Business Finance Notes PDF

Business finance Instructor: Rohit Agnihotri Manitoba Education  Costs Cost behaviour — There are three common cost behaviours: 1.Variable costs 2.Fixed costs 3.Mixed costs Manitoba Education ...

Business finance Instructor: Rohit Agnihotri Manitoba Education  Costs Cost behaviour — There are three common cost behaviours: 1.Variable costs 2.Fixed costs 3.Mixed costs Manitoba Education  Key Characteristics of Variable Costs ▪ Total variable costs change in direct proportion to changes in volume ▪ Variable cost per unit remains constant ▪ Slope of the line represents variable cost per unit Total variable cost (y) = Variable cost per unit of activity (v) x Volume of activity (x) y = vx Variable Costs (1 of 2) Variable Costs (2 of 2)  Relevant Range ▪ The range of operations within which the total fixed costs and the variable cost per unit remain constant ▪ Most commonly this is an issue of organizational capacity  Key Characteristics of Fixed Costs (1 of 2) ▪ Total fixed costs stay constant over relevant range* ▪ Fixed costs per unit of activity vary inversely with changes in volume *Relevant range is the normal operating range of activity  Key Characteristics of Fixed Costs (2 of 2) Examples of fixed costs: ▪ Property taxes and insurance ▪ Depreciation and maintenance on parking ramp, hotel, and room furnishings ▪ Pool, fitness room, and spa upkeep ▪ Cable TV and wireless internet access for all rooms ▪ Salaries of hotel department managers (housekeeping, food service, special events, etc.) ▪ Committed fixed costs ▪ Discretionary fixed costs Fixed Costs (1 of 2)  Fixed Costs (2 of 2) y=f Total fixed cost (y) = Fixed amount over a period of time (f)  Key Characteristics of Mixed Costs ▪ Total mixed costs increase as volume increases ▪ Mixed costs contain both variable and fixed cost components ▪ Fixed component: Banff Rocky Mountain Resort’s utilities are mixed costs because the hotel requires a certain amount of utilities just to operate ▪ Variable component: the more guests at the hotel, the more water, electricity, and gas are required. Mixed Costs If a hotel were completely empty, the utilities would cost $2,000 per week. These costs increase by $8 per guest.  Cost Equation ▪ Is a mathematical equation for a straight line that can be used to predict total cost ▪ Total mixed costs increase as volume increases because of the variable cost component. ▪ Mixed costs per unit decrease as volume increases because of the fixed cost component. ▪ Total mixed cost graphs slope upward but do not begin at the origin—they intersect the y- axis at the level of fixed costs. ▪ Total mixed costs can be expressed as a combination of the variable and fixed cost equations: Total mixed costs = variable cost component + fixed cost component y = vx + f where y = total mixed cost v = variable cost per unit of activity (slope) x = volume of activity f = fixed cost over a given period of time (vertical intercept)  Relevant Range (1 of 2) ▪ Band of volume where total fixed costs remain constant ▪ The hotel expansion, if carried out, will increase the hotel’s fixed costs to a new level.  Relevant Range (2 of 2) ▪ Band of volume where variable costs per unit remain constant ▪ With more capacity, negotiate greater volume discounts on the toiletries, lowering variable toiletries cost per guest Other Cost Behaviours (1 of 2)  Other Cost Behaviours (2 of 2) ▪ Curvilinear costs are not linear – they do not fit into any neat pattern ▪ Approximate this type of cost as a mixed cost  Summary Problem 1 (1 of 2) ▪ Fitness-for-Life’s fixed operating costs were $10,000 per month ▪ Variable operating costs were $1 per member per month ▪ Club’s existing facilities serve up to 750 members per month ▪ Complete the following schedule for different levels Monthly Operating Cost 100 Members 500 Members 750 Members Total variable costs Total fixed costs __________ ___________ __________ Total operating costs __________ ___________ __________ Variable cost per member Fixed cost per member __________ ___________ __________ Average cost per member ‗‗‗‗‗‗‗‗‗‗‗ ‗‗‗‗‗‗‗‗‗‗‗ ‗‗‗‗‗‗‗‗‗‗‗  Summary Problem 1 (2 of 2) Why should the manager not use the average cost per member to predict total costs at different levels? 100 Members 500 Members 750 Members Total variable costs $ 100 $ 500 $ 750 Total fixed costs 10,000 10,000 10,000 Total operating costs $ 10,100 $ 10,500 $ 10,750 Variable cost per member $ 1.00 $ 1.00 $ 1.00 Fixed cost per member 100.00 20.00 13.33 Average cost per member $ 101.00 $ 21.00 $ 14.33  Sustainability and Cost Behaviour E-banking and e-billing serves to reduce variable costs for both the bank and society at large: ▪ reduced demand for printed bills reduces both the demand for paper, ink/toner, shipping and disposal ▪ resulting is a reduction in the harvesting of trees, production of dyes, use of fuel for transportation and landfill space required ▪ costs are reduced to business and savings trickle down to the customer  CVP Example Facts: Kay’s Posters Kay has an e-tail poster business. She currently sells each poster for $35, while each poster has a variable cost of $21. Kay has fixed costs of $7,000. Kay is currently selling 550 posters. Kay’s relevant range is 0 to 2,000 posters. Contribution Margin Income Statement KAY MARTIN POSTERS Contribution Margin Income Statement Month Ended August 31 Sales revenue (550 posters) $ 19,250 Less: Variable expenses (11,550) Contribution margin 7,700 Less: Fixed expenses (7,000) Operating income $ 700  Unit Contribution Margin Kay’s e-tail poster example from previous slides Sales price per poster $ 35 Less: Variable cost per poster (21) Contribution margin per poster $ 14 Now assume sales are 650 units: Contribution margin (650 posters  $14 per poster) $ 9,100 Less: Fixed expenses (7,000) Operating income $ 2,100  Contribution Margin Ratio Contribution margin ratio = percentage of each sales dollar that is available for covering fixed expenses and generating a profit. Unit contribution margin $14 Contribution margin ratio = = = 40% Sales price per unit $35 Contribution margin $7,700 Contribution margin ratio = = = 40% Sales revenue $19,250 Numbers above are from the Kay’s e-tail poster example on previous slides.  Kay Martin Posters (1 of 2) ▪ Kay generates $70,000 of sales revenue one month ▪ She can estimate her operating income by multiplying her projected sales revenue by the contribution margin ratio to get the total contribution margin ▪ Then she subtracts fixed expenses: Contribution margin ($70,000 sales  40%) $28,000 Less: Fixed expenses (7,000) Operating income $21,000  Kay Martin Posters (2 of 2) Contribution margin ($70,000 sales  40%) $28,000 Less: Fixed expenses (7,000) Operating income $21,000 ▪ To verify this estimation, we can calculate Kay’s contribution margin income statement: Sales revenue (2,000 posters  $35/poster) $ 70,000 Less: Variable expenses (2,000 posters  $21/poster) (42,000) Contribution margin (2,000 posters  $14/poster) $ 28,000 Less: Fixed expenses (7,000) Operating income $ 21,000  Break-even Point Break-even point: ▪ Sales level at which operating income is zero If sales above break-even, then profit If sales below break-even, then loss ▪ Fixed expenses = total contribution margin ▪ Total sales = total expenses  Calculating Break-even Point Three approaches to calculating break-even: 1.Income statement approach 2.Shortcut approach using unit contribution margin 3.Shortcut approach using contribution margin ratio  Income Statement Approach Contribution Margin Income Statement Sales - Variable Expenses Contribution Margin - Fixed Expenses SALES REVENUE − VARIABLE EXPENSES − FIXED EXPENSES = OPERATING INCOME  Sales price   Variable cost   per unit  Units sold  −  per unit  Units sold  − Fixed expenses = Operating income     ($35  Units sold) − ($21  Units sold) − $7,000 = $ 0 ($35 − $21)  Units sold) − $7,000 = $ 0 $14  Units sold = $ 7,000 Units sold $ 7,000/$14 Sales in units = 500 Posters Shortcut Approach to Calculating Break-Even Using the Unit Contribution Margin Fixed expenses + Operating income Sales in units = Contribution margin per unit $ 7,000 + $ 0 Sales in units = $14 = 500 posters Shortcut Approach Using the Unit Contribution Margin Ratio Fixed expenses + Operating income Sales in dollars = Contribution margin ratio $ 7,000 + $ 0 Sales in dollars = 0.40 = $17,500 Dividing fixed costs by the unit contribution margin provides break-even sales in units. Dividing fixed costs by the contribution margin ratio provides break-even in sales dollars. Finding the Volume Needed for a Target Profit Using Unit CM CVP analysis helps managers determine what they need to sell to earn a target amount of profit. Fixed expenses + Operating income Sales in dollars = Contribution margin ratio $7,000 + $4,900 = $14 $11,900 = $14 = 850 posters 850 posters  $35 sales price/poster = $29,750 sales revenue  Finding the Volume Needed for a Target Profit Using Ratio CVP analysis helps managers determine what they need to sell to earn a target amount of profit. Fixed expenses + Operating income Sales in dollars = Contribution margin ratio $7,000 + $4,900 = 0.40 $11,900 = 0.40 = $29,750  Finding the Volume Needed for a Target Profit Using the Income Statement As with break-even calculations, the income statement may be used to determine the production level required for a target profit. SALES REVENUE − VARIABLE EXPENSES − FIXED EXPENSES = OPERATING INCOME ($35  Units sold) − ($21  Units sold) − $7,000 = $ 4,900 ($35 − $21)  Units sold − $7,000 = $ 4,900 $14  Units sold = $ 11,900 Units sold Units sold $11,900/$14 Sales in units Units sold = 850 posters