Business decisions and your finances: Cost/volume/profit analysis

You can tell at a glance that the Beta Company's contribution margin for the year was 34 percent. This means that, for every dollar of sales, after the costs that were directly related to the sales were subtracted, 34 cents remained to contribute toward paying for the direct costs and for profit.

Contribution format income statements can be drawn up with data from more than one year's income statements, if you're interested in tracking your contribution margins over time. Perhaps even more usefully, they can be drawn up for each product line or service you offer. Here's an example, showing a breakdown of Beta's three main product lines:

Although we've only shown the top half of the contribution format income statement, it's immediately apparent that Product Line C is Beta's most profitable one, even though Beta gets more sales revenue from Line B. It appears that Beta would do well by emphasizing Line C in its product mix. Moreover, the statement indicates that perhaps prices for line A and line B products are too low. This is information that can't be gleaned from the regular income statements that your accountant routinely draws up each period.

Breakeven analysis

Once you know your variable costs as well as your overall fixed costs for the business, you can determine your breakeven point: the volume of sales needed to at least cover all your costs.

You can also compute the new breakeven point that you'd need to meet if you decided to increase your fixed costs (for example, if you undertook a major expansion project or bought some new office equipment).

Your breakeven point can be determined by using the following formulas:

• Sales Price per Unit — Variable Costs per Unit = Contribution Margin per Unit
• Contribution Margin per Unit divided by Sales Price per Unit = Contribution Margin Ratio
• Breakeven Sales Volume = Fixed Costs divided by Contribution Margin Ratio

Example

Assume that the financial statements for Lillian's Bakery indicate that the bakery's fixed costs are $49,000, and its variable costs per unit of production (loaf of raisin coffee cake) are $.30.

Further assume that its sales revenue is $1.00 per loaf. From this information, it can be determined that, after the $.30 per loaf variable costs are covered, each loaf sold can contribute $.70 toward covering fixed costs.

Dividing fixed costs by the contribution to those costs per unit of sales tells Lillian's Bakery at what level of sales it will break even. In this case: $49,000/$.70 = 70,000 loaves.

As sales exceed 70,000 loaves, Lillian's Bakery earns a profit. Sales of less than 70,000 loaves produce a loss.

Lillian's Bakery can see that a 10,000 loaf increase in sales over the breakeven point to 80,000 loaves will produce a $7,000 profit, and a 30,000 loaf increase to 100,000 will produce a $21,000 profit. On the other hand, a decline in sales of 10,000 loaves from breakeven to 60,000 loaves will produce a loss of $7,000, and a 30,000 decrease from the 70,000 breakeven point produces a $21,000 loss.

In the example above, a 25 percent increase in sales from 80,000 loaves to 100,000 loaves would produce an increase in profits from $7,000 to $21,000. Similarly, a small drop in sales below breakeven would produce a substantial increase in loss. How is this explained?

There is obviously more involved than simply trying to determine the breakeven point. In the next section, we'll show that the concept of operating leverage explains why the mix of fixed and variable costs can have a large effect on your profit levels, as your sales volume increases and decreases.

Here's a handy interactive calculator that'll do a breakeven computation for you.

Breakeven analysis and costs, sales volume and pricing

Once you've determined your breakeven point, you can use it to examine the effects of increasing or decreasing the role of fixed costs in your operating structure.

The large increase in profits as a result of relatively modest increases in sales over the breakeven point, as well as the large increase in losses as a result of modest sales declines below the breakeven point, can be attributed to the degree to which fixed costs contributed to the sales.

The extent to which a business uses fixed costs (compared to variable costs) in its operations is referred to as "operating leverage." The greater the use of operating leverage (fixed costs, often associated with fixed assets), the larger the increase in profits as sales rise and the larger the increase in loss as sales fall.

Tip

The employment of a high level of fixed assets (with fixed costs) at high volume increases the profit potential of a business. At low sales volume, however, losses multiply; and difficulty in meeting your fixed costs, such as payments for plant and equipment, may ensue.

For most small businesses, limiting downside risk is more important than increasing potential profits, so it's wise to keep your fixed costs low wherever possible.

A business often can choose between a high level of fixed assets and a lower level of fixed assets. For instance, some equipment items are substitutes for labor (and labor is commonly considered a variable cost). If labor is not replaced with equipment, fixed costs are held lower, and variable costs are higher. With a lower level of operating leverage, the business shows less growth in profits as sales rise, but faces less risk of loss as sales decline.

Example

Joe's Carpentry Shop's fixed costs are $28,000 and its variable costs per unit of production (bird call) or sales are $.60. Its sales revenue is $1.00 per bird call. Each bird call can contribute $.40 toward covering fixed costs. Joe's breakeven point is the same as Lillian's Bakery in the previous example: $28,000/$.40 = 70,000 units.

As with Lillian's Bakery, as sales exceed 70,000 bird calls, Joe's Carpentry Shop earns a profit. Sales of fewer than 70,000 bird calls produce a loss. Presented graphically, however, a picture emerges that is very different picture from that of Lillian's Bakery:

Joe's Carpentry Shop can see that a 10,000 unit increase in sales over break-even to 80,000 bird calls will produce a $4,000 profit, and a 30,000 unit increase to 100,000 bird calls will produce a $12,000 profit. Similar losses occur as sales drop below break-even.

If we compare Lillian's Bakery in the first example and Joe's Carpentry Shop in the second example, it is apparent that Lillian's Bakery will benefit more from increased sales than will Joe's Shop.

On the other hand, the higher degree of operating leverage in the bakery will cause Lillian's to suffer greater losses on sales declines.

Breakeven analysis shows the effect of increased investments in fixed assets that lower variable costs but increase fixed costs. A decision to go with heavier investment in fixed assets and to increase operating leverage will, to a large extent, be determined by your perception of the economy and of the ability of your business to meet higher sales levels necessary to support the fixed costs.

Also consider the degree to which sales expansion is practical. Increased volume can result in price weakness or higher-than-expected costs as you exceed your optimum levels of production.