• Breaking even - A big deal!

  • Have you ever wondered why no name products and house brands are often able to be sold at prices so far below the comparable national brands? Of course there are lower marketing and handling costs but there is often a larger factor in the pricing of the manufacturer to the retailer that results in the lower selling price to the consumer.

    Most businesses do not focus on what it takes to break even, as they set higher goals for their profitability, and so they should. However, the ability to manage the profits of a business is considerably enhanced, in many cases, where management has a clear understanding of the break-even volume of the business and the split in expenses between variable and fixed expenses. Consider these three concepts and how they enable your business to maximize profits by adjusting the pricing of your product, where appropriate.

    If you know at what level the business achieves its break-even point, every dollar of sales that exceeds that point is much more profitable than the previous dollar of sales, as you no longer have to pay to cover any overheads. If the overheads have already been covered in that period, the entire gross margin is going to flow through to the bottom line, subject only to the need to add overhead to manage the additional volume, which is almost always at a lower rate than the pre-break-even sales. In most businesses the additional overhead to manage additional volume, especially for short-term spikes in sales, is very low and always much lower than the average overheads in the pre-break-even period.

    Let’s look at a simple example, to illustrate the point:

    So, why is this so significant? As always, additional information enables management to make better decisions.

    Consider if a major potential customer approaches you in a month where you have orders for sales exceeding your break-even point, with a non-negotiable order to supply them with a large volume of goods, at a lower price than your normal mark-up. Now, you are in a position to decide whether the additional order should be accepted, as it will bring in a contribution to your bottom line. In the above example, you would accept the order if the gross margin on the additional sale is over 30%, as any margin over the cost of the goods will add to your bottom line.

    Of course, there are other factors to consider, such as:

      • Additional resources required to fill the order that will add to overheads e.g. staff working at overtime rates, additional administrative costs, additional facilities, etc.;

     

      • What price will that customer expect the next time he places an order;
      • Your reputation, if word gets out that you will supply at low prices;
      • Etc.

    However, consider your ability to capture market share or address markets that you do not normally service. If you were able to enter a new market in which you could supply goods at a price that did not have any overheads in your selling price, what would that do for your sales and bottom line?

    This approach is often referred to as contribution accounting. In this concept one looks at 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) as providing a “contribution” to covering overheads. In some companies they 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 and covering a portion of overheads than if one does not accept the sale.

    As a result it is critical to distinguish between your variable costs and fixed costs. Life also tends to be a little more complex than theory and one has to be alert to the fact that many costs are semi-fixed or at least somewhat variable. In most businesses the distinction is relatively simple and it is only with large changes in volume that fixed costs become variable. For example a very large increase in production may require additional warehousing and shipping staff (normally fixed costs) to manage the increased goods to be handled.

    So, now you can see that when a retailer approaches a manufacturer to supply a no name or house brand product, that manufacturer is often already at or above his break-even volume and so is forced by the retailer to sell the additional product at a price that does not include the manufacturers overheads (or forgo the sale and allow her competitor to make that sale).

    What sales could you make that do not need to include any, or significantly less than your normal, overhead costs?

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