Tuesday, 22 October 2013

Billy's Second Law: The Break-even


Starting a business without doing a break-even is like snowboarding out of bounds in the fog.  You might have the ride of your life, but there is a good chance you’ll wind up lost, injured or dead!

Everybody has a million dollar idea...that won't work!


Maybe it is the last vestiges of my education as a “math geek” or maybe it is just my general scepticism, but you really need to know what you need to do before you get started.  The best way to start, in my opinion, is to do your break-even.  Now to many this will sound like just some numbers oriented accounting crap that gets in the way of the creative soul of the entrepreneur.   Tough luck. 
I know what you are thinking, because I hear the same story over and over.  I had a friend (or relative, or acquaintance’s mothers sister-in-law’s next door neighbour) who didn’t do any of this accounting crap, and now they are rich.  Well, a girl I went to high school with won the $1,000,000 national lottery but I still don’t recommend lottery tickets as a part of a balanced investment portfolio.  Doing the break-even doesn’t mean your business will succeed or not succeed, but it merely tells you what it will take to succeed. Every business can succeed – but not every business will succeed. 

The break-even tells you how much revenue you need to generate to cover your fixed and your variable costs.  Your fixed costs are the costs to run the business – you know the overheads.  Overheads include telephone, wages, advertising, automobile office supplies and the like.  These are costs that you incur whether you make the sale or not.  Your variable costs, or your cost of goods, are the costs to make the product or to provide the service. 

I first learned about break even from my mother.  My mother was a nurse. She equated any purchase around the house to the number of shifts she had to work at the hospital.  If we asked for anything, Mom would ask, rhetorically of course, “Do you know how many shifts at the hospital I have to work to buy that?”  As soon as I learned to divide by $50 (a Registered Nurse’s take home pay at the time.) I just answered the question!  Do you know how many shifts at the hospital I have to work to buy you kids’ new skis?” “That all depends Mom – 3 shifts for the Élan’s, five for the K2’s with Solomon bindings.”  “Smart ass!” she replied.   (My mother is a bit of a smart ass as well.   After my loving tribute to her at her sixtieth birthday party responded by saying that birth control should be made retroactive.  Way to go Mom!)
It is crucial that you know what level of sales you need before you start the business. Once you know this level of sales, ask yourself these three questions:
  • Will my market support this level of sales? (Market Sufficiency)
  • Can I physically produce or provide this level of sales? (Practical Capacity)
  • Can I sell to at least this level of sales? (Sales Strategy)
If the answer to all of these is yes...you may just be on to something.  If the answer is no, then you may have to develop a new idea, change your prices, your costs or your market place. 

By the way, the break-even formulae are:

Break-even in Units =
Fixed Costs
(Price – Cost)
Break-even in Revenue=
Fixed Costs
Gross Profit %

By the way, the same analysis works for evaluating projects and new expenditures for an existing company.  Remember, it’s hard to succeed in business if you don’t know the target.  The break-even may not be the final destination, but it is certainly one of the steps along the way.
Next week, working along the same theme, I will post one of the most important business lessons for budding entrepreneurs, the dangers of falling in love too soon.

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