There’s no question that startup businesses are incredibly exciting and, at the same time, extremely risky. So, it’s important to have a framework in place that helps you make sound choices when it comes to your finances and business strategy. In this blog, we will be discussing the importance of profitability and break-even analysis for your startup. We will also provide tips on how to calculate these metrics and effectively use them in your business decisions.
The best small businesses plan for economic challenges and prepare for when times are not as profitable. Break-even analysis is a method of determining the point at which a business would neither make nor lose money. This article discusses various break-even analysis methods, why it’s important to ensure your profitability, and how you can apply this financial principle to your startup or small business.
At the end of this article, you should be able to answer the following questions with ease:
How do you create a break-even analysis for a startup?
Do you factor in startup costs in your break-even analysis?
What revenue do you need to break even and achieve profitability?
What is break-even in a startup?
When starting a new business or project, one of the most important concepts to understand is the Break-even Analysis, which is the amount of revenue required to cover the expenses. A good grasp of this is essential since even businesses with significant sales revenues can incur losses.
Recognizing startup costs can help small business owners determine the sales volume needed to cover business expenses on an ongoing basis. This breakeven analysis, as a vital component of the business plan, is best evaluated before deciding to pursue a business venture. If a business does not break even or show a path to breaking even, the entrepreneur can make amendments or consider another business.
This is a common mistake among a few startup businesses that rely solely on investor funds to operate. We have seen startups receive millions of dollars in funding, but because there is no clear path to profitability, most of these funds are squandered on just meeting operating costs.
To be clear, most small businesses and startups might have to make losses initially until they become profitable, but the idea is that every business should have a clear plan on how to make profits. This usually begins with estimating the costs and determining the level of revenue required to match up. More on this below. Guesswork is not a good approach to estimating costs if the business is a startup.
Among the many reasons to understand the Break-even point are:
It indicates how many units of a business offering must be sold to avoid losses.
It aids in predicting when profit will be made.
Fixed and variable costs are identified and managed.
It aids in determining whether the selling price needs to be adjusted.
It aids in determining the margin of safety. This is actual sales minus break-even sales, which tells how much sales can drop before a venture turns unprofitable).
Before embarking on a venture, its viability and risk are assessed.
Without a commercial background, this might sound complicated to the average business owner. However, conducting a break-even analysis simply indicates the sales needed to cover all costs. Performing the analysis requires three basic components.
What is the break-even analysis?
A break-even analysis is a calculation used to determine when your business will begin to make money. It can be thought of as the point at which you start to make a profit on every sale you make. The break-even analysis determines when you stop losing money on each sale.
The break-even analysis can be made in two ways:
While these methods are different, they both use the same calculation of the cost to sales revenue (C/S) ratio. The formula for calculating a business’s break-even point is as follows:
Costs = fixed costs + (variable costs * units sold)
Revenue = selling price * units sold
C/S Ratio = total revenue / total costs
This means that your profit margin will be equal to the selling price minus the fixed and variable costs when you reach break-even.
A business owner should understand how to calculate the C/S ratio of a product or service to determine whether the company can remain profitable if that product or service is sold in the future. They will also know when their business becomes unprofitable by calculating the point at which sales revenue is less than total expenses (fixed costs + variable costs). This analysis helps businesses decide on pricing strategies as well as profit margins.
What are the advantages of break-even analysis?
The advantages of break-even analysis are that it can help to identify whether a business is profitable or not and to determine the necessary changes to make to improve profitability. The break-even analysis is especially useful in business-to-business sales. It helps to determine the point of profitability and the cost of selling goods or services.
There are a few more advantages to conducting a break-even analysis:
-It helps you identify areas of your business where you are losing money and where you can make changes to reduce your losses.
-It also helps in setting foreseeable goals and objectives to achieve within a specific timeline.
-It determines the number of resources that you need to allocate towards your business to be successful.
-It helps in understanding the financial health of a business.
-It helps in making informed business decisions.
-It can help in forecasting future cash flows.
-It can help you identify any potential losses or profitability shortfalls in your company.
-It can help you evaluate the reasons for any drop in sales and decide on the necessary countermeasures.
-It also provides you with an overview of your overall financial situation.
How to calculate the break-even point?
There are a few steps that you need to take to calculate the break-even point:
-The first step is identifying and calculating your fixed costs.
The second is identifying and calculating your variable costs.
The third is determining your total revenue.
Finally, you need to determine your fixed and variable costs in relation to your total revenue.
The concepts are explained further below:
A. Fixed costs
The fixed costs in a small business are operational expenses that do not change from month to month. These expenses remain constant no matter how much is sold. Nonetheless, you must be aware of the total cost of everything, which can include rent, employee salaries, office/computer expenses, subscriptions, bank fees, professional fees (paid to accountants and lawyers, for example), supplies, telephone and utilities, and anything else that is specific to the business and for which a fixed amount is paid. It should be noted that this can include direct costs such as labor and machinery because the inputs to these costs do not vary with the output, i.e. the volume of product sold.
B. Variable costs
Variable costs include sales commissions, shipping, and inventory – anything that can rise or fall with sales volumes. These costs effectively vary with each product or service sold. These include the materials, packaging, labels, and shipping, among other things.
A commercial venture must earn enough in sales to cover its fixed and variable costs to make profits. To remain profitable, a delicate balance of price and volume is required. Depending on the type of product or service provided, price may be the most crucial factor to:
(1) cover costs – if it costs X naira to sell a product, a business owner may simply put the price as X+1 naira to ensure that the company is profitable.
(2) boost volumes: the pricing mix may determine how to boost the sales volumes.
In a simple example, John sells phones. John buys his phones from the manufacturer for ₦100,000 and sells them for ₦150,000, making a gross profit of ₦50,000 on each phone. On average, he spends about ₦10,000 on packaging, selling, and distribution expenses. John has total fixed costs of ₦800,000 per month covering rent, staff costs, electricity bills etc.
Break-Even Point Formula
Fixed Costs/ (Unit Sale Price-Variable cost per unit)
Let us test this out:
Revenue = Unit Price * Units Sold
= ₦150,000 * 20phones
Variable Costs = Unit Variable Cost * Units Sold
= (₦100,000+10,000) * 20phones
Fixed Costs= ₦800,000
Breakeven= Revenue-Variable Costs-Fixed costs=0
If John’s sales are fewer than 20 phones (or ₦3m) per month, he is losing money—he would lose ₦40,000 for every phone sold. But, if his sales are greater than ₦3m per month, he is making a profit—₦40,000 for every phone above 20 phones sold each month.
A break-even analysis helps determine whether the overhead cost is realistic or needs to be reduced. Maybe, in the example above, for John, it is impossible to sell more than 15 phones in a month. If that is the case, then the fixed cost of ₦800,000 per month is too high for his business and needs to make some changes— negotiate a lower rent, add an additional profitable product line, or move to a new location. The possibilities are endless but there is now information available to decide about profitability.
When Should You Use Break-Even Analysis?
When it comes to starting a new company or business,
Designing a brand-new product or service for the market
Changing a new avenue of distribution
Changing your company’s model of operation
What are the Break-even Analysis’s limitations?
It is not possible to determine the break-even point for a start-up business.
It is also difficult to calculate the breakeven point for a company that is in the pilot stages of its operations.
The break-even analysis can only be done for a defined period and not for an indefinite period.
It is not always reliable as it can be influenced by several factors.
The limitation of the break-even analysis is that it cannot be used to project future cash flows.
The Break-even Analysis does not account for the costs of lost sales, which could occur if the company is unable to generate a profit from its current sales levels.
It does not consider the opportunity cost of capital, which is the forgone capital that could be used for other ventures.
It does not consider the long-term viability of the company.
It takes no account of competition.
Every business has fixed costs that must be paid each month, even if there are no sales that month. Variable costs are incurred when products or services are sold. External market conditions can change, and a profitable product or service may not sell as much (think of those businesses that stocked Blackberry phones when they went out of style). A break-even analysis is the simplest way to determine how many products a company must sell to achieve the desired level of profitability.
Many small business owners usually bring a product or service to the market before having a full understanding of the total costs. This, in turn, influences how much to charge for any specific product or service, which can have a negative impact on profits. Not only will the company have to deal with market volatility, but it may also lose customers due to inconsistent pricing. Why should customers trust the value of a product or service if the value cannot be well-marketed?
One of the most important tools for making good business decisions is conducting a break-even analysis. You can estimate whether a profitable idea exists and the best pricing strategy to achieve those objectives.
You can contact us if you need assistance with break-even analysis.