Expansion plans are often driven by a desire to boost sales in the hope that higher profits will follow and sometimes that works. In other cases, sales do go up, but profit stagnates. In the end you wind up working harder and longer for nothing.
So if you’re thinking about expanding your business, you need to analyse three fundamental factors: Costs, contribution margin and breakeven.
Here’s a step-by-step guide to help understand and analyse these factors before you make any move toward buying new equipment, expanding your plant or implementing a new business idea.
- Fixed and Variable Costs: Break down your costs into one or another of these two categories. 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’s left from sales after you deduct the variable costs. If you sell a product for $10 and variable costs are $8, you have a $2 contribution margin that then goes to cover fixed costs and then add to your profits.
- Breakeven: The amount of dollars and time it takes the contribution margin to match fixed costs is your breakeven. Until your margin exceeds fixed costs, you’re in the red.
Once you calculate these factors, you’re ready to analyse the impact of expansion. Let’s say your company makes chocolates that it sells for $10 a box. Variable costs are $8, so your contribution margin is $2. If your fixed costs are $100,000, you need to sell 50,000 boxes to break even.
Now you want to expand and that will raise your fixed costs to $125,000, while your contribution margin stays the same. Applying the breakeven formula (fixed costs divided by contribution margin), you’re going to have to sell 62,500 boxes to make a profit, 12,500 boxes more than before the expansion.
|Fixed costs ($)||Variable costs ($)||Sales price ($)||Margin ($)||Breakeven (units)|
Understanding these factors is critical to deciding whether you’re better off keeping the status quo or charging ahead with an expansion. But these calculations aren’t the whole story. You also need to consider how different business conditions ahead could change cash flow, liquidity and profitability.
Other Uses for the Calculations
Understanding breakeven and contribution margins can also help you answer these questions:
- 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)
If you have any questions or concerns regarding the article, or if you’re looking to expand your business, please contact Commercial Associates on 02 9299 1200 to arrange a complimentary discussion with myself or one of our expert advisors.