Financial tools key to success
October 8, 2007
Managing a business’ finances can be a huge undertaking. It can be a daunting task to connect how an increase in advertisement will impact sales, and most importantly, how the increase will affect the balance sheet.
There are financial tools available to help decide how to raise wages or change product or service prices and still maintain the current net profit. One such tool is the breakeven analysis.
Breakeven analysis determines the point when sales cover costs, which means there is not a loss or profit. By using the tool, a business owner will know their cost of doing business. As a result, pertinent questions can be answered prior to hiring a new employee and knowing what sales must be generated if rent increases by $3,000 can be calculated.
All businesses have costs, which are distinguished in two categories: variable and fixed.
Variable costs are directly created by the generation of sales. Fixed costs occur regardless of how much product is sold or how many services are rendered.
The types of variable and fixed costs vary from industry to industry and business to business. Inventory, labor, commission, and utilities are typical variable costs. Advertising, accountant fees, insurance and salaries are typical fixed costs.
To determine the breakeven point, costs must first be identified as variable or fixed. If costs are not easily identified, the rule of thumb is to be conservative and define the cost as fixed. The second step is to compute the Variable Cost Percentage, which is total variable costs divided by sales. If the VCP equals 65 percent, it means for every $1 in sales generated 65¢ is spent on variable cost.
Once sales dollars are generated to cover variable costs, the Contribution Margin Percentage is calculated. The CMP is computed by subtracting the VCP from 100 percent (100-65 = 35).
This means 35¢ is available for fixed costs out of every $1 generated in sales.
So what sales amount is needed to reach the breakeven point?
If fixed costs total $75,000, the sales figure to breakeven is $214,286. The computation is to divide Total Fixed Costs by the CMP ($75,000/35 percent) and express it as a decimal.
Why is this important to a business owner? Computing breakeven is not as important as knowing how the results can influence day-to-day business decisions.
For example, if wages are raised by $500, sales must increase by what amount to maintain the current level of net profit? The answer: $1,429 in additional sales.
The computation: 500/.35 = $1,429.
A thorough knowledge of the impact of variable and fixed costs should be clear prior to increasing or decreasing costs or changing sale prices for any business to grow successfully.
Sandra Taylor-Sawyer is director of the Small Business Development Center at Clovis Community College. Call the center at 769-4136 or visit their Web site, http://www.nmsbdc.org/clovis