FINANCIAL PLANNING Business Studies 2011

Calculating revenue, costs and profit

Revenue REVENUE – the income the firm receives from selling the product or service that it provides The total revenue for a firm for any given period can be calculated by multiplying the selling price (revenue per unit) by the number of units sold in that period Example: A company Z sold in September 10 ice-creams, 5$ each. What is a company’s revenue? _________________

Costs Variable cost – is one that varies in direct proportion to output. For example, if a firm makes twice as many bags of crisps, they will need twice as many potatoes. TOTAL VARIABLE COSTS = VARIABLE COST PER UNIT X QUANTITY PRODUCED

Costs Fixed cost – is one that does not change in relation to output. Example: Managers’ salaries – they remain the same whether 10,000 or 20,000 bags of crisps are produced per month

Total costs Total costs – is the figure gained by adding the total variable costs at any level of output to the fixed costs being paid by the business TOTAL COSTS = VARIABLE COSTS + FIXED COSTS

Profit Profit – is the excess of revenue over costs PROFIT = TOTAL REVENUE – TOTAL COSTS Or PROFIT = (QUANTITY SOLD X SELLING PRICE) – [(QUANTITY SOLD X VARIABLE COST PER UNIT) + FIXED COSTS]

Boosting profit The quest for profit lies at the heart of the objectives of almost every business How? Increasing total revenue (unless costs rise faster) Increase price Increase number of units sold Decrease costs (either variable or fixed, or both)

What next? There are two ways that a firm can choose to use its profit: Retain the profit in the business and use to buy extra assets that will help the firm in the future (e.g. ) Pay out profit to the owners of the business

Examples Firm X has a variable costs per unit $5. Revenue is $12,000 earned by selling 1,000 units. If they made $2,000 profit, what are the fixed costs?

Examples Firm Y makes a profit $5,000 by selling 1,000 units for $10 each. If fixed costs are $3,000, what are the variable costs?

Break-even analysis Break-even is the term used to describe a situation in which a firm is making neither a profit nor a loss. It is generating enough revenue to cover its costs Break-even point = Fixed costs/ (Selling price – Variable costs per unit)

Example Calculate the number of units that would need to be sold to break-even of a firm sells its products for $5 per unit, has variable costs of $2 per unit and fixed costs of $6,000

When? Break-even is always a useful tool, for both small and large firms. The type of business that will make the most use of break- even analysis include:

Break-even is particularly useful for firms that: Break-even is of limited use to firms that: Make and sell one standard productAre subject to severe seasonality Only make products to order – meaning all output is sold Find it hard to identify the actual variable and fixed costs involved in making their product Only operate in one marketOperate in fast-moving markets

Cash flow management and forecasting Cash flow is the flow of money into and out of the business in a given period of time Cash flow is vital: bills are paid when they are due Cash flow problems are the most common reason for business failure. Cash flow forecasting attempts to predict the future flow of cash into and out of the business

Cash flow of a new restaurant The business will receive an injection of of capital of $20,000 The restaurant will open in February and expects a slow start with sales gradually building each month Rent for the building costs $1,000 per month, but the owner requires two months’ rent in advance Wages are estimated to be $1,500 per month And there are other expenses of $400 per month

JanuaryFebruaryMarchAprilMay Income Capital20,000 Sales2,0004,0004,5006,000 Total income20,00002,0004,0004,5006,000 Expenditure Equipment17,000 Materials ,0001,2000 Rent2,0001,000 Wages1,500 Other expenses400 Total expenditure Monthly balance Opening balance Closing balance

Example JanuaryFebruaryMarchApril Cash in Cash out Net cash flow020 Opening balance10 Closing balance

Key terms Creditors – individuals or other businesses that are owed by the business Debtors – individuals or companies that owe money to the business Liabilities – what the business owes Liquidation – being forced to hand your business over a liquidator, who will sell off the firm’s assets to repay its debts; this usually means the business closes down

Setting a budget Three budgets: income, expenditure and profit Budgets are needed as a control tool once an organisation has grown to a size that prohibits the boss from making all spending decisions How? Incremental budgeting – adding a certain percentage on to last year’s budget to allow for inflation Zero budgeting – setting each budget to zero at the start of each year and asking each budget holder to justify each penny that is allocated to their budget

Budget variance analysis Budgeted figures are compared with actual results to identify any variance (difference) between the two figures. A difference that represents a positive result for a company’s profitability is referred to as _______________ variance So a decline in profitability is referred to as an _________ variance

Example BudgetActualVariance Income Expenditure Profits10090

Ratios Net profit margin (NET PROFIT/SALES REVENUE) X 100 Shows what percentage of the firm’s total sales revenue is left over once all costs have been deducted Net profitSales revenue Net profit margin Company A$20,000$400,000 Company B$9,00$60,000 The net profit margin is a measure of profitability – the rate at which profit is made, rather than just an absolute figure for profit

Ratios Return on capital (NET PROFIT/CAPITAL INVESTED) X 100 It states the return an investor receives as a percentage of what they invest. Therefore it can be directly compared with the savings rates or with the same calculation for alternative uses for the money invested. Net profitCapital invested Return on capital Branch X$125,000$250,000 Branch Y$200,000$320,000

Cash flow versus profit Why profit? Generate a return for investors Generate money for use in business Why cash flow? Pay the bills Cash for planned expenditure Business fail for two reasons – they are not profitable or they run out of cash. So a good healthy business will have both a good cash flow and be making profit