Unit 2: Managing a business Finance Using budgets Chapter 16

Unit 2: Managing a business Finance What is a budget? A budget is an agreed plan establishing, in numerical or financial terms, the policy to be pursued and the anticipated outcomes of that policy. In Unit 1 the setting of budgets was discussed. The focus was on planning a budget. In Unit 2 the actual using of budgeting is studied. How can budgeting help the business to improve its performance?

Unit 2: Managing a business Finance Benefits and drawbacks of using budgets Benefits They provide direction and coordination. They can motivate staff. They improve efficiency. They encourage careful planning. Drawbacks They are difficult to monitor fairly. Allocations may be incorrect and unfair. Savings may be sought that are not in the interests of the firm. They may be inflexible.

Unit 2: Managing a business Finance Features of good budgeting A good budget should: be consistent with the aims of the business be based on the opinions of as many people as possible set challenging but realistic targets (be SMART) be monitored at regular intervals be flexible

Unit 2: Managing a business Finance Variance analysis variance analysis: the process by which the outcomes of budgets are examined and then compared to the budgeted figures. The reasons for any differences (variances) are then found. favourable variance: when costs are lower than expected or revenue is higher than expected. adverse (unfavourable) variance: when costs are higher than expected or revenue is lower than expected.

Unit 2: Managing a business Finance Calculating variances A variance is calculated by the following formula: variance = budget figure – actual figure For variance analysis, use ‘F’ for favourable variances and ‘A’ for adverse variances, rather than positive or negative numbers. A favourable variance would happen when: actual income is greater than budgeted income actual costs are below budgeted costs An adverse (or unfavourable) variance would be shown when: actual income is less than budgeted income actual costs are above budgeted costs

Unit 2: Managing a business Finance Calculating variances: the golden rule The golden rule: knowing the effect a variance has on profit tells you whether it is favourable or adverse. A favourable variance will mean more profit than expected. An adverse variance will mean less profit than expected.

Unit 2: Managing a business Finance Example variance calculation: income budget Income budget for XYZ Ltd, April 2009 Source of income Budgeted income (£) Actual income (£) Variance (£)F/A Product A7,5007,600100F Product B6,0005,700300A Total income13,50013,300200A

Unit 2: Managing a business Finance Example variance calculation: expenditure budget Expenditure budget for XYZ Ltd, April 2009 Item of expenditure Budgeted expenditure (£) Actual expenditure (£) Variance (£)F/A Raw materials2,7002,500200F Labour costs2,4002,45050A Administration and other costs 4,500 0– Total expenditure 9,6009,450150F

Unit 2: Managing a business Finance Example variance calcualtion: profit budget Profit budget for XYZ Ltd, April 2009 Item of income/ expenditure Budgeted profit (£) Actual profit (£) Variance (£)F/A Total income13,50013,300200A Total expenditure 9,6009,450150F Budgeted profit3,9003,85050A

Unit 2: Managing a business Finance Interpreting the variances 1What factors might have caused the variances for XYZ Ltd? In small groups find: aTwo factors WITHIN the business that might have led to the variances in the INCOME budget. bOne factor OUTSIDE the business that might have led to the variances in the INCOME budget. cTwo factors WITHIN the business that might have led to the variances in the EXPENDITURE budget. dOne factor OUTSIDE the business that might have led to the variances in the EXPENDITURE budget. 2Suggest two actions the business might take to improve matters.

Unit 2: Managing a business Finance Interpreting the variances: answers Possible answers include: 1a Successful marketing of product A. Low-quality production of product B. 1b Adverse media publicity concerning product B. 1c Efficient production methods, leading to lower wastage of raw materials. Workers being given a wage rise that was higher than expected. 1d An unexpected shortage of raw materials, leading to higher prices being charged by suppliers. 2 Introduce new quality assurance measures for product B. Investigate alternative suppliers or different raw materials.

Unit 2: Managing a business Finance Calculating variance: income budget Complete the variance analysis for XYZ Ltd’s income budget. The budgeted income column has been provided. Actual income for XYZ’s two products were: product A: 3,000 units were sold at a price of £2.70 product B: 6,400 units were sold at a price of £1.25 Income budget for XYZ Ltd, May 2009 Source of income Budgeted income (£) Actual income (£) Variance (£)F/A Product A (3,200 x £2.50)8,000 Product B (6,000 x £1.30)7,800 Total income15,800

Unit 2: Managing a business Finance Calculating variance: expenditure budget Complete the variance analysis for XYZ Ltd’s expenditure budget. The budgeted expenditure column has been provided. Actual expenditure was as follows: Raw materials were 25% of the actual income. Labour costs were 25p per unit (9,400 × 25p). Administration and other costs were £4,200.

Unit 2: Managing a business Finance Expenditure budget for XYZ Ltd, May 2009 Item of expenditure Budgeted expenditure (£) Actual expenditure (£) Variance (£)F/A Raw materials (25% of £15,800) 3,950 Labour costs (9,200 x 25p)2,300 Administration and other costs 4,600 Total expenditure10,850

Unit 2: Managing a business Finance Calculating variance: profit budget Complete the variances for XYZ Ltd’s profit budget, based on your variances for the income and expenditure budgets. Profit budget for XYZ Ltd, May 2009 Item of income/ expenditure Budgeted profit (£) Actual profit (£) Variance (£)F/A Total income15,800 Total expenditure 10,850 Budgeted profit4,950

Unit 2: Managing a business Finance Income budget: answers Income budget for XYZ Ltd, May 2009 Source of income Budgeted income (£) Actual income (£) Variance (£)F/A Product A (3,200 x £25)8,0008,100100F Product B (6,000 x £13)7,8008,000200F Total income15,80016,100300F

Unit 2: Managing a business Finance Expenditure budget: answers Expenditure budget for XYZ Ltd, May 2009 Item of expenditure Budgeted expenditure (£) Actual expenditure (£) Variance (£)F/A Raw materials (25% of £15,800) 3,9504,02575A Labour costs (9,200 x 25p)2,3002,35050A Administration and other costs 4,6004,200400F Total expenditure10,85010,575275F

Unit 2: Managing a business Finance Profit budget: answers Profit budget for XYZ Ltd, May 2009 Item of income/ expenditure Budgeted profit (£) Actual profit (£) Variance (£)F/A Total income15,80016,100300F Total expenditure 10,85010,575275F Budgeted profit4,9505,525575F

Unit 2: Managing a business Finance Interpreting the variances What were the main factors that led to the variance in XYZ’s profit for May 2009? Possible answers are: The price increase for product A led to a small fall in demand, which led to sales revenue increasing. (Lower volume would also have saved on variable costs.) The price cut for product B led to a significant rise in demand and an increase in income (but a rise in variable costs too). There was a major cut in administration costs of almost 10%. Although variable costs rose per unit produced, they were the same as the budget. Conclusion: the main reason for the favourable variance in profit was the significant saving in administration and other costs. The price changes of both products also helped to boost income.

Unit 2: Managing a business Finance Using budgets: follow-up exercise Complete the questions in case study 1 at the end of Chapter 16.

Unit 2: Managing a business Finance Chapter 17 Improving cash flow

Unit 2: Managing a business Finance Causes of cash-flow problems cash flow: the amounts of money flowing into and out of a business over a period of time. Firms may have shortages of cash for a variety of reasons: seasonal demand overtrading, arising from over-expansion over-investment in fixed assets credit sales poor stock management poor management of suppliers unforeseen change, e.g. a strike losses or low profits

Unit 2: Managing a business Finance Ways of improving cash-flow problems (1) There are many ways of improving cash flow. The method(s) chosen may vary according to the cause of the cash-flow problem. The AQA specification identifies five main ways of improving cash-flow problems. These are shown on this slide and the next: Bank overdraft. An agreement whereby the holder of a current account in a bank is allowed to withdraw more money than there is in the account. Short-term loan. This is a sum of money provided to a firm or an individual for a specific, agreed purpose. Repayment of the loan will usually take place within 2 years.

Unit 2: Managing a business Finance Ways of improving cash-flow problems (2) Factoring. When a factoring company (usually a bank) buys the right to collect the money from the credit sales of an organisation. Sale of assets. This process can improve cash flow by converting an asset (e.g. property or machinery) into cash, which can then be used to ease the problem. Sale and leaseback of assets. Assets that are owned by the firm are sold to raise cash and then rented back so that the company can still use them for an agreed period of time. The benefits and problems of using each of these five methods of improving cash flow are discussed after the next slide.

Unit 2: Managing a business Finance Ways of improving cash-flow problems (3) Some other ways of improving cash flow (not specified in the AQA specification) are listed below: Careful cash management (e.g. setting aside a contingency fund for emergencies). Effective debt management — chasing up customers who have not paid on time. Stock management — making sure that money is not tied up in excessively high stock levels. Diversifying to create a range of products that sell throughout the year. Careful budgeting.

Unit 2: Managing a business Finance Benefits of a bank overdraft It is easy to arrange and, once agreed, tends only to need confirming on an annual basis. It is very flexible, as the overdraft can be used to pay for whatever the business requires at the time. Interest is only paid on the level of the overdraft that is actually used. Furthermore, interest is only paid on a daily basis. Unlike with a bank loan, a firm that uses a bank overdraft does not need to provide security (collateral).

Unit 2: Managing a business Finance Problems of a bank overdraft Bank overdrafts are based on flexible interest rates, so it is difficult to budget accurately — the bank may change its rate of interest. The rate of interest charged on an overdraft is usually higher than that charged on a short-term bank loan. Agreements to provide an overdraft normally allow the bank to demand immediate repayment.

Unit 2: Managing a business Finance Benefits of short-term loans Bank loans are usually at a fixed rate of interest. The interest and repayment schedule is calculated at the time of the loan, so it easy for the business to know whether it can afford to repay the loan and budget for repayment. The rate of interest charged on a bank loan is usually less than that charged on an overdraft, so it can be a cheaper solution to a cash-flow problem. A bank loan may be set up for a long period of time, to help the firm.

Unit 2: Managing a business Finance Problems of short-term loans Interest is paid on the whole of the sum borrowed. The business will need to provide the bank with security (collateral). Short-term loans can often only be used for a specific, agreed purpose.

Unit 2: Managing a business Finance Benefits of (debt) factoring Improved cash flow in the short term. Lower administration costs. Reduced risk of bad debts. Can encourage businesses to be cautious and careful with their provision of credit, to ensure that all debts are factored.

Unit 2: Managing a business Finance Problems of (debt) factoring The main problem is the cost to the business, which will lose between 5% and 10% of its revenue. The factoring company will charge more for factoring than it would for a loan, as there are administrative expenses involved in chasing up the debts. Customers may prefer to deal directly with the business that sold them the product. An aggressive factoring company may upset certain customers, who will blame the original seller of the product.

Unit 2: Managing a business Finance Benefits of sale of assets Selling assets can raise a considerable sum of money, particularly in the case of a large asset such as a building. If a particular asset is no longer helping towards the business’s overall success, sale of the asset will not only ease the cash-flow problem, but also enhance the overall profitability of the business.

Unit 2: Managing a business Finance Problems of sale of assets Assets such as buildings and machinery may be very difficult to sell quickly. A business trying to make a quick sale usually has to accept a much lower price than its true value. It is a fundamental principle of business that a firm should not sell fixed assets to improve liquidity, as the fixed assets enable it to produce the goods and services that create its profit.

Unit 2: Managing a business Finance Benefits of sale and leaseback This will overcome a cash-flow problem by providing an immediate inflow of cash, usually of quite a significant level. A firm can be more flexible, as new and more efficient assets can be leased. The ownership of fixed assets can lead to a number of costs, such as maintenance. Sale and leaseback eliminates these costs. Owning an asset can distract a business from its core activity because it has to get involved with activities such as property management or organising a transport fleet.

Unit 2: Managing a business Finance Problems of sale and leaseback In the long term, the firm will usually pay more in rent than it receives from its sale. As a result, sale and leaseback will also reduce the value of the firm’s assets that can be used as security against future loans. The business may eventually lose the use of the asset when the lease ends, as a competitor may be prepared to pay a higher rental for the lease.

Unit 2: Managing a business Finance Finding the causes of a cash-flow problem: group exercise Find three or four possible causes of the forecast cash-flow problems in the situation below. * In quarters 2 and 3, customers will be given 6 months’ credit when they buy product A, to boost sales 2009 Qtr 1 (£000s) 2009 Qtr 2 (£000s) 2009 Qtr 3 (£000s) 2009 Qtr 4 (£000s) Opening balance01916(24) Sales income: product A* Sales income: product B Total inflows Raw material costs Wages Capital costs00260 Total outflows Net cash flow19(3)(40)9 Closing balance1916(24)(15)

Unit 2: Managing a business Finance Finding the causes of a cash-flow problem: answers (1) Possible causes: credit given to customers of product A leading to 6 months’ delay in receiving cash steadily declining sales of product B, bringing in less income significant increase in wage payments in quarter 3 large expenditure on capital costs in quarter 3

Unit 2: Managing a business Finance Finding the causes of a cash-flow problem: individual exercise Find three or four possible causes of the cash-flow problem in the situation shown below Qtr 1 (£000s) 2010 Qtr 2 (£000s) 2010 Qtr 3 (£000s) 2010 Qtr 4 (£000s) Opening balance02510(26) Sales income (total inflows) Raw material costs Wages Capital costs0000 Vehicle purchase03200 Loan repayment00240 Total outflows Net cash flow25(15)(36)7 Closing balance2510(26)(19)

Unit 2: Managing a business Finance Finding the causes of a cash-flow problem: answers (2) Possible causes: seasonal sales — dramatic fall of income in quarter 3 purchase of £32,000 vehicle in quarter 2 repayment of loan — £24,000 in quarter 3 large increase in raw material costs in quarter 4 has prevented recovery

Unit 2: Managing a business Finance Solving cash-flow problems (1) In groups, discuss: possible solutions to the cash-flow problems listed on the slide ‘Finding the causes of a cash-flow problem: group exercise’ possible solutions to the cash-flow problems listed on the slide ‘Finding the causes of a cash-flow problem: individual exercise’

Unit 2: Managing a business Finance Solving cash-flow problems (2) Possible answer to problems (group exercise) ProblemPossible solution Credit given to customers of product ADebt factoring Declining sales of product BChange marketing Increase in wagesInvestigate reason Capital costsLease asset

Unit 2: Managing a business Finance Solving cash-flow problems (3) Possible answer to problems (individual exercise) ProblemPossible solution Seasonal demandBroaden product range Purchase of assetLease asset Repayment of loanSpread repayment over time Raw material costsResearch other suppliers

Unit 2: Managing a business Finance Chapter 18 Measuring and increasing profit

Unit 2: Managing a business Finance Profit and profitability profit: the difference between the income of a business and its total costs. profit = revenue – total costs profitability: the ability of a business to generate profit or the efficiency of a business in generating profit.

Unit 2: Managing a business Finance Measure of profitability Two ways of measuring profitability will be considered. Both measures investigate how efficient a business is in terms of achieving a profit. net profit margin: compares the profit made with the sales income of the business/branch. return on capital: compares the profit made with the amount of capital invested by the entrepreneur or financial backer.

Unit 2: Managing a business Finance Net profit margin This ratio is calculated as follows: net profit margin (%) =net profit before tax × 100 sales income (turnover) For example: net profit = £20,000 sales income = £80,000 net profit margin (%) =£20,000 × 100 = 25% £80,000

Unit 2: Managing a business Finance Interpreting the net profit margin (1) To assess the meaning of a net profit margin, two comparisons are usually made: Comparison over time. Is the net profit margin increasing (suggesting improvements in efficiency) or decreasing (implying a decline in efficiency)? Comparison to other firms or branches/divisions. These comparisons are useful because they look at the business’s success (or failure) relative to other businesses. It is much easier to make high net profit margins in some industries* than in others; this calculation avoids judgements that may be affected by this factor. *These industries usually sell fewer items at higher prices, so a high net profit margin is not a guarantee of higher overall profit levels.

Unit 2: Managing a business Finance Interpreting the net profit margin (2) What conclusions can be drawn about the net profit margins of the three companies in the table above? Company Net profit margin (%) 2005 Net profit margin (%) 2006 Net profit margin (%) 2007 Net profit margin (%) 2008 Company A Company B Company C

Unit 2: Managing a business Finance Interpreting the net profit margin: conclusions With all three companies, comparisons should be made with competitors in the same industry. This analysis assumes that the three companies are in direct competition. Company A earns a consistent net profit that has increased steadily over the 4 years. In 2008, it recorded the highest net profit margin, so it is the company that appears most likely to be successful in the future. Company B has been the most successful business for 3 of the 4 years, so its overall performance has been the best of the three companies. However, its net profit margin has fallen each year and the trend suggests that it is unlikely to be as successful as Company A in the future (unless there are specific, temporary reasons for 2007 and 2008 not being such good years). Company C has made a consistent profit each year but it has been less profitable than the other two companies and its owners may be concerned at the relatively low levels of profit being made. However, in some competitive industries (such as supermarkets) Company C’s net profit margins are only slightly below the average.

Unit 2: Managing a business Finance Return on capital This ratio is calculated as follows: return on capital (%) = net profit × 100 capital invested For example: net profit = £20,000 capital invested = £100,000 return on capital (%) =£20,000 × 100 = 20% £100,000

Unit 2: Managing a business Finance Interpreting the return on capital (1) To assess the meaning of the return on capital (%), three comparisons are usually made: Comparison over time. Is the return on capital increasing or decreasing? Comparison with other firms or branches/divisions. Is the money invested in this business providing a better return than the money invested in other businesses? Comparison with bank interest rates. The opportunity cost for many investments is the interest that could have been gained from placing the money in a bank account. As there is no real risk in this investment, the return on capital invested in a business needs to be higher than the interest rate offered by a bank.

Unit 2: Managing a business Finance Interpreting the return on capital (2) What conclusions can be drawn about the return on capital of the three companies in the table above? Company Return on capital (%) 2005 Return on capital (%) 2006 Return on capital (%) 2007 Return on capital (%) 2008 Company A Company B Company C Bank interest rate (%)

Unit 2: Managing a business Finance Interpreting the return on capital: conclusions Company A has steadily improved and made excellent returns on capital. It is clearly the best company in which to invest. Company B performed well in 2005 and 2006, but its performance became unsatisfactory in 2007 and has worsened again in Its overall return is below the bank interest rate and it is not a good investment unless the reason for its sudden decline can be discovered and put right. Company C has only performed satisfactorily in one year (2008). However, it has been improving its profitability and would seem to be a better investment for the future than Company B.

Unit 2: Managing a business Finance Methods of improving profits/profitability Many methods can be used. Three main methods are: increasing the price decreasing costs increasing sales volume

Unit 2: Managing a business Finance Increasing the price Increasing the price will widen the profit margin. Therefore each product sold will generate more profit. This strategy will be particularly effective if the product is a necessity or has no close substitutes, as customers will be willing to pay the higher price. BUT…this strategy will fail if the higher price leads to customers switching to rival products or just giving up on buying the product. The business must analyse the likely effect of any price increase in situations where there are many close competitors. It is possible that the price rise may cause such a large fall in demand that the higher profit margin will be offset by a dramatic fall in quantity, so the overall profit may fall. In situations where there are many competitors, it may actually be more profitable to cut the price.

Unit 2: Managing a business Finance Price elasticity of demand To assess the impact of price changes on profit, an understanding of price elasticity of demand is needed. This is provided in Chapter 32. After reading about price elasticity of demand, refer back to Chapter 18. Price elasticity of demand will enable you to provide more sophisticated responses to questions about price changes.

Unit 2: Managing a business Finance Decreasing variable and fixed costs Variable costs If the firm can cut its variable costs, the profit margin will increase. This means that each product will yield more profit. BUT…if the change in costs leads to a decrease in quality (e.g. inferior raw materials) or efficiency, the demand for the product may fall. Fixed costs Profit will also increase if fixed costs, such as rent, are reduced. BUT…not if the cost cutting leads to lower sales (e.g. locating the shop in a place that is less accessible to customers).

Unit 2: Managing a business Finance Increasing sales volume If costs and price remain the same, it is still possible to increase profits by increasing the volume of products sold. A business can achieve this by a number of methods, such as: increasing marketing developing new products improving quality BUT…all of these methods will cost money.

Unit 2: Managing a business Finance Numerical example: background information A business sells 500 units of a product at £10 each. Its fixed costs are £2,000 and its variable costs are £3 per unit. Calculate the profit made on this product. Answer TR – TC = £5,000 – (£2,000 + £1,500) = £5,000 – £3,500 = £1,500 Research reveals the following: 1An increase in price to £12 will lead to a fall in sales to 450 units. 2Cheaper raw materials will reduce variable costs to £2.50 per unit. 3A poster campaign costing £800 will increase sales by 10%.

Unit 2: Managing a business Finance Numerical example: exercise Will the changes on the previous slide increase or decrease the profit? Taking each change in isolation, calculate the profit made from: 1An increase in price to £12, which leads to a fall in sales to 450 units. 2Cheaper raw materials, which reduce variable costs to £2.50 per unit. 3A poster campaign costing £800, which increases sales by 10%. Should the business make these three changes?

Unit 2: Managing a business Finance Numerical example: answers 1 and 2 1TR = £12 × 450 TR =£5,400 FC = £2,000 TVC = £3 × 450 = £1,350TC =£3,350 Profit =£2,050 Profit increases by £2,050 – £1,500 = £550. Note how some of the increase in profit has come from lower variable costs because fewer products are made. 2TR = £5,000 FC = £2,000 TVC falls to 500 × £2.50 = £1,250 profit = TR – TC = £5,000 – (£2,000 + £1,250) = £5,000 – £3,250 = £1,750 Profit increases by £1,750 – £1,500 = £250.

Unit 2: Managing a business Finance Numerical example: answer 3 and conclusion 3Sales volume increases by 10% from 500 to 550 units. FC increases by £800. TR = 550 × £10 = £5,500VC = 550 × £3 = £1,650 FC = £2,000 + £800 = £2,800 profit = £5,500 – £1,650 – £2,800 = £1,050 Profit increases by £1,050 – £1,500 = –£450 (the business’s profits fall by £450). Conclusion The business should carry out actions 1 and 2 but not implement action 3.

Unit 2: Managing a business Finance Extension work Calculate the final profit if actions 1 and 2 only are implemented. How much profit would be made if all three options were implemented?

Unit 2: Managing a business Finance Other methods of improving profit/profitability Some other methods of improving profits are noted below, but this is not an exhaustive list: investment in fixed assets product development marketing staff training Note how each of the functional areas can contribute to improved profitability. Can you add to this list?

Unit 2: Managing a business Finance Distinction between cash and profit Profit is calculated by subtracting expenditure from revenue. It is easy to assume that a profitable firm will be cash rich, but this is not necessarily true. Liquidity is the ability to convert an asset into cash without loss or delay. The most liquid asset that a business can possess is cash. Many firms will not have their profit in the form of cash, so a high profit may not guarantee a high level of cash. It is also possible for a firm to have low profits but high cash levels. For example, a business that has just borrowed a large sum of money will have high cash levels, regardless of its profit levels.

Unit 2: Managing a business Finance Why a profitable firm might be short of cash The firm has built up its stock levels. Its wealth will lie in stocks on shelves rather than cash. The firm has given credit to its customers. Its wealth will be in debtors (people who owe money to the firm). The firm has used its profit to pay dividends to shareholders or repay long-term loans; it may be short of cash. The firm has purchased fixed assets, such as new machinery or vehicles.

Unit 2: Managing a business Finance Measuring and increasing profit: follow-up work Complete the questions in the case study on Cadbury at the end of Chapter 18.