Ernesto Hontoria
Selling is not enough.
You must obtain a margin on sales that allows you to cover the cost of running the
business. There is a tendency in the retail industry to focus too much
attention on sales, often forgetting the relationship between margin, sales
volume, the cost structure, and the profitability. In this type of business,
salespeople are usually encouraged to reach certain sales targets, but little
emphasis is placed on understanding that what keeps the business afloat is the
margin obtained from those sales, rather than the sales themselves; that that
the company must cover all its costs with the margin obtained from sales in
order to be profitable.
When I was a kid, my mom
had a children's clothing store, and her never ending concern was the sales. She
used to come home, at nights, complaining that sales were weak, not as good as
she expected, except in December, when she came exhausted,
but happy to have sold so much! For her, if sales went well, and money came
into the cash machine, everything was well; her store was rocking! I don't recall
ever seeing her calculating how much margin she needed to make from sales to
cover her costs, though intuitively she knew how much she needed to sell in order
to pay all the expenses of the store and make some profit from it. Sales were the important thing. There was no margin, price and volume strategy behind to position her store or achieving certain profit. It was as if the rest of the elements of the
business, anything other than sales, were secondary. Or at least, nothing else
but sales came out of her lips when at night she returned home and complained
about how lazy the day had been.
My mom was - of
course! - a saleswoman. She was always in front of her store serving her customers.
At that time, all the records, sales and everything was manually done in big notebooks.
At the end of every month an accountant picked those notebooks up along with all the invoices
and receipts from the store, to determine how much money had come in and gone
out. Accounting was a post-mortem exercise. By the time the accountant came for the notebooks, invoices and receipts, my mother already knew very well
if the money had been enough to cover expenses. The store's checkbook was infallible
in that respect.
Unlike my mom, I work
in finance. My role is to analyze the numbers, understand where the income
comes from, what is the cost structure, and to look for the profitability of the
business. Whether it is a large or a small business, the income obtained from
the sales should cover the costs to replace the inventory sold, and any other
cost incurred in running the business, pay the debts that are contracted and
allow the owners to obtain some profit. I will try in these lines to show how the
margin and the volume of sales are related to the cost structure in order to determine
the profitability of the business.
Let’s start by
clarifying a few terms.
Margin and volume
We call sales the income the business receives in exchange for the merchandise, products or services it delivers to its customers. Volume is the amount, the physical quantity
of those sales, which can be measured in physical units of the product or
products delivered, or in money (dollars, pesos, euros, or bolivars received).
Margin is what is left
of sales revenue after the cost of merchandise sold has been deducted. This cost is
normally referred as Cost of Goods Sold, and in general terms is the same as
the value of inventory delivered to the customer. The margin is in plain words,
the proportion of sales that allows the business to cover its costs, since in
order to operate, to continue selling, the business will need to replace the
inventory sold and for this it must reserve, from the total income from sales,
a portion equal to the cost of the merchandise sold.
Take, for example, a
mango seller who buys mangoes at one peso and sells them at 1.5 pesos. If he
sells 100 mangoes a day, his daily sales (sales volume) will be 150 pesos (100
mangoes x 1.5 pesos each), but as he spent 100 pesos buying those mangoes (100
mangoes x 1 peso each), his daily margin will be 50 pesos (150 pesos – 100 pesos)
or 33.3% of the sales value ($ 50 / $ 150). The mango seller will have 50 pesos
a day to cover his costs and make a profit, since the remaining 100 pesos are
the cost of the merchandise sold and he will need them the next day to replace
the mangoes he sold (inventory), otherwise he will not be able to continue his
business. These 100 pesos are a kind of a fund that the seller requires for the
continuity of the business (he cannot dispose of them) and it is known in
finance as working capital.
In economies with high
inflation, margins should be calculated using the replacement value of the
inventory. If the mango seller knows, for example, that the mangoes he bought
today at one peso will cost him 1.25 pesos tomorrow, he will have to increase
his working capital (the fund he requires for business continuity) by 25 pesos.
That is, he will only have 25 pesos of his income (no longer 50) to cover his daily
costs and make a profit. The mango seller will need 125 pesos to replace the
next day the mangoes he is going to sell today. In these circumstances, it is
the replacement value of the inventory, rather than the cost of goods sold, what
serves as a reference to establish a margin and volume strategy.
The sales margin is
usually expressed as a percentage of the sales value. If a product is bought
for 4 pesos and sold for 10 pesos, the sales margin is 60%. For each unit sold,
a margin of 6 pesos (10 - 4) is obtained, that is 60% of 10 pesos.
The Cost Structure
Businesses, like stores, kiosks,
drugstores, companies of any kind, usually have fixed costs and variable costs. Fixed costs
are all those expenses that do not depend on the level of sales (for retailers),
or the level of production (for manufacturing companies). Payroll, telephone,
and rents, for example, are usually fixed costs: whether there is sales or not, whether the factory is running producing goods or has been shutdown for maintenance, the company will incur in those cost.
Variable costs, on the
other hand, depend on the level of sales or production. Examples of them are
the commissions that sellers earn for the sales they make, the bonuses that
workers in factories can receive for reaching certain levels of production, many
consumables such as wrapping paper, bags, boxes or other packaging that customers
used to take products home, the raw material used in producing final goods, or merchandise sold. If the business does not sell, or does not produce, variable
costs are not incurred.
As in everything,
there are more complicated costs that have fixed and variable elements;
Electricity and utilities among them. Most services have a fixed - and minimum
- rate that must be paid and another that is related to the level of consumption.
If a factory produces at its maximum, its consumption of energy, and probably
of other services such as water, will increase. In general, the higher the
production, the higher the consumption of these kind of services. But if the company
stop producing for a month, say for a Christmas break, those costs will not go
away completely. Although smaller, the company will still be incurred
on them, because they have a fixed component in the contract. Some authors call
this type of cost mixed cost.
The cost structure of
a company is the combination of fixed, variable, and mixed costs that the company
incurs to produce and sell the goods or provide the services for which it was
created. Knowing how this structure of cost is key to determine the breakeven
point and to establish volume and price strategies that allow the company to position
competitively in the market.
The Path to Profitability...
To cover the fixed costs, including here the fixed portion of the mixed costs, is the first hurdle that any company must overcome to be profitable. That is, the margin obtained from sales must be greater than the fixed costs that the company has. An insightful reader will argue that this is obvious, and that the margin obtained must also cover the variable portion of mixed costs plus all variable costs, which is undeniable. The point is that variable and mixed costs are going to change with the level of sales, while fixed costs are a kind of barrier, a stable reference, that determines the minimum point that the company's income must reach in order to be profitable. If that minimum point is not attained, the business does not go to the party; is destined to close its doors.
Once the pitfall of
covering fixed costs has been overcome, the path to profitability requires to
pass the breakeven point. The breakeven point is the combination of volume and
sales margin that barely covers all costs incurred by the company. That is,
the point where the income obtained from sales equals the combination of
fixed, variable, and mixed costs incurred by company to achieve those sales. It is
the boat's waterline. The business is profitable if the waterline is above the
water level, the costs being the water in which the company navigates. On the
contrary, if the water level is above the waterline, it is necessary to take
measures to lighten the load of the boat, or to reduce the water that may have
entered, to keep the boat afloat.
The Breakeven Point
Let’s imagine we want
to start a business on our own. A shoe store, for example. We have seen a place
that we consider a good point to establish a store. The owner of the premises
rents it for a thousand pesos a month. At the beginning, we are not thinking of
hiring employees, we are going to dedicate ourselves to open and run the store
by our own, and later, when sales allow it, we could hire someone to help us run
the business.
The cost structure of
this business that we are thinking of setting up is very simple. We have a rent
that does not depend on sales (it is a fixed cost). Services such as water, electricity,
and telephone, will not depend on how many shoes we are going to sell per month,
either. There are no sales commissions because there are no employees. The only
variable cost is the commission charged by credit or debit cards when customers
choose to pay with them. The rest are fixed costs.
As we have already said,
the first stumbling block is covering fixed costs. In this case rent and services. Assuming that services cost about 300 pesos per month,
the minimum margin that should be obtained for the sales of shoes to cover the
costs of the premises should be above 1,300 pesos per month (the rental of the
premises plus the services).
How many pairs of
shoes do we have to sell to cover those fixed costs? The answer depends on the
price and sales margin. If shoes are sold at an average price of 80
pesos per pair and sales margin is 30%, the minimum sales volume to cover fixed
costs is 54 pairs of shoes per month. That is, for each pair of shoes sold, the
business will receive 24 pesos ($ 80 x 30% = $ 24), therefore, to reach 1,300
pesos per month, at least 54 pairs of shoes must be sold ($ 1,300 ÷ $ 24 = 54).
Of course, if the
sales margin is higher, fewer pairs of shoes will need to be sold to cover costs,
but if it is lower, more shoes will have to be sold as can be seen in the table
below.
|
Margin |
20% |
25% |
30% |
35% |
40% |
45% |
50% |
|
Pairs of shoes to cover
fixed costs |
81 |
65 |
54 |
46 |
41 |
36 |
33 |
Unfortunately for many
businesses the margin depends on factors that are often beyond their control.
The first of these is the price at which the product can be sold. Almost any
business that we think of will have competitors selling the same or similar products.
These competitors will seek to protect their sales levels and maintain their
profits. They will surely react to the prices we put on the shoes we plan to
sell, if they feel that we threaten their market share. In other words, the
price at which the shoes can be sold in the business we plan to set up, will
depend largely on the supply of shoes that are nearby, plus many other factors
that are much more complex and less controllable, such as the customer
perception of the brand, design and quality of the shoes, and practically anything
else that customers may have in mind about the holy shoes.
Customers perceptions are so important that even in the case of products unique in the market and without competition, the sale price will largely depend on how much buyers are willing to spend on a product such as the one we are offering, and this will depend on how they perceive the product.
Although price is the
main driver that retailers have in hand to influence sales and secure margin, it is not entirely under their control.
The second element
that comes into play to determine the sales margin is the acquisition cost of
the merchandise we plan to sell (or the production cost in a factory case). In
the way that we find opportunities to reduce the cost of the merchandise we
intend to sell, we will have more room to play with the sales margin. How efficient
we are producing the merchandise, or how diligent we are when selecting
suppliers and negotiating with them the price (cost for us) of acquiring
products, is key to gain room for playing with the margin in a competitive
market.
Suppose that we lock a
deal with a supplier and will pay 50 pesos for each pair of shoes that we plan
to sell in our store. We could rewrite the previous table in the following way:
|
Margin |
20% |
25% |
30% |
35% |
40% |
45% |
50% |
Selling Price |
62,50 |
66,67 |
71,43 |
76,92 |
83,33 |
90,91 |
100,00 |
|
Pairs of shoes to cover
fixed costs |
104 |
78 |
61 |
48 |
39 |
32 |
26 |
Now,
with these sales volumes at hand, we can ask ourselves more operational
questions about the business: How easy (or difficult) would it be to sell, say,
61 pairs of shoes at 72 pesos per pair (30% margin), in the neighborhood where we
plan to open the store? Could the same pair of shoes be sold for 100 pesos
instead? Does the population density of the area where the store is to be be
located allow to sell more than 100 pairs of shoes per month? How many
different models and sizes must be needed in the store to be able to sell 54,
61 or 100 pairs of shoes per month? How much space is required to store that
inventory? How often do we need to replace the merchandise, and how long it will
take to our supplier to deliver the shoes? How much money is required to buy
the inventory needed?
The answers to these
questions will help to land our dreams. But we have not finished yet. We still need
to cover the costs of the commission charged by the credit card, and something, no less important: we need to make a profit that will allow us to live from
the business. If we assume that half of the sales are made through credit cards,
the fee to sell, let’s say 54 units at 80 pesos, would be in the order of 130
pesos.
|
54 shoes x 80 pesos
each = 4,320 pesos Half of the sales are paid
with credit cards = 2,160 pesos Credit card fee = 6% x 2,160
pesos = 130 pesos |
Logically,
once this fee is included, we need to sell more shoes to cover all costs. But what
if more than half of the buyers use their credit cards? or what if the
commission charged by credit cards is higher than 6%? When we have so many assumptions
that can change, the breakeven point becomes a moving target that varies every
time we modify the assumptions on which we base our projection. Calculating this
moving target would be cumbersome, but fortunately we have wonderful tools in spreadsheets
like Excel to help us.
Using a simple
economic model and a data table built in Excel, we have obtained the results below. It
was assumed that the acquiring cost of each pair of shoes is 50 pesos and the
commission charged by the bank for the use of credit cards is 6%. The table
automatically calculates the pairs of shoes that we need to sell to cover all
costs, under each different combination of margin and proportion of customers paying
with credit card. The beauty of this data table is that when one or more of the
assumptions, such as the acquiring cost of the shoes, or the card fee change,
the numbers in the table are automatically updated.
|
Pairs of shoes to reach Breakeven Point |
Price: |
|||||||
|
62.50 |
66.67 |
71.43 |
76.92 |
83.33 |
90.91 |
100.00 |
||
|
Margin |
||||||||
|
20% |
25% |
30% |
35% |
40% |
45% |
50% |
||
|
Proportion of Credit Card Sales to Total Sales |
10% |
107 |
80 |
62 |
49 |
40 |
32 |
26 |
|
20% |
111 |
82 |
63 |
50 |
40 |
33 |
27 |
|
|
30% |
114 |
84 |
65 |
51 |
41 |
33 |
27 |
|
|
40% |
118 |
86 |
66 |
52 |
41 |
34 |
27 |
|
|
50% |
122 |
89 |
67 |
53 |
42 |
34 |
28 |
|
|
60% |
127 |
91 |
69 |
54 |
43 |
35 |
28 |
|
|
70% |
132 |
94 |
71 |
55 |
44 |
35 |
28 |
|
|
80% |
137 |
97 |
72 |
56 |
44 |
36 |
29 |
|
|
90% |
142 |
99 |
74 |
57 |
45 |
36 |
29 |
|
|
100% |
149 |
103 |
76 |
58 |
46 |
37 |
30 |
|
Please, follow Follow the link to see how to build a data table: How to create data table?
We cannot forget that, at the end of the day, we must pay for the roof and bring food to the table. In other words, all the work, time and effort we are dedicating to run the business must produce an economic benefit for us. Let’s pretend we aspire to take home at least 3,000 pesos a month, which could be the equivalent of a salary. Introducing this new assumption in our model as a fix expense (we need to eat every month no matter what), the table would be as follows:
|
Pairs of shoes to reach Breakeven Point |
Price: |
|||||||
|
62.50 |
66.67 |
71.43 |
76.92 |
83.33 |
90.91 |
100.00 |
||
|
Margin |
||||||||
|
20% |
25% |
30% |
35% |
40% |
45% |
50% |
||
|
Proportion of Credit Card Sales to Total
Sales |
10% |
355 |
264 |
205 |
163 |
131 |
107 |
87 |
|
20% |
366 |
271 |
209 |
165 |
133 |
108 |
88 |
|
|
30% |
378 |
278 |
213 |
168 |
135 |
109 |
89 |
|
|
40% |
391 |
285 |
218 |
171 |
137 |
111 |
90 |
|
|
50% |
405 |
293 |
223 |
175 |
139 |
113 |
91 |
|
|
60% |
420 |
301 |
228 |
178 |
142 |
114 |
93 |
|
|
70% |
435 |
310 |
233 |
182 |
144 |
116 |
94 |
|
|
80% |
453 |
319 |
239 |
185 |
147 |
118 |
95 |
|
|
90% |
471 |
329 |
245 |
189 |
149 |
119 |
96 |
|
|
100% |
491 |
339 |
251 |
193 |
152 |
121 |
98 |
|
