COST, REVENUE & BREAK EVEN ANALYSIS

1. COST, REVENUE & BREAK EVEN ANALYSIS IB BUSINESS & MANAGEMENT A COURSE COMPANION (p232-249)

2. COSTS & REVENUE • Once a business has worked out how toproduce, it needs to think about how much to produce. • This will depend on a number of factors, but in most cases production managers will focus on at least ensuring that they have covered their costs and not made a loss. • The following simple formula can act as decision-making framework PROFIT = TOTAL REVENUE – TOTAL COSTS.

3. Not for Profit Organizations • Even if a business is a not-for profit organization it must still abide by the formula. • Although it may not make profits it must as least cover it costs and so no make any losses.

4. Non-Governmental Organizations (NGOs) • NGOs need to make enough money to not only cover their immediate costs, but also to ensure that they can reinvest for the future. • Eg: Greenpeace will need enough money to pay lobbyists or buy boats for direct action such as monitoring whaling for scientific purposes by Japanese vessels.

5. REVENUE • Revenue is fundamental to all production decisions. • It is the total money earned from selling the product. • It also known as sales, sales revenue or turnover, and it appears in the top line of a profit and loss account or part of cash in a cash flow statement. • All these items refer to the “operational income” of a business – that is money earned from its business operations.

6. REVENUE Non-Operational Activities • Sometimes a business can earn money from non-operational activities, such as selling shares in a subsidiary or company assets generally. • This form of revenue is classified as non operational income.

7. Total Revenue Formula Total Revenue (TR) = Price (P) x Quantity (Q) Example • If a car dealer were to sell 100 BMW 5 Series Cars in 2011 for $200,000 each, there would be $20,000,000 in revenue. 100 x 200,000. • Remember that revenue is very different to profit.

8. Profit MarginFast Food Outlet vs Fine Dining Restaurant • With a fast food outlet there is a very low profit margin as the competition is very fierce and demand is relatively elastic – so the business cannot afford to put their prices too high. • Prices will not be much more than their costs. • This means a fast food restaurant is dependent on a high volume of sales (for standardized mass produced meals) to generate sufficient profit to operate. • In contrast, the profit margin for a fine dining restaurant per customer will be significantly higher than the fast food chain’s average customer.

9. Different Types of Revenue • Cash Sales: Money paid directly as cash. • Credit Sales: Money paid on credit using Visa or Mastercard, AMEX or Diners Club. • Debit Card: Money transferred electronically from a bank account. • Cheque: Money transferred from a bank account using a hand-written note. • Loyalty Cards: Money transferred from a bank account into a special store account. • Direct Debit: Money transferred from a bank account for regular payments such as mortgage or cable TV monthly fee. • Annual Fee: Money paid once a year. Eg: subscriptions to a tennis club or a car tax.

10. Which Revenue Source is Preferred? • Some businesses prefer one form of payment to another. • Eg: An internet company such as Amazon finds it much easier to accept credit card payments, but a local baker will obviously prefer cash.

11. COSTSFive Categories of Cost There are five categories of costs that can overlap each other: • Fixed Costs: Costs that do not change as output does. (eg: cost of buying a factory) • Variable Costs: Costs that do change as output does. (eg: cost of buying stock) • Semi-variable Costs:Costs that are made up of fixed and variable components. (eg: basic line cost for renting phone + call costs) • Direct Costs: Costs that are directly related to output. • Indirect Cost:(Overheads) Costs that are indirectly related to output.

12. Fixed Costs - Examples Example • A car dealer may have to pay for the rent of the car showroom, even if there are no customers. • Businesses often refer to these must pay costs as overheadsas they appear as expenses in the profit & loss account, because they are indirect costs of production. • Interest payments on loans could be another example of fixed costs.

13. Variable Costs • Variable Costs – costs which do vary directly with production. • Eg: If we are selling stock we will order or make less stock. • Therefore our variable costs can change. • In the Profit & Loss Account, the stock we do use appears as the cost of goods sold.

14. The Relationship Between Different Costs Fixed = Indirect Costs Variable = Direct Costs Semi-Variable – Partly Direct & Partly Indirect

15. How to we calculate total costs? Total Costs (TC) = Fixed Costs (FC) + Variable Cost (VC) TC = FC + VC

16. Semi-Variable Costs • The semi-variable costs (also known as quasi-variable costs) are a combination of fixed and variable costs. Example – Salary of a Car Salesperson • The salary of the car salesperson is typically made up of two parts – a fixed element (the basic wage) and a variable element (the commission) which is dependent on the number of cars sold.

17. Semi-Variable Costs Electricity Costs • Electricity bills are usually split into a fixed element – the standing charge and a variable element – which is taken from the electricity meter and indicates how much has been used.

18. Costs – Classification Exercise

19. Contribution to Fixed Costs • An important business tool is the contribution a product makes to the overall profitability of the business. • When it knows this, a business can decide which product to focus on, so as to expand production, increase investment and ultimately improve sales. • This is particularly useful for a business that has a range of products as the business will be able to judge whether one is outperforming another.

20. Contribution to Fixed Costs • In the Boston Consulting Group (BCG) matrix, this can be a difference between a star, cash cow and dog product.

21. How do we calculate the total contribution for a company? We use the following formula: Total Contribution = Total Revenue – Total Variable Costs

22. The Contribution Per Unit We can calculate the contribution per unit for the business by using the following formula: Contribution = price – variable costs (per unit) Example • We sell a luxury care for $200,000. • We sell 100 cars. • Our Total Variable Costs are $15,000,000 • Insert into formula: $200,000 - (15,000,000) = $50,000 per car. 100

23. The Contribution Per Unit Further Explanation of Car Example • Each car contributes $50,000 which can be subtracted from fixed costs to generate the eventual profit for the business.

24. BREAK EVEN ANALYSIS • Another important tool to help production decisions is break even analysis. • This is especially relevant for a new businesses or for starting a new venture. • The idea is to calculate the minimum product that would have to be sold for the business to break even – that is: just to cover the costs and no more than that. • If a business manages to produce and sell more than the break even quantity it will make a profit.

25. How to calculate the break even output? Profit = Total Revenue – Total Costs. If Profit is O, break even is: Total Costs = Total Revenue

26. Three Methods for calculating the Break Even Level of Output We can calculate the break even level of output using the following three methods: • Creating a Table • Drawing a Chart/Graph • Using a Formula

27. Semi Variable Costs & Break Even Analysis • For break even analysis we do not consider semi-variable costs because this would make things must too complicated, so we must always divide costs into fixed or variable proportions.

28. Table Method for Break Even Analysis Example Question • Business: A vendor selling face Rolex watches in the Philippines. • A vendor has to pay a sum of $US1000 to secure the right to sell his watches outside the tourists hotels on the beach. He paid this to the local enforcers (mafia) • On average a tourist would pay $US 50 for a watch and the watches typically cost him US $25 from his supplier.

29. Table Method for Break Even Analysis Example Question (continued) • Note that fixed costs (the fee for the right to sell watches) had to be paid “up front” before he had sold any watches – the sum was a one-off payment, no matter how many watches were sold. • Variable Costs are 0 if nothing has been sold. • Unsold watches can be returned to the supplier • The price stays the same throughout. Some tourists were good at haggling and some were not, but the average price is $50. • If nothing has been bought, the total revenue for 0 is 0. • After this total revenue goes up by multiplying price & quantity.

30. BREAK EVEN ANALYSIS – VENDOR SELLING WATCHES EXAMPLE

31. Watches Example – Analysis • After completing the previous table, it is obvious that the watch seller breaks even by selling 40 watches. • For every watch sold after this, the vendor will make a $25 profit.

32. The Formula Method for Break Even Analysis Break Even Quantity = Fixed Costs Contribution Per Unit. Contribution = price – variable cost per unit. Fixed Costs = $1000 Contribution = $50 - $25 = $25. 1000/25 = 40 watches.

33. Graph Method For Break Even Analysis • It is possible to transfer some of the information in the table to a graph. • The vertical axis will have costs and revenue on it and the horizontal axis will have the quantity of watches sold. • To this we can add fixed costs, which we can draw as a line parallel to the horizontal axis starting at $1000. • The line is parallel to the horizontal axis because these costs do not change as more watches are sold – the costs are fixed.

34. Tip: Do not attempt to draw a break even graph, until you have calculated/ determined the break even point using the formula. Source: http://fast4cast.com/break-even-calculator.aspx

35. How is profit & loss represented in the graph? • The amount of profit or loss is given by the vertical distance between the total cost and total revenue lines. • As the vendor sells more watches, his losses get smaller (the distance between total costs and total revenue gets less) • After break even, the distance between total costs and total revenue increases, which means he makes more profit the more he sells. • However, he must sell a minimum of 40 watches before making a profit at all.

36. The Margin of Safety • If the watch vendor sells 60 watches, then he is said to have a margin of safety of 20 watches. • The margin of safety is just the difference between actual sales and break even sales - it like a safety net. • Note: It is the margin of safety output (quantity) we are interested in, not revenue, profits etc.

37. Graphs & Break Even AnalysisExamination Tip • If you need to draw the graph in an examination, always do the calculation using the formula first. • It helps centrethe two axes so the scale will work out clearly. • Always aim to try to place the break even quantity point-mid way on the horizontal axis.

38. Break Even Analysis - Exercise • A school publishes a magazine. • 400 copies are printed. The costs are as follows: • Fixed Costs: $600 • Variable Costs: $2 per magazine. The school will charge $4 for a copy of the magazine. Using the three different methods produce a table, graph and equation to show the break even quantity of magazines. Note: Do the equation first.