. This converts roughly to 200 hours a month, so we have to sell 60 cups an hour. This is a cup a minute for every minute we are open.
Does this seem feasible? Let us assume not, and evaluate some options.
(1) Cut expenses
Remember that we are still in the planning stage here, and experience has shown that prospective entrepreneurs almost always underestimate expenses. Let's pass on this approach.
(2) Raise prices
We could plan on charging $1.25 per cup from the beginning, for a contribution margin of $1 per cup. The arithmetic is easy; to cover $9,000 in fixed expenses we need to sell 9,000 cups of coffee per month. The most important factor here is what the competition is charging.
(3) Broaden our product line
For the sake of clarity in demonstrating relationships between price, cost, and sales volume, we have considered a simplified version of how a real coffee shop might operate. The market severely constrains the amount we can charge for an ordinary cup of coffee, and a one product shop would have limited appeal. Perhaps we could also offer gourmet coffees, which cost us $0.50 per cup to brew, at $2.00 per cup. We could also offer baked goods, which cost us $0.30 each, at $1.30.
Suffice it to say that the break-even calculation now becomes a bit more complex, and outside what we are trying to accomplish here. Feel free to try it on your own.
This has been a very brief overview of how break-even analysis can be used in helping the entrepreneur better understand the relationship of the financial factors involved in measuring the feasibility of a proposed venture. From a preliminary analysis of selling prices that the market will bear, prevailing costs, and reasonable expectations of sales volumes, the entrepreneur can avoid making serious mistakes and may discover significant opportunities.
john b. vinturella, ph.d. has almost 40 years experience as a management and strategic consultant, entrepreneur, author, and college professor. For 20 of those years, Dr. Vinturella was owner/president of a distribution company that he founded. He is a principal in business opportunity sites john b. vinturella, ph.d. and john b. vinturella, ph.d., and maintains business and political blogs.
expert residential cleaners Park Ridge ..I love the excitement of starting up a new home... Read More
Storytelling and writing a business plan actually go hand in... Read More
Many companies are reluctant to dive into outsourcing ocean because... Read More
This week I coached a wonderfully lovely woman I'll call... Read More
Canada's lean leaders need to look beyond the horizon and... Read More
With the help of balanced scorecard strategy map, it is... Read More
Can you imagine going on a road trip without knowing... Read More
It is always said "If you Fail to Plan, you... Read More
Please take a moment before you read any further and... Read More
Creativity is one of the greatest tools for success in... Read More
In 1989, Sony founded its Institute of Wisdom at the... Read More
The boom of the dot-com era in 1999 brought the... Read More
The decision to sell, or not to sell your business... Read More
The goal of almost every business owner is to generate... Read More
"Most great plans aren't. They are just nice, high-level ideas."That's... Read More
Have you ever done a SWOT analysis? No, it's not... Read More
Mobile auto detailing equipment becomes very inexpensive around March each... Read More
Succession planning, like any business acumen, is both an art... Read More
Do you work in or own a business that's affected... Read More
To Grow (Catapult) Your Business That's Why.When it's in your... Read More
More than $117 billion passed hands from Internet shoppers to... Read More
Entrepreneurs often give little if any consideration to their computer... Read More
To stop a computer virus you must understand how it... Read More
What gets measured gets done.How do you keep your business... Read More
Q: A key investor in my business has suggested that... Read More
green cleaning service Park Ridge ..( * - the word 'product' can be substituted to... Read More
A survey released by the American Institute of Certified Public... Read More
Diversify - to make diverse, give variety, to balance, to... Read More
1. Attempt Succession Planning Without Other Strategic Plans. Succession plans... Read More
The decision to sell, or not to sell your business... Read More
Making money doesn't make your reputation... your reputation makes you... Read More
If you own a pressure washing business one of the... Read More
"Most great plans aren't. They are just nice, high-level ideas."That's... Read More
To stop a computer virus you must understand how it... Read More
Richard L. Daft one of the country's recognized academic leadership... Read More
"Bozo" ? A clown with a forlorn look, always finding... Read More
Ask a small business owner about their strategic plan and... Read More
Most companies that are worthy of raising venture capital have... Read More
If ever there were an industry where we want zero... Read More
Conventional wisdom has it that there are only three ways... Read More
ACTION PLANNING: Action Planning is a process to develop strategies... Read More
While writing an article recently on effective ways to bridge... Read More
I love the excitement of starting up a new home... Read More
Do you work in or own a business that's affected... Read More
If you've ever listened to Warren Buffett talk about investing,... Read More
A recent conversation started with a typical question, "How's business?"... Read More
Imagine spending the same amount of money on marketing and... Read More
Scenario OneDuring a recent presentation, a business owner was given... Read More
When developing the competition section of your business plan, companies... Read More
More than $117 billion passed hands from Internet shoppers to... Read More
Strategic Planning |