What does this do to the bottom line?
This question keeps on popping up and complicating business decisions. Not being able to answer it leads to bad business decisions being made. And it is a major cause of small businesses going bust.
For example, do you know what will happen if your sales volume drops? How far can it drop before you really start to eat red ink? And if you lower your prices in order to sell more, how much more will you have to sell to make the same profit?
If we choose to borrow capital, how much will sales volume have to increase to cover those costs? And if you take on a new employee, how much more turnover is required to pay the extra salary?
To be able to answer these questions, you need to have a good understanding of what your fixed costs, variable costs and profit margins are. You also need a good understanding of the relationships between these variables.
Cost/volume/profit analysis helps you answer these, and many more, questions about your business operations. The most important concept is the distinction between fixed costs and variable costs and what this means to you.
Getting to grips with this distinction enables you to do quick "back-of-the-envelope" calculations of the financial impact your business decisions have. The rest of this article examines this distinction.
Types of Costs
Variable costs include sales commissions, shipping charges, delivery charges, cost of direct materials or supplies, wages of temporary employees, and sales or production bonuses. They all increase as sales go up and decrease as sales come down. So they can be directly built into selling prices.
Fixed costs encompass rent, interest on debt, insurance, plant and equipment expenses, business licenses, and salary of permanent staff. Because they are not directly linked to sales, fixed costs have to be recovered by spreading them across all sales transactions.
Deciding which costs are fixed and which are variable is not always easy. Some costs appear to be both fixed and variable.
Combination costs : a certain minimum level is incurred regardless of sales levels. But increases in sales volume also cause these costs to rise. Your phone bill is an example. You pay a line charge that is the same each month. And you also pay a charge based on the number of calls you make., which is usually linked to sales volumes.
To simplify things, just decide which type (fixed or variable) best describes the cost and classify the whole item accordingly. For example, in a telemarketing business, phone call charges are normally far greater than line charges, so you'd classify the entire bill as variable.
Relevant range of activity: It's important to realize that fixed costs are "fixed" only within a certain range of activity. Rent is fixed; But only until your sales increase to the point where you need to rent an additional workplace, in which case it might double.
In the long term, all costs become variable. But for the purpose of understanding your cost structure, costs that stay constant over a 12 month period are regarded as fixed.
Pricing For Profit
Let's consider how the fixed/variable cost relationship is used to support making basic business decisions.
We use an example to illustrate the different cost/revenue/profit relationships. In our example business, costs for the past year are categorized to give the following cost structure:
From these figures, we can work out some useful ratios :
The Markup, or the percentage you increase cost-of-sales by to get to the sales price, is the most useful. It is calculated by simply subtracting Variable Costs from Sales and dividing by Variable costs.
Markup = ($1,2m - $650k)/$650k = 84.6%
If, in your business you negotiate on price, it is useful to know how much you can afford to give away. And the relationship between Fixed and Variable costs tells you this.
Your Gross Profit has to at least cover your Fixed Costs for you to make a profit. So, on average, your Markup must be no less than Fixed Costs/Variable Costs. In the example :
Break-Even Markup = $400/$650 = 61.5%
Pricing at a 61.5% markup for the full year would mean that Fixed Costs of $400k would be recovered. But there would be no profit.
If you are finding that your Markup is regularly falling below your Break-Even Markup, you business is probably heading for a loss. And you need to take corrective action.
Employing another person, leasing new equipment and embarking on an advertising campaign all increase your monthly Fixed Costs. Knowing how much you have to sell to cover extra costs like these, helps you decide whether the expense is worthwhile.
You do this by dividing the additional cost by your Gross Profit Margin. First you need to work out your Gross Profit Margin.
GP% = (Sales - Variable Costs)/Sales = ($1,2m - $650k)/$1,2m = 45.8%
So if the business employs a new member of staff at an annual cost of $23,000, additional sales for a year needed to cover the extra cost is :
Increase in sales required = $23k/0.458 = $50,218
In this example, employing the extra resource will only be worthwhile if it generates more that $50,218 in sales.
Remember that employing the extra person may not have a direct affect on sales. But the required additional sales could be achieved by people who are released from time consuming non productive tasks by the new person.
This is a simple and very handy calculation. Work out your Gross Profit percentage and use it in this way to support resourcing decisions.
Leveraging Profits
A clear understanding of how a change in sales impacts on profitability, is essential for good financial management of your business. Knowing how Profits will respond to an increase (or decrease) in Sales, supports using an informed and balanced business strategy to improve financial results.
Increasing Sales while Fixed Costs (i.e. rent, salaries, interest etc) stay the same, causes an even bigger increase in Profits. The magnitude of this multiplier effect is what is called the Degree of Operating Leverage (DOL) in the business. It indicates how sensitive profits are to a change in sales.
Your DOL depends on the relationship between Fixed Costs and Variable Costs (raw materials, components, hourly paid labor etc.). The higher your fixed costs are, the greater the impact a change in sales has on profits.
If that all sounds foreign, consider these examples. Companies A and B have the same level of sales and profits. But different relationships between fixed and variable costs causes the DOL, or the response of profits to changing sales, to differ widely :
Now let's see what happens when these two companies increase sales by 10%. Remember that Variable Costs will also increase by 10% (they are volume driven costs). But Fixed Costs will stay the same.
Company B's high level of fixed costs means that a 10% increase in Sales caused a 40% increase in profit. Company A, on the other hand, enjoyed a much smaller increase in profits. Clearly, increasing sales has a much more powerful leveraging effect on profits in company B than it does in company A.
To calculate the Degree Of Operating Leverage for your business, use this formula :
DOL = (Sales - Variable Costs)/(Sales - Total Costs)
Remember to treat your living costs as a fixed cost. It is the minimum amount that you have to take out of the business, no matter how little revenue is generated.
The Bottom Line
If your operating leverage is very high, you can catapult profitability by using more productive resources in your business. Employing more people to increase production spreads the high level of Fixed Cost over a much bigger volume. Unit total-cost comes down and the business becomes a lot more profitable.
A high level of operating leverage also means that you are exposed to more risk. If sales decline suddenly, profits will fall a lot faster and a lot further. The airline industry is a typical example of this happening. High operating leverage has meant that declining numbers of passengers has caused many airlines to go bust in recent years.
If, on the other hand, your business has relatively low fixed costs but high variable costs, a different strategy will produce better results. Low operating leverage suggests that you need to look for opportunities to add more value for your customers. It will mean that you will be able to increase your prices, and profits will take off. And you probably need to improve productivity.
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