What do these questions have in common? Each relates to how changes in costs, volume, and pricing affect your bottom line. By the end of this article, we'll have given you a single analysis model to help you answer these questions more accurately than ever before.
And, we'll also dispel one of the biggest "cost" myths around - at least regarding employee costs. It goes like this: "for every dollar you pay me in wages, it only takes one dollar of sales to cover." Baloney. I can immediately think of at least two major contradictions: 1) there are some direct (or variable) costs that have to come out first, and 2) there are a whole raft of "other" costs that attach to that one dollar of salary - FICA, FUPA, FEEPA...let's just say "the 'F taxes."
This really speaks to the issue that most employees don't really understand how a company makes a profit. So let's show them.
It all starts with the concept of break-even analysis. Many of you may remember break-even from some long ago undergrad accounting course. Your professor went through various mathematical gyrations, then finished by drawing two intersecting lines with a downward arrow pointing at a number that indicated break-even - the amount of sales at which a company neither made nor lost money.
"So what," you thought then (and I bet you say now). "Who wants to just break even?" And you're right. Calculating your break-even point is just the beginning. Break-even analysis is a financial tool that illustrates the relationship between COST-VOLUME-PROFIT, and as such can help you answer the questions above - and more.
We first need to define two broad classes of costs - based on how they behave in the business. First, fixed costs. Within a reasonable sales range, fixed costs do not vary with sales or production volume. Examples would include administrative salaries, rent, interest, insurance, utilities, depreciation.
Next, variable costs. Variable costs are those which are directly proportional to the sales volume (i.e., no sales, no variable costs). Examples would include direct materials (cost of goods sold), commissions, royalties, and bad debts. Think of variable costs this way: sales cause variable costs. If sales don't cause them, consider them fixed costs.
Now to calculate break-even. From your existing profit and loss statement, you total all your current fixed costs. Let's say your total comes to $100,000. Add up your total variable costs. Next, you calculate your total variable costs as a percent of your total sales. Let's say your "variable cost percent" turns out to be 75 percent.
This means that for every $1.00 of sales, 75 cents goes to variable costs. What's left? Yes, 25 cents. To cover what? Fixed costs. So now we have to answer the question, "What amount of sales do I need to cover $100,000 of fixed costs?" The answer, of course, is $400,000 - this is your break-even point. I've diagrammed it below, using the term "contribution margin" to replace the term "what's left?"
Break-even Calculation Break-even Proof
Total Fixed Costs: $100,000
Variable Cost % 75% Sales $400,000
Less: 75% variable cost $300,000
Contribution Margin $100,000
Less: fixed costs $100,000
Net Profit $0
100% (Sales) - 75% (*VC%) = 25% (**CM%)
$100,000 (Sales) /.25 (CM%) = $400,000 (Break-even sales)
*VC = Variable Costs **CM = Contribution Margin
But, as we said earlier, the key issue is not so much how to calculate break-even - it's how to use it. For example, our employees once lobbied to pay for an outside coffee service. Our annual cost for this coffee service was going to be $1,000. How much in additional sales did we need to cover this increase?
$1,000 (Proposed FC increase) / .25 (CM%) = $4,000 (additional sales needed)
Yes, sales had to increase $4,000 just to pay for the coffee service. Knowing this, we were inspired to take turns buying the beans and brewing the coffee ourselves. And it's these "creepers" you must watch every day - because with a contribution margin of 25 percent for every $1.00 increase in "fixed costs" (as they "creep" up on you), you have to achieve a $4.00 sales increase just to stay even. Every business owner and every employee should know how much in sales need to be able to fill in the blanks in this sentence, "For every $1 in fixed costs, I need to make $______ in sales to cover it."
$Fixed Costs / Contrimbution Margin % = Break Even
Let's use break-even analysis to determine how much in sales a new salesperson (or manager) needs to make in order to cover their costs. Here are your assumptions:
Based on earlier analysis, you determine your total cost structure of your company to be:
$661,000 ($VC) / 1,081,000 (Sales) = .612 or 61.2% (VC %)
Contribution Margin = 100% -61.2% = 38.8% or .388
Fixed Cost increase = 35,000 + 2,500 = 37,500
Commission impact on Contribution Margin = 38.8% - 2% (Commissions %) = 36.8%
$37,500 (Additional FC) / .368 (Adjusted VC%) = $101,902 (Additional sales needed)
That's the minimum in sales this new person needs to make in order to cover the additional costs of base salary, extras, and commission; i.e., before they're an asset to the company - and not a liability. Now you (and your new manager or sales associate should you decide to hire him or her) have a specific target when you sit down to set sales goals and evaluate performance.
And you've got a new tool to help you reevaluate every dollar your company spends. In addition, if you teach your employees this concept, they'll be in a much better position to help you make the profit that has been so elusive to many businesses these past eighteen months.
Steve LeFever and Dave Ashcraft are, respectively, Chairman and Vice President of Business Resource Services/Seattle. For over 10 years, they have provided financial training, performance benchmarking, and accountability/bankability modeling for franchisors and franchisees. Contact them at: 800.488.3520 x14 - or email@example.com. Please email them with any suggestions for topics you'd like to see covered in future columns.
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