264 CHAPTER 11 MANAGING RISKS
How many coconuts do you need to sell?
After the stress of reading about unfamiliar statistical terms, our discussion now becomes
really easy again. Every reader of your business plan wants to know how much you have
to sell to break even. You break even when you just cover the costs of buying or making
the product and other operating expenses (indirect costs such as office rental, administra-
tion fees and so on).
Here is a real-life example. Suppose that you sell coconuts at the roadside. You buy
them for one peso each and sell them for five pesos. Your gross profit is four pesos a coco-
nut. You have to sell 20 to break even – to cover the 80 peso operating costs of renting the
stall each day. The 21st coconut starts earning you net profit.
Remember that operating costs do not include those items that go into cost of sales –
otherwise you would be double counting, or perhaps I should say double dividing.
A PICTURE IS WORTH A THOUSAND WORDS
There is a neat little chart that illustrates break even and adds great value to your busi-
ness plan. It provides a usefully graphic indicator of how much you have to sell to make it
worth being in business.
If you examine how gross sales revenue increases as your sales increase, you will find a
curve similar to that shown in Figure 11.3. The more you sell, the more you earn. The curve
flattens off because usually sales taper away as the market becomes saturated. There
comes a point when people just will not pay as much as five pesos for a coconut.
You can also show how costs increase with quantity. This curve starts above zero
because you have an underlying level of fixed expenses that you have to meet even if you
are not doing anything (your coconut stall). The curve then slopes more gently than sales,
reflecting the fact (I hope) that your prices exceed product costs. However, I would expect
the curve to turn upwards at higher volumes due to the quaintly named law of diminish-
ing returns – you have to start employing coconut sales assistants who become more and
more difficult to manage, and so on.
The point where the two curves cross indicates your break even sales revenue and quan-
tity. You uncovered all the costs and prices associated with your own business in Chapters
8 and 9. You could easily draw this chart yourself. I am willing to bet that it will have two
straight lines. This is how it is shown in simple introductory books, and it is how most people
project costs and revenues. It does not matter too much – straight lines work well enough
The number of units that you have to sell to break even is operating costs
divided by gross profit per unit.
t
HOW MANY COCONUTS DO YOU NEED TO SELL? 265
over a limited range of production and sales. But I wanted to draw your attention to it to
help you review your analysis and decide if you could improve your techniques.
One message is that rather than identifying break even as a precise figure, it is better
to consider it as a range (19–21 coconuts). Add a bit on each side to give you a margin for
error because it is rarely as simple as the example given.
BREAK EVEN AND CAPACITY PLANNING
If you consider the scale along the bottom of Figure 11.3 to run from 0–100% of capac-
ity, then the break even quantity indicates the minimum capacity level at which you can
operate. The difference between this and 100% indicates your room for manoeuvre.
If you can refine your figures enough, you might be able to identify the
optimum production level. Notice how profits are revealed by the gap
between sales and costs on the right-hand side of Figure 11.3. Profit is
maximised where the two lines are furthest apart. As noted, many simple texts
show two straight lines that continue to diverge indefinitely – implying that the
more you sell the more money you make. In practice, profits and costs sometimes
change direction and start to converge again as shown here. In such instances,
profit is maximised where the two lines are furthest apart – before they start
moving back together. Selling too much can be counterproductive. There is a limit
to how many coconuts your customers can consume.
t
Total sales revenue
Costs =
Revenue
Money
Profit
Loss
Quantity
Break even
quantity
Total costs
Figure 11.3 Plotting to break even
266 CHAPTER 11 MANAGING RISKS
THE CHANCES OF BREAKING EVEN
Knowing how many coconuts you have to sell to break even is helpful. Knowing the likeli-
hood of actually breaking even would be better still. You have probably guessed that I
am going to refer to the normal again. Let me take a different example. A re-seller has
established that she can source about 100,000 telephones, but there is a 10% chance that
deliveries will be 10% lower than this. She needs to sell 85,000 to break even. What is the
probability of failure?
The facts
Expected supply: 100,000 telephones.
Alternative scenario: 10% possibility that supply will be 90,000 or fewer telephones.
Model: the telephones are supplied by a large number of manufacturers who in
turn source their components from many different companies and countries – it is
therefore considered appropriate to assume that supplies are distributed normally.
The arithmetic
Take the above figures, work through the seven steps to deviation (page 261), and
you will find that the standard deviation is approximately 7700.
Next, from the four steps to a score (page 262), the z score associated with 15,000
(100,000 less 85,000) is 1.9.
Finally, from Figure 11.2, the percentage associated with a z score of 1.9 is 2.8% –
call it 3%.
The conclusion
There is a 3% chance that this venture will fail to break even due to supply constraints.
The situation is illustrated in Figure 11.4.
The normal curve was just used to predict the likelihood of a re-seller being able or fail-
ing to source adequate supplies. The same logic can be applied to production – and also
to the sales side of the break even equation (and to many other situations).
You need to check your break even point/range and the likelihood that it will be
achieved and then bettered. If the risks of falling short are unacceptable you have to go
back to revise your strategy and plan as described in Chapter 6.
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