Making More Money From Your Business - Part 2

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Making More Money From Your Business - Part 2 of 3 - Variable Costs and Your Business's Breakeven Point 

This Profitability Thinking blog post is the second in a series of three about making more money from your business.  The topic today is variable costs and your breakeven point.  Using this information as the prism through which you look at your business can be very helpful in understanding what is really going on with your business. 

Although not separated on a typical income statement, there are two types of costs:  variable costs and fixed costs. Variable costs are costs associated with the production and sale of products or services that increase or decrease with volume such as cost of goods sold (direct labor and materials), sales commissions, delivery charges, sales bonuses, and direct supplies.  All of these costs increase and decrease with the level of sales.  Total variable costs as a percent of sales should remain relatively constant within the normal range of sales in which your business typically operates.  

Fixed costs are costs which happen whether a product or service is sold or not, such as rent, insurance, interest on debt, facilities, the salaries of office workers, advertising and promotion, and utility bills.  Fixed costs in absolute terms (dollars rather than percentage) should also remain relatively constant within the normal range of sales in which your business typically operates. 

When you subtract variable costs from sales you get a contribution margin, which is labeled as such because it is the portion of a sale that contributes to the payment of fixed costs and then to profit.  Contribution margin is usually expressed as a percentage of sales or in dollars per unit, and is relatively constant within the normal range of business activity.  

As an example, if you sell $1,000 worth of a product and your variable costs are $530, then the remaining $470 is your contribution margin.  In this case, your variable cost is 53% of sales and your contribution margin is 47% of sales.  If your sales consisted of a single product that you sold for $10.00, then your variable cost per unit would be 53% of $10.00, or $5.30.  Your contribution margin per unit would be 47% of $10.00, or $4.70. 

The key concept in breakeven analysis is that you start every month in a hole for the amount of your monthly fixed costs.  You then apply the contribution margin from sales during the month against the fixed costs to fill that hole until you sell enough to breakeven.  Once you breakeven, the contribution margin on additional sales is applied to profit.  

The way to calculate your breakeven is to divide your fixed costs by your contribution margin percent.  

$ of Fixed Costs / % of Contribution Margin equals $ of Sales to break even 

Once you get past breakeven, your contribution margin % of sales is profit as the fixed costs have already been paid for.  The breakeven calculation can then be used to project profits.  To illustrate: 

$ of Sales * % of Contribution Margin equals $ of Contribution Margin.  Subtract your $ of Fixed Costs from your $ of Contribution Margin to determine your Operating Profit

 If you know your sales and you know your contribution margin and you know your fixed costs, you can project your profit.  Breakeven analysis allows you to do "what if" analysis, changing any of the variables to project a profit level under those projected conditions.  Once you can do profit projection calculations, the next step is to devise strategies to influence those variables and create the projected level of profit in reality.

 Doing breakeven analysis provides several important benefits: 

  • If you know the breakeven of your business or your business initiative, you will have a frame of reference as to whether what you are doing makes sense.
  • You can use the above described profit modeling to determine the best combination of price and volume, thereby aiding in pricing decisions.
  • Breaking costs into variable and fixed allows you to better determine what it really costs to deliver a unit of product or service to your customers by eliminating the "noise" of fixed costs.
  • You can determine the breakeven of marketing and advertising initiatives by knowing the increase in sales required to generate the contribution margin necessary to cover the added marketing expense.
  • In the same way as determining the breakeven on marketing expense, you can determine the breakeven on investments in additional employees, plant or equipment. 

You can improve your contribution margin by: 

  • Raising prices either because you have room to do so or by adding value to your product or service.  Last week's blog post was entirely about pricing.
  • Lowering your variable costs by buying better, value engineering your product, changing the commission and bonus structure, or finding a substitute component that is cheaper but is adequate for its intended use. 

In a 900 word blog post, it's difficult to cover in detail how to determine variable costs, and calculate and use breakeven analysis.  However, there are resources close at hand.  On the Profitability Thinking website, there are the following resources: 

  • The book Profitability Thinking which covers this topic in detail in chapters 4 and 5.
  • Links to two videos that cover the topic.
  • A breakeven calculator.
  • Business Coaching to help you see your business in a new way using these and other tools.

Once you understand how to use this tool, you will not want to be without it.  Determining your variable costs to calculate your business's breakeven point allows you to look at your business in a whole new way.

For a printable PDF of the blog post, click here.

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