Break even analysis made simple
How many sales do you need to cover your costs and break even?
It’s an important question whether you’re selling widgets, iPhone apps, or consulting services. This is the simplest possible formula:
# of sales needed to break even= total expenses / average price per sale
Here’s what this looks like with actual numbers:
Where do these numbers come from?
Before we dive in, I’d like to stress that you only need to make your best guess for now. You don’t have to get every number exactly right. Taking a few minutes to do this exercise will show you where you need to gather more data to improve your estimate.
And yes, I know that the MBAs and CPAs are shuddering because this doesn’t properly account for cost of goods sold (COGS), but we’re keeping it simple for the moment. We’ll talk about COGS in a minute.
Here’s a quick video walkthrough:
Your Business Eventually Needs to Be Profitable
Let’s assume that it’s true that your business eventually needs to be profitable (I’m looking at you, Uber). You get there by making enough money to cover your costs, and you make money through sales.
Average Selling Price per Unit — for Software as a Service
The simplest case is if you’re just selling one thing through a single sales channel, like subscription software at $10 per person per month. In this case your average selling price is $10 per unit per month.
It gets more complicated if you also offer an annual subscription for $100 up front (which is $8.33 per month). If 60% of your customers pay monthly and 40% pay annually then your average selling price per unit is $9.33 per unit per month.
Now let’s say you add a 25% discount for companies who sign up more than 50 people and pay annually (which is $6.25 per person per month). If 50% of your customers are individuals paying monthly, 30% are individuals paying annually, and 20% are companies, then your average selling price is $8.75 per unit per month.
Here’s what the math looks like:
What If You’re Selling Widgets?
If you’re selling popsicles, iPhone-controlled pet devices, or any other physical item then you’ll be dealing with two prices:
- Retail Price, which is what you charge customers who purchase from you directly. They might pay $100 when they order from your website.
- Wholesale Price, which is the discounted price you charge retailers who sell your product in their stores or websites. You might charge $40 per unit. This allows the retailer to mark the price up 2.5 times to the same $100 you charge on your website ($40 times 2.5 equals $100).
If 40% of your sales are direct at your $100 retail price and the remaining 60% are through your channels at your $40 wholesale price, then your Average Selling Price per Unit is $64. The math looks like this:
If you have a Black Friday sale then you’ll need to factor the lower price into your calculations. Or you could just assume that the sum total of all of your retail sales will average 10% below your list price. Your best guess is fine for now.
Total Expenses
We’re going to start by lumping all of our expenses together. Here’s what companies usually spend money on:
- Salaries
- Consulting and professional services
- Rent
- Sales, including commissions
- Marketing, public relations, and events
- Advertising
- Raw materials
- Computers and other hardware
- Utilities
- Software and subscriptions
- Server costs
- Insurance
- Furniture
- Etc.
In this example we’re going to take our best guesses for what we’ll spend in each category during the year and add them all together to get a single number.
Remember to include your own salary, otherwise this is going to be an expensive year for you.
# of Unit Sales Needed to Break Even
Now we simply take our Total Expenses number and divide it by our Average Selling Price per Unit. This gives us how many sales we need to make to cover our costs.
Easy, right?
The reason I wrote this article is I talk to a lot of founders who:
A) Don’t know how many sales they need to make to break even and
B) Don’t have a realistic plan to make that many sales
Cost of Goods Sold (COGS)
Let me start this section by reminding you that I’m not an accountant, and you should definitely talk to a CPA about your finances.
In real life, the math doesn’t work right if we lump all of our expenses together. MBAs and CPAs divide expenses into cost of good sold (COGS, also called cost of sales or cost of revenue) vs. everything else.
According to Investopedia.com, COGS “are the direct costs attributable to the production of the goods sold by a company. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs.”
Cost of goods sold (COGS) are the direct costs attributable to the production of the goods sold by a company. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good.
If you’re making widgets, this is the cost of raw materials plus the labor required to transform those materials into a finished product. This process results in you owning a warehouse full of inventory.
If you’re making apps, this is the cost of your servers plus your technical support staff, but doesn’t include the time your developers spend creating the product (here’s a good article on Cost of Sales for software-as-a-service).
For now, I recommend that you look up COGS for your type of business to find the typical range for your industry. Then take your best guess. You can refine it later.
Here are some numbers:
Your number of units required to break even will change once you include COGS, which is why it’s important. The larger your COGS the less money you make on every sale — and the more units you have to sell to cover your other expenses. Supermarkets only make a little bit of money on each item they sell, so they need to sell a ton of items. Ferrari, on the other hand, sells only sells a few cars each year (see below).
Starbucks sells lots of cups of coffee — and they charge a lot for them! I paid $5 for a latte this morning, and they’ll keep raising prices whenever they can. It’s a profitable business model.
Apple is the pinnacle of this strategy because they sell a ton of devices while making great money on each one. That’s why they’re one of the most profitable companies in the world.
Your Realistic Plan
Now comes the fun part!
What is your plan to make 21,429 sales? If you’re currently making 50 sales from your website each week that’s 2,600 sales per year (50 sales per week times 52 weeks = 2,600 sales per year).
Where will the other 18,829 sales come from?
If you run Facebook ads you may be able to double sales from your website to 100 per week, but you’ll also add to your expenses and change your break even calculation.
Maybe you can find a channel partner in the form of another website that will do some promotion and sales for you. If they’re able to make 25 sales per week that gives you another 1,300 sales per year. But you’ll need to cut them in on your profit so you’ll make less from each sale.
Each new strategy forces a recalculation. A simple spreadsheet is a lifesaver, and I’ve provided one for you here.
Ferrari Example
An extreme example is Ferrari, which is a multi-billion dollar business that sells less than 8,000 cars per year — because they make about $200,000 on each one they sell.
Mobile App Example
Let’s say you’re selling an iPhone app for $5 and the app store takes a 30% cut. You basically are selling to Apple at a wholesale price of $3.50 ($5 minus Apple’s 30% cut). So to make $100,000 you need to sell 28,571 apps.
Now you can work backwards to figure out how many people you’ll have to reach with your marketing to convert that many to paid. And it hopefully costs you less than $100,000 including your salary.
Widget Example
Let’s say you’re wholesaling widgets for 50 cents each. You’re going to have to sell 200,000 widgets in order to make $100,000. How will you sell 200,000 widgets? Can you do it in a few big orders? Or will you need to have a mix of direct and channel sales? And will it cost you more or less than $100,000 to manufacture, ship, and sell all those widgets?
Keeping It Simple
Remember, you only need to take your best guesses for now. The idea is get into the ballpark and you can refine your numbers over time.
Doing this exercise makes your pitch deck stronger, and helps you attract investors.
Here’s an example for a company selling mobile apps (you would simply provide the numbers highlighted in blue):
Here’s an example for a company selling widgets:
I’ve put together a quick worksheet to help you figure it out — without any complicated math. I’ve included everything in this article, along with a three year forecast. Please let me know how it goes!
Mike Lingle is obsessed with helping founders grow their businesses. I’m a serial entrepreneur, mentor, and executive in residence at Babson College. Check out my Rocket Pro Forma if you want to quickly create your financial projections.
