P1M3 How Profit is Calculated

After the last module What Is Profit,   I hope you are clearer about what profit is and that you are determined to make more profit…much more profit from your business.

This module will get into the nuts and bolts of how profit is created.

Why Understanding How Profit Is Created Is So Important

When you understand how profit is made at a fundamental level you will gain an intuitive feel for ideas and whether they will increase your profit or prove to be time-wasting or money-wasting distractions.

You will also have the ability to get back to basics and calculate for yourself the impact of decisions you are considering.

This module can give the impression it starts slowly and suddenly goes fast.

I don’t think it does…it’s more like a nine piece jigsaw puzzle.

You can’t interpret the picture when there are only two or three pieces but suddenly it becomes clear.

You need to have a firm understanding of the basics and then you will be astonished at the power of what I have to show you in this module.

What You Will Learn In This Module

In this third module of Pillar 1 Your Key Numbers we will cover:

  • The basics of how profit is created.
  • The different kinds of cost your business incurs and why it is so important to be able to tell the difference.
  • Then we will look at the idea of break even point analysis and explain why, even if your business is making big profits, it is an important concept to keep in mind and even measure.
  • We’ll then look at how we can adapt the break even model to meet your new Profit Target.

I am going to be talking through some numbers examples in this module so please stop and make sure you understand at each stage or read it through several times.

The reaction I get from this training is really exciting. I’ve heard plenty of people say things like “Wow – finally the finance light has been turned on in my brain.”

Sales And Costs

OK let’s start nice and simple and start taking apart your business so you can see what drives profit and improved performance.

Sales depend on the volume you sell and the price you sell at.

Your costs are a little more complicated since you will have some which change with volume and some which stay fixed in the short term – these are called variable costs and fixed costs.

Read: Sales and Costs

The Real Income

There is a trap which many fall into.

It’s thinking that higher sales mean more profits.

And what ever you do to increase sales will make you more money.

Unfortunately it’s nonsense!

This is why you need to understand your fixed and variable costs and learn how to focus on your real income.

Read: The Real Income

Read: Sales Increase & Contribution Fall

It is the contribution on sales that matters and not the sales value itself.

Never forget that – always think contribution (and cash).

Sales and Contribution

Contribution rises as sales increase

If we look at a graph of sales, variable costs and contribution, we can see three lines going out from the origin.

The higher the volume sold, the bigger the gap between the lines but each has the same basic relationship…as volume increases, the total sales value, total variable costs and total contribution all increase.

Adding Fixed Costs To See Profit Or Loss

We can make things a little more complicated…but much more revealing if we add fixed costs to the graph.

Loss to the left, profit to the right

By definition fixed costs don’t change with the volume sold, so the fixed cost line on the graph is horizontal to the Volume Sold x axis. It’s the same value across the range we are looking at.

We can also draw a total cost line (fixed plus variable costs) which is the broken red line on the graph parallel to the variable cost line.

If volume is low and below the point where the Sales and Total Costs lines meet, the business makes a loss.

If volume is high and above point where the Sales and Total Cost line meet, the business makes a profit.

What’s The Big Insight?

At this stage, I don’t blame you if you are asking what’s the big insight.

All I’ve done is shown you that Profit = Sales (or Revenue) minus Costs and put it in a complicated graph.

You knew that profit equals sales minus costs already didn’t you?

Well stand by your beds, this is where it gets interesting.

Break Even Point

The complicated graph can be stripped down to a much simpler graph where one line is the horizontal red line representing fixed costs and the green line which increases from the origin is the contribution- that’s sales minus variable costs.

Break Even Point - where Contribution = Fixed Costs

It’s now much easier to see where contribution equals fixed costs which means the business doesn’t make a profit or a loss…it breaks even.

This point is known as the Break Even Point and represents the volume you need to sell at a given fixed cost level and contribution per unit.

What we’ve done is taken the complicated financial performance of your business down to three key numbers – volume, contribution and fixed costs.

I think you’ll be amazed at what you can when you have those three numbers.

But first let’s work through a numbers example.

Read: Break Even Point: A Numbers Example

You may not like working with numbers but this is really important.

You must become comfortable with working through these three magic numbers – volume, contribution and fixed costs.

Calculating The Break Even Point

Fortunately there is an easy way to calculate the break even point and you don’t have to keep guessing and working through the numbers until you find it.

Break Even Point = Fixed Costs divided by Contribution per Unit

Read: Calculating the Break Even Point

If you are just starting the business or you are losing money, it’s important to calculate the level of sales you need to move you to your break even point.

The first aim is to break even…and then to make a profit.

Let’s now look at how to use this cost – volume – profit relationship to understand the dynamics of a business.

Three Ways To Make More Profit

The Break Even model is also known as the Cost Volume Profit model and that can be a better name when you are not focusing on the Break Even Point.

It shows that there are only three ways to increase profit:

  1. Sell more volume
  2. Increase the contribution rate per unit (by increasing the selling price or reducing the variable costs)
  3. Reduce the fixed costs

Read: Three Ways To Make More Profit (Accountants)

Your Profit Point Target

I know you don’t want to break even in your business.

That’s not what this program is about.

You can use the same Break Even Point logic to target the Profit you want, by treating your profit target as a fixed cost.

Then you can calculate the sales needed to reach your target at your contribution rate assumption.

Read: Your Profit Point Target

A Quick Summary

Let’s just quickly recap what we know about increasing profit if you are trading below your break even point or target profit point and I’ll do it in the order I’d suggest you want to tackle them in.

First, reduce your fixed costs wherever possible. We’ll take a deeper look at this in a few minutes.

Second increase your contributions.

You can do that by increasing your selling prices – and that’s partly covered in Pillar 3 Your Strategic Market Position since the most effective pricing is strategic.

There is also a bonus Hidden Profit module on pricing.

Or the second way to increase contribution rates is to lower your variable costs.

Some service businesses have very small variable costs – for example as a consultant and coach, my variable costs are minimal.

For other businesses – those that buy and sell or make and sell,  variable costs are often huge numbers. These may provide more opportunities for improved contribution rates than increasing selling prices.

The third way to increase profit is to increase sales volumes.

If you are trading above your break even point and past your profit targets, I recommend you still monitor the measures.

It is a great indicator of increased risk as costs have a nasty habit of creeping up during the good times.

Reducing Costs

If you need a quick fix to your Profit, then reducing costs can be faster than finding ways to increase revenue and contribution from customers.

Scope however is limited which is why most of the focus in the Eight Pillars of Business Prosperity system is on increasing contribution.

Read: Reducing Costs

In particular, please take notice of the zero based thinking question from Brain Tracy

“Knowing what I know now would I…”

It is a very powerful way to look at any difficult decision.

What If Analysis With The Cost Volume Profit Model

During this module, we have taken your business and reduced its performance down to a few simple numbers and relationships.

You will be surprised at the kind of commercial decisions you can make with the Cost Volume Profit model by looking into the future, making what-if assumptions and seeing the results.

Read: What If Analysis

This is where it all gets exciting because this is the start of managing for profit.

It is number crunching but it’s the kind of “back of the fag packet” number crunching which can make or save you a fortune.

Key Lessons

Don’t assume more sales value or volume means profit.

I’ve shown you sales units and values can increase and profit decrease – the sales rep’s proposal and the first advertising proposal (see What If Analysis)

I’ve shown you sales can decrease in volume terms and profit increase. In different examples I can do it for sales value as well.

It is contribution that matters not sales and price is a major profit driver.

Things To Do

This has been a very large and very important module so it’s essential you understand the lessons.

1 – Do The Exercises To Practice Using The Cost Volume Profit Model

I have put together some question and answer exercises so you can practice the concepts before you try to apply it in your business. You’ll be impressed with the type of commercial questions you can answer.

CVP_Questions

CVP_Questions&Answers

My advice is to try to answer the questions without peaking at the answers. It will show you how much you have understood.

Then check your answers.

Or if you struggle…work through the Questions with Answers first with a calculator and checking where my numbers come from.

Then try the questions yourself.

I don’t think you’ll remember the answers unless you’ve got a photographic memory.

When I was at University, I would sit in lectures and think to myself “this is so easy and obvious” and I wouldn’t do the exercises. I didn’t think I needed to because it was just arithmetic.

But I got a nasty shock when it came to exam time.

The answers weren’t so logical and as easy to find as I thought.

It took me a long time to learn my lessons but when I did my professional chartered accountants qualifications and my income depended on my success I did every example set.

Do the questions – it is much easier to make sure you understand the idea in a controlled environment where the numbers are easy to deal with than still being unsure when you try to apply it in your business.

If it’s as easy as you think it won’t take many minutes and if it isn’t easy, then you need to learn and the best way of learning is by doing.

Not just reading the pages again. That’s passive – you will learn much more by doing.

2 – Apply What You’ve Learnt To Your Business

After you’ve done the exercises, you will have a better understanding of the concepts so now we will apply them to your business.

Step 1 –  identify your fixed and variable costs.

You will be easy to slot some things into the categories straight away but others you may be unsure about.

The basic variable test is “If I sell more, does this cost automatically increase?”

If you make to sell, you can ask “If I make more, does this cost automatically increase?”

Strictly this will give you the variable production costs but it will be the same if any difference between production and sales goes into inventory or stock.

If in doubt, treat a cost as a fixed cost…it’s better to have a fixed cost that varies as the business grows than to have a variable cost that is really fixed and won’t go away if you don’t do very well.

Step 2 – Add up your variable costs and fixed costs.

When you’ve decided which cost is fixed and which is variable, put values to them from your last accounts.

Step 3 – Select Your Unit of Volume

You need to find some kind of unit so you can calculate variable cost per unit, selling price per unit and contribution per unit.

Some businesses have a natural unit but others don’t .

We will be looking at more complex situations in the next module.

Step 4 – Calculate Your Break Even Point

Remember the formula is fixed costs divided by your contribution per unit.

Step 5 – Calculate Your Target Profit

Then decide what profit you want and calculate your Target Profit Point – that’s the total of profit plus fixed costs divided by your contribution per unit.

Step 6 -Try What Ifs On Your Business

Then start looking at ways you can reach your target profit:

  • What if you increased contribution rates
  • What if you could reduce your fixed costs
  • What if you increased your fixed costs.

Get a feel for how your business needs to develop and what you need to do.

How Ambitious Is Your Target Profit?

I’ve found that coaching clients, some set low goals and say they want to increase profit by £10,000 per year.

Others will set huge goals and say they want profits to be half a million.

I don’t know what you want so lets set a reasonable stretch goal.

Can you calculate your Double Profit point and look at alternative ways to reach that target unless you are close to break even and you need to do much more than double your profits.

3 – Make Some Cost Savings

Review your costs and cut back where you are not getting value for money.

Remember the zero based thinking question…

”Knowing what I know now would I still…”

Step 4 – Start Building Up Your Key Numbers Report

Start monitoring your contribution, volume sold, contribution per unit and your break even point each month if you can.

You may be lucky enough to have accounting information available already although you may need to write a report to correctly analyse variable and fixed costs.

You will find your Break Even Point can jump around each month because your fixed costs change so much – this is probably due to discretionary spending on things like one-off training or costs like repairs where you didn’t have much alternative.

If your Break Even Point does jump around, I recommend you calculate your statistics on a cumulative, year to date basis as well and calculate the average month.

One option I like in practice is a moving annual statistic because it’s normal to think in terms of financial years and it shows the trend clearly.

See: Calculating Moving Annual Break Even Statistics (if you want to go this far)

Words Of Caution

This has been a mammoth module.

The cost volume profit relationship we’ve covered is an extremely powerful technique for understanding your business and calculating the profit impact of decisions.

I do have a few words of caution.

Defining costs as variable or fixed will vary over time and big volume changes.

In the short term many costs are fixed.

Over the long term many costs are varied by decisions.

If you have a shop and your business grows, at some stage you may decide to move to a bigger store and your fixed costs take a step up. Or you will add shop assistants and see your staff costs jump up.

Fixed costs have a nasty habit of creeping up with growth. The little luxuries creep in because you are doing so well and you can take on staff and tolerate second rate performance because the business is doing so well.

This is one of the reasons I like to monitor break even points when things are good because it keeps you focused on the risk of something outside of your control affecting your sales.

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