HNC – Business Management Techniques Session 3 Costs and Budgets HNC – Business Management Techniques Session 3 As part of this unit you will need to be able to use financial statements and determine how a business is managing its financial resources. There are three main ways of doing this, costs and budgets, financial statements and basic ratio analysis. In this session we look at the first of these – costs and budgets.

Fixed and Variable Costs Fixed costs Do not change regardless of the number of goods that are sold Variable Costs Change according to output The management of costs is very important when managing financial resources. It they are not managed properly, it can lead to a business not being able to pay its expenses and even the closure of the business. Keeping within a budget, increasing income to cope with change, managing working capital and ensuring money is set aside for emergencies is all part of the balancing exercise. There are two main types of cost: Fixed costs are those costs that do not change regardless of the number of goods that are sold or services that are offered. These include Rent, insurance, and salaries. These costs have to be paid no matter what. Variable costs are those that change directly according to how many products are made, for example an engine manufacturer will have requirements for amounts of gaskets, valves, etc that vary according to how many engines are made.

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Uses of Break-Even Analysis Calculating the level of sales needed How changes in output affect profit How changes in price affect BE point and profit How changes in costs affect BE point and profit

Calculating BE using Contribution Contribution = selling price – variable cost Fixed Costs BEP = Contribution It is possible to calculate the break-even point if a firm knows the value of its fixed costs, variable costs and the price it will charge. The simplest way to calculate the BE point is to use contribution. Contribution is the amount of money left over after the variable cost per unit is taken away from the selling price. (Refer to worksheet B_01_BreakEven.doc) Joseph Cadwallader.

Calculating BE using TR and TC Total Cost = Fixed cost + Variable cost Total Revenue = price x quantity sold Break even occurs when TC = TR Another way of calculating the break-even point is to use the total costs and total revenue equations. (Refer back to worksheet).

Profit and Loss Profit = TR – TC At any level of output below BEP the firm will make a loss. Total cost and total revenue equations can also be used to calculate the amount of profit or loss the firm will make at particular levels of output. At any level of output below the break-even point the firm will make a loss. Output produced above the break-even level will make a profit. (Refer back to worksheet)

Break-Even Charts The use of graphs is often helpful in break-even analysis. It is possible to identify the breakeven point by plotting the total cost and total revenue equations on a graph, called a break-even chart. Out put is measured on the horizontal axis and revenue, costs and profit are measured on the vertical axis. What does the break-even chart show? The value of total cost over a range of output. For example, when Joseph produces 1,500 benches costs are £120,000 The value of total revenue over a range of output. For example, when Joseph produces 1,500 benches total revenue is £150,000 Some charts show the level of fixed costs over a range of output, for example Joseph’s fixed costs are £60,000 The level of output needed to break-even. The break-even point is where total costs equal total revenue of £100,000. This is when 1,000 benches are produced At levels of output below the BEP losses are made, this is because total costs exceed total revenue At levels of output above the BEP a profit is made, this profit gets larger as output rises The relationship between fixed costs and variable costs as output rises. At low levels of output fixed costs represent a large proportion of total costs. As out put rises, fixed costs become a smaller proportion of total costs The profit at a particular level of output. If Joseph produces 1,500 benches, profit is shown by the vertical gap between the total cost and total revenue equations.

Margin of Safety Margin of Safety how much sales can fall by before a loss is made What if a business is producing a level of output above the break-even point? It would be useful to know by how much sales could fall before a loss is made. This is called the margin of safety. It refers to the range of output over which a profit can be made. It can be identified on the break-even chart by measuring the distance between the break-even level of output and the current (profitable) level output. Q using the chart in your handout, identify the margin of safety for Joseph Cadwallader. A if Joseph produces 1,200 benches the margin of safety is 200 benches. This means that output can fall by 200 before a loss is made. It Joseph sells 1,200 benches the chart shows that total revenue is £120,000, total cost is £108,000 and profit is therefore £12,000. Businesses prefer to operate with a large margin of safety. This means that if sales drop they still might make some profit. With a small margin of safety there is a risk that the business is more likely to make losses if sales fall.

Advantages of Break-even analysis Visual analysis of financial position Profit/loss at different levels of production Effect on break-even point Margin of safety – changes in price or costs A break-even chart is an easy visual means of analysing the firm’s financial position at different levels of output. Business decision makers can see at a glance the amount of profit or loss that will be made at different levels of production. The chart can also be used to show the effect on the break-even point, the level of profit and the margin of safety of changes in costs or price.

Limitations to break-even analysis Assumes all output is sold and no stocks are held Chart is drawn for a given set of conditions Effectiveness depends on the quality and accuracy of data used Assumes that the total cost and total revenue functions are linear Break-even analysis as an aid to business decision-making does have some limitations. It is often regarded as too simplistic, and many of its assumptions are unrealistic It assumes that all output is sold and no stocks are held. Many businesses hold stocks of finished goods to cope with changes in demand. There are also times when firms cannot sell what they produce and choose to stockpile their output to avoid laying off staff. The break-even chart is drawn for a given set of conditions. It cannot cope with a sudden increase in wages and prices or changes in technology The effectiveness of break-even analysis depends on the quality and accuracy of the data used to construct cost and revenue functions. If the data is poor or inaccurate, the conclusions drawn on the basis of the data are flawed. For example if fixed costs are underestimated, the level of output required to break-even will be higher than suggested by the break-even chart Throughout the analysis it has been assumed that the total cost and total revenue functions are linear. This may not always be the case.

Key Terms Break-even – where a business sells just enough to cover its costs   Break-even chart – a graph containing the total cost and total revenue functions, illustrating the break-even point Break-even point - the level of output where total revenue and total cost are the same Margin of Safety – the range of output between the break-even level and the current level of output, over which a profit is made

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