- February 24, 2013
- Posted by: Javier González Montané
- Categories: Cost reduction, Sales, Turnaround
Many times we have listened that increasing sales have a positive effect in profits because fixed costs are sharing with more sales units (CVP Cost-Volume-Profit Analysis). What it is not many times remembered is that this is true under a few hypotheses (we are going to review some of them):
- Selling price is constant for any volume: Although, it is quite common using discounts’ prices in order to increase or even maintain sales volume. Be aware that low margins are a cause of turnaround need.
- Costs are linear: Sometimes firms have operational and managerial problems. This situation is quite common in turnaround (e.g. special projects with a wrong risk management process can be turned a planned positive margin into big losses). Those problems are showing an erratic negative behavior of costs. In this case more sales could mean much higher costs, and additional losses.
- Costs are accurately classified in fixed and variable: Make this classification is accurately not an easy task. When we are talking about companies in troubles, this assumption use to be wrong. Unfortunately, in turnaround many times that classification is wrong, so it is one of the causes of wrong decisions.
- All units produced are sold, there is no significant change in the size of inventory: When we are pushing sales, sometimes large accounts (with important negotiation power) initial selling conditions are changed at the shipping or invoicing time affecting negative to stock. Again in turnaround situations are quite often to find some over optimistic people in the sales department, and the consequence is overstock.
CVP Cost-Volume-Profit Analysis
Moreover, we have to highlight that growth need an additional investment/capital. Thus, for increasing sales importantly we need an additional capital needs to create stock, more production capacity, finance customer days of payment, and so on. Usually in turnaround project we do not have the extra capital for investments, we need capital to sustain the current business.
So in turnaround we should work to improve sales process. But until the firm is not stabilized, we should likely focus on profitability (eliminating unprofitable products and customers) rather than on growing sales. Although, that decision must be studied case by case.