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Category: Business Strategy
Tags: break-evencostingpricingprofitsales
Entities: Anilbreak-even pointcontribution
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If I ask you what is profit, give me a formula for profit. Chances are you will say it is income minus expense.
Income will usually be the sales and the expenses can be numerous heads of
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expenses. There could be 100 heads of expenses even.
Guys, if this is the way I give you the information which we usually do, it will never make sense to you. I suggest if you examine all your heads of expenses,
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you will be able to classify them into two types. Some expenses by nature will be variable, others fixed.
So if you now represent your expenses as variable and fixed. Now tell me what is the new
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formula for profit that emerges? Profit will now be your sales or your income less variable cost less fixed cost.
Right? Imagine somebody is in the business of manufacturing furniture.
Give me one example of variable cost in
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the manufacturer of furniture wood. Let us say this person consumes 100 rupees of wood per table manufactured.
Give me one example of a fixed cost to run this business. Let's say they hire this room to make furniture in and they pay a rent
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of 10,000. Now imagine they make only one table.
What does one table cost this company? 10,100.
The raw material cost is 100. And the entire fixed cost will have to be bought
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by a single table. And if this organization wants to make a profit, they'll have to sell this table for higher than 10,100.
Then they realize selling price is not in our control. Selling price is dictated by competition.
Selling price
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is dictated by the market. And if all their competitors are selling tables similar to theirs for let's say 250 rupees, this organization realizes we will also have to price a product at 250 max, maybe less but not more.
So they
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also price it at 250. I've always said, you know, as business people, as business leaders, you should be able to look at your company's top line and know the bottom line without waiting for accountants to tell you that.
And guys, if I give you a traditional P&L, you
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will never be able to do that because there's an income and there are numerous heads of expenses. But if you represent the data like this now, it's not difficult to know the bottom line.
top line minus variable cost minus fixed cost is bottom line or profit or loss.
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But folks, sales minus only the variable cost, not the fixed cost. That stage has also been given a name.
Folks, if you're not familiar that with that word, then the earlier you familiarize yourselves, the better. It is probably amongst the
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most important words in the costing lexicon. Sales minus variable cost is called contribution.
So guys, what's the revised formula for profit? Sales less variable cost is equal to contribution.
Contribution less fixed cost is equal to
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profit. Profit can be positive or negative.
Let's complete the table. How much is the top line of this company if they sell one table?
250. Less variable cost 100.
So contribution 150. Less fixed cost 10,000.
So bottom
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line 9850. So the owner of this company comes to you.
Give me some advice. My business is making a loss.
What advice will you give this person? Advice will obviously be make and sell more.
You're making a loss because you're selling one table. They heed your advice.
They
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double the output. Sales becomes 500.
Variable cost 200. Contribution 300.
Fixed cost is still 10,000. Still a loss.
So they make three tables 750 300 contribution 450 fixed cost 10,000 loss
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950. So they take a quantum leap and make 10 tables.
Sales 2500 variable cost 1,000 contribution 1,500 fixed cost 10,000 loss 8 12,000. By now this
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business owner is beginning to get fed up. He says, "I would like to know when am I going to break even.
I want all of you to watch this table carefully and help me deise a formula for break even
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point." Tell me why are they making a loss guys? Sales minus variable cost is contribution.
Contribution minus fixed cost is profit. They are making a loss because the contribution figure is smaller than the fixed cost.
But as the quantity starts going up, the sales
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figure is moving up, the variable cost is moving up, the contribution is moving up, but the fixed cost is not moving up. Table by table, they're narrowing the gap.
It is not difficult to visualize. As the quantity of tables keeps on increasing, the figure of contribution
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will go on increasing. A stage will come where contribution is 10,000 and fixed cost is 10,000.
That's the break even point. Or I'm trying to tell you till such time that your organization's contribution, see what an important word contribution is.
Till such time that
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your organization's contribution is lower than the fixed cost, the organization makes a loss. The point where contribution equals the fixed cost is the break even point.
When contribution exceeds the fixed cost is where you will make a profit. So tell me
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what is the condition necessary to break even? Contribution should be equal to fixed cost.
How much is the fixed cost of this company? 10,000.
How much is the contribution per unit? 150.
So how many tables should they make in order to generate a contribution of 10,000? What
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divide by what? 10,000 divide by 150.
What is 10,000? Fixed cost.
What is 150? Contribution per unit.
Here's the formula. You've created the formula.
Now formula for break even point is fixed cost divided by contribution per unit.
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How much does it work out to? 66.66.
So this company makes 66 tables. Sales 16,000.
Variable cost 6600. Contribution 9900.
Fixed cost 10,000. Oh, still a
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loss. Why is there a loss still?
Because break even had worked out at 66.66. They are making 66 tables less.
So they make the 67th table. sales variable cost contribution fixed cost.
Ah they made a
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profit and if they make the 68th table sales 17,000 variable cost 6800 contribution 10,200 fixed cost 10,000 bottom line 200 I have a question for all of you. Can you
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please tell me why is contribution called contribution? The word contribution tells you it contributes to something.
But every table this person sells contributes to his cash box an extra 250. So why don't we say the
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contribution is 250. You may say Anil, how can you call 250 as contribution?
250 is the gross revenue. To earn 250 he has to spend money.
Fair enough. Then minus what he has spent.
If you can't call the top line as the contribution, then minus whatever he has spent, call
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the bottom line as contribution. But neither the top line nor the bottom line.
An in between line is called contribution. What is this a contribution towards?
Why is contribution called? Contribution.
Tell
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me guys what was the bottom line? When this person made one table it was9850.
Then he made the second table. What happened to the bottom line?
970. By how much did the loss go down because he made the second table?
150. What was the
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bottom line when they made 67 tables? 50.
Then they made 68 tables. How much of the bottom line?
200. By how much did the profit increase because they made the 68th table?
Again 150 which is the contribution. Contribution is called
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contribution because this is the contribution of every unit made and sold to the company's bottom line. If you're making losses, losses go down to the extent of contribution.
If you're making profit, profit go up to the extent of contribution. What is this company's
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break even point? 67.
Imagine they've got a fantastic sales team. The break even is 67.
In a short period of time, their sales guys have sold not only 67 tables, they've sold 100 tables. Let's work out the profitability results of
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100 tables. 100 tables at the rate of 250 gives you a sales turnover of 25,000.
The variable cost at the rate of 100 would be 10,000. How much is the fixed cost of this company?
10,000. Now 10,000 is the fixed cost of 100 tables.
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So what is the effective fixed cost per table? Another 100.
So what does the table cost this company? 200.
Or a 100 tables cost them 20,000. Folks, this company makes a table at an in-house cost of 200.
The sales guys go and sell
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it in the market for 250. Every table sold they earn 50.
They have sold 100 tables. At 50 rupees profit per table the bottom line of the company is 5,000.
Early morning the owner of this company calls a sales meeting gathers all his
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sales guys in a room and tells them you know I have some good news for you. What is the good news?
He informs his sales team. You guys are aware we are a relatively new table manufacturing company.
You guys are also aware our company's break even point is 67. He
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tells them, I'm so happy to inform you because you sales guys have done such a wonderful job. In a short period of time, our company has not only broken even, we have gone beyond break even.
Our break even is 67. You guys have sold
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100 tables. He said, "Let me share the profitability results with you." He informs them that we as a company manufacture a table at an in-house cost of 200.
You guys are selling it in the market for 250. Every table that you sell, we earn 50.
You have sold 100
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tables at the rate of 50 rupees per table. The company is making a profit of 5,000.
Now he tells his sales guys two jobs in front of you. Job number one guys go out into the field and carry on doing the good work that you're doing.
And job number two, he says we have
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competition. He says go out into the field and see that as far as possible business comes to us doesn't go to the competitors.
How will you do that? He says if you're out in the field and you bump into a potential customer and the customer says give me a quotation how much will you quote 250.
But let's say
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the competitor's person is also there and they say we can give it to you at 240. Then what will you do?
Then don't watch them take the order away. Then even you reduce the price but don't reduce the price to such an extent that we make a loss.
We are not that desperate to deny orders to competition
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that we make a loss. But so long as we don't make a loss, I am empowering you to play around with prices.
Guys, are the instructions clear? What instructions are given to the sales guys?
Go out into the field as far as possible. Sell my tables at the
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stipulated selling price of 250. However circumstances demand give a discount, but don't give so much discount that we make a loss.
His guys go out. They bump into a customer.
Customer says, "How much is your table for?" They say, "$ 250." The competition sales guy is also
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there. He says, "I can give it to you at 240." What do you suggest this company salesperson to do?
Can he afford to say 230 without violating boss's instructions? Yes.
He says 230, the competition says 220. Can this person
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say 210? The competition sales guy says 205.
Can this person say 202? The competitor says 200.
Now if he wants the order, he'll have to go below 200. What should he do?
Should he go below 200 and take the order or should he tell the
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competition, you keep it? Now guys, I often give a definition of finance management.
I say finance management is not only what happens in the finance department. Finance management is happening 24 by7 in the actions of every individual in the organization.
Because
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my definition of finance management is the ability to understand the impact on the organization's bottom line of every action of yours. By your action, if the company's bottom line becomes stronger, you should do it.
And if it hurts the bottom line, do not do it. So let us say at this stage, the customer interrupts.
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He says, "Stop arguing both of you. My budget is 150.
Take it or leave it." Now this salesman has to take a call. Should I accept this order at 150?
He must understand if I accept this order at 150, will my company's bottom line become stronger or weaker? If it becomes
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stronger, say yes. If it become weaker, say no.
Let's find out. If he says yes, now you sold how many tables?
101. But the 101st table is sold at 150.
So what is the new top line? 25,150.
Not important. What is important is what will it do to your bottom line?
Tell me
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what is the old bottom line of 100 tables? 5,000.
Why is it 5,000? Because this company makes a table for 200, sells it for 250.
Every table sold, they make a profit of 50. They've sold 100 tables, earned 50 rupees per table.
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Bottom line, 5,000. What about the 101st table?
Guys, when you make a table for 200, sell it for 250, you earn 50. Now, you made a table for 200 and sold it for 150.
How much did you lose on one table? 50 bucks.
On 100 tables, how much did
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you earn? 5,000.
So what is the bottom line of 101 tables? 4950.
Has the bottom line improved or become worse? Should you say yes to this customer or no?
Guys, new sales 25150. New variable cost 10,100.
Fixed cost
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10,000. New total cost 25 20,100.
New bottom line. Oops.
Oops. It did not become 4950.
It became 5050. It went up.
How did it happen? You sold a table that cost you 200 for 150.
How did the bottom
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line go up? This is where the concept of contribution comes in.
What formula did I give you for contribution? Selling price minus variable cost.
How much did you sell this table for? 150.
What is the variable cost of this company? 100.
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On this order, did you generate a positive contribution or a negative contribution? You have generated a positive contribution of 50.
My second question to you was why is contribution called contribution? It contributes straight to the bottom line.
Guys, what
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was the old profit of this company? 5,000.
What is the contribution of this table? 50.
So what is the new bottom line? 5050.
Can any saleserson afford to say I don't need to understand this. I'm a non- finance person.
But the question still remains, a product that costs you
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200, you sold for 150 and you made a profit. How did that happen?
Did it happen? Because this company has already broken even.
How much is the break even point of this company? 67.
What happens at break even point? Break even point is the point where you have recovered not
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only the variable cost but the lumpsum fixed cost also. Beyond break even point no more fixed cost to be incurred.
Who is this customer? Is this your only customer or is it your marginal customer?
Guys, we are discussing a topic called marginal costing. Marginal means additional.
This guy is a marginal
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customer. So long as the marginal customer pays you more than the marginal cost, which is the variable cost and leaves behind a positive contribution, you cannot go wrong.
But would this logic have worked had the company not
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broken even? How much is the break even point of this company?
67. Imagine they're not broken.
Even today they are selling 50 tables. Sales of 50 tables at the rate of 250 12,000.
Variable cost of 50 tables at the rate of 100 5,000.
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Fixed cost still 10,000. Now 10,000 is the fixed cost of 50 tables.
So what is the effective fixed cost per table? 200.
Now what does a table cost this company guys? They make a table at an in-house cost of 300.
Due to competition they are
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forced to sell it at 250. Every table sold they lose 50.
They sold 50 tables lost 50 rupees per table. Bottom line minus 2500.
Under these circumstances this company's salesperson bumps into a customer who says I'm very very keen to
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buy a table from you but I have budgetary constraints. Can't go beyond 150.
Take it or leave it. Now should you take it or leave it?
Let's find out guys. What if you take it?
Logic is still the same. Understand the impact on the bottom line.
If bottom line improves, say yes. If it becomes worse,
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say no. New top line 51 tables.
The 51st table sold at 150. So the top line will become 12,650.
More important is what will it do to your bottom line? What is the old bottom line guys?
50 tables. They make a table for 300, sell it for
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250, lose 50 per table. They sold 50 tables, lost 50 per table.
Bottom line - 250. 50.
First table when you make a table for 300 and sell it for 250 you lose 50. Now you sold it for 150.
Now
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how much did you lose? 150.
On one table they lost 150. On 50 table they lost 250.
So on 51 tables what is the loss? 2650.
Did the loss increase or decrease? It went up.
Should you say yes to this customer or no? Guys, new sales 12650.
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New variable cost 5,100. New fixed cost 10,000.
New total cost 1,5100. What the new bottom line?
Oops, it went down. Loss went down.
So again they made a profit. Now how did it happen?
Last time you told me it happened because they
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have already broken even. Now they haven't even broken even.
Because I don't remember telling you at any stage that contribution is called contribution after break even. Did I ever say that?
Contribution is contribution. Period.
If
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you're making profit, profit goes up to the extent of contribution. If you're making losses, losses go down to the extent of contribution.
Guys, understanding contribution is a gamecher. In tough days, only people who understand this will survive.
And my
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experience is even the few people who do understand this, they say, you know, once I break even, I can give a discount. Damn it.
If you've already broken even, why are you spoiling your market by giving a discount? The desperation to give discount is when you're struggling to break even.
So even
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those who understand this where they should be applying this concept they don't and where they should not be applying it they do.