Saturday, April 5, 2008

The Margin. Part IV.

Last post about The Margin I said we make $30 profit on every order. That sounds like total bunk so let me explain. I should have said we would make $30 profit on every order. How could we do that? We could if we didn't have any other expenses.

What are the other expenses? Well, we've included all our variable costs when we calculated the margin. What's left? The pesky fixed costs! Let me show how they affect profit. And, forgive the possible ridiculousness of this, but I'm in a certain mood so I'll explain with nautical pictures.

Imagine it's last summer. August 1st, 2007. We're about to start our fiscal year. We begin the year at break even, neither profitable nor with a loss. Imagine break even as the surface of the sea. Above lies fresh air and profit.

Before we take our first sale we commit ourselves to paying for some things like rent and manager salaries. Since we're going to pay for these things whether we take a sale or not we think of them as "fixed." We call these expenses fixed costs. (Variable costs are the other kinds of costs, the ones we pay only when we take a sale.)

Since we're going to pay fixed costs no matter what we essentially start the first day of our fiscal year with a big loss. The loss is equal to our fixed costs for the year. This year fixed costs were $3.5 million. You can imagine fixed cost like a weight that drops us under sea level. Down, down, down we go, 3.5 million dollars below the break even surface.
How do we get back to the break even surface and, hopefully, above to fresh air and profit? We take sales. Each sale is like a step that lets us get closer to the surface. How fast do we rise? That's where the margin comes in: each step puts us $30 closer to the surface. In other words, each order gives us $30 to pay fixed costs and step closer to break even for the year.

How many sales does it take to get to break even? I'll save you the math.

$3.5 million ÷ $30 profit per order = 116, 667.

That's how many orders we have to take to break even this year. As soon as we take order 116,668, we make our first bit of profit. How much? Well, we know that number now: $30.


Susan Ederer said...

Hey Mo, Does that 116,668 number stand as our "make a profit" goal regarless of mistakes? How does the cost of mistakes factor into when we start to turn a profit? Susan

Mo Frechette said...


Good question. In the post called "Part II" I calculated the margin. The first part of that calculations -- food cost -- includes mistakes.

So the answer to your question comes in two parts.

1. If we continue to make mistakes at the same pace as our average -- the number I used to calculate the margin -- 116,668 is correct.

2. If we make less mistakes, then it will take less orders to get to profitability.

Makes intuitive sense, right: Less mistakes, more profit?

Thanks for asking,


Anonymous said...

Mo, thanks for clarifying! So it is really important to remember that making FEWER mistakes than we planned for means we'll have our heads above water sooner and MORE mistakes means we're underwater longer. Thanks!! Susan