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LawBiz® TIPS – Week of June 14, 2016

Cost Analysis and the Mathematical Mix

Do you know what your firm's break-even point is?

A cost analysis of your operations will help determine the answer. There are two common models for approaching this analysis. You can either look at your projected revenue and figure out what your cost structure should be so that you can make a profit, or you can look at your costs and determine how much revenue you need to cover these costs and make a profit. Is one method better than the other?

A number of years ago, when I taught entrepreneurship as an adjunct professor at U.C.L.A., I invited into the class a client of mine to discuss how he set prices for his goods and services. He focused on how much it cost him to produce one unit and then how much less it would cost him if he were able to produce multiple units. Then he would evaluate how many units he thought that he could sell. If that number were less than the number he used to estimate his lowest possible cost of production, he would return to the calculation process to see if he could save money somewhere in the manufacturing process. He did this until he was successful, at the very least, in breaking even. I, on the other hand, would talk about approaching the pricing process from the revenue side of the equation, determining market factors and value to the customer, in order to set the price and determine profitability.

One evening, when we were having this discussion, I realized that both my client and I were doing the same thing—determining pricing and profitability. We were simply approaching the process from opposite ends of the equation. One was from the revenue side: Revenue (R) = Profits (P) + Expenses (E). The other approach was from the expenses side: Expenses (E) = Revenue (R) – Profits (P). The mathematical calculations on both sides led to the same conclusion: P = R – E, or Profits = Revenue – Expenses.



Cost Analysis and the Mathematical Mix

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