Calculating the profitability threshold of your business
The profitability threshold is the break-even point at which a business becomes profitable. This threshold is reached when the total cost to run your business is equal to its total revenues. Above this threshold, the business is deemed to have reached the enviable profit zone. Below this threshold, the business will struggle to generate a profit, or survive over the long haul. The value of this threshold can be expressed in the number of units of a product sold, in revenue received or in periods of time (months or years, for example).
As an entrepreneur, knowing your business’s profitability threshold, or the break-even point, is invaluable. It will improve the financial planning for your business, sharpen your strategy for pricing and setting revenue goals and prevent you from making bad business decisions. Demonstrating that your plan is viable is also a good way to convince investors or bankers to finance your company. Especially when creating or launching a new product, adding a new sales channel or when changing a business model.
Calculate your profitability threshold
This may seem somewhat more complicated when you’re selling a variety of products. You could take one product at a time or set an average price based on all the products sold, however. In this type of situation, it’s better to take several scenarios into account, to make sure you are as prepared as you can be. “The best is to rely on a one-year period so you get a better idea of all the fixed costs. This way, you can divide the fixed costs by the gross margin (revenues minus variable costs),” explains Marie-Andrée Giroux, FCPA, FCMA, and president of Cofinia conseil inc. The end result is your profitability threshold in dollars. Divide this number by the unit price to obtain the profitability threshold in the number of units sold.
Fixed costs are the costs that remain unchanged, regardless of the number of products sold. Think about your administrative expenses, such as rent, insurance, salaries (accounting or reception), software subscription services, etc. Variable costs are the costs that vary depending on the number of products sold. For example, these costs includes expenses for materials, commissions, transaction fees and labour.
List your data
First of all, make a list of your operating costs— that is, the costs to manufacture your product, the rent and the banking fees. List all the other expenses to be incurred as well. Then, divide all of these expenses into variable or fixed costs.
Ms. Giroux provides a simple calculation method as an example:
Identify your production costs and estimate the number of units produced based on these costs.
Determine an average price for your products and calculate your estimated income by multiplying the average price by the number of units produced.
It’s worth noting that some data have their limits, however. The profitability threshold analysis does not, for example, help assess the demand for your product, as this is not stable. In fact, you may even decide to change your pricing, which could have an impact on the number of people who want to buy your product. You also have to make sure your data is reliable. Some costs are considered as both fixed and variable costs. According to the president of Cofinia conseil Inc., having to list your expenses as either fixed or variable costs sometimes complicates the calculation. For example, some costs could very well be listed in either category. If your company hires salaried workers, their compensation has to be considered as a fixed cost. If you hire resources on a part time or hourly basis based on the volume of orders received, their compensation must be recorded as a variable cost. Not forgetting a single expense is yet another challenge for you! You also have to ensure the accuracy of the data entered.
Lastly, knowing the profitability threshold of your business will give you a better sense of its potential for success. Make sure you can tap experts in the financial field and don’t hesitate to seek advice from reliable accountants to make adjustments to your business, if need be.
For a deeper dive into this issue, follow the link to the CFO Masqué website: Calcul du seuil de rentabilité : quelques pièges à éviter