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 Bakery: 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 below break-even.

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.