Expansion Analysis: “The Rest of the Story”
Growth – the all-American measure of success. But what kind of growth? And how do you measure growth in relation to success? For too many job shops and contract manufacturers, intelligent and well-intended owners settle for sales volume alone as the primary indicator of achievement. Steve LeFever of Profit Mastery explains how there’s more to it than that.
Posted: March 22, 2013
Next, I ask him what his variable cost percentage is. Same answer. Since you find the variable cost percentage the same way, he tells me variable costs are 60 percent of sales.
Now all I need to know is how much he will need to invest and his required ROI. Well, he plans to invest $1 million and his required ROI is 20 percent. Therefore, of course, he needs to make $200,000 per year. I’ve diagramed the financial analysis below:
Facts: Variable Cost Percent = 60 percent
Fixed Costs = $250,000
Target Profit = $200,000
Formula: Required Sales = (Fixed Costs + Target Profit)/ (100 percent – Variable Cost Percent)
Calculation: $450,000/ (100 percent – 60 percent) = $450,000/ .4 = $1,125,000 required sales
What this says in words is this: With a variable cost percentage of 60 percent, my client must achieve sales of $1,125,000 to cover his fixed costs and produce the target profit. His comment to me: “That sounds OK, but can I do it?”
My answer: “How should I know? I’m just a finance guy!” To do the other half of the analysis – the marketing part – requires additional effort, so I dispatch myself to the small town he’s targeted for expansion and I review the market. My competitor analysis is outlined as follows:
Competitor 1 – $650,000
Competitor 2 – $550,000
Competitor 3 – $500,000
Sales Going Out of Town – $500,000
TOTAL MARKET: $2,200,000
As I see it, my client needs a 50 percent market share. What’s the likelihood of getting it in a small market where he’s unknown and all three competitors are known and well-established? About the same as the proverbial snowball?
Who can use this expansion analysis process? Any shop. For any kind of growth – be it expansion of existing facilities or the opening of additional locations. And a sales analysis is only half the story. An accurate knowledge of your costs and how they behave is really “the rest of the story.”
Furthermore, expansion is not the only story. The analysis works just as well in the decision to sell locations – degrowth, you might say. Some of you have seen banks closing branches, and lots of us have recently seen larger firms spinning off divisions. Sort of the reverse of the merger and diversification mania of the 1960s-70s. Remember, though, that it’s the exact same analysis when your own company faces these issues.
Admittedly, the process isn’t perfect and the risks are several: only doing half the analysis, being wrong anyway, and not evaluating whether the growth is accomplished at the expense of increasing levels of debt. Nevertheless, the process is better than proceeding blindly. Indeed, sometimes it’s most useful in predicting what won’t work, rather than what will.
Always keep this in mind: Sales alone are not an adequate predictor; don’t go after volume for volume’s sake.
My client’s decision? “Well,” he said, “I’ll admit that the sales volume and market share projections make this look pretty risky, but I’m not worried . . . because I can borrow all the money!” My response? I offered him a huge discount for immediate cash payment of our bill.
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