How Accountants Tell You How To Increase Profit using The Cost Volume Profit / Break Even Analysis Model
The break even point model (numbers example link) makes it clear there are only three ways to make more profit.
The first way is you can sell more
We have already seen the impact of that in our numbers example.
Secondly you can increase the contribution rate per unit.
This can be done in one of two main ways:
- Increasing the selling price per unit while keeping the cost per unit constant.
- Reducing the cost per unit while keeping the selling price constant.
In our example, we had fixed costs of £2,000 and a contribution per unit of £40 giving us a break even point of 50 units.
Suppose we increase the contribution per unit from £40 to £50 – by increasing the selling price or reducing the variable costs.
Then the break even point reduces from 50 to 40 units. That’s the £2000 fixed costs divided by the new £50 contribution.
And if we were selling 50 units before and breaking even and we can still sell 50 units we will make a profit of £500 – that’s an extra £10 contribution for each of the 50 units sold.
The third way to increase profit is to reduce the fixed costs.
For example, if contribution stays at £40 per unit and fixed costs reduce to £1,600 the break even point is again 40 units – that’s £1,600 divided by 40.
When you start changing all three in the right way, things get really exciting.
It’s time to move away from numbers and go back to the graph.
We started at the break even point 1 where the unbroken green contribution and red fixed costs lines intersected.
If we move either side of point 1, the gap between the two lines is the profit or loss at that volume.
We know as sales volumes increase, profits increase provided contribution per unit and fixed costs stay the same.
If we can increase contribution per unit (moving to the green broken or dotted line) with the original fixed costs, the break even point reduces to point 2.
It’s the same if we reduce fixed costs – moving to the red dotted line and keep the original contribution rate. We are back at point 2.
If we make both changes – increasing contribution and reducing fixed costs, the break even point reduces to point 3.
Return to P1M3 How Profit Is Created
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