Formulas: Revenue:Quantity sold x Selling Price per itemProfit:Total Revenue-Total Costs (TR-TC)
Profit (also known as surplus) is what is left after total costs have been deducted from revenue.
Profit is a prime objective of most business.In effect there are two ways of improving profit:
- Increase Sales Revenue
- Decrease Costs
Profit is important because:
- Profit is used as a measure of success by the owners of a business who have invested capital/money into it.
- Banks and other lenders will be unlikely or unwilling to lend to a business that does not either forecast a profit or make one.
- Profit provides a source of finance for further expansion of a business.
Costs (1) - Fixed and Variable Costs
Costs are the expenditures made by a business as part of its trading operations.
Costs can be either Fixed or Variable.
Fixed Cost:A cost that does not change with the level of output/sales.
Variable Cost:A cost that does change directly with the level of output/sales.
Fixed costs don't change with output.
- Examples of Fixed Costs are:Salaries,Marketing,Rent on a factory,Cost of new machinery.
Variable costs rise and fall as output changes.
- Examples of Variable Costs are:Hourly wages of operatives,Power and Raw Materials.
Semi Variable Costs Example:Telephone Bills
Costs (2) - Direct and Indirect Costs
Direct Costs are linked to a product or service.
For example: The cost of raw materials and the hourly wages paid to factory workers making a product are direct costs.
Indirect Costs(Also known as overheads) can't be directly linked to only one product or service.
For example:Wages and salaries paid to people who aren't directly involved in making the product e.g Senior Managers and Canteen Workers).
Direct Costs:(almost always)Variable Costs
Indirect Costs:(almost always)Fixed Costs
Formulas:Gross Profit: Direct Costs - Revenue
Net Profit: Total Costs - Revenue
Contribution is the difference between Sales Revenue and the Variable Costs of production.
It is method to calculate to break even (B.E).
Contribution is a business method to assess what contribution a production makes to costs which leads to profit.
Contribution:Sales Revenue (SR) - Variable Costs (VC)
Profit:Contribution - Fixed Costs (FC)
Contribution per unit: Selling price per unit - Variable Costs p/Unit
Total Contribution:Unit contribution x no . of units sold
Contribution per unit: This is the difference between the selling price of one unit and the variable cost of producing one unit.
Example:Sara and Jack originally planned the contribution per customer to be £7 (£10-£3).If they served 500 customer in one week then the total contribution would have been: 500 x £7 = £3500This would be used to pay the restaurants weekly fixed costs and any surplus is profit.
Break Even Analysis (1)
Break even point is the level of sales a business needs to cover their costs.
Breaking even means covering your costs.It is a point of which a business doesn't make a profit or a less.
B.E is always shown as the number of units made or sold.
When sales are below the break even point, costs are more than revenue = Loss
When sales are above the break even point, revenue exceeds costs = Profit
New businesses should do B.E analysis to find the break even point as Banks and Venture Capitalists loaning money to the business's will need to see a B.E analysis as part of the business plan.
Established business'suse B.E to work out how much profit they'll make and also to predict the impact
Break Even Analysis (2) Cont.
Why Calculate B.E?
- To set targets (In terms of past performance)
- Monitor progress
- Review and change where appropiate
There are 3 main ways to calculate Break Even (B.E)
Formula:Break Even = Fixed Costs/Contribution
Example: Harry sets up a business to print T-shirts. The Fixed Costs of premises and the T-Shirt printers are £3000.
The variable costs per T-Shirt (T-Shirt, ink and wages) are £5
Each printed T-Shirt sells for £25--Contribution per unit: £25 - £5 = £20
Break Even Output: £3000/£20 = £150--So, Harry has to sell 150 T-shirts to break even.
Break Even Analysis (3) Cont.
- Tabular Method
Break Even Analysis (4) +'s and -'s
Advantages of B.E Analysis
- It is a relatively simple and quick concept and the formula can be understood and used by many entrepeneurs.
- The information deducted from B.E analysis can be vital when taking a decision whether to go ahead with a business proposal.
- Break even analysis/charts let business forecast how variations in sales will affect costs,revenue and profits.
- It is widely used to support applications from entrepeneurs for loans/financial applications.
Disadvantages of B.E Analysis
- B.E analysis only tells you how many units you need to sell to break even.It doesn't tell you how many you're actually going to sell.
- It assumes that all output produced is sold - this may not be the case.
- Misleading or inaccurate data leads to incorrect B.E forecasts.
Cash Flow (1) - Cashflow is not the same as profit
Cash flow is all the money flowing into and out of the business over a period of time. It is calculated at the exact time the cash physically enters or leaves the bank account/till.
The cash flow cycle is the gap between money going out coming in.
- Business's need to pay money out for fixed assets (e.g. buildings, machinery and vehicles) and operating costs to fulfill and order before they get paid for that order.(New business's need money to spend on start-up costs before they've even started to get any sales at all.
- This delay between money going out and money coming in is the cash flow cycle.
- Its important to make sure that there is always enough money to pay suppliers and wages.Not paying suppliers and employees can be something of disaster.
- If a business produces too much,they'll have to pay suppliers and staff so much that they'll go bankrupt/insolvent before they have the chance to get paid by their customers.This is called overtrading.
Cash flow calculations are pretty much the most important thing to a business in the short term.Businesses need cash to survive.Looking at the long term - profit is important - making profit is the main objective for businesses.
Cash Flow (2) Key Terms
- Creditors:Suppliers owed money by the business.(Purchases have been made on credit).
- Credit Control:The monitoring of debts to ensure that credit periods are not exceeded.
- Bad Debt:Unpaid customer bills that are now very unlikely to ever be paid.
- Overtrading:Expanding a business rapidly without obtaining all of the necessary finance so that a cash flow shortage develops.
Cash Flow (3) - Cash Flow Forecasts and why Foreca
Businesses make Cash Flow Forecasts(AKA prediction) to help them make decisions.
- Cash flow forecasts (AKA cash budgets) show the amount of money that managers expect to come into the business and flow out of the business over a period of time.
- Managers can use C.F forecasts to make sure that they always have enough cash around to pay suppliers and employees.Managers who forecast C.F can predict when they'll be short of cash, and can arrange a loan/overdraft in time to cover the difficult spot.
- Businesses show C.F forecasts to banks and venture capitalists when trying to get loans and other finance.C.F forecasts can prove that the business has an idea of where its going to be in the future.
Cash Flow Forecasting isn't always accurate.
- Cash flow forecasts can be based on false assumptions about whats going to happen.
- Circumstances can suddenly change after the forecast has been made.Costs can go up.Machinery can break down and may need mending.Competitors can put their prices up/down which affects sales.
- Good cash flow forecasting needs lots of experience and lots of research into the market.
- A false forecast can have disastrous results.A business that runs out of cash can go bankrupt/insolvent.
Cash Flow (5) - Constructing and Interpreting a Ca
Cash Flow (6) - The causes of cash flow problems
Causes of Cash Flow Problems
Lack of Planning
- A lack of planning can make cash flow problems more likely.Planning can see if any potential cash flow problems will arise.If you plan then you can prevent/ease the problem.
Allowing customer too long to pay debts
- In many trading situations businesses will have to offer trade credit to customers in order to be competitive.Allowing customers too long to pay means reducing short term cash inflows which could lead to cash flow difficulties.
- A C.F forecast can never be guaranteed to be 100% accurate.Unforseen increases in costs e.g A breakdown of a delivery van that needs to be replaced - or a dip in predicted sales income - or if a competitior lowers price unexpectedly could lead to a negative net monthly cash flow.
Two others are Overtrading and poor credit control.
Why Calculate costs of production?
When planning to start a new business,entrepeneurs will need to forecast likely costs.These predictions allow:
- A forecast of profit or loss to be made - will the business be a successful one?
- Forecasts of the likely break-even of output.
- Cash flow forecasts to be drawn up so that financial planning is undertaken.
- Pricing decisions to be made based on cost data.
Once a new business is up and running why should the owner need to know what what costs are being incurred?There are several reasons for this:
- Keeping a check of actual costs against the forecasted costs that were part of the original business plan.Is the firm exceeding these costs and,if so why?
- Using cost information to help in the pricing decision.
- Calculating wether costs are greater or less than revenue - is the firm profitable at this level of sales or not?