Basic, lesson 1 of 4
How a business makes money
Before you value a company you should be able to say, in two sentences, who pays it, for what, and why the last unit sold is more or less profitable than the first.
8 min, 3 checks
1Price, volume, and cost
Revenue is units times price. Costs split into variable costs, which rise with each unit (materials, shipping, sales commissions), and fixed costs, which do not (rent, salaried staff, software). The gap between price and variable cost per unit is the contribution margin. Fixed costs divided by contribution margin is the breakeven volume.
Worked example
A made-up kitchen appliance maker
- 1Price per unit: $50. Variable cost per unit: $30. Contribution: $20.
- 2Fixed costs: $40m a year.
Breakeven is $40m / $20 = 2m units a year. Every unit above that adds $20 of profit.
Check 1
A subscription costs $120 a year and $40 a year to serve. Fixed costs are $16m. How many subscribers to break even, in millions?
2Operating leverage
A business with high fixed costs sees profit swing more than revenue. That is operating leverage. It is good news when volume grows and bad news when it falls, and it is one reason acquirers love combining two high fixed-cost businesses: one set of fixed costs can serve both.
Check 2
Revenue $100m, variable costs 60% of revenue, fixed costs $30m. Revenue rises 10%. By what percent does operating profit rise?
Check 3
Which business has the most operating leverage?
Terms in this lesson: Fixed and variable costs, Contribution margin, Break-even analysis.
3 checks in this lesson. Sign in to keep your progress.