1. Assessing Financial Impacts in Budgets and Planning MIR 889 2014 Andrew Graham

2. Objectives for Today Sources of Capital Activity-Based Costing Cost-Volume-Profit Analysis Cost Sources Cost Behaviour

4. Jason Inc. produces stereo sound systems under the brand name of J-Sound. The parts for the stereo are purchased from an outside supplier for $10 per unit (a variable cost). Variable Cost

5. Total Variable Cost Graph Total Costs $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 102030 0 Units Produced (in thousands) Unit Variable Cost Graph $20 $15 $10 $5 0 Cost per Unit 102030 Units Produced (000) Variable Costs

6. Total Costs $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 102030 0 $20 $15 $10 $5 0 Cost per Unit 102030 Number of Units Produced Units Produced (000) Direct Materials Cost per Unit Total Direct Materials Cost 5,000 units$10$ 50,000 10,00010l00,000 15,00010150,000 20,00010200,000 25,00010250,000 30,00010300,000 Variable Costs

7. The production supervisor for the Minton Company Mississauga plant is Jane Sovissi. She is paid $75,000 per year. The plant produces from 50,000 to 300,000 bottles of air freshener depending on sales. Fixed Costs

8. Number of Bottles Produced Total Salary for Jane Sovissi 50,000 bottles$75,000$1.500 100,00075,0000.750 150,00075,0000.500 200,00075,0000.375 250,00075,0000.300 300,00075,0000.250 Salary per Bottle Produced Fixed Costs

9. Total Fixed Cost Total Costs $150,000 $125,000 $100,000 $75,000 $50,000 $25,000 100200300 0 Unit Fixed Cost Bottles Produced (000) Number of Bottles Produced Cost per Unit $1.50 $1.25 $1.00 $.75 $.50 $.25 100200300 0 Units Produced (000) Total Salary for Jane Sovissi 50,000 bottles$75,000$1.500 100,00075,0000.750 15,00075,0000.500 20,00075,0000.375 25,00075,0000.300 30,00075,0000.250 Salary per Bottle Produced

10. Simpson and Associates out of Kingston Ontario manufactures sails using rented equipment. The rental charges are $15,000 per year, plus $1 for each machine hour used over 10,000 hours. Mixed Costs

11. Total Mixed Cost Total Costs 0 Total Machine Hours (000) $45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 10203040 Mixed costs are usually separated into their fixed and variable components for management analysis. Mixed costs are sometimes called semi-variable or semi-fixed costs.

12. Costs Sources

13. Creating Costs An organization creates different costs at different stages: – Starting up – Early growth – Reaching the boundaries of existing capacity – Expanding product lines – Expanding capacity – Redefining the business – Continued growth These costs are not created evenly over time and should be planned for

14. Changing Cost Structures The composition of manufacturing costs has changed substantially in recent years Many formal cost systems were first implemented in the early 1900 ’ s: – Direct labor represented a large proportion, sometimes 50% or more, of the total manufacturing costs – Direct material costs were also substantial – Capacity-related costs generally represented a small fraction of total manufacturing costs Capacity cost is a fixed expense that does not change with the level of production or activity, but is a necessary part of the business. Examples are lease payments, depreciation, insurance, utilities, IT systems and insurance costs.

15. Changing Cost Structures Today, direct labor is only a small portion of manufacturing costs – E.g., in the electronics industry direct labor is often less than 5% of the total manufacturing cost The cost of direct materials remains important, representing 40% to 60% of the costs in many plants The big change has been the vastly increased share of total costs from capacity-related costs.

16. Changing Cost Structures The increase in capacity-related costs results from: – The shift toward greater automation, which requires more production engineering, scheduling, and machine setup activities – The emphasis on better customer service – The increase in support activities required by a proliferation of multiple products Further, both flexible and capacity-related costs associated with design, product development, distribution, selling, marketing, and administrative activities have increased

17. Changing Cost Structures Changing cost structures have caused cost systems allocating indirect costs using volume measures to become increasingly inaccurate in computing product costs Many costing systems take costs that did not vary proportionally with volume, accumulate them, and then allocate them using a measure of volume These systems often underallocate costs to cost objects (e.g., product lines) produced in low volumes

18. What are some changes happening in the cost structure of HR in organizations that will increase or decrease costs?

19. Cost-Volume-Profit Analysis Contribution Margin Break Even Point

20. Sales (50,000 units)$1,000,000 Variable costs 600,000 Contribution margin$ 400,000 Fixed costs 300,000 Income from operations$ 100,000 The contribution margin is available to cover the fixed costs and income from operations. Contribution Margin

21. 100% 60% 40% 30% 10% Contribution Margin Ratio = Sales – Variable costs Sales Contribution Margin Ratio = $1,000,000 – $600,000 $1,000,000 Contribution Margin Ratio = 40% Sales (50,000 units)$1,000,000 Variable costs 600,000 Contribution margin$ 400,000 Fixed costs 300,000 Income from operations$ 100,000 Contribution Margin

22. 100% 60% 40% 30% 10% The contribution margin can be expressed three ways: 1. Total contribution margin in dollars. 3. Contribution margin ratio (percentage). 3. Unit contribution margin (dollars per unit). $20 12 $ 8 Sales (50,000 units)$1,000,000 Variable costs 600,000 Contribution margin$ 400,000 Fixed costs 300,000 Income from operations$ 100,000 Contribution Margin Ratio

23. Cost-Volume-Profit Chart Sales and Costs ($000) 0 Units of Sales (000) $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs$100,000 Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs$100,000 60% Total SalesVariable Costs 12345678910

24. Cost-Volume-Profit Chart Sales and Costs ($000) 0 Units of Sales (000) $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs$100,000 Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs$100,000 60% 40% Contribution Margin 100% 60% 40% 12345678910

25. Cost-Volume-Profit Chart Sales and Costs ($000) 0 Units of Sales (000) $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs$100,000 Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs$100,000 Fixed Costs 100% 60% 40%TotalCosts 12345678910

26. Cost-Volume-Profit Chart Sales and Costs ($000) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 12345678910 Break-Even Point Units of Sales (000) Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs$100,000 Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs$100,000 100% 60% 40% $100,000 $20 = 5,000 units

27. Cost-Volume-Profit Chart Sales and Costs ($000) 0 Units of Sales (000) $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs$100,000 Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs$100,000 100% 60% 40% Operating Profit AreaOperating Loss Area

28. Margin of Safety

29. Margin of Safety = Sales – Sales at break-even point Sales The margin of safety indicates the possible decrease in sales that may occur before an operating loss results. Margin of Safety = $350,000 – $250,000 $350,000 Margin of Safety = 28%

30. Cost-Volume-Profit Chart Sales and Costs ($000) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 12345678910 Break-Even Point Units of Sales (000) Margin of Safety

31. Assumptions about Reliability of Cost-Volume- Profit Analysis 1.Total sales and total costs can be represented by straight lines. 2.Within the relevant range of operating activity, the efficiency of operations does not change. 3.Costs can be accurately divided into fixed and variable components. 4.The sales mix is constant. 5.There is no change in the inventory quantities during the period.

32. Activity Based Costing

33. It gets complicated…. So far we have been talking about single products and single units with small overhead Reality today is that most business are complex, multi product, multi sites with growing overhead and downstream costs Using the traditional unit-based approach to costing leads to distortions in product price and misallocation of overhead

34. Differences between ABC and Traditional Costs Traditional costing allocates all manufacturing overhead to products. ABC costing only assigns manufacturing overhead costs consumed by products to those products Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base. ABC costing also uses non-volume related allocation bases. Traditional costing disregards selling and administrative expenses because they are assumed to be period expenses. ABC costing directly traces shipping costs to products an includes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned to products.

35. What Activity Based Costing Does Costs are first attributed to activities Each activity is examined to determine its relationship to the product and product costs Breakdown overhead into meaningful activities Assign costs to products or outcomes based on this analysis

36. What it is used for Product pricing and mix decisions Cost reduction and process improvement decisions Design decisions

37. Sources of Capital

40. Business Angels are private investors who invest in unquoted small and medium sized businesses. They are often businessmen and women who have sold their business. They provide not only finance but experience and business skills. Business Angels invest in the early stage of business development filling, in part, the equity gap.

41. Business Angels Individuals looking for investment opportunities of their own money Often retired but still interested in business Generally small sums Could be an individual or a small group Generally have some say in the running of the company Often play a big role in start-ups: financing and skills transfer Example: Estimated that 90% of outside equity capital in seed/startup stage companies is sourced from angels

42. Venture Capital Pooling of capital in the form of limited companies – Venture Capital Companies Looking for investment opportunities in fast growing businesses or businesses with highly rated prospects May also provide advice, contacts and experience as well pressure to perform Key characteristics: looking for big return fast, will take ownership interest, focused on rate of return not rate of growth

43. Main DifferencesBusiness AngelsVenture Capitalists PersonalEntrepreneursMoney managers Money InvestedOwn moneyFund provider Firms fundedSmall, early stageMedium to large Due diligence doneMinimalExtensive Location of inv.Of concernOf lesser concern Contract usedSimpleComprehensive Monitoring after inv.Active, hands-onStrategic Involvement in mgtImportantOf lesser concern Exiting the firmOf lesser concernHighly important [Ten3 website, business angels ] Angels versus Venturers

44. Internal Sources of Finance and Growth ‘Organic growth’ – growth generated through the development and expansion of the business itself. Can be achieved through: Generating increasing sales – increasing revenue to impact on overall profit levels Use of retained profit – used to reinvest in the business Sale of assets – can be a double edged sword – reduces capacity?

45. External Sources of Finance Long Term – may be paid back after many years or not at all! Short Term – used to cover fluctuations in cash flow ‘Inorganic Growth’ – growth generated by acquisition

46. Long Term Shares (Shareholders are part owners of a company) – Ordinary Shares (Equities): Ordinary shareholders have voting rights Dividend can vary Last to be paid back in event of collapse Share price varies with trade on stock exchange – Preference Shares: Paid before ordinary shareholders Fixed rate of return Cumulative preference shareholders – have right to dividend carried over to next year in event of non-payment – New Share Issues – arranged by merchant or investment banks – Rights Issue – existing shareholders given right to buy new shares at discounted rate – Bonus or Scrip Issue – change to the share structure – increases number of shares and reduces value but market capitalisation stays the same

47. Long term Loans (Represent creditors to the company – not owners) – Debentures – fixed rate of return, first to be paid – Bank loans and mortgages – suitable for small to medium sized firms where property or some other asset acts as security for the loan – Merchant or Investment Banks – act on behalf of clients to organise and underwrite raising finance – Government Grants Loan guarantees Loans

48. Short Term Bank loans – necessity of paying interest on the payment, repayment periods from 1 year upwards but generally no longer than 5 or 10 years at most Overdraft/ Line of Credit facilities – the right to be able to withdraw funds you do not currently have – Provides flexibility for a firm – Interest only paid on the amount overdrawn – Overdraft limit – the maximum amount allowed to be drawn - the firm does not have to use all of this limit

49. 'Inorganic Growth' Acquisitions The necessity of financing external inorganic growth – Merger: firms agree to join together – both may retain some form of identity – Takeover: One firm secures control of the other, the firm taken over may lose its identity

50. Alternative Sources of Funding Crowd Funding Micro-financing