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