Know Thy Costs and Manage the ‘Creepers’

How will my landlord’s proposed rent increase impact my net profit? Can I afford to hire that new salesperson? What do I need to do in sales in order to hit my target profit? How much do I need to increase my prices in order to cover any new expense item?

What do these questions have in common? Each relates to how changes in costs, volume, and pricing affect your bottom line. For example, suppose we posed the question: “If your costs go up $1,000, what do you have to make in increased sales just to stay even?” Far too many times, the answer is “$1,000” … and that’s a bad sign.

Last time we shared a visual concept called the Cup Theory to help give you a picture of how dollars flow through your company. The theory illustrated what’s left over after variable costs to cover fixed costs and contribute to net profits. This month we’ll talk more about those costs and give you a wonderful tool to manage costs along with a method to analyze your cost decisions.

The right tool for the job.

The problem is understanding how costs behave; the tool is break-even analysis. Break-even analysis is a financial tool that illustrates the relationship among cost, volume, and profit. “Break-even” is defined as the exact sales volume at which a business neither makes a profit nor incurs a loss.

To calculate break-even, we must first define two broad classes of costs based on how they behave in the business. First, there are fixed costs: Within a reasonable sales range, fixed costs do not vary with sales or production volume. Examples would include administrative salaries, rent, interest, insurance, utilities, and depreciation. Variable costs are those that are directly proportional to sales volume—i.e., no sales, no variable costs. Examples include direct materials (cost of goods sold), commissions, and bad debts. Think of variable costs this way: Sales cause variable costs. If a cost isn’t the result of sales, consider it a fixed cost.

To calculate break-even from your existing profit and loss statement, total all your current fixed costs. Let’s say the total comes to $100,000. Next, calculate your total variable costs as a percentage of total sales; let’s say this figure turns out to be 75%.

What does this mean in terms of one dollar? Well, for every dollar of sales, 75 cents goes to variable costs, which leaves … yes, 25 cents to cover fixed costs. Now the question is: How many 25 cents are in $100,000 of fixed costs? The answer: 400,000. This means that you will have to do $400,000 to break even. I’ve diagrammed it below, using the term “contribution margin” to replace the term “what’s left?”

The key issue is not so much how to calculate break-even as it is how to use it. For example, we once discovered that after our company contracted for a coffee service, our annual costs went up $1,000. How much in additional sales did we need to cover this increase?

Yes, sales had to increase $4,000 just to pay for the coffee. These are the “creepers” you must watch every day— because for every $1 increase in “fixed costs” (as they “creep” up on you), you have to achieve a $4 sales increase just to stay even.

As you add these costs up in your business, you may find a few new ways to “manage the creepers.”

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