Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
How many units--products or hours of service--do you have to sell to cover your costs? Don't know? Then it's about time you found out! Follow these five steps for figuring out your break-even point. It's the key to determining your pricing and profitability.
Step 1. Determine the per-unit selling price and direct costs of the product or service you provide. Direct costs are classified as the costs that go into creating the product or service (that is, direct materials and direct labor). So let's say you have a gift basket business. The direct costs would be the price of the basket, the items in the basket, the wrap for the basket, and the labor involved in putting the basket together.
Step 2. Calculate your contribution margin in dollars per unit. Once you know the selling price and direct costs of each product or service unit you sell, you can calculate your contribution margin in dollars per unit. This is the amount of money you get over and above your direct costs for each unit you sell. (You can define your unit as either a product or hour of service.) Again, using the gift basket business as an example, if your selling price was $50 and your direct costs added up to $40, then your contribution margin in dollars would be $10 per unit. This is the amount you can contribute towards your overhead costs from each sale of your product or service.
Step 3. Calculate your overhead costs. What are all the other costs you incur in your business that need to be covered before you can start earning a profit? Overhead costs include such things as insurance, indirect labor, rent, taxes, dues and subscriptions, advertising, office supplies and so on. This is calculated in total, not on a per-unit basis. You need to know how much money it takes to run your business because you've got to cover these costs in addition to your direct costs before you can start making a profit.
Step 4. Determine your break-even point. Once you know your overhead costs, take that total number and divide it by your contribution margin in dollars per unit (the answer from Step 2 above). For example, if your overhead costs were $1,000 and your contribution margin from each unit you sell is $10, then your break-even in units would be $1000/$10 or 100 units. So, continuing with the gift basket business example, you must sell 100 gift baskets at $50 each to break even.
Remember, there's no profit in your business until you've covered your direct and indirect (overhead) expenses. Only after selling 100 units will you break even. Starting with the 51st unit, you'll be earning a profit. If you've determined that, based upon market predictions, you can only sell 40 items per month, you'll never earn a profit and you need to reconsider your business idea or your pricing. Increasing your pricing and trying to trim costs may just increase your contribution and profitability margins enough to keep you in business.
Step 5. You need to recalculate your break-even point on a regular basis. As your selling price, direct costs and indirect costs change, so will your break-even point. So it's absolutely imperative that you recalculate it as the other costs of doing business change. Without knowing your break-even point, you'll never know just what you have to do to make a profit.
Calculating your break-even point is something you need to incorporate as part of your pricing policy to ensure that you're making money on every unit you sell and that you'll be able to be profitable based on your costs and your sales. If you're not profitable, you will not stay in business. It's as simple as that.
Every type of business can incorporate this equation into their pricing module. No matter whether you own a service- or product-based business, you've got to have a good understanding of your direct and indirect costs and how they affect your pricing and profitability models. It might just mean the difference between a profitable and nonprofitable year for you.
If you don't know your break-even point, you're running your business blindly. It's a fact that thousands of companies go out of business every year. Why? One decisive factor is they just don't know their numbers. Why not make a difference in your business this year and get to know your break-even point?