Break-even analysis identifies the point at which your business starts to make a profit. You can work out the break-even point using any timescale, eg weekly, monthly, yearly, etc.
To calculate the break-even point you need to know the following:
the total fixed costs of your business - these include rent and rates, your drawings, loan repayments, etc;
the total variable costs for producing your product - these include labour, materials and packaging; and
the selling price of your product.
Once you have these figures, you can work out your break-even point using four simple calculations and plotting the findings on a graph.
Although accountants define costs in several different ways, there are, effectively, just two types of cost. The first cost is that which is directly attributable to the product or service. Direct costs include raw materials and sub-contract work. If you make desks, for example, the cost of wood will be a direct cost. Within reason, the cost will be the same for each desk, no matter how many desks you make. When you make a sale the income first has to cover the direct costs relating to that sale. Whatever is left is called gross profit or contribution.
Depreciation is an allowance for wear and tear on the equipment used in your business. As time passes, your equipment will usually lose value, and this can be considered a cost to your business. You need to think about how long you expect your assets to last. For example, if you purchase a computer system, you may forecast that in 5 years it will be obsolete. That means the depreciation rate is 20% per year. If you determine it to be 2 years, then it will be 50% per year. This does not have any effect on cashflow, just on how profits are calculated. Deprecation is an accounting cost that must be included to give a Profit & Loss account more relevance.
Advice on how to prepare a financial forecast for your business.
The greatest danger when setting a price for the first time is to pitch it too low. Raising a price is always more difficult than lowering one, yet there are great temptations to undercut the competition. It is clearly important to compare your prices to your competitors’, but it is essential that your price covers all your costs. There are a number of possible pricing strategies from which you might choose. These include:
It is important to know how sensitive your forecast is to changes. Sensitivity analysis looks at ‘what if?’ scenarios. What happens to your cash position, for example, if sales fall by 10%? What happens if your main supplier increases raw material prices by 12%? Sensitivity analysis is particularly used by financial institutions when considering propositions for a loan. If your business is particularly susceptible to small changes, then you probably do not have a sufficiently large profit margin. You will thus be less likely to receive the loan required. You may find it difficult to cut costs. You may not be able simply to increase prices to improve your margins - that might deter customers. Are there other ways in which you can push up the margins, eg by increasing output?
VAT is tax paid on the value added at each stage of delivery of a product or service. It is a method whereby businesses act as tax collectors for the Government. If you are registered for VAT, by submitting a VAT return you can claim back what you have paid in VAT, and hand over what you have collected.