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

Authors

  • Paul Dunn Northeast Louisiana University
  • Leo Cheatham Northeast Louisiana University
  • Carole Cheatham Northeast Louisiana University

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 ).

References

I. Adizes, I. Corporate Lifecycles: How and why Corporations Grow and Die and What to Do About /1 (Englewood Cliffs, New Jersey: Prentice Hall, 1989).

Blue, Thomas R., Carole B. Cheatham, and Barbar M. Rushing. "Decision Thresholds andDevelopmental Stages in the Expanding Business," Journal of Business and Entrep­ reneurship (March, 1989), 20-29.

Boag, David A., and Ali Dastmalchian. "Market Vulnerability and the Design and Man­ agement of the Marketing Function in Small Firms," Journal of Small Business Management , 26 (October, 1988), 37-43.

Di Pietro, William, and Banshi Sawhney. "Business Failures, Managerial Competence, and Macroeconomic Variables," American Journal of Small Business, 2 (October, 1977), 4-15.

Ferguson, C. E. Microeconomic Theory (Homewood, Illinois: Richard D. Irwin, 1966).

Hanks, Steven H. "Organization Life Cycle: Integrating content and Process," Journal of Small Business Strategy, I (February, 1990), 1-12.

Rice, G. H., and R. E. Hamilton. "Decision Theory and the Small Businessman," American Journal of Small Business, 4 (1979), 1-9.

Rao, C. P., Mark A. Kreighbaum, and Jan M. Hawes. "International Market Involvement and the Business Cycle," Journal of Small Business Management , 21 (October, 1983), 31-37.

Stephenson, Harriet B. "The Most Critical Problem for the Fledging Small Business: Getting Sales," American Journal of Small Business, 9 (Summer, 1984), 26-33.

Tyebjee, Tyzoon T., Albert W. Bruno, and Shelby H. Mcintyre. "Growing Venture Can Anticipate Marketing Stages," Harvard Business Review, 61 (Jan.-Feb., 1983), 62-66.

Weston, J. Fred, and Eugene F. Brigham. Essentials of Managerial Finance (New York: The Dryden Press, 1987), 309-30.

Downloads

Published

1991-06-04

Issue

Vol. 2 No. 2 (1991)

Section

Articles

License

The Journal of Small Business Strategy (the “Publisher”) and the Author(s) agree as follows:
 
1.Author(s) hereby grant to Publisher all right, title, and interest in and to the Work, including copyright to all means of expression by any method now known or hereafter developed, including electronic format. If Publisher does not publish the Work within two (2) years of the Effective Date, copyright shall revert back to the Author. Publisher agrees to always credit Author(s) as the author(s) of the Work.
 
2.Publisher hereby grants Author a royalty-free, limited license for the following purposes, provided the Work is always identified as having first been published by Publisher.
    •The right to make and distribute copies of all or part of the Work for use in teaching;
    •The right to use all or part of the material contained in the Work in a book by the Author(s), or in a collection of the Author(s)’s work;
    •The right to use and distribute the Work internally at the Author(s)’s place of employment, and for promotion and any other non-commercial purposes;
    •The right to use figures and tables from the Work for any purpose;
    •The right to make presentations of material from the Work;
    •The right to use and distribute the Work on the Author(s)’s Web site and on the Author(s)’s university’s institute repository;
Such license shall be effective when the Work is first published in the Journal of Small Business Strategy.
 
3.The Author(s) represents and warrants that the Work: (a) is the Author(s)’s original work and that Author(s) has full power to enter into this agreement; (b) does not infringe the copyright or property right of another; (c) contains no materials which is obscene, libelous, defamatory or violates another’s civil right, right of privacy, or is otherwise unlawful; and (d) has not been previously published, in whole or in part. Author(s) shall indemnify and hold Publisher harmless against loss or expenses arising from breach of any such warranties.

How to Cite

A Practical Approach to Determining When to expand and When to Stabilize. (1991). Journal of Small Business Strategy (archive Only), 2(2), 1-15. https://libjournals.mtsu.edu/index.php/jsbs/article/view/244