Break Even, Part I: The Cup Theory of Profitability

There are two ways to generate profit: You can simply go from day to day and hope it happens, or you can identify the primary "drivers" of profitability—and manage them. Sadly, far too many jewelers opt for the "jump and hope" approach, even though the managed approach offers so many advantages.

In the last few articles, we've talked about financial statements and ratio analysis as one way to get your arms around the management of your business. But in the financial time continuum of your business, financial statements represent past history. We can't change yesterday; we can only learn from it. We can have an impact only on today and tomorrow. For the next couple of articles, we'd like to share an analysis tool called "break even" that can help you make significantly better decisions for the future.

Now, you're probably expecting some technical financial mumbo-jumbo, right? Not so—just the simple picture below.

This diagram outlines in a simple, straightforward way how sales dollars flow through a company. A useful and effective method of assessing cost-volume-profit relationships is through the application of break-even analysis. "Break-even," of course, refers to the point at which there is no profit and no loss—i.e., revenues exactly covering costs. Now, we know no one is in business to break even—except at tax time—but it's a useful concept for evaluating strategic options. But this analysis revolves around a second concept—contribution margin.

Contribution margin. First, a definition: Contribution margin represents the percent of each sales dollar left after variable costs are removed. (Variable costs represent those costs that are both proportional to sales and caused by sales.) However, I tend to call it "what's left"—because that's what it is.

Basically, whatever remains of each sales dollar after subtracting the variable costs represents the funds available to cover fixed costs. By definition, fixed costs represent those costs that exist independently of sales—i.e., they are neither proportional to nor caused by sales. They are there whether or not you sell anything.

A certain percentage of each sales dollar—and it varies from business to business—remains after the proportional or variable costs are removed. This remaining portion of each sales dollar is contributed to the amount necessary to cover the fixed costs; hence the name "contribution margin."

If you have just enough dollars contributed to cover all fixed costs, financial people say you are at "break-even"—no profit, no loss. If sales produce a contribution margin greater than the fixed costs, you have a profit. And if sales are not sufficient to produce enough dollars to cover fixed costs, you have a loss.

Filling the cups. It is perhaps easiest to visualize this concept as a series of cups stacked on top of one another. The figure at the beginning of this article is a graphic representation of this "cup theory." The top cup represents the costs that are variable. As you can see, all the funds "left over"—or contributed—flow down to fill the cup labeled "fixed costs" on the second level. Once the fixed costs have been covered (or the cup "filled") any remaining funds flow down to the third level and become profits.

This concept is an extremely useful tool—not so much to calculate the exact break-even point, but rather to investigate the impact on required sales volume. Suppose we change the size of the cups? In other words, what happens to required sales volume if the contribution margin (the size of the variable cup) changes? And what is the impact on sales volume if the size of the fixed-cost cup changes?

First, let's talk about fixed costs. If the fixed cost "cup" gets bigger, you need more dollars of contribution margin to fill it; thus, break-even sales increase as fixed costs increase. Conversely, as fixed costs decrease (the size of the cup decreases), fewer contribution dollars are required and "break-even sales" is a smaller figure.

Now, let's look at changing the variable cost percentage—or the contribution margin. As the variable-cost percentage increases, the size of the variable-cost "cup" increases, and there is a decrease in the amount contributed from each sales dollar. Thus, you need more sales dollars to fill the fixed-cost "cup," and break-even sales rise.

Clearly, just the opposite is true when the variable-cost percentage decreases and the contribution margin increases. With a decrease in the size of the variable cost "cup," there is an increase in the amount contributed from each sales dollar. Correspondingly, you need fewer sales dollars to fill the fixed cost "cup," and break-even sales decrease.

So the real value in "break-even" analysis lies not just in calculating the current break-even sales, but rather in evaluating the impact on sales volume of changes in either variable costs or fixed costs—or both. By attaching numerical formulas to the concepts we've outlined here, we can assess the required volume change, given a measurable change in the cost structure. To a measurable degree, it is possible to analyze marketing strategies in light of varying cost structures.

Knowing your costs. The core of this analysis, however, is rooted deeply in the importance of knowing your costs. Quite frankly, this is often the weakest area for most jewelers. In the absence of any firm grip on costs, many jewelers set their prices based solely on the competition. This, of course, presumes your competitors know their costs ... and the rest, as they say, is history.

Take a few minutes to think through the concepts we've presented here. Next month, we'll walk through four simple steps to determine your break-even numbers and explain how to use this tool to make critical business decisions.

For more information on the JCK/BRS Profit Mastery workshops and FIT Performance Groups for jewelers, visit www.brs-seattle.com or call (800) 488-3520.