Question: How would you calculate your break-even point? What are your contribution margin per unit and total fixed costs?
When starting a business, once you are done with the planning stages, I think every ounce of your effort should focus on reaching break-even. In my “3 Necessities to Start a Business” post, you should have the idea and the strategy, and now you are executing. You will achieve break-even when your net income is zero.
Because the world is not black and white, let’s first be clear that this is not always the number one goal. In many venture-backed businesses, especially in the technology industry, owners do not care about breaking even as fast as possible. They care about building a product that is going to have a huge upside, even if it’s a longer term position. The content of this post is meant to serve the average entrepreneur, especially one who is starting a business with savings or a family loan.
Whether you’re boot-strapping it, you have a bank loan, or you have some angel investors, the bottom line is that you have a limited runway before your business needs to take off and start showing a profit. Again, this could vary for many reasons, such as the source of your funding, your industry, or the product that you’re creating. Take all of these things into account when you’re creating your strategy, but that strategy should include the break-even point, even if it’s years down the line.
I’d like to discuss two related, but different, ways of looking at breaking even in your business: One is a detailed look at individual products’ contribution margins, and the other is a high-level view of the business’ top-line required. I recommend focusing on the former for your initial plan. Once your business has some history under its belt, then the latter may be useful. The concept is the same in both: You need to sell enough products to cover all your fixed costs (costs that don’t change based on number of units sold, such as rent and utilities).
First, looking at contribution margin per unit: This is the amount of profit contributed by each unit sold. To calculate it, take a product’s price less it’s costs of goods sold (all variable prices). For example, if you sell an ice cream cone for $5, and it costs you $2, $1, and $1 for the ice cream, cone, and labor, then your contribution margin is $5 – $4 = $1. If your fixed costs are $10,000/month, then you need to sell 10,000 ice cream cones to break even.
Now, looking at overall break-even point, if your overall contribution margin ratio is 50%, then you would need revenue of $20,000/month to break even, because subtracting $10,000 in variable costs leaves enough to cover $10,000 in fixed costs. Compare this to the previous example: Those ice cream cones had a ratio of 20%, so you would have had to sell $50,000/month. Looking at the overall margin can be useful to analyze your product mix—how much you sell of each product.
If you’re getting to the point of executing your business strategy, get your mind centered around breaking even. If you are starting out as a solo entrepreneur, be sure to include your salary in your fixed costs. The salary needs to be enough to cover all of your personal expenses. Otherwise, where will the money come from? Lead off with this mentality, and you will be on your way to blow past the break-even point and into profitability.