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In an earlier lesson, we suggested that one of the advantages of our coffee
shop idea was that the venture could break even at what seems to be an easily
achievable volume. This was a rather cursory reference to an important tool
called break-even analysis. A break-even analysis examines the interaction
among fixed costs, variable costs, prices, and unit volume to determine
that combination of elements in which revenues and total costs are equal.
Fixed costs are those expenses necessary to keep the business open, and
are not impacted by sales volume. They will include such things as rent,
basic telephone expenses and utilities, wages for core employees, loan
or lease payments, and other necessary expenditures. An entrepreneur should
also include a living wage for himself/herself as a fixed cost. Variable costs include those expenses that change as a result of sales
volume. This can be a relatively simple relationship, as in cost of goods
sold, where for example the variable cost of baked goods sold at our coffee
shop is what we pay the baker for them, $0.30 each. Variable costs can
also be very complex; for example, higher sales in one area of our business
may increase long distance charges. Labor costs may be fixed for full-time
employees, then, as sales increase, some overtime is incurred until additional
personnel can be justified. Generally, an initial break-even analysis focuses on a relatively narrow
range of sales volume in which variable costs are simple to calculate.
The variable cost in our coffee shop is simply the cost of goods sold.
For a pizza delivery operation, it might be the cost of ingredients, and
some cost allocated for operation of the delivery vehicle. A general term
often used for the difference between selling price and variable cost
is "contribution margin," or the amount that the unit sale contributes
to the margin available to pay fixed costs, and generate profit (we hope). Now let's take a look at how break-even analysis can be helpful to us.
For this example, let’s assume we have determined that the level
of fixed costs (salaries, rent, utilities) necessary to run our coffee
shop on a monthly basis is $9,000. In addition, a cup of coffee that we
sell for $1 costs us $0.25 for the bulk coffee, filters, and water. The contribution margin of a cup of coffee is, therefore, $0.75. We can
now calculate how many cups of coffee we have to sell to cover our fixed
costs: Let us say, further, that the fixed cost estimate was based on being
open 6 days a week, 8 hours a day. This converts roughly to 200 hours
a month, so we have to sell 60 cups an hour. This is a cup a minute for
every minute we are open. Does this seem feasible? Let us assume not, and evaluate some options.
(1) Cut fixed expenses
Remember that we are still in the planning stage here, and experience
has shown that prospective entrepreneurs almost always underestimate
expenses. Let’s pass on this approach. (2) Raise prices We could plan on charging $1.25 per cup from the beginning, for a contribution
margin of $1 per cup. The arithmetic is easy; to cover $9,000 in fixed
expenses we need to sell 9,000 cups of coffee per month. The most important
factor here is what the competition is charging. (3) Broaden our product line For the sake of clarity in demonstrating relationships between price,
cost, and sales volume, we have considered a simplified version of how
a real coffee shop might operate. The market severely constrains the amount
we can charge for an ordinary cup of coffee, and a one product shop would
have limited appeal. Let us say we will also offer gourmet coffees, which cost us $0.50 per
cup to brew, at $2.00 per cup. We will also offer baked goods, which cost
us $0.30 each, at $1.30. The break-even calculation is now indeterminate,
that is, there are an infinite number of solutions without making some
additional assumptions. We will assume that two-thirds of our coffee sales will be regular coffee
(call the number of cups R, the remaining third, gourmet coffee, G). Let
us further assume that half of all coffee purchasers also buy a pastry
(P): Since this must equal fixed costs at break-even: $2.25*R = $9000; R =
4000 Relating back to our assumptions, each month we must sell 4000 cups of
regular coffee, 2000 cups of gourmet coffee, and 3000 pastries. Does this
seem more feasible? This has been a very brief overview of how breakeven analysis can be
used in helping the entrepreneur better understand the relationship of
the financial factors involved in measuring the feasibility of a proposed
venture. From a preliminary analysis of selling prices that the market
will bear, prevailing costs, and reasonable expectations of sales volumes,
the entrepreneur can avoid making serious mistakes and may discover significant
opportunities.
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