I will introduce you to a way to target your ideal profit based on the break even point formula.
Too often a business owner will have an ideal profit in mind but won’t have worked back from that goal to understand what size and type of business will generate that kind of profit.
I believe you need to be using intentional business planning.
The Break Even Point Formula
The break even point is the position where a business neither makes a profit of loss in a period.
It is based on the cost volume profit relationship that accounts assume although there are some practical difficulties.
The Break Even Point Formula is:
Fixed Costs
Contribution margin % or contribution margin per unit
Using the contribution margin % will generate a sales revenue value for the business to break even while using the contribution margin per unit will generate the sales volume needed.
Example, fixed costs of £400,000 and contribution margin of 30% creates a break even point of:
400,000/30% = £1,333,333
The Profit & Loss Account would show:
Sales 1,333,333
Contribution 400,000
Fixed Costs (400,000)
Profit £0
What is The Ideal Profit?
To avoid confusion in owner-manager businesses where the method of profit extraction is often done by whatever method reduces the overall tax bill, I find it easiest to target a profit before any owner’s salary, payroll costs and benefits are deducted.
Adapting The Break Even Formula To Find The Sales For Your Ideal Profit
If you apply the concept in its purest form, without trying to reflect real world issues, the formula to find the sales value for your ideal profit is:
(Fixed Costs + Ideal Profit)
Contribution margin %
Taking the example above and targeting a profit of £100,000 gives an ideal profit formula calculation of:
(400,000 + 100,000)/30% = £1,666,667
Sales 1,666,667
Contribution 500,000
Fixed Costs (400,000)
Profit £100,000
If you want to find the sales volume, use the contribution margin per unit.
Adapting The Ideal Profit Formula For Real World Issues
First I believe it’s a good idea to recognise the concept of fixed costs creep.
This is where, despite the definition of fixed costs, the expenses increase as the business gets bigger and more complex.
Initially I was tempted to include an allowance to recognise a % of sales value e.g. the fixed costs creep allowance could be 5% of sales in some businesses and 10% in others and even more in some.
But that creates problems with the formula as it means the sales to find the ideal profit formula depends on itself creating a calculation loop.
The two ways around this are:
To include a fixed cost creep allowance in the top line, making the ideal profit formula:
Fixed Costs + Ideal Profit + Fixed Cost Allowance
Contribution margin %
The example, if you assume a fixed cost allowance of £50,000,
(400,000 + 100,000 + 50,000)/30%
= £1,833,333
Sales 1,833,333
Contribution 550,000
Fixed Costs (450,000)
Profit £100,000
Alternatively, you can apply an uplift to the sales value of 5% to 10% and make the formula:
(Fixed Costs + Ideal Profit) x (1 + Fixed Cost Allowance %)
Contribution margin %
In the example we’ve been using, if we allow 10% for fixed cost increases,
(400,000 + 100,000)/30%*(1 + 10%)
= 1,833,333
Sales 1,833,333
Contribution 550,000
Fixed Costs (450,000)
Profit £100,000
The second method, building a percentage uplift into the equation has the benefit that it is immediately scalable as you calculate the sales needed to reach different profit targets without having to make some kind of intuitive assessment.
I should also point out that you can’t accept your fixed costs “As Is” if you want to make it easier to get to your ideal profit.
If you’re wasting money on staff (or family members) who contribute far less than they earn, you’re building a big barrier between you and the money you want. Please see Are You (Or A Team Member) Part Of The Cargo Or The Crew?
You need to trim your fixed costs and get rid of areas where you are wasting money (see Zero Based Thinking For Difficult Decisions and How To Reduce The Break Even Point In A Business )
How Much Should The Fixed Cost Uplift Be In the Ideal Profit Formula?
This depends on three things:
- The contribution margin. You can’t plan growth where fixed costs increase at a faster rate than the contribution on sales.
- How determined the business owners intend to be to stay frugal. Some feel the need to invest in costs that present a better image.
- The pressure within the business to need extra resources to process additional transactions. I explain in the article about fixed cost creep that costs are driven by many things and pressure builds up to a stage where additional resources have to be bought.
If you are looking at a business which must experience a big growth in sales value, it is a good idea to include an extra cost allowance in the top line of the ideal profit formula to allow for additional sales and marketing costs.
(Fixed Costs + Ideal Profit + Marketing Costs) x (1 + Fixed Cost Allowance %)
Contribution margin %
This recognises the different cause and effect relationships at work:
- Many fixed costs respond to the level of business activity – they increase as the effect of increased sales revenue.
- Sales and marketing costs are intended to cause the increased sales revenue.
Again, like fixed costs, it may be better to allow for the extra marketing costs on the other side of the equation so that they automatically increase as the profit target increase.
(Fixed Costs + Ideal Profit) x (1 + Fixed Cost Allowance %) * (1 + Marketing Costs %)
Contribution margin %
The Growth Impact On Contribution Margins
So far we have assumed that current contribution rates can be assumed to apply in a future, bigger business.
It is certainly true that some variable costs should reduce as volumes increase. The business owner should be able to negotiate better buying prices and the business may become more efficient through economies of scale and economies of learning.
However, to get the growth in sales revenue, the business may have to offer lower prices to attract sales from bigger companies or financial incentives to get the existing customers to buy more.
This means that it is wise to allow for a lower average contribution margin going forward.
This will increase the sales needed to reach the ideal profit and mean more fixed cost resources are needed to support the bigger business.
The formula can then become
(Fixed Costs + Ideal Profit) x (1 + Fixed Cost Allowance %) x (1+ Marketing Costs %)
(Existing Contribution margin % – Reduction in Contribution %)
Taking the example I’ve been using, where I’m going to allow 10% for extra sales and marketing costs and a 3% reduction in contribution rate from 30% to 27%, the sales to reach the ideal profit of £100,000 is…
(400,000 + 100,000)/(30%-3%) *(1 + 10%) * (1 +10%)
=500,000/27%*1.1*1.1
= £2,240,741
The Profit & Loss Account will look like this:
Sales 2,240,741
Contribution 605,000
Fixed Costs (455,000)
Marketing Cost (50,000)
Profit £100,000
How Accurate Is The Ideal Profit Formula?
The quality of the calculation depends on the quality of the thinking behind the assumptions.
The idea isn’t to be exact but to give an indication of the approximate size of the business needed to give the business owner the profit he or she wants.
It’s intended to help close the gap between this is where you are to this is where you want to be.
You could do a profit forecast under particular assumptions and look at the results, and decide the profit isn’t up to standard. Then you could do another forecast by tweaking some assumptions.
And keep going through this iterative process until you reach your ideal profit.
But that would take a lot of time and again, there is no certainly that the forecast you have is accurate.
The Ideal Profit Formula is a very quick way to understand the ball-park of the size of business needed.
Practical Tips To Using The Ideal Profit Formula
I would make your assumptions on the conservative, cautious side.
Growth is unpredictable and every banker sees plenty of hockey stick forecasts that show sales and profits shooting up in future years. Few of them are reached.
