Saturday, March 07, 2009

Profit and Loss and Scalability

The economy's tanking over the last year and a half has opened my eyes a bit to the way businesses earn profit. I had never put any thought into it, and had never realized how fragile the state of profitability is. I had been assuming that if your sales fell by half, your profits also fell by half; this is so blatantly untrue that I feel a bit stupid for ever thinking it. I had never realized how many businesses work with extremely narrow margins of profitability.  As an example, I talked recently with the manager of a car-rental company, and he said their profitability point was when they had 92% of their cars rented. If they had a hundred cars in their inventory, and they had eight sitting on the lot unused, they were breaking even; if they had twenty cars on the lot, they were hemorrhaging money.

I think my problem was that I had spent too much time listening to business statistics. When you hear that Amalgamated Widgets makes ten dollars on every widget they sell, that's (probably) true, but it's also misleading -- it's got a host of unspoken assumptions behind it, the biggest being "...assuming we sell a million widgets this year". The ten-dollar figure is net profit, after paying all fixed and per-unit costs, and a lot of it is dependent on scale. The material cost of making a widget even varies with scale; if you buy your widget grommets in lots of a hundred, you're paying more per grommet than if you bought them in cases of ten thousand. And you need a guy manning the widget press, the widget amalgamator, the widget demagnetizer, and the widget wrapper, whether they're making a hundred an hour or five an hour; your labor cost per widget is cheaper if you make more of them.

Your fixed business costs (electricity and water and rent and insurance and admin staff -- any cost not immediately dependent on production) also weigh more heavily on your profit the fewer you sell; if you sell fewer widgets, each widget bears a proportionally greater portion of the fixed costs. If your insurance is a thousand dollars a month, and you sell a thousand widgets, a dollar of each widget's sale price goes towards insurance; if you only sell five hundred widgets, insurance now eats two dollars of the price of each widget sold.

All this is a long way of saying that I had never connected exactly how major a 3% drop in sales can be. It makes the economic outlook seem even more intimidating....

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