Assessing Financial Impacts in
Budgets and Planning
MIR 889 2014
Andrew Graham
Objectives for Today
Cost Behaviour
Cost Sources
Cost-Volume-Profit Analysis
Activity-Based Costing
Sources of Capital
Cost Behaviour
Variable Cost
Jason Inc. produces stereo sound systems
under the brand name of J-Sound. The parts
for the stereo are purchased from an outside
supplier for $10 per unit (a variable cost).
Variable Costs
$300,000
$250,000
$200,000
$150,000
$100,000
$50,000
0 10 20 30
Units Produced
(in thousands)
Unit Variable Cost Graph
$20
Cost per Unit
Total Costs
Total Variable Cost Graph
$15
$10
$5
0
10 20 30
Units Produced
(000)
$300,000
$250,000
$200,000
$150,000
$100,000
$50,000
Cost per Unit
Total Costs
Variable Costs
$20
$15
$10
$5
0
10
20
30
Units Produced (000)
0
10
20
30
Units Produced (000)
Number of
Units
Produced
5,000 units
10,000
15,000
20,000
25,000
30,000
Direct
Materials
Cost per Unit
Total Direct
Materials
Cost
$10
10
10
10
10
10
$ 50,000
l00,000
150,000
200,000
250,000
300,000
Fixed Costs
The production supervisor for the Minton
Company Mississauga plant is Jane
Sovissi. She is paid $75,000 per year. The
plant produces from 50,000 to 300,000
bottles of air freshener depending on sales.
Fixed Costs
Number of
Bottles
Produced
Total Salary
for Jane
Sovissi
50,000 bottles
100,000
150,000
200,000
250,000
300,000
$75,000
75,000
75,000
75,000
75,000
75,000
Salary per
Bottle
Produced
$1.500
0.750
0.500
0.375
0.300
0.250
Unit Fixed Cost
$150,000
$125,000
$100,000
$75,000
$50,000
$25,000
Cost per Unit
Total Costs
Total Fixed Cost
0
100 200 300
Bottles Produced (000)
Number of
Bottles
Produced
50,000 bottles
100,000
15,000
20,000
25,000
30,000
$1.50
$1.25
$1.00
$.75
$.50
$.25
0
100 200 300
Units Produced (000)
Total Salary
for Jane
Sovissi
Salary per
Bottle
Produced
$75,000
75,000
75,000
75,000
75,000
75,000
$1.500
0.750
0.500
0.375
0.300
0.250
Mixed Costs
Simpson and Associates out of Kingston
Ontario manufactures sails using rented
equipment. The rental charges are $15,000 per
year, plus $1 for each machine hour used over
10,000 hours.
Total Costs
Total Mixed Cost
$45,000
$40,000
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
0
10
20
30
40
Total Machine Hours (000)
Mixed costs are
sometimes called
semi-variable or
semi-fixed costs.
Mixed costs are
usually separated into
their fixed and
variable components
for management
analysis.
Costs Sources
Creating Costs
• An organization creates different costs at different
stages:
– Starting up
– Early growth
– Reaching the boundaries of existing capacity
– Expanding product lines
– Expanding capacity
– Redefining the business
– Continued growth
• These costs are not created evenly over time and
should be planned for
Changing Cost Structures
• The composition of manufacturing costs has changed
substantially in recent years
• Many formal cost systems were first implemented in
the early 1900’s:
– Direct labor represented a large proportion, sometimes 50%
or more, of the total manufacturing costs
– Direct material costs were also substantial
– Capacity-related costs generally represented a small fraction
of total manufacturing costs
Capacity cost is a fixed expense that does not change with the level of
production or activity, but is a necessary part of the business. Examples are
lease payments, depreciation, insurance, utilities, IT systems and insurance
costs.
Changing Cost Structures
• Today, direct labor is only a small portion of
manufacturing costs
– E.g., in the electronics industry direct labor is often less
than 5% of the total manufacturing cost
• The cost of direct materials remains
important, representing 40% to 60% of the
costs in many plants
• The big change has been the vastly increased
share of total costs from capacity-related
costs.
Changing Cost Structures
• The increase in capacity-related costs results from:
– The shift toward greater automation, which requires more
production engineering, scheduling, and machine setup
activities
– The emphasis on better customer service
– The increase in support activities required by a proliferation
of multiple products
• Further, both flexible and capacity-related costs
associated with design, product development,
distribution, selling, marketing, and administrative
activities have increased
Changing Cost Structures
• Changing cost structures have caused cost systems
allocating indirect costs using volume measures to
become increasingly inaccurate in computing
product costs
• Many costing systems take costs that did not vary
proportionally with volume, accumulate them, and
then allocate them using a measure of volume
• These systems often underallocate costs to cost
objects (e.g., product lines) produced in low volumes
What are some changes happening in
the cost structure of HR in
organizations that will increase or
decrease costs?
Cost-Volume-Profit Analysis
Contribution Margin
Break Even Point
Contribution Margin
Sales (50,000 units)
Variable costs
Contribution margin
Fixed costs
Income from operations
$1,000,000
600,000
$ 400,000
300,000
$ 100,000
The contribution
margin is
available to cover
the fixed costs
and income from
operations.
Contribution Margin
Sales (50,000 units)
Variable costs
Contribution margin
Fixed costs
Income from operations
$1,000,000
600,000
$ 400,000
300,000
$ 100,000
100%
60%
40%
30%
10%
Sales – Variable costs
Contribution Margin Ratio =
Sales
$1,000,000 – $600,000
Contribution Margin Ratio =
$1,000,000
Contribution Margin Ratio =
40%
Contribution Margin Ratio
Sales (50,000 units)
Variable costs
Contribution margin
Fixed costs
Income from operations
$1,000,000
600,000
$ 400,000
300,000
$ 100,000
100%
60%
40%
30%
10%
$20
12
$ 8
The contribution margin can be expressed three ways:
1. Total contribution margin in dollars.
3. Contribution margin ratio (percentage).
3. Unit contribution margin (dollars per unit).
Sales and Costs ($000)
Cost-Volume-Profit Chart
$500
$450
$400
$350
$300
$250
$200
$150
$100
$ 50
0
Total Sales
Variable
Costs
60%
1
2
3
4
5
6
7
Units of Sales (000)
Unit selling price
$ 50
Unit variable cost
30
Unit contribution margin
$ 20
Total fixed costs
$100,000
8
9 10
Sales and Costs ($000)
Cost-Volume-Profit Chart
$500
$450
$400
$350
$300
$250
$200
$150
$100
$ 50
0
Contribution
Margin
40%
60%
1
2
3
4
5
6
7
Units of Sales (000)
Unit selling price
$ 50 100%
Unit variable cost
30 60%
Unit contribution margin
$ 20 40%
Total fixed costs
$100,000
8
9 10
Sales and Costs ($000)
Cost-Volume-Profit Chart
$500
$450
$400
$350
$300
$250
$200
$150
$100
$ 50
0
Total
Costs
Fixed Costs
1
2
3
4
5
6
7
Units of Sales (000)
Unit selling price
$ 50 100%
Unit variable cost
30 60%
Unit contribution margin
$ 20 40%
Total fixed costs
$100,000
8
9 10
Sales and Costs ($000)
Cost-Volume-Profit Chart
$500
$450
$400
$350
$300
$250
$200
$150
$100
$ 50
0
Break-Even Point
1
2
3
4
5
6
7
Units of Sales (000)
Unit selling price
$ 50 100%
Unit variable cost
30 60%
Unit contribution margin
$ 20 40%
Total fixed costs
$100,000
8
9 10
$100,000
= 5,000 units
$20
Sales and Costs ($000)
Cost-Volume-Profit Chart
$500
$450
$400
$350
$300
$250
$200
$150
$100
$ 50
0
Operating Profit Area
Operating Loss Area
Units of Sales (000)
Unit selling price
$ 50 100%
Unit variable cost
30 60%
Unit contribution margin
$ 20 40%
Total fixed costs
$100,000
Margin of Safety
Margin of Safety =
Sales – Sales at break-even point
Margin of Safety =
Sales
$350,000 – $250,000
$350,000
Margin of Safety = 28%
The margin of safety indicates the
possible decrease in sales that may occur
before an operating loss results.
Sales and Costs ($000)
Cost-Volume-Profit Chart
$500
$450
$400
$350
$300
$250
$200
$150
$100
$ 50
0
Break-Even Point

Margin of Safety
1
2
3
4
5
6
7
Units of Sales (000)
8
9 10
Assumptions about Reliability of Cost-VolumeProfit Analysis
1. Total sales and total costs can be represented by
straight lines.
2. Within the relevant range of operating activity, the
efficiency of operations does not change.
3. Costs can be accurately divided into fixed and
variable components.
4. The sales mix is constant.
5. There is no change in the inventory quantities
during the period.
Activity Based Costing
It gets complicated….
• So far we have been talking about single
products and single units with small overhead
• Reality today is that most business are
complex, multi product, multi sites with
growing overhead and downstream costs
• Using the traditional unit-based approach to
costing leads to distortions in product price
and misallocation of overhead
Differences between ABC and
Traditional Costs
• Traditional costing allocates all manufacturing overhead to
products. ABC costing only assigns manufacturing
overhead costs consumed by products to those products
• Traditional costing allocates all manufacturing
overhead costs using a volume-related allocation base.
ABC costing also uses non-volume related allocation bases.
• Traditional costing disregards selling and administrative
expenses because they are assumed to be period expenses.
ABC costing directly traces shipping costs to products an
includes nonmanufacturing overhead costs caused by
products in the activity cost pools that are
assigned to products.
What Activity Based Costing Does
• Costs are first attributed to activities
• Each activity is examined to determine its
relationship to the product and product costs
• Breakdown overhead into meaningful
activities
• Assign costs to products or outcomes based
on this analysis
What it is used for
• Product pricing and mix decisions
• Cost reduction and process improvement
decisions
• Design decisions
Sources of Capital
Business Angels are private investors who
invest in unquoted small and medium sized
businesses. They are often businessmen and
women who have sold their business. They
provide not only finance but experience and
business skills. Business Angels invest in the
early stage of business development filling, in
part, the equity gap.
Business Angels
• Individuals looking for investment opportunities
of their own money
• Often retired but still interested in business
• Generally small sums
• Could be an individual or a small group
• Generally have some say in the running of the
company
• Often play a big role in start-ups: financing and
skills transfer
• Example: Estimated that 90% of outside equity
capital in seed/startup stage companies is
sourced from angels
Venture Capital
• Pooling of capital in the form of limited companies –
Venture Capital Companies
• Looking for investment opportunities in fast growing
businesses or businesses with highly rated prospects
• May also provide advice, contacts and experience as well
pressure to perform
• Key characteristics: looking for big return fast, will take
ownership interest, focused on rate of return not rate of
growth
Angels versus Venturers
Main Differences
Business Angels
Venture Capitalists
Personal
Entrepreneurs
Money managers
Money Invested
Own money
Fund provider
Firms funded
Small, early stage
Medium to large
Due diligence done
Minimal
Extensive
Location of inv.
Of concern
Of lesser concern
Contract used
Simple
Comprehensive
Monitoring after inv.
Active, hands-on
Strategic
Involvement in mgt
Important
Of lesser concern
Exiting the firm
Of lesser concern
Highly important
[Ten3 website, business angels ]
Internal Sources of Finance and Growth
• ‘Organic growth’ – growth generated through the
development and expansion of the business itself. Can be
achieved through:
• Generating increasing sales – increasing revenue to
impact on overall profit levels
• Use of retained profit – used to reinvest in the business
• Sale of assets – can be a double edged sword – reduces
capacity?
External Sources of Finance
• Long Term – may be paid back after many years or not at
all!
• Short Term – used to cover fluctuations in cash flow
• ‘Inorganic Growth’ – growth generated by acquisition
Long Term
•
Shares (Shareholders are part owners of a company)
– Ordinary Shares (Equities):
•
•
•
•
Ordinary shareholders have voting rights
Dividend can vary
Last to be paid back in event of collapse
Share price varies with trade on stock exchange
– Preference Shares:
• Paid before ordinary shareholders
• Fixed rate of return
• Cumulative preference shareholders – have right to dividend carried over to next year in
event of non-payment
– New Share Issues – arranged by merchant or investment banks
– Rights Issue – existing shareholders given right to buy new shares at discounted
rate
– Bonus or Scrip Issue – change to the share structure – increases number of shares
and reduces value but market capitalisation stays the same
Long term
• Loans (Represent creditors to the company – not owners)
– Debentures – fixed rate of return, first to be paid
– Bank loans and mortgages – suitable for small to medium
sized firms where property or some other asset acts as
security for the loan
– Merchant or Investment Banks – act on behalf of clients
to organise and underwrite raising finance
– Government
• Grants
• Loan guarantees
• Loans
Short Term
•
•
Bank loans – necessity of paying interest on the payment, repayment periods
from 1 year upwards but generally no longer than 5 or 10 years at most
Overdraft/ Line of Credit facilities – the right to be able to withdraw funds
you do not currently have
– Provides flexibility for a firm
– Interest only paid on the amount overdrawn
– Overdraft limit – the maximum amount allowed to be drawn - the firm
does not have to use all of this limit
'Inorganic Growth'
• Acquisitions
• The necessity of financing external inorganic growth
– Merger:
• firms agree to join together – both may retain some
form of identity
– Takeover:
• One firm secures control of the other, the firm taken
over may lose its identity
Alternative Sources of Funding
• Crowd Funding
• Micro-financing