How can you tell if your business idea will be profitable? Honestly, you can't. But this shouldn't keep you from researching the financial soundness of your idea. Prepare a "break-even analysis" (determine your break-even point) to get an idea of whether your business will succeed.
What a Break-Even Analysis Tells You
A break-even analysis shows you the amount of revenue you'll need to bring in to cover your expenses, before you make even a dime of profit. If you can attain and surpass your break-even point -- that is, if you can easily bring in more than the amount of sales revenue you'll need to meet your expenses -- then your business stands a good chance of making money.
Many experienced entrepreneurs use a break-even analysis as a primary screening tool for new business ventures. They won't write a complete business plan unless their break-even forecast shows that their projected sales revenue far exceeds their costs of doing business. The good news is that a break-even analysis is part of every business plan, so if you start by doing a break-even analysis now, you'll have already started work on your business plan.
How to Prepare a Break-Even Analysis
To perform a break-even analysis, you'll have to make educated guesses about your expenses and revenues. You should do some serious research -- including an analysis of your market -- to determine your projected sales volume and your anticipated expenses. Business plan books and software can teach you how to make reasonable revenue and cost estimates.
You'll need to make the following estimates and calculations:
- Fixed costs. Fixed costs (sometimes called "overhead") don't vary much from month to month. They include rent, insurance, utilities, and other set expenses. It's also a good idea to throw a little extra, say 10%, into your break-even analysis to cover miscellaneous expenses that you can't predict.
- Sales revenue. This is the total dollars from sales activity that you bring into your business each month or year. To perform a valid break-even analysis, you must base your forecast on the volume of business you really expect -- not on how much you need to make a good profit.
- Average gross profit for each sale. Average gross profit is the money left from each sales dollar after paying the direct costs of a sale. (Direct costs are what you pay to provide your product or service.) For example, if Antoinette pays an average of $100 for goods to make dresses that she sells for an average of $300, her average gross profit is $200.
- Average gross profit percentage. This percentage tells you how much of each dollar of sales income is gross profit. To calculate your average gross profit percentage, divide your average gross profit figure by the average selling price. For example, if Antoinette makes an average gross profit of $200 on dresses that she sells for an average of $300, her gross profit percentage is 66.7% ($200 divided by $300).
Calculating Your Break-Even Point
Once you've calculated the numbers above, it's easy to figure out your break-even point. Simply divide your estimated annual fixed costs by your gross profit percentage to determine the amount of sales revenue you'll need to bring in just to break even. For example, if Antoinette's fixed costs are $6,000 per month, and her expected profit margin is 66.7%, her break-even point is $9,000 in sales revenue per month ($6,000 divided by .667). In other words, Antoinette must make $9,000 each month just to pay her fixed costs and her direct (product) costs. (Note that this number does not include any profit, or even a salary for Antoinette.)
If You Can't Break Even
If your break-even point is higher than your expected revenues, you'll need to decide whether certain aspects of your plan can be changed to create an achievable break-even point. For instance, perhaps you can:
- find a less expensive source of supplies
- do without an employee
- save rent by working out of your home, or
- sell your product or service at a higher price.
If you tinker with the numbers and your break-even sales revenue still seems like an unattainable number, you may need to scrap your business idea. If that's the case, take heart in the fact that you found out before you invested your (or someone else's) money in the idea.
Further Financial Analysis
If your break-even forecast shows you'll make more revenue than you need to break even, you can consider yourself fortunate. But you still need to figure out how much profit your business will generate, and whether you'll have enough cash available to pay your bills when they are due. In short, a break-even forecast is a great screening tool, but you need a more complete analysis before you start investing real money in your venture.
The following are additional financial projections that should also be part of your business plan, to round out your business's financial picture.
- A profit-and-loss forecast. This is a month-by-month projection of your business's net profit from operations.
- A cash flow projection. This shows you how much actual cash you'll have, month by month, to meet your expenses.
- A start-up cost estimate. This is the total of all the expenses you'll incur before your business opens.
Don't Forego a Break-Even Analysis
Although creating a break-even forecast might sound complicated, you owe it to yourself to prepare one as one of the first steps in your business planning process. Now is the time to get used to using cost estimates and profit margins, if you're going to succeed in business. And as you can see, a realistically prepared break-even forecast will tell you whether your idea is a sure winner, a sure loser or, like most ideas, needs modifications to make it work. Plus, you'll have a big headstart on your business plan!