The Mastermind Digest

August 2008

Last month, in an article Breaking even - a big deal! I explained why it is important for a business to be aware of the volume at which it breaks even. How to utilize contribution accounting facilitates making decisions that can result in significantly more profit for the business. Every dollar of sales, at a price in excess of your variable costs (cost of goods sold and any overheads that vary in relation to volume), provides a "contribution" to covering fixed overheads. Some companies make this assessment of the contribution for each sale (even prior to achieving break-even) on the grounds that accepting an order at a low selling price is worthwhile, if there is a contribution to overheads. The business is better off having that sale to cover a portion of overheads.

Last month's article focused on the application of this concept to businesses that are operating at greater than break-even sales. However, this concept can be very effectively applied to businesses that are below their break-even sales, especially if that is a temporary situation.

While this concept is mostly applied in a manufacturing or processing environment it can also be applied to many other industries. The most obvious is when retailers have numerous major sales or promotions in their slow periods and they often are operating at below their break-even sales level. Even in the administrative aspect of a business it makes sense to try to shift the workload to times when projects will not cause you to incur additional costs.

So how does this work in real-life situations, where you are not achieving your break-even point? Volumes could be low for any number of reasons, as is unfortunately common in these tough times: Business may be slow, growing or seasonal so it is important to consider how to inject more volume into the slow months to avoid draining the profits achieved in lucrative periods.

The starting point begins with a careful analysis of your costs and expenses that must be divided into fixed costs and variable costs. Some costs are semi-variable, e.g. premises (rent, mortgage interest, etc.) and are usually fixed until a point at which you exceed the capacity of those premises and then an additional cost would be necessary to step up to the next level. A break-even analysis is always done with an estimate of the break-even value of sales. So it should be easier to categorize expenses as either variable or fixed if you know whether you are close to the point at which a cost is likely to step up to the next level.

There are many break-even sales calculation articles and calculators available on the internet. Search for "break even sales calculation" to help navigate this important calculation. Alternatively, a simple review of your monthly financial statements for each of the most recent months may enable you to estimate the break-even sales required just as accurately. I recommend using both approaches to see if you can confirm your break-even sales level.

The changes below become even more applicable where there is a period in which the business is operating at capacity and unable to meet the needs of customers without extended delivery times. Any ability to shift production from a period in which your capacity and inventory cannot meet the demand, reduces the risk that the customer will go to your competitor, thereby losing the sale entirely and possibly all future sales for that customer. So it is also critical to know at what production level you will be at capacity.

Capacity is the short-term limit of production that you can produce without a significant additional investment or increase in fixed costs. Note that if you value capacity in terms of sales capacity on the earnings statement for a month, it is often not reflective of real capacity as it includes either an increase or draw-down of inventory. Therefore the sales on the earnings statement must be adjusted by the selling price of that inventory increase or decrease. E.g. if you find that your sales in a recent month, when your profit was a break-even, were $1,000,000, you should also look at the change in your inventory level in that month. If your inventory increased by $100,000 then your break-even production level is actually (assuming a 30% gross margin = 70% variable expenses): $1,000,000 + (100,000 / (1.00 – 0.30)) = $1,142,857.

So, how do you use this information to your advantage? The first step is to predict when you will be operating at below your break-even sales. When you know the periods that are affected, you can focus your efforts to do the following:

  • Shift the timing of events that affect your capacity so that they are incurred when you have the surplus capacity, e.g. encourage (or where you can, mandate) that vacations be taken or do routine maintenance in the slow months. Assuming that the cost is going to be incurred anyway you may as well sustain it when the reduction in capacity will not affect you.
  • Consider asking a customer who regularly places an order in peak season to move the order and possibly the shipping as well, to your slow period. If you can negotiate a price that exceeds all your variable costs, then this excess is a contribution to the fixed costs in that period and will reduce your loss for the period;
  • Put in an extra effort to increase your sales in the slow periods e.g. have a sale. If you consider that the fixed costs are a sunk cost, i.e. that you are going to incur them anyway, then you may want to lure customers to place an order for that time period, which may have been placed with a competitor, by offering a bigger discount or lower price than you normally would be prepared to;
  • Consider producing for inventory, where your product line is not entirely comprised of custom-made products, so that you have an advantage of being able to provide quicker than usual delivery when the market picks up and hopefully quicker than your competitors. This is of course dependant on you having or securing enough capital to finance the working capital costs of the additional inventory until you sell them and the customer pays for them;
  • Another approach is to ask your customer to place his order earlier than the normal time frames for that customer and offer a discount if payment is made on time. With a little luck, your customer has the capital to do it. E.g. I you offer 5% for 60 days, it is equivalent to 30% p.a. (5% / 60 x 365 = 30.4%) – a very good deal for the customer. This is also an excellent deal for you as, in addition to securing the customer early, you have utilized the capacity that is not being used in the slow period thereby not allocating any fixed costs to this order and freeing up your capacity to service other customers in the busier period.

Knowing at what level of sales both your break-even and your capacity are achieved, enable you to focus your efforts on the slow periods and shift sales, shift costs and attract additional sales to that period, thereby increasing your total sales without incurring additional fixed costs. The results of these efforts can improve your bottom line dramatically.

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