Once you've determined your breakeven
point, you can use it to examine the effects of increasing or decreasing the
role of fixed costs in your operating structure.
The large increase in profits as a result of relatively modest increases in
sales over the breakeven point, as well as the large increase in losses as a
result of modest sales declines below the breakeven point, can be attributed to
the degree to which fixed
costs contributed to the sales.
The extent to which a business uses fixed costs (compared to variable costs)
in its operations is referred to as "operating leverage." The greater
the use of operating leverage (fixed costs, often associated with fixed assets),
the larger the increase in profits as sales rise and the larger the increase in
loss as sales fall.
The employment of a high level of fixed assets (with fixed
costs) at high volume increases the profit potential of a
business. At low sales volume, however, losses multiply; and
difficulty in meeting your fixed costs, such as payments for
plant and equipment, may ensue.
For most small businesses, limiting downside risk is more
important than increasing potential profits, so it's wise to
keep your fixed costs low wherever possible.
A business often can choose between a high level of fixed assets and a lower
level of fixed assets. For instance, some equipment items are substitutes for
labor (and labor is commonly considered a variable cost). If labor is not
replaced with equipment, fixed costs are held lower, and variable costs are
higher. With a lower level of operating leverage, the business shows less growth
in profits as sales rise, but faces less risk of loss as sales decline.
Joe's Carpentry Shop's fixed costs are $28,000 and its
variable costs per unit of production (bird call) or sales are
$.60. Its sales revenue is $1.00 per bird call. Each bird call
can contribute $.40 toward covering fixed costs. Joe's breakeven
point is the same as Lillian's Bakery in the previous example:
$28,000/$.40 = 70,000 units.
As with Lillian's Bakery, as sales exceed 70,000 bird calls,
Joe's Carpentry Shop earns a profit. Sales of less than 70,000
bird calls produce a loss. Presented graphically, however, a
picture emerges that is very different picture from that of Lillian's
Joe's Carpentry Shop can see that a 10,000 unit increase in
sales over break-even to 80,000 bird calls will produce a $4,000
profit, and a 30,000 unit increase to 100,000 bird calls will
produce a $12,000 profit. Similar losses occur as sales drop
If we compare Lillian's Bakery in the first example and Joe's Carpentry Shop
in the second example, it is apparent that Lillian's Bakery will benefit more
from increased sales than will Joe's Shop. On the other hand, the higher degree
of operating leverage in the bakery will cause Lillian's to suffer greater
losses on sales declines.
Breakeven analysis shows the effect of increased investments
in fixed assets that lower variable costs but increase fixed
costs. A decision to go with heavier investment in fixed assets
and to increase operating leverage will, to a large extent, be
determined by your perception of the economy and of the ability
of your business to meet higher sales levels necessary to
support the fixed costs. Also consider the degree to which sales
expansion is practical. Increased volume can result in price
weakness or higher-than-expected costs as you exceed your
optimum levels of production.