Thursday, December 3, 2020

Margin, Volume, Cost Structure and Break-Even Point

 Ernesto Hontoria

VersiĆ³n en castellano: Margen, volumen y el punto de equilibrio

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


With this new sales setting, it would be worth repeating the operational questions we mentioned above, about the size we need to storage the shoes, the initial investment to acquire the inventory, the location of the store, the demographics of the neighborhood, the average household income, to see if the business is still attractive.