Module 5.2 - Financial sustainability

Module 5.2.
FINANCIAL SUSTAINABILITY
NESsT
2018
Project co-funded by the European
Union funds (ERDF and IPA)

Financial Sustainability Module
• Congratulations, you’ve made it this far!
• This module builds on assumed knowledge acquired through the undertaking of
the last module
– Financial Management.
• In this section, you will learn about:
• Past performance analysis
• Performance management
• Projections

Financial Sustainability Module
The objective of this course are:
1. To familiarize the learners with the basic financial performance ratios.
2. To provide practical exercise for learners to analyze these ratios and their evolution.
3. To understand the concept of cost center performance management through
practical example.
4. To provide guidelines for learners on how to perform a simple financial performance
analysis on their own enterprise.

Past performance analysis
• Financial statements formats differ
from country to country. However,
differences from one statutory
framework to other are not
significant.
• If you are an Ltd. most probably,
your financial statements will
resemble this template of profit
and loss on the main categories:
Year 1
Sales revenue / turnover $$$$$$$
Cost of goods sold $$$$$
Gross profit $$$$$
Operating expenses
Payroll $$$$
Rent $
Utilities $
Marketing $
Other services $
EBITDA $$
(Earnings before interest,
tax, depreciation and
amortisation)
Interest $
Depreciation $
Taxable profit $$
Tax $
Profit after tax / net profit $$

• A social enterprise might benefit from other
types of revenues such as grants, subsidies
or revenues from the sales of fixed assets.
• From case to case, these may appear in
different places on the profit and loss
statement.
• Can be taxable or non-taxable.
• When analyzing performance, it is important to
exclude these revenues from ratio
computations as they are not incurred in the
normal course of business, hence they are not
relevant in determining operational efficiency.
Learning
points!
Year 1
Sales revenue / turnover $$$$$$$
Cost of goods sold $$$$$
Gross profit $$$$$
Operating expenses
Payroll $$$$
Rent $
Utilities $
Marketing $
Other services $
EBITDA $$
amortisation)
Interest $
Depreciation $
Taxable profit $$
Tax $
Profit after tax / net profit $$
Other revenue
Other revenue

Important performance indicators
Gross profit = Sales revenue less Cost of
goods sold (all variable costs)
Gross profit margin = Gross profit / Sales
revenue * 100
EBITDA = Gross profit less operating expenses
Operating profit margin = EBITDA / Sales
revenue *100
Profit after tax / net result = EBITDA less
interest, depreciation and tax
Net profit margin = Profit after tax / Sales
revenue *100
Year 1
Sales revenue / turnover 220,000
Cost of goods sold 170,000
Gross profit 50,000
Gross profit margin 23%
Operating expenses
Payroll 20,000
Rent 6,000
Utilities 1,000
Marketing 1,500
Other services 3,000
EBITDA 18,500
amortisation)
Operating profit margin 8%
Interest 4,000
Depreciation 1,000
Taxable profit 13,500
Tax 2,160
Profit after tax / net profit 11,340
Net profit margin 5%
Please observe other revenues are not part of the
performance indicators computation as they are a result of one-
off events and / or efforts outside the business course.!

? What is a good gross profit / operating profit / net profit ratio?
!
It depends. Profit ratios are typically benchmarked against
industry standards. A 25% gross profit ratio is generally
considered a good operational performance. However, it all
depends how much it is eroded by operating expenses and
interest.
?
!
Why is the difference between gross profit ratio and net profit
ratio so large?
Let’s take a look!
Year 1
Sales revenue / turnover 220,000
Cost of goods sold 170,000
Gross profit 50,000
Gross profit margin 23%
Operating expenses 31,500
Payroll 20,000
Rent 6,000
Utilities 1,000
Marketing 1,500
Other services 3,000
EBITDA 18,500
amortisation)
Operating profit margin 8%
Interest 4,000
Depreciation 1,000
Taxable profit 13,500
Tax 2,160
Profit after tax / net profit 11,340
Net profit margin 5%
63% of opex
19% of opex
10% of opex
22% of EBITDA
!
Payroll is heavy on the enterprise making up 63% from total
operating costs. The rent is also quite important making
up 19% of operating expenses. And the company is also
indebted, with interest eating up 22% of EBITDA.

? What is a business driver?
!
A business driver is a factor that determines
changes in the success and growth of a
business. It can influence the business in a positive
or negative way. A business driver can be internal
or external.
! Business drivers can be also grouped as costs,
revenue or investment business drivers.
!
Multiple year financial performance analysis
can highlight business drivers, hence helping the
company to react to changing circumstances.
Example of business drivers
Number of products in the portfolio for designer;
Number of retail shops for a retailer;
Capacity for a restaurant;
Average revenue per purchase for a coffee shop;
Average room occupancy for a hostel;
Gross profit margin;
Interest rate;
Exchange rate;
Tax rate etc.

Analyze the financial performance over the
3 years using gross profit ratio, operating
profit ratio and net profit ratio.
What are your observations?
Year 1 Year 2 Year 3
Sales revenue / turnover 220,000 700,000 450,000
Cost of goods sold 170,000 420,000 346,500
Gross profit 50,000 280,000 103,500
Operating expenses 31,500 158,000 102,500
Payroll 20,000 140,000 90,000
Rent 6,000 6,000 6,000
Utilities 1,000 3,000 1,500
Marketing 1,500 5,000 2,000
Other services 3,000 4,000 3,000
EBITDA 18,500 122,000 1,000
Interest 4,000 4,000 4,000
Depreciation 1,000 1,500 1,500
Taxable profit 13,500 116,500 (4,500)
Tax 2,160 18,640 -
Profit after tax / net
profit 11,340 97,860 (4,500)

Now, let’s do it together!
Gross profit margin improves significantly
between Year 1 and Year 2, but gets back at
23% in Year 3. Why do you think that
is?
Operating profit margin improves also
between Year 1 and Year 2 by 9%, far less
than the increase of 17% of gross profit
margin, but decreases to near 0% in Year 3.
What do you think is the reason for
this?
Net profit margin improves also by 9%
between Year 1 and Year 2 and becomes
a loss in Year 3.
Gross profit 50,000 280,000 103,500
Gross profit margin 23% 40% 23%
Operating expenses 31,500 158,000 102,500
Payroll 20,000 140,000 90,000
Rent 6,000 6,000 6,000
Utilities 1,000 3,000 1,500
Marketing 1,500 5,000 2,000
EBITDA 18,500 122,000 1,000
Operating profit
margin
8% 17% 0%
Interest 4,000 4,000 4,000
Taxable profit 13,500 116,500 (4,500)
Tax 2,160 18,640 0
Profit after tax / net
profit
11,340 97,860 (4,500)
Net profit margin 5% 14% -1%

Learning
points!
• The company was quite successful in securing revenue in Year 2.
The exponential increase of 218% shows that most probably a
new client was acquired or a new contract signed. However, this
turnover could not have been maintained and it drops by 36% in
Year 3.
• The company leverages economies of scale. Cost of goods
sold increases, which is normal, as revenue also increases, but
at a lower rate, only by 147%. This might mean the company was
able to negotiate some volume discounts or be more efficient
with production.
• Payroll costs have increased by 600%. It appears the
enterprise hired more and / or specialized staff to deliver on
the newly acquire contracts.
Revenue % evolution n/a 218% -36%
Cost of good sold %
evolution
n/a 147% -18%
Payroll 20,000 140,000 90,000
Payroll % evolution n/a 600% -36%
Rent 6,000 6,000 6,000
Utilities 1,000 3,000 1,500
Utilities % evolution n/a 200% -50%
Marketing 1,500 5,000 2,000
Marketing % evolution n/a 233% -60%
Interest 4,000 4,000 4,000
Depreciation % evolution n/a 50% 0%
Taxable profit 13,500 116,500 (4,500)
Tax 2,160 18,640 0
Profit after tax / net profit 11,340 97,860 (4,500)
Net profit % evolution n/a 763% -105%

Learning
points!
Cost of good sold %
evolution
n/a 147% -18%
Payroll 20,000 140,000 90,000
Rent 6,000 6,000 6,000
Utilities 1,000 3,000 1,500
Marketing 1,500 5,000 2,000
Interest 4,000 4,000 4,000
Taxable profit 13,500 116,500 (4,500)
Tax 2,160 18,640 0
• Utilities expenses increased in line with revenues, showing
perhaps increased use of production facilities.
• It is highly possible that increased spending in marketing (a
200% increase from Year 1) brought the additional increase in
revenue in Year 2.
• Interest expense remained flat, which is evidence that either
the contractual terms provide that interest is paid yearly on
the total amount withdrawn at the beginning of the contract
or otherwise that the company is not making any principal
payments. The increase in depreciation shows that some
new infrastructure was acquired.
Why did the company go from such a good profit in Year 2 to a
loss making position in Year 3??

Learning
points!
Cost of good sold %
evolution
n/a 147% -18%
Payroll 20,000 140,000 90,000
Rent 6,000 6,000 6,000
Utilities 1,000 3,000 1,500
Marketing 1,500 5,000 2,000
Interest 4,000 4,000 4,000
Taxable profit 13,500 116,500 (4,500)
Tax 2,160 18,640 0
• Look closely!
• Revenues decrease, but cost of goods sold do
not decrease with the same percentage,
causing the gross profit margin to erode by
18%. It is possible that the new revenue would
have come for new products for which the bill of
material is comprised of materials which are more
difficult to source or have prices very sensitive to
volume order changes.
• It appears that the enterprise hired much more staff or
at higher costs to deliver on the new contracts. The
payroll costs structure changes and in Year 2, Payroll
costs became 20% of revenues and it stays that way
in Year 3. Even if the payroll costs decrease by 36%,
in line with revenue, it is possible that in Year 2, the
enterprise over hired.

Cost of good sold %
evolution
n/a 147% -18%
Payroll 20,000 140,000 90,000
Rent 6,000 6,000 6,000
Utilities 1,000 3,000 1,500
Marketing 1,500 5,000 2,000
Interest 4,000 4,000 4,000
Taxable profit 13,500 116,500 (4,500)
Tax 2,160 18,640 0
Learning
points!
• What other scenarios are possible?
• There could have been a general increase in salary together
with hiring to deliver on new contracts during Year 2.
• The company might have launched a new line of products /
services and Year 2 saw the first sales materializing. The
company might consider to retain part of the newly hired staff
as it is expecting these sales to become mainstream revenue
in the future.
Cost of good sold %
evolution
n/a 147% -18%
Payroll 20,000 140,000 90,000
Rent 6,000 6,000 6,000
Utilities 1,000 3,000 1,500
Marketing 1,500 5,000 2,000
Interest 4,000 4,000 4,000
Taxable profit 13,500 116,500 (4,500)
Tax 2,160 18,640 0

• Observe how a change in one business driver affects performance: the company
managed to boost revenue in Year 2 (most probably as a result of sustained marketing efforts,
which shows in marketing costs) and this triggered a need to hire more people to sustain this
growth. Direct cost management was pretty efficient and cost of goods sold grew at a lower
rate than revenue.
Learning
points!
• Observe how no description of the company’s activity is provided, yet so many information about performance
can be derived from its financial evolution alone!
• In reality, you will know all about the business drivers of your enterprise, but a multiannual
past performance analysis will help you determine the effect of those changes on the
bottom line profitability of the business.

• Now, try the same analysis with your business!
• Determine gross profit margin, operational profit margin and net profit margin.
• Determine structure of operating costs: which costs hold the higher weight in
operating costs and why?
• Take a period of 3 fiscal years which you consider relevant for your business.
• Observe how these evolve over the years. What are the causes of this evolution?
• Determine evolution rates from year to year for revenue and all the major costs.
• What business drivers can you identify and how did they impact the business?

But I am an NGO and my financial statements look very different!
?
!
That is true, NGOs tend to have different reporting frameworks in
most countries than Ltd.
If your enterprise is in that category, most probably your
financial statements will look something like this:
This format is rather synthetic, but we will start to analyze it first!
Year 1
Non-profit activities revenue $$$$
Non-profit activities expense $$$
Non-profit activities result $
Commercial activities revenue $$$$
Commercial activities expense $$$
Commercial activities result $
Total revenue $$$$$$$$
Total expense $$$$$$
Final result $$
Often, social enterprises are not individually incorporated, but
function as an income generating arm of an NGO.

• Although the table does not offer generous information on
which to base a performance analysis on, it does offer some
important data.
• What are your observations?
• First and foremost, you would probably notice a profit
from non-profit activity.
• Allegedly, for NGOs, grant resources need to be
matched against expenses, so technically a profit
would not be possible.
• What do you think the positive figure under Non-
profit activities result represents?
Year 1
Non-profit activities revenue 500,000
Non-profit activities expense 400,000
Non-profit activities result 100,000
Commercial activities revenue 200,000
Commercial activities expense 150,000
Commercial activities result 50,000
Total revenue 700,000
Total expense 550,000
Final result 150,000

The positive result under Non-profit activities result is
not a profit per say, but the result of a timing
difference between the cash in of grant money and
the expenses matched against that respective
installment.
!
For example, let’s assume that a grant contract provisions for a
500,000 installment to be disbursed at mid year. The expense
budget for the next 6 months is 400,000, the remaining 100,000
would be spent in the next financial reporting period.
The organization would record the 500,000 received as an
installment as revenue, but only the portion actually spent
could be reported as an expense.
The remaining 100,000 presented as a profit is in fact
a cash reserve which would be matched against next
period’s budgeted expenses.
Year 1

Year 1
Unspent grant money 100,000
Commercial activities profit margin 25%
% commercial revenue in total
revenue
29%
What do you think about the income generating arm of this NGO?
Do you think it commercial activities are important to the NGO?
What comments can you make about the financial performance
of the commercial activities?
Do you see any potential issues with this model?
?

Year 1
revenue
29%
Learning
points!
• Commercial activities profit margin is 25%. This profit margin
would need to be benchmarked against industry standard to
determine if it is a competitive one.
• Commercial revenue makes up 29% of the total revenue of
the organization. This is a good position to start with, but it all
depends on the strategy of the NGO. Is the aim of commercial
activities to generate profit and contribute to increased financial
sustainability of the organization as a whole? Or its purpose is
different?

Year 1
revenue
29%
Learning
points!
• However, the main flaw of analyzing commercial activities
performance under this format is that it may harbor hidden
costs.
• It is often the case that social enterprises owned by NGOs use the
mother organization’s resources for free (staff, space, equipment)
• In this case, the 25% commercial activities profit margin is not a
real one, because the mother organization is supporting a part of the
business costs.
• So, what commercial costs could hide under non-profit activities
expense?

Year 1
revenue
29%
Learning
points!
Revised commercial
activities profit margin
18%
Revised commercial
activities expense
165,000
Revised commercial
activities result
35,000
SE Manager salary 15,000• Observe how the commercial
activities profit margin changes if
we include the social enterprise
manager’s salary in the overall
expense!
• All the facto expenses made by
the mother organization for the
purposes of commercial
activities must be included in
the commercial activities
expense when computing
commercial profit margin.

Learning
points!
• However, it is often the case that NGOs do not report all commercial activities expenses under
the right heading when submitting the statutory financial statements for various reasons
• Even so, as a management practice, for internal tracking purposes, commercial activities expenses
need to be tracked separately.
• Failure to consider all relevant expenses might put the organization in difficulty to price the products
or to accurately compute the breakeven point. That is why, NGOs that have a commercial revenue
making arm, even if not incorporated as a separate legal entity, are encouraged to maintain separate cost
centers for keeping track of commercial revenue and expense.
• Furthermore, the level of detail to which commercial expenses are being tracked should be the same
as shown in previous slides, in displaying the case of an Ltd.

Performance management
• Let’s start with an exercise!
Year 1 Year 2
Revenue 400,000 600,000
Expense 100,000 614,000
Profit / loss 300,000 (14,000)• Please comment on performance based on the figures
presented for the 2 years. As enterprise manager,
could you base any decisions on these figures?
• How about now? Year 1 Year 2
Revenue 400,000 600,000
Expense 100,000 614,000
Raw material 73,000 400,000
Labour 20,000 200,000
Utilities 5,000 10,000
Maintenance 2,000 4,000
Profit / loss 300,000 (14,000)
• Although a breakdown of expenses is available,
this doesn’t provide much more information as
compared to the first table.
Year 1 Year 2 Variations
Revenue 400,000 600,000 50%
Expense 100,000 614,000 514%
Raw material 73,000 400,000 448%
Labour 20,000 200,000 900%
Utilities 5,000 10,000 100%
Maintenance 2,000 4,000 100%
Profit / loss 300,000 (14,000) -105%• Variations show the enterprise managed an
increase in turnover of 50%, but the expenses rose
out of control at 514%. Out of all expense, labor
costs rose the highest, at 900%.
• But why?

Year 1 Year 2
Revenue 400,000 600,000
Product 1 400,000 500,000
Product 2 - 100,000
Expense 100,000 614,000
Raw material
Product 1 73,000 100,000
Product 2 - 284,000
Labour
Product 1 20,000 52,000
Product 2 - 164,000
Utilities 5,000 10,000
Maintenance 2,000 4,000
Profit / loss 300,000 (14,000)
Learning
points!
• We can observe now that the company has launched a new
product in Year 2 which is partially responsible for the
decrease in performance.
• The new product generates 100,000 in revenue, but takes
448,000 to produce. It might also be partially responsible
for
the increase in utilities and maintenance costs.
• It appears the enterprise started a new product line that is
currently making losses.
• However, we would be wrong to stop with the performance
analysis here.

Revenue 400,000 600,000
Product 1 400,000 500,000 25%
Product 2 - 100,000
Expense 100,000 614,000
Raw material
Product 1 73,000 100,000 37%
Product 2 - 284,000
Labour
Product 1 20,000 52,000 160%
Product 2 - 164,000
Gross profit margin
Product 1 77% 70% -7%
Product 2 n/a n/a
Utilities 5,000 10,000 100%
Maintenance 2,000 4,000 100%
Profit / loss 300,000 (14,000)
Learning
points!
• It appears that Product 1 also underperformed in Year 2.
• Its gross profit margin decreased by 7%.
• Raw material costs rose by 37%, by 12% more than revenues
which might be a sign of operational inefficiencies,
increases in the price of raw material
or changes in bill of material.
• An alarming increase of 160% in labor costs should
make management wonder whether labor efficiency
has decreased. It might also be possible that the
structure of staff changed, hence requiring an update in
payroll grid. However, some business driver change is
reflected by this important variation.

?
! The most important thing is to determine the exact cause of profitability decrease!
What would you do with regards to the underperformance of Product 1? Do you consider it
alarming? What steps would you take to prevent a continued decrease in performance?
!
In earlier slides, we presented several assumptions. For example, you would need to know if the 37%
increase in raw material cost is due to price increase of raw material or usage of more material (losses,
damaged products or change in bill or material). In order to have this information, separate evidence of
raw material unit prices and quantities used for both Product 1 and Product 2 is needed.
!
No lesser importance is to be attributed to labor costs variations. Are these due to increases in fixed
salary, overtime or bonuses? In order to have this information, separate evidence regarding labor
costs per hour and the hours needed to make the product for both Product 1 and Product 2.

Based on the performance analysis presented, would you discontinue Product 2? If so, why?
?
!
The correct answer is: it depends! It happens often that newly launched products generate losses for a
period of time. This might happen because the target public gets a while to acknowledge and try the
product. Most products take more than a year to reach breakeven point. However, raw material costs
are larger than revenue, which means the enterprise is not even making a gross profit. It appears that
the company is charging a price too small and cannot even cover the variable costs yet.
!
Last, but not least, the indirect costs which in this case are utilities and maintenance should be
allocated to products. Every category of costs needs to be analyzed separately to determine what is
the driver for that cost and establish a rule for allocation of indirect costs to products.
Cost-center approach. Keeping detailed records on the revenue and expense generated by each
product of the portfolio line is typically referred to as cost-center thinking. There might be other cost-
center records relevant for the enterprise as well such as cost and revenue per distribution channels,
cost and revenue per employee or department.
!

• Let’s practice the same exercise with a social enterprise
functioning under the umbrella of an NGO.
• What are your observations?
Non-profit activities revenue 500,000 900,000 200,000
Non-profit activities expense 400,000 700,000 100,000
Non-profit activities result 100,000 200,000 100,000
Commercial activities revenue 200,000 500,000 800,000
Commercial activities expense 150,000 300,000 400,000
Commercial activities result 50,000 200,000 400,000
Total revenue 700,000 1,400,000 1,000,000
Total expense 550,000 1,000,000 500,000
Final result 150,000 400,000 500,000

Unspent grant money 100,000 200,000 100,000
Commercial activities profit margin 25% 40% 50%
Total revenue 700,000 1,400,000 1,000,000
Total expense 550,000 1,000,000 500,000
Final result 150,000 400,000 500,000
revenue
29% 36% 80%
• Now, let’s try it together!
• We can observe that non-profit activities result
increases between Year 1 and Year 2. This is not
unusual, as often NGOs cash in installments on
payment schedules that differ from calendar
years. Hence, at cut-off point, there are high chances
that there are money unspent in the bank which is due
to be spent in the next calendar year.
Learning
points!

Unspent grant money 100,000 200,000 100,000
Commercial activities profit margin 25% 40% 50%
Total revenue 700,000 1,400,000 1,000,000
Total expense 550,000 1,000,000 500,000
Final result 150,000 400,000 500,000
revenue
29% 36% 80%
• Commercial activities profit margin increases
progressively throughout the years, displaying
increased operational efficiency.
Beware of potential hidden costs of business
under the non-profit activities expense.
• Overall, the enterprise seems to become more
sustainable over the years.
!
• Commercial revenue increases significantly and it
becomes the main stream of revenue for the
organization, reaching 80% of total revenues in
Year 3.
Learning
points!

Projections
In the course of doing business, regardless if social or commercial, almost any entrepreneur will find herself in
the situation of having to look forward into the future.
Regardless if done for a loan application or to determine if staffing plan is sustainable, financial projections
need to be made as accurately as possible based on the best information available at the time of the
planning.
So, what would be the best assumption at the time of planning?
?
When historical information is available, there is a best practice to start from past achievement. The
assumption behind this is that if nothing changes, the clients will continue purchase the products / services at
same level in the foreseeable future.
But rarely market realities remain flat throughout the time, hence historical based assumptions need
to be adjusted with market dynamics expectations.!
!

Projections
Let’s take the very simple case discussed in the previous
chapter, Performance Management.
Revenue 400,000 600,000
Product 1 400,000 500,000 25%
Product 2 - 100,000
Expense 100,000 614,000
Raw material
Product 1 73,000 100,000 37%
Product 2 - 284,000
Labour
Product 1 20,000 52,000 160%
Product 2 - 164,000
Gross profit margin
Product 1 77% 70% -7%
Product 2 n/a n/a
Utilities 5,000 10,000 100%
Maintenance 2,000 4,000 100%
Profit / loss 300,000 (14,000)
First, you would need to decide the structure of the
product portfolio.
Would you keep Product 2 or discard of it? Why?
How about Product 1? What would be your basis
of forecasting revenue and cost for this product?

Projections
In order to make realistic projections, more details on
historical performance would be needed!
Let’ try now!
Product 1. We notice the increase in revenue is
due to an increase in volumes sold. This might
show strengthening of market, building consumer
preference or perhaps weakening competition.
Before projecting Year 3 revenue, ask yourself the
following questions:
Is the price going to stay the same?
Is it safe to assume that the volume levels of Year 2
will maintain in Year 3 / decrease / increase by 25%
(the percentage growth between Year 1 and Year 2)
Revenue Prod 1 400,000 500,000 25%
Unit price 100 100
Volume 4,000 5,000
Revenue Prod 2 - 100,000
Unit price - 200
Volume - 500
Material Cost Prod 1 73,000 100,000 37%
Unit cost 18 20
Volume 4,000 5,000
Material Cost Prod 2 - 284,000
Unit cost - 568
Volume - 500
Labour Cost Prod 1 20,000 52,000 160%
Labour Cost Prod 2 - 164,000
Utilities 5,000 10,000 100%
Maintenance 2,000 4,000 100%
Profit / loss 300,000 (14,000)

Projections
Whatever the answer to these questions, it needs to be supported
by internal and external data!!
For example, let’s assume that you want to increase the
prices by 10%. Why do you plan for this increase? To be in
line with competition / cover additional costs connected to
product upgrade? Is 10% that a significant increase as
compared to inflation rate? Will customer react negatively to
this increase in prices and decrease purchases?
How about volumes?
Say that the 25% increase between Year 1 and Year 2 is due
to acquiring a new customer. Was the 1,000 units purchase a
one-off or is that expected to continue in the future?
For accurately projecting sales, it is important to
understand the causes of historical variations, the
likelihood they repeat and the market dynamics.
!
Revenue Prod 1 400,000 500,000 25%
Unit price 100 100
Volume 4,000 5,000
Unit price - 200
Volume - 500
Unit cost 18 20
Volume 4,000 5,000
Unit cost - 568
Volume - 500
Labour Cost Prod 1 20,000 52,000 160%
Utilities 5,000 10,000 100%
Maintenance 2,000 4,000 100%
Profit / loss 300,000 (14,000)

Projections
Revenue Prod 1 400,000 500,000 25%
Unit price 100 100
Volume 4,000 5,000
Unit price - 200
Volume - 500
Unit cost 18 20
Volume 4,000 5,000
Unit cost - 568
Volume - 500
Labour Cost Prod 1 20,000 52,000 160%
Utilities 5,000 10,000 100%
Maintenance 2,000 4,000 100%
Profit / loss 300,000 (14,000)
Analogously, we notice unit cost has risen from 18 per
unit to 20 per unit. What caused this variation? Was it
an increase in supplier price? Change of bill of material
that triggered a larger quantity to be used or perhaps
more expensive materials? Is this increase due to
operational inefficiencies?
Knowing the exact cause of unit cause increase, you
apply sound judgement and determine whether unit
costs will likely stay flat or expected to increase over
time. It will also give you the more realistic estimation
of cost in the foreseeable future.
In financial forecast, it is a good practice to project
conservatively which means the revenues would be
projected at the lowest figure out of several outcomes
possible and expenses at the highest or at least moderate
figure out of several outcomes possible.
!

Projections
Revenue Prod 1 400,000 500,000 25%
Unit price 100 100
Volume 4,000 5,000
Unit price - 200
Volume - 500
Unit cost 18 20
Volume 4,000 5,000
Unit cost - 568
Volume - 500
Labour Cost Prod 1 20,000 52,000 160%
Utilities 5,000 10,000 100%
Maintenance 2,000 4,000 100%
Profit / loss 300,000 (14,000)
For projecting all the other costs, you need to identify
what drives these costs and how are they
connected with changes in revenue.
!
For example, labor costs recorded an increase of 160%,
which changed the proportion of labor costs from 5% from revenue
to 10% of revenue. This might be due to an overall increase in salaries,
production bonuses, changes in staff structure.
Is this change permanent? Are salary increases
planned in the future? In what amounts and when? Are
new hires going to join the team? What would be their
seniority level and compensation?
It is safe to assume that a certain size of the production
team will have a limited capacity of production, hence
increases in revenue levels need to come with step
increases in labor costs as production teams exhaust their
capacity.
!

Projections
Revenue Prod 1 400,000 500,000 25%
Unit price 100 100
Volume 4,000 5,000
Unit price - 200
Volume - 500
Unit cost 18 20
Volume 4,000 5,000
Unit cost - 568
Volume - 500
Labour Cost Prod 1 20,000 52,000 160%
Utilities 5,000 10,000 100%
Maintenance 2,000 4,000 100%
Profit / loss 300,000 (14,000)
Other costs such as utilities and maintenance might
have different drivers.
For example, utilities expenses will most likely vary
with production levels, while maintenance expense
will depend on the size and age of production
infrastructure.
In the present case, 4,000 units of Product 1 generate
5,000 as utilities expense. Extrapolating, 5,000 units of Product 1
sold in Year 2 will consume utilities in amount of 6,250.
Hence the balance of 3,750 could be attributed to Product 2,
representing 4% of revenue generated by Product 2.
Maintenance expense has doubled. This is either
because Product 2 needs a different infrastructure to be
produced or perhaps equipment is aging and needs
more frequent servicing. If the latter, then progressive
increase in these expenses needs to be taken into
consideration when projecting for the remaining useful
life of assets.

Projections
Revenue Prod 1 400,000 500,000 25%
Unit price 100 100
Volume 4,000 5,000
Unit price - 200
Volume - 500
Unit cost 18 20
Volume 4,000 5,000
Unit cost - 568
Volume - 500
Labour Cost Prod 1 20,000 52,000 160%
Utilities 5,000 10,000 100%
Maintenance 2,000 4,000 100%
Profit / loss 300,000 (14,000)
Product 2. This product requires a strategic decision on whether
to be discontinued or not.
In Year 2 it sold 100,000 worth of revenue, ¼ of Product 1.
Whether this is an achievement or not, it needs to be analyzed vs.
competition and market trends.
However, the main problem with this product is that it sold for
200 per unit and consumed materials worth of 568 per unit,
almost three time the price before even considering labor costs.
Hence, in deciding to continue Product 2, you must make sure
that either:
• High material costs are due to operational causes (perhaps
overconsumption of material due to learning curve – first
production cycle) that can be remediated through mitigating
actions;
• If 568 is the real material costs and production is streamlined,
then this should be passed onto the customer via price
increase.

Projections
Revenue Prod 1 400,000 500,000 25%
Unit price 100 100
Volume 4,000 5,000
Unit price - 200
Volume - 500
Unit cost 18 20
Volume 4,000 5,000
Unit cost - 568
Volume - 500
Labour Cost Prod 1 20,000 52,000 160%
Utilities 5,000 10,000 100%
Maintenance 2,000 4,000 100%
Profit / loss 300,000 (14,000)
With a very short history of being into existence, Product 2 has a weaker
base for projection on historical performance. Hence external market
data will be highly relevant as well as internal capacities.
!
For example, it is to be determined if the team structure that gave
rise to labor costs of 164,000 is the optimum for this product and
whether the team worked at full capacity.
Computation of breakeven point for this product would be useful
as well as comparison with the market. Will the enterprise be able to
achieve the market share that would allow it to at least cover variable
and allocated fixed costs to Product 2?

Wrap-up and conclusions
Performance analysis, performance management and projections have a common
denominator: historical evolution of financial indicators gives important information about
the drivers of the business.
Cost-center thinking and detailed cost center evidence is mandatory for obtaining relevant
insights regarding past performance, planned performance and financial projections.
A good understanding of the business model is a base for realistic planning when you can
connect variation of expenses with revenue evolution and explain all variances using
market dynamics and internal operations facts.
While historical performance is a good starting base for financial projections, assumptions always
need to be substantiated by market data and internal operations data.
“Without data, you are just another person with an opinion.” W. Edwards Deming

Module 5.2 - Financial sustainability

Recommended

Recommended

More Related Content

What's hot

What's hot (17)

Similar to Module 5.2 - Financial sustainability

Similar to Module 5.2 - Financial sustainability (20)

More from szpinter

More from szpinter (14)

Recently uploaded

Recently uploaded (7)

Module 5.2 - Financial sustainability