Posted by: davidhayden | May 16, 2010

How do you know when your CNC job will make money?


Many small shops I have worked with started as a simple concept making a single part in a garage or small space. At first more of a hobby than a business. (much like my little publishing company).

Then things change usually for the better. As the shops continue to do good work they start getting more parts from the same customer or more customers. Somehow, with a lot of effort what started as an avocation or hobby in a garage, is now a small business.

There are a couple if issues that arise when a small company starts to grow. Both are vitally important to survival and sustained growth. The first and the primary topic of this article is understanding the break even analysis. Just as important, and the subject of a future article is the art of managing cash flow. Without a good understanding of both these concepts, the chance of survival is minimal if not non-existent.

So what is the break even analysis? The break even analysis answers the basic question about how much work do you have to do to earn back the money you have invested in a job. For example, suppose you are making door panels on your CNC Router or maybe brass bushings for for some medical device. Obviously after you buy the raw materials, you are not going to make your money back on the first door panel or brass bushing. So how many do you have to make to become profitable?

Good question. To understand to solution to the problem, you first have to understand the language of the break even analysis.

Fixed Cost (FC): The sum of all costs required to produce the first unit of a product. This is a fixed amount and does not change with an increase or decrease in units produced. For example, if you are just setting up your shop to make the custom panels you may have fixed expenses that include: the cost of the router, the cost of shipping the router, the additions to your garage to accommodate the router, the cost to have a larger electrical service added to the garage, and so on. These are expenses you have to make to enable you to go into the CNC router business.

Variable Cost (VC): Costs that vary directly with the production of one additional unit. These costs would include such things as: the cost of the wood, the cost of electricity used, the cost of consumable items like router bits, glue, sand paper, and so on. If you never run the router, you will not have any of these expenses. But as your volume increases, so do your expenses.

Unit Price (UP): This is the amount of money you charge the customer for each unit they buy. Obviously the more you charge, the sooner you may be able to break even on the job. But as we all know, there is a limit to what we can charge. So this number must be something greater than your variable cost and something less than or equal to what the market will pay for the unit.

Contribution (C): Often called profit, this it the amount of money you earn per unit that is in excess of the variable cost. For example, if your variable cost to make a unit is $15 and you sell the unit to the customer for $20, the contribution is $5.

I like to call this contribution rather than profit and here is why. Suppose you paid $10,000 for a CNC router and you made 100 door panels at $5 “profit” ($20 UP – $15 VC= $5 Contribution) each. Have you really made a profit in your business? Not yet, you are still $9,500 away from breaking even. BUT, you have contributed $500 towards paying off the fixed expense.

So the first simple formula to remember is Contribution = Unit PriceVariable Cost (C=UPVC).

There is an old joke we used to throw around in a shop I worked for. At the time we were selling some finished parts at a price that was below our variable costs. Our joke was “that’s ok, we will make it up on volume!”

Break Even (BE): The break even defines how many units must be sold to recover all fixed and variable costs before a single dollar of real profit has been earned. The formula for calculating the Break Even point is very simple. It is Break Even = Fixed Costs / Contribution (BE=FC/C).

So, if you have been following along with the door panel example, you know that to break even on the investment, the shop must sell 2000 door panels.

FC = $10,000
VC = $15
UP= $20
C = UPVC = $5
BE= FC/C = $10,000/$5 = 2000 units

Here is another reason to think in terms of contribution instead of profit. Suppose you want to invest in a new machine. Your current machine is maxed out and can produce no more. So you need to expand. Obviously, you probably not pay off the machine with the first order you take. In fact, until you ramp up your sales, it is possible the machine may spend a good bit of time sitting idle.

If you only think in terms of “profit” you could make one of two classic mistakes. The first is that you see a job where you stand to make a large per piece “profit” and you really want that job. It is easy to fall into the trap of buying the machine for the one job then find your self paying for a piece of hardware that sits most of the time.

When you think in terms of “contribution” then you realize the job you want so bad, only contributes a portion of what it will take pay for the machine. Once in that mindset, you now can think clearly about how much work you will need to get to make the machine pay for itself.

If you can’t project enough work to pay for the machine, the “profit” you might make on that hot job is meaningless.

The second classic mistake is to think just the opposite way. That is, you look at the cost of the machine and think, “I can’t make enough ‘profit’ on this job to pay for the machine, therefore I should not buy it.”

Again, when you think in terms of contribution, you realize that, while the potential job will not pay for the machine, it certainly contributes to its payoff. Some questions you may want to answer before you make the decision to buy the machine are:

  • How much work is needed at what contribution to pay the machine off in X years or X months?
  • How much marketing or my time would be required to get enough work to keep the machine busy?
  • How much could I sell the machine for at the end of the job?
  • How much does it cost me per month to keep the machine if it is not producing?
  • What could I sell the machine for if I needed to sell it in one or two months.

By answering these questions you may find that it is a sound investment to buy the machine.

Here is a real life situation I was personally involved with. I worked for a large company that started outsourcing as much as they could. The predominant thinking was, “why should we make this in house when we can buy it on the outside for less money?”

On the surface it sounded like logical thinking, but the point I argued (and lost) was different. My argument was that, regardless of our “internal costs,” if the work was kept in house, whatever we made in excess of the variable costs, would go along way towards offsetting our huge fixed costs.

Even if it was cheaper on the outside, if we did nothing to reduce our fixed cost, then we we would be hurting the company even more. Without the contribution, we would never recover our fixed costs. It seemed simple to me, if the fixed costs were too high, outsourcing was exactly the wrong thing to do.

Advertisements

Responses

  1. […] Claims Processing: Delta Dental of California Here are a few related blogs on this subject: How do you know when your CNC job will make money? « The CNC Project – How do you know when your CNC job will make money? « The CNC Project Should I hire salesmen […]

  2. Rigid CNC aluminum rotor head for precision and smooth movements. Door Panels Hardware

  3. Very good information. Thanks a lot 🙂

    regards

    Jithesh.V

    • Thanks. You are most welcome.

  4. If only more than 80 people would hear this..

  5. Hi There Cnctips,
    Thanks for the above, The job of teaching has changed over the years. Teachers have more to do than just teach today. The training for teachers is ongoing throughout their career. This is especially true for special education teachers. Special Ed teachers are teachers, advocates, knowledgeable about various disabilities, experts at creating special education lessons and at writing IEPs (Individual Education Programs). Special education teacher jobs are in high demand because one other thing a special ed teacher needs is dedication to doing everything they can to aid their students in reaching their full potential. If you are looking into a special education career there are some things you need to know in order to make the cut in this field.
    Cheers

  6. Capitol investment in a business is not an expense it is what it says an investment. On one side you have the expenditure on the other an asset the books are balanced. The cost of the machine is not the price paid it is the depreciation that is a cost against future profit not the $10,000 investment. Technically if you have manufactured 100 panels at $5.00 profit you have made $500 minus the value of depreciation of the machine in the same period.

    • Thanks for making the distinction Derek. I appreciate your input.

  7. Hi David

    Do you have any Idea why 5 axis CNC machine heads are so expensive?

    • Derek,
      Sorry O had somehow missed this message. Yes it is very complicated making
      a precision 5 axis machine. Think about the precision that has to be
      built into a 5 axis machine. On X Y or Z if you are off location by .0001 that
      is your error.

      But with a tilting head if you are off by .0001 the amount of error seen in
      the finished product will be a function of the length of the tool. So 5 axis
      machines have to have incredibly close tolerances if they are worth their salt.
      That precision costs a lot of money to manufacture.

      It goes without saying that the stresses involved are a function of the tool
      length and angle of departure from normal as well. So 5 axis machines are
      always balancing the ability to articulate with the need for rigidity.


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Categories

%d bloggers like this: