Investment requirements will differ for different levels of growth

Deciding the rate at which your company should grow is challenging, demands flexibility and has differing investment requirements

By: Phoenix Lee/

Deciding the rate at which your company should grow is challenging and demands flexibility. Flexibility can be difficult if you already have a preconceived idea of the growth level you want. Your idea may exceed the capacity of the business’s management and equity positions.

It is helpful to develop several projections because different levels of growth will have different investment requirements and profit results.

For example, if a business is expected to grow to $500,000 in sales per year, you may be able to continue renting a facility. However, if the business is expected to grow to $800,000 in sales per year, a new facility may be required and its cost will affect the projected profit. The same can be true with items of equipment, which also depend on the relationship between the short- and long-term potential.

The addition of a new building can have a short-term, negative impact on profitability, but it also can result in an improved profit margin for the business within three to five years. Because input into a business operation is not always proportional and can come in steps, completing several projections based on different options will help determine which projection is best and what kind of investment requirements you will need.

Individual circumstances may require growth to be pursued at a slower pace, yet you can end up with similar profits. For example, you currently operate a business with sales of $600,000 per year, and you want the business to grow to sales of $2 million by the third year. You might project both of the following growth trends:

Example A
Year 1    $1.0 million
Year 2    $1.5 million
Year 3    $2.0 million

Example B
Year 1    $1.8 million
Year 2    $1.9 million
Year 3    $2.0 million

As you can see, the result is the same. Example B illustrates an initial high, fixed investment, used to support expansion, with slower growth following. For example, a successful restaurant with sales of $600,000 may build two more restaurants in different locations and thus triple its total sales. Example A reflects a situation in which growth is obtained more gradually by incurring variable costs and reinvesting profits in the business.

For example, a restaurant may attempt to increase its growth by maintaining the same single location, but adding new services or additional operating hours. You can further control your growth rate by recognizing that all fixed costs are variable over time.

Strictly speaking, fixed costs are those costs that are stable for a given period (e.g., one year). However, when you consider growth over a three- to five-year period, fixed costs can be treated more like variable costs. For example, alternatives to purchasing a new, full-size facility may include leasing facilities, constructing a smaller facility or creating unique distribution channels.

Computer spreadsheet programs are excellent to develop projections and investment requirements as they easily allow what if analysis in determining different levels of growth.

The costs of a growth cycle can be incurred in blocks or steps. This is especially true for equipment and buildings; however, it can also apply to marketing costs. For example, a manufacturing company may have only one machine that completes a process required of all its products. To double production capacity, the company must decide between adding a second shift or adding a second machine.

Adding a second machine doubles costs in the form of depreciation and other operating costs; adding a second shift doubles personnel costs. Either way, the company must consider the marketing option of adding a salesperson in order to increase its sales volume to in turn support higher fixed costs.

Determining the Break-even Point

Break-even analysis can help you make decisions because it allows you to visualize the relationships between costs that are spread over time. Such analysis involves dividing costs into two categories: fixed costs and variable costs.

Fixed costs are those costs that do not vary over a period of time, or generally do not fluctuate with changes in sales volume. These costs include the purchase price of buildings and equipment. Variable costs are costs that vary depending on the time period or the sales volume generated. These costs usually include the cost of materials purchased for retail operations and labor costs.

The textbook approach to break-even analysis is based on the units of production. For business activities, it is better to base such analysis on the dollar volume of sales of the business. Break-even analysis can be expressed as a dollar amount and can be displayed on a graph. On a projected income statement, a convenient way of breaking out fixed costs and variable costs is to treat the cost of goods sold and labor as variable costs and all other expenses as fixed costs.

The break-even point can be calculated as follows. First calculate the contribution margin, which is defined as the percentage of sales available for use toward fixed costs and profit. In the above sample income statement, the variable costs (goods plus wages) are 50 percent of sales, so the contribution margin is 50 percent. The actual break-even point is the fixed costs ($40,000) divided by the percentage of sales the variable costs represent (50 percent), which equals $80,000.

At this point, all fixed costs as well as variable costs are covered. To verify your answer, multiply 50 percent by $80,000. The answer is the amount of the fixed costs, or $40,000. The variable cost at this rate is $40,000 or 50 percent of $80,000.

The break-even point can be calculated using different assumptions of what should be included in the fixed-cost portion. If the business needs to generate enough profit to pay the owner’s wages plus the recovered debt principal and income tax obligations, these costs should be included with the fixed-cost amount; thus, the break-even point will be higher.

The break-even sales level usually covers a year; however, the time increment can be broken down into months, weeks or days. In the above example, the break-even point of $80,000 is equivalent to $266 per day (assuming a 300-day work year). This figure should be set as your average daily goal; however, don’t forget to consider seasonal sales and daily fluctuations as well.

It is difficult to assure accurate projections, but if each dollar item in a projection is carefully considered with regard to the volume or capacity of the business, the resulting figure should be relatively accurate and help determine the level of investment requirements.

Final income statements tend to show costs higher than what was projected. If plans are made carefully, the result might be that profit is very similar to what was projected; but some of the items will be higher or lower than planned.

In projecting income in order to determine investment requirements, compile figures conservatively. Bankers know it is very easy to come up with lofty profitability projections and may discount an application on that basis. Projections should indicate the ability of the business to pay off debt while earning a reasonable return on labor and investment.

Decisions on whether to grow and the rate at which to grow should be based on the concept of improved value. Profits can be drawn by the owner or reinvested in the business where they can increase the asset basis of the business. A recommended strategy for the owner-manager is to consider a combination of these options.