It’s standard for a small business to take two or three years to turn a profit. But every entrepreneur hopes to be there faster. The best way to determine when a business will start becoming profitable is with a break-even analysis. This article shares how to create a break-even analysis for small business.
Since every business is distinct, there is no set timeline for a new business to become profitable. Yet, how high the startup costs are will directly impact the time it takes to turn a profit. That’s because it will take longer to recoup that investment, and you’ll need to break even before seeing revenue profits.
What you are selling, and how, will make a difference too. “Launching a new product takes a long, long time before it’s profitable. Figure about three years — more than 1,000 days,” according to Entrepreneur. However, a home-based business could be profitable more quickly, as it doesn’t have the same startup costs. Online businesses, too, can see profits sooner. However, again, it will depend on your costs.
Hence, the need for a break-even analysis. Here’s what you need to know about how to create a break-even analysis for small business:
- What is break-even analysis
- Why is it needed
- How to calculate your break-even point
- How to lower your break-even point
What Is Break-Even Analysis
First, you need to know that just because your business isn’t profitable yet, that it’s doing poorly. The Small Business Chronicle lists “three ways to measure profitability: for the principals, for the investors and for the business as a whole.”
A business might be showing a loss on paper, yet the entrepreneur could be taking out a substantial salary as a business expense. At least the principal is profiting, though this is not a great long-term business strategy. Investors could also make a profit so long as they are being paid back at a fixed interest rate, whether or not the business is earning or losing money.
To understand when the business as a whole will be profitable, you need a break-even analysis. As we’ll discuss in more detail below, you will determine what amount of revenue is needed to cover your business expenses before you see a profit.
Why Is It Needed
A break-even analysis is a common component of a business plan. It highlights critical information you need to know in starting your business. It can help you price smarter, evaluate your fixed costs, limit financial surprises, and set sales revenue targets.
With a break-even analysis, you’re less likely to make decisions based on how excited you are about your great idea. You’ll have concrete data available to make fact-based decisions. This can help to cut your risk of making decisions that lead to financial strain.
If you’re pitching investors, they’ll want to see your break-even analysis. They will be looking for your analysis to help prove that your business plan is viable. They will use your break-even analysis to determine when they can expect to recoup their investment.
How to Calculate Your Break-Even Point
Preparing a break-even analysis for small business requires you to analyze your market and make some estimates about your expenses and revenues. You’ll need to calculate:
- Fixed costs such as monthly rent, utilities, and insurance
- Sales revenue, the total dollars you expect to bring in monthly or yearly. Note: this is based “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, which captures how much money you make after paying variable costs for that sale
- Average gross profit percentage, calculating how much of each dollar is gross profit. E.g., if you sell a vintage dress for $30, but it cost you $10 to buy it, that’s a $20 profit, so a gross profit percentage of 66.7% ($20 divided by $30)
Once you have this information, you can calculate your break-even point. You will divide estimated annual fixed costs by the gross profit percentage to determine the amount of sales revenue needed to break even. So, if you had fixed costs of $2,000 per month and a 66.7% gross profit percentage, the math would be $2,000 divided by .667. That’s $2998. So, you need to make that much each month to cover your fixed and direct costs and make a profit.
Want some help with the math? Try this Break-Even Analysis Template.
How To Lower Your Break-Even Point
The break-even point for small business can be lowered. The moving pieces are your fixed costs, variable costs, and gross profit. So, you might reduce your costs or increase your selling price to impact gross profit.
Every time a manufacturer closes an assembly line and cuts thousands of jobs, it’s reducing its fixed costs. With fewer fixed costs, they don’t need as many sales to make a profit.
As a small business, you might change the supplier you are working with or alter the materials used in your product to reduce the variable costs per unit. This can increase your profit margin too.
Increasing the price point can also help. Yet, you need to be wary of sacrificing quality or increasing the selling price so much that it causes you to sell fewer units.
Using Your Break-Even Analysis
With a break-even analysis for small business, you gain an important reference point. For example, if you’re considering investing in a new professional business website, the break-even analysis can help you determine what impact that will have on your profitability. Use your break-even information to make operating decisions, service debt, find investors, and keep your business on a path for success.