Unit 5 Flashcards
Decision making to improve financial performance (156 cards)
1
Q
What is a financial objective?
A
A specific goal or target relating to the financial performance, resources and structure of a business.
2
Q
What do financial objectives link closely with?
A
- Corporate objectives
- Marketing objectives
- Operations objectives
- Budgeting
- Shares and shareholders
- Decision making
3
Q
Key benefits of using financial objectives
A
- Focus for decision making.
- Specific and measurable way of assessing the success and failure of a business.
- Provides clear targets for managers to achieve.
- Improve coordination - give departments a common purpose.
- Shareholders - can assess if a business is a worthwhile investment.
- Outside organisations - suppliers and customers - can confirm the financial viability of a business.
- Improve efficiency - by examining the reasons for success and failure.
4
Q
Key limitations of using financial objectives
A
- Difficult to set realistic objectives - eg. for new activities.
- External factors beyond your control - PESTLE e.g. competition.
- Difficult to measure accurately.
- Reasons for success or failure may be impossible to determine.
- Responsibility for achievement - may rest with the financial department, but the actual performance will be dependent on the performance of all departments.
- May conflict with other objectives, both financial and non-financial.
5
Q
What are the key financial objectives?
A
- Profit objectives (revenue objective and costs objectives)
- Cash flow objective
- Return on investment objective
6
Q
What are profit objectives?
A
Targets for the surplus of revenue over costs.
- Profit objectives can be satisficing or maximisation.
- Making a profit is the aim of the majority of businesses in private sector.
- Businesses may set specific objective for profit - may be a particular figure/percentage increase, or may be set in terms of a profit margin.
- Profit maximisation sometimes mentioned, but is difficult to judge whether it’s actually been achieved, and a business making unreasonably high profit can be the subject of a great deal of criticism, as is the case with some utility companies.
7
Q
What are revenue objectives?
A
Targets set for the amount of money coming into a business from sales.
- Revenue objectives look at maximising revenue and creating as many sales as possible (market share).
- A knowledge of the likely revenue of a business is essential - starting point for creating a budget.
- The objective set might depend on the type of market a business is operating in and the state of economy.
- In addition, any objective set would have to be coordinated with other functional areas, e.g. marketing and operations.
8
Q
What are cost objectives?
A
Limits set on the amount of money leaving the business.
- Cost objectives are about minimising costs either variable or fixed.
- Businesses operate in a highly competitive environment and as a result face increasing pressure on costs. Cost minimisation has therefore become important objective (achieving lowest possible unit costs of production).
- As an alternative to cost minimisation, a business might set an objective of reducing costs by a certain percentage or target a specific area of the business that is seen to be underperforming.
9
Q
What are the different types of profit?
A
- Gross profit
- Operating profit
- Profit for the year
10
Q
What is gross profit? + how is it calculated
A
The difference between a business’ sales revenue and the direct costs of production such as materials and direct labour.
Gross profit = revenue - variable costs (VC also called cost of sales)
11
Q
What is operating profit? + how is it calculated
A
The difference between the gross profit and the indirect costs of production or expenses such as marketing and salaries (revenue minus both the direct and indirect costs of production).
Operating profit = sales revenue - all costs of production
or
Operating profit = gross profit - fixed/indirect costs (also called expenses)
12
Q
What is profit for the year (net profit)? + how is it calculated
A
The figure for operating profit does not include other expenditure such as interest payments or tax to be paid or other income such as interest received or money received from the sale of assets, which profit for the year does.
Profit for the year = operating profit - other expenses and tax + any other income
- These costs are not linked from the usual activity of the business and this income isn’t coming from the usual activity of the business, e.g. it could have come from the sale of a building or some interest received.
13
Q
What is cash flow?
A
The difference between the actual amount of money a business receives (inflows) and the actual amount it pays out (outflows) over a period of time.
14
Q
What are cash flow objectives?
A
Targets set for the amount of and timings of cash inflows and outflows to ensure that the business has enough cash to pay day-to-day expenses.
- Businesses may set cash flow objectives to increase liquidity to avoid insolvency (unable to pay debts).
15
Q
What is the importance of cash flow objectives?
A
Although it is possible to survive as a business in the short to medium term while making a loss, it is impossible to survive for long without cash to make immediate payments. It is therefore vital that a business manages its cash flow carefully by setting objectives.
16
Q
What is liquidity?
A
A measure of how much cash a business has to pay for its day-to-day expenses.
17
Q
Examples of cash flow objectives
A
- Reduce borrowings to target level.
- Minimise interest costs.
- Reduces amounts held in inventories.
- Reduce amounts owed by customers to improve cash flow.
- Reduce seasonal swings in cash flow.
- Increase supplier payment terms.
- Targets for monthly closing balances.
18
Q
What types of businesses may find it more difficult to control their cash flow?
A
- A business with a fluctuating demand, e.g. some months of the year demand high but in other months may be low, or a business that doesn’t operate all year round (seasonal business).
- A business that supplies a product or service that takes a very long time to produce or sell, e.g. construction.
- A business that invoices its customers (customers do not have to pay when they place an order) or a business that allows its customers trade credit (from 30 to 90 days).
- A start up business.
19
Q
Pros of having a positive cash flow
A
- Pay suppliers on time
- Pay employees on time
- Ability to handle unforeseen events
- Take advantage of opportunities
- Means to expand business
20
Q
How to calculate net cash flow
A
Cash inflows minus cash outflows
(This is the money left in the business’ account)
21
Q
Why is cash flow vital in the short term and profit vital in the long term?
A
CASH is important in the short run as it is needed to pay creditors and workers.
- Without sufficient cash, creditors (in extreme cases) can take you to court and declare you bankrupt or insolvent in the case of companies.
- Workers who will not be paid on time will be demotivated, resulting in poor productivity, high absenteeism (absences) and labour turnover.
PROFITS are essential for the long term survival of the business, otherwise no institution would be interested to invest in a business which gives them low return on their capital investment.
22
Q
What are some of the reasons cash flow and profit differ due to timing?
A
1) Credit sales is immediate revenue but not inflow. Credit purchases is an immediate cost but not outflow.
2) Buying fixed assets is an outflow but not a cost. Depreciation is a cost but not outflow.
3) Bank loans are long term costs but immediate inflows.
23
Q
What is capital expenditure?
A
The money spent on fixed assets such as buildings and equipment and represents long-term investment into the business.
24
Q
What are examples of things that businesses invest capital expenditure on?
A
- Machinery
- New staff
- Existing staff
- New product
- Existing product
- Advertising campaign
- Other businesses
- Stocks and shares
- Bank account
25
When will investment occur in a business?
- When a business first sets up
- As a business grows and develops
26
What will objectives for investment depend on?
- The overall corporate objectives, e.g. growth.
- The type of business.
- The state of the economy.
- The market in which the business is operating.
27
What is meant by return on investment?
Measures the profit made as a % of the initial investment.
28
How to calculate return on investment?
ROI = (profit made from investment) / cost of investment) x 100
29
What is a return on investment objective?
A target for the minimum acceptable return on an investment, measured as operating profit as a percentage of the investment, e.g. 10% return.
- This formula could also be used when a business is deciding between two different investments. With this type of decision however it is important to remember that any returns (profit) will only be forecasts, and any predictions made may be influenced by a manager's own bias towards a particular investment.
30
Why do we need ROI?
- Measuring tool (predictions) - is the investment worth it?
- Measuring tool (actual) - was it worth it?
31
What is the value of setting financial objectives?
Setting financial objectives is key as it enables to:
- measure how well a business is doing financially (profit measure) and to compare the performance over time/years (look at the trend)
- identify potential areas where the business could improve (gross profit, operating profit or net profit)
- control spending (cost targets)
- provide sales targets
- prevent a business running out of cash (cash flow target)
- measure the reward that shareholders receive from their investment or set expectations when making an investment (ROI)
- help limit the risk of long-term debts (gearing ratio target)
- help support loan application from banks or funding request from investors
32
What is a budget?
A financial plan for the future, anticipating the revenues, costs and profit of a business.
- Shows 'forecasted' or 'budgeted' figures.
33
What are the reasons for setting budgets?
- To support bank loan application or share issue.
- For financial control - avoid overspending or waste.
- For decision making - identifying underperforming areas and decide what to do or change.
- To help forward planning.
- To provide targets for staff - basis for rewards.
- To assign responsibility - budget holders are accountable for performance.
34
How can a budget be analysed?
Analysing a budget means calculating and investigating the discrepancies (differences) between actual results and the budgeted figures.
- Variance analysis.
35
Define variance
A variance means a difference. In business it means the difference between a budgeted figure and an actual figure.
Variance = budgeted figure - actual figure
36
What is variance analysis?
The process of looking at the variances within a budget and trying to understand the reasons why these differences have occurred.
37
What is a favourable variance?
A positive (or favourable) variance means that the difference between the budgeted and the actual figure has a positive impact on the finances of the business.
- When costs are lower than forecasted.
- When profit or revenues are higher than forecasted.
38
What is an adverse variance?
A negative (or adverse) variance means that the difference between the budgeted and the actual figure has a negative impact on the finance of the business.
- When costs are higher than expected.
- When profit or revenues are lower than forecasted.
39
How might an adverse variance occur from something good that has happened in the business?
An adverse variance might result from something that is good that has happened in the business:
- e.g. higher production costs than budget (adverse variance) due to sales being significantly higher than budgeted (favourable variance).
40
How can a business respond to adverse sales variances?
- Increase promotions.
- Change distribution (instead of selling through retailers only, sell online).
- Withdraw the product if it is clear that there is no longer a sufficient demand for it and all improvement have been exhausted.
- Reduce the price (only if PED > -1 so price elastic).
- Look for new segments or new geographical markets to sell the product.
- Improve the product (product life cycle extension).
- Train staff to improve customer service.
41
How can a business respond to adverse cost variances?
- Find cheaper suppliers.
- Change production method to reduce unit cost.
- Invest in automation and replace staff with machines or robotics to reduce staff costs and reduce unit cost (more capital intensive).
- Invest in better machinery to reduce unit cost.
- Increase size of orders to benefit from purchasing economies of scale (bulk order discount).
- Find cheaper premises.
42
How can a business respond to favourable variances?
- Increase production or re-stock to meet higher than expected demand or increase the price as demand is stronger than expected and benefit from higher profit margins.
- Reduce price of product/service if costs are below expectations (business can pass on reduction in costs to its customers), which may increase sales.
- Reinvest into the business or pay shareholders a higher dividend if profits exceed expectations.
43
How might an favourable variance occur from something bad that has happened in the business?
A favourable production material variance could be generated from using lower-quality raw materials, which in turn could manifest itself a drop in sales.
44
Pros of budgeting
- Gives senior and functional managers spending guidance which encourages spending disciplines.
- Helps support a business if they are looking to obtain finance and increases the chances of them obtaining finance.
- Targets can be set for each part of a business, allowing managers to identify the extent to which each part contributes to the business' performance.
- Inefficiency and waste can be identified, so that appropriate remedial action can be taken.
- Budgeting should improve financial control by preventing overspending.
- Can help improve internal communication.
- Delegated or devolved budgets can be used as a motivator by giving employees authority and the opportunity to fulfil some of their higher-level needs, as identified by Maslow.
45
Cons of budgeting
- If a senior manager sets a budget but doesn't have expertise in a specific area, it could lead to over-ambitious targets and demotivation.
- Historical or amended budgets are based on previous years which may encourage the 'use it or lose it' mentality which will lead to waste.
- If budgets are not frequently reviewed it could lead to budgetary slack.
- Middle management may over-estimate costs.
- The operation of budgets can become inflexible. E.g. sales may be lost if the marketing budget does not change when competitors implement major promotional campaigns.
46
What are incomes budgets?
The forecasted earnings from sales and are sometimes called 'sales budgets'.
- For a newly established business, they will be based on the results of market research.
- Established businesses can also call upon past trading records to provide information for sales forecasts.
- Income budgets are normally drawn up for the next financial year on a monthly basis.
47
What are expenditure budgets?
An expenditure budget sets out the expected spending of a business, broken down into a number of categories. The titles given to these categories will depend on the type of business.
- A manufacturing business will have sections entitled 'raw materials' or 'components', whereas a service business may not.
48
What are profit (or loss) budgets?
Profit and loss budgets are calculated by subtracting forecast expenditure (or costs) from forecast sales income.
- Depending on the balance between expenditure and income, a loss or a profit may be forecast.
- It is not unusual for a new business to forecast (and actually make) a loss during its first period of trading.
49
What is the process of setting budgets?
Stage 1: Prepare income budgets
- Market research
- Trading records (for established businesses)
Stage 2: Construct expenditure budgets
- Use income budget as a guide
- Potential suppliers may offer information on costs
Stage 3: Forecast profit or (loss) by comparison of income and expenditure
50
Internal influences on financial objectives and decisions
Corporate objectives:
- Any financial targets need to be linked to the overall corporate objectives.
- E.g. an objective of growth might lead to improved financial performance in the long term, but in the short term might lead to a decline in performance as more money is used to finance growth.
Resources available:
- The ability to achieve financial targets may be limited by the resources available, such as the availability of skilled labour and the money available to finance the targets set.
Operational factors:
- The ability to achieve financial targets will be limited in the short term by the physical capacity of a business.
51
External influences on financial objectives and decisions
Competitor actions:
- May be due to competitors launching a new marketing campaign, price cuts or the development of new products or services.
Market forces:
- Markets and fashion change over time and, unless a business can lead or keep up with changes, financial targets may be missed.
- E.g. shopping habits have changed with the growth of online shopping, and these changes have had an impact on high streets, with the closure of many retail outlets.
Economic factors:
- Changes in economy, such as the 2008 recession, are likely to result in financial targets being missed, whereas increasing growth may lead to better performance.
- Changes in interest rates can also impact on performance, illustrating the need for all businesses to review targets in the light of any changes in economy.
Political factors:
- Change of government and legislation can also have an impact.
- E.g. an increase in the minimum wage or the introduction of new health and safety legislation will incur additional costs which, if not passed on to the consumer, will impact financial targets.
Technology:
- Changes in technology may have various impacts, such as facilitating quicker and easier monitoring of financial data.
- Introduction of technology, which may in the long term, lead to greater efficiency and improved performance, is likely to have a significant cost in the short term.
52
What is a cash flow forecast?
A cash flow forecast is a plan or budget for future cash inflows, cash outflows and net cash flows over a period of time.
53
What are the three sections of a cash flow forecast?
- Receipts (revenue) or cash inflow in which the expected total month-by-month receipts are recorded.
- Payments (expenses) or cash outflow in which the expected monthly expenditure by item is recorded.
- Running balance in which a running total of the expected bank balance at the beginning and end of each month is recorded. These are termed 'opening balances' and 'closing balances'.
54
What are the golden rules of cash flow forecasts?
- Money is only recorded when cash changes hands.
- It tells us nothing about profit - a profitable business can have poor cash flow, and still go bankrupt.
- The closing balance of one month is the opening balance of another month.
- A negative closing balance does not mean that the firm is bankrupt.
- Net cash flow + opening balance = closing balance
- () signs means negative cash
55
What are the values of a cash flow forecast?
- To highlight when a business will be short of cash, e.g. May, June?
- To highlight by how much the business will be short of cash, e.g. £500 or £5m?
- To anticipate issues with cash flow and take action, e.g. ask for overdraft or loan?
- To see if timings could be changed, e.g. delay a purchase or ask to spread out repayments.
- To avoid running out of cash and liquidation.
- To manage extra cash, e.g. invest it or expand.
56
Limitations of cash flow forecasts: what types of issues can happen?
Sales prove lower than expected:
- Easy to be over-optimistic about sales potential.
- Market research may have gaps.
Customers do not pay up on time:
- A notorious problem for businesses, particularly small ones.
Costs prove higher than expected:
- Perhaps because purchase prices turnout higher.
- Maybe also because the business is inefficient.
- A common problem for a start-up.
- Unexpected costs always arise - often significant.
57
List the potential causes of cash flow (or liquidity) problems
- Too much production capacity.
- Excess inventories held.
- Allowing customers too much credit.
- Overtrading.
- Seasonal demand.
- Suppliers wanted to be paid quickly.
58
How can too much production capacity cause cash flow or liquidity problems?
- Spending too much on fixed assets.
- Made worse if short-term finance is used (e.g. bank overdraft).
- Fixed assets are hard to turn back into cash in the short-term.
59
How can excess inventories held cause cash flow or liquidity problems?
- Excess stocks tie up cash.
- Increased risk that stocks become obsolete, BUT...
- There needs to be enough stock to meet demand.
- Bulk buying may mean lower purchase prices.
60
How can allowing customers too much credit cause cash flow or liquidity problems?
- Customers who buy on credit are called "trade debtors"
- Offer credit = good way of building sales, BUT...
- Late payment is a common problem.
- Worse still, the debt may go 'bad'.
61
How can overtrading cause cash flow or liquidity problems?
- Where a business expands too quickly, putting pressure on short-term finance.
- Classic example: retail chains - keen to open new outlets; have to pay rent in advance, pay for shop-fitting, pay for stocks; large outlay before sales begin in new store.
- Businesses that rely on long-term contracts also at high risk of overtrading.
62
How can seasonal demand cause cash flow or liquidity problems?
- Where there are predictable changes in demand and cash flow.
- Production or purchasing usually in advance of seasonal peak in demand = cash outflows before inflows.
- This can be managed - cash flow forecast should allow for seasonal changes.
63
What can cash flow or liquidity problems lead to?
- Increase in financial costs: fees and interest are charged for using an overdraft facility.
- Poor credit score making it difficult to obtain trade credit with suppliers or finance from banks in the future.
- Suppliers asking for cash payments up front before delivering, or even refusing to supply the business altogether. If a business can't pay for or buy new stock it may not be able to function.
- Unpaid suppliers taking legal action against the business (taking the business to court non-payment) which could lead to insolvency or bankruptcy (or liquidation).
64
What are receivables (as an amount of money £)?
Represent the money owed to a business by customers for goods and services purchased on credit (haven't paid their invoice yet).
- Future cash inflows.
65
What are receivables (as an amount of days)?
Represent the average length of time it takes for a business' customers to pay for the goods and services purchased on credit.
- The average for receivables is 30 days (this is the usual trade credit period).
66
What are payables (as an amount of money £)?
Represent the amount of money owed by a business to pay its suppliers for goods and services purchased on credit.
- Future cash outflows.
67
What are payables (as an amount of days)?
Represent the average length of time it takes for a business to pay its suppliers for goods and services purchased on credit.
68
Define asset
Something the business owns that could be sold.
69
Ways of improving cash flow
- Make a cash flow forecast and monitor cash in and out.
- Chase late payers and incentivise customers to pay early.
- Don't overstock.
- Negotiate longer trade credit with suppliers.
- Set up an overdraft.
- Negotiate monthly repayments.
- Check customers' credit rating.
- Don't take on too many orders.
- Sell assets.
- Lease/rent rather than buy outright.
- Use debt factoring.
- Apply for short term loan
70
What is an overdraft?
A form of credit: the bank allows a business to carry on spending money even when its bank account balance drops below zero.
- This facility must be agreed in advance with the bank and the business mustn't spend beyond the limit of its overdraft.
71
What is debt factoring?
Debt factoring (factoring or debt recovery) is when a business sells an unpaid invoice to a debt recovering company.
- It will immediately receive a percentage of the amount due in cash.
- The debt recovering company will then take on the responsibility for chasing the customer who hasn't paid the invoice.
72
Advantages of asking for or increasing an overdraft as a method of improving cash flow
- It is easy to arrange.
- Flexible - can be use to pay for whatever the business requires at the time.
- Interest is only paid on the level of the overdraft that is actually used.
- Unlike with a bank loan, a firm that uses a bank overdraft does not need to provide security (collateral).
73
Disadvantages of asking for or increasing an overdraft as a method of improving cash flow
- Bank overdrafts are based on flexible interest rates - difficult to budget accurately.
- High rate of interest.
- Banks can demand immediate repayment.
74
Advantages of managing customers & suppliers to ensure a positive net cash flow each month
- Negotiate longer terms for trade credit from suppliers.
- Offer shorter periods of trade credit to customers.
- Give customers an incentive to pay upfront, e.g. give a discount for payment on an order.
- Ask customers to pay a deposit.
- Ask suppliers to spread the cost over a period of time, e.g. monthly instalments rather than all in one payment.
- Check customers' credit record to make sure they haven't got a track record for late payments or failing to pay.
75
Disadvantages of managing customers & suppliers to ensure a positive net cash flow each month
- Suppliers may not agree to longer terms for trade credit.
- Customers may go elsewhere if shorter periods of trade credit are offered.
76
Advantages of applying for a short term loan as a method of improving cash flow
- Bank loans are usually at a fixed rate of interest - so can budget for repayment.
- Interest rates less than overdraft.
- A bank loan may be set up for a long period of time, to help the firm.
77
Disadvantages of applying for a short term loan as a method of improving cash flow
- Interest is paid on the whole of the sum borrowed.
- The business will need to provide the bank with security (collateral).
78
Advantages of using debt collection specialists to deal with late payers as a method of improving cash flow
- Improved cash flow in the short term as the debt collector specialist buys the unpaid invoices from the business.
- A % of the invoice is paid cash into the business' account.
- Lower administrative costs: no more time wasted chasing late payers (no more phone calls, emails, letters, etc.)
- Reduced risk of bad debts (customers not paying their invoices) as a debt collector specialist usually has a better success rate at getting customers to pay.
79
Disadvantages of using debt collection specialists to deal with late payers as a method of improving cash flow
- Cost is high - 5% to 10% of its revenue.
- An aggressive factoring company may upset certain customers, who will blame the original seller of the product.
80
Advantages of leasing or renting rather than buying outright as a method of improving cash flow
- Allows a business to spread the costs over a number of months or years by paying regular smaller monthly instalments.
- The asset can be bought at the end of the leasing period.
- Save costs on maintenance.
- The business may be able to ask for regular upgrades of equipment/machinery which means that it can benefit from the latest technology.
81
Disadvantages of leasing or renting rather than buying outright as a method of improving cash flow
- In the long term, the firm will usually pay more for leasing or renting the equipment than paying cash or outright for it.
- The business will not own the asset until the end of the leasing contract and all the payments have been made.
- The business may never own the equipment if it is rented.
82
Advantages of selling assets as a method of improving cash flow
- Can raise a lot of money, e.g. sale of buildings or land.
- If a particular asset is no longer needed, sale of the asset will not only ease the cash-flow problem, but also enhance the overall profitability of the business.
83
Disadvantages of selling assets as a method of improving cash flow
- Assets, e.g. buildings or land, may be very difficult to sell quickly.
84
Define profitability
Measures the quality of a business' profit by comparing profits with a second variable, e.g. sales or capital invested.
85
Which stakeholders particularly care about profitability?
- Shareholders (dividends)
- Managers (targets)
- Employees (job security)
86
What is a profit margin?
A ratio that expresses business' profit as a percentage of its revenue over some trading period.
- E.g. gross profit margin, operating profit margin, net profit margin.
87
How to calculate profit margin
(profit) / (sales revenue) x 100 = %
88
Analysis of a business' gross profit margin
This ratio can help businesses to understand how much profit is being made from buying and selling goods.
- THE HIGHER THE BETTER.
- Enables the firm to assess the impact of its sales and how much it costs to generate (produce) those sales.
- A gross profit margin of 45% means that for every £1 of sales, the firm makes 45p in gross profit.
- If it is low or falling, this may indicate that a firm is not managing its costs of sales effectively, e.g. are the cost of raw materials increasing? It can also indicate sales are in decline.
89
Analysis of a business' operating profit margin
Operating profit margin is a measure of a firm's profitability by looking at the relationship between operating profit and sales revenue.
- If it is low or falling, this may indicate that a firm is not managing its expenses effectively, e.g. wages are increasing or overheads are going up. It may also indicate sales are in decline.
90
Analysis of a business' net profit margin
Net profit (profit for the year) really provides a more accurate reading on how much profit a business has made as it takes away all of the costs and not just those we had in the buying and selling of our goods.
- If the profit for the year margin is low or falling this may indicate that a business' gross profit or operating profit are in decline, interest rates have changed, or taxation rates have changed.
91
How can a business assess its profit margins?
- Compare the figure with previous year(s)
- Compare the figure with competitors
92
List the methods of improving profit and profitability
- Increase sales
- Reduce variable costs
- Increase price
- Reduce fixed costs
93
How can a business increase sales to improve profit and profitability
- Increase promotion
- Find new market(s)
- Introduce new product(s)
94
Disadvantages of increasing sales to improve profit and profitability
- Could be expensive
- May fail
- May take a long time
95
How can a business reduce variable costs to improve profit and profitability
- Finding cheaper suppliers
- Buying more efficient machinery
- Cut wages costs
96
Disadvantages of reducing variable to improve profit and profitability
- Could reduce quality
- Requires investment
- Could be costly
- Reduce motivation
97
How can a business increase price to improve profit and profitability
- Improve current product and increase price.
- Introduce new product with a high price.
98
Disadvantages of increasing price to improve profit and profitability
- Revenue may fall if the PED is elastic (between -1 and 0)
- Customers may switch to competition or substitute
99
How can a business reduce fixed costs to improve profit and profitability
- Relocating to cheaper premises
- Sell premises and rent back
- Reducing administration costs
- Reduce marketing
- Use capacity more fully - spread fixed costs
100
Disadvantages of reducing fixed costs to improve profit and profitability
- Could damage image
- Could increase transport costs
- Could become understaffed
- Could reduce sales
101
How could the marketing department of a business contribute to improving profitability?
- Improve the product or service.
- Launch a new product.
- Find a new market segment.
- Change the price.
- Sales promotions.
- Advertising.
- Increase places where the product is sold.
- Sell on the internet.
102
How could the finance department of a business contribute to improving profitability?
- Source cheapest source of finance.
- Set and monitor budgets.
- Analyse 'variances' to ensure maximum efficiency.
- Manage cash flow more efficiently to avoid having to use an overdraft (expensive).
- Check customers' credit rating to avoid 'bad debts'.
- Negotiate 'trade credit' with suppliers, e.g. 30 days or more.
- Calculate profitability measures, e.g. profit margin (gross, operating and net profit margins).
103
How could the operations department of a business contribute to improving profitability?
- Source cheaper suppliers.
- Buy in bulk to benefit from economies of scale.
- Reduce unit cost.
- Increase labour productivity.
- Reduce waste.
- Implement lean production: cell production, JIT & Kaizen.
- Invest in better machinery.
- Move to capital intensive production.
- Monitor and improve capacity utilisation.
- Outsource when required.
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How could the human resources (HR) department of a business contribute to improving profitability?
- Reduce labour turnover.
- Reduce absenteeism.
- Provide training.
- Improve recruitment & selection process so that the right people with the right skills & experience are hired, e.g. innovative skills.
- Set rewards for achieving targets.
- Select the right type of employment contracts to minimise costs, e.g. zero hour contracts or part-time.
- Make redundancies if necessary.
105
When does break-even occur?
Total revenue (£) = Total costs (£)
- The business does not make a profit or loss.
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What is the break-even output?
The level of output (number of units) at which a business' sales generate just enough revenue to cover all its costs of production.
- At the break-even level of output the business makes neither a profit nor a loss, so the sales revenue equals the total costs.
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What is the break-even point?
The point at which total costs are covered and no profit or loss is made.
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What is contribution?
The idea of using the money left over from the selling price of a product, once variable costs have been paid, to contribute or pay off the fixed costs.
- The difference between sales revenue and variable costs.
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What is contribution per unit? + how to calculate
Selling price minus variable cost per unit. The contribution per unit is used to pay the fixed costs.
- In other words, it contributes to the fixed costs.
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What is total contribution? + how to calculate
The contribution from ALL the units sold.
= contribution per unit x number of units sold
or
= total sales - total variable costs
Once the total contribution = fixed costs: BREAK-EVEN
- Any contribution after break-even = profit.
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What would the break even point for a factory be?
When the number of products manufactured generate enough revenue to cover all of the costs of producing the product.
- Revenue = total costs of manufacturing the product
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What would the break even point for a service provider be, e.g. an airline or a cinema or a festival?
When the number of tickets sold generate enough revenue to cover all of the costs of providing the service.
- Revenue = total costs of providing the service
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How to calculate break even point
(Fixed costs) / (selling price per unit - variable cost per unit)
or
(Fixed costs) / (contribution per unit)
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What is margin of safety?
The margin of safety is the difference between the actual output (how many products have been produced in total) and the break even point.
- The number of units a business produces and sells above its breakeven point.
= actual output - breakeven output
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How can you work out profit using margin of safety?
Profit = margin of safety x contribution per unit
116
How to calculate profit using total contribution?
Profit = total contribution - fixed costs
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TRUE OR FALSE: Fixed costs will fall with output
False
118
TRUE OR FALSE: Variable costs will increase with output
True
119
TRUE OR FALSE: Rent is an example of a fixed cost
True
120
TRUE OR FALSE: Product material costs are an example of a variable cost
True
121
TRUE OR FALSE: Fixed costs minus variable costs = total costs
False
122
What is a breakeven chart?
A visual representation of revenue and total costs to show when they become equal.
123
How to construct a breakeven chart
1) Give the chart a title.
2) Label the axis (horizonal - output in units, vertical - amount of revenues and costs in £)
3) Draw on the fixed cost line (this is horizontal)
4) Draw on the variable cost line (starts at 0)
5) Draw on the total cost line (starts from fixed cost line)
6) Draw on the sales revenue line (starts from 0)
7) Label the breakeven point where sales revenue = total cost (this is the intersection between the revenue line & total cost line)
8) Mark on the selected operating profit (SOP), which is the actual or forecast level of the company's output)
9) Mark on the margin of safety (difference between the SOP and the breakeven point)
10) Mark clearly the amount of profit and loss.
124
What would be the impact of a higher selling price on the contribution per unit and the breakeven output? + explain
- Contribution per unit: increases
- Breakeven output: decreases
Fewer sales will be necessary to break even because each sale generates more revenue, while costs have not altered.
125
What would be the impact of a lower selling price on the contribution per unit and the breakeven output? + explain
- Contribution per unit: decreases
- Breakeven output: increases
Each sale will earn less revenue for the business and, because costs have not altered, more sales will be required to break even.
126
What would be the impact of a higher variable cost per unit on the contribution per unit and the breakeven output? + explain
- Contribution per unit: decreases
- Breakeven output: increases
Each unit of output costs more to produce, so a greater number of sales will be necessary if the firm is to break even.
127
What would be the impact of a lower variable cost per unit on the contribution per unit and the breakeven output? + explain
- Contribution per unit: increases
- Breakeven output: decreases
Every unit of production is produced more cheaply, so less output and fewer sales are necessary to break even.
128
What would be the impact of an increase in fixed costs on the contribution per unit and the breakeven output? + explain
- Contribution per unit: not affected
- Breakeven output: increases
More sales will be required to break even because the business has to pay higher costs before even starting production.
129
What would be the impact of a decrease in fixed costs on the contribution per unit and the breakeven output? + explain
- Contribution per unit: not affected
- Breakeven output: decreases
Because the business faces lower costs, fewer sales will be needed to ensure that revenue matches costs.
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Pros of breakeven analysis
1) It is a useful tool for management as it predicts:
- Breakeven output
- Margin of safety
- Estimates profits at different outputs
- By changing the 'sales price' you can predict the new breakeven output, margin of safety and profit.
2) Highlights the importance of trying to keep fixed costs as low as possible.
- If you are able to keep your fixed costs as low as possible so that your breakeven output is low and your margin of safety is high.
- This means lower risk.
3) Data generated can be used in a business plan which is useful when looking for finance.
- Can support loan applications + negotiations with banks.
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Cons of breakeven analysis
1) Based on predicted data, NOT on actual data.
2) Many unrealistic assumptions, e.g.:
- One same price being used.
- No waste.
- All units produced are sold.
- Production costs stay the same.
- Only one product is sold.
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Overall evaluation of breakeven analysis
The value of a breakeven analysis depends on the accuracy of the predicted data.
Some data could change including:
- price
- variable costs
- fixed costs, e.g. rent, leasing, etc.
133
Define short-term finance
Short-term borrowing that is normally repaid within 12 months.
- It is usually needed to pay bills or overcome cash shortages.
134
Define long-term finance
Long-term borrowing that is normally repaid after one year or more.
- It is usually needed to fund growth.
- E.g. to buy machinery or robotics, to build a factory, to launch a new product, etc.
135
List the internal, short-term and long-term sources of finance
- Retained profits
- Sale and leaseback
136
List the external, short-term sources of finance
- Overdrafts
- Debt factoring
137
List the external, long-term sources of finance
- Bank loans
- Venture capital
- Share capital (or equity)
- Crowdfunding
138
What is retained profit?
This is profit that is not paid to shareholders and has been retained in the business from previous years for future investment.
- A business will only have access to this source of finance if it is profit-making.
139
Advantages of using retained profit
- Cheapest source of finance (no interest)
- Doesn't need to be repaid.
- No loss of control - does not dilute the ownership of the company.
- Very flexible.
140
Disadvantages of using retained profit
- Shareholders may want to receive the money (dividend) and refuse to leave the profit in the business.
- Danger of hoarding cash.
- High profits and cash flows would suggest the business could afford debt.
141
What is a bank overdraft?
Facility or agreement with a bank to take out more money from an account than a business has in it but only up to an agreed limit.
142
Advantages of using a bank overdraft
- Flexible way of borrowing money: take as much cash out when needed and pay as much cash back in when available (no set repayments)
- Useful for businesses with yo-yoing cash flows (unpredictable or varying cash inflows)
- Quick and easy to arrange.
143
Disadvantages of using a bank overdraft
- Interest charged can be high (higher than bank loan): likely to be an expensive way of borrowing money.
- No set interest rate: can be changed at anytime by the bank - difficult to budget.
- The bank can cancel this facility at any time (be prepared to be asked to repay)
- Difficult to calculate the real cost of borrowing as interest is charged daily on the amount borrowed.
- Mustn't go over the limit.
144
What is a bank loan?
Set amount of money borrowed from a bank with fixed interest and set repayment dates (the money must be repaid at specific dates)
145
Advantages of using a bank loan
- The cost of borrowing money is clear and fixed: it is the interest charged.
- Easy to set a budget as repayment dates and amounts are set in the loan contract.
- No loss of control or interference in the running of the business- the borrower retains ownership of the company.
- Improved cash flow.
146
Disadvantages of using a bank loan
- The full amount borrowed plus interest must be repaid.
- Repayments must be done on time whether the business has enough cash or not.
- If repayments are not made, the bank can take the business to court (risk of liquidation).
- A collateral (asset with a value worth the same as the loan, e.g. house) may be needed to secure the loan.
- A firm that is highly geared may be seen as high risk.
- Can be charged a penalty for early payment.
147
What is debt factoring?
Using the services of a debt recovering or factoring business to collect invoice payments from customers.
148
Advantages of using debt factoring
- Cash is received upfront (% of invoice value)
- Possible solution to a cash flow problem due to late payers.
- Relieves the business from having to chase customers for late payment of invoice.
- Can provide credit checks on customers.
- Reduces risk of bad debts.
149
Disadvantages of using debt factoring
- The debt recovering or factoring business will charge a fee (cost of recovering the money), reducing profitability of business.
- Customers may not want to deal with a factoring business and this may damage the business' relationship with its customers.
150
What is venture capital?
Finance obtained from the sale of shares to wealthy individuals also called venture capitalists, business angels or private investors.
- Wealthy individuals can 'team up' and pull their capital together to form a venture capital firm to lend larger amounts.
- This applies to mainly small and medium-sized businesses that may struggle to raise money from traditional sources.
151
Advantages of using venture capital
- No interest charged.
- No set repayment date(s).
- Venture capitalists can provide advice, experience or useful contacts.
- Venture capitalists are usually willing to take risks (a bank will not). This may be the only option available to risky businesses.
152
Disadvantages of using venture capital
- Loss of control of the business: venture capitalists will ask for shares in the business in return for their investment.
- Venture capitalists may interfere in the running of the business.
- The profit will be shared with the venture capitalists.
- Venture capitalists may want their money back and force the sale of the business.
153
What is share capital or share issue?
Finance obtained from the sale of shares either privately for an Ltd of via the Stock Exchange for a Plc.
154
Advantages of share capital or share issue
- Large amounts of capital can be raised (millions).
- No interest charged.
- No set repayment date(s)
155
Disadvantages of share capital or share issue
- Loss of control of the business: shareholders will have shares and own part of the business.
- The profit will be shared among the shareholders.
- Financial performance and key decisions must be communicated to shareholders and the public.
- Shareholders have voting rights for key decisions (AGM)
- Being listed on the Stock Exchange is costly and time consuming.
156
What is crowdfunding?
Method of raising finance from a large number of people who each contribute a small amount of money.
- This can be made possible through the internet.
- E.g. Lunar Missions Ltd, a private moon drilling mission that has raised over $1m by this method.
