Use The Cost Volume Profit Model To Target Your Ideal Profit
You can use the same Break Even Point logic to target the Profit you want, by treating your profit target as a fixed cost.
Then you can calculate the sales needed to reach your target at your contribution rate assumption.
In the numbers example, we had fixed costs of £2,000 and a contribution per unit of £40.
Suppose we want to target £6,000 profit per month.
Then adding together the £2,000 fixed costs plus £6,000 profit means we need £8,000 contribution if we are going to reach the target profit.
At £40 contribution per unit that means we need to sell 200 units, each and every month to hit the profit target.
Break Even Thinking Provides A Reality Check
I once had a turnaround client, that is a business which was losing money and wanted help to get back to profit.
When we’d got to grips with the numbers, I was able to show that the break even point was over 90% of their practical capacity whilst they were trading at around 60% capacity.
To break even, they would have to make and sell just about everything they could possibly make.
This situation was a result of actively taking part in a price war. They were trapped in the busy fools syndrome and something major had to change for the business to have any hope of making a profit.
Evaluating Different Options
Instead of focusing purely on volumes and sales, we can start to look at the other components of profit.
In our numbers example, 200 units may not be possible because of operational or market constraints, so we can start to evaluate the units needed to meet our profit target at higher levels of contribution.
- Sales would have to be 160 units at £50 contribution per unit.
- 100 units at £80 contribution per unit
- Or 80 units at £100 contribution per unit.
They all give the £8,000 contribution needed for the £6,000 profit.
Do you start to see how powerful this simple technique is to clarify what you have to do to make the money you want?
Return to P1M3 How Profit Is Created
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