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Business Plan Elements – 10

March 31, 2009

As a first step, even before you attempt to write a business plan , you need to take some time and understand Start Up Costs and Breakeven Analysis.

Some businesses can be started on a shoestring budget, while others may require considerable investment in inventory or equipment.  When you are planning to start a business, it is critically important that you understand what it is going to cost you to get the business up and running and to make sure your business will reach and exceed the breakeven point.

In order to determine how much start-up money you will need, you must estimate the costs of your business for at least the first several months.  Since every business is different and has its own specific cash needs at different stages of development, there is no universal method for estimating startup costs. However, it is vitally important to know that you will have enough money to launch your business venture.

To determine your start-up costs, you must identify all the expenses your business will incur during the start-up phase. Some of these expenses will be one-time costs, such as the fee for incorporating your business, necessary equipment, even the price of a sign for your building. Some expenses will be ongoing, such as the cost of utilities, inventory, insurance, etc.  While identifying these costs, decide whether they are essential or optional. A realistic startup budget should only include those elements that are absolutely necessary to start the business.

These essential expenses can then be divided into two separate categories: fixed (overhead) expenses and variable (related to business sales) expenses. Fixed expenses will include figures like the monthly rent, utilities, and administrative and insurance costs. Variable expenses will include inventory, shipping and packaging costs, sales commissions, and other costs associated with the direct sale of a product or service.

The most effective way to calculate your start-up costs is to develop a worksheet that lists all the various categories of costs (both one-time and ongoing) that you will need to estimate prior to starting your business.

Once you have an idea of your start-up costs you then need to do the “breakeven analysis.”

Breakeven analysis is a tool used to determine when a business will be able to cover all its expenses and begin to make a profit.  Knowing your start-up costs and your on-going expenses provide you with information you need so that you can calculate how much sales revenue will be required to pay these ongoing expenses related to running your business.

Simply stated, the breakeven point occurs when your total revenues reach the total of all of your costs associated with achieving those revenues.

To calculate your breakeven point you will need to know your fixed and variable costs. Again, fixed costs (overhead) are expenses that do not vary with sales volume, such as rent and administrative salaries. These expenses must be paid regardless of sales.   Variable costs, such as the cost of goods,  fluctuate directly with sales volume.  These include the cost of things like purchasing raw material inventory, manufacturing a product and shipping it.  The formula for determining your breakeven point requires no more than simple arithmetic.

The 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 need to make educated guesses about your expenses and revenues. These should be based on 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 estimates and calculations for these items:

Fixed costs – The “overhead” does not vary much from month to month. It includes the 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. A valid break-even analysis must be based on the volume of business you reasonably and realistically expect — not on how much you might need to actually make a 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 Jane 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 Jane 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 pretty easy to figure out the 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 Jane’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, Jane 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 Jane.)

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 or do without an employee o 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.

Should that be the case, take heart in the fact that you found out before you invested your (or someone else’s) money in the idea.

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.

Beyond your start-up costs and breakeven analysis, there are two more 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.

For more information, be sure to contact SCORE Lancaster at (717) 397-3092 or visit us on the web at www.scorelancaster.org

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