There are four specific ways in which profit performance of a business can be improved, which are as follows:
- Increasing the volume of sales: Considering the example I, the present volume of sales is 8,000 units and the maximum production capacity 10,000 units. If the sales are increased to the maximum production capacity, there will be an increase in variable expenses only. The profit will increase from, Rs.6,000 to Rs. 10,000. It will be seen that though the increase in sales volume has been only to the extent of 25 per cent, profit has increased by 67 per cent.
- Increasing the selling price: An increase in the price increases the contribution margin and reduces the break-even point. Continuing with Example I, if the selling price is increased by 10 per cent, the profit will increase from Rs. 6,000 to Rs. 9,200 showing an increase of more than 50 per cent.
- Reducing the variable expenses per unit: If the variable expenses are reduced by 10 per cent to Rs. 1.80, the profit will increase from Rs. 6,000 to Rs. 7,600 at the present volume of sales. This increase is more than 25 per cent, which is more than the percentage reduction in variable expenses. In cost-volume-profit relationship, the higher proportionate increase in profit than the change in selling price or the volume of sales or the variable expenses is called the leverage effect. At times, it is not possible to increase the prices, but to increase the volume of sales and to reduce the variable expenses is possible.
- Reducing the fixed cost: A reduction in fixed costs, without a change in variable expenses and the selling price, would lead to an equal change in the profits. For example, if the fixed expenses are reduced from Rs. 10,000 to Rs. 9,000 in the above illustration, profit will increase from Rs. 6,000 to Rs. 7,000. As a change in the fixed costs does not change the contribution margin per unit, there is no leverage effect.
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