I’ve been writing in previous columns about business plans, and now it’s time to consider four financial-planning tools that are part of any business plan. We will look at one of these — the Break-Even Analysis — in this column, and save the remaining three — Profit/Loss Forecast, Start-Up Cost Estimate, and Cash Flow Projection — for future columns.
Taken together, these four tools will help you determine the financial health of your current business, or the likelihood of success for a proposed start-up business.
By the way, don’t be intimidated by the serious-sounding names of these tools — this isn’t doctoral-level economics, merely Math 101. The easiest way to create these tools is with Microsoft Excel or a similar spreadsheet program. You can also simply use a pencil, a sheet of paper, and a calculator. Anyone thinking about starting a new business should take the time to work through all four of these financial-planning tools. Business plans usually start with a break-even analysis because it gives you a quick snapshot of your business’s chance of financial success.
But before we start, let’s define some terms.
Sales revenue is the money you receive for providing whatever goods and/or services your business offers. In other words, sales revenue is the bottom line on your invoice: Please Pay This Amount.
For people in the creative professions, such as image-makers, this typically includes your creative fee plus any expenses billed to the client, such as supplies, travel, meal, assistants, and so forth. You get a check and deposit it in your business banking account — that’s sales revenue.
Obviously, you can compute sales revenue on a monthly, quarterly, or annual basis, whichever is most useful. You can also track sales revenue by client, sales revenue by type of project, etc.
Sometimes called “overhead,” these recurring costs are a function solely of your being in business. They are not related to specific projects — your business has to pay them day-in and day-out, whether you are rushing from assignment to assignment or sitting around waiting for the phone to ring.
Some examples of fixed costs would be advertising, insurance, interest on loans, legal and professional services, office equipment and supplies, rent or lease on office space, repairs and maintenance, business taxes and licenses, travel and meals (not related to a specific project), utilities, and wages paid to employees.
Note that if you plan from the outset to pay yourself a salary, this should be included as a fixed cost. However, many owners of new businesses forgo a salary until the business is profitable, relying instead on other sources of income for day-to-day living expenses.
Those of you who have filled out the IRS Form 1040, Schedule C, will realize that these fixed costs come directly from Part II of the form, called Expenses. The important thing to remember about fixed costs, however, is that they are generally unreimbursed expenses. In other words, most clients will balk if you try to bill them for a portion of your fixed costs.
The usual test for a fixed cost is this: does the cost vary depending on how much work I’m bringing in? If the answer is no, you can assume the cost is a fixed cost. If the answer is yes, the cost is likely a variable cost.
Also known as “costs of the sale,” these are costs directly related to a specific project commissioned by a client. For example, if you have costs for traveling to a location shoot, staying in a hotel, hiring an assistant, providing meals for yourself and your crew, these are variable costs.
Note that if you use a fee-plus-expenses method of billing, your variable costs are generally those that can be billed to your client. When billing a client, most businesses add a certain percentage, or markup, to the actual amount they pay for variable costs — in other words, you buy wholesale and sell retail. Unlike fixed costs, variable costs do fluctuate depending on how much work you are bringing in.
Working a lot? Chances are you will have high variable costs. Sitting around waiting for the phone to ring? Your variable costs are likely to be zero.
In effect, then, variable costs discount the value of your sales revenue. Why? Because for every dollar of sales revenue you earn, you have to pay a certain percentage to cover your variable costs. In essence, it costs you something to earn that dollar.
Remember: sales revenue includes reimbursement for expenses, i.e., your variable costs. Part of the check you deposit in the bank includes this reimbursement, which covers costs you’ve probably already paid; travel, hotel, assistant, meals, etc. So a certain percentage of every sales dollar is transitory and doesn’t really count: here it comes from the client, but whoosh, there it goes to the credit-card company or payroll for your crew.
Gross Profit Percentage
Simply put, this is the amount of each sales-revenue dollar you get to keep, after deducting the variable costs. So, for example, if about 30 percent of your invoiced total is actually spent on variable costs, then your gross profit percentage would be 70 percent, or 0.70. What this means, of course, is that your sales revenue is not worth what it seems — you need to discount it by 30 percent to find the true value. It’s like instant inflation — a dollar ain’t worth what it used to be.
Note that if you have various lines of business — such as assignment photography, stock photography, and leading workshops and seminars — each may have a different gross profit percentage. In other words, you may get to keep more of every dollar earned by selling a stock photograph than by shooting a large-scale photography or videography assignment, which would tend to have high variable costs. If you do have various lines of business, simply calculate the gross profit percentage for each to come up with an average gross profit percentage.
The break-even analysis, as its name implies, asks a very simple and basic question: after discounting your sales revenue to take into account your variable costs, will you have enough money to cover your fixed costs?
Notice that the break-even analysis does not predict whether your business will live long and prosper, only whether it has a chance of breaking even. Obviously, you need to do more than just break even in order to survive and grow your business. But remember, the break-even analysis is used mostly to determine if there is any hope of your business succeeding — it is merely a first step. Many new businesses take several years to reach profitability.
To complete the break-even analysis, you must first make three estimates:
- Annual sales revenue. This is the total you can expect to bill for your first year in business; the figure includes all the charges on your typical bill, i.e., fees plus expenses.
- Average gross profit percentage. This is how much of each billed dollar you get actually to keep, after you pay the variable expenses, or costs of the sale. If you have multiple products or services, each with a different gross profit percentage, you simple average them. If you have a single product or service, you don’t need to average anything.
- Annual fixed costs. This is the annual total you expect pay for all recurring expenses not related to specific assignments or projects, such as advertising, office equipment and supplies, rent, utilities, etc.
Once you have made these estimates, you are ready to calculate your break-even point. Simply take your estimated annual fixed costs and divide by your average gross profit percentage: annual fixed costs / average gross profit percentage = break-even point.
For example, let’s say you’ve estimated your annual fixed costs at $30,000 and your average gross profit percentage at 70 percent, or 0.70. Then $30,000 / 0.70 = $42,857. In other words, you would need an annual sales revenue of $42,857 just to cover your fixed costs. If you estimated your annual sales revenue as being, say, $40,000, you would have some catching up to do. If you estimated your annual sales revenue as being $50,000, however, you would be in the clear.
Some caveats. Be conservative in estimating your annual sales revenue, especially if this is your first year in business. Talk to other professionals. How much did they make when just starting out? What are the going rates? How many assignments can you hope to get during your first year? Be realistic in estimating your gross profit percentage and your annual fixed costs. Have you covered all your bases and taken everything into account?
Finally, if you are not making your break-even point, you have three options: (1) increase annual sales revenue, either by getting more work or by charging higher fees; (2) increase your gross profit percentage by increasing the spread, or markup, between what you actually pay for your variable costs and what you bill your client for these expenses; and (3) reduce your fixed costs, or overhead.
Stay tuned for more about financial planning for your business in future columns. As always, please share your thoughts!