- A measure of business success - A key source of finance for investment in future growth - A reward for risk taking Total revenue - total costs = Profit (or loss)

- The amount (value) of a product that customers actually buy from a firm - Revenue arises through the trading activities of a business - The value of revenue achieve in a given period is equal to the quantity of products sold multiplied by the price that customers paid Total revenue = volume sold x average selling price

- Amounts that a business incurs in order to make goods or provide services - Are the things that drains away the profits made by a business - The difference between making a good and a poor profit margin - The main cause of cash flow problems in business - Change as the output or activity of a business changes

- Profit made on individual products - Used in calculating how many need to be sold to cover business total costs - The difference between sales revenue and variable costs of production

- Understanding the breakeven positions is key to understanding what a business needs to do to do to operate profitably - However breakeven analysis makes certain assumptions, so be aware of its limitations Three methods of calculating breakeven level of output - A table - Formula - Graph

- The chat approach helps visualise the concept of breakeven

3.5 Flashcards by Tom Marsh

Importance of profit

A measure of business success
A key source of finance for investment in future growth
A reward for risk taking

Total revenue - total costs = Profit (or loss)

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Demand

The amount of a product customers are prepared to buy

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Revenue

The amount (value) of a product that customers actually buy from a firm
Revenue arises through the trading activities of a business
The value of revenue achieve in a given period is equal to the quantity of products sold multiplied by the price that customers paid

Total revenue = volume sold x average selling price

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Main ways for a business to increase revenue

Increase quantity sold
> Lower price (elastic demand)
> Increase demand by other means (marketing mix, added value)
Achieve a higher selling price
> Raise price (inelastic demand)
> Product differentiation

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Costs

Amounts that a business incurs in order to make goods or provide services
Are the things that drains away the profits made by a business
The difference between making a good and a poor profit margin
The main cause of cash flow problems in business
Change as the output or activity of a business changes

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Variable and fixed costs

Variable costs
- Cost which vary directly with the level of output
- Lower risk for start ups; no sales = no variable costs

Fixed costs
- Costs which do not vary directly with the level of output
- Fixed costs increase the risk of a start-up

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Examples of variable costs

Raw materials
Energy
Packaging
Wages based on hours worked or amount produced
Marketing costs based on sales

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Examples of fixed costs

Business rates
Rent
Salaries
Advertising
Insurance, banking & legal fees
Software
Consultant and adviser costs
Design and development

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Calculating total costs

Total costs (TC) = Fixed costs (FC) + Variable costs (VC)

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Problems estimating costs

Some costs are easy to estimate and control
- Rent
- Salaries

Others are much harder
- Raw materials - affected by wastage
- Product returns or refunds - affected by quality
- Where the entrepreneur does not have detailed experience of a market

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Ways or measuring profit

Profit is the reward or return for taking risks & making investments

Profit in absolute terms
- The £ value of profits earned

Profit in relative terms
- The profit earned as a proportion of sales achieved or investment made

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Contribution

Profit made on individual products
Used in calculating how many need to be sold to cover business total costs
The difference between sales revenue and variable costs of production

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Contribution formulas

Contribution = Total sales revenue - variable costs

Contribution per unit = Selling price - variable costs per unit
OR
Contribution
——————-
Output

Total contribution = Contribution per unit x number of units sold

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Breakeven

Understanding the breakeven positions is key to understanding what a business needs to do to do to operate profitably
However breakeven analysis makes certain assumptions, so be aware of its limitations

Three methods of calculating breakeven level of output
- A table
- Formula
- Graph

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Breakeven analysis key assumptions

Selling price per unit stays the same, regardless of the amount produced
Variable costs per unit is the same across all levels of output
All output is sold
Fixed costs do not vary with output - they stay the same

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Using a formula for breakeven

Contribution per unit = Selling price per unit - variable cost

Breakeven output (units) =
Fixed costs (£)
———————————–
Contribution per unit (£)

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Breakeven chart

The chat approach helps visualise the concept of breakeven

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Margin of safety

The margin of safety is the difference between actual output and the breakeven output

Actual output - break even output

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Effects on breakeven

Changes:
- Higher selling price
Effect on contribution per unit:
- Higher
Effect on breakeven output:
- Lower

Changes:
- Lower selling price
Effect on contribution per unit:
- Lower
Effect on breakeven output:
- Higher

Changes:
- Higher variable cost per unit
Effect on contribution per unit:
- Lower
Effect on breakeven output:
- Higher

Changes:
- Lower variable cost per unit
Effect on contribution per unit:
- Higher
Effect on breakeven output:
- Lower

Changes:
- Increase in fixed costs
Effect on contribution per unit:
- No change
Effect on breakeven output:
- Higher

Changes:
- Decrease in fixed costs
Effect on contribution per unit:
- No change
Effect on breakeven output:
- Lower

Strengths of breakeven analysis

Focuses on what output is required before a business reaches profitability
Helps management and finance providers understand the viability and risk of a business or business idea
Margin of safety calculation shows how much a sales forecast can prove over-optimistic before losses are incurred
Illustrates the importance of keeping fixed costs down to a minimum
Calculations are quick and easy

Limitations of breakeven analysis

Unrealistic assumptions
Sales are unlikely to be the same as output
Variable costs do not always stay the same
Most businesses sell more than one product
A planning aid rather than a decision-making tool

Receivables

The sum of money outstanding from customers (debtors)

Payables

The sum of money owed to suppliers (creditors)

Inventory

The cash value of working capital and finished goods held in the business

Cash flow is Important

- Cashflow is a dynamic and unpredictable part of life for most businesses - Cashflow flow problems are the main reason why a business fails - Regular and reliable cash flow forecasting can address many of the problems

Main kinds of cash flow

Cash inflows - Cash sales - Receipts from trade debtors - Sale of fixed assets - Interest on bank balances - Grants - Loans from bank - Share capital invested Cash outflows - Payments to suppliers - Wages and salaries - Payments for fixed assets - Tax on profits - Interest on loans & overdrafts - Dividends paid to shareholders - Repayment of loans

Why cash flow forecasting is important

- CASH IS KING - If a business runs out of cash it will almost certainly fail - Few businesses have unlimited finance - cash is limited, so it needs to be managed carefully

Why produce a cash flow forecast

- Advanced warning of cash shortages - Make sure that the business can afford to pay suppliers and employees - Spot problems with customer payments - As an important part of finical control - Provide reassurance to investors and lenders that the business is being managed properly

Key to effective cash flow forecasting

- They to cash flow management is having good information - A good cash flow forecast: > Updated regularly > Makes sensible assumptions > Allows for unexpected changes

Common problems with cash flow forecasts

- Sales prove lower than expected - Customers do not pay up in time - Costs prove higher than expected - Imprudent cost assumptions

Managing cash flow

Cash flow management is a crucial day-to-day activity for every business

What is a cash flow problem

When a business does not have enough cash to be able to pay its liabilities

Main causes of cash flow problems

- Low profits - Too much production capacity - Excess inventories held - Allowing customers too much credit & too long to pay - Overtrading - Unexpected changes in the business - Seasonal demand

Too much spending on capacity

- Spending too much on fixed assets - Made worse if short-term finance is used - Fixed assets are hard to turn back into cash in the short-term

Too much inventory

- Excess stocks tie up cash - Increased risks that stocks become out of date or perished BUT - There needs to be enough stock to meet demand - Bulk buying may mean lower purchase price

Allowing customers too much credit

- Customers who buy on credit are called "trade debtors" - Offer credit is a good way of building sales BUT - Late payment is a common problem - The debt may go "bad"

Overtrading

- Where a business expands too quickly, putting pressure on short-term finance - Businesses that rely on long-term contracts also at high risk of overtrading

Seasonal demand

- Where there are predictable changes in demand & cash flow - Production or purchasing usually in advance of seasonal peak in demand = cash outflows before inflows - Cash flow forecast should allow for seasonal changes

How to manage cash flow problems

- Make and action reliable cash flow forecasting - Manage working capital effectively - Choose the right sources of finance

Managing working capital

Effective working capital management focuses on: - Inventories - Debtors (receivables) - Creditors (payables)

Improving working capital

Debtors - Amounts owed by customers Creditors - Amounts owed to suppliers Inventories - Cash tied up in raw materials, work in progress and finished goods

Managing amounts owed by customers

Credit control - Policies on how much credit to give and repayment terms and conditions - Measures to control doubtful debtors - Credit checking Selling off debts to debt factors Cash discounts for prompt payment Improved record keeping

Debt factoring

- The selling of debtors to a third party - This generates cash - It guarantees the firm a percentage of money owed to it - But will reduce income and profit margin made on sales - Cost involved in factoring can be high