1. CHAPTER 6 Financial Modeling for Short-Term Decision-Making
PowerPoint Presentation by
LuAnn Bean Professor of Accounting Florida Institute of Technology
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 6: Financial Modeling for Short-Term Decision-Making
Managerial Accounting 11E
Maher/Stickney/Weil

2. ☼ ☼
CHAPTER GOAL
This chapter explains and illustrates financial modeling. Financial modeling can
Provide an overview of an organization’s financial activities
Help managers make specific decisions
Financial modeling relies on concepts of fixed and variable cost behavior.
This chapter explains and illustrates financial modeling. Financial modeling can:
Provide an overview of an organization’s financial activities
Help managers make specific decisions
Financial modeling, a simple but appealing tool, provides a sweeping overview of an organization’s financial activities or can help managers make specific decisions. Financial modeling relies on concepts of fixed and variable cost behavior.

3. LO 1
FINANCIAL MODEL
Financial modeling enables analysts to test the interaction of economic variables in a variety of settings. It requires analysts to develop a set of equations that represents a company’s operating and financial relations.
A financial model, which works in much the same fashion as a simulator, enables analysts to test the interaction of economic variables in a variety of settings. These models require that analysts develop a set of equations that represent a company’s operating and financial relations.
Financial models offer several benefits to users. Once the model is developed, analysts can use it for business purposes without becoming overwhelmed by the related number crunching. Like the simulators just discussed, many models allow an organization to study the impact of a possible business action by reviewing the potential results before taking that action. The models help managers identify a bad project or decision ahead of time, before it negatively impacts the company involved.
Be warned about GIGO—garbage in, garbage out. Using financial models can present problems. Sound models do not automatically improve decision making. A model is only as good as the assumptions it uses. Faulty assumptions or bad data result in faulty output—sometimes worse than useless because they send managers off in wrong directions.

4. COST-VOLUME-PROFIT (CVP)
LO 2
COST-VOLUME-PROFIT (CVP)
CVP can be used to answer questions such as
What effect on profit can GM expect if it builds a larger SUV?
How will NBC’s profit change if ratings increase for its evening news program?
How many subscribers must a Dish Network obtain to break even for the year?
What happens if Verizon reduces fees charged to customers?
One basic financial model, the cost-volume-profit (CVP) model, summarizes the effects of volume changes on an organization’s costs, revenue, and income. Users can extend such analysis to include the impact on profit of changes in selling prices, service fees, costs, income-tax rates, and the organization’s mix of products or services. For example, CVP can be used to answer questions such as:
What effect on profit can GM expect if it builds a larger SUV?
How will NBC’s profit change if ratings increase for its evening news program?
How many online subscribers must Dish Network obtain to break even for the year?
What happens if Verizon reduces fees charged to customers?

5. EXAMPLE: Early Horizons Daycare
EHD
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EXAMPLE: Early Horizons Daycare
Early Horizons Daycare is a daycare center that defines a unit of output as “service provided for 1 child for a month.” Building capacity is 30 children. An accountant developed the following estimates:
Price per child per month
$ 600
Variable cost per child per month
200
Fixed costs per month
5,000
Early Horizons Daycare is a daycare center providing child care service from 7 AM to 6 PM, weekdays only. The business defines a unit of output as “service provided for one child for a month.” The building capacity for the business is 30 children The accountant at Early Horizons developed the following cost and price estimates: Price per child per month, $600; variable cost per child per month $200; fixed costs per month, $5,000.
Continued

6. EHD
LO 2
CAPACITY and COSTS
Early Horizons Daycare has a capacity of 20 units (relevant range), after which it must hire more staff.
Variable costs include
Snacks and food
Supplies
A portion of insurance
Fixed costs include:
Rent and utilities
Minimum staffing
Despite the fact that the building can hold 30 children, the relevant range for the business is 20 children, after which it must hire more staff. The estimated variable costs include two snacks and lunch every day, various paper products and soap, a variable cost component of insurance, and supplies such as toys and crayons. The fixed costs include rent, utilities, a fixed cost component of insurance, and minimum staffing requirements of three full-time “Big Friends,” a part-time “Big Cook/Housekeeper,” and some volunteers.

7. BREAK-EVEN POINT: Definition
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BREAK-EVEN POINT: Definition
Is the point in the basic CVP model where revenues equal costs.
Total Revenue = Total Costs
Analysts can use the basic CVP model to find the break-even point, namely, the volume of activity that produces equal revenues and costs for the organization. The organization has no profit or loss at this sales level.

8. BREAK-EVEN: Table Format
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BREAK-EVEN: Table Format
Using break-even computations:
Sales Revenue (12.5 X $600)
$ 7,500
Less Variable costs (12.5 X $200)
2,500
Contribution Margin (CM)
$ 5,000
Less Fixed costs
5,000
Operating profit $
This slide shows the break-even computations.

9. CONTRIBUTION MARGIN: Definition
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CONTRIBUTION MARGIN: Definition
Is the excess of revenue over variable costs.
Total Revenue – Variable Costs
The contribution margin per unit is the selling price per unit less variable costs per unit. How could we compute Early Horizon’s break-even point if we did not already know it is 12.5 children per month? An analyst can use either a contribution-margin approach or an equation approach.

10. Can we use contribution margin to compute break- even (BE) volume?
EHD
MANAGERS WANT TO KNOW!
LO 2
Can we use contribution margin to compute break- even (BE) volume?
YES!
BE Volume =
Fixed cost / CM per child
How could we compute Early Horizon’s break-even point if we did not already know it is 12.5 children per month? An analyst can use either a contribution-margin approach or an equation approach.
BE volume = Fixed cost ÷ CM per child

11. CONTRIBUTION MARGIN APPROACH
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CONTRIBUTION MARGIN APPROACH
Using the contribution margin approach:
Break-even Volume = Fixed Costs / CM per child
= $5,000 / $400
= 12.5 children
Using the contribution margin approach, BE volume = Fixed cost ÷ CM per child. We calculate 12.5 children.
Click the button to skip equation approach

12. EHD
LO 2
EQUATION APPROACH
Using the equation approach (Operating profit at break-even = 0):
Operating profit 0
= Sales revenue - Costs
= Sales revenue -Variable costs (VC) – Fixed costs (FC)
= (Unit selling price (SP) × Sales volume)
- (VC per unit × Sales volume) - FC
($600 - $200) × Sales volume = $5,000
An alternative approach to finding the break-even point uses the equation
Operating Profit = Sales Revenue − Costs
One expression of the income calculation is the following:
Sales Revenue − Variable Cost −Fixed Costs = Operating Profit
Expanding this yields:
(Selling Price per Unit × Sales Volume) − (Variable Cost per Unit × Sales Volume) − Fixed Costs = Operating Profit
which equals
[(Selling Price per Unit − Variable Cost per Unit)× Sales Volume]−Fixed Costs = Operating Profit
The break-even point occurs where operating profit equals zero, so setting the above expression equal to zero and moving fixed costs to the other side of the equal sign, the equation becomes:
[(Selling Price per Unit − Variable Cost per Unit)× Sales Volume] = Fixed Costs
Again we find that the breakeven sales volume is 12.5 children per month.
Sales volumeBE = $5,000/$400 = 12.5 children/month

13. Can we graph the relationships in CVP analysis?
MANAGERS WANT TO KNOW!
LO 2
Can we graph the relationships in CVP analysis?
YES!
Can we graph the relationships in CVP analysis? Yes, a graph discloses more information than the break-even calculation and enables a manager to see the effects on profit of changes in volume.

14. Break-even Volume = Fixed Costs / CM
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By graphing revenues and costs on same graph, you can find BE, profit and loss areas.
The graph shows sales volume on the horizontal axis and two diagonal lines: total revenues and total costs. The vertical distance between the lines on the graph is the profit or loss for a given sales volume (i.e., the difference between revenues and costs). The breakeven point is where the total revenue and total cost diagonals cross.
Break-even Volume = Fixed Costs / CM
EXHIBIT 6.1

15. EXHIBIT 6.2 EHD Slope of line is variable cost per unit. LO 2
Exhibit 6.2 is a profit-volume graph. The profit-volume graph shows one line that represents operating profits of the company for a given sales volume. It combines the two lines (revenues minus costs) shown in Exhibit 6.1.
Break-even Volume = Fixed Costs / CM
EXHIBIT 6.2

16. TARGET PROFIT: CM Approach
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TARGET PROFIT: CM Approach
Sales revenue (20*$600)
$ 12,000
Less Variable costs (20*$200)
4,000
Contribution Margin
$ 8,000
Less Fixed costs
5,000
Operating profit
$ 3,000
Target profit Volume = (Fixed costs + Target Profit) / CM
= ($5,000 + $3,000) / $400
Finding the break-even point, where target profit is zero, is only one example of using the cost-volume-profit equation. We can also use it to find the unit sales necessary to achieve a specified profit. Target profit Volume = (Fixed cost + Target profit) / CM
“How many children lead to profits of $3,000?” Management will often ask this type of question. We call the answer to this question a “target profit.” How could we compute Early Horizon’s target profit of $3,000?
The analyst can easily integrate target profit into the CVP model in order to figure how to cover the fixed costs and earn $3,000 in operating profit. The result is 20 children.
# children = 20
Continued

17. TARGET PROFIT: Equation Approach
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TARGET PROFIT: Equation Approach
Sales revenue (20 X $600)
$ 12,000
Less Variable costs (20 X $200)
4,000
Contribution Margin
$ 8,000
Less Fixed costs
5,000
Operating profit
$ 3,000
Sales revenue – Variable costs - Fixed costs = Operating Profit
($600 - $200) × Sales volume - $5,000 = $3,000
$400*Sales volume = $8,000
Using the equation approach, again sales volume is equal to 20 children.
Sales volume = 20 children
Continued

18. TARGET PROFIT: Reminder
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TARGET PROFIT: Reminder
Sales revenue (20 X $600)
$ 12,000
Less Variable costs (20 X $200)
4,000
Contribution Margin
$ 8,000
Less Fixed costs
5,000
Operating profit
$ 3,000
Target profit Volume = (Fixed costs + Target Profit) / CM
The cost-volume-profit model is one example of a financial model. Companies tailor their financial models to meet their particular needs. In this section we illustrate several uses of a financial model. Other analysts use other formats.
Remember that Target profit Volume = (Fixed costs + Target Profit) / CM.
A change in any of these variables requires new analysis. Most analysts use computer spreadsheets (e.g., Excel) for evaluating changes in the financial model variables (e.g., price per child, variable cost per child, and number of children enrolled).
Continued

19. EARLY HORIZONS DAYCARE: Sensitivity Analysis
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EARLY HORIZONS DAYCARE: Sensitivity Analysis
Base Cost
FC $500
VC $10
Price $60, Vol. 2
Assumptions
Price/child
$ 600
$ 660
VC/child
$ 200
$ 210
Monthly FC
$5,000
$4,500
Children enrolled 20 18
Model results: IS
Sales revenue
$ 12,000
$ 11,880
Less VC
4,000
4,200
3,600
Total CM
$8,000
$7,800
$ 8,280
Less FC
5,000
4,500
Operating profit
$3,000
$3,500
$2,800
$ 3,280
Alt #1
Alt #2
Alt #3
EXHIBIT 6.3
Can EHD improve operating profit by changing cost or selling price? Let’s start with our original case and use a sensitivity analysis to look at three alternatives. At our base cost, operating profit is $3,000. Typically, analysts focus on how changes will affect operating profit.
Alternative 1 shows that a 10 percent (= $500/$5,000) decrease in fixed costs results in a percent (= $500/$3,000) increase in operating profit.
Alternative 2 shows that a 5 percent (= $10/$200) increase in variable costs results in a 6.67 percent (= $200/$3,000) decrease in operating profit.
Alternative 3 shows that a 10 percent (= $60/$600) increase in price and a 10 percent (= 2/20) decrease in volume results in a 9.33 percent (= $280/$3,000) increase in operating profit.
Which situation would you choose? Using this analysis, management can begin to analyze how operating profit varies as model variables change. As we have seen, Alternative #1 is the best choice if EHD can decrease fixed costs by $500.

20. MARGIN OF SAFETY: Definition
LO 3
MARGIN OF SAFETY: Definition
Is the excess of projected (or actual) sales units over Break-even unit sales level.
Sales units – BE Sales units or
Sales dollars – BE Sales dollars
The margin of safety is the excess of projected (or actual) sales units over the break-even unit sales level.
The formula for margin of safety is: Margin of Safety = Sales Units (or dollars) −Break-Even Sales Units (or dollars).

21. COST STRUCTURE: Definition
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COST STRUCTURE: Definition
Refers to the proportion of fixed and variable costs to total costs.
OPERATING LEVERAGE: Definition
The cost structure of an organization refers to the proportion of fixed and variable costs to total costs. Cost structures differ widely among industries and among firms within an industry.
An organization’s cost structure has a significant effect on the sensitivity of its profit to changes in volume. An organization’s operating leverage is the extent to which an organization’s cost structure consists of fixed costs. Operating leverage is high in firms with a high proportion of fixed costs and a small proportion of variable costs. High operating leverage means high contribution margin per unit. The higher the firm’s fixed costs, the higher the break-even point. Once the firm reaches the break-even point, profit increases significantly.
Is the extent to which an organization’s cost structure is made up of fixed costs.
Note: the higher the fixed costs, the higher the break-even point.

22. What is the contribution margin ratio?
LO 4
What is the contribution margin ratio?
Contribution margin ratio (CMR) is the contribution amount per dollar of sales.
CM / Sales
The contribution margin ratio is the contribution amount per dollar of sales, or the contribution margin divided by sales.

23. EHD
MANAGERS WANT TO KNOW!
LO 6
How can a company determine the effect of taxes will be on its profits?
After tax profits =
Before tax profits X (1 - tax rate)
How can a company determine the effect of taxes on its profits? This is determined by multiplying before tax profits times one minus the tax rate.

24. SUMMARY OF SIMPLIFYING CVP ASSUMPTIONS
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SUMMARY OF SIMPLIFYING CVP ASSUMPTIONS
Can separate total costs into fixed and variable
Cost and revenue behavior is linear. Implies the following in the relevant range
Total fixed costs do not change
Variable costs per unit remain constant
Selling price per unit remains constant
Product mix remains constant over relevant range
A summary of assumptions is required to make the CVP model work and includes:
1. We can separate total costs into fixed and variable components.
2. Cost and revenue behavior is linear throughout the relevant range of activity. This assumption implies the following:
a. Total fixed costs do not change throughout the relevant range of activity.
b. Variable costs per unit remain constant throughout the relevant range of activity.
c. Selling price per unit remains constant throughout the relevant range of activity.
3. Product mix remains constant throughout the relevant range of activity.
Assumptions of the CVP model make it easy to use, but they also make it unrealistic. Before criticizing the model on this score, however, consider the costs and benefits of relaxing those assumptions to create more realism. Often the cost of more realism exceeds the benefits from improved decision making.

25. EHD
LO 8
USING ABC FOR EHD
Previously, Early Horizons Daycare used a financial model with only volume (number of children) as the cost driver. What if multiple cost drivers using the cost hierarchy are identified and used?
Now let’s go back to our Early Horizons Daycare example. Previously, Early Horizons Daycare used a financial model with only volume (number of children) as the cost driver. What if multiple cost drivers using the cost hierarchy are identified and used?

26. HIERARCHY OF COSTS: Reminder
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HIERARCHY OF COSTS: Reminder
Activity Category
Example
Capacity
Size limitations
Building size: 30 children
Customer
Needs
Children transported
Product
Production needs
Field trips
Batch
A room of 5 children
Unit
Variable costs
Child
Recall the hierarchy of costs and how they might apply to the Early Horizons Daycare.
◾ Unit-level activities are performed for each individual unit of product or service.
◾ Batch-level activities are performed to benefit multiple units of output equally and simultaneously (i.e., in batches). Related costs are traced easily to specific batches, but not to individual output units.
◾ Product-level activities support a specific product or service, that is, an entire product line. Such activities may include product design, product advertising, and maintaining product specifications.
◾ Customer-level activities allow the firm to meet the needs of specific customers. Examples of related costs include those attributable to unique packaging, shipping, and distribution needs and to personnel who are assigned to handle specific customer accounts.
◾ Facility-level activities give an organization the capacity to produce goods and services. Such activities are at the highest level of the activity hierarchy and tend to support all organizational processes. Typical examples include the activities of top management and operating the physical plant.

27. COST EQUATION Total Cost = (Unit-level cost × #children) +
EHD
LO 8
COST EQUATION
Total Cost =
(Unit-level cost × #children) +
(Batch-level cost × # rooms) +
(Product-level cost × #field trips) +
(Customer-level cost × #children transported) +
(Capacity-level costs × #facilities)
These activity categories will change the nature of the CVP model. The basic model assumes that certain costs (the variable costs) vary with sales volume while others, the fixed costs, remain constant. Armed with this information, Early Horizons’ accountant can develop a financial model to consider alternative scenarios for financial planning and decision making similar to the following:
Total Cost = (Unit-level cost X #children) + (Batch-level cost X # rooms) + (Product-level cost X #field trips) + (Customer-level cost X #children transported) + (Capacity-level costs X #facilities)
Continued

28. EHD: ABC and Sensitivity Analysis
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EHD: ABC and Sensitivity Analysis
Increase to 22
Decrease to 15
Base Case
Sales
$ 12,000
$ 13,200
$ 9,000
Unit-level costs
400
440
300
Batch-level costs
2,800
3,500
2,100
Product-level costs
Customer-level costs
800
500
Facility-level costs
4,700
Operating profits
$ 3,000
$ 3,480
$ 1,100
EXHIBIT 6.8
This sensitivity analysis shows the base case. Second, if we increase to 22 children, notice that operating profits increase by $480. Finally, if the number of children decreases to 15, operating profits drop significantly to $1,100. Why? Look at product-level and facility level costs. These are fixed and do not allow flexibility for the drop in revenue.

29. End of CHAPTER 6
End of Chapter 6.