Profit is essential in business. This is the first goal of any entrepreneur. Making profit should be your first priority in your business idea. This does not mean that you will become a ferocious capitalist! Not at all, it means you want to develop a sustainable business, a sustainable organization. Profit proves your business is running alright, and that you have the resources for further investments and for further projects.
However, before making profit, you want to make sure that what you sell covers your production costs. Now, let’s understand your costs. Any business costs are of two types: variable and fixed costs. The variable costs are those costs that vary accordingly with the quantity of the products you produce. For instance, if you open a bakery, some of your direct costs will be represented by what you pay for the ingredients you use in baking the cakes. If you cook more cakes, your direct costs related to the ingredients will increase proportionally. The fixed costs are those that stay the same no matter how many cakes you cook… for instance, you still have to pay the rent for the bakery shop, no matter how many cakes you cook in one month. Here, you can also include the costs that are hard to show how exactly they vary when you cook less or more cakes. For instance, the costs with the electricity you use for your business. You know that it varies somehow with the number of cakes you make, but it is hard and too much time consuming to calculate it. So, it is better to include it as fixed costs, using a monthly average for it.
Now that you know your costs you could say that your total production costs will look like this:
Total costs = Fixed costs + X number of products*Variable costs/product
Whatever you sale in one month or one year represent your total revenues, and it could be described like this:
Total revenues= X number of products sold * the price / product
Now, you need to calculate your break-even point, which represents the number of products you need to produce and sell in order to cover your production costs; that means that you need to see how many “cakes” you need to make per month / per year so that your total revenues will equal your total costs.
Here is how you calculate the break-even point:
Total revenues = Total costs
X number of products sold * the price / product = fixed costs + X number of products*variable costs/product
X number of products sold * the price / product – X number of products*variable costs/product = fixed costs
X number of products sold (the price / product-variable costs/product)=fixed costs
X number of products sold=fixed costs : (the price / product-variable costs/product)
Total revenues = Total costs
X * 5 euros = 2000 euros + 3 euros*X
X*5 euros – X*3 euros = 2000 euros
X* (5euros-3euros)=2000 euros
X=2000 euros : 2 euros
Thus, in this case, the entrepreneur should produce 1000 of his / her products to cover his / her fixed costs (of 2000 euros/month), and the variable costs of 3 euros/product.
The break-even point is essential in making decisions regarding prices, and also regarding the optimization of the production. It brings a pragmatic view over the costs you can afford, the price you need to establish for your products, and over the work you and your employees need to make in order to make some profit.
Let’s say now, that you want to make some profit – about 500 euros per month. Here is how you calculate how many products you need to sell in order to get this profit:
Total revenues – Total costs = 500 euros
(X*5 euros) – (2000 euros+X*3 euros) = 500 euros
X*5 euros – 2000 euros – X*3 euros = 500 euros
X*2 euros = 500 euros + 2000 euros
X=2500 euros/2 euros
Thus, the entrepreneur needs to make and sell 1250 products in order to get 500 euros profit.
These estimations, for break-even point and for certain profit, are the basic financial tools any entrepreneur should be able to use. These help you then to build the estimated budget and the cash flow for your business, and support you in forecasting costs, production, number of employees needed, etc., and in developing the sales strategy.