The driving force in many expansion plans is to generate higher sales, with the hope that profits will rise. But before making moves to buy new equipment, expand your plant or implement a new business idea, you need to grasp the profit angle.
In some cases, an expansion plan boosts sales but not profits. You wind up working longer and harder for nothing.
You may think, “if we lose a little bit on each deal, we can make it up on volume.” That sounds good but may prove difficult in reality. To prevent problems, analyze three factors of success. Here’s a step-by-step guide.
Once you calculate these factors, you’re ready to analyze the impact of expansion. Let’s say your company makes Belgian chocolates and sells them in quarter-pound boxes at $10 apiece. Your variable costs are $8, giving you a contribution margin of $2 on each box to cover fixed costs and provide a profit. Your fixed costs are $100,000, so you need to sell 50,000 boxes to break even.
But you want to expand and fixed costs will rise to $125,000. Your contribution margin stays the same. Using the breakeven formula (fixed costs divided by contribution margin), you now have to sell 12,500 more boxes, or 62,500 total.
Once you get the figures, it’s a good idea to talk to your financial advisor about how cash flow, liquidity and profitability could change, depending on business conditions. But fundamentally, a solid grasp on these factors is critical to deciding whether you’re better off keeping the status quo or charging ahead with an expansion.