Understanding your financials (Part 2) – Calculating your business’ break-even point

“A fool and his money are soon parted”
- Thomas Tusser -

And now back to our lemonade stand…

Jenny and I looked at each other, then up at the ceiling and back to staring at each other. We were puzzled. We did not know how much we should charge for each cup of lemonade. We were smart enough to know we need to price our lemonade intelligently. We knew if we price it too low we will have many clients but we will not be able to cover our costs. We also knew if we charge too much, no one will come and drink our tasty lemonade.

After talking with my mom, Jenny and I understood the importance of calculating the break-even point or the point at which the money we pay out (our lemonade stand expenses) is equal to the amount of money which our lemonade stand will receive from our thirsty clients. At that point, our lemonade stand costs and revenue are the same, or it is the point we will “Break-Even”. You can find more about break-even at “Understanding your financials (Part 1) – What is your business’ break-even point?”.

So we decided to go ahead and calculate our costs of making one jug of lemonade… we thought we got it, we figured out that the cost of making one jug of lemonade:
• 20 lemons cost $2
• 10 plastic cups cost $0.50
• A cup of sugar cost $0.10 (assuming one pound of sugar can fill 10 cups)

So our cost of making a jug of lemonade is $2.60. We figured out each jug can make 10 cups of lemonade. Using our calculator (don’t tell mom!), we calculated that the cost of making each cup is $0.26. But we then realized (it was really mom who told us) that making the jug of lemonade is not our only cost. We also needed to pay mom her $10 startup loan, which we used to buy all the needed materials. Mom was nice enough to spread the loan over the summer vacation. She charged us 10 payments of $1 a week plus cleaning my bedroom at least once a week.

I remembered Charlie sitting across the table from me, sipping his hot chocolate. We were talking about the lemonade stand. Charlie smiled and said, “This issue is one of the key business challenges and a key to running a successful business. It is an issue which each business owner faces. It does not matter if you are the owner of a law firm, a chocolate store, an advertising company, a web design firm, a subscription based business or even a lemonade stand. Understanding your business costs and its break-even point is one of the keys to pricing your product or services”.

I nodded…thinking about Jenny and I.

Charlie continued and said, “As a business owner, you are tasked to calculate two types of costs or expenses. Variable costs and fixed costs, variable costs are expenses which are directly related to the activity of your business, they will change in proportion to your business activity. Variable costs will be the sum of all these expenses”.

You know by now, Charlie can be really “academic”, he likes the big words.

Let me explain by giving an example, variable costs for our lemonade stand are the money we need to pay for the material (such as lemons and sugar) and products (plastic cups) in order to make the jug of lemonade and to serve lemonade juice in plastic cups to our thirsty clients. More clients drinking lemonade will cause a need for more material and products and therefore these variable costs will be higher, fewer clients drinking lemonade means we will need to buy less of the material and products and therefore the variable costs will be lower.

Charlie took one more sip and continued “variable costs are costs directly related in creating a product, directly related to completing a project, or directly related to providing a service. It can be salaries for employees providing a service or material costs related to manufacturing a product”. I nodded and Charlie continued “Fixed costs on the other hand are expenses paid by the business which tend to remain the same regardless of an increase or decrease in the business activity, or the amount of goods or services produced. For example rent expense is a fixed cost”.

I jumped and said “I remembered the fixed costs of my lemonade stand. These were paying off my mom’s loan (which was 10 payments of $1 every week of the summer vacation) as well as buying the lemonade stand. Regardless of how many cups of our tasty lemonade we sold we still needed to pay $1 at the end of every week to my mom.”

I remember Charlie smiling and telling me “let’s go back to the time when building a lemonade stand empire was your dream”.

Jenny and I sat in my room. We knew it will cost us $2.60 to make a 10 cup jug of lemonade, and now after a long discussion with mom which started with “why is your room still a mess, young lady!?!”, so embarrassing, and ended with our understanding of business costs, we understood we needed to add $1 a week to our costs.

Now it was time to make some assumptions in order to calculate our true break-even point. Jenny and I assumed we will work only during the weekends in our lemonade stand business because we had this amazing film making camp we attended during the week. And we will work 4 hours a day (during the hot hours when people are thirsty).

We also assumed in the worst case, we will sell only a single jug of lemonade over the weekend, and in the best case scenario, we will sell one jug of lemonade every hour or eight jugs over the weekend.

Jenny took out our yellow legal notepad and wrote:

Worst case weekend:
• 1 lemonade jug – $2.60 (we did not know it back then but these were our variable costs)
• One loan payment of $1 (yes, you are right, these were our fixed costs)

Total cost – $3.60 (one jug of lemonade) and cost per cup 36 cents (each jug holds 10 cups of lemonade)

Best case weekend:
• 8 lemonade jugs (one per hour) – $2.60*8 = $20.80 (calculator here we come)
• One loan payment of $1 (remember, regardless of our business activity the fixed costs remains the same)

Total cost – $21.80 and cost per cup 27 cents (selling a total of 8 jugs or 80 cups)

We were so happy, I know it sounds crazy but Jenny and I knew our break-even point! What else do 10 year old girls want to know?

Our break-even cost (for our tasty cup of lemonade) based on our assumptions will be between 27 cents and 36 cents. Now we knew we cannot price our tasty cup below 36 cents or we will lose money (in the worst case scenario), and no 10 year old girl wants to lose money!

So now we just need to decide how much to charge for a single cup. It is much easier to decide now, what do you think?

I finished the story, Charlie stood up clapping, and said “I wish more business owners will go through this process, a lot of misery may be spared”.

I know this story did not answer all your questions, like, what happened if Jenny (it will never happen to me) by mistake pushed the jug and it dropped on the floor spilling all the juice? What happened if it was rainy one weekend and we would not have even a single client coming over?

These are important questions and all need to take into consideration when setting your product or services pricing, and I promise to discuss much more in future blog posts (including setting an intelligent price when knowing your costs), but for now, Charlie asked for another hot cup of chocolate and the delicious chocolate muffin. He is my best client you know :-)

Question: What surprised you the most when you understood your products’ or services’ break-even point?

Liz (A lover of profitable lemonade)

About the Author: Liz
SWEETNESS COMES FROM THE HEART

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