How much money will you need to start your small business?

How much money will you need to start your small business?

One common question potential small business owners have is this – How much money will you need to start your small business?

If you’re here looking for a magic number, you won’t find it in this article.

I’ll be the first to tell you that there’s no magic number. This is for the simple fact that every business is unique and has different needs

However, there are some elements of expenses that are similar across all types of businesses. There are also methods to calculate how much money your business needs. We’ll look into all of these shortly

Before we proceed, I’ll assume that you already have a business plan and also validated your business idea  to considerably increase your chances of success

The Different types of businesses

Different types of businesses will mean different types of start up costs

Generally, businesses fall into 1 of the categories below or a combination of these categories

Brick-and-mortar business

Brick-and-mortar businesses involve having a physical location, such as a storefront. 

They typically have a higher startup cost due to higher rental, inventory costs and also renovations costs to make their store-front more presentable

These types of businesses are also dependent on foot traffic, which means that they need to be located in areas where rental tends to be more expensive. It’s also worth knowing that there are cases where paying a higher rental fee is worth it

The main benefit of running a brick-and-mortar business is that it is often associated with legitimacy and deeper customer trust

Online businesses

Online businesses do not require a physical presence

Because of that, the main benefit of an online business is often associated with a lower startup cost; which is why a lot of people tend to start online businesses

However, due to the ease of starting an online business, many segments of the online business are already saturated. Competition is intense and price slashing is a common practice.

Service providers

Service providers, like the name suggests, are businesses who provide a service instead of selling a product.

Service providers can often choose whether they want to have a physical presence or not

Usually, even with a physical presence, the cost to start up a service provider business is still lower than a brick-and-mortar business because there is no need to hold any inventory.

The office location for service providers also do not need to be in a high foot-traffic area as compared to brick-and-mortar businesses

Why you need to have a start up budget

Too little financing is one of the main reasons a new business fails

This goes to show that the survivability of any small business is dependent on its cash flow.

In order to understand your cash flow, you will need a start up budget, and a start up budget is an essential part of any good business plan

A start up budget helps your small business to: 

Ensure that you have enough cash flow

You need to be clear about how much cash your small business needs to continue operating on a monthly basis. 

By knowing this, it is easier for you to set monthly sales goals and take action to achieve them in order for your small business to thrive

Even more importantly, you need to know how long your new business needs to stay afloat before you can start bringing in any potential revenue

Understanding the categories of your small business expenses

What categories of expenses are you allocating the most of your budget to? Does it make sense for your business?

A start up budget acts as a handy tool to give you clarity on whether your start up expenses are essential or non essential

You can also gain a deeper understanding on the different types of costs associated to your small business

One time costs vs ongoing costs

A renovation cost or a website development cost is a one time cost. Office rental or employee salaries are ongoing costs

Essential costs vs optional costs vs later costs

Essential costs are things you absolutely need to spend on to start your business. For example, a business license

Optional costs are things that are nice to have, but might not be necessary to your small business. For example, a high-end computer for video editing

Later costs are things that you might need when your business is growing. Such as an extension of the current equipments that you have, or a bandwidth upgrade for an e-commerce site

Appeal to investors

Your start up budget will come in handy when you are looking for people to invest in your business, or even when you are applying for a business loan

If you are able to clearly demonstrate where the funds are needed and how do you expect to get a return on the investment, you will make a stronger case compared to not having a budget at all

Common types of start up costs

Here is a list of some of the costs that are common throughout the various types of small businesses. Use this list to help in calculating your small business start up cost and add in other costs as necessary

  • Company incorporation fees
  • Salary
  • Business equipment and supplies
  • Utilities (Phone bill, electricity bills, internet bills)
  • Permits and licenses
  • Office space rental (or co-working space costs)
  • Marketing, advertising, and promotion
  • Marketing collateral costs
  • Legal costs
  • Accounting costs
  • Insurance
  • Inventory
  • Website
  • Software subscription fees
  • Idea validation costs [link to article]

How to calculate your small business’ startup costs

Step 1: List down all possible startup expenses

Do a brainstorm session and list down all possible startup expenses in a spreadsheet, try to be as specific as possible

For example, instead of just listing down office equipment, break it down to individual items such as laptop, printer, external hard drive, pen drive, etc

Step 2: Put them into their relevant categories

Split out your ongoing costs, these are costs that you need to incur on a monthly basis. For example, salaries, software subscription fees, and advertising costs

We will need these numbers to calculate your small business runway later

For all other costs, categorize them as essential, optional, or later costs

For a more comprehensive startup budget, you can also categorize all the details under a main category. For example, advertising costs and marketing collateral costs can be categorized under Marketing

Step 3: Determine your small business runway

Small Business Runway : The number of months your small business can stay afloat with your current cash reserve, assuming that you do not generate any revenue

Knowing your business runway is very important. As a new business, you will need more time to build your brand awareness and reach out to your customers before revenue starts flowing in

If you have prepared for an adequate business runway (say 3 to 6 months), you can focus on taking your business off the ground instead of worrying about survival

For example, if your monthly ongoing costs is $5000, and you have $20,000 in the bank, that means you have 4 months worth of runway

Step 4: Calculate your break even point (BEP)

Break Even Point (BEP) : The point when a small business’ sales exactly cover its expenses

It’s important to know your break even point calculation so that:

  1. You know how many units of products you need to sell each month to cover your costs
  2. You know whether your runway will last you long enough to break even

You need to know 3 variables in order to calculate your break even point

  1. Fixed costs : Expenses that you need to pay money on a monthly basis regardless whether you make a sale or not (Salary, rent etc), you can find your fixed costs in your start up budget
  2. Variable costs : Costs that changes according to sales (cost of a product, costs that incur when a service business takes on a new client)
  3. Average price of your product / service

The formula to calculate your BEP is:

BEP = Fixed Costs / (Price of product – Variable cost)

Here’s a sample of a product seller and a service provider’s BEP calculation

For product sellers

Break even points for product based businesses are more straightforward to calculate

For example, I run a bakery that sells bread, my costs are as follows:

  • Fixed costs : $5,000 a month (For salaries, rent etc)
  • Variable costs : $0.7 / bread ($0.5 for me to produce a piece of bread + $0.1 for packaging + $0.1 for electricity)
  • Average price of my bread : $2

My BEP is $5000/($2-$0.7) = 3846 units

This means that, in order for me to break even, I need to sell 3846 pieces of bread every month, or 128 pieces of bread every day

Service providers

For service providers, you need to think about the costs that you will incur every time you take on a new client

These costs might be different than a product business and it depends on the nature of your service

For example, let’s say I provide website design services to other small businesses and have the following costs:

  • Fixed costs : $10,000 (Salary, monthly software subscriptions, server rental)
  • Variable costs :  $1,500 ($500 for digital assets required to build a website, $300 for website hosting, $200 for travelling and meeting costs, $500 for external designer costs)
  • Average price of a website : $2,000

My BEP is $10,000/($2,000-$1,500) = 20 clients

This means that, in order for me to break even, I need to secure 20 clients every month

Linking your BEP to your small business runway

Knowing your Runway and also your BEP allows you to plan your business budget properly

Going back to the example of me providing website design services:

Let’s say I have budgeted for a runway of 3 months

Is it realistic for me to get 20 clients a month starting for month 4?

If it’s not, then it might be time for me to rethink some of the following:

  • Does my business model make sense?
  • Do I need to decrease my fixed costs in order to lower my breakeven point?
  • Are there any ways I can increase my average selling price?

Limitations of the break even analysis method

While the break even analysis is a handy tool that helps you determine a sales goal or road to profitability, break even analysis generally have the following limitations:

  1. It is difficult to accurately calculate fixed and also variable costs for 1 unit of product or 1 client. Furthermore, as output level increases or the number of clients increases, the way variable costs are calculated will change too, due to factors like economies of scale. The break even analysis does not take these factors into consideration
  2. Most small businesses sell more than 1 product, so break even becomes complicated to calculate

Therefore, break even analysis should always be seen only as a supplementary tool in your decision making process, instead of a standalone decision making tool

Step 5: Fine tune your budget and add a buffer

Now that you know the various costs involved in starting up your business, it’s time to start fine tuning your budget

With your new understanding about your BEP and your small business runway, you might want to remove, add, or delay certain expense items

Lastly, I highly recommend adding a buffer of 10% into your budget to account for things that you did not anticipate for

In my experience throughout all the years of running my small business, there will always be unexpected expenses every month 

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