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The Cost of Growth

Business owners are often confronted with the opportunity and/or desire to expand and grow their businesses.  It might be as simple as hiring a new employee, or as complicated as adding a second location.  We see establishments in town investing in new buildings and façade upgrades.  Correctly calculating the cost of growth is the most important part of any business expansion.  A simple break-even analysis will reveal to the business owner the concrete cost of his latest idea. Consider this example:

Bob wants to increase his hours of operation to evenings and Saturdays.  To do this, he will need to add a part time worker and this will increase his payroll and expenses by $15,000 a year.  The increased revenue Bob will need to cover this new employee is the difference between his break-even point before and after the hire. 

To figure the break-even point, he must first calculate his variable cost percentage.  Variable costs are expenses that are only incurred if a sale is made.  The variable cost percentage is a percentage of total sales.  Bob had $620,000 in total sales and spent $496,000 on variable costs.  His variable cost percentage is 80%.  The 20% that is left over is known as the contribution margin.  The contribution margin covers fixed costs (expenses that occur whether a sale is made or not) and profit.  The break even sales number is found by dividing the total fixed costs by the contribution margin.  Bob’s fixed costs before the new hire were $109,200.  His break-even sales before the new hire were $546,000.

To figure Bob’s break-even sales after the new hire, he needs to add the new fixed expense of the new hire into his fixed costs and re-calculate.  His new break-even sales point will be $621,000. 

Bob now understands that he will have to increase sales by $75,000 to pay for a $15,000 increase in expenses.  This simple calculation will help Bob monitor his sales in the coming months to decide if the evening and weekend hours are going to be able to support the new hire.

This calculation can be applied to a building expansion or a new piece of equipment.  In most cases you can add the loan payment for the expansion to your fixed costs and re-calculate.  If you are paying cash for the new project, add your required rate of return to the fixed costs and re-calculate.  You may need to do some extra calculations when adding a new machine or product line as your variable costs may change as well.

This same calculation can be used if a business owner is contemplating a price change.  For example; Bev had a candy shop and wanted to drop all of her prices by 10% to compete with the new shop down the street.  Her total sales were $100,000 and her variable costs were $60,000 giving her a contribution margin of 40%.  Her fixed costs were $20,000, making her break-even sales $50,000.  If she drops her prices by 10%, her new contribution margin will be 33% making her new break-even sales amount $60,000.  Bev had to increase her sales by $10,000 (20%) to cover the discount.  Only time will tell if the lower prices will produce the higher volume sales needed ($120,000) to earn the same profit.

Your SBDC Consultant can help you evaluate your break-even point and develop growth plans for your business. 

Mark Yarick joined the Small Business Development Center in January 2014 to provide service to small businesses located in Suwannee, Hamilton and Columbia counties. His professional experience includes work in the automotive field with hands on management and production supervision as well as warranty and customer service. He has been a small business owner since 2002 and will spearhead the SBDC efforts in Agribusiness.

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