If you are planning to manufacture or create a product, you will need to do a “Break Even” analysis. The point of this is to find out at what point your sales (sometimes called receipts) will cover the costs incurred and when you can expect to start making a profit.
This is an important exercise and will help you see if your business idea is viable. For example:
O number of sales = you are working at a loss and could end up in trouble
X number of sales = pay your bills
XX number of sales = pay your bills and make some money
We can project the costs of the product we are going to make and the amount of the sale we expect to achieve when that product is sold.
The point at which sales covers costs is called THE BREAK EVEN POINT.
To find this point, we need to recap on some of our accounting terms:
FIXED COSTS = the costs which stay the same regardless of what work we do and how much we produce. Examples of this would be rent, rates, fixed salaries, etc.
VARIABLE COSTS = the costs which vary with the amount of output. Eg: Eggs cost 6p each. If we need two eggs to make one omelets our variable cost will be 12p; we need four eggs to make two omelets so our variable cost to produce two omelets will be 24p, etc.
Now consider the following restaurant, Charlie’s Chattery.
It has fixed costs/overheads of £15,000.
The chef makes one omelet with a variable cost of 12p. It is sold for £2.50. The difference between the SELLING PRICE and the VARIABLE COST is £2.38. This is called a CONTRIBUTION. And each omelet sold will make a similar contribution – which goes towards meeting the FIXED COSTS.
Use your calculator to check these figures……Charlie’s Chattery needs to cover £15,000 of fixed costs. £2.38 divided by £15,000 is 6302.5. This will mean it has to sell 6302.5 omelets before BREAK EVEN is achieved.
ONLY THEN will it move into PROFIT.
Any omelets produced over and above the 6302.5 that are needed to meet the Fixed Costs are known as “THE MARGIN OF SAFETY”.
If costs rise (variable ones) you may be able to pass them onto the customer. i.e: Variable Cost rises, Sales price rises at equal rate.
However, if competition means we have to reduce our sales price, the break even point will reduce and we will have to sell more (each item giving a smaller contribution to fixed costs) to reach the break even point.
This is not a calculation you should do only during initial business planning; knowing your product and careful planning will mean you are ahead in the market place; it is hard work being self employed and often even tougher when you are disabled, so protect yourself and your business with regular reviews of your costs, sales and competitors. This means that changing trends will not catch you unawares and you will have the opportunity to take positive action to maintain your level of profit.