Overcoming Fixed Costs to Generate Business Profit
Almost every business has fixed costs — costs that are locked in for the year and remain the same whether annual sales are at 100 percent or below half your capacity. Fixed costs are a dead weight on a business. To make profit, you have to get over your fixed costs hurdle.
How do you get over the fixed costs hurdle? Obviously, you have to make sales. Each sale brings in a certain amount of margin, which equals the revenue minus the variable expenses of the sale.
Say you sell a product for $100. Your purchase (or manufacturing) cost is $60, which is called the cost of goods sold expense. Your variable costs of selling the item add up to $15, including sales commission and delivery cost. Thus, your margin on the sale is $25. Here’s how it breaks down:
$100 sales price – $60 product cost – $15 variable costs = $25 margin.
(Margin is before interest and income tax expenses.)
Your annual fixed operating costs total $2.5 million. These costs provide the space, facilities, and people that are necessary to make sales and earn profit. Of course, the risk is that your sales will not be enough to overcome your fixed costs. This leads to the next step, which is to determine your break-even point.
Break–even refers to the sales revenue you need just to recoup your fixed operating costs. If you earn 25 percent average margin on sales, in order to break even you need $10 million in annual sales: $10 million × 25 percent margin = $2.5 million margin. At this sales level, margin equals fixed costs and your profit is zero (you break even). From here on it gets much more interesting.
Until sales reach $10 million, you’re in the loss zone. After you cross over the break-even point, you enter the profit zone. Suppose your annual sales revenue is $16 million, or $6 million over your break-even point. Your profit (earnings before interest and income tax) is $1.5 million ($6 million sales over break-even × 25 percent margin ratio = $1.5 million profit).
After you cross over the break-even threshold, your entire margin goes toward profit; each additional $100 sale generates $25 profit. Suppose, for example, that you had made $1 million in additional sales. You would earn $250,000 more profit — an increase of 16.7 percent over the profit earned on $16 million sales revenue.