The driving force in many expansion plans is to generate higher sales, with the hope that profits, too, will rise.
But before making moves to buy new equipment, expand your plant or implement a new business idea, you need to grasp the profit angle.
In some cases, an expansion plan boosts sales but not profits. You wind up working longer and harder for nothing.
You may think, “if we lose a little bit on each deal, we can make it up on volume.” That sounds good but may prove difficult in reality. To prevent problems, here’s a step-by-step guide.
- Fixed and Variable Costs. Break down your costs as either fixed or variable. Fixed costs don’t change over any reasonable time period while variable costs are related to sales. (The more sales, the more variable costs.)
- Contribution Margin. This is what remains from sales after you deduct the variable costs. So if your product sells for $10 and your variable costs run $8, your contribution margin is $2. From that margin, you cover fixed costs and add to your profits.
- Breakeven. This is the amount of dollars and time it takes the contribution margin to match fixed costs. To calculate it, divide fixed costs by contribution margin. You don’t realize a profit until the contribution margin exceeds fixed costs. Until then, you’re in the red.
Once you calculate these factors, you’re ready to analyze the impact of expansion. Let’s say your company makes Belgian chocolates and sells them in quarter-pound boxes at $10 apiece. Your variable costs are $8, giving you a contribution margin of $2 on each box to cover fixed costs and provide a profit. Your fixed costs are $100,000, so you need to sell 50,000 boxes to break even.
But you want to expand and fixed costs will rise to $125,000. Your contribution margin stays the same. Using the breakeven formula (fixed costs divided by contribution margin), you now have to sell 12,500 more boxes, or 62,500 total.
|Fixed costs||Variable costs||Price||Contribution margin||Breakeven|
Once you get the figures, it’s a good idea to talk to your financial advisor about how cash flow, liquidity and profitability could change, depending on business conditions. But fundamentally, a solid grasp on these factors is critical to deciding whether you’re better off keeping the status quo or charging ahead with an expansion.
Other Ways to Use these Figures
In addition to planning for an expansion, understanding breakeven and contribution margins can help your business in other ways. With a basic grasp of the concepts, you can answer these questions:
- What if my lease payment rises? How much more will I have to sell to counter the increase?
- I want to cut my prices to match the competition. How much more do I have to sell to maintain profit levels?
- Sales are likely to slow down next year. How much do I have to lower costs to maintain profit levels?
- How can I add $100,000 to my profits? (Use profits in the formula as an additional fixed cost and run the numbers to get the amount of sales.)