Thursday, 19 September 2013 13:13

When Getting Even Isn't A Bad Thing

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Flipping channels a few weeks ago I landed on a dad that was desperately trying to teach his children the lesson of earning an honest dollar. To bring his point across as easily as possible he chose to help them build their very own lemonade stand. In theory you could tell that from the youngest to the oldest they got the idea-I sell lemonade and people give me money. The humorous part was watching as the dad tried to explain the inner workings of their lemonade empire. How do you get the money to start, what ingredients are needed (and at what cost), and how do you determine if your operation is successful or not? The children understood one thing and one thing only, ‘I sell lemonade and people give me money.’ Let’s be honest, small business financials are far less sexy than its marketing counterpart. This made me wonder if over the years I had developed a ‘let someone else worry about the details . . . how much money do I stand to make attitude’. So I set out on a little experiment of my own. If I had to teach small business financials to my own kids or simply put a concept like break-even analysis into layman’s terms, could I do it successful?

Step 1: Understanding Break-Even

There are many tools that a small business owner can use to gauge the financial health of their organizations. In my case I have chosen to do an examination of the break-even analysis. A break-even analysis is a financial examination tool that lets you know what you need to sell on a monthly or annual basis in order to cover the cost of doing business. I’ve always been a big fan of math but an even bigger fan of formulas that tend to make calculations easier. To figure out your company’s break-even try keeping the following formula in mind; break-even equals your total fixed cost divided by your contribution margin or BREAK-EVEN = TOTAL FIXED COST / CONTRIBUTION MARGIN. The following sections will provide the steps needed to help us figure out our break-even point.

Step 2: Determine Your Fixed Cost

To reach our break-even point, the first thing we need to do is figure out our total fixed cost. Fixed costs are business expenses that are not dependent on the amount of goods and services produced-also known as overhead. Simply put, if your company fails to make one dime, fixed costs are the expenses that will need to be paid regardless. For our example we will focus on determining a monthly break-even point. Also, we will bypass our traditional drive-way lemonade stand model because we have bigger aspirations. We are going to be opening a small but premium lemonade kiosk at the local mall. Although our model is less capital intensive than opening a full lemonade bar, our kiosk will carry more cost than setting up shop on our front lawn. The following outlines the basic expenses for our lemonade kiosk. Our kiosk rental, utilities, salary, marketing and insurance expenses bring our total monthly fixed costs to $3,820. In moving our formula along the next thing that we will need to figure out are our variable costs.

Step 3: Taking Into Account Variable Cost

Now that we have figured out what our overhead is going to be, it’s time to determine what the cost is to deliver our particular product or service better known as variable costs. Variable costs are costs that vary and can either increase or decrease depending on production or sales volume. In the case of our lemonade kiosk we are selling premium lemonade based on an old family recipe. One large batch will cost us $10 to make and will make 133 servings at a cost of 7.5 cents per serving. Water cost for every cup of lemonade is 3.4 cents, branded cups will costs us 5 cents and miscellaneous supply costs per serving are equal to 2 cents. This brings our total variable costs per serving of lemonade to 17.9 cents. This might be a bit more costly than a glass of Country Time but then again we are serving premium lemonade. At 133 servings per batch of mix this would bring our total variable costs to $23.80 (133 servings x 17.9 cents per serving). Finally, we have established that our per unit sales cost, or the price that we will sell each cup of lemonade for will be $3.50 a cup.

Step 4: Understanding Revenue and Contribution Margins

Next we will need to determine our contribution margin which brings us one step closer to reaching our break-even point. A contribution margin is the amount from each sale that goes toward covering the company’s fixed costs or overhead expenses. In the last step we established our per unit sales cost at $3.50 a cup. We also determined that because we are selling premium lemonade that our variable cost will be a bit higher than most and come out to $0.179 per serving. Using our formula we determine that our contribution margin is $3.321.

CONTRIBUTION MARGIN = PER UNIT SALES COST – VARIABLE COST

$3.321= $3.50 - $0.179

Step 5: Determining Your Break Even

Looking back over the steps in our lemonade kiosk example, we were able to determine our fixed cost, variable cost, per unit sales costs and our contribution margin. From this point finding our break-even point should be pretty straightforward. Using the formula below that we introduced in Step 1, we determine that we will need to sell 1,150 servings of lemonade per month in order to break-even. Any sales beyond that point should be considered as a starting point for greater profitability.

BREAK-EVEN = TOTAL FIXED COST / CONTRIBUTION MARGIN

1,150 Servings of Premium Lemonade = $3,820 / $3.321

Break-even analysis is by no means a definitive financial measure for a small business, however, it does provide some interesting insight. For starters break-even analysis is relatively simple and depending on the complexity of your business can be completed in a short period of time. Break-even analysis provides you with a solid financial metric that you can you use to leverage against your desired sales goals. Finally, I learned that if anyone thinks they are going to hold the attention of two lads while they lecture on something as exciting as numbers, then they are surely kidding themselves.

Cavanaugh L. Gray

Cavanaugh L. Gray (cgray@ecafellc.com) is the Director of Business Development for The Entrepreneur Café, L.L.C (877) 511-4820.  For more information on what makes a great start-up or to read a chapter from his new book The Entrepreneurial Spirit Lives: 25 Tales to Help Entrepreneurs Start, Grow, and Succeed in Small Business log on to www.ecafellc.com.  For more information on how to start, grow and succeed in small business, ‘Like’ on Facebook, ‘Follow’ on Twitter @TheECafe or ‘Connect’ on LinkedIn.

Website: www.ecafellc.com