How to Determine When Your Startup Will Break-Even
The process of calculating the breakeven point for your startup is really quite simple in theory. The problem is that it is hard to predict for most businesses because the process requires you to make a number of assumptions.
If these assumptions are wrong, your breakeven point could change drastically. This can cause a series of problems like a cash shortage, which will then cause you to either invest more of your personal money, find new investors, or secure a loan, all of which can be quite painful.
1. Calculate Gross Profit per Unit
One of the most important financial concepts you will need to learn in running your new business is the computation of gross profit. And the tool that you use to maintain gross profit is markup.
The gross profit on a product is computed as:
Sales - Cost of Goods Sold = Gross Profit
To understand gross profit, it is important to know the distinction between variable and fixed costs.
Variable costs are those things that change based on the amount of product being made and are incurred as a direct result of producing the product.
Variable costs include:
a) Materials used
b) Direct labor
e) Plant supervisor salaries
f) Utilities for a plant or a warehouse
g) Depreciation expense on production equipment
Fixed costs generally are more static in nature. They include:
a) Office expenses such as supplies, utilities, a telephone for the office, etc.
b) Salaries and wages of office staff, salespeople, officers and owners
c) Payroll taxes and employee benefits
d) Advertising, promotional and other sales expenses
f) Auto expenses for salespeople
g) Professional fees
Variable expenses are recorded as cost of goods sold. Fixed expenses are counted as operating expenses (sometimes called selling and general administrative expenses).
While the gross profit is a dollar amount, the gross profit margin is expressed as a percentage. It's equally important to track since it allows you to keep an eye on profitability trends.
This is critical, because many businesses have gotten into financial trouble with an increasing gross profit that coincides with a declining gross profit margin.
The gross profit margin is computed as follows:
Gross Profit / Sales = Gross Profit Margin
There are two key ways for you to improve your gross margin. First, you can increase your prices. Second, you can decrease the costs to produce your goods. Of course, both are easier said than done.
An increase in prices can cause sales to drop. If sales drop too far, you may not generate enough gross profit dollars to cover operating expenses. Price increases require a very careful reading of inflationary rates, competitive factors, and basic supply and demand for the product you are producing.
The second method of increasing gross profit margin is to lower the variable costs to produce your product. This can be accomplished by decreasing material costs or making the product more efficiently.
Volume discounts are a good way to reduce material costs. The more material you buy from a supplier, the more likely they are to offer you discounts.
Another way to reduce material costs is to find a less costly supplier. However, you might sacrifice quality if the goods purchased are not made as well.
Whether you are starting a manufacturing, wholesaling, retailing or service business, you should always be on the lookout for ways to deliver your product or service more efficiently.
However, you also must balance efficiency and quality issues to ensure that they do not get out of balance.
Let's look at the gross profit of ABC Clothing. as an example of the computation of gross profit margin. In Year 1, the sales were 1 crore and the gross profit was 25,00,000 resulting in a gross profit margin of 25 percent (Rs 25,00,000/1 Crore). In Year 2, sales were 1.5 Crores and the gross profit was Rs 45,00,000, resulting in a gross profit margin of 30 percent (45,00,000/1.5 Crores).
It is apparent that ABC Clothing earned not only more gross profit in Year 2, but also a higher gross profit margin. The company either raised prices, lowered variable material costs from suppliers or found a way to produce its clothing more efficiently (which usually means fewer labor hours per product produced).
ABC Clothing did a better job in Year 2 of managing its markup on the clothing products that they manufactured.
Many business owners often get confused when relating markup to gross profit margin. They are first cousins in that both computations deal with the same variables. The difference is that gross profit margin is figured as a percentage of the selling price, while markup is figured as a percentage of the seller's cost.
Markup is computed as follows:
Markup Percentage = (Selling Price - Cost to Produce) / Cost to Produce
Let's compute the markup for ABC Clothing for Year 1:
(1 Crore - Rs 75,00,000) / Rs 75,00,000 = 33.3% (Markup Percentage)
Now, let's compute markup for ABC Clothing for Year 2:
(1.5 Crores - 1.05 Crores) / 1.05 Crores = 42.9% (Markup Percentage)
While computing markup for an entire year for a business is very simple, using this valuable markup tool daily to work up price quotes is more complicated. However, it is even more vital.
Computing markup on last year's numbers helps you understand where you've been and gives you a benchmark for success. But computing the markup on individual jobs will affect your business going forward and can often make the difference in running a profitable operation.
2. Calculate Fixed Monthly Expenses
Once you have gross profit you need to determine what your fixed expenses look like each month. Generally what I do is add up all of my monthly expenses, and then take any of my annual or or quarterly expenses and just divide by 12 months or 4 months respectively to come up with the monthly expense equivalent.
3. Determine Number of Units Sold to Breakeven
Now all you need to do is take your fixed monthly expenses divided by your gross profit per unit, and you will be able to determine how many units you need to sell in order to breakeven.
4. How Much Time to Breakeven
Now you can take it one step further and try to estimate how many days, months, or years it will take you to reach a breakeven point. For example, if you found out in the step above that you need to sell 500 units a month to breakeven and you are only selling 250 units a month now, you can estimate how long it will take to breakeven by figuring out how long it takes your sales team to sell one more unit and then multiply that by 250. If your sales team is increasing the monthly units sold by 5 units per day, then you would expect to reach a breakeven point in 50 days (250 divided by 5).
5. Funding Needed to Reach Breakeven
You can take it one final step by determining how much funding you will need in order to reach a breakeven point. If you know it is going to take you 50 days and your fixed monthly expenses are INR 10,00,000 per month, then your fixed expenses per day is INR 33,334.
For 50 Days it will cost you 16,66,666 INR. You need to borrow, or invest approximately INR 17,00,000 in order to survive until you reach a breakeven.
There you have it. The calculations are really pretty simple. The hard part is predicting your cost of goods sold, your monthly expenses, and how long it will take you to generate new sales. If your assumptions are correct, this process will give you a good idea as to when and how you will breakeven.