Profit, Profitability, and Break-Even Analysis

Learning Objectives  Understand the difference between efficiency and effectiveness.  Distinguish between profit and profitability.  Compare accounting and entrepreneurial profit.  Understand the relationship of profit margin and asset turnover on the earning power of a company.

Learning Objectives (continued)  Given the variable costs, revenue, and fixed costs of a business, determine the break-even point and contribution margin.  Construct and analyze a break-even chart when given variable costs, revenue, and fixed costs of a business.

Learning Objectives (continued)  Understand the use of leverage and its relationship to profitability and loss.  Compare and contrast the degree of operating, financial, and combined leverage and their effect on the profitability of a corporation.  Distinguish between Chapters 11, 13, and 7 bankruptcy.

Efficiency and Effectiveness  Efficiency is obtaining the highest possible return with the minimum use of resources.  Effectiveness, on the other hand, is accomplishing a specific task or reaching a goal.

Profit Versus Profitability  Profit is an absolute number that is earned on an investment. Accounting profit, for a business, is typically shown at the bottom of an income statement as net income. Entrepreneurial profit is the amount that is earned above and beyond what the entrepreneur would have earned if he or she had chosen to invest time and money in some other enterprise.

Profit Versus Profitability (continued)  Profitability can be measured in a business by using a ratio that is obtained by dividing net profit by total assets. Profitability, therefore, is our Return on Investment (assets).

Earning Power  The earning power of a company can be defined as the product of two factors: The company’s ability to generate income on the amount of revenue it receives, which is also known as net profit margin; and Its ability to maximize sales revenue from proper asset employment, also known as total asset turnover.

Earning Power Formulas  Earning power is equal to net profit margin multiplied by total asset turnover which is equal to return on investment (total assets).

Break-Even Analysis  Break-even analysis is a process of determining how many units of production must be sold, or how much revenue must be obtained, before we begin to earn a profit.  For break-even quantity:

Break-Even Graph

Break-Even Analysis (continued)  Break-even dollars: Where VC is variable cost expressed as a percentage of sales (revenue). For retail firm: VC percentage =(Cost of Goods Sold)/(Net Sales) For manufacturing firm: VC percentage = (Variable cost of a unit)/(Selling price)

Break-Even Analysis (continued)  Contribution margin is the amount of profit that will be made by a company on each unit that is sold above and beyond the break-even quantity.  Contribution margin is also the amount the company will lose for each unit of production by which it falls short of the break-even point.

Profit and Break-Even  Desired profit with break-even analysis in quantity to produce. VC is variable cost per unit  Desired profit with break-even analysis in dollars. VC is a percentage of sales dollar (e.g., cost of goods sold as a percent).

Break-Even Charts

Leverage  Leverage uses those items that have a fixed cost to magnify the return to a company. Fixed costs can be related to company operations or related to the cost of financing. Interest expenses paid on the amount of debt incurred is the fixed cost of financing. A firm is heavily financially leveraged if the fixed costs of financing are high.

Leverage (continued)  Degree of operating leverage (DOL) is the percentage change in operating income divided by the percentage change in sales.

Leverage (continued)  Degree of financial leverage (DFL) is the percentage change in earnings per share divided by the percentage change in operating income.

Leverage (continued)  Degree of combined leverage (DCL) is the percentage change in earnings per share divided by the percentage change in sales.

Bankruptcy  Bankruptcy for a business occurs when the liabilities of the firm exceed the assets and the business does not have sufficient cash flow to make payments to creditors. There are essentially three types of bankruptcy, Chapter 11, Chapter 13, and Chapter 7.

Bankruptcy (continued) Chapter 11 bankruptcy occurs when a business seeks court protection while it develops a reorganization plan. Chapter 13 bankruptcy is reserved for individuals and sole proprietorships and is similar to, but much simpler than, Chapter 11. Chapter 7 bankruptcy requires liquidation of all assets of the business, and payment to the creditors.

Bankruptcy (continued)  Bankruptcy Abuse, Prevention, and Consumer Protection Act. Signed into law by President Bush on April 20, Took effect October 17, Makes it much more difficult for individuals and business to declare Chapter 7 bankruptcy. Establishes a means test to determine if an individual filing Chapter 7 is abusing the system. Imposes federal guidelines for using the homestead exemption.

Table 5-3