Does That Expansion Make Sense?

Useful When:

• Introducing a New Product Line
• Increasing Advertising Expenditures
• Adding Sales People
• Expanding Product Lines
• Pricing Products
• Increasing Plant Capacity

The question: What are my incremental (extra) costs associated with the project and what is my projected incremental profit/loss at different sales levels?

Too often you hear a business owner remark: "I don't know what my extra costs are for this new product, but I have a feeling they're around $60,000. So we have to sell about 1,500 units to get our money back."

Sometimes those feelings are wrong. That's because new business projects are usually filled with enthusiasm and wishful thinking. Both cloud objectivity. But, there's no reason to limit your estimates to a feeling. It's easy enough to get the hard facts, and this advisory will show you how.

It doesn't make any difference whether the project is advertising, hiring sales people in a new territory, purchasing equipment, or spending on research and development. In any case, it's necessary and possible to estimate revenue, cost and profit. However, you must set up your books in such a way that you can collect and analyze income and cost data.

For example, let's assume you want to spend an additional $50,000 in marketing to increase sales. How can you readily determine breakeven and additional profit you will make?

First, review the two methods of reporting sales and profit results (see accompanying box). Under the Traditional Method of reporting it is difficult to compute the number of units you need to sell to break even on an additional $50,000 expenditure. However, under the Contribution Margin Method it's easy to compute. Here's how.

Step 1: Sales Needed To Recapture Costs

As shown in the accompanying box, XYZ Company expects to sell 20,000 units at an average price of $50 per unit, generating $l million. Using the data from the Contribution Margin Method we can easily compute how many units must be sold to justify the $50,000 additional marketing expenditure. Here's the math.

The contribution profit margin is 60% ($600,000 divided by $1 million sales). This 60% is after deducting variable costs of 40% (variable manufacturing costs (20%) and variable general, selling, and administrative expenses (20%).

If you want to spend $50,000 to increase sales, to determine the sales needed to break even compute the following:

Step 2: Units Needed To Recapture Costs

In terms of units needed to break even, simply compute the following:

Breakeven calculation: units needs from sales

Two Methods of Reporting Sales and Profit

Checking your results. The additional revenue from the sale of 1,667 units at $50 should equal exactly the expense of $50,000 plus the additional variable costs associated with producing 1,667 units. Since total variable costs are $20 per unit ($400,000 total variable costs divided by 20,000 units), the following can be computed:

Additional Marketing Expense                                  $50,000

Additional Variable Expenses (1,667 units times $20)  33,333

Breakeven in Sales               $83,333

Computing Your Profit

You are now able to compute your total profit (or loss) on the $50,000 expenditure at different unit levels. With a selling price of $50 and the variable cost per unit of $20 (40%), the profit contribution per unit is $30 (a contribution margin of 60%).

For example, assume the following unit sales and the resulting incremental profit or loss on the $50,000 additional marketing expense:

Incremental Profit and Loss

Units 1,000 2,000 3,000

Profit Contribution ($30 per unit)             $30,000      $60,000 $90,000

Additional Marketing Expense                (50,000) (50,000) (50,000)

Incremental Profit (Loss)                        ($20,000)      $10,000 $40,000

As calculated, selling only 1,000 units will not justify spending an additional $50,000 in marketing; nor does it appear that 2,000 units justifies the expenditure. However, when you get above 2,000 units, it starts to make sense. Recall the number of units needed to break even is 1,667 which we calculated in step 2.

Discuss this advisory with your accountant and ask him or her to explain how your company's financial reporting can be changed to obtain the data necessary for computing the contribution profit margin.