Tuesday, April 10, 2012

Fixed Cost Coverage Ratio

It’s been a long day with lots of customers interacting with your team and buying many of your products and services. Your staff seemed busy and you felt productive. But did your business actually move forward or backward? Did you win or lose today? Here is the main number you should track every day in your business to answer these important questions.

The number of times your business covers its fixed costs each day is the how you determine if you win or lose, and that is called the Fixed Cost Coverage Ratio. In order to derive this critical number, you need to calculate your daily sales volume and divide it by your break-even volume. I will explain how to figure this out for your company.

Variable Costs
You need to start by determining your variable costs. Variable costs change based on your daily sales, and they are expressed as a percentage. This usually includes materials, direct labor, and staff wages that are paid based on production. On average, let’s assume this number is 30% for your business. This means that for every $1 in collect-able sales you produce, you pay $0.30 to the variable parts of your business.

Contribution Margin
For the sake of this article and the example below, I will assume that the variable cost percentage subtracted from 100% equals the contribution margin, or the percentage of every dollar of collections that is left after paying the variable costs to cover the fixed costs. In this example the contribution margin is, therefore, 70%.

Fixed Costs
Now we need to discuss fixed costs. Fixed costs do not change, regardless of your daily sales volume, and they are expressed as a flat dollar amount. This usually includes your rent, insurance, salaries and wages not tied to production, utilities, marketing, etc. I suggest business owners include all of their compensation in this number, regardless of what the compensation might be called (i.e. salary, dividends, guaranteed payment, interest, etc). Let’s assume your fixed costs are $50,000 per month.

Break-Even Calculation
To determine break-even, we need to divide the fixed costs by the contribution margin ($50,000 divided by 70%), which equals about $71,500 of monthly production required to pay your variable costs and barely have enough left to cover your fixed costs. This means you did not make any profit during the month.

To be more specific, if your business is open 20 days per month, you need to produce $3,575 per day to break-even. But hopefully you didn’t decide to own your business just so you could break even. The goal is produce as much more than $3,575 per day as is possible.

The Ratio
The concept of the fixed cost coverage ratio is to determine how many times your production each day can cover your fixed costs. By dividing your daily production by the break-even, you will know your ratio. If the ratio is one, then the business is being run at break-even. If the ratio is above one, then you are profitable. If you drop below one, then you lost money that day.

For example, if you sell $5,363 in a day, your break-even coverage ratio is 1.5 ($5,363 divided by $3,575). This is a good, profitable day. If the next day you only sell $3,225, then your break-even coverage ratio is 0.90, meaning you lost money that day.

Empowered with this daily metric, you no longer need to wonder how you did each day. I recommend you revisit your variable and fixed costs quarterly to make any appropriate adjustments to your calculation. As you improve this ratio, you’ll find your cash flow and profitability increase significantly.