Part One of this series was an introduction to breakeven analysis. It defined what breakeven analysis is and gave a quick example of how it is calculated. Part Two talked about using breakeven analysis for upper level analysis of a business. This part will discuss using breakeven analysis to help with decision making for specific projects.
I did an analysis of margins by product line for a company. They were selling products from different manufacturers. Looking at the results after the data had been compiled it was clear that one of the manufacturers had a better profit margin than the others. We discussed how to shift our product mix towards the more profitable items. One of the suggestions was to increase the commissions on those products to get the sales force to highlight those products to the customer. I analyzed this proposal.
There was no way of knowing the exact amount that the sales mix would change with different commissions. And thus, there was no way to give an exact number for the results of the change. I decided to use breakeven analysis to assist with the decision. I wanted to show at what point the costs of increased commissions would equal the extra margin generated from shifting the product mix. Then the decision would be based on whether or not we could beat that number.
Ok, now I’m going to throw out some numbers to use so you can see how I calculated the breakeven point. These are, of course, made up numbers just for discussion purposes. ABC Company sells 1,000 units per month in total. Sales are divided between Product Line A with 80% and Product Line B with20%. Product Line A has a sales price of $250 and a cost of $200 per unit. Product Line B has a sales price of $300 and a cost of $200 per unit. ABC Company pays its salespeople a commission of $25 per unit. The proposal is to change the commission rate on Product Line B to $50 per unit.
Now let’s do the calculation. The cost of the increased commissions would be the difference between the new and the old commission rates multiplied by our current product mix. Current sales of Product Line B would be 200 units (1,000 total units x 20% share). The commission difference is $25 ($50 proposed less $25 current.) So, the cost of the increased commissions would be $5,000.
Next, we need to calculate the change in product mix that would be needed to cover the $5,000 cost. The margin on Product Line A is $25 (Sales price $250 less cost of $200 and less commission of $25.) The margin on Product Line B is $75 (Sales price $300 less cost of $200 and less commission of $25.) The margin difference is $50 per unit. However, with the new commission rate Product Line B would have a $25 additional cost from commissions. The new margin on Product Line B is $50 (Sales price $300 less cost of $200 and less commission of $50.) The margin difference is $25.
In order to breakeven then the mix would have to change by 200 units. This is calculated by dividing the additional costs by the margin difference ($5,000 divided by $25.)
Having this data changes the discussion from a general, “Maybe this will work” to a more concrete, “If we make this change will we be able change the product mix by at least 200 units?” We can’t know for certain what the final impact will be, but by putting a minimum number out there might generate a consensus around whether that number can be beaten.
The company I did this for decided to increase their commissions on the higher margin product line based on this type of analysis. The change in the commission rate incentivized the sales force to sell more of the higher margin product and the breakeven target was met and exceeded easily.
I hope you can see how having a target can clarify decision making. And I also hope you’ll be able to use this type of analysis. The next post in this series will talk about a breakeven analysis I did for a private school.