Accounting & Financial Analysis 111 Lecture 12 Cost – Volume – Profit Analysis Horizontal & Vertical Analysis Common Errors in End of Period Reports Essential Financial Reports Specialist Accounting Assistance

Cost - Volume - Profit (C-V-P) Analysis This relates to the sessions were we discussed the Break-Even point, variable costs, semi-variable costs, and fixed costs. The equation for Break-Even point is: Sales = Variable costs + fixed costs (= $0 profit) The break-even point can be expressed in $ dollars, or in units of sale This relates to the sessions were we discussed the Break-Even point, variable costs, semi-variable costs, and fixed costs. The equation for Break-Even point is: Sales = Variable costs + fixed costs (= $0 profit) The break-even point can be expressed in $ dollars, or in units of sale

Cost - Volume - Profit (C-V-P) Analysis 2 We have established that a company goes into business so that they will make a net profit from their trade So Net Profit is an important element in any equation that is measuring business costs and management efficiency. Costs, volume of sales, and profit margin are interrelated. If either costs or volume change they will affect the profit. We have established that a company goes into business so that they will make a net profit from their trade So Net Profit is an important element in any equation that is measuring business costs and management efficiency. Costs, volume of sales, and profit margin are interrelated. If either costs or volume change they will affect the profit.

Cost - Volume - Profit (C-V-P) Analysis 3 C-V-P analysis is the technique used to analyse the interdependency of the three elements using the knowledge that a change in one of the elements will have a consequential affect on the other two. It is used to assist in setting the sale price in order to cover the variable costs, fixed costs and the required net profit. C-V-P analysis is the technique used to analyse the interdependency of the three elements using the knowledge that a change in one of the elements will have a consequential affect on the other two. It is used to assist in setting the sale price in order to cover the variable costs, fixed costs and the required net profit.

Cost - Volume - Profit (C-V-P) Analysis 4 The equation : Sales revenue = Variable costs + Fixed costs + net profit Sales revenue = Variable costs + Fixed costs + net profit (Where sales revenue = No. of units sold * Price per unit) Refer back to session 8 for demonstration of setting the profit margin required and the affect it would have on the sales volume. The equation : Sales revenue = Variable costs + Fixed costs + net profit Sales revenue = Variable costs + Fixed costs + net profit (Where sales revenue = No. of units sold * Price per unit) Refer back to session 8 for demonstration of setting the profit margin required and the affect it would have on the sales volume.

Profit Margin The profit margin can be determined in a number of ways: 1) Knowledge of contributory margin per unit. 2) Knowledge of fixed costs. 3) As per market analysis and budget forecasts. 4) Expected rate of return on sales revenue. 5) Expected return on asset value. 6) Expected return on capital. 7) Statistical data relating to industry benchmarks. 8) A study of competitors, their pricing and activities. The profit margin can be determined in a number of ways: 1) Knowledge of contributory margin per unit. 2) Knowledge of fixed costs. 3) As per market analysis and budget forecasts. 4) Expected rate of return on sales revenue. 5) Expected return on asset value. 6) Expected return on capital. 7) Statistical data relating to industry benchmarks. 8) A study of competitors, their pricing and activities.

Profit Margin 2 The first six points are internal management decisions but even a carefully studied cost evaluation may need to be adjusted after considering the market expectations and product availability. It is possible to appoint Specialist Agencies to investigate the current trends in products & pricing; and to conduct a public survey to establish customer expectations and reactions to price variations The result of these studies will help in determining the pricing structure in a competitive market and will have a direct affect on the profit margin. The first six points are internal management decisions but even a carefully studied cost evaluation may need to be adjusted after considering the market expectations and product availability. It is possible to appoint Specialist Agencies to investigate the current trends in products & pricing; and to conduct a public survey to establish customer expectations and reactions to price variations The result of these studies will help in determining the pricing structure in a competitive market and will have a direct affect on the profit margin.

Horizontal and Vertical analysis In order to confirm their performance company’s compare certain key performance indicators over a number of years. They can compare a one line item such as ‘sales’ (units or $ value), wages, gross profit, net profit, accounts receivable etc. Or they can compare a relationship between certain figures, such as cost of goods sold is 40% of sales, and check whether this percentage will change over the years. In order to confirm their performance company’s compare certain key performance indicators over a number of years. They can compare a one line item such as ‘sales’ (units or $ value), wages, gross profit, net profit, accounts receivable etc. Or they can compare a relationship between certain figures, such as cost of goods sold is 40% of sales, and check whether this percentage will change over the years.

Horizontal analysis Comparing a trend over different periods. E.g. monthly, quarterly, half yearly, or yearly. There must be a starting point which would be determined as 100% All other points will relate to the starting point and give the percentage variation from that point. So we can say that sales are 110% compared to last year. Or sales have increased 180% compared to Comparing a trend over different periods. E.g. monthly, quarterly, half yearly, or yearly. There must be a starting point which would be determined as 100% All other points will relate to the starting point and give the percentage variation from that point. So we can say that sales are 110% compared to last year. Or sales have increased 180% compared to 2002.

Example: Horizontal Analysis Prepare a horizontal analysis for sales revenue using 2001 as the base year. 2001$620, $670, $713, $775, $837,000 Prepare a horizontal analysis for sales revenue using 2001 as the base year. 2001$620, $670, $713, $775, $837,000

E.g: Horizontal Analysis (2) YEAR Sales $620,000 $670,000 $713,000 $775,000 $837, %108%115%125%135%

Horizontal analysis (2) Horizontal analyses are also applicable to compare the actual results to the budget results Use the budget as the base 100% for comparison purposes. Sales for the month could be 105% on budget. Horizontal analyses are also applicable to compare the actual results to the budget results Use the budget as the base 100% for comparison purposes. Sales for the month could be 105% on budget.

Vertical Analysis When analysing financial statements management will be interested in comparing the relationship between two figures over a number of years. E.g in an Income Statement how does the Contribution margin, Gross profit and Net profit vary in relation to sales revenue each year E.g in an Income Statement how does the Contribution margin, Gross profit and Net profit vary in relation to sales revenue each year When analysing financial statements management will be interested in comparing the relationship between two figures over a number of years. E.g in an Income Statement how does the Contribution margin, Gross profit and Net profit vary in relation to sales revenue each year E.g in an Income Statement how does the Contribution margin, Gross profit and Net profit vary in relation to sales revenue each year

Vertical Analysis (2) YearSales revenueGross ProfitNet Profit 2001$620,000$279,000$93, $670,000$308,200$107, $713,000$342,240$128, $775,000$395,250$170, $837,000$426,870$175,770 YearSales revenueGross ProfitNet Profit 2001$620,000$279,000$93, $670,000$308,200$107, $713,000$342,240$128, $775,000$395,250$170, $837,000$426,870$175,770 Calculate the percentages for each year and compare results.

Vertical Analysis (3) solution Year Sales revenue Gross Profit GP as % of Sales Reve nue Net Profit NP as % of Sale s Reve nue 2001$620,000$279,00045%$93,00015% 2002$670,000$308,20046%$107,20016% 2003$713,000$342,24048%$128,34018% 2004$775,000$395,25051%$170,50022% 2005$837,000$426,87051%$175,77021% $3,615,000$1,751,56048%$674,81019%

Analysing company performance A company’s performance depends on the management structure and techniques applied to develop the business and to monitor it. There are various ways to monitor the company’s performance: A company’s performance depends on the management structure and techniques applied to develop the business and to monitor it. There are various ways to monitor the company’s performance:

Analysing company performance (2) Check actual activity to budget plan. Check actual activity to previous years. (Horizontal analysis) Check percentage returns and compare to other periods. (Vertical analysis) Check actual activity to industry benchmarks Compare ratios to industry benchmarks Compare financial reports on historic basis Check actual activity to budget plan. Check actual activity to previous years. (Horizontal analysis) Check percentage returns and compare to other periods. (Vertical analysis) Check actual activity to industry benchmarks Compare ratios to industry benchmarks Compare financial reports on historic basis

Essential financial reports The three main financial reports that a company prepares are: Income statement aka Profit & Loss (Statement of financial performance) Balance sheet (Statement of financial position) Cash flow statement The three main financial reports that a company prepares are: Income statement aka Profit & Loss (Statement of financial performance) Balance sheet (Statement of financial position) Cash flow statement

Income statement aka Profit & Loss (Statement of financial performance) This report shows the trading profit made by the company over the reporting period. The principle sections of the report are: Contribution margin Gross profit Net profit before tax Net profit after tax (transferred to retained profit account in the balance sheet.) This report shows the trading profit made by the company over the reporting period. The principle sections of the report are: Contribution margin Gross profit Net profit before tax Net profit after tax (transferred to retained profit account in the balance sheet.)

Balance sheet (Statement of financial position) This shows the financial health of the company = “What it is worth” The company’s worth is the value of the owner’s equity. Total assets – total liabilities. In other words the accounting equation: (Assets – liabilities = Owner’s equity ) Ratios are applied to the balance sheet in order to establish the company’s ability to meet it’s debts and other commitments. This shows the financial health of the company = “What it is worth” The company’s worth is the value of the owner’s equity. Total assets – total liabilities. In other words the accounting equation: (Assets – liabilities = Owner’s equity ) Ratios are applied to the balance sheet in order to establish the company’s ability to meet it’s debts and other commitments.

Cash flow statement Used to explain the application of funds. i.e.How did the company invest the inflow of money it received during the year? This statement shows the: Opening cash balance All cash received – either through trade sales, sale of fixed assets or loans. All cash paid out – trade expenses, purchase of fixed assets, income tax paid, loans made to other companies or individuals. Closing balance which must reconcile to the Bank amount in the balance sheet. Used to explain the application of funds. i.e.How did the company invest the inflow of money it received during the year? This statement shows the: Opening cash balance All cash received – either through trade sales, sale of fixed assets or loans. All cash paid out – trade expenses, purchase of fixed assets, income tax paid, loans made to other companies or individuals. Closing balance which must reconcile to the Bank amount in the balance sheet.

Cash flow statement (2) Needs to be effectively monitored in order to maintain financial stability. The following processes should be applied as part of the company policy & procedures: Needs to be effectively monitored in order to maintain financial stability. The following processes should be applied as part of the company policy & procedures:

Cash flow statement (3) Processes Regular inspection of debtor’s subsidiary ledger and follow up on overdue accounts. Careful assessment of amount of stock (inventory) required. Supplier’s accounts to be paid on time to avoid interest charges and to maintain credit standard. Take advantage of special discounts when cash is available Regular inspection of debtor’s subsidiary ledger and follow up on overdue accounts. Careful assessment of amount of stock (inventory) required. Supplier’s accounts to be paid on time to avoid interest charges and to maintain credit standard. Take advantage of special discounts when cash is available

Common errors in end of period reports 1) Expense accounts not properly analysed to identify if accruals are required. (Check outstanding purchase orders, and dates of last utility bills received.) 2) Expense accounts may include prepayments made that need adjusting in the final statements. 3) End of month sales not processed. Adjust revenue to reflect. 4) Deposits received for future sales included in the sales figure. 5) Inventory not adjusted to reflect closing stock value. 1) Expense accounts not properly analysed to identify if accruals are required. (Check outstanding purchase orders, and dates of last utility bills received.) 2) Expense accounts may include prepayments made that need adjusting in the final statements. 3) End of month sales not processed. Adjust revenue to reflect. 4) Deposits received for future sales included in the sales figure. 5) Inventory not adjusted to reflect closing stock value.

Common errors in end of period reports 2 6) Depreciation for end of period not processed. 7) Provisions not adequate for known expenses (Workers compensation for injury incurred, or major repair to motor vehicles, legal litigation) 8) Provisions no longer required but still appearing in the balance sheet. 9) Subsidiary books not balanced to general ledger control accounts. May give rise to an adjustment. 6) Depreciation for end of period not processed. 7) Provisions not adequate for known expenses (Workers compensation for injury incurred, or major repair to motor vehicles, legal litigation) 8) Provisions no longer required but still appearing in the balance sheet. 9) Subsidiary books not balanced to general ledger control accounts. May give rise to an adjustment.

Specialist accounting assistance It is important for a company to have access to specialised firms of financial advisors it is not always necessary to employ qualified accountants to manage the administration department. A consultancy function is often undertaken by the company's auditors who already possess a good understanding of the company activities They are able to develop procedures that can be followed by administration staff and monitored during audit periods. It is important for a company to have access to specialised firms of financial advisors it is not always necessary to employ qualified accountants to manage the administration department. A consultancy function is often undertaken by the company's auditors who already possess a good understanding of the company activities They are able to develop procedures that can be followed by administration staff and monitored during audit periods.

Specialist accounting assistance 2 Quality assurance agencies are also available for consultation on issues regarding administrative procedures They can recommend methods to be adopted and can set them up if required. Under the quality assurance licence an annual audit is required to confirm compliance. The point is that specialist assistance may be required from time to time and it is desirable to establish a contact that can be called on when needed. Quality assurance agencies are also available for consultation on issues regarding administrative procedures They can recommend methods to be adopted and can set them up if required. Under the quality assurance licence an annual audit is required to confirm compliance. The point is that specialist assistance may be required from time to time and it is desirable to establish a contact that can be called on when needed.

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