When you’re an entrepreneur and you find a good business idea, you’re probably anxious to get going. You’d like to launch a company to sell a product based on that idea.
But before you start, take some time to create a business plan. The more specific you can make your plan, the better. The process of creating a plan helps you find weaknesses. If the market for your product is too small, or if you can’t charge a high enough sale price to be profitable, the business plan may reveal that weakness.
Your planning should go into detail on your assumptions about sale price, cost and sales volume. Consider these accounting concepts as you create your business plan.
Back of a napkin
Cost-volume-profit (CVP) analysis is a great way to look at sale price, cost and sales volume on a very basic level. In fact, you could sit with a business partner and do these calculations on the back of a napkin.
CVP is a tool to perform “what-if” analysis. You can change the assumptions in the formula and see how they impact your results.
Here’s the formula for CVP analysis:
Sale price(x) = Variable cost(x) + Fixed costs + Profit
(Where “x” equals number of units sold)
How to use the CVP formula
You can describe the CVP formula this way: Given assumptions about a sale price, variable costs, units sold and fixed costs, what will my profit be?
Now, you’ll notice that there are five variables. You can input amounts for four of the variables and solve for the 5th one.
Here’s an example that computes a profit: Assume that you own Riverside Sporting Goods company. You business manufactures hiking gear. One of your products is a jacket for hikers. You input the following variables to determine your total profit for jackets:
$120 Sale price (60,000 units sold) = $60 Variable cost (60,000 units sold) + $2,000,000 Fixed costs + ? Profit
In this case, the sale price, the units sold, the variable cost and total fixed costs are all known. Using algebra, you can compute the profit of $1,600,000.
Breakeven is defined as a level of sales that generates a profit of $0. Here’s a simple example that describes a breakeven situation in business:
You’re going to have a booth at a trade show. You’ll spend 3 days at the trade show and attempt to sell your product to new customers. Your finances are tight, so you ask yourself this question: How much do I have to sell at the trade show to recover all of my costs?
Well, your incur the cost of airfare, hotel, rental car and your food. You’ll also need to cover the cost of registering as a vendor at the trade show, and the cost of your booth.
Once you add up all of your costs, your breakeven level looks like this:
(Total trade show costs) / (sale price per unit) = Breakeven level in units
If your trade show costs total $4,000 and you sell a unit of product for $100, you’ll need to sell 40 units to breakeven. If you can’t sell 40 units over the 3 days, you’ll end up losing money.
Using the CVP formula for breakeven
OK- let’s use the CVP formula and compute breakeven for the jackets. The sale price, variable costs and total fixed costs will be the same. However, for breakeven, we’ll set the profit to $0 and solve for the number of units sold:
$120 Sale price (x units sold) = $60 Variable cost (x units sold) + $2,000,000 Fixed costs + $0 Profit
In this case, we solve for x, the number of units sold. Just to be clear, let’s walk through the algebra:
$120x = $60x + 2,000,000 + $0
$60x = $2,000,000
x= 33,333 (With rounding)
Your breakeven level in units is 33,333. If you sell 1 more unit above 33,333, you’ll earn a profit. This statistic is critically important. If Riverside can’t consistently sell more than 33,333 units, they won’t generate a profit. An investor or a lender may not consider Riverside to be a viable company.
Setting target profit
One component of your annual business plan should be a profit goal, or a target profit. Once you decide on that target, plug that into your CVP formula. Use the formula to do “what if” analysis. Your goal is to determine if you can set a sale price and manage costs well enough to reach your target profit.
Assume that your target profit is $2,200,000. That’s a higher profit that was listed earlier. Just as we did with breakeven, we’ll solve for the units sold:
$120 Sale price (x units sold) = $60 Variable cost (x units sold) + $2,000,000 Fixed costs + $2,200,000 Profit
Here’s the algebra:
$120x = $60x + 2,000,000 + $2,200,000
$60x = $4,200,000
Not surprisingly, you have to sell more units to reach the higher profit number. To increase profit from $1,600,000 to $2,200,000, sales have to increase by 10,000 units (70,000 vs. 60,000). Do you consider that level of sales reachable?
If you don’t think 70,000 units is an attainable sales level, you could change some of your other assumptions in the CVP formula. You could, for example, increase your sale price or attempt to decrease your costs. Those changes would help you reduce the number of units you need to sell to meet your target profit.
Margin of safety
Margin of safety represents the amount that your sales could decline before you reach breakeven. In this example, the breakeven level is 33,333 units. To earn $2,200,000, however, you have to sell 70,000.
Your margin of safety is the difference between these two sales levels (70,000 units – 33,333 units), or 36,667 units. Sales can decline up to 36,667 units before you reach breakeven.
Margin of safety is your cushion. After all, it’s difficult to forecast your exact results. You could generate 50,000 units in sales and be profitable. At 40,000 units sold, you’re still earning a profit. The lesson here is to plan a reasonable margin of safety. In that way, you can still earn a profit if your actual sales are lower than expected.
Planning your business operations is time consuming. The process requires thought and judgment. Use these tips to plan for your business. By going through the process, you may find weaknesses in your business plan. Use this process to set yourself up for success.