A Practical Approach to Determining When to expand and When to Stabilize

Paul Dunn, Leo Cheatham, Carole Cheatham

Abstract


A  successful  young  firm  experiencing  rapid  sales  growth   can  suddenly   encounter   declining profits  due  to  decreasing  contribution  margins   because   of   production   capacity   limitations. Expansion  is  not  an  automatic  solution  because  it  increases  fixed  costs  and  raises  the  first breakeven point . This paper is designed to provide strategies for  planning for  the combined  effects fixed costs, variable costs, revenues and sales will have on profits if additional  sales  growth  is attempted .   Rapidly   increasing   variable  production    costs  signal   the  need  to  consider  expansion, but product demand strength and life cycle stage affect the decision. Either of these can be respon­ sible for  declining contribution margins resulting  in  lower than anticipated  profits  at higher sales levels . Because of  higher fixed  costs  caused  by  expansion ,  the  business  cannot  return  to  sales levels  that  were  profitable   before  the  expansion.

 

Why is it possible for a prosperous small business experiencing rapid sales growth to begin encountering declining profits even  though  sales  continue  to  increase?  Traditional  breakeven analysis illustrated in Exhibit I implies a path of "smooth sailing" once a firm is able to generate sufficient volume to reach the  critical "breakeven" hurdle. In fact, this  concept  has  been  a major source of deception because it implies that the only requirement for an increase in  profits  is  an increase  in  sales.

 

Unfortunately, the inexperienced entrepreneur tends to view the sales volume/profit relationship in this simplistic manner, forgetting about two key limitations of linear breakeven analysis. Total revenue is depicted as a straight line based on the assumption that prices of products sold do not change regardless of volume, while total cost is shown as a straight line based on the assumption that variable cost per unit sold is constant and is not affected by the level of sales (11 ).


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References


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