Understanding Business Accounting For Dummies, 2nd Edition (69 page)

Calculating its break-even point calls attention to the amount of fixed expenses hanging over a business. As explained earlier, a business is committed to its fixed expenses over the short-run and cannot do much to avoid these costs - short of breaking some of its contracts and taking actions to downsize the business that could have disastrous long-run effects. Sometimes the total fixed expenses for the year are referred to as the ‘nut' of the business - which may be a hard nut to crack (by exceeding its break-even sales volume).

In the example (see Figure 9-2) the business actually sold 520,000 units during the year, which is 87,500 units more than its break-even sales volume (520,000 units sold minus its 432,500 break-even sales volume). Therefore, you can determine the company's earnings before tax as follows:

Second Way of Computing Profit

Contribution margin per unit £32

× Units sold in excess of break-even point
87,500

Equals: Earnings before tax £2,800,000

This second way of analysing profit calls attention to the need of the business to achieve and exceed its break-even point to make profit. The business makes no profit until it clears its break-even hurdle, but once over this level of sales it makes profit hand-over-fist because the units sold from here on are not burdened with any fixed costs, which have been covered by the first 432,500 units sold during the year. Be careful in thinking that only the last 87,500 units sold during the year generate all the profit for the year. The first 432,500units sold are necessary to get the business into position in order for the next 87,500 units to make profit.

The key point is that once the business has reached its break-even sales volume (thereby covering its annual fixed expenses), each additional unit sold brings in pre-tax profit equal to the contribution margin per unit. Each additional unit sold brings in ‘pure profit' of £32 per unit, which is the company's contribution margin per unit. A business has to get into this upper region of sales volume to make a profit for the year.

Calculating the margin of safety

The
margin of safety
is the excess of its actual sales volume over a company's break-even sales volume. This business sold 520,000 units, which is 87,500 units above its break-even sales volume - a rather large cushion against any downturn in sales. Only a major sales collapse would cause the business to fall all the way down to its break-even point, assuming that it can maintain its £32 contribution margin per unit and that its fixed costs don't change. You may wonder what a ‘normal' margin of safety is for most businesses. Sorry, we can't give you a definitive answer on this. Due to the nature of the business or industry-wide problems, or due to conditions beyond its control, a business may have to operate with a smaller margin of safety than it would prefer.

Doing What-If Analysis

Managing profit is like driving a car - you need to be glancing in the rear-view mirror constantly as well as looking ahead through the windscreen. You have to know your profit history to see your profit future. Understanding the past is the best preparation for the future.

The model of a
management profit and loss account
shown in Figure 9-2
allows you to compare your actual profit with what it would've looked like if you'd done something differently - for example, raised prices and sold less units. With the profit model, you can test-drive adjustments before putting them into effect. It lets you plan and map out your profit strategy for the
coming
period. Also, you can analyse why profit went up or down from the
last
period, using the model to do hindsight analysis.

The management profit and loss account profit model focuses on the key factors and variables that drive profit. Here's what you should know about these factors:

Even a small decrease in the contribution margin per unit can have a drastic impact on profit because fixed expenses don't go down over the short run (and may be hard to reduce even over the long run).

Even a small increase in the contribution margin per unit can have a dramatic impact on profit because fixed expenses won't go up over the short run - although they may have to be increased in the long run.

Compared with changes in contribution margin per unit, sales volume changes have secondary profit impact; sales volume changes are not trivial, but even relatively small margin changes can have a bigger effect on profit.

You can, perhaps, reduce fixed expenses to improve profit, but you have to be very careful to cut fat and not muscle; reducing fixed expenses may very well diminish the capacity of your business to make sales and deliver a high-quality service to customers.

The following sections expand on these key points.

Lower profit from lower sales - but that much lower?

The management profit and loss account shown in Figure 9-2 is designed for managers to use in profit analysis - to expose the critical factors that drive profit. Remember what information has been added that isn't included in the external profit and loss account:

Unit sales volume
for the year