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Viability Of Your Business Idea

I'd guess 90% of the businesses which people want to start are not viable. The businesses don't support sufficient profit margins to shield them from increases in their costs. The businesses don't offer a sustainable, competitive advantage which will allow them to survive and grow. These people are often underestimating the sales needed to break-even, and they are overestimating their anticipated sales in general.

At the very least, for your business idea to work, you must be able to produce and deliver your product or service at a cost which is below the price you will charge for the product or service. Surprisingly, some people miss this!

Sales Price - Your Cost = Profit

If "Profit" above is negative, you lose and it is called a "loss"! Your cost to produce the product is usually a function of how many units you are selling. Make a reasonable estimate of how many units you think you can sell, and make a reasonable estimate at your costs. If possible, set your sales price close to what similar businesses charge. If doing so sets your profits well below where you think they will be, you might have a problem.


Break-Even Analysis

One of the first things you should do is to estimate how many units of your product you must sell to break even. Calculating your break-even point is very easy for most products.

Start with the price for which you will sell your product. Let's call this price SP for sale's price. You can set your selling price to whatever you want, providing people are willing to pay that price.

Suppose we are selling a game for a price of $20. So, SP=$20.00

Your product will have some associated per unit cost for you to produce and deliver the product to the customer. This cost is referred to as a variable expense because your total company expense varies with the number of units you are selling.

(Sometimes this variable cost on a per unit basis also changes with the number of units produced. For example, let's assume it costs $5 per game to have your game product manufactured, if you produce 1,000 units. Your variable cost per unit is $5. However, if you were to produce 10,000 units, maybe, your cost per unit would only be $4.00. In this case your variable cost per unit is $4. This changing cost on a per unit basis for different levels of production is not what is meant by "variable cost." We will assume the variable cost is fixed on a per unit basis.)

Assume your variable cost is $5.00 per unit. That is your cost for each game. Call this cost-per-unit, or variable cost V. V=$5.00

Notice, if you had no fixed costs or overhead, your profits would just be the selling price minus your variable per unit expense. Here it would be SP - V = $20.00 - $5.00 = $15. As soon as you sold one unit, you'd be making money!

However, in the real world, your company will also have some fixed overhead expenses which are not directly attributable to the number of units produced. For example, you might have a monthly rent expense which is the same regardless of how many units you sell. Call your total overhead expenses of keeping the business open F for fixed expenses. Suppose your only fixed expense is monthly rent at $200 per month. F = $200.

Your sales must amortize this overhead expense effectively. Clearly, the money each sale can contribute toward paying the overhead is just SP - V or $15 per unit. This difference is called "contribution" because it contributes to paying overhead and, eventually, earning a profit. Call this contribution C. C = $15 per unit.

It should be clear that if we divide our fixed expenses by the contribution per unit, that we get the number of units we must sell to break even.

Break-Even Number of Units = F/(SP - V)

Here, Break-Even Number of Units = F/(SP - V)= $200/($20 - $5) = 13.33 units or about 14 units.

You can check your answer by working backwards. Assume you sell exactly 13.33 units. This means your sales revenue is 13.33 * $20.00 = $266.60. Your total per unit cost for the 13.33 games is 13.33 * $5.00 = $66.65. The difference between your revenue and the direct per unit cost you pay for the game is $266.60 - $66.65 = $199.95 or about $200 neglecting round off error. That exactly covers your overhead cost, F.

The significance of overhead and how it affects profitability and company growth is discussed in detail in Thinking Like An Entrepreneur.

Below are some more presentations on the topic of break-even analysis:


There are two methods of pricing. The first is sometimes called "skimming" and involves aiming to have higher-priced products. The goal is to have the word "quality" associated with your product or "status." Think, Mercedes. The second pricing method is sometimes called "market penetration." The goal is to have a low-enough price that bargain shoppers want to buy your product, rather than your competitors'. Think Hugo.

Obviously, you won't have both the best prices and the best products, unless you happen to have no competition or the competition is grossly ineffective! The variation of price across similar products is usually moderate when compared to the difference in price among different products.

The other businesses in the industry are not idiots. Don't assume they are so inefficient that you will beat them on both price and quality!

Other things which can compromise viability of your idea include legal issues. No, you can't grow Ganja! No, you can't sell explosives marketed to freeway drivers outraged with traffic delays! No, without a medical license, you can't become a home surgeon!

But, the greatest limitations should be those you place upon yourself when choosing a business. Be sure your business at least has the possibility to be profitable!


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