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**The Cigar Box® Method Profit calculations made easy**

by Olivier van Lieshout Global Facts Dear Teacher and Student, This PowerPoint has a HANDOUT. Teachers are suggested to follow the guidelines provided as exactly as possible. I suggest to use five simple rules: Questions are underlined. Take time to wait for an answer. Get everybody’s involvement. Don’t try to save time by allowing Mrs WiseGirl, or Mr WiseGuy to quickly give all the answers. Probe other students as well. Suggestions to write on the whiteboard (or blackboard, whatever is available) are bold italic. Use your own experience to expand. Don’t skip questions/answers/exercises. Don’t click before it is indicated. Some exercises and slides are OPTIONAL. In the interest of time they may be skipped, or given to be reviewed at home. Your feedback is welcome.

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**Cigar Box method CB1: cost price for one single product**

CB2: cost price for a range of products CB3: cost price monitoring on a daily basis CB4: investment analysis CB5: value chain analysis CB6: pyramid analysis Visit: for free downloads. CB1 calculates cost price, gross margin, contribution and break even of a single product. With 22 figures, to be entered in the spreadsheet boxes below, a complete picture is obtained of the profitability of a product. Scenarios and sensitivity analysis can be carried out by simply changing the figure in a box. The percentages can be used to benchmarks the cost price: are we cheaper, more expensive or average? CB2 is a planning tool. It helps decisions to expand or shrink your portfolio of products. It contains multiple CB1 sheets: one sheet for each SKU. CB3 is a monitoring tool. It helps management to track production cost for each SKU and every day. CB4 is an investment analysis tool. It creates the basic financial tables to make an investment decision and calculates if you can obtain a loan or not. CB 4 assumes that you know the cost price, gross margin and contribution of all your products. CB4 is the oldest Cigar Box and has been used over 12 year. Most of the pre-investment studies implemented by Global Facts were made with this instrument. The CB4 Cigar Box uses 7 tables which serve as input and output at the same time. CB5 provides a simple, one spreadsheet solution to calculate prices and margins for a single product in a supply chain from producer to trader, exporter, importer, retailer. It also calculates who makes a profit and who does not earn enough to make a living. The system of Living Wage, used in the Fair Trade business, is used to compare earnings with the need of a person to make a living. In all Cigar Boxes figures in BLUE are assumptions, figures in BLACK contain formulas and links and should not be edited, unless the user is skilled in excel.

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**Contents CB1 training The five profit parameters Calculating profit**

Filling the Cigar Box Get a laptop and practice!

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**Part 1 The five profit parameters Learning objectives:**

There are only five profit parameters. Difference variable and fixed costs. Difference bookkeeping and cost accounting.

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**How to calculate profit ?**

PROFIT / LOSS Tax (5) REVENUES UP COSTS REVENUES - P (1) q (2) VC (3) FC (4) x + COSTS DOWN The egg is a company. Click1. It produces a profit or a loss. Click2. Question: What makes profits to go UP? After answers, Click3. Revenues. Click4. Question: What makes losses to go DOWN? After answers, Click5. Reduction of costs. Click6. So, profit is revenues Click7. minus Click8. costs. Click9. Revenue is a multiplication. Question: what multiplied by what? After answers, Click10. Price, ok. Question: Price is a function of what? What influences the price? After answers, Click11. So, price is mainly influenced by demand and supply and by quality. There are also other factors of course. Question: revenues is price multiplied by what? After answers, Click12. Quantity, volume, ok. Question: what influences the quantity you can sell? After answers, Click13. So, the quantity you can sell of a certain product is mostly influenced by its price and quality, but also by market access, i.e. through which market channels (shops, traders, internet) can you reach your customers. Again, other factors maybe important too. Click14. Now it becomes a little more difficult. Costs are the sum of two components. Question: costs is what summed up by what? After answers, Write on the white board: VC = variable cost, FC = fixed costs. Explain: VC must vary with the quantity produced. No production, no cost. FC does not vary with the quantity produced, they are fixed per month, per year. Click15. Let’s first look at VC, variable costs. Question: which VCs can you think of when producing a 1-liter bottle of water? After answers. Click16. Write on the white board: Variable costs are the sum of: VC1 – raw materials and ingredients (the inputs), VC2 – processing cost like casual labor, energy, fuel (needed for converting inputs into outputs), and VC3 – primary and secondary packaging. Further explain: variable cost are expressed per unit, like the price, e.g. in $/kg. Therefore, VC must be multiplied by the quantity produced to find the total variable costs. Click17. Let’s now look at fixed costs. Question: what types of fixed costs can you think of when, again, producing bottles of water? After answers, Click18. Write on the white board: Fixed costs are the sum of: FC1 – depreciation, FC2 – interest and FC3 – overheads. Click19. Question: finally, what lastly influences the profit? After answers, Click20. Yes, taxes. Question: what influences the amount of taxes to be paid? After answers, Click21. Creative bookkeeping and connections! P = price q = quantity sold VC = variable cost (raw materials, processing, packaging) FC = fixed cost (depreciation, interests, overhead) Tax = taxes, duties (creative bookkeeping, connections, …)

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**But four can be influenced by the entrepreneur!**

Profit parameters There are ONLY FIVE parameters P Price (per unit) VC Variable cost (per unit) q Quantity (in units per period) FC Fixed cost (per period) T Tax % of profit (per period) Note: q, FC, T must always refer to the same period. But four can be influenced by the entrepreneur! Click1. Question: there are only five parameters that you need to calculate profit. Can you list them? Write CORRECT answers on the whiteboard. After answers are exhausted: Click2-3. Explain that both P (price) and VC (variable cost) are always expressed per unit. Provide examples from your own experience: price of bread per loaf, price of maize per bag, price of sugar per kg. VC of a bottle of water, per bottle; VC of a leather bag, per bag; etc. Click4. Explain that it is international convention to write q in small letters, as opposed to the others, which are written in CAPITAL LETTERS (you can’t help it either!). Provide examples, such as: number of bags sold per month; quantity of dolls produced per day; etc. Click5. Stress that FC is always expressed per period. Provide examples, such as: rent per week, salaries per month; marketing cost per quarter; taxes per year. etc. Click6. Explain that T refers only to profit tax, it is expressed as a % of the profit. Other taxes, like land tax, road tax, social taxes are included in the fixed costs. Click7. Explain that it is not possible to work with a quantity per month, while using the fixed costs per year. Click8. Explain that the entrepreneurs cannot influence Taxes and therefore these are not considered in the rest of this lecture. Fiscal specialist can help better.

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**Profit parameter 1: Price**

Price has many components: Price Click1. but, with many components. Click2. First let’s look at the price of a product. When invoiced, a price must always state the INCO-term and the place. Write on whiteboard. “The price is $18 CIF Rotterdam”. Question: what does this mean? After answers: Click3. The delivery terms are called INCO-terms, they are standardized by the International Chamber of Commerce. In profit calculations, we work only with EXW, the Ex Works price. This is the net price we receive to pay the goods from the factory. All delivery costs, transport, port handling, insurance, commissions have to be subtracted from the invoiced price to arrive at the Ex Works price. I suggest, in the interest of time, not to elaborate this point. You can refer to the other ACCESS! Module dealing with INCO-terms.

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**Profit parameter 2: VC Variable cost has four main components: VC**

VC1 Cost of raw materials and ingredients VC2 Cost of processing inputs into outputs VC3 Cost of packaging VC4 Cost of delivery transport, sales commission, import duties Click1. Variable costs have three components. Click2. Read aloud all three categories. How these are calculated is explained in Part 3. Click5. The real challenge of profit calculation is to obtain correct information. Where to obtain correct data ?

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**Internal & external VC Internal are all VCs inside the factory:**

VC1 Cost of Ingredients VC 2 Cost of processing VC3 Cost of packaging VC = VC1 + VC2 + VC3 External are VCs outside the factory: VC4 Cost of delivery P(C&F) – VC4 = P(EXW) VC4 = P(C&F) – P(EXW)

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**Profit parameter 3: quantity**

q = actual quantity sold per period qCAP = quantity at full capacity utilization quantity/hour * hours/day * days/year (harvest season) 3 ton/hour * 22 hours/day * 90 days/yr = 5940 ton/year qBE = break-even quantity, where profit = 0 Click1. q (we always small letter, unlike the other symbols which are in CAPITAL LETTERS). q= the actual quantity sold in a certain period (not the quantity produced!). Usually per year. Click2. q CAP is a reference figure: how much can we maximally produce (and thus sell) per year? Question: who knows the formula for calculating the maximum capacity. After answers: Click3. read the formula aloud. Click4. This is an example. (If you wish, you can make more examples on the whiteboard). When ready: Click5. q BE is the break-even quantity sold, that is: the quantity where the profit is zero.

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**Profit parameter 4: FC Fixed cost has three main components: FC**

FC1 Depreciation of fixed assets FC2 Interest paid on capital FC3 Overhead salaries, repairs, transport, marketing, etc Click1. Fixed costs also have three components. Click2. Read aloud all three categories. How these are calculated is explained in Part 3. Click5. The real challenge of profit calculation is to obtain correct information. Where to obtain correct data ?

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**Recognize costs - exercise**

Are the following Variable or Fixed costs? Ingredients Labels Bank charges Machine repair Raw material transport Product transport Depreciation Social tax Diesel for the boiler Electricity in the factory Electricity in the office Casual labor Management salary Detergents and gloves Interest on loans Carton boxes Click1. Read aloud. Click2-9. Read aloud and let students answer. Answers: 1=VC, 2=FC, 3=VC, 4=FC, 5=FC, 6=VC, 7=FC, 8=FC Click10. Let students write the answers on paper, maximally 2 minutes. Review the answers: 9=VC, 10=VC, 11=FC, 12=VC, 13=FC, 14=VC, 15=FC, 16=VC. OPTIONAL Assess the score of the students. If the average score is below 75% (6 good answers per student), repeat the operation using the first block.

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**Part 2 Calculating profit Learning objectives: Margin & Contribution**

Cost price calculation Profit calculation formulas Difference bookkeeping and Cigar Box method

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**Five profit parameters + three analysis parameters**

P = price q = quantity VC = variable cost FC = fixed cost T = taxes Margin, Contribution, Cost price

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**Margin and contribution**

What is MARGIN? Margin = earnings per unit Margin = price – variable cost per unit Margin = P – VC What is CONTRIBUTION? Contribution = earnings per period Contribution = margin per unit * units sold Contribution = (P – VC) * q

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**Three calculation methods**

Bookkeeper’s method Trader’s method Cigar Box method

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**“Total revenue, minus total cost is profit”**

Profit formula 1 Bookkeeper’s method Profit = Revenues – Total costs Formula: Profit = P*q – (VC*q + FC) “Total revenue, minus total cost is profit”

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**Profit formula 2 Trader’s method Profit = Profit per unit * Units sold**

Profit = (P – VC – FC/q) * q “Price less total cost per unit, multiplied by the number of units is the profit”

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**Profit formula 3 Cigar Box method Profit = Contribution – Fixed costs**

Profit = (P – VC) * q – FC “Price less variable cost is the margin per unit, multiplied by the number of units is the contribution, minus fixed cost is profit”

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**Three profit calculation methods**

Bookkeeper’s method Profit = P*q – (VC*q + FC) Trader’s method Profit = (P – VC – FC/q) * q Cigar Box method Profit = (P – VC) * q – FC P = 10, q=10, VC=5, FC=30 = 10*10 – (5* ) = – ( ) = 100 – 80 = 20 = (10 – 5 – 30/10) * 10 = (10 – 5 – 3) * 10 = 2 * 10 = 20 = (10 – 5) * 10 – 30 = 5 * 10 – 30 = 50 – 30 = 20

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**Cost price formula Is cost price calculated per period or per unit?**

Answer: per unit! $0.40 per kg; $30 per carton; $23,000 per car What is the formula? Answer: TC/q = VC + FC/q In words: Cost price per unit = variable cost + fixed cost per unit

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**Cost price calculation**

Formula: TC/q = VC + FC/q P = 10, q = 10, VC = 5, FC = 30 Cost price per unit = /10 = = 8 P = 10, q = 15, VC = 5, FC = 30 Cost price per unit = /15 = = 7 Is the cost price a constant figure? Answer: no, it fluctuates with q, the quantity sold! Variable cost is fixed & Fixed cost is variable…. Therefore: the Trader’s method is not used!

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**Comparing the other methods**

Bookkeeping: P*q – (VC*q + FC) – T = PAT Sales per period Costs per period Taxes per period Cigar Box: (P–VC) * q – FC – T = PAT Margin per unit units per period per period Contribution per period End result: is the same! This slide compares the structure of the two formulas and concludes that, whatever formula is being used, the end result will be the same.

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**Why Cigar Box method? Bookkeeping: Cigar Box: Profit yr 2: up 25%**

Click1. Let’s first look at the bookkeeping. Click2. In year 1, the company sells The variable costs for inputs cost The contribution was 700. Deducting fixed costs of 500 leaves a profit of 200. Click3. In year 2, the company receives more orders for B (20 units) and for C (13 units). The profit goes up to 250. Click4. That means an increase of 25%. The bookkeeper suggests to uncork the champagne! Question: you join the bookkeeper in his celebrations? Click5. Let’s now look what Cost Accounting does. Click6. Same company, year 1. The cost accountant calculates the actual inputs used during production. Product B uses 160, while the sales price is only 150. The margin is -10! The more the company sells, the bigger the losses… Click7. In year 2, the company, unable to change the price or the inputs utilization, decides to cancel the orders for B and produce only A and C. Result: profit increases to 450. Click8. An increase of 125% compared to the year before. The champagne tasted real good that year. Question: And what happened to the bookkeeper? Question: why do you think the order for B increased by 100%? Answer: product B was obviously too cheap, and that must have been why new orders came in fast. In other words: the bookkeeping method (calculate only per period) conceals the losses of B by the profits from products A and C. The cost accounting method calculates the cost and margin per unit and reveals the loss of B. New sales orders can take this into consideration. Question: can you give an example of a situation where the company accepts to take the losses in B? Profit yr 2: up 25% Profit yr 2: up 125%!

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**Profit parameters (repetition)**

There are ONLY FIVE parameters P Price (per unit) VC Variable cost (per unit) q Quantity (in units per period) FC Fixed cost (per period) Tax Tax % of profit (per period) Not more! Question: How many parameters influence profit after tax? Write CORRECT answers on the whiteboard. After answers; Click1. Five! Question: Which parameters are these? And are theyexpressed per period or per unit? After answers; Click2-6 and read aloud Click7. But… (continue without asking questions)

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**Analysis parameters per unit or per period?**

Margin is….? Margin per unit Margin = price – VC Contribution is….? Contribution per period Contribution = margin * q Cost price is ….? Cost price per unit Variable cost + Fixed cost per unit = VC + FC/q That’s all

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**Recognize costs - exercise**

Which cost types are these? Apples Stickers Bank commission Repair on evaporator Sugar transport Transport crates of beer Depreciation Pension payment Furnace oil for the boiler Electricity in the factory Import duties Harvest labor Management perks Detergents and gloves Sales commission Beer creates Click1. Read aloud. Click2-9. Read aloud and let students answer. Answers: 1=VC, 2=FC, 3=VC, 4=FC, 5=FC, 6=VC, 7=FC, 8=FC Click10. Let students write the answers on paper, maximally 2 minutes. Review the answers: 9=VC, 10=VC, 11=FC, 12=VC, 13=FC, 14=VC, 15=FC, 16=VC. OPTIONAL Assess the score of the students. If the average score is below 75% (6 good answers per student), repeat the operation using the first block.

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**Part 3 Using the Cigar Box Learning objectives: Filling the Cigar Box;**

Analyze the results! Importance of capacity utilization.

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**profit P FC VC q P-VC profit per unit Break-even Capacity Utilization**

contribution This is the Cigar Box. There are 2 columns and 8 boxes. In the left column, all amounts are per unit; in the right column, the amounts are per period. In the left column in this example, the unit is USD per ton. Others are: KES per lb; Euro per drum; etc. In the right column in this example, the unit is USD per year. Obviously the currency in both columns must be the same. For ease of comparison it is important to standardize these units. === This example is for profit calculation of tomato paste 25 Brix. It is processed from fresh tomatoes of 4.5 Brix. Tomato paste is packed in aseptic bags of 220 kg, packed in a steel drum. One Cigar Box sheet must be used for one single product only. For two products, two sheets must be used. For three products, three sheets, etc. Please note that all data are entered in blue, while the formulas are in black. This helps to make changes in the future: ONLY CHANGE THE BLUE FIGURES. Click1. Box 1 is to calculate the ex works price. Click2. Box 2 is to calculate the variable costs. VC1, VC2 and VC3. The % of VC1, VC2 and VC3 are very useful benchmarks to analyze the efficiency of a factory. Click3. Box 3 calculates the margin per unit and the margin %. All figures are black, so in this box there are only formulas. The margin in this example is P-VC = 756 – 614 = 142; the margin % = 19%. Click4. In box 4, you enter the quantity sold (3600 ton of tomato paste per year). Next, the margin per unit multiplied by the quantity sold per year results in the contribution of tomato paste per year: 142 * 3600 = 511,623. Contribution is not the same as profit, because …. Click5. …. because the fixed costs still need to be paid. Box 5 is used to calculate the fixed costs of a company. Once this is done the profit can be calculated: Profit = Contribution – Fixed costs = 511,623 – 344,400 = ? Click6. …. a profit of 167,223, or a profitability of 6%. In box 6 the Revenues (EXW) and the Total costs are also given. Profit is thus calculated in two ways: 1) Revenues – Costs and 2) Contribution – Fixed costs. Click7. In box 7 the cost price is calculated. It is per unit: VC + FC/q. Also the profit per unit is calculated. Please note that the cost price goes up or down with the volume q sold. The % on the right help with analysis. Click8. Box 8 also serves for analysis: the break-even volume for both finished goods (sales) and for the required inputs (raw material) are calculated. Click9. Finally, the Cigar Box helps with capacity utilization calculation. P-VC profit per unit Break-even Capacity Utilization

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**Sales price P Sales Price = Amount per unit, INCO-term City.**

Tomato paste price = USD 1000 per ton, DDP Moscow. DDP = delivered, duties paid. Delivered to Moscow in this case. The import duties in Russia are 10% or USD 100 per ton. VC4 = transport and commission = USD 144 per ton. Hence the Price EXW = = USD 756 per ton. Click1-6. Read aloud. Point to the box with the appropriate number. OPTIONAL: Make other examples. E.g. with VAT, without VAT, etc.

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**Variable cost VC Three types of variable cost:**

VC1, cost of everything which is consumed: raw material and ingredients. VC2, cost of processing raw material into the finished product: energy, steam, casual labor, detergents, diesel, gas. VC3, cost of primary (jar, cap, label) and secondary (carton box, shrink wrap, pallet) packing material. Click1. Read aloud. Explain: that for food products, consumption means eating. For non-food products, like a leather bag, consumptions means used. For food products, the composition of VC1 depends upon the recipe determined by a food technologist in the factory and it is usually checked by the laboratory. This is standard procedure. The main cost component is of course the raw material: the apple in the apple juice, the cucumber in the pickles, the tomato in the tomato paste. The minor components are the ingredients: sugar in the jam, salt in the ketchup, oil in the tinned fish, etc.) === OPTIONAL: ask students to give examples of raw material and of ingredients. Click2. Read aloud. Explain: VC2 have long been denied as important. Steam, water, electricity and casual labor, were all very cheap. In the recent years almost all governments have stopped subsidizing gas/fuel/water which has led to spectacular price increases. And increases in the cost price, increase in VC2. This triggers change in behavior: insulation of cooking equipment, recycling of hot water. It is only the beginning, but the trend is clear: companies saving on VC2 with efficient equipment and operations will be more competitive. OPTIONAL: ask students, who have companies, which measures they have taken to reduce VC2. Click3. Read aloud. Explain: VC3 is straightforward. Primary plus secondary packing cost. These costs are easy to get: price of the glass bottle, the cap, the label, the carton box, the shrink foil. What is less obvious is the availability of good quality packing material. Export quality packing material must often be imported and paid for in foreign currency and this is not always easy. OPTIONAL: ask students, who have companies, what packing material they use, and where they get it.

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**Raw material & ingredients VC1**

The price of the raw material, delivered to the factory = 71/ton. The processing ratio is the quantity of raw material needed for one unit of finished good. Here: 6 kg tomato for 1 kg of paste. Raw material cost = 71 * 6 = 429 The higher the losses, the higher the processing ratio, the more costly the finished good. Calculate the cost of all other ingredients in the recipe: 12 VC1 = = 441. Click1-6. Read aloud. Point to the box with the appropriate number. Explain: the percentage cost of the raw material is 70%, ingredients only 2%. In other words, if a cost saving is needed: first try to lower the cost of the raw material: Either with a lower RM price, or a more efficient processing ratio. OPTIONAL: 1. Ask students to give examples of recipes of food products and distinguish between the cost of raw material and ingredients. 2. Ask students to give examples of ‘recipes’ of non-food products: Leather lady’s bag. Bicycles. Again, distinguish between the cost of the main raw material (leather, steel pipes) and other parts (zippers, buttons, light, tires).

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**Processing cost VC2 Calculating VC2 is not easy.**

Processing cost are calculated per hour. And divided by the production volume in units per hour. To arrive at the processing cost per unit. One must measure the use of steam, electricity, casual labor. Not just guess it! And measure the output per hour. Get the correct data! After that, calculation is easy: 124 / 2 = 62 Click1-4. Read aloud. Write on the whiteboard the formula: cost per hour / units per hour = cost / unit. Question: is this formula understood? After answer. Click5-9. Read aloud. Explain: The percentage cost of the processing is 10%. This is not very high, compared with VC1. But, compared , ingredients only 2%. In other words, if a cost saving is needed: first try to lower the cost of the raw material: Either with a lower VC2 use, or a higher productivity.

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**Packing cost VC3 Packing cost are calculated per sales unit:**

1 aseptic bag in 1 steel drum = = 21.8; Other examples of sales units: 24 bottles per carton = 24*(bottle + cap + label) + 1 box + 1 sticker; 10 sachets per bag = 10*sachet + 1 bag + 1 adhesive sticker Calculate the number of sales units per unit of calculation: unit of calculation is ton = 1000 kg 4.4 drums of 225 kg per ton: 1000 / 225 = 4.4 add the packing losses, say 2.2%, multiply 4.4 by 102.2% = 4.5 VC3 = cost of packing * number of packs per unit = 21.8 * 4.5 = 99 Click1. Read aloud. Question: What is a sales unit? Answer: the unit in which the product is packed and sold. After answer. Click2. Explain: the sales unit of tomato paste is a drum of 220 kg. The paste is packed aseptically in a plastic bag, sealed and then lifted into a galvanized steel drum. The cost of which is 3.2 for the bag and 18.6 for the drum. Click3. Read aloud. === OPTIONAL Question: Write is two examples of sales unit for food products and two examples of sales units for non-food products? Check the answers. After answer. Click4. Read aloud. Question: what is the unit of calculation in the current example? After answers: Click5. Read the answer aloud. Question: how to calculate the number of sales units per unit of calculation? After answer: Click6. Read the answer aloud. Click7. Read aloud. OPTIONAL Question: A bottle weighs 100 grams and 24 bottles are packed in a crate. What is the unit of sales? Answer: the crate. How many crates in a ton? Answer: 1000 / (0.100 * 24) = 1000 / 2.4 = 416.7 Question: The percentage cost of the packing is 16%. If a cost saving is needed, how can you reduce VC3? Answer: you can only lower VC3 with lower prices of the packing material needed or reduce the packing losses. If this is not possible, then different packing is needed.

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**Total variable cost VC VC = VC1 + VC2 + VC3 Finished good losses**

Warehouse losses, theft, pilferage, etc…. If there are 2% losses, enter 2% in FG losses % box. VC = (VC1 + VC2 + VC3) * (1+ FG losses %) VC = ( ) * 1.02 = 614 Click1. Read aloud. Click2. Read aloud. Question: what are finished good losses? Answer: Losses of the packed product, ready to be sold. Question: how can finished good losses occur? After answers: Click3-6. Read aloud.

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**Margin P–VC Margin, or gross margin, is expressed per unit:**

Margin = P(EXW) – VC = 756 – 614 = 142 Click1-3. Read aloud. Question: What is the purpose of calculating the margin % ? After answers: Click4. Read aloud. Question: what is a reasonable margin? After answers: Click5-7. Read aloud. Explain: these percentages have to be taken as guidelines.

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Margin % (P–VC) / P * 100% Margin % = Margin / P(EXW) * 100% = 142 / 756 = 19% Margin % helps us to evaluate, if a margin is risky or not. Usual risk levels in food processing and manufacturing are: Click1. Read aloud. Question: What is the purpose of calculating the margin % ? After answers: Click2. Read aloud. Question: what is a risky margin? After answers: Click3. Read aloud. Click4. Read aloud. Explain: when the margin is below 15%, a small reduction in the sales price, will lead to a negative margin. That is why this margin % is only acceptable if all parameters are fully under control. E.g. in when producing under a contract with fixed prices. If understood: Click5. Read aloud. Explain. The Cigar Box uses a traffic light system: RED = danger/stop! ORANGE = warning/improve! GREEN = safe/continue! Click6. Read aloud. Click7. Read aloud. Explain: all these percentages have to be taken as guidelines.

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**Contribution (P–VC) * q**

The volume, or quantity sold is expressed in units per period. In this example, 3600 ton of tomato based are sold. Contribution is expressed per period: Contribution = Margin per unit * quantity per period = = 142 * = 511,623 Click1-2. Read aloud. Explain: Quantity sold is usually the most difficult parameter to estimate. Click3-5. Read aloud. Question: Is contribution the same thing as profit? Answer: NO, because the fixed costs still need to be paid for!

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**Fixed costs Three types of fixed cost:**

FC1, cost of investments: depreciation. FC2, cost of debts: interest. FC3, cost of all overheads. Salaries, social taxes, pensions, etc.. Repairs, maintenance Office & transport cost Marketing Etc….. Click1. Question: What are the three types of fixed cost? After answers: Click2. Read aloud. Explain that the term depreciation, like the other terms will be explained in the next slides. Click3-8. Read aloud.

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**Depreciation FC1 Use a realistic value for the productive assets.**

For a tomato processing company this is about 1.8 million. Use a realistic depreciation rate. Here: the replacement period of the factory is 12.8 years. The depreciation = 1 / 12.8 * 100% = 7.8% FC1 = Asset value * depreciation % = 1,800,000 * 7.8% = 140,000 Click1-6. Read aloud. To reduce the cost of depreciation is not possible. Once an investment in a factory has been made, the depreciation cost is fixed. For advanced reading: FC1. Depreciation. Owners and management have a tendency to conveniently forget to depreciate. And lower their cost price. This results into lack of cash for future investments, even for replacement investments. The Cigar Box suggests to include always a realistic amount of depreciation, which, if saved on a separate account, will enable the entrepreneur to make the future investments needed. Purchase value minus residual value at the end of the economic life, divided by the number of years. The economic life depends on the costs for maintenance and repairs, which tend to increase over time. The equipment should be replaced when annual repair and maintenance costs become higher than the annual depreciation.

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**Interest FC2 Use the real amount of the debts, with a minimum of**

40% of the asset value. For this company this is about 720,000 Use a realistic interest rate. Here: 18.7% per year. FC2 = Debt value * interest rate = 720,000 * 18.7% = 134,400 Click1-2. Read aloud. To reduce FC2, either the loan amount or the interest rate must be lowered. Of course, interest rates fluctuate, but to reduce the interest is very difficult. Once an loan has been taken to finance the factory operations, FC2 is usually fixed. For advance reading: FC2-interest. Question: why use a debt amount of at least 40% of the asset value? Answer: a healthy balance sheet shows a debt-equity ratio of at least Higher % of debt also happens: and even 60% debt – 40 equity. The reason for this is the use of the leverage factor in financing. If the interest paid for debt is lower than the profitability, then debt capital should be used to increase the return on equity. If the interest paid for debt is higher than the profitability, than less debt money must be used. See text books on finance for further understanding. FC2. Interest. This cost is usually transparent as bank loans are usually hidden. Interest rates can be as high as 25% per year. Shortage of working capital is often the result of the fact that the owners believe that they will not be able to repay the working capital loans at such interest rates, which is a clear proof that education in cost pricing is still very much needed.

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**Overhead FC3 Enter the number of full-time equivalent staff (FTE)**

10 workers, working 6 months per year = 10 * 6/12 = 5 FTE 10 workers, working 4 months per year = 10 * 4/12 = Calculate their salaries, incl. all taxes and emoluments: 50,000 Calculate one lump sum amount for all other overheads: 20,000 FC3 = salaries + all other overhead = 50, ,000 = 70,000 3.3 FTE Click1. Read aloud. Question: what means FTE exactly? After answers: Click2. Read aloud. Explain that these 10 workers work 50% of the time, hence they count as 5 fulltime workers. Click3. Read aloud. Question: this equals how many FTE? After answers: Click4. Explain: Explain that these 10 workers work 33% of the time, hence they count as 3.3 fulltime workers. Click5. Read aloud. Explain that the 50,000 is just an assumption. Exact calculations are needed from the bookkeeping. Click6. Read aloud. Explain that the 20,000 is just again an assumption. Exact calculations are always needed from the bookkeeping. Click7. read aloud. To reduce FC3 is a matter of cost control and thus good management.

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**Total fixed costs FC FC = FC1 + FC2 + FC3**

The contribution of tomato paste must exceed these costs. In case more than 1 product is produced, FC must be shared. Calculate FC % attributed to product and enter in the box: 100% FC (attributed to product) = FC * FC % attributed to product Click1-2. Read aloud. Click3. Read aloud. Question: What if the contribution is lower than the fixed costs? Answer: Losses will occur! After answers: Click4-6. Read aloud. Explain: the way fixed costs are divided over a portfolio of products is the subject of Cigar Box 2: Portfolio Analysis. More information can be found on the website:

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Profit Two methods Cost accounting method: Profit = Contribution – Fixed costs Bookkeeping method: Profit = Total revenues – Total costs Result is the same! Question: Do you know which two methods exist for calculation of the profit? After answers: Click1. Read aloud. Click2. Explain the earlier obtained figures. Click3. Read aloud. Click4. Explain, writing on the whiteboard that Revenue equals P * q = 756 * 3600 = 2,711,600 Total cost equals VC * q + FC = 614 * ,400 = 2,210, ,400 = 2,554,377 Profit = Revenues – Total cost = 2,711,600 – 2,554,377.

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**Summary Cost price Cost price = total cost per unit**

Please note that the Cost Price of an item is not a constant figure. It goes up or down when the volume sold fluctuates: more sales higher q lower FC/q lower cost price The reverse is also true: less sales lower q higher FC/q higher cost price lower profit per unit!

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**Break-even Break-even point is where the profit is zero.**

Revenues – Cost = 0 or Contribution – Fixed cost = 0 Why calculating the break-even quantity? When Price, VC and FC are known and q is unknown How many drums can be sold per year? BE volume (sales) = minimum volume needed to sell to make a profit. BE volume (raw material) = minimum volume needed to process. How much raw material do we need to buy? = 6 * 2423 = 14,538 tons Question: what is the meaning of ‘breaking even’? After answers: Question: What is a break-even point? After answers: Click1-2. Read aloud. Question: what is the name of the first method of profit calculation? Answer: the bookkeeping method. Question: what is the name of the second method of profit calculation? Answer: the cost accounting method. If this clear: Click3. Read question aloud. Answer: click4, read aloud. Explain: click5. in this example: how many drums of tomato paste can be sold per year? In other words: click6, read aloud. Question: In order to be able to sell, the factory must first… …? Answer: Produce! Question: And in order to be able to produce, the factory must first… …? Answer: Buy raw material! Click7. Read aloud. Click8. Click9. The Cigar Box automatically calculates both BE sales and BE raw material. Question: these BE’s are expressed in what? Answer: in units per period: tons of paste per year, tons of tomato per harvest, etc…

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**Capacity q = quantity sold = 3,600 tons of paste per year**

qCAP = quantity produced at full capacity utilization quantity/hour * hours/day * days/year (harvest season) 2 ton/hour * 22 hours/day * 110 days/yr = 4,840 ton/year utilization = q / qCAP * 100% = 3,600 / 4,840 = 74.4% Question: A factory can never sell more than what? Answer: than the maximal installed capacity! Click1. Read aloud. Explain: The question is can the factory produce this 3,600 tons? In order to know this, we must calculate…. Click2. Read aloud. Question: what are the three factors, you need in order to calculate q CAP? After answers.. Click3. Read aloud. Click4. Explain: in this example, the factory can process 12 ton of tomato into 2 ton of paste per hour. The factory can work maximally 22 hours per day, because it needs 2 hours for cleaning and small repair work. The tomato harvesting season is 110 days. Because industrial tomatoes cannot be stored, the 110 days is also the length of the production season. Hence 4,840 tons of paste can maximally be produced. Click5. Read aloud. Explain: this factory works at 74% capacity utilization.

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**Capacity utilization How does Capacity utilization affect Cost Price?**

Higher utilization % higher q lower FC/q VC does not change, hence lower cost price TC: TC1 = VC + FC/q1 = / 100 = 48 TC2 = VC + FC/q2 = / 120 = 44 With same P, lower TC higher profit per unit Profit 1 = Price – TC1 = 60 – 48 = 12 Profit 2 = Price – TC2 = 60 – 44 = 16

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**Capacity utilization 2 Conclusion: with 20% increase in volume,**

How does Capacity utilization affect the Profit ? higher capacity utilization more units are sold and higher profit per unit. Profit = units sold * profit per unit Profit 1 = * 12 = 1200 Profit 2 = * 16 = 1920 Increase Increase % 20% 33% 60% Conclusion: with 20% increase in volume, the profit increases by 60%!! OPTIONAL. This is a test slide to find out if the students have understood the basics of profit calculation.

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**Part 4 Practice Learning objective:**

Each person, with own laptop and CB1 installed, able to obtain correct data from the sources provided and fill in into CB1 Able to carry out a series of sensitivity tests.

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Crème de la Ferme Logical Food Technologies B.V. has developed Crème de la Ferme. Crème de la Ferme is an instant cheese powder consisting of fresh natural healthy traceable ingredients. The powder is a mixture of milk powder and natural or natural identical flavors. The instant cheese powder is dissolved in hot water and pasteurized, which gives a stable healthy cheese spread that should be hot-filled and sealed. With the use of a base and flavor powder a variety of cheese flavors can be produced easily. Crème de la Ferme cheese base powder is supplied in 25 kg bags and the cheese flavor powder is supplied in 2,5 kg bags. The bags are made of a multi-layer paper with a poly inner liner. The base and flavor powders are mixed with 110 – 125% water. This gives the client the possibility to produce cheese spread locally at a very competitive price. Cheddar, Gouda, Emmentaler, Parmesan Goat cheese, Mozzarella, Camembert Feta, Cream cheese Local licensees / purchasers of Crème de la Ferme have opportunity to add local herbs, spices, etc to enlarge their product range. Cost for freight, local legislative requirements, import duties, certification for Halal, Kosher, or GOS are charged extra.

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**Melted cheese from powder**

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**Production and Filling**

Production takes place in batches of kg. Batch processing time is 7 minutes, or about 8-9 batches per hour. During one batch, the equipment consumes about €1,25 in steam and electricity. Six workers are needed per 8 hour shift. The product can be sold at €5,80 per kg in the shop. The filler can do 4,800 cups per hour. Cup size can vary from 100 to 250 gram. The price for a cup, seal and label is: 100 gram = €0,085 150 gram = €0,10 A carton box takes: 100 gram = 18 cups 150 gram = 12 cups Box + label cost €0,50

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Recipe and Investment

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**CB1 Fill in the data Gouda Melted Cheese in 150 gram cups.**

Fill in the Cigar Box using the data above. Make your own assumptions where needed. Time needed: Experienced person: 5 minutes Learner: ?? Good luck!

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Cost-Volume-Profit Relationships

Cost-Volume-Profit Relationships

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