Will Your Business Make Money?
Some people have a bigger problem than others when opening a new business. These are folks who are positively enamored with their business concept and are desperately eager to begin. They are so smitten and eager to start, they have no patience with the economic realities involved in their business. If you recognize this tendency in yourself, it’s extra important that you prepare a financial forecast carefully and pay attention to what it tells you. This step tells you whether your idea is a sure winner or a sure loser or, like most ideas, whether it needs work and polishing to make it presentable.
How can you tell if your business idea will be profitable before you implement it? The honest answer is, you can’t. This essential fact makes business scary. It also makes it adventurous. After all, if it were a sure thing, everyone would go into business.
Just because you can’t be sure you will make money doesn’t mean you should throw up your hands and ignore the whole problem. You can and should make some educated guesses. I like to call them SWAGs (“Scientific,” Wild Ass Guesses). The challenging part is to make your profit estimate SWAGs as realistic as possible and then make them come true.
The best way to make a SWAG about your business profitability is to do a break-even forecast. Although a break-even analysis or forecast can never take the place of a complete business plan, it can help you decide if your idea is worth pursuing.
Most financial backers expect you to know how to apply break-even analyses to your business. Your backer may ask what your profits will be if sales are slightly higher or lower than your forecast.
Many experienced entrepreneurs use a break-even forecast as a primary screening tool for new business ventures. They won’t write a complete business plan unless their break-even forecast shows that the sales revenue they expect to obtain far exceeds what they need just to pay all the bills. Otherwise, they know their business will not last very long.
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Project development note: The break-even analysis described below does not apply to a project development, since only one sale occurs. This exercise is designed for a continuing business with ongoing sales revenue. Before they begin, developers must know how much profit they will make after the project is completed. A developer prepares a break-even forecast every time she calculates the likely sale proceeds and subtracts estimated costs. Developers can skip this section, unless they need a refresher course on break-even analysis.
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To complete a break-even forecast of your business, you’ll make four separate estimates:
- Sales revenue. This consists of the total dollars from sales activity that you bring into your business each month, week, or year.
- Fixed costs. These are sometimes called “overhead,” and you must pay them regardless of how well you do. Fixed costs don’t vary much from month to month. They include rent, insurance, and other set expenses.
- Gross profit for each sale. This is defined as how much is left from each sales dollar after paying for the direct costs of that sale. For example, if Antoinette pays $100 for a dress that she sells for $300, her gross profit for that sale is $200.
- Break-even sales revenue. This will be the dollar amount your business needs each week or month to pay for both direct product costs and fixed costs. It will not include any profit.
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Math alert: The following section requires that you make some simple mathematical calculations, which you’ll use to analyze your business before writing a complete plan. If the very thought of math makes your head spin, you’ll probably want to find someone to help you.
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Forecast Sales Revenue
Your first task is to estimate your most likely sales revenue by month for your first two years of operation. This is both the hardest thing to do and the most important part of your business plan. Much of your hope for success rides on how accurately you estimate sales revenue.
Keep in mind that you’re honestly trying to decide if your business will be profitable. This means that you must base your forecast on the volume of business you really expect—not on how much you need to make a good profit. If you estimate sales too high, your business won’t have enough money to operate. But if you estimate sales too low, you won’t be prepared or able to handle all the business you get.
Here are some methods different types of businesses use to forecast sales revenues.
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Retail Sales Revenue Forecast
The simplest way to forecast retail sales revenue is to find the annual sales revenue per square foot of a comparable store. Then multiply that dollar figure by your estimated floor space to derive an estimate of your annual sales revenue.
Example:
A similar business shows $200 of sales per square foot per year. If you have 1,000 square feet of floor space, your estimated annual sales revenue will be $200,000 (1,000 × $200). Naturally, your estimate should take into account everything that makes you different from the other store.
Some chain stores, such as supermarkets and drugstores, have refined the art of estimating sales to a science. Of course, they have the advantage of learning from their experience with their other stores. Even so, they occasionally make bad estimates.
Supermarket executives first gather statistics on how much the average person living in town spends every week in grocery stores. In some states, these numbers are available by obtaining total sales volume of grocery stores from the state sales tax agency; normally that data is broken down by county. They estimate how many people live in the area for which sales volume statistics are gathered. Dividing the sales volume data by the number of people in the area gives them the average sales per person from grocery stores.
Then they compare the average sales per person with state averages. If it’s higher, it might mean that people living in the area have a higher-than-average income. They can verify that by referring to the United States Census, which lists average income per family and per person for every census tract. If the income per person is average or below average, and sales per person are higher than average, it probably means that people come from surrounding areas to do their shopping. If the sales per person are lower than average in the area, it might mean that income is below average or that people leave the area to do their shopping. On the basis of this sort of data, together with an analysis of competition and demographics, supermarket executives can develop relatively accurate estimates of sales volume for a new store.
Service Business Sales Revenue Forecast
To estimate sales revenue for a service business, you’ll need a good understanding of what steps you go through to generate a billable sale. Then make a forecast of how many times you expect to go through all those steps every week or month and how much revenue you’ll derive from those steps.
Don’t forget to allow time for internal matters and marketing. If you’re a sole proprietor, you’ll need to allow somewhere between 20% and 40% of your time for nonbillable activities. If you have employees or partners, you’ll want to make similar allowances for them.
The sales revenue forecasting process for Central Personnel Agency shows the kind of logical process you’ll need to go through. (Central’s complete business plan is provided in Appendix A.)
Manufacturing or Wholesale Business
Sales Revenue Forecast If you plan to be in a manufacturing or wholesale business, read the sections “Retail Sales Revenue Forecast” and “Service Business Sales Revenue Forecast”, just above, and combine some of the concepts to estimate your sales volume. If you know as much about your business as you should, it shouldn’t be difficult to develop a reasonable estimate. If you’re having great diffi culty, the chances are that you need to learn more about your business.
Example:
Patty plans to import and wholesale modems for Acme computers. Acme has told her that they have sold 100,000 computers to date and projections show about 1,000 per month for the next three years. Patty realizes she doesn’t know what percentage of Acme owners will want modems and decides to conduct a mail survey of Acme owners before completing her sales forecast.
Project Development Sales
Revenue Forecast Project developers are not required to complete a monthly sales revenue forecast. They need to know the likely amount they can sell the project for before they begin work; all revenue comes when the project is sold.
Forecast Fixed Costs
For most small businesses, the difference between success and failure lies with keeping costs down. Many smart people start successful businesses in a spare room in their house, the corner of a warehouse, or a storefront in a low-rent neighborhood. Unfortunately, others sink their original capital into essentially cosmetic aspects of their business, such as fancy offices, and then go broke.
Make a list of the fixed or regular monthly expenses of your business. Your objective is to develop a dollar amount of expense that you are committed to pay every month. This is your “nut,” or the dollar figure you must be able to pay to keep the business viable. Include rent, utilities, salaries of employees, payroll taxes, insurance payments, postage, telephone, utilities, bookkeeping, and so forth. Some costs will be paid each month and others will be paid once or twice a year. If a cost is less than about 10% of your total fixed costs, you can divide the cost by 12 and show an amount each month. If the cost is larger than 10% of the total, record the cost in the month you expect to pay it. You can choose whether to include a draw for yourself as part of the fixed costs. If you plan to take your compensation only if the business shows a profit, do not include your draw.
Your fixed-cost list should also include some “discretionary costs”—expenses that change from time to time due to your conscious decision. For example, your promotion expenses may change occasionally as you increase or decrease advertising to take advantage of slow or busy times. Include them in the fixed-cost category even though the amount may fluctuate from time to time.
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By completing this simple exercise, Antoinette has gained important information. She now knows that she must sell enough every month so that she has atleast $16,050 left after accounting for the merchandise she sells. On an annual basis, that’s $192,600 ($16,050 multiplied by 12). Antoinette must also bear in mind that she has not shown any salary or draw for herself. To prosper, she obviously must not only cover fi xed costs, but also must take in enough to make a decent living.
Forecast Gross Profit for Each Sales Dollar
How much of each sales dollar will be left after subtracting the costs of the goods sold? That number will pay fi xed costs and determine your profi t for your business. At this stage, you are trying for a broadbrush, quick and dirty forecast, so it’s okay to make a rough estimate of your average gross profit.
Let’s look at how Antoinette calculates her gross profi t for her fi rst year of business. Antoinette plans to sell about half her products at double the cost she pays. A dress she buys for $125 she sells for $250. That means that her gross profi t per dress sale is 50%. She plans to derive her selling price for sale dresses, mark-downs, and accessories by adding one-half of her cost to her selling price; for example, if a belt cost her $10, she’ll sell it for $15.
The calculations are similar for different type businesses. Service businesses will have higher gross profit margins than retailers; most revenue is gross profit because little merchandise is sold. Wholesale businesses will be similar to the retail example. Manufacturing businesses will be similar in appearance even though the cost of goods will include materials from a variety of sources and any labor that is paid per piece.
Project developers have only variable costs in each project. There are usually no fixed costs since the developer’s business ends with the sale of the project. However, if a project developer works on several projects at the same time, he may have some fi xed costs that continue after any particular project is sold. For a project developer, the gross profit is the difference between the project’s selling price and all the project costs.
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Forecast Gross Profit for a Start-Up Business
For a new business, calculate the average gross profi t for your business by following these steps:
- For each product or service that you sell, list every individual item that goes into that product, including piece-rate labor and commissions. For example, Antoinette buys dresses from outside suppliers and resells them. The cost of the dress is the major component of the total product cost. She may add the cost of the preprinted bag to derive the total cost of the sale.
- Once you have a complete list of all the cost components for your products or services, add up the cost of each item.
- Write the selling price of the item below the total cost of the item.
- Subtract the total cost from the selling price to derive the gross profit from each sale of that item.
- Divide the selling price into the gross profit to derive the gross profit percentage for each product.
- Repeat for each product you’ll sell; if you have more than four or five individual products, then it’s better to group them by gross profit percentage rather than to make an estimate for each individual product.
- Write down how much total dollar sales you expect for each product or product group.
- Multiply the gross profit percentage by the total dollar sales to derive the dollar gross profit from each product.
- Add together the total dollar gross profit figures to derive the total dollar gross profit from the year’s sales.
- Divide the dollar gross profit by the annual sales revenue to derive the average gross profit percentage for the year’s sales.
Completing this gives you an average gross profit percentage for your business.
Forecast Gross Profit for an Existing Business
If you’re already operating and have a profit and loss statement for your business from prior months, your job is even easier. Simply subtract the total cost of sales from the total revenue to get the gross profit for the period. Then, convert the dollar gross profit figures to a percentage of sales revenue by dividing total dollar gross profit by total sales for the period. The percentage gross profit figure you get will be the percentage gross profit figure you use for your break-even forecast.
If you’re already operating and your expansion will change the percentage of total sales revenue that each product group brings, then you will need to forecast your new average gross profit by following the procedure for a new business listed just above.
Forecast Your Break‑Even Sales Revenue
Now that you have the fixed costs per month for your business and the average gross profit per sale, you can estimate how much revenue you will need to just break even. You can use any period you wish, although most people use a month or a year. As this chart shows, it’s simple to calculate. Just divide the fixed costs by the average gross profits expressed as a decimal.
|
A |
B |
C |
|
Fixed costs per
month (or year) |
Average gross
profit Percentage expressed as a decimal |
Break-even sales revenue (A ÷ B) |
|
.......... |
.......... |
.......... |
Example:Ronnie Ryann runs the Religious Sounds Round Table in Rye, New York. It’s a small business, but she loves it dearly. The gross profit on the CDs, tapes, and videos she sells is 50%. This is the same as saying that after adding up the cost of the products, packaging, and postage (all variable costs), Ronnie is able to sell at double this amount. Ronnie rents 1,000 square feet for $800 per month, pays her part-time clerk $950 per month, and budgets $650 per month for utilities, taxes, and so forth. This means her operating expenses (all fixed costs) are $2,400 per month. (Her costs seem low because some parts of New York State are behind the inflation curve.) Therefore, Ronnie has to sell $4,800 of records per month to break even. Her salary comes out of the money she takes in over the $4,800. Fortunately, it will cost Ronnie very little in extra overhead to sell up to $10,000 of records per month, so if she can achieve this volume, she will get to keep close to half of it.
How to Calculate Your Profit
Perhaps you’re lucky enough that your break-even sales forecast shows you’ll make more than you need to break even. If so, you can easily calculate your profit. Simply multiply your projected sales revenue that is over the break-even point by your average gross profit percentage.
Example:
Deborah needs $140,000 to break even in her bookkeeping business. Her projected sales revenue shows that she will be bringing in $185,000 the first year—or $45,000 more than she needs to break even. To determine the profit, she multiplies her average gross profit percentage (0.692) by $45,000. Her profit will be $31,140.
If Your Forecast Shows a Loss
What will you do if your break-even sales forecast shows that you’ll lose money? First of all, don’t panic. You’ll need to do some sober, serious, and meticulous thinking. Carefully check all your numbers and double-check your arithmetic. Incidentally, many people doing this exercise for the first time make some simple mistake in arithmetic that throws off the whole forecast. You might have someone with good math skills review your work.
Let’s look at Antoinette’s situation and see how her figures have turned out.
|
A |
B |
C |
|
Fixed costs per
month (or year) |
Average gross
profit Percentage expressed as a decimal |
Break-even sales revenue (A ÷ B) |
|
$192,600 |
0.382 |
$504,188 |
Antoinette needs $504,188 in sales revenue just to break even. That is $104,188 more than she expects the first year and $4,188 more than she expects for the second year. Despite her enthusiasm and determination, Antoinette’s first reaction to this news is to panic and consider giving up. After some reflection, she reexamines the calculations to make sure she hasn’t made a mistake in her arithmetic. Then she starts considering her options. Should she abandon her idea and work for someone else? Should she proceed with her loan application and fudge figures to show a profit? Or is there some other alternative?
• you can increase the sales revenue by selling more of your product or service
• you can reduce fixed costs
• you can increase the gross profit percentage by raising selling prices or by lowering your product cost.
Let’s see how Antoinette applies that knowledge to her break-even analysis.
First, Antoinette thinks about increasing sales. Maybe she was too conservative in her original sales forecast. What would happen if she increased her annual sales forecast by $150,000 (to $550,000) and kept the same fixed costs and gross profit margin? That is more than the break-even sales and should be enough to give her a profit for her efforts. How much profit? Let’s see.
Revision 1: Increase Sales Volume to $550,000
|
Annual sales |
$550,000 |
|
Annual fixed
costs |
192,600 |
|
Gross profit |
0.382 |
|
Break-even
sales ($192,600 ÷ 0.382) |
504,188 |
|
Sales over
break-even ($550,000 − $504,188) |
45,812 |
|
Profit
($45,812 × 0.382) |
$ 17,500 |
Antoinette concludes that a very aggressive sales increase alone brings her a small profit, but believes that the sales increase of $150,000 is very high. The profit resulting from that sales increase is probably not enough to justify the risk of that high an increase in the sales forecast.
If a sales increase of $40,000 or $50,000 would show that profit, she would be more comfortable increasing sales. She just isn’t sure she can do as well as the most established women’s clothing store in the mall in her first year. After all, the range of women’s clothing sales per square foot per year is $200 to $250, and she used the $250 figure to project sales of $500,000 in the second year.
As a second thought, and even though she has no idea how to accomplish it, she wonders what would happen to profits if she reduced fixed costs by $50,000 per year (about one-quarter of the current total) and left the sales forecast at $400,000 and her gross profit at 38.2%. Let’s see what would happen.
Revision 2: Reduce Fixed Costs by $50,000
|
Annual sales |
$400,000 |
|
Annual fixed
costs ($192,600-50,000) |
142,600 |
|
Gross profit |
0.382 |
|
Break-even
sales ($142,600 ÷ 0.382) |
373,300 |
|
Sales over
break-even ($400,000 − $373,300) |
26,700 |
|
Profit
($26,700 × 0.382) |
$10,200 |
That fixed cost reduction shows a profit of $10,200, but it requires a reduction of one-quarter of the fixed costs. Antoinette believes it will be very difficult to reduce fixed costs that much. Perhaps a combination of fixed-cost reduction and sales increase will improve the profits enough and still be possible. Before she thinks about that option, though, she completes the break-even forecast analysis by seeing what will happen if she can increase the average gross profit to 50% while leaving the sales revenue and the fixed costs the same. She doesn’t know if she can really do it, but wants to see what will happen to the numbers.
Revision 3: Increase Gross Margin to 50%
Annual sales | $400,000 |
Annual fixed costs | 192,600 |
Gross profit | 0.5 |
Break-even sales ($192,600 ÷ 0.5) | 385,200 |
Sales over break-even ($400,000 − $385,200) | 14,800 |
Profit ($14,800 × 0.5) | $7,400 |
It seems that Antoinette needs to find some combination of higher sales estimates, lower fixed costs, and higher gross profit margin that will improve profits so that she can make a living wage. But the really critical part is this: She must be absolutely sure that she can meet all the forecast changes she makes.
Antoinette was sure of her first forecasts; unfortunately, those forecasts produced a loss for the first year of business. Now, while she can manipulate the numbers to show a profit, the danger is that the numbers may not be achievable. She may be able to create a good-looking business plan but may be unable to meet those revised projections. Or, just as dangerous, she may become uneasy about the project’s success. A lack of confidence may just be enough to take the edge off her drive and dedication and enough to make the project fail.
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