Starting a business: Working out the cost of breaking even

In the second of a three-part series on starting a company, fictitious health supplement business Nectarmin finds out how much it will have to sell to make a profit.

It sounds simple - sell your wares for more than it costs to produce them and you'll make a profit.

But working out the costings and cash requirements to ensure a business is viable is something many small businesses fail to do accurately.

Not only is break-even analysis the "technical territory" where many small business owners fear to tread, Deloitte Growth Solutions partner Greg Anderson says many lack the skills to do it themselves.

"What that means is they don't know how much they have to sell to make money and that knowledge is so crucial," he says.

Working through the costings for Nectarmin, Anderson found the business could expect to make a profit of 92c for every energy drink and $14.67 for every bottle of tablets sold.

Therefore, it needs to sell 7065 bottles or 443 packets of tablets each month to break even. Based on this information, Anderson advises Nectarmin to focus its energy on selling tablets rather than the bottles as they produce more profit.

THE ANALYSIS

To work out the financial viability of Nectarmin, Small Business has sought help from Deloitte on the break-even and contribution margin analysis.

The concepts are illustrated on the graph below to show a possible scenario for the Nectarmin business.

It is expected it will take some months to build up revenue but the business will still have to pay fixed costs (leases, interest on debt, insurance, wages of non-sales related staff).

There will also be variable costs which will vary with the volume of sales (purchases, freight).

Nectarmin can expect to incur costs in excess of revenue for some months.

The biggest worry then is - will it have enough capital to survive these first few months?

THE COSTS

Having gained this understanding, the company can work out what its actual costs might be (of course, these are purely fictional).

FIXED COSTS

Nectarmin could expect to incur the following monthly expenses: Professional fees (lawyers and accountants) of $2000, marketing $1000, office and administration $2500, advertising $600 and interest $400.

Total fixed costs $6500 a month.

In addition, it will incur variable costs for manufacturing and freight.

These need to be calculated per unit of sales.

To break even, Nectarmin needs to sell either 7065 bottles a month or 443 packets of tables a month (fixed costs divided by contribution margin).

Because Nectarmin expects to sell both products, it needs to calculate a break-even point based on its mix of sales.

Assuming it will sell 10 bottles for every packet of tablets, its break-even volume is 2730 bottles and 273 packets a month, which will generate $13,650 revenue monthly.

Nectarmin now needs to consider whether these monthly sales levels are achievable and in what time frame it expects them to be achieved.

2730 bottles divided by 12 equals 228 cartons a month

273 packets divided by 10 equals 28 cartons a month.

Nectarmin hopes to be able to achieve these sales levels consistently after four months.

This begs the question of how it will fund the expenses for the first four months. Deloitte has prepared a forecast cashflow statement that shows, even after allowing for payment of expenses in the month after they are incurred, it will have net cashflow deficit of $35,850 in the first four months.

This is a result of the fixed costs during periods of low revenue and the impact of having to pay for the manufacture of minimum purchase quantities.

That is to say it will have to manufacture in batches far greater than our initial monthly sales volumes to obtain supply.

In fact minimum purchase quantities offered by the manufacturers are:

Bottles: 500 cartons (12s) equal $9000

Tablets: 100 cartons (10s) equal $10,000

Fortunately, the drink manufacturer has agreed to hold surplus inventory in their premises.

Nectarmin's forecasts show during the first year its cash requirements will peak at a level of $38,850 which, allowing for variations, means this business will need pretty much all of its $50,000 available.

Although finances will be tight, and the owner is living off other sources of income, it may be able to avoid borrowing from the bank other than perhaps a small overdraft.

However, to borrow anything at all from a bank will require security over some real assets. Because Nectarmin does not have a history of trading, it is most likely the bank will want to register a charge against a property or the like.

Of course, if you don't own a house, borrowing from a bank to fund a business start-up is not very easy.

Deloitte advises that most often start-up capital needs to be raised from friends and family.

It is only after a business is established and can demonstrate good cashflows that funding can be more readily obtained from banks and other institutional lenders.

ACCOUNTING SYSTEMS

Deloitte has advised Nectarmin of the importance of establishing an accounting system and monthly management reports as a means of comparing its actual financial performance with our forecasts.

In the event that actual performance falls short of forecasts, it will need to reassess business plans immediately to avoid financial difficulty.

Deloitte has agreed to review these accounts with it each month and mentor it through the difficult period of coming to grips with managing a business.

Oh, and of course, it will still have to register the company with the Inland Revenue Department for income tax and GST. It is essential to register for GST before Nectarmin starts in business to ensure it can reclaim any GST charged to it by suppliers.

* If you have any questions you would like answered in relation to this article, please email Greg Anderson.