‘Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.’
Wilkins Micawber, fictional character from the novel David Copperfield by Charles Dickens
In a nutshell
‘Profit planning’ is an important business discipline. It impacts pricing (see Chapter 32 Profitable pricing), budgeting (see Chapter 34 Budgeting and forecasting) and investment appraisal (see Chapter 35 Investment appraisal).
Essentially it is a method of calculating forecast profits for different products and services.
Profit planning requires an understanding of variable and fixed costs as well as the concept of ‘contribution’.
By using simple ratios businesses can calculate target profits and their sensitivity to the break-even sales revenue.
Need to know 
This chapter covers three steps in profit planning:
1 Cost classification
The first step in profit planning is to classify operating costs into ‘variable’ and ‘fixed’ categories.
| Variable costs | Fixed costs |
| Costs which are ‘variable’ will change with business activity. | Costs which are ‘fixed’ are the opposite to variable, i.e. they do not change when ‘activity’ (the volume of goods or services) changes. |
For example:
| For example:
Fixed costs can, however, change over time. |
2 The concept of contribution
Consider the example of XYZ Ltd, which sells two products X and Y and makes £250,000 overall profit.
| Product X | Product Y | Total | |
| £’000 | £’000 | £’000 | |
| Sales revenue | 700 | 300 | 1,000 |
| Variable costs | (200) | (150) | (350) |
| Fixed costs | (200) | (200) | (400) |
| Profit/(loss) | 300 | (50) | 250 |
On first read, one may suggest that XYZ Ltd should stop selling product Y as it is showing a loss of £50,000 and instead focus solely on product X which makes a profit of £300,000.
The challenge is that in many businesses fixed costs are often centrally allocated on an arbitrary basis to departments (such as product Y).
If the total fixed costs of £400,000 relate to costs of running a warehouse, which has been allocated to each product equally, the costs would be unavoidable (i.e. they would still exist with or without product Y). Discontinuing product Y will mean that product X alone must absorb all the fixed costs of £400,000. This would in effect reduce product X’s overall profit from £250,000 to £100,000 as follows:
| Product X | |
| £’000 | |
| Sales revenue | 700 |
| Variable costs | (200) |
| All fixed costs | (400) |
| 100 |
Instead, a company should calculate contribution when making profit planning decisions:
Therefore, XYZ Ltd should consider contribution at the product level and profit at the company level as follows:
| Product X | Product Y | Total | |
| £’000 | £’000 | £’000 | |
| Sales revenue | 700 | 300 | 1,000 |
| Variable costs | (200) | (150) | (350) |
| Contribution | 500 | 150 | 650 |
| Fixed costs | (400) | ||
| Profit | 250 |
This analysis shows that despite initially appearing to make a loss after allocated fixed costs, product Y still makes a positive contribution of £150,000 towards fixed costs and profit. Therefore, product Y should not be discontinued. This assumes that the fixed costs of £400,000 would still exist with or without product Y.
3 The contribution percentage of sales ratio
The contribution percentage of sales (CPS) ratio, alternatively known as the profit to volume ratio, is particularly useful in profit planning.
CPS can be illustrated using the example of XYZ Ltd:
| £’000 | |
| Total contribution | 650 |
| Total sales | 1,000 |
| CPS (contribution/sales) | 65% |
The CPS ratio can be used to calculate the following:
- aThe sales revenue required to break even
- bThe sales revenue required to achieve a target profit.
a The sales revenue required to break even
This is calculated as follows:
For XYZ Ltd:
| Fixed costs | £400,000 |
| CPS | 65% |
| Break-even sales revenue (rounded) | £615,000 |
The calculation below demonstrates that XYZ Ltd will break even with a sales revenue of £615,000, assuming products X and Y continue to be sold in the same mix (70/30 in revenue terms).
| Product X | Product Y | Total | |
| £’000 | £’000 | £’000 | |
| Sales revenue | 431 | 184 | 615 |
| Variable costs* | (123) | (92) | (215) |
| Contribution | 308 | 92 | 400 |
| Fixed costs | (400) | ||
| Profit | 0 | ||
| Note: * Variable costs vary directly with sales revenue. | |||
Once break-even levels of sales are calculated, it is useful to review the margin of safety. This answers the question ‘by how much would sales have to fall before a product (or service) makes a loss?’ The margin of safety can be expressed as either an absolute amount or as a percentage.
For XYZ Ltd:
| £’000 | |
| Original sales revenue | 1,000 |
| Break-even sales revenue | 615 |
| Margin of safety | 385 |
| Margin of safety % | 38.5% |
This means that sales revenue can fall by £385,000 or 38.5% before the company makes a loss, assuming that products continue to be sold in the same mix.
b The sales revenue required to achieve a target profit
The above techniques can be developed further to help drive business performance through budget planning and target setting.
This is calculated as follows:
This can be illustrated for XYZ Ltd, for an illustrative 20% increase in profit from £250,000 to £300,000.
As proof of the above:
| £000 | |
| Sales revenue | 1,077 |
| Variable costs* | (377) |
| Contribution | 700 |
| Fixed costs | (400) |
| Profit | 300 |
| * Variable costs will vary directly with sales revenue | |
This means that a 7.7% increase in sales revenue is required to achieve a 20% increase in profits.
A visual representation
Profit planning can be represented visually on a chart.
- ■Sales revenue is represented by an upwards sloping line. Increasing or decreasing the sales price will cause this line to increase or decrease its gradient.
- ■FC represents fixed costs and the starting position of the total costs line. Higher or lower fixed costs will mean this line starts at a higher or lower position.
- ■VC represents variable costs. Increasing or decreasing variable costs will increase or decrease the gradient of the total costs line.
- ■Point BEP, the intersection of sales revenue and total costs, represents the break-even point. The break-even sales revenue is the corresponding point on the vertical axis. The break-even output (in units) is the corresponding point on the horizontal axis.
- ■The chart clearly demonstrates the revenue/output which is loss making as well as the revenue/output which is profit making.
- ■Target profit and margin of safety can be easily added to this chart, to further aid analysis.
Why is this important? 
Profit planning enables a business to forecast the impact of changes in sales revenue on profit. This is useful for setting prices (see Chapter 32 Profitable pricing), budgeting and forecasting (see Chapter 34 Budgeting and forecasting) and when performing investment appraisal (see Chapter 35 Investment appraisal).
The CPS ratio can be used to determine which are the most profitable products and services in a company’s portfolio. It can then divert resources to the highest earning products and services, develop new products and services or alternatively attempt to make the lowest earning more profitable.
In practice 
Businesses should attempt to influence their break-even points through a combination of the following activities. The activities will need to be balanced as they are interconnected.
| Activity | Impact | Risk |
|---|---|---|
| Increase prices. | This will increase contribution and the CPS ratio, which will lower the volume of sales required to break even. | This is challenging to achieve without offering additional value and value and perhaps needing to increase variable costs. |
| Reduce variable costs by sourcing less expensive supplies and labour. | As above. | If this reduces quality and service, it may impact on the sales volume. |
| Increase the quantity sold by increasing market share or entering new markets. | This will not impact on the CPS ratio and will instead increase total contribution, which will increase profit. | This may be challenging to achieve without increasing overheads such as sales, marketing and distribution. |
| Reduce fixed costs by controlling overheads. | This will increase the margin of safety as a lower sales revenue will be required to break even. | If this reduces quality and service, it may impact on the sales volume. |
Limitations of contribution and the CPS ratio
- ■If the mix of products/services sold changes (for example, XYZ Ltd was to sell more of product X than product Y) the overall CPS ratio would also change.
- ■If fixed costs change with ‘activity’ the break-even point will change. Some fixed costs will change in the medium to long term. For example, if a business grows significantly and larger premises are required, its rent will become what is known as a ‘stepped’ fixed cost.
- ■Not all relationships are linear. For example, businesses may offer volume discounts to certain customers, reducing price and therefore the CPS ratio. Similarly, businesses may receive volume discounts from their suppliers and variable costs per unit may fall at higher levels of output, increasing the CPS ratio.
- ■The calculation of break-even sales revenue for individual products and services should include only ‘avoidable’ fixed costs specific to each product – however, in practice these may be hard to identify accurately.
Nice to know 
Operating risk
Operating risk (or operating gearing) looks at the percentage of variable and fixed costs in a business. The higher the percentage of fixed costs to profit, the higher the operating risk.
For businesses with a high percentage of fixed costs, a small change in sales volume will result in a large change in operating profits. These businesses can do very well in times of growth, yet struggle, or even fail, when trade declines.
Note that a similar relationship can be ascertained by comparing contribution to profit.
Example
Companies A and B operate in the same type of business and have identical revenues of £200,000 p.a. The difference between the two companies is their operating cost structure:
- ■Company A’s operating costs are 20% fixed and 80% variable.
- ■Company B’s operating costs are 80% fixed and 20% variable.
The following table considers the impact of a 25% fall in sales revenue.
| Company A (20% operating gearing) | Company B (80% operating gearing) | |||
| Current | 25% fall in revenue | Current | 25% fall in revenue | |
| Sales revenue | 200,000 | 150,000 | 200,000 | 150,000 |
| Variable costs | (80,000) | (60,000) | (20,000) | (15,000) |
| Fixed costs | (20,000) | (20,000) | (80,000) | (80,000) |
| Operating profit | 100,000 | 70,000 | 100,000 | 55,000 |
| 30% fall in operating profit | 45% fall in operating profit | |||
A 25% change in revenue leads to a 30% change in operating profit for company A and a 45% change for company B.
As company B has a higher percentage of fixed costs, its operating profits are more volatile.
A rise in sales revenue
The same magnification would apply if revenue increased. Company B would experience a higher percentage growth in profits than company A.
Although company B has a higher operating risk than company A, it has a higher ‘contribution margin’ and therefore has more flexibility with pricing (see Chapter 32 Profitable pricing).
Company A versus company B is an example of the trade off between risk and return.
Optional detail 
Mixed costs
Some costs are also ‘mixed’ in that they include an element of both fixed and variable costs. For example, a phone bill typically consists of a fixed rental charge plus a variable charge for calls made. To calculate ‘contribution’ mixed costs will need to be split into their fixed and variable parts.
CVP analysis
Accountants sometimes refer to profit planning with calculations of contribution as CVP (cost–volume–profit) analysis.
Contribution per unit
This chapter has looked at total contribution. CVP analysis can also be undertaken on a unit basis, looking at sales price per unit, variable cost per unit and therefore contribution per unit.
Although more complicated, this has the added benefit of being able to calculate a break-even sales quantity (units sold) in addition to the break-even sales revenue demonstrated in this chapter.
Reflect and embed your understanding 
- 1How can ‘profit planning’ be used in practice?
- 2What types of business decisions influence the CPS ratio?
- 3What are the consequences of high operating risk and how should it influence business decisions?
For the authors’ reflections on these questions please go to financebook.co.uk
Where to spot in company accounts 
Profit planning is an internal process and therefore does not feature in company accounts.
Within the narrative of annual reports there may be references to terms such as ‘margins’, ‘contribution’, ‘break even’, ’operating risk’ and ‘cost analysis’, which can indicate the existence of ‘profit planning’ in some format.
Consolidate and apply
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 430.
Watch out for in practice 
- →Does ‘profit planning’ using the concept of contribution take place?
- →Is the organisation operating close to its break-even point?
- →Are variable and fixed costs by product and service identifiable?
- →Are prices and variable costs linear over the standard range of activity?
- →Levels of fixed operating costs in the business (operating risk). Unless the business has a healthy interest cover (see Chapter 26 Long-term solvency performance measures), it is inadvisable to combine high operating risk with high financial risk (gearing).