Hilton Maher Selto

12 Financial and Cost-Volume-Profit Models McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

12-3 Definition of Financial Models Accurate, reliable simulations of relations among relevant costs, benefits, value and risk that is useful for supporting business decisions. Relationships between costs, revenues, & income. Relationships between current investments and value. Pro forma financial statements.

12-4 Objectives of Financial Modeling

12-5 Basic Cost-Volume-Profit (CVP) Model Profit = Revenue - Variable Cost - Fixed Cost Makes the following assumptions : Revenue can be estimated as:Revenue can be estimated as: Sales Price (SP) × Units Sold Variable Cost can be estimated as:Variable Cost can be estimated as: Variable Cost per unit (VC) × Units Sold Fixed Cost (FC) will remain fixed over the relevant range.Fixed Cost (FC) will remain fixed over the relevant range. Profit = Revenue - Variable Cost - Fixed Cost Makes the following assumptions : Revenue can be estimated as:Revenue can be estimated as: Sales Price (SP) × Units Sold Variable Cost can be estimated as:Variable Cost can be estimated as: Variable Cost per unit (VC) × Units Sold Fixed Cost (FC) will remain fixed over the relevant range.Fixed Cost (FC) will remain fixed over the relevant range.

12-6 CVP Model and the Break- Even Point Profit = Revenue - Variable Cost - Fixed Cost Use the above model, but assume that Profit = $0 so that Break-Even is where: Revenue = Variable Cost + Fixed Cost (SP × Sales Units) = (VC × Sales Units) + FC Using the above relationship, we can identify the number of units we need to sell in order to break even. Profit = Revenue - Variable Cost - Fixed Cost Use the above model, but assume that Profit = $0 so that Break-Even is where: Revenue = Variable Cost + Fixed Cost (SP × Sales Units) = (VC × Sales Units) + FC Using the above relationship, we can identify the number of units we need to sell in order to break even.

12-7 Break-Even Model - Example Planet, Inc. sells Model XT telescopes for $2,000 each. Fixed costs totaled $300,000, variable costs were $800 per unit. How many units does Planet need to sell in order to Break-Even? Planet, Inc. sells Model XT telescopes for $2,000 each. Fixed costs totaled $300,000, variable costs were $800 per unit. How many units does Planet need to sell in order to Break-Even? (SP × Sales Units) = (VC × Sales Units) + FC ? ?

12-8 Break-Even Model - Example Planet, Inc. sells Model XT telescopes for $2,000 each. Fixed costs totaled $300,000, variable costs were $800 per unit. How many units does Planet need to sell in order to Break-Even? Planet, Inc. sells Model XT telescopes for $2,000 each. Fixed costs totaled $300,000, variable costs were $800 per unit. How many units does Planet need to sell in order to Break-Even? (SP × Sales Units) = (VC × Sales Units) + FC Break Even Sales Units = FC ÷ (SP - VC) = $300,000 ÷ ($2,000 - $800) = $300,000 ÷ $1,200 = 250 Telescopes (SP × Sales Units) = (VC × Sales Units) + FC Break Even Sales Units = FC ÷ (SP - VC) = $300,000 ÷ ($2,000 - $800) = $300,000 ÷ $1,200 = 250 Telescopes

12-9 (SP - VC) is referred to as Contribution Margin (CM) (SP - VC) is referred to as Contribution Margin (CM) Contribution Margin Approach In the previous example, we used: FC ÷ (SP - VC) to compute Break- Even Units. In the previous example, we used: FC ÷ (SP - VC) to compute Break- Even Units.

12-10 Basic CVP in Graphical Format Quantity of Tickets Sold Cost & Revenues Fairfield Blues sells tickets for $7. Fixed Costs are $450,000 and Variable Costs per unit are $2 per ticket. The Revenue and Cost lines can be overlaid to get a picture of the CVP relationship. Exh. 12-1

12-11 Quantity of Tickets Sold Cost & Revenues Basic CVP in Graphical Format Revenue = $7 × Units Sold Total Cost = ($2 × Units Sold) + $450,000 Fixed Costs = $450,000 Exh. 12-1

12-12 Quantity of Tickets Sold Cost & Revenues Basic CVP in Graphical Format Profit Area is the amount by which revenue exceeds total cost. Loss Area is the amount by which total cost exceeds revenue. Break-Even is where the two lines intersect. Exh. 12-1

12-13 CVP and Target Income Break-Even analysis uses $0 for profit. Target Profit analysis, puts a $ target in the profit variable, but uses the same model as Break-Even analysis. Planet, Inc. sells Model XT telescopes for $2,000 each. Fixed costs are $300,000, variable costs are $800 per unit. How many units does Planet need to sell in order to have target profit of $120,000? Planet, Inc. sells Model XT telescopes for $2,000 each. Fixed costs are $300,000, variable costs are $800 per unit. How many units does Planet need to sell in order to have target profit of $120,000? Target  = (SP - VC) × Sales Units - FC ? ? Sales Units = (Target  + FC) ÷ CM per unit = ($120,000 + $300,000) ÷ $1,200 = 350 Telescopes Target  = (SP - VC) × Sales Units - FC Sales Units = (Target  + FC) ÷ CM per unit = ($120,000 + $300,000) ÷ $1,200 = 350 Telescopes

12-14 Operating Leverage Reflects the risk of missing sales targets. Measured as the ratio between contribution margin and operating income. Reflects the risk of missing sales targets. Measured as the ratio between contribution margin and operating income. A high operating leverage is indicative of high committed costs (e.g. interest). A relatively small change in sales can lead to a loss. A low operating leverage is indicative of low committed costs (e.g. interest). More of the costs are variable in nature.

12-15 Computer Spreadsheet Models 1. Gather all the facts, assumptions, and estimates for your model; i.e., parameters. 2. Describe the relations between the parameters. This usually results in an algebraic equation. 3. Separate parameters and formulas.

12-16 Modeling Taxes After-tax  = Before-tax  × (1 - Tax Rate) Adding the tax rate to your profit model, will have no effect on the computation of break-even. Adding the tax rate to your profit model will increase the number of sales units necessary to reach target profit. After-tax  = Before-tax  × (1 - Tax Rate) Adding the tax rate to your profit model, will have no effect on the computation of break-even. Adding the tax rate to your profit model will increase the number of sales units necessary to reach target profit. With careful planning, many investments and transactions can be structured to minimize the tax implications.

12-17 Modeling Multiple Products When a company sells multiple products, modeling requires: 1. An estimate of the relative proportion of each product in the “sales mix”. 2. A computation of the Weighted Average Unit CM. When a company sells multiple products, modeling requires: 1. An estimate of the relative proportion of each product in the “sales mix”. 2. A computation of the Weighted Average Unit CM.

12-18 Modeling Multiple Products Planet plans to add two new telescopes to its line, The Earth II Model and the Junior Model. Relative sales and cost estimates are: (CM 1 × Sales % 1 ) + (CM 2 × Sales % 2 ) + (CM 3 × Sales % 3 ) ? ? = ($1,200 × 25%) + ($700 × 40%) + ($350 × 35%) = ($1,200 × 25%) + ($700 × 40%) + ($350 × 35%) = $ $ $ = $ (CM 1 × Sales % 1 ) + (CM 2 × Sales % 2 ) + (CM 3 × Sales % 3 ) = ($1,200 × 25%) + ($700 × 40%) + ($350 × 35%) = ($1,200 × 25%) + ($700 × 40%) + ($350 × 35%) = $ $ $ = $702.50

12-19 Limitations of Modeling

12-20 Modeling Multiple Cost Drivers Cost drivers should be grouped based on their type. The cost model for multiple cost drivers would look like: Total Cost = (Unit variable cost × Sales units) + (Batch cost × Batch activity) + (Product cost × Product activity) + (Customer cost × Customer activity) + (Facility cost × Facility activity) Cost drivers should be grouped based on their type. The cost model for multiple cost drivers would look like: Total Cost = (Unit variable cost × Sales units) + (Batch cost × Batch activity) + (Product cost × Product activity) + (Customer cost × Customer activity) + (Facility cost × Facility activity) Note that units sold is no longer the sole cost driver.

12-21 Theory of Constraints 5. Increase the bottleneck’s capacity 1. Identify the appropriate measures of value 4. Synchronize all other processes to the bottlenecks 6. Avoid inertia and return to Step #1 2. Identify the bottlenecks 3. Use bottlenecks properly

12-22 End of Chapter 12 Yep! I’m feeling constrained NOW!