How to Make $1 Equal $10
One of the most precarious traps for the small business is chasing the revenue curve. This phenomenon is especially noticeable in the current recession, or any downturn. Chasing the revenue curve simply means that your expenses, and the way you have your expenses structured, are at such a level that you are constantly trying to get more sales to stay above the breakeven point.
Here’s how it happens. Expenses are broken down into two categories: fixed and variable. There is also a category called semi-variable, but let’s just deal with the two. Although these categories warrant a detailed discussion, the following definitions will serve our purposes now. Fixed expenses are those that do not change over the short term, or stated in another way, expenses that do not change over a given range of production. Examples of fixed expenses include leases, fixed payments on capital equipment such as vehicles, mortgages, and so on. Whether your sales are up or down, these fixed payments must be made. Variable expenses, on the other hand, are those which change with the level of production. Examples include labor (with limitations), rental of equipment, materials and other direct items used in production, and so forth.
As a business is growing, and is fat and happy, it tends to add capital equipment (fixed expense) since more units can be produced with a given amount of labor (variable expense). The up side to this strategy is that unit costs come down over a larger range of production and profits are greater. The down side, of course, is that when the revenue curve falls, as in a recession, the business bumps into the breakeven point more quickly and may even lose money. Invariably, the business cannot pull the cost curve down as fast as the revenue curve falls, so the chase is on.
A business that tends to keep more of its expense variable rather than fixed has an upside and a down side as well. The up side is that as the revenue curve falls in a downturn, variable expenses are easier to cut, and therefore, it may be possible to pull the cost curve down fast enough to avoid losses. The downside is that this business will not able to make the same level of profits as the business with more capital equipment. There is, of course, a balance which depends on the type of business. All other things equal, more variable is safer, more fixed is more profitable.
Recession prone businesses should err on the safe side, recession-proof businesses can be more aggressive. In any case, cost cutting measures should always be a priority. Take this example: if a business has a 10 percent net profit, for each $10 in sales, $1 in profit is made. To make $1 then, you have to sell $10. However, if you save $1 in expense, that’s $10 in sales you don’t have to make, and that may be $10 in sales hard to come by in a downturn. In this case, $1 is worth $10.