Friday, February 1, 2008

Crunch The Numbers Before Writing The Plan

Want to start a business? Everybody says the first step is writing a business plan. I beg to differ. In my view, the first step is calculating your breakeven point and your cash burn rate. Why are these numbers important? They tell you how much cash you need to reach your breakeven point. Without this information, an entrepreneur is raising money in the dark. Only a fool opens the doors without first raising enough money to sustain the business to breakeven. And an even bigger fool invests in a business which by it's own calculation can't stay in business without raising new money at some point after launch. The #1 reason new businesses fail is that they are undercapitalized from their inception.

How does one calculate the break even point? Here are the two basic formulas for the task.

Breakeven = Fixed Costs / Gross Profit Percentage

Gross Profit Percentage = (Revenue - Variable Costs) / Revenue

Thus, the first step to calculating a business's breakeven point is determining gross profit percentage. Let's take an easy example.

2007 Revenue, Joe's Bar & Grill$350,000
2007 variable costs, Joe's Bar & Grill$250,000
Gross Profit Percentage28.5%

Now we are in position to calculate the break even point. Fixed costs are, as the name implies, those costs that do not changed with variations in revenue (i.e., they are fixed). Sometimes these are referred to as sunk costs. In the case of Joe's Bar, let's say Joe has the following fixed costs:

Real estate lease payments$36,000
Equipment lease payments$12,000
Salaried Employee$40,000
Total Fixed Costs (yearly)$103,000

This results in a breakeven point for Joe's Bar & Grill of $361,000 in sales. The bar business was not kind for our hypothetical Joe in 2007 as the business's revenue was $11,000 below breakeven level for the year.

If you are a new business running these projections, the question then becomes when do you reach the projected breakeven point? What is your burn rate? Do you have enough cash raised to make it to breakeven? Remember that every new business runs into unexpected expenses and/or revenue hiccops. You need to have a cash cushion built into your projections.

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