View stunning SlideShares in full-screen with the new iOS app!Introducing SlideShare for AndroidExplore all your favorite topics in the SlideShare appGet the SlideShare app to Save for Later — even offline
View stunning SlideShares in full-screen with the new Android app!View stunning SlideShares in full-screen with the new iOS app!
Break - Even Analysis (Cost/Volume/Profit Analysis)
This is a planning and control technique.
make informed decisions about pricing your product or service and the cost to produce it.
compare your actual results with those that you have forecast. (For example, your restaurant may require you to sell 10,000 meals at $10.00 per meal = $100,000 in order to break even annually. This works out to 192 meals a week or 28 per day. If on the first day of operation you sell 30 meals…you are on track to break even!)
Break - Even Analysis (Cost/Volume/Profit Analysis)
The break-even point can be found using the following equation:
If sales are expected to push the firm beyond its current physical capacity, (beyond the relevant range) cost behaviour assumptions must be revised.
$ of Sales and Costs # of units produced and sold Total Revenue Total Costs Fixed Costs Relevant Range
Break - Even Analysis (Cost/Volume/Profit Analysis) Number of units produced and sold $ of Sales and Costs Total Revenue Line 1 2 $20 $10 The slope of the revenue line is determined by the price that you set for your product or service. Sales revenue when price per unit is $10.00.
Break - Even Analysis (Cost/Volume/Profit Analysis) Number of units produced and sold $ of Sales and Costs Total Revenue Line 1 2 $20 $10 The slope of the revenue line is determined by the price that you set for your product or service. Sales revenue when price per unit is $5.00.
Break - Even Analysis (Cost/Volume/Profit Analysis) Number of units produced and sold Total Revenue Line $7.50 $10 Total Variable Cost Contribution Margin per unit = $2.50 The slope of the revenue line is determined by the price that you set for your product or service. $ of Sales and Costs 1 2 If variable cost per unit is less than price per unit, there is a positive contribution margin.
For most small businesses, it is relatively easy to determine the variable cost per unit.
What you want to determine is how much it costs you in terms of direct material and direct labour to produce your product or service.
Once you know the variable cost per unit, this becomes a good guide to you in the pricing decision. Obviously, if you price your product under your variable cost per unit, you will lose money each time you sell one unit. The more you sell, the more money you lose.
The average customer will purchase a dozen bagels, some cream cheese and a coke.
You have determined that your variable costs to produce this ‘average customer purchase’ as follows:
Variable Cost per unit
Coke and cup $0.85
12 Bagels cooked (materials and electricity) 2.99
Cream cheese and container 1.65
Straw/napkins/bag and other condiments 0.75
Direct labour costs (counter help & cook) 2.75
Total variable cost per unit $8.99
Given your analysis you initially price coke at $2.00 and a dozen bagels with cheese for $8.50 giving you a contribution margin of $1.51 per unit. Total cost to the customer is $10.50 plus PST and GST or $12.08
You now find out that the Great Canadian Bagel sells coke for $1.75 and a dozen bagels with cheese for $6.50 for a total cost to the customer of $9.49 (including Gst and Pst)…this is below your estimated variable cost per unit!
The Great Canadian Bagel is a franchise that benefits by the fact that the franchisor has tremendous buying power (centrally negotiates purchases and prices with suppliers for flour, cream cheese and coke). This gives them a competitive advantage over you...
Variable Cost per unit Great Canadian Bagel
Coke and cup $0.85 $0.45
12 Bagels cooked (materials and electricity) 2.99 1.50
Cream cheese and container 1.65 1.20
Straw/napkins/bag and other condiments 0.75 0.50
Direct labour costs (counter help & cook) 2.75 2.75
Faced with this pricing and costing analysis, you have some choices:
forget about going into this business
seek to negotiate arrangements where your direct operating costs can be lowered
devise a product or marketing strategy that would induce consumers to purchase your products over the Great Canadian Bagel product (higher quality product, perceived greater value that justifies the higher price)
seek to locate your business somewhere there is no direct competition. (Nipigon, Marathon, Atikokan, Sioux Lookout)
Of course, further analysis will be required (before proceeding) to determine whether you could actually make a profit at the business.
Let us assume for a moment that you have decided to locate your proposed business in Nipigon where you are sure that there is no competition, and it is unlikely competition would enter the market after you arrive.
You estimate that once established, you will face the following fixed costs each year to run the business:
Annual building lease costs (12 months @ $2,000/month) $24,000
Capital assets such as buildings and equipment and land are very costly, but usually have a useful life of greater than one year.
Buildings and equipment tend to wear out over time (ie. They have a useful life of perhaps 10, 20 or 30 years)
Land doesn’t wear out.
The cost of the buildings and equipment is spread out over their useful lives, and only the amount of wastage (wear and tear) is deductible from income in that year for the purposes of calculating taxes.
CCRA predominantly uses one method of depreciation…it is known as Capital Cost Allowance.
CCA gives rise to a ‘Tax Shield Benefit’ to the Company
CCA is a non-cash deduction from income that would otherwise be subject to income taxation.
As a result of the CCA deduction, taxable income is reduced.
This results in a savings in tax payable.
The tax shield benefits is equal to: T(CCA)
t = corporate tax rate
CCA = the dollar amount of CCA claimed
A firm with a 40% corporate tax rate and a $2,000 CCA deduction will save $800 in taxes.
4 K. Hartviksen
Example: Consider two firms that report $10,000 in earnings before CCA and taxes, face a 40% tax rate. One firm has no CCA to claim, the other can claim $2,000 in CCA
Company A Company B
Earnings Before CCA & Tax $10,000 $10,000
CCA 2,000 0
Taxable Income $ 8,000 $ 10,000
Taxes @ 40% 3,200 4,000
Net Income $ 4,800 $ 6,000
Add back non-cash expense 2,000 0
Cash flow from Operations $ 6,800 $ 6,000
5 K. Hartviksen Note that company A is better off by $800 because of the $2,000 non-cash deduction of CCA. That is the amount of taxes saved.
Assets are grouped into pools or classes and depreciated as a group
CCA rates are found in the regulations to the Income Tax Act and can be changed by Order-in-Council
There is no need for an estimate of salvage value or useful life
1/2 of the regular CCA rate for the class applies to the net additions to the pool for that year.
CCA cannot be used to create a tax loss.
7 K. Hartviksen
CCA Over Time - A Simple Example Assume you acquire a depreciable asset with a cost base of $100,000 and there are no other assets in this pool. The CCA rate for the pool is 10%. Note you are allowed only 1/2 the regular CCA rate on the net additions to the pool in the year of acquisition. 8 K. Hartviksen
The initial estimate can and probably will be revised depending on your first iteration of the forecasts.
Separate the estimate into two categories:
Fixed assets (plant and equipment)
You do this because when you look for financing for these investments, the fixed assets can usually be pledged as collateral for any borrowing, whereas the working capital needs usually has to be financed out of the owner’s equity.
Planning to have cash available to pay bills of the business as they become due is a critical aspect of business survival…it is a management skill.
Understanding the cash flow cycle of a firm can help you manage those elements that are critical to ensuring you can pay your bills.
Cash flow forecasting through a cash budget provides important information to you and to your potential funding partners about your operating financial needs and most particularly, the timing and magnitude of any projected cash deficits or surpluses.
Cash and Materials Flow Shareholders’ equity Debt Cash Taxes Cash Sales Raw Materials Inventory Finished Goods Inventory Work-in-process Inventory
allow us to forecast the cash flows of a firm over time (between balance sheet dates).
identifies the timing and magnitude of expected cash surpluses and deficits - thereby providing the manager with the opportunity to prepare, in advance, to finance expected deficits, or to invest surpluses.
may be used as the basis for pro forma financial statements.
a ratio is just one number over another number. If the ratio is ‘poor’ when compared to something else, it could be a result of the numerator, or the denominator, or both.
a ratio is just a number. It must be compared to something else if it is to begin to take on some meaning. Common comparators include:
industry average ratios
historical ratios for the firm itself
other current ratios for the same firm
it is important to take the ‘context’ into account when interpreting the financial performance of the firm...what industry is the firm in? how rapidly has the firm been growing? what is happening in the industry?
ratio analysis is a starting point in analyzing the firm. It must be supplemented by analysis of the overall economy, the industry, etc.
You can see from the common size data, that this firm differs from the industry in overhead costs and in interest expense. Without further information it is difficult to draw any specific conclusions, however, you should note, that direct operating costs are in line with the industry. Why is selling and admin. expenses double that of the industry? The firm’s fixed financing costs are low...is it just low cost or are they using less debt than others in the industry?
Your business plan forecasts your firm’s future financial performance.
Conduct ratio analysis on your forecast position
determine whether you should pursue your plans
revise your plans….
Role of Ratios in Your Business Plan Prepare Pro Forma Financial Statements based on your business plans Analyze your forecasts using ratio analysis Once you are satisfied with your forecasts…proceed to raise the capital and implement the plan Revise plan if necessary
The Articulation of forecast Income Statements and Balance Sheets
Articulation refers to the fact that the forecast income statements and balance sheets are integrally linked.
Assets like building and equipment are stated on the balance sheet at their net value (net of depreciation)
The retained earnings account on the balance sheet will be the accumulated retained earnings over time as found historically on the income statements. (The difference between last year’s R/E balance and next years, is the amount of income after tax that is retained in the firm.)