It is often said that in a negotiation, knowledge is power. One vital piece of information that will give you great insight is understanding your provider’s break-even point. This is because once your provider is operating at a level that is above their breakeven point, any new business will only attract marginal costs and is therefore very profitable for the provider.

Before you’re ready to look at a vendor’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 rent for the premises 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 holidays are sold.

Variable costs, on the other hand, change with the volume of production. When manufacturing 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 all three.

Now that you’re familiar with these types of costs, you’re in a position to understand an important concept when analyzing a vendor’s costs: break-even analysis. Draw a break-even chart 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. Adding these two costs together 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 break-even point. In other words, it is the level of production at which the value of sales equals total costs. With production below this level, the supplier loses money. Above, the provider makes profit.

This can be very useful information to have in a negotiation. For example, if the supplier is currently operating above its break-even 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 £20 of business they make above their breakeven point, 70p is additional profit. You can negotiate with a supplier to share this…still giving them a profit but also giving you a discount.

A real win-win!