In this tough economy, it is important for the business owner to review two critical analytical tools to ensure the success of his/her firm.
Breakeven Analysis
Let’s take a look at how increases and decreases in sales and expenses affect your bottom line.
It is very helpful to break down expenses into “fixed” and “variable” categories to better understand how each expense category is affected by an increase/decrease in sales. Fixed expenses are those that remain level/constant regardless of the sales level. Variable expenses are those that will go up or down in relation to a change in sales. Some expenses have both fixed and variable aspects to them.
Examples of “fixed” expenses are rent (not tied to a percentage of sales), telephone, depreciation, most utilities and administrative salaries. Examples of “variable” expenses are sales commissions (tied solely to a percentage of sales), cost of goods sold, shipping expenses and supplies. Examples of expenses that have both fixed and variable aspects to them include rent (which may have a fixed portion and a portion based on a percentage of sales), license/franchise fees, sales commissions (commissions paid once sales reach a certain level) and insurance (premium based on sales).
| Sales | $1,000,000 |
| Variable Expenses (75 percent of sales) | $750,000 |
| Profit left over to offset fixed expense | $250,000 |
| Fixed Expenses | $200,000 |
| Profit | $50,000 |
Break-even point of company is $800,000 in sales:
| Sales | $800,000 |
| Less: Variable Exp ($800,000 x .75) | $600,000 |
| Profit left over to offset fixed expense | $200,000 |
| Fixed Expenses | $200,000 |
| Profit | $0 |
Current sales of $1,000,000 are $200,000 above the break-even point. This is commonly known as the margin of safety. You have the comfort of knowing that sales could decline 20 percent ($200,000) and your company would still be above break-even. Reducing fixed expense brings down the break-even level. In the example, if fixed expense is reduced by just $25,000, it drops the break-even point to $700,000, thus raising the margin of safety by $100,000.
| What happens if sales increase to | $1,200,000 |
| Variable Expenses ($1,200,000 x .75) | $900,000 |
| Profit left over to offset fixed expense | $300,000 |
| Fixed Expenses | $200,000 |
| Profit | $100,000 |
So, in this example, an extra $50,000 in profit is generated from a $200,000 (20 percent) increase in sales. Sounds good, but you must also consider whether you can afford the increase in sales. What is the effect on A/R, inventory, A/P, machinery and equipment, etc. Do you have the capital/cash or access to the capital/cash to finance the sales growth?
Cash Flow Analysis
Comparative balance sheet data show the change that has taken place in a company’s working capital position. Analysis of comparative balance sheet data together with a review of activities of the period will reveal the sources and the uses of working capital.
Examples of sources of cash:
- Owners make additional cash deposit/investment
- Bank or other financing
- Decrease accounts receivable
- Decrease inventory
- Increase accounts payable
- Net profits
Examples of uses of cash:
- Pay down debt
- Decrease accounts payable
- Increase inventory
- Increase accounts receivable
- Purchase machinery & equipment
- Net Loss
| Effect on Cash | ||||
| 12/31/10 | 12/31/09 | Increase | Decrease | |
| Cash | $75,000 | $70,000 | ||
| Notes Receivable | 5,000 | 5,000 | 0 | 0 |
| Accounts Receivable | 80,000 | 83,000 | 3,000 | |
| Inventory | 60,000 | 71,000 | 11,000 | |
| Machinery & Equipment | 83,000 | 44,000 | $39,000 | |
| Total | $303,000 | $273,000 | ||
| Notes Payable | $58,000 | 39,000 | 19,000 | |
| Accounts Payable | 5,000 | 25,000 | 10,000 | |
| Owner's Equity | 80,000 | 30,000 | 50,000 | |
| Retained Earnings | 150,000 | 179,000 | 29,000 | |
| Total | $303,000 | $273,000 | $83,000 | $78,000 |
About the Author
Partner B2BCFO®
Charlie Yacoobian, CPA is a partner in the firm B2BCFO®, offering comprehensive part-time Controller/CFO services to small and mid-size businesses and can be reached at (661) 714-2588 or cyacoobian@b2bcfo.com.
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