When companies calculate their break even point, there’s one pivotal aspect of the analysis that points the way to increasing profit and reaching break even sooner. Within the break even analysis, there’s what is commonly referred to as the “profit contribution”. This profit contribution is based on the amount of profit generated with each additional unit sold.
Increase this profit contribution portion of the break even analysis, and the company reaches break even sooner, and more importantly, increases its profits. The intention is to identify those cost drivers that have the biggest impact on the profit contribution, and put a plan together to reduce their impact. Once successful, profit will increase and the company can further duplicate efforts across other product lines. So, how is this done?
Understanding the Profit Contribution Analysis
Before going into the details of what’s involved within the profit contribution, it’s probably best to review the break even calculation itself. The calculation simply involves taking stock of a company’s fixed cost structure, its variable cost structure and its product’s selling price. Here is the calculation for the break even point and the profit contribution.
- Fixed Costs = F
- Selling Price = $P
- Variable Costs = V
- Break Even Point = BE
- BE = F/($P-V)
- Profit Contribution Portion = ($P-V)
The profit contribution portion of the calculation includes the selling price ($P) minus the company’s variable costs (V). With each additional unit sold, the profit contribution is added to the sum of the previous unit’s profit contribution. Where the company’s combined profit contribution meets the company’s fixed costs is where the company has officially reached break even.
Any point below this intersection point is a loss for the company and any point above is considered profit. I've included a graph below and a link to a post that provides further insight into the profit contribution.
To see how the break even analysis plays out in graph format above (with various prices), please read the following post “Break Even Analysis Tool for Small & Medium Sized Manufacturers”.
Increasing a Product or Service’s Profit Contribution
There are essentially three ways to improve a company’s break even point. First, the company could reduce its fixed cost structure. Second, it could lower its variable cost structure and third, it could increase its product or service’s price. While all of these are much easier said than done, it’s important to note that a company can’t simply raise a product’s price to increase its profit.
The fact is, there are simply too many factors that go into determining a product’s price. Reducing fixed costs often involves reducing overhead, and since companies often see that as a last resort, we’ll ignore the idea of reducing this portion of the equation. So, what’s left?
The Importance of Reducing Variable Costs
All other things being equal, the only portion of the equation left is the company’s variable costs. Now, there are a myriad of ways to reduce variable costs. Companies can increase product throughput by reducing manufacturing cycle times, they can reduce their purchase prices on parts and materials, reduce their inventory carrying charges and freight costs, and ultimately, enact an aggressive plan to reduce waste in all its forms.
Since variable costs pertain to both the labor and material costs associated with each unit manufactured, then reducing these costs will ultimately increase the company’s profit contribution for each and every unit sold.
When it comes to analyzing the profit contribution within the break even analysis, it’s important to immediately identify those variables that can be adjusted to improve results. In most cases, companies will decide to concentrate on reducing their variable cost structure. Price and fixed costs are often items a company decides not to mess with too much.
Within this blog are several tips on increasing production throughput, reducing inventory carrying costs and controlling freight costs. Just do a quick search on any of these topics and there should be plenty of information available. If not, email me your question.
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