Fixed costs are those costs that do not change for different levels of output and sales. Variable costs are those costs that change for different levels of output and sales. Operating leverage can be a risky strategy. A highly leveraged firm (too much in fixed costs), as it experiences a downturn in sales, may be unable to lower expenses on the way down.
Break-even means a level of operations at which a business neither makes a profit nor sustains a loss. At this point, revenue is just enough to cover expenses. Break-even analysis enables you to study the relationship of volume, costs, and revenue. The business owner/manager is required to define a sales level; in terms of dollars earned or units sold using cost estimates.
Maria must understand that her product sales will not cover her in monthly overhead expenses. The cost of selling $650,000 in retail goods could easily be $325,000 at the wholesale price, so the $650,000 in sales revenue only provides about $225,000 in gross profit available for overhead costs. Additionally, Maria should not have started a new venture based on seeing a small increase of $50,000. In addition, if the variable cost per unit for making lemon cookies is higher in the new unit, the decision will lead to reduction in overall profits.
Part 2 of Maria’s cookie simulation has the sales manager approaching the production manager with a bulk order for an addition 1000 mint cookies, and order in which Maria would like to accept. The COO has to find a way to produce those 1000 cookies without lowering profits or affecting the contribution margin. The only method to accept the cookie bulk order is to lower production so plant capacity can process the order. The high seller, or the product with the highest contribution margin and profits, should not suffer the cut in production. This will lower profits and the bulk order would not be acceptable. Maria’s suggestion for lower production on both cookies lines gives undesirable results. The correct solution to satisfy the sale is to lower the current mint cookie production to meet the bulk order; however, this will cause the consumer market to become to have an inventory shortage.
Three things learned from the simulation include 1) A change in sales volume will not affect the selling price per unit (generally), 2) fixed costs will remain the same at all volume levels; and 3) variable costs will increase or decrease in direct proportion to any increase or decrease in sales volume. The break-even point for manufacturing lemon cookies in the new unit was 563,000 packs. We chose to produce 600,000 resulting in operating profits from the new unit. This increased overall profits by meeting production targets. Increased sales do not necessarily mean increased profits. If you know your company's break-even point, you will know how to price your product to make a profit.
There is a close relation between contribution margin and break-even as they are both focusing on fixed costs. A contribution margin is the difference between your income and your variable costs. By subtracting all the direct variable costs of production from sales, the amount remaining is applied to fixed costs and then profits.
Knowing a company’s contribution margin helps one make better decisions about pricing, and adding or subtracting from a product line. Reducing unit prices can boost sales, and results in better profits, but this is not the only way to realize a profit. When faced with the decision whether to accept or reject the bulk order of cookies, an analysis of the affect on contribution margin helped the decision process. Accepting the bulk order by reducing the current production volumes for mint cookies was the optimal decision. When seeking to maximize operating profits, it is better to produce more of the product that has a greater contribution margin per unit. It is also useful to know what your margin of safety is. The contribution margin is the amount your total sales and fees can drop by before your business starts making a loss.
Ennis, Inc., a printed business product supplier, reported a rise in profit for third-quarter 2004. The company reported net income of $6.1 million, or 35 cents a share, compared to $4.5 million, or 27 cents a share, in the same quarter a year ago. The company's third-quarter revenue increased 38 percent to $91.8 million from $66.4 million for the same period last year. Ennis acquired several businesses during the year 2004. As with Aunt Connie’s Cookies, the added size and nature of their business enabled them to increase their operating leverage by changing the level of activity, and increased profits by producing a product with the greatest contribution margin per unit (i.e. printed business forms).
Ennis, Inc. has a lot going for them at this point, and it is crucial that they make key operating decisions, and utilize all of their resources. Ennis Inc. recently acquired all the capital stock of Royal Business Forms Inc. in exchange for about 178,000 Ennis shares. “The company said the transactions, along with the acquisition of Crabar/GBF Inc. in June 2004, represents a significant change in the size and nature of Ennis' business” (Dallas Business Journal, 2005).
Since these acquisitions were towards the end of the fiscal year, they had very little effect on the 3rd quarter numbers that the article reviews. If Ennis is careful, they could substantially increase their revenue by millions of dollars. One of the key operating decisions they have to make, is whether to continue to produce the products of the acquired companies, or to scale back to their “normal” products. An extended product line could boost business, but it could also be too much for Ennis to handle.
Another key operating decision faced by Ennis Inc., is whether to adopt the processes employed by the acquired companies, or to convert everything to their way of doing business. The added assets (building, equipment, etc.) could be used to increase product output, expand the product line, or both. The optimal decision will be the choice that maximizes profits, and makes the best use of production capacity.
Ennis Inc. offered this in their business owner toolkit: One of the important, yet relatively simple, tools afforded by cost/volume/profit analysis is known as contribution margin analysis. Your company's contribution margin is simply the percentage of each sales dollar that remains after the are subtracted. When you know the contribution margin, you can make better decisions about whether to add or subtract a product line, about how to price your product or service, and about how to structure any sales commissions or bonuses.”
References
University of Phoenix. (Ed). (2005). Contribution Margin and Breakeven Analysis. [University of Phoenix simulation]. Retrieved January 24, 2005, from University of Phoenix, rEsource, FIN540 - Business Regulation simulation Web site: .
Dallas Business Journal. (2005). Ennis Inc. reports 3Q operating results. Retrieved January 25, 2005 from .
