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.
post construction cleaning Deerfield ..Remember reading "Alice in Wonderland?"She asks the Cheshire Cat, "which... Read More
Possibly THE most frequently asked question of me is "What... Read More
Writing a business plan for a franchised outlet of a... Read More
Many companies are reluctant to dive into outsourcing ocean because... Read More
I read once that something like 30 percent of all... Read More
Running a business, whether it be an offline multi-billion dollar... Read More
Many business start-up kits or consultants will tell you one... Read More
If you own a pressure washing business one of the... Read More
If you own a mobile franchise business and wish to... Read More
We all agree Strategic Planning is a critical part of... Read More
Canada's lean leaders need to look beyond the horizon and... Read More
If you are a successful franchise of a large franchise... Read More
There's nothing automatic about corporate growth, particularly in the information... Read More
Microsoft Business Solutions Great Plains serves mid-size and large clients... Read More
There is a story, about a business owner who wasn't... Read More
A strategic alliance is when two or more businesses join... Read More
The first task before hiring a contractor for home remodeling... Read More
ACTION PLANNING: Action Planning is a process to develop strategies... Read More
Richard L. Daft one of the country's recognized academic leadership... Read More
David E. Gumpert, author of Burn Your Business Plan, often... Read More
Many cities have home pages on the Internet. Many of... Read More
The current state of the available technology at the disposal... Read More
Making money doesn't make your reputation... your reputation makes you... Read More
Let us look at a few of the big distribution... Read More
It doesn't take a Terrorist Act, Tsunami or Earthquake to... Read More
Airbnb cleaning service Bannockburn ..No "meme" isn't a typo and Got Milk, the more... Read More
As a business owner, you've likely created a hurricane plan... Read More
Is there really anything as a problem? Does chaos or... Read More
Would you like to jumpstart your online or offline business... Read More
American Eagle Outfitters and Wet Seal Stores have issued statements... Read More
Creativity is one of the greatest tools for success in... Read More
It doesn't take a Terrorist Act, Tsunami or Earthquake to... Read More
Part 1A few weeks ago I attended a seminar sponsored... Read More
Mobile auto detailing equipment becomes very inexpensive around March each... Read More
From time to time there seems to be a flurry... Read More
David E. Gumpert, author of Burn Your Business Plan, often... Read More
There are no "rules of thumb" in the pursuit of... Read More
GETTING STARTED WITH SUCCESSION PLANNING: PART IA survey of 4,300... Read More
Every decade we seem to come up with a buzz-word... Read More
Growing your own small business can be one of the... Read More
Cassy was an employee of a nonprofit who had been... Read More
Note to Northwest Airlines ? It's not about fuel costsFor... Read More
Conventional wisdom has it that there are only three ways... Read More
By cranking up others development to meet your business needs,... Read More
If you're a solo professional like I am, you know... Read More
Writing a business plan is an essential part of the... Read More
There is a story, about a business owner who wasn't... Read More
Want to become more strategic? Add these traits to your... Read More
Scenario OneDuring a recent presentation, a business owner was given... Read More
1. Attempt Succession Planning Without Other Strategic Plans. Succession plans... Read More
Strategic Planning |