Lee Rust, Owner, Florida Corporate Finance
Too often I see company budgets or financial projections that show a smooth increase in sales and related expenses. Corporate growth, however, is never linear. Instead, the growth in expenses follows a step function as capacity is added to match increasing sales.
Think of a simple manufacturing facility operating at less than capacity. As sales increase, the cost of manufacture as a percent of those sales should decrease. The same number of employees and equipment produces more goods for sale. That relationship holds until the facility is operating at full capacity. At that point, any increase in sales will require an investment in more people, more machinery, and higher utility expenses to run the machines. As those expenses step up, the manufacturing cost as a percent of sales also increases, and gross profits go down. In addition, at some point more people will be required in administration, and those expenses will also step up. With the new capacity in place, however, the continued growth in sales can once again result in a decrease in costs as a percent of those sales. That is the step function in practice.
As you might imagine, the step function related to the growth of expenses is more pronounced for a small company than for a larger one. If you have only two people in manufacturing, adding a third to increase capacity increases direct labor cost by 33.3 percent. If you have twenty people, adding another increases labor cost by only 4.8 percent. Big difference.
When planning your company budgets, compiling projections, or simply thinking about the effects of a growth in sales, don’t forget the step function and the relationship between capacity and expense. The sales growth might be a smooth increase or close to linear; the related expenses won’t be.
Although seldom in my long career, I’ve even seen profitable companies grow into bankruptcy. Once full capacity was reached, the cost of making the next step up to support a higher level of sales exceeded the company’s ability to finance the increase in costs. The result was a lack of cash and related working capital that then caused problems with suppliers and eventually lead to losses that could not be sustained.
In earlier articles, I’ve talked about budgets and financial projections. Those are particularly helpful planning tools but to be helpful must be realistic. As you plan for growth, think about capacity and output related to your employees, equipment, and facility. When compiling budgets or projections, it’s always best to start with sales. Then analyze the number of employees needed to generate those sales in production, in administration, and in your sales department. By adjusting the number of employees in relation to the level of sales and then converting the number of employees into the cost of employing them, you’ll see the step function in practice. Do the same for equipment and facility needs and then for other expenses. The results will be a realistic financial forecast that doesn’t anticipate a consistent relationship between the levels of sales and expenses.
In business school, corporate expenses are often divided into three major categories: Fixed, Semi-Variable, and Variable. Without embarking on a B-school lecture, fixed cost don’t vary with sales until full capacity is reached. Variable expenses do track sales, such as material purchased for production. And semi-variable costs lie between the other two. As you might imagine, the fixed costs show the greatest step function effect; variable costs show none, and semi-variable costs step up at certain sales levels but at a lower percentage than the increase in sales. For planning purposes, it’s helpful to understand which of your corporate expenses are in each of those three categories.
Why does the step function matter? Because planning for the future matters, and that planning must be based on a realistic assessment of revenues, costs, and the ability to generate profits as both of those change.
Some time ago, I heard that the true purpose of financial projections is to make astrology look acceptable. When you compile your company’s budgets or projections, make sure that’s not the case for you.
Lee Rust, owner of Florida Corporate Finance, specializes in Mergers & Acquisitions, Corporate Sales, Strategic Planning, Financing and Operations Audits. He can be reached by phone at 407-841-5676 or by email at hleerust@att.net.
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