There is a powerful tool that you can utilize if you know your fixed and variable costs. This tool is called Cost Volume Profit (CVP) Analysis. I know, your eyes probably started glazing over after hearing accountant-speak like that, and I don’t blame you. But here’s what it means. If you know your fixed and variable costs, you can quite easily determine the following:
Your break-even point in either revenue (dollars) or volume (# units sold).
Your sales targets required, either in revenue (dollars) or volume (# units sold), in order to reach a profit target.
How to make strategic purchasing decisions, based on the output of your business.
Yes, if the word “business modeling” came to mind, that’s exactly what this allows you to do! You can model out the fundamentals of a business before starting one, or model out a business strategy for an existing business in order to establish targets that can be used as key performance indicators! Ok, let’s keep calm and keep moving on with the details.
Before we dive into the details though, let’s take a quick pause to nail down some operational definitions.
Fixed Costs: costs that do not vary as a function of output or sales
Example: Rent for retail space
Variable Costs: costs that fluctuate as a function of output or sales
Example: Material costs for each product sold
What does this mean? It means that, if you sell widgets as a product, your fixed costs should remain the same in a given period of time whether you sell 1 or 100 widgets. In contrast, if you sell 100 widgets, your variable costs will be greater than if you sold 1 widget. Here’s an example to illustrate the point.
Assume the materials to produce 1 widget cost your business $5.
As we can see in the table above, the rent, which is a fixed cost, remains constant at $1,500 for the period regardless of how many widgets are sold. The materials, on the other hand, vary with the number of widgets sold, with a cost of $5 for 1 widget, and $500 for 100 widgets sold.
Strategic Purchasing Decisions
So, an obvious question that is asked is, “is it better to have fixed or variable costs?”. The answer to that question is the classic “it depends”. There are a number of variables that would impact this decision, but let’s consider one of the important ones, which is the sales or output of your business. Generally speaking (and I say generally because it really does depend on specific situations), businesses with lower sales or output, whether that’s seasonal or because they are in start-up phase, or for some other reason, often lean toward variable costs, as costs will theoretically be relatively low with lower output or sales. As sales and output begin to increase, however, it is important to look at the pricing arrangements that you have with your vendors, as it may become more favourable to have fixed costs at some point, which will help keep your costs fixed as your sales ramp up, allowing you to benefit from the added profit with each sale.
The graph below helps us understand this dynamic visually.
As we can see above, a company would be in an operating loss at the beginning (Point A) if it went with the fixed cost option. And so the preference may be for variable costs, where there is still a margin of profitability (Region B), and as sales increase the variable costs also increase. There becomes a point, however, as sales increase, where the variable costs become greater than the fixed costs (Point C), and so it is near this point where organizations may look at changing their cost structures in favour of more fixed costs. In doing so, they earn more profit with each additional dollar in sales compared to what they would have earned had the costs been variable. An organization that is able to increase its operating income like this by increasing its sales, which has low variable costs, is considered to have high operating leverage.
Understanding Your Break-Even
Alright, let’s look at some numbers now. Once you have established which of your costs are fixed and variable, you can determine your break-even point. This is the point, either in dollars of sales, or units of product sold, where your business would break even. That is, the point where you have made enough sales to cover your fixed costs for a period of time. So how do you calculate your break-even? First, we need to calculate what is called the Contribution Margin.
Contribution Margin = Price Per Unit – Variable Costs Per Unit
Let’s take our previous widget example, which has variable direct costs of $5 per widget. If we sell the widget for $12, then the contribution margin is $7. That is, for each widget sold, $7 of margin is earned which can be contributed toward covering fixed expenses and profit. It’s worth noting here that if you do not properly understand your costs for each of your products, you may end up in a situation where you have a negative contribution margin, which means you would be losing money with each unit sold. Sometimes that’s a strategic decision, as in the case of loss-leaders, but it’s something you want to be aware of so that decision can at least be strategically made. Let’s add one more layer of complexity, which is a bit more realistic.
In the above example, there are a number of different variable costs per unit, that all add up to the total variable costs per unit. The contribution margin of this product is $14.75, which means that with each unit that is sold, $14.75 can be contributed to covering fixed expenses and profit. One more quick calculation before we dive into calculating break-even. That is the Contribution Margin Ratio.
Contribution Margin Ratio = Contribution Margin ÷ Price per unit
For our example above, the contribution margin ratio is 14.75 ÷ 30 = 0.49. What this number means is that 49 cents of every dollar of sales can be contributed to covering fixed expenses and profit. It's a handy number to be aware of! Now we’re ready to calculate our break-even amounts.
Break-Even ($ Sales) = Fixed Costs ÷ Contribution Margin Ratio
Break-Even (# Units) = Fixed Costs ÷ Contribution Margin
Here we can see these numbers play out in a continuation of our example, looking at fixed costs for a month:
In the example above, where we may be looking at fixed costs over the course of a month, we can see that the company will need to sell $11,797 in revenue, or 394 units, in order to break even, which means in order to cover fixed costs for the month of $5,800.
Understanding Your Sales Targets
So, it’s helpful to know how to calculate your break-even, to ensure you are generating enough sales to not be losing money in a given period. How do we determine the sales required in order to generate a desired profit? The easy way to think of that is by thinking of the profit as another added fixed cost.
Sales Target ($ Sales) = (Fixed Costs + Target Profit) ÷ Contribution Margin Ratio
Sales Target (# Units) = (Fixed Costs + Target Profit) ÷ Contribution Margin
We are effectively adding the target profit to the fixed costs within the break-even calculation we looked at earlier.
Here’s an expansion of the previous example we looked at, assuming a target profit of $5,000 for the month.
Here we see that, for a target profit of $5,000 for the month, there would need to be $21,967 in revenue, or 733 units sold.
From the above, you should now be able to calculate your break-even, as well as your sales targets, both in dollars of sales and in number of units sold. To summarize the steps:
Determine which of your costs are fixed and which are variable.
Calculate your contribution margin and contribution margin ratio for your product(s)/service(s).
Add in your target profit if applicable.
Calculate the break-even or sales target amounts, both in dollars of sales, or number of units.
It does require some up-front work in determining which of your costs are fixed and which of your costs are variable. It’s worth noting that some costs are both, such as mobile data, where you may pay a fixed fee for a certain amount of data, and then it becomes a variable cost ($/GB) once you have exceeded your data limit. There is a way to calculate this out, but it’s a bit more complex than we are looking to get into here.
If you want to take this analysis a step further, you can calculate your contribution margin for different products that you have. This will help you determine if you have any products or services that may actually be losing money with each sale, and are therefore cannibalizing your profitable products or services, and you can also then determine what the optimal product/service sales mix is – which products or services to prioritize - as you set your sales targets. Though this also gets a bit more complex than we are going in this post, generally (and again, I say generally here because specific circumstances may warrant otherwise), a strategic approach with multiple products or services is to prioritize those which have the highest contribution margin.
If this analysis is something that you would like to dive into further, you can download a free detailed CVP analysis tool here.
The information above is intended to be of a general nature, and is not intended to address the circumstances of any particular individual or entity, and is not able to capture changes that may be enacted that would impact the information above following the date of publication. As such, there is no guarantee that the information above is accurate as of any given date following publication, and so no one should act on or make specific decisions based on the information above without first receiving professional advice that can take into consideration specific circumstances for each person or entity. Should you wish to discuss your specific situation, you can contact me here.