Conceptual Framework of Financial Performance

• Financial performance depends on revenue and cost.• Revenue is provided from sales of merchandise by retailers, sales of

products and sale of services.• Companies generate three types of costs including discretionary,

engineered and committed costs.• Various costs fall into one of these three categories based on the

cause and effect relationships involved.• These three cost concepts are summarized in next slides.

Discretionary Cost• Many activities are viewed as beneficial to an organization, even though

the benefits obtained or value added by performing the activities cannot be defined precisely , either before or after the activity is completed.• The costs of the inputs, or resources required to perform such activities

are referred to as discretionary costs. • These costs are discretionary in the sense that management must choose

the desired level of the activity based on intuition or experience .• Examples include employee training, advertising, sales promotion, legal

advice

Engineered costs• Engineered costs result from activities with reasonably well defined

cause and effect relationships between inputs and outputs and costs and benefits.• Direct material costs provide a good example.• Engineers can specify precisely how many parts (inputs) are required

to generate a specific output such as a microcomputer, a coffee maker, an automobile, or a television set.• Value addition by the activity is easy to measure.

Committed costs• Committed costs refers to the costs associated with establishing and

maintaining the readiness to conduct business. • The benefits obtained from these expenditures are represented by

the company's infrastructure. • For example, the costs associated with the purchase of a franchise, a

patent, drilling rights.

Marketing ROI• It is different from Corporate ROI.• It is basically a relationship between Net Marketing Margin (NMM)

and Investment in Marketing Operation.• Here manufacturing and marketing department are two different

profit center so performance measurement will be separate.• So amount of total costs and revenue have to be earmarked

differently.• For manufacturing organization non marketing allocations will be

more that of trading organization.

COST–VOLUME –PROFIT ANALYSIS

CVP ANALYSIS• Shows the relationships between cost sales and net profit.• It helps to ascertain the financial performance at a given level of

sales.• It helps to know the break even level for an organization where total

revenue equalize the total cost.

Assumptions;

• Fixed cost remain static & marginal costs are completely variable at all levels of output.• Selling prices are constant at all sales volume.• Factor prices are constant at all sales volume .• Efficiency and productivity remain unchanged. In a multi product

situation ,there is constant sales mix at all level of sales.• Turnover level is only relevant factor affecting cost & revenue.• Value of production is equal to volume of sales.

ELEMENTS-• MARGINAL COST EQUATION • CONTRIBUTION MARGIN .• PROFIT /VOLUME RATIO .• BREAK EVEN POINT .• MARGIN OF SAFETY.

MARGINAL COST EQUATIONSALES=VARIABLE COSTS +FIXED

EXPENSES+P/LOR

S-V=F+P/L

CONTRIBUTION MARGIN-

CONTRIBUTION =SELLING PRICE –MARGINAL COSTOR

C=F+P/LOR

C-F=P/L

PROFIT /VOLUME RATIO;

P/V=CONTRIBUTION /SALESOR

F+P/L/V.C+F.C+P/L=[F+P/S]OR

S-V/S=CHANGE IN PROFITS OR CONTRIBUTION/CHANGE IN SALES

BREAK EVEN POINT;

B.E.P=FC/P/VOR

TOTAL FIXED EXPENSES/S.P PER UNIT-MC PER UNITOR

TOTAL FIXED EXPENSES/CONTRIBUTION PER UNIT

VALUE OF SALES TO EARN DESIRED AMOUNT OF PROFIT ;

SALES=F.C+D.P/P/V RATIO

MARGIN OF SAFETY ;

• MOS=PROFIT/P/V RATIO

Assignment 1• ABC Ltd has provided the following information• Sales @ Rs. 5 per unit.- 20000 units• Variable cost p.u.-Rs.3• Fixed Cost – Rs.8000• Calculate PV Ratio and Break even sales.

Assignment 2• Following data is given by XYZ Ltd.• Sales @ Rs 10 pu -100000• Variable cost per unit – Rs.6 • Fixed cost – 300000• Calculate Margin of safety.

Assignment 3• A company producing a single product sells it at Rs.50pu . Unit variable cost is Rs.35

and fixed cost is Rs.1200000.• Find out Break Even Sales and P/V ratio.• New break even sales if variable cost increase by Rs.3 pu without increase in selling

price.• Increase in sales required if profits are to be increased by Rs.2.4 lakh• Percentage increase or decrease in sales volume units to set off• An increase of Rs.3 in the variable cost per unit• A 10% increase in selling price without affecting existing profit profits quantum• Quantum of advertisement expenditure permissible to increase sell by 1.2 lakhs

without affecting existing profit quantum.

Assignment 4Material cost 120 Labour Cost 30 Overhead is 12Selling price – 270 Fixed cost – 14 lakhsSales – 40.5 lakhs.During forthcoming year direct workers will be entitled a rise in 10% Material cost will rise by 7.5% and overhead by 5% Fixed cost will rise by 3%Find New sales price in the forthcoming year if current P/V ratio is tobe maintained.Number of units that would require to be sold during the forthcoming year to have the same amount of profit in the current year without increasing the selling price.

Concept of Return on Investment• ROI = Net Profit/Capital Employed• Further Decomposed it is the multiplication of Net Profit Ratio and

Capital turnover Ratio• NPR is NP/Sales• CTR is Sales/Capital Employed

Assignment 1

• Fixed asset – 100 • Working Capital – 100• Sales 400 Variable cost of sales 300• Fixed Cost Operation – 40• Fixed cost Finance Charges – 20• Calculate ROI, CS Ratio and Capital Turnover Ratio, Margin of safety

Assignment 2• From the following details and with the help of previous data find out Marketing ROI.• 10% of operational fixed asset represents automobile ware house and office

equipment used for marketing division.• 60% represents finished inventory and net receivables• Finance charges is calculated at the rate of 10% on Capital employed.• Rs320 is the transfer prices of goods from manufacturing to marketing.• Marginal cost for marketing dept is 350 includes 320 from transfer price and 30

additional variable marketing expenses.• Operation fixed cost allocated to non marketing departments as 18• Calculate the Marketing NOI for the said department.

Assignment 3• A company has a margin of safety at 20% and a profit of Rs.4 lakhs. If

its contribution to sales is 0.4 calculate its current sales and fixed cost.

Multi Product Sales Mix• A manufacturer may have more than one product and also their sales.• The relative proportion of each product sold in the aggregate sales is

termed as sales mix• A change in the mix of products sold usually affects the weighted

average P/V Ratio and hence the BEP• So when the product have different P/V Ratios changes in the sales

mix will affect the BEP.

Assignment• Three products X Y and Z have their sales at 100000, 60000, 40000

respectively. Their variable costs are 80000, 42000, 24000 respectively. Fixed cost for the firm is 27000 find out the break even sales for the firm.• If Rs.40000 sales of the product X could be shifted equally to product

Y and Z then what will be the new profit and new BEP sales for the firm.

Impact of selling price, Fixed Cost and Variable cost on BEP.• An increase in selling price increases the amount of contribution

resulting in improvement in P/V Ratio and vice versa.• The increase or decrease in fixed cost does not affect the P/V ratio

even though it may increase or decrease the total profit.• Increase in variable cost per unit will reduce the contribution and

result to decrease in P/V Ratio and vice versa.• The increase in P/V Ratio means lower break-even point and higher

margin of safety and vice versa.

Make an analysis of the below mentioned assignment.• Selling price per unit Present Rs.50 Proposed Rs.40• Variable Cost per unit Present Rs.30 and Proposed Rs.30• Fixed Cost p.a. Rs.60000 in both arrangements.• Production units 10000 units in both the cases.• Calculate P/V Ratio Break Even Point and Margin of safety and

comment on the situations of lowering selling price per unit in the light of previous slide’s discussion.

Assignment • A company wants to buy a new machine to replace one which is having a

frequent break down. It received offers for two models M1 and M2.Further details of these two models are given below. • Installed capacity in units for M1 10000 and for M2 10000• Fixed overhead p.a. for M1 Rs. 240000 and for M2 Rs. 100000• Estimated profit at the above capacity M1 Rs 160000 and M2 Rs.100000.• The product manufactured using this type of machine M1 or M2 is sold at

Rs.100 per unit.• You are required to find out the Break Even level of sales for each model.• The level of sales at which both the models will earn the same profit.

Assignment• The following figures relate to a company manufacturing a varied

range of product.

Total Sales Total Cost

Year ended 31st March 2005 22,23,000 19,83,600

Year ended 31st March 2006 24,51,000 21,43,200

Assuming stability in price with variable cost carefully controlled to reflect predetermined relationship and an unvarying figure cost calculate the followingP/V Ratio, Fixed Cost,Fixed Cost % to Sales, Break even point and margin of safety for the year ended 2005 and 2006.

Assignment• XYZ Ltd has to decide between launching one or two similar new

products. It does not have the production capacity to launch both the product. Fixed Cost for the company is Rs.20000 p.a. Product A can be sold at Rs.400 per item and product B at Rs.350 per item. The variable unit cost are Rs.240 for Product A and Rs.200 for product B. The likely demand for both the products are given by the following probability distribution. Calculate the Break-even point for both the product and estimate the profitability of these two products.

Likely Demand Probability of A Probability of B100 0.1 0.3200 0.3 0.4300 0.4 0.2500 0.2 0.1Total 1.0 1.0

Practical application of Linear Programming technique• Allocation of scares resources : Limited resources to be allocated to

various products.• Product mix problems – Capacity utilization optimization so that profit

can be maximized.• Determinations in joint product profitability – In case of product

involving joint cost where one or more of the joint products may be processed further. LP may help determine the profitability of further processing.• Cost volume profit analysis – for Multi product cost volume profit

analysis.

To formulate the LPP• Objective Functions : The objective functions of each problem is a

mathematical representation of the objective in terms of a measurable quantity such as profit, cost, revenue etc.• It should be an optimization function either to maximize or to minimize.• Constraint functions : There are always certain limitations on the use of

limited resources like labour, machine, raw material etc. • Such constraints must be expressed as linear equalities or inequalities

in terms of decision variables.• The solution of an LP model must satisfy these constraints.

Guidelines for formulations• Express objective function in words.• Define the objective function whether to maximize or minimize.• Express them in mathematical terms.• Express it as a linear function of decision variables multiplied by their

profit or cost considerations. • Define decision Variables: Express each constraints in words• Formulate the constraints imposed by the resource availability and express

them in linear equality or inequality in terms of decision variables defined..

Assignment• A firm is engaged in producing two products. A and B. Each unit

of product A requires 2 kg of raw material and 4 labour hours for processing, where as each unit of B requires 3kg of raw materials and 3 labour hours for the same type. Every week, the firm has an availability of 60 kg of raw material and 96 labour hours. One unit of product A sold yields Rs.40 and one unit of product B sold gives Rs.35 as profit. Formulate this as an Linear Programming Problem to determine as to how many units of each of the products should be produced per week so that the firm can earn maximum profit.

Assignment• A firm can produce 3 types of cloth, A , B and C.3 kinds of

wool are required Red, Green and Blue.1 unit of length of type A cloth needs 2 meters of red wool and 3 meters of blue wool.1 unit of length of type B cloth needs 3 meters of red wool, 2 meters of green wool and 2 meters of blue wool.1 unit type of C cloth needs 5 meters of green wool and 4 meters of blue wool. The firm has a stock of 8 meters of red, 10 meters of green and 15 meters of blue. It is assumed that the income obtained from 1 unit of type A is Rs.3, from B is Rs.5 and from C is Rs.4.Formulate this as an LPP

Example for Formulation• A company can produce three products A,B and C. Products use a machine which

has 400 hours capacity in the next processing period.• Each unit of product uses 2, 3 and 1 hour respectively of the machines capacity.• There are only 150 units available in the period of a special component which is

used singly in product A and C.• Only 200 kgs of special alloy is available in the product . Product A uses 2kgs per

unit and product C uses 4 kgs per unit.• There is an agreement with a trade association to produce not more than 50

units of product B in the period.• The company wishes to have the production plan which maximizes contribution

where contribution per unit for A, B and C are Rs.8, Rs.5 and Rs.10 respectively