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Cost Pro

Laurie Owen provides a simple formula to determine whether expansion makes financial sense for you.

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FOR MANY JEWELERS, growth often means a physical expansion of an existing store or the opening of additional stores. Is it worth the cost? There are two parts to the answer: finance and marketing. The financial analysis answers the question, “What do we need?” and the marketing analysis answers the question, “What will we get?”

[inset side=right]At the same time, the marketing folks analyze the target market area so that they can accurately predict sales, or “How much will we get?”[/inset]Let’s look at how the big guys do it. Suppose a large quick-serve franchise is looking at a new location. By knowing accurately their fixed and variable costs, they can calculate a break-even sales volume level. With thousands of existing outlets to use as models, they know their costs to the penny, exactly what they need to invest and their target return on investment. They can then calculate the required profit. Then, considering the target profit as “fixed” — the cost of money — they can easily calculate the required sales to cover the costs and supply the necessary profits and the answer to the question, “What do we need?”

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At the same time, the marketing folks analyze the target market area so that they can accurately predict sales, or “How much will we get?”

Next, the marketing and finance people put the puzzle together. If what they will get is greater than what they need, it’s a go. The other way around, and it’s a no-go.

Last year, one of our group members was thinking about opening a second store and wanted to know whether it would be worth it. We started by figuring her fixed costs (the costs that neither rise nor fall with sales) to be $250,000 per year.

Next, we determined her variable cost (the costs that rise and fall with sales) percentage at 60 percent of sales. After talking with other jewelers who recently expanded with similar projects, she determines her investment costs to be $1 million. Given the level of risk involved and other investment options available to her, she determined that her required return on investment was 20 percent. Using our break-even formula below, we determined she needs to make $200,000 per year. We plug these numbers into our break-even formula to get her targeted sales.

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Facts

  • Fixed costs = $250,000
  • Variable cost percentage = 60%
  • Contribution margin = 100% – 60% = 40% or .40
    (Contribution margin is whatever is left over from each dollar of sales after taking out variable costs)
  • Target profit = $200,000 (20% x $1,000,000)

Formula

  • Required sales = Fixed Cost + Target Profit ? contribution margin

Calculation

  1. $250,000 + $200,000 = $450,000
  2. 100% – 60% = 40% (or .40)
  3. $450,000 ? .40 = $1,125,000 required sales

With a variable cost percentage of 60 percent, our member must achieve sales of $1,125,000 to cover fixed costs and produce the target profit. Her comment to me: “That sounds OK, but can I do it?”

An accurate knowledge of your costs and how they behave is really “the rest of the story.” After conducting a market analysis, my client determined she needed at least a 50 percent share of the market in her potential new location, a share not likely in a small market where she’s unknown and all three competitors are known and well-established. She decided instead to focus on building profitability, sales and cashflow in her existing location.

Admittedly, the process isn’t perfect, and the risks are several: only doing half the analysis, being wrong anyway and not evaluating whether the growth is accomplished at the expense of increasing levels of debt. Nevertheless, the process is better than proceeding blindly; sometimes it’s most useful in predicting what won’t work, rather than what will.

Who can use this expansion analysis process? Anyone. For any kind of growth — be it expansion of an existing location or the opening of additional locations. A sales analysis is only half the story. An accurate knowledge of your costs and how they behave is really “the rest of the story.”

  • Lucky Numbers
  • Get A Perfect Figure: 2.2%

That’s the amount of every sales dollar that the average top 25% of jewelers spent on administration and support wages. * Other jewelers spent slightly more ? 2.8 percent. To figure, track administration and support wages separately from sales. Have people doing some sales and some admin work? Have them track hours in each area to get an accurate estimate.

* Source: THE 2005 FIT Jewelers Benchmark Study

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Money Math

Do you know how many dollars in sales you need to make for every $1 you spend on a new hire, a new ad campaign, or new product line?

  • Step 1
    • Figure out your contribution margin.
    • Total your variable costs (the costs that rise and fall with sales) and divide that by total sales to get your variable costs percentage.
  • Step 2
    • Take that percentage and subtract from 100 percent.
    • For example, total variable costs are $600,000; sales are $1,000,000. Variable costs are 60 percent. Contribution margin = 40%, or 100%-60%, or .40
  • Step 3
    • Divide that one dollar by your contribution margin. $1.00/.40 = $2.50 For every dollar I spend, I need to sell $2.50 to recover it.

This story is from the May 2007 edition of INSTORE.

Laurie Owen was INSTORE's financial columnist during the first decade of the publication's history.

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