Have you ever thought what discounting as a pricing strategy does to your break even point?
What's break even all about?
Before we look at that, let's look at a few basics.
All businesses have a certain level of fixed costs which are incurred irrespective of the amount of business being done. Fixed expenses cover costs such as rent, advertising, bank charges, administration wages, computer system charges, training, accounting fees, electricity, rates, company vehicles, building or office repairs and maintenance.
It is absolutely vital that good control of fixed expenses is maintained in every business, because as you will see, if expenses are greater than Gross Profit there is no bottom-line profit or Net Profit.
Of course all fixed costs are ultimately variable, but they tend to be variable in lumps rather than directly related to the volume of activity. An extra staff member may ultimately be required, or more space rented to meet growing requirements.
As sales volume grows relative to the fixed expenses, the proportion of fixed costs per unit of sale will decline, leading to increased profits irrespective of the contribution margin. And that occurs once you get past the break even point.
When you make a sale you incur variable costs, i.e. those costs directly associated with delivering your product or service. The more you sell the more of these costs are incurred. Variable costs include goods purchased for resale, direct labour costs (where applicable), freighting products or services to the customer, shop floor consumables, sub-contract and so on. They are usually grouped under the Cost of Sales (of Cost of Goods Sold) in your Profit & Loss Statement, or should be shown there (but that is another subject).
So if you look at your costs at any one point during the year they will include the fixed costs plus the variable costs incurred for that volume of business done up to that point in time.
If you were drawing a graph of this you would show the base of the graph representing units and the vertical representing dollar. Fixed costs would be a flat line parallel to the base of the graph, with the variable cost line starting where the fixed cost line met the vertical side of the graph.
Now we come to the sales line. It starts from the bottom left corner of the graph (zero dollars) and rising more steeply than the variable costs line, because the unit sales figure includes the variable costs for the unit of sale, plus a margin to cover the fixed costs and a contribution to profit. This is the Gross Profit.
And the more margin you have, the more steeply the sales line will rise.
Why is this important?
But, and it's a big but, we don't make a profit until we cover all the variable costs incurred, and all the fixed costs. The point at which this is reached is known as the "breakeven point". And the more we sell after this point is reached, the more profit is made.
You can calculate where this point is by dividing your overheads (i.e. the fixed costs) by your Gross Profit margin. Let's take an example.
Gross Profit margin: 35%
Breakeven: $200,000 / .35 = $571,428
That is, you would need sales of $571,428 just to cover all your fixed costs. All sales after that point would contribute a 35% of the value of sale to your profits.
So the lower your gross profit margin the flatter the sales line on your graph, and the more you have to sell before you break even.
If our fixed costs increase, and there are no other changes, then we will have to sell more before we make a profit.
We can increase our overall profits by going out - increasing sales. Or we can do so by going up, selling lower volumes but with greater margins.
In summary, gross profit is the key to profitability. You have to decide what is the best approach in your market. Is it a price sensitive market, requiring you to have low margins, but giving you sales volumes, or is it one where you expect to sell less but with a greater margin.
How to use break-even as both a management tool and a marketing weapon
One of the best uses of breakeven analysis is to play with various scenarios. For instance, if you add another person to the payroll, how many extra sales dollars will be needed to recover the extra salary expense? If you borrow, how much will be needed to cover the increased principal and interest payments?
Many owners, especially retailers, like to calculate a daily breakeven. This gives everyone a target to shoot at for the day.
You can use break even analysis to test:
- New Investment
- Cost justification
- Setting sales objectives
- Product Line analysis
- Profit planning
Let's take a very simple example.
You operate a smoko van, (in Australia a smoko van is a van or cart that that goes around industrial areas and building sites to sell hot food, sandwiches and drinks during tea/coffee breaks). You van sells just....meat pies. Here are the complex financials:
- Running costs for the smoko van are $200 per week
- Wages are $400 per week
- Pies cost $1.85 to make
- Pies sell for $3.85
1. How many meat pies must be sold each week to break even?
- Gross profit = $3.85 - $1.85 i.e. $2.00 or 51.95%
- Fixed costs = $200 + $400 i.e. $600
- Break even = $600 / 51.95% i.e. $1,155 or at $3.85 each, 300 meat pies
2. What would be the profit if the van sold 50% more than the break even point?
- Increased sales = 300 x 150% i.e. 450
- Increased profit = 450 x $2.00 i.e. $900.00
3. What would be the break even point if running costs went up to $220 per week and wages to $450?
- Increased fixed costs = $220 + $450 i.e. $670
- Break even = $670 / 51.95% i.e. $1,289r or 335 meat pies
4. If the pies were discounted to $3.25, how many would have to be sold to break even, assuming no change to the running costs?
- Gross profit = $3.25 - $1.85 i.e. $1.40 or 43.08%
- Break even = $600 / 43.08% i.e. $1,650 or at $3.25 each, 428 meat pies
You will note the impact of discounting compared to rising fixed costs. While you might want to discount to sell the remaining meat pies at the end of the day, it would be foolish to base your overall strategy on discounting. It moves your break even point a lot further out. And there's a lot more work involved just to get there.
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