First 1164 words of the document:
back to basics
5 Costs per unit 8 Profitability
Ten things you need to know about Total costs divided by the number of units sold gives cost
per unit (a.k.a. unit costs). This is not the same as variable
Measuring profit in relative terms, e.g. in relation to last
year's profit or in relation to sales revenue.
costs because unit costs include the fixed costs shared out Example: while many commentators praised Sainsbury's in
among the units sold. early 2013 for taking market share from Tesco, the
Example: if variable costs per unit are £4, fixed costs are Daily Telegraph criticised the grocery retailer for having a
£4,000 and sales are 2,000 units, the cost per unit is £6 net profit margin of just 3.4%.
(£12,000/2,000). Advantage: profitability is the right way to measure
Advantage: unit costs can be compared with selling price (a) the effectiveness of a firm's strategy and (b) whether the
to measure profit per unit. business is being pulled in the right direction.
Disadvantage: unit costs involve averaging the cost data. Disadvantage: high profitability might mean little if the
This can create distortions. business is struggling to achieve the sales level that gives it
recognition in the marketplace.
1 Breakeven Ian Marcousé provides a framework of
At breakeven all costs are covered by the revenue generated.
ten key concepts to aid your revision
6 Financing by debt 9 Profit vs cash
Formula: Fixed costs For any business, equity capital represents security while
Contribution per unit loan capital involves risk. Debt-financed growth leaves a Profit shows the medium-to-long-term effect of a financial
Example: a business with £40,000 of fixed costs, a £6 selling business vulnerable if difficult trading is made worse by transaction whereas cash flow shows the immediate effect
price and a £4 variable cost per unit has a breakeven point of
3 Contribution high repayment bills plus the need to repay the capital.
Example: a new business might be funded with 50% share
on a firm's bank balance.
Example: selling £1 million of property for cash will boost
Advantage: shows the minimum sales level needed to avoid (equity) capital, 30% long-term loans and 20% overdraft. the bank balance by £1 million, but may lessen the firm's
making losses. The amount contributed by sales towards covering fixed This means 50% is funded by debt, which is riskily high. ability to make profits in the longer term.
costs. This can be measured per unit of sale (contribution Advantage: forecasting the impact of a deal on both profit
Disadvantage: may flatter to deceive -- breaking even Advantage: if the business proves highly profitable it is
per unit) or as total contribution (quantity sold × and cash flow ensures that the business understands the
may be quite easy, but the real test of business sustainability good to only have to pay bankers rather than spread the
contribution per unit). short-term and longer-term impacts on the firm's finances.
is profit. profits around many shareholders.
Example: if a business sells 200 units at £3 each, with Disadvantage: the inputs determining profit and cash flow
Disadvantage: every business hits bad patches, especially
variable costs of £1 per unit, the contribution per unit is £2 are the same, therefore both are affected by a problem such
new ones, so it is irresponsible to be overly dependent on
and total contribution is £400. as an unhappy customer who is unwilling to pay a bill.
2 Cash is king
debt that needs to be serviced and repaid.
Advantage: contribution is used widely in business
decision making, for example in breakeven analysis, in
pricing decisions and in decisions about whether or not to
For new firms, fast-growing firms and in recessions, cash is
more important to a business than profit.
outsource production. 7 Private equity 10 Uncertainty
Disadvantage: as contribution ignores fixed costs, there is
Example: camera retailer Jessops went into administration
a risk that decisions could be made (on pricing for example) With every financial technique it is important to remember
in January 2013 because it was no longer able to pay its
that under-provide for fixed costs, leading to losses. that things can go wrong for reasons out of your control.
bills, i.e. there was a shortage of cash.
Uncertainty leads to the risk that positive expectations may
Advantage: the tougher things get for a company, the end in disappointment.
greater the pressure on cash (suppliers refuse to give
credit, bankers get fussier about overdraft limits etc.), so it
becomes the top priority.
4 Costs Example: an entrepreneur making revenue forecasts for a
new business should be cautious, in the hope that errors
A form of venture (risk) capital that is usually based on a will be on the upside not the downside. In the same way,
Disadvantage: in the long term, profit generates the The breakdown of costs into fixed and variable provides high level of debt. This is intended to force managers to cost forecasts should be pessimistic on the upside.
finance for expansion and renewal. Cash is king only in the businesses with crucial information for decision making. be as lean as possible, i.e. high pressure to meet the huge
Advantage: caution in forecasting should help in beating
short term. Variable costs vary in direct relation to output; fixed costs interest payments on the debt.
budgets, which will impress bankers and investors.
do not change when output changes. Example: since the Glazer family made Manchester United
Disadvantage: the inherent optimism of the entrepreneur
Example: if a business has 50p of variable costs per unit Football Club private (previously it had been a plc), the club
sometimes means that even the `pessimistic' allowance for
and £500 of fixed costs, sales of 2,000 units will generate has had to pay more than £400 million in interest charges
uncertainty proves insufficient.
total costs of £1,500. on the £525 million of debt that the Glazers loaded onto its
Advantage: by calculating total costs it is possible to balance sheet.
quickly estimate possible profits. Breaking the costs into Advantage: supporters of private equity say that it is a
two parts helps identify both the gross and the net profit way to squeeze the most out of management and staff to
from a business decision. achieve higher performance.
Disadvantage: the breakdown into fixed and variable is a Disadvantage: critics believe that the risks involved in
bit of a simplification. There can be semi-variable costs that private equity are one-sided: heads and the owners win,
act as a hybrid: part fixed and part variable. tails and the staff lose.
16 Business Review November 2013 17