How to Calculate the Profitability of Your Small Business Idea
by Ben on December 11, 2011
Do you dream of opening your own restaurant, retail shop or service company but lack the confidence or expertise to make your small business idea a reality? Over the next few months I’ll be devoting some time writing about starting and running small businesses based on my own experiences as an entrepreneur (I run several internet websites) and as a business student.
One of the first steps in developing your business plan is to determine the profitability of your business idea. In other words, based on your forecasted amount of sales, how much profit will your small business idea generate? This may seem like a challenging question, but when broken down into simple steps, calculating the profit margin of your small business is a very straightforward process.
In this example, let’s assume you have always dreamed of opening a taco stand near the local city park. Your friends and family have always complimented you on your outstanding tacos and you believe the high seasonal traffic levels near the park would support your business idea.
How to Calculate the Breakeven Point of Your Small Business Idea
Step #1: Identify Your Variable Costs
To keep things simple, we can assume the ONLY thing we are selling at our taco stand are the taco’s themselves (for each additional item we add to the menu, we would simply repeat these steps).
The first step in determining the profitability of your small business plan (taco stand) is to identify the variable costs associated with the sale of one of the tacos. Variable costs are items that “vary” depending on the number of tacos sold. An example of a variable cost would be taco shells. If you sold 10 tacos your cost of taco shells sold would be 10 times higher than if you had only sold 1 taco (pretty easy so far, right?).
To help move things along, I have created the following chart displaying the estimated “variable costs” of selling one taco.
Step 2: Identify Your Fixed Costs
The next step in calculating the profitability of your taco stand (or other business idea) is to calculate what the fixed costs of your business will be. Fixed costs are expenses that stay “fixed” no matter how many tacos you sell. For instance, whether you sell 1 or 10,000 tacos in a month, your monthly concession stand permit fee will likely remain the same. As with the variable costs above, I have created a chart below with some hypothetical fixed costs to help us figure out if we have a viable small business idea.
Depreciation Expenses : Understanding depreciation expenses is critical to understanding the profitability of your small business idea. Even if you pay cash for the various equipment needed to run your taco stand, you still need some method of calculating the equipment’s affect on your monthly operating costs. One method of handling this is to use straight-line depreciation where you “write-off” the equipment’s cost evenly over a certain number of years. In our example, I chose to “write-off” the equipment over a 5 year period (60 months) which ended up being $1,0833.33/month. You don’t
actually need to “pay” this money to anyone (unless you’re financing or leasing the equipment), it is just an expenses you’ve already pre-paid and must take into consideration to determine the “true cost” of running your business.
Step 3: Set the Selling Price of Your Taco:
Now that you know how much it costs to make one of your tacos, you need to set a selling price. Based on some hypothetical market research, lets assume that you’ve decided $2.00 is a fair price to charge for one of your super yummy tacos.
Step 4: Calculate the Contribution Margin of One Taco
The “contribution margin” is a fancy term business schools use to refer to the amount of money generated in selling a product or service above and beyond the variable costs of manufacturing or producing the product. In our example of the taco stand, contriubution margin refers to how much money selling one taco “contributes” to paying other things such as the fixed costs we talked about above and PROFIT for the owner(s).
To calculate the contribution margin for selling one taco, we simply subtract our variable costs $.062 from our selling price of $2.00. The contribution margin of selling one taco is $2.00 – $0.62 = $1.38
Step 5: How to Calculate the Break-Even Point of Your Small Business
Now that you know the “contribution margin” from selling one of your tacos, you can calculate how many tacos you need to sell to cover the taco stand’s fixed expenses, in this example this will also be our break-even point (the point where we’ve sold enough tacos to cover all of our fixed and variable expenses for the month but have yet to make any profit).
To calculate the break-even point, simply divide the “hypothetical” fixed expenses identified above by the contribution margin from selling one taco. In this example we’ll need to sell $5,683.33/$1.38 = 4,119 tacos to break-even.
Step 6: How Many Tacos Must You Sell to Make a Profit of $7,500/month
Let’s be honest, we’re not going to go through the trouble of selling tacos all month without the belief that there will be some financial gain, right? Let’s assume that you want to make a profit of $7,500 per month with your taco stand. How many tacos must you sell to obtain that level of profitability?
To calculated how many tacos we need to sell to make $7,500 per month in profit we simply add the $7,500 as a monthly expenses to our fixed expenses (just like we did for our employees). When we reexamine how many tacos we need to sell to meet our new fixed monthly expenses (including your $7,500 profit), we divide our new fixed monthly expenses ($5683.33 + $7,500 = $13183.33) by our contribution margin ($1.38): $13,183.33/$1.38 = 9554 tacos or about 318 tacos per day!
This is a very basic example, but hopefully it has given you some insight on how to calculate the profit potential of your own small business idea(s). Stay tuned for more small business ideas in the future!
THANKS for reading my personal finance blog. You can learn more about my site here or you can jump right into the juicy stuff by reading my family's own detailed debt free success story (which has formed the foundation of this site). Please consider signing up for my free email updates ! Source: www.treesfullofmoney.com