What does break-even analysis do for us

An alarming number of people go into small businesses with little or no understanding of the financial side of running a business.  I’ve spoken to one woman who is setting up a company. When I suggested she draw up a spreadsheet of her costs and estimated revenues she replied that she just couldn’t get her head around figures and was going to leave all that to the accountant.  To be honest, I think that’s a bit like driving a car and only seeing road signs every six months.  I guess it’s one of the reasons that I get so many opportunities to buy businesses cheaply and turn them round.

I am quite happy for business people to be uncertain how accountants draw up the annual report from the bookkeeping figures; but I’m also convinced that you’ve got to be able to understand enough about finance to help with two processes.  You need to know enough to use the numbers to help with planning, and also to read the signals that the numbers give on your progress.  Of these signals, break-even analysis is by far the most important at the beginning of new business project.

The difference between success and failure in a new business revolves around how long it takes for the business to start making a profit.  While you are still spending more money than you’re receiving in sales revenues, you remain uncertain whether your dream business is going to come true or turn into a nightmare of sleepless nights.
Here’s how it works.  Every month you are going to spend money, whether anyone comes through the door to buy something or not.  These expenses are called, quite reasonably, fixed costs.  They include the rental or mortgage costs of the premises, insurances, staff costs, maintenance work, marketing costs and so on.  As part of your plan you need to make an absolutely complete list of these.  Don’t miss anything out or the calculation will go horribly wrong.

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 Tip from Shaf – Get the basics right
Make sure you have done an outline break-even analysis before you agree to buy a fixed asset, for example.  I know two guys who bought a boat with the intention of offering a ferry service on a major river.   They didn’t do the numbers until after they had signed contracts for the boat.  By the time they realized that the ferry service could not make a profit they were down the price of the boat and up to their ears n debt.

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The other costs are called variable costs and in retail premises, for example, only really occur when a customer buys something.  They are the direct costs of your product - the ingredients on the plate in the restaurant or the cost of the pen in the newsagent.  The more you sell, the higher the variable costs, but since you’re selling the items for more than you paid for them the higher is also the contribution that the sale has made towards, in the first place, your fixed costs and subsequently your profits.  People call it all sorts of things but I find the word contribution fits the bill best.  When you have worked out the difference between what customers paid for your products and what you paid for them you have the contribution that the profit on that revenue has made to fixed costs.
Here’s the formula in equation form:
    Revenues
          -    direct costs
         =    contribution
          -    fixed costs
         =    net profit
 
I’ll come back to this topic in another blog and show you some examples of break-even analysis at work