Innovative thinker (group 3)
Product Pricing Management
Financial Analysis
Learning objectives
 Introduce basic financial arithmetic.
 Understand cost calculation.
 Recognize how breakeven analysis, how its used and
what are its shortcoming.
 Understand the role of costs.
 Analyses performance.
 Recognize the need for financial ratio and
performance metrics.
Basic financial Arithmetic
Definition:
Financial arithmetic is dynamic estimation of the value
of money. The fundamental assumption of financial
arithmetic is the certainty that the nominal value of
money in circulation increases with time.
Types of Interest Rates
 Simple interest
 Compound interest
 Nominal and Effective Interest Rates
 Real Interest Rates
 Geometric Rates of Return
Simple interest
Definition:
Interest is calculated on the original sum invested.
Typically used only for a single time period.
Formula
Interest  Principal  P   periods t   rate  r 
S  P  Ptr  P 1  rt 
S
P
1  rt 
Compound interest
Definition:
Compounding involves accumulating interest on
previous interest payments, which will generate further
interest.
Formula
• The sum or future value accumulated after n periods is:
S  P 1  i 
n
The present value of a future sum is:
P
S
1  i 
n
Compound interest cont.….
The backbone of many time-value calculations are the present
value (PV) and future value (FV) based on compound interest.
 Present Value
PV = FV (1+r) n
 Future Value
FV = PV (1+r) n
Note: The PV and FV formulas are the inverse of each other!
Nominal and Effective Interest Rates
• Is when interest is compounded over a period
different from that expressed by the interest rate,
e.g. more than once a year.
Formula
m
j

i  1    1
m

where:
j  nominal rate per period
m  number of compounding periods
which occur during a single nominal period
Real Interest Rates
• The real interest rate is the interest rate after taking out the
effects of inflation.
• The nominal interest rate is the interest rate before taking out
the effects of inflation.
Formula
 1 i 
i*  
 1
 1 p 
where:
i*  real interest rate
i  nominal interest rate
p  expected inflation rate
Geometric Rates of Return
 The rate of return between two dates, measured by the change in
value divided by the earlier value.
 The
average
of
a
sequence
of
geometric
rates
of return is found by a process that resembles compounding.
 Average geometric rate of return is also referred to as the average
compound rate of return.
Formula
1
n
 Pn 
i
 1
 P0 
where:
Pn  final value or price
P0  initial value or price
n  number of periods
Cost Calculation
Definition:
All payments made by a firm in the production of a good or
service are called the cost of production.
Types of Cost








Opportunity cost
Fixed cost
Variable cost
Total cost
Average cost
Average Fixed cost
Average Variable cost
Marginal cost
Opportunity cost
Definition:
The value of the next best alternative that must be
sacrificed when one makes a choice.
Fixed cost (FC)
Definition:
Are those costs that do not vary with the quantity of
output produced.
Formula
Total Fixed Cost = Total Cost – Total Variable Cost
OR
Average Fixed Cost x Quantity
Variable cost (VC)
Definition:
Are those costs that do vary with the quantity of output
produced.
Formula
Total Variable Cost = Total Cost – Total Fixed Cost
OR
Average Variable Cost x Quantity
Total cost (TC)
Definition:
the market value of the inputs a firm uses in
production.
Formula
Total Cost = Total Fixed Cost + Total Variable Cost
OR
Total Cost = Average Cost x Quantity
Average cost
Definition:
Average costs can be determined by dividing the firm’s
costs by the quantity of output it produces.
Formula
Average Cost = Average Fixed Cost + Average Variable Cost
or
Total Cost
Average Cost = ---------Quantity
Average Fixed Cost
 This is the fixed cost per unit of output. AFC steadily
decreases as more of a good is produced.
Formula
Total Fixed Cost
Average Fixed Cost = --------------Quantity
Average Variable Cost
 This is the variable cost per unit of output. AVC will
decrease, reach a minimum and then increase as
more of a good is produced. The curve is U-shaped.
Formula
Total Variable Cost
Average Variable Cost = --------------Quantity
Marginal cost (MC)
Definition:
Cost of producing one extra unit of output.
Formula
MC = Change in Total cost
Change in Quantity
Activity
Output
Total fixed
cost
(Q)
Total
variable
cost
Total cost
N$
N$
N$
0
50
3
88
4
100
9
150
10
158
16
200
17
205
Average fixed
cost
Average
variable cost
Average (total)
cost
N$
N$
N$
Marginal cost
N$
-
-
-
-
BREAKEVEN ANALYSIS
DEFINITION
• The break even point is the
point where the gains equal the
losses. The point defines when
an investment will generate a
positive return. The point where
sales or revenues equal
expenses. The point where total
costs equal total revenues.
There is no profit made or loss
incurred at the break even
point. It is the lower limit of
profit when prices are set and
margins are determined.
Breakeven analysis
Formula
Break even point:
= (fixed cost)/(contribution per unit)
Where,
Contribution = selling cost – variable cost
Fixed cost = Contribution - profit
Application of break-even analysis in
market conditions
Fixed Cost
Monthly Rental
$100
Insurance(600 per year, so 600/12 = 50 )
$50
TOTAL MONTHLY FIXED COST
$150
Variable Cost
Materials
$3
Labor
$4
TOTAL VARIABLE COST
$7
Selling Price
$10
BREAK-EVEN POINT CALCULATION
Break-Even Point
Break -Even Point
Fixed Cost / (Selling cost – Variable Cost)
= $150 / ($10 - $7)
= 50
To break-even the company must sell 50 units per month.
If the Company just broke even, then its Profit and Loss Statement would look like the
following:
Monthly Profit and Loss Statement
Sales
Gross Sales
($10 per unit times 50 units)
$500
Less Cost of Goods Sold
($7 per unit times 50 units)
$350
Net Sales
$150
Expenses
Rent
Insurance
Total Expense
Net Profit
$100
$50
$150
$0
S
A
L
E
S
UNITS SOLD
Activity 2
Mountain view is small, romantic bed and breakfast hotel located near
Grahamstown, The charge of R500 per double room is for one night’s
accommodation excluding breakfast. (Patrons can walk across the road to an
independent coffee shop for a delicious breakfast) The retired couple who own and
manage the hotel estimate that the variable cost per room is N$200 per day. This
includes cost such as electricity, laundry, cleaning and utilities. The hotel’s fixed
cost, which include council rates, water rates and land taxes, total R420 000 per
year. The hotel has 10 double rooms. The hotel charges per room and a couple
sharing a room will pay the same rate as a single person per room.
Required:
 Contribution margin per unit of service (a unit of service is one night’s
accommodation per room).
 Contribution margin ratio
 Annual breakeven point in units of service and in Rands of service revenue
 The number of units of service required to earn a target net profit of R600 000
for the year (ignore income taxes)
Solution
Contribution margin per unit of service
= nightly charge/room – variable cost/room
= R500 – R200
= R300
Contribution margin ratio
= Contribution margin per unit/nightly room charge
= R300/R500
= 0.60
Annual break even point in units of service
= fixed cost/contribution margin per unit
= R420 000/R300
= 1400 nights of accommodation
Uses of B/E
 Break-even analysis provides a quick estimate of how much
the firm must sell to break even and how much profit can be
earned if a higher sales volume is obtained.
 Helps the business to determine the cost structures, and the
number of units that needs to be sold in order to cover the
cost or make a profit.
 Help determine how practical the business idea is, and
whether or not it is worth pursuing.
 It is useful to see what can be done to reduce costs or
increase sales.
LIMITATIONS OF BREAKEVEN ANALYSIS
 Break-even analysis is only a supply side (i.e. costs only) analysis,
as it tells you nothing about what sales are actually likely to be
for the product at various prices.
 It assumes that fixed costs (FC) are constant
 It assumes average variable costs (VC) are constant per unit of
output, at least in the range of likely quantities of sales.
 It is difficult in determining whether a cost is fixed or variable
using a breakeven. Additionally, break-even analysis ignores
demand.
Role of Cost
Definition:
Cost is the value of money that has been used up to produce
something. Cost is part of Cost management which is an activity of
managers related to planning and control of costs.
 Managers have to take decisions regarding use of materials,
processes, product designs and have to plan costs or expenses to
support the operating plan for their department or section.
 It provides a variety of data for many day-to-day decisions as well as
essential information for longer-range decisions.
 To charge whatever they want for their products. The manager
need cost price to decide the price.
Performance analysis
 Examination of various financial performance
indicators(such as return on assets and return on equity)
in comparison with the results achieved by the
competing firms of about the same size.
 It also looks at the human resource managements,
examination of the performance of current employees to
determine if training can help reduce performance
problems such as low outputs, uneven quality, excessive
waste.
 Performance analysis can also be analyzed more into
details by looking at activity analysis, job analysis and
task analysis.
Performance analysis cont.…..
 It can also be analyzed as the process by which a
manager or consultant examines and evaluate an
employees work behavior by comparing it with preset
standards, documents are results of the comparison and
uses the results to provide feedback to the employees to
show were improvements are needed and why.
 Performance appraisals are employed to determine who
needs what training and who will be promoted, demoted
or retained.
Tools to assess Financial performance
Financial Ratio
 Are ratio that can be extracted from the financial statement. It
can be used to compare your firms performance during
different time period.
Benchmarking
 Is a way of measuring your product, services and processes
against those of other organizations, in the same industry
sector. This help the manager to assess the company’s
performance.
Financial ratios
 Profitability Ratios
 Activity Ratios
 Liquidity Ratios
 Productivity Ratios
Profitability Ratios
 Profit on sales = net profit / net sales (how much does each $ of
revenue contribute to profit, so if Profit on Sales = 12% this means
that 12cents in each $ of revenue goes to profit)
 Return on assets = net profit / total assets (how much is each $ of
assets contributing to profit)
 Return on net worth = net profit / net worth
Activity Ratios
 Inventory turnover = cost of goods sold / average inventory at cost
(number of times in the year when average amt. Of inventory
is completely sold out)
 Asset turnover = net sales / average total assets
(are all assets being efficiently used to generate sales?)
 Receivables turnover = net sales / average accounts receivable
(length of time it takes for customers to pay)
Liquidity Ratios
 Current ratio = current assets / current liabilities
 Current liabilities to inventory = current liabilities / inventory
NB
 Liquidity ratio help companies answer the question of
whether they will able to meet their debts?
Productivity Ratios
 Space productivity
= net sales / square foot of selling space
 Personnel productivity
= selling expense / net sales
 Accounts payable to sales
= accounts payable / net sales
Operating Performance Ratios
 Fixed-Asset Turnover
 Sales/Revenue Per Employee
 Operating Cycle
Debt Ratio
 Overview of debts
 Debt Ratio
 Debt-Equity Ratio
 Capitalization Ratio
 Interest Coverage Ratio
 Cash Flow To Debt Ratio
Investment Valuation Ratios








Per Share Data
Price/Book Value Ratio
Cash Flow Coverage Ratio
Price/Earnings Ratio
Price/Earnings To Growth Ratio
Price/Sales Ratio
Dividend Yield
Enterprise Value Multiple
Cash Flow Indicator Ratios
 Operating Cash Flow/Sales Ratio
 Free Cash Flow/Operating Cash Ratio
 Cash Flow Coverage Ratio
 Dividend Pay-out Ratio
Financial metrics
 Liquidity metrics
 Efficiency metrics
 Leverage metrics
 Profitability metrics
 Valuation metrics
 Growth Metrics
References
• Charles T., (2000). Cost Accounting: Managerial
ed.). New Jersey: Prentice Hall
Emphasis
(10th
• Varian, H., R. (2010). Intermediate microeconomics: A modern
approach (8th Ed.). New York: W. W. Norton & Company.
• Solution Matrix Limited (2015). Financial Metrics Explained.
Retrieved from https://www.business-caseanalysis.com/financial-metrics.html
• Lot, R. (2015). Financial Ratio Tutorial. Retrieved from
http://www.investopedia.com/university/ratios/