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Finance for Non-Financial Managers Fifth Edition

Finance for Non-Financial Managers Fifth Edition. Slides prepared by Pierre G. Bergeron University of Ottawa. Profit Planning and Decision-Making. Chapter Objectives.

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Finance for Non-Financial Managers Fifth Edition

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  1. Finance for Non-Financial ManagersFifth Edition Slides prepared by Pierre G. Bergeron University of Ottawa

  2. Profit Planning and Decision-Making Chapter Objectives • Explain various cost concepts related to break-even analysis such as fixed and variable costs, the relationship between sales revenue and costs, the contribution margin, the relevant range and relevant costs. • Draw the break-even chart and calculate the break-even point, the cash break-even point, and the profit break-even point, and how they can be applied in different organizations. • Differentiate between different types of cost concepts such as committed and discretionary costs, controllable and non-controllable costs, and direct and indirect costs. Chapter Reference Chapter 9: Profit Planning and Decision-Making

  3. Relevance of Break-Even Analysis Break-even analysis helps to: Price existing or new products and services. Decide whether to introduce a new product or service, open a new plant, hire a sales representative, open a new sales office, launch an advertising program. Modernize or automate an existing plant. Expand an existing plant. Change the cost structure (fixed versus variable).

  4. 1. Fixed and Variable Costs Fixed costs Period costs Constant costs Standby costs Characteristic Element of fixedness and must be paid with passage of time. Variable costs Direct costs Out-of-pocket costs Volume costs Characteristic Vary almost automatically with volume. Rent, interest, insurance, property taxes, office salaries, amortization, telephone Sales commission, direct labour, packing material, electricity, overtime premiums, equipment rental, truck expenses

  5. Connection Between Revenue and Costs Factors that affect profit: Volume of production Prices Costs (fixed and variable) Changes in product mix Cost per Unit (in $) G 16 14 12 10 H E F C D A B 40 60 80 100 % of Capacity

  6. PV ratio The Contribution Margin Sales revenue Less variable costs: Direct material Direct labour Total variable costs Contribution margin Less fixed costs: Manufacturing Administration Total fixed costs Operating profit $ 1,000,000 750,000 250,000 200,000 $ 50,000 $ 500,000 250,000 150,000 50,000 PV Ratio $250,000 $1,000,000 .25

  7. Revenue 10.00 Variable costs 2.00 Revenue$10.00 Insurance Contribution margin 8.00 Car payment (principal or amortization) 1,875 trips 15,000 8.00 Interest Break-even point Dispatcher fees Total costs Variable costs $2.00 Gas $15,000 Maintenance & repairs Fixed costs 5,625 trips 45,000 8.00 2. J. Smith’s Break-Even (Taxi Driver) $ $ $ $ Fixed costs Costs/Revenue $ $ = Variable costs $ $ = 6,000 Trips

  8. J. Smith’s Break-Even (Taxi Driver) With salary With salary No salary No. of trips Sales revenue ($10.00) Variable costs ($2.00) Contribution margin Fixed costs Salary Profit P.V. Ratio 6,000 $ 60,000 $ 12,000 $ 48,000 $ 15,000 $ 30,000 $ 3,000 .80 5,625 $ 56,250 $ 11,250 $ 45,000 $ 15,000 $ 30,000 0 .80 1,875 $ 18,750 $ 3,750 $ 15,000 $ 15,000 0 0 .80

  9. Finding the Break-Even Point Using the Formula Unit selling price $ 15.00 (P) Fixed costs $200,000 (F) Unit variable costs $ 10.00 (V) Break-even calculation Step 2: $200,000 ÷ $5.00 = 40,000 units (volume) Step 3: 40,000 units X $15.00 = $600,000 (sales revenue) Step 1: Contribution margin Selling price $15.00 Variable costs $10.00 Contribution margin $ 5.00

  10. Break-Even Point Calculation In Units Fixed costs Price per unit sold – Variable cost per unit or unit contribution B.E.P. = $200,000 $15.00 - $10.00 B.E.P. = = 40,000 units X $15.00 $ 600,000 In revenue Step 2: Find the sales revenue break-even point B.E.P. = = = $600,000 Step 1: Find the PV ratio PV = = = .333 Unit contribution Unit selling price $5.00 $15.00 $200,000 .333 Fixed costs PV

  11. Sales revenue 600,000 Variable costs 400,000 Contribution margin 200,000 Fixed costs 200,000 Profit/loss 0 Break-Even Point By Using the PV Ratio Finding the break-even point when units are not known, you need to re-structure the P&L statement $ $ $ $ $ Step 2: Find the sales revenue break-even point B.E.P. = = = $600,000 Step 1: Find the PV ratio PV = = = .333 Contribution Sales revenue $200,000 $600,000 $200,000 .333 Fixed costs PV

  12. Break-Even Point (Retail Store) Suits Jackets Shirts Ties Socks Overcoats Total No. of units 800 200 700 500 2,500 500 Unit selling price $300 $150 $50 $50 $8 $300 Sales revenue $500,000 Variable costs $275,000 25,000 Total variable costs $300,000 Purchases Sales commission Contribution margin $200,000 (rent, telephone, salaries, security system) Fixed costs $100,000 Profit $100,000 Contribution margin$200,000 Sales revenue $500,000 Fixed costs$100,000 PV ratio .40 50% of objective OK!!! = = .40 or $0.40 = = $250,000

  13. Cash Break-Even Point In Units Fixed costs - Amortization Price per unit sold – Variable cost per unit = $200,000 - $50,000$150,000 $15.00 - $10.00 $5.00 = = = 30,000 units In revenue = = = $450,000 Fixed costs - Amortization PV $150,000 .333

  14. Profit Break-Even In Units Fixed costs + Profit objective Price per unit sold – Variable cost per unit = $200,000 + $20,000$220,000 $15.00 - $10.00 $5.00 = = = 44,000 units In revenue = = = $660,000 $220,000 .333 Fixed costs + Profit objective PV

  15. Sensitivity Analysis Base case Break-even Break-even in units in revenue 40,000 $600,000 Change in Fixed costs (increased by $50,000 to $250,000) 50,000 $750,000 Selling price (increased by $0.50 to $15.50) 36,364 $563,642 Variable costs (decreased by $0.75 to $9.25) 34,782 $521,730

  16. Break-Even Wedges Company A Company B Revenue Revenue Total costs Total costs PV = .40 PV = .30 Fixed costs Fixed costs Company C Company D Revenue Revenue Total costs Total costs PV = .30 PV = .40 Fixed costs Fixed costs

  17. Where Break-Even Analysis Can be Used • Company-wide • Trucking operation • Plant • Direct mail advertising • District or sales territory • Taxi business • Retail store • Movie theatre • Production centre • Advertising program • Department store • Travel agency • Product/division • Hotel business • Service centre • Restaurant business • Machine operation • Book publishing • Airline business

  18. 3. Other Cost Concepts Committed costs: Costs that must be incurred in order to operate a business. Discretionary fixed costs: Costs that can be controlled by managers. Controllable costs: Costs that operating managers are accountable for. Non-controllable costs: Costs that are not under the direct control of managers. Direct costs: Materials and labour expenses that are directly incurred when making a product or providing a service. Indirect costs: Costs that are necessary in the production cycle but that cannot be clearly allocated to specific products or services.

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