It is often said that in a negotiation, knowledge is power. One vital piece of information that will give you great insight is understanding the breakeven point of your provider. This is because once your supplier is operating at a level that is above its breakeven point, any new business will only attract marginal cost and therefore be very profitable for the supplier.
Before you are ready to analyze a supplier’s breakeven point, there are a couple of concepts you need to understand; those of fixed costs and variable costs.
Fixed costs, as the name implies, are costs that do not vary with the volume of activity. For example, in a manufacturing company that makes widgets, the on-premises rent will remain the same regardless of how many widgets are produced. Similarly, in a service business, such as a travel agency, the manager’s cost remains the same no matter how many vacations are sold.
Variable costs, on the other hand, change with production volume. When making widgets, material costs will vary in proportion to the number of widgets produced.
Semi-variable costs are a combination of variable and fixed. An example of a semi-variable cost is that of a supervisor. Your costs would normally be treated as a fixed cost, but if production levels are high, overtime may be required and this would provide the variable cost element.
The total costs are obviously the sum of the three.
Now that you understand these types of costs, you are in a position to understand an important concept when analyzing a supplier’s costs: equilibrium analysis. Draw a break-even graph by first plotting the fixed costs. Since this does not vary with the output, it is a horizontal line. Variable costs have a gradient that is determined by the cost per unit of production. The sum of these two costs gives you the total cost.
If you now draw the sales line, the point where the total cost line and the sales line intersect is the breakeven point. In other words, it is the level of production where the value of sales equals total costs. With production below this level, the supplier loses money. Above it, the provider makes a profit.
This can be very useful information to have in a negotiation. For example, if the supplier is currently operating above its breakeven point, the additional sales will have a large impact on the bottom line. To be specific, if the supplier’s variable costs are 30% of the value of sales, then for every £ 1 of business that exceeds its breakeven point of 70 pence there is an additional profit. You can negotiate with a supplier to share this … still giving them a profit but also giving you a discount.
A true mutual benefit!
