Given the number of times we've had clients ask for help evaluating their product or service mix this past year, I figured it was time for a bit more of a technical discussion. So get that fresh cup of coffee and use this entry to begin to ponder how your products or services help -- or hurt -- your business.
Knowing the profitability of each individual product/service you provide can help you make decisions to improve your bottom line. You may want to discontinue products and services that aren’t particularly profitable while promoting the ones that improve your overall results.
One basic method of looking at profitability is called cost-volume-profit analysis (CVP). At its core CVP relies on the separation of fixed and variable costs to determine the break even point of a product (or service) and how much it contributes to profit after reaching this point.
Fixed costs are those that stay the same regardless of the amount of products produced or services delivered. These are often called overheads. Variable costs vary as the volume produced changes. In a manufacturing setting each additional unit produced will add to the variable cost. In a service business each additional customer served adds to the variable cost.
CVP analysis assumes that the number of units sold is equal to the number of units produced. Under this assumption total cost = total fixed cost + total variable cost (where total variable cost = variable cost per unit x the total number of units produced).
Let’s look at a hypothetical example. If a company sells one product and has:
- $100,000 fixed costs per year
- a unit variable cost of $500
- a unit selling price of $1200
Then total costs = $100,000 + $500x, where x equals the number of units produced (and you thought you would not have to use your high school algebra).
The number of units you will need to sell to breakeven is calculated as:
Break Even Point = fixed costs / (selling price-variable costs) = $100,000 ÷ $700 = 143 units.
The difference between the sales price and the variable cost is called the contribution margin. This is how much each unit of product contributes to fixed costs, and eventually to profit after fixed costs have been covered. On a larger scale, the contribution margin for a company equals the total sales minus variable costs.
Looking at our example again, you can use CVP to calculate the total number of units required to reach a profit goal. Let’s say you want to earn $200,000 profit from the product you are producing. You can calculate how many units you need to produce in order to reach your goal:
(Profit Goal + Fixed Cost) ÷ Contribution Margin = number of units required
($200,000 + $100,000) ÷ $700 = 429 units
You can also use CVP to compare several products once you know the difference between the selling price and our variable cost to produce each product. Let’s say you are thinking of replacing the product in the previous example with a new one. This new product has a selling price of $1,000 and a unit variable cost of $500. So its contribution margin is $500. If you want to breakeven with this product you’ll need to produce 200 units ($100,000 ÷ $500). If you want to reach you profit goal of $200,000, you’ll need to produce 600 units ($300,000 ÷ $500). So, all other things being equal, you wouldn’t want to switch to the new product with its lower contribution margin.
When using CVP analysis, it’s important to realize that it makes several simplifying assumptions. For instance, CVP analysis assumes that the sales price, variable cost per unit produced, total fixed cost and the sales mix are constant for a product or service though, in reality, these amounts can vary with changes in the amount produced. You also need to look at qualitative factors before making decisions. For example, a product with a lower contribution margin might be more popular, resulting in a higher sales volume.
What is most important for you though? What is most important is that you always try to make your business decisions based on sound analysis and not just what you think is best. Put pencil to paper and see what happens. If you're in doubt about how to evaluate your choices make an appointment with us or your CPA.
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