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I'm Karl Ulrich, I'm a Professor at the Wharton School.

Â This session is on breakeven analysis.

Â There are really two distinct uses of the term breakeven in the context of

Â entrepreneurship.

Â The first, you might call breakeven time.

Â It's also sometimes called payback time or payback period.

Â Essentially, it's how much calendar time would be required for

Â a lump sum investment to be recovered from positive cash flow and

Â I'll give you an example here in a minute.

Â The second use of the term is really breakeven quantity and

Â this refers to how many units, transactions, quantity of product, orders,

Â customers must we experience per unit time in order to cover our fixed costs?

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I'll go through both of these with some examples.

Â The second idea of breakeven quantity

Â is also sometimes referred to by the strange term, covering the nut.

Â And that means, the nut is a term that refers to what are my monthly fixed

Â expenses and how much do I have to sell to cover the nut?

Â That is, to recover or pay for my monthly fixed expenses.

Â First, breakeven time or payback time or

Â payback period and let me just give you an example.

Â Let's imagine that you're considering converting

Â all of your delivery trucks from gasoline to compressed natural gas.

Â Prices for compressed natural gas are quite low right now, much lower even,

Â than gasoline and so,

Â if you convert to this alternative fuel you can save monthly operating expenses.

Â Let's imagine that buying a truck costs $40,000 U.S. dollars and

Â let's imagine you save $1,000 a month in fuel costs by converting to CNG or

Â compressed natural gas.

Â Then put simply, the payback is 40 months.

Â That's just 40,000 divided by 1,000 per month saving, so

Â the breakeven time is 40 months, or the payback period is 40 months.

Â Now let me just say, this is most commonly used in association with a lump sum,

Â single investment that has some future savings associated with it,

Â it's actually not very commonly used in other parts of entrepreneurship.

Â You wouldn't normally see this in the context of financing or discussion

Â with an investor, it would be more used in association with a lump sum investment.

Â On the other hand, this notion of breakeven quantity

Â is commonly used in entrepreneurship, and let me start by giving an example.

Â I'm a founder and investor in a company called Belle-V Kitchen,

Â and we make a quite lovely bottle opener shown here.

Â Actually, I have one with me.

Â Belle-V Kitchen makes a bottle opener shown here.

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I want to start with the definition we've used in this course for

Â financial sustainability for a company that sells things.

Â The basic condition that's required for financial sustainability is that

Â the quantity sold times the difference between the price and

Â the cost of each unit has to exceed the fixed costs of operating the business.

Â Put simply, P minus C, or price minus cost is the gross margin, that's how

Â much you make on each unit of product and the quantity sold is the quantity sold.

Â The quantity sold times your profit per unit,

Â that must exceed the fixed cost of operating the business.

Â If you can achieve that, then you can achieve financial sustainability for

Â the business.

Â In setting breakeven quantity, we simply turn that around and ask the question,

Â how many units would be required for us to cover our fixed cost, F?

Â That can be expressed by the expression, quantity Q,

Â breakeven quantity Q is equal to the fixed cost per unit period F

Â divided by the profit margin per unit sold, or P minus C.

Â Let me give you a numerical example to make that clear.

Â Let's imagine that it costs us $300,000 per year to operate the business.

Â These are the costs that don't vary with the quantity sold,

Â this is things like rent, advertising,

Â salaries we pay to the bookkeeper and to the marketing person.

Â Let's say that's $300,000 per year and

Â let's imagine that we sell these at a price of $25 and

Â that they cost us $13.44 to make.

Â That our breakeven quantity would be 300,000 divided by

Â the difference between $25, our price, and 13.44, our cost.

Â If you do that arithmetic, it comes out to 25,952 units per year or

Â more typically, it's expressed monthly, so it'd be 2,163 units per month.

Â The breakeven analysis simply says,

Â we have to sell a little bit more than 2,000 units per month,

Â about 2,200 units per month in order to cover the nut, in order to breakeven.

Â Now if you don't sell a product and

Â instead sell a service, then with recurring revenues and

Â recurring customers, then you think about it just a little bit differently.

Â I'm also an investor in a company called Gridium that sells software to companies

Â that manage commercial office buildings and they sell it on a subscription basis.

Â They have a couple of different subscription plans but

Â some of them cost $79 a month, some of them cost $150 per month.

Â It's essentially the same analysis but

Â instead of asking how many transactions do we need to have per month,

Â you ask how many customers do we have to have in our system,

Â on our system, subscribing to our service to cover the fixed cost?

Â So, a very similar kind of analysis,

Â I don't think you'll have any trouble doing it.

Â But I do want to point out that it's a little bit different for recurring

Â services like you see in software service businesses or in other kinds of services.

Â Now, there are some issues in breakeven analysis.

Â It's fairly useful as a way to just test your intuition

Â of how much business would we really have to do to sustain

Â a company of the size we're imagining this business to be?

Â It's good for calibrating your intuition around the feasibility of a new business

Â but it does assume a fixed level of spending.

Â It assumes that F, in fact, is fixed but those costs aren't really fixed.

Â Those costs are the results of a managerial decision

Â based on how big you think the company can be, how much resource you think you're

Â going to need over the coming months in order to support that business.

Â The breakeven calculations are probably best framed as, if we were

Â this size of an organization, if we made this kind of commitment to rent and to

Â payroll and to advertising, how many units would we have to sell to cover the nut?

Â How many units would we have to sell to breakeven, to cover those fixed costs?

Â