chapter 9 m arket a nalysis, f orecasting, p lanning, c ontrol b reakeven p oint a nalysis and p...

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CHAPTER 9MARKET ANALYSIS, FORECASTING,

PLANNING, CONTROLBREAKEVEN POINT ANALYSIS AND

PRODUCTION FUNCTIONS

EBD-301Accounting and Finance For Entrepreneurs

Dr. David P Echevarria

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Introduction “If you don’t know where you going, any road will get you there.”

Three Important Questions1.What business we are in?2.With whom are we competing? 3.How can we improve our competitive position?

Dr. David P Echevarria ALL RIGHTS RESERVED


Introduction A few of the 10 major reasons businesses fail

1. A lack of knowledge of the market and of the competition2. Market segmentation and failure to articulate a strategy for expanding your market3. Failure to engage in adequate financial planning and control processes and to review those plans and controls on a regular basis



Introduction Environmental Scanning (ES)

1. A research process that seeks to collect all types of information relevant to their business2. The object: to help the owner-manager make better decisions

Expanding market, entering new markets (products and/or segments)

3. All activities or happenings internal or external to the business requires analysis to determine if they are beneficial or detrimental to the business



Market Analysis Need to understand impact of current trends on business Characteristics of the Macro-Economy

1. Is the economy expanding or contracting? An expanding economy increases the probability for growing the business A contracting economy focuses our thoughts on survival strategies

2. Keep in mind that markets are continuously changing and that change requires an appropriate response



Market Analysis Looking beyond your current market to the potential market for your products, goods, and/or services

1. Target market is considerably larger than the customers you already reach2. Look to those customers you hope to reach in the future

Sources of Information1. Chamber of Commerce2. U.S. Government Agencies (Commerce, Labor, Census Bureau)Dr. David P Echevarria


Market Analysis Key strategy: Segmenting your market

1. Targeting your marketing message2. Helps to focus on specific customer needs

Provide the type of goods or services they are most likely to need

Key tasks:1. Determining the size of your relevant market2. At what rate is it growing?3. Knowing the size and growth rate of your relevant market helps to make better forecasts



Forecasting Trying to get a handle on the future is the most difficult task facing the owner-planner

Market attributes that assist the planner1. We have business performance data from the past2. Trends tend to persist until they don’t3. Some relationships persist over time

Activity costs as a percent of sales: Inventory, wages, short-term liabilities



Forecasting Estimates of future sales activities also provide estimates of profits Profits compensate the owner(s) and provide capital to expand the business A growing business may require additional investments in assets

If profits insufficient to expand business, we will have some idea of the magnitude of external financing required (borrowing)



Financial Planning Techniques: Percent of sales

The simplest method used in financial planning and cash budgeting is the Percent of Sales Method

1. Operating Expenses Labor, Materials Overhead Expenses: utilities, supplies, marketing and advertising, rent

2. Non-Operating Expenses Interest Expense, Taxes

3. Example: E (Cash) = C(%) x Forecast Sales Receivables, Inventory, Payables (wages, taxes, trade

accounts)



Financial Planning Techniques: Percent of sales

Using Microsoft Excel as Planning Tool1. Each category of expense, assets and liabilities that can be expressed as a percent of sales 2. Percentages can be changed to run “what-ifs”

Impact of changes in Federally or State mandated payroll taxes Increases in license fees and excise taxes Increases in cost of supplies and materials used by the business

3. The Cash Budget Key planning document A detailed cash budget will also help to prepare pro forma financialsDr. David P Echevarria


FORECASTING TECHNIQUES: REGRESSION ANALYSIS

Regression Analysis uses two factors; a constant and a slope or variable factor.

Y = a + b(x)1. Intercept (a): the autonomous or level of investment or cost that is more or less constant over time2. Slope (b): the rate of change in Y as X changes

Example: Cash = $80 + 0.07 * $Sales1. $80 is the constant portion2. 0.07 implies for each dollar of sales, we must add 7 cents in cash



PERCENT OF SALES VS. REGRESSION ANALYSIS

Some Caveats1. Both methods assume a linear relationship

Y and X will change at roughly the same rates2. Both methods may yield similar results


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Cash: Actual vs. Predicted - % of Sales Method

Cash Pred Cash

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Actual Cash vs. Predicted by Linear Regression

Cash Pred Cash


Financial Planning and Control Forecasting future business performance in terms of revenues and expenses, assets, liabilities, and owner’s equity is the substance of financial planning:

1. Establishing Goals2. Identifying courses of action (or strategies) to achieve goals

Control Function:1. Budgets and Courses of Action become milestones against which we measure progress2. Failure to meet budgets or milestones requires reassessment of planning processes and reality checks on strategies



THE CASH BUDGET Cash budgets are planning and control tools

1. Provide estimates of revenues and disbursements2. Identify the timing and magnitude of inflows and outflows3. Identify periods when business will generate excess or insufficient cash flows 4. Identify needs and timing for short-term borrowing

Cash Budgets also used to prepare pro forma statements1. Income Statement (or Profit and Loss)2. Balance Sheet (Assets, Liabilities, and Owner’s Equity



BREAKEVEN POINT ANALYSIS Profitability analysis requires determining the point at which the business will breakeven

1. Breakeven point is the point at which sales revenues are sufficient to cover all our operating expenses.

Operating Income = zero Operating Expenses = variable costs plus fixed costs Variable Costs = labor and materials used to produce goods Fixed Costs = all other operating expenses incurred by the business

Rent, utilities, advertising, etc.

2. BEP = Sales - Total Variable Costs - Total Fixed Costs = 0



BREAKEVEN POINT ANALYSIS

Graph captures the relationship that exists between the Total Revenues (TR) of the business (output = sales dollars) and the Total Operating Costs (TC) as output goes from zero to very large values.

BEP is the point at which TR = TC

FC = fixed (overhead) costs



BREAKEVEN POINT ANALYSIS

The implicit assumption in BEP analysis is that no variable costs are incurred if output is zero.

However, that does not mean that the business is not incurring fixed costs. (Rent, electric and telephone, support staff, etc.)



Breakeven Point Example The take-out pizza business:

1. Average Cost to produce a 12” pizza $1.50 in materials (dough, tomato sauce, cheese, toppings.) $1.20 in labor Total variable Cost = $2.70

2. Average selling price for pizza = $7.003. Contribution to overhead = $7 minus $2.70 = $4.304. Total Monthly Operating Expenses = $7,5005. BEP (units) = $7500 / $4.30 = 1745 pizzas per month6. BEP (sales) = 1745 * $7/pizza = $12,215



BREAKEVEN POINT ANALYSIS IN PRACTICE

Business owner/managers must have an idea of what level of sales the business must achieve in order to meet their cash expenses

1. Sales above the BEP should yield operating profits. 2. Operating profits must in turn be sufficient to service debt, pay the necessary taxes, and 3. Result in an amount sufficient to generate a suitable return on invested capital.

The business's cost structure is partly a function the labor-capital intensity ratio (production function) and the efficiency of organizational structure and internal controls.



Operating Leverage and the Production Function

Two ways to increase profitability1. Increase sales2. Decrease operating costs

Direct: labor and materials (production) Indirect: “Fixed” overhead expenses

3. Operating Leverage = mix of labor and capital used to produce the goods or services you sell to your customers

Labor represents the number of employees required to produce the product you sell to your customers Capital represents the equipment or machinery used by your employees to produce the goods




Two Types of Business Structure1. Labor Intensive: most of the goods produced by hand (the pizza business)2. Capital Intensive: most of the goods produced using machines (automobiles)

Labor intensive have low degrees of operating leverage Capital intensive have high degrees of operating leverage Degree of Operating Leverage determines how much sales you must generate to breakeven and how fast profits grow above BEP




Labor Intensive Production Function

Capital Intensive Production Function




Labor Intensive production functions characterized by low breakeven points

Capital Intensive production functions characterized by high breakeven points

Advantage of capital intensive operations: profits grow at a faster rate for each dollar of sales above the BEPsales level



ESTIMATING THE DEGREE OF OPERATING LEVERAGE

Degree of Operating Leverage (DOL) can be estimated using data from the income statement

1. DOL = Gross Profit ÷ Operating Income2. Example from Table 9.2: DOL = 2.00x

It takes $2 in gross profits to generate $1 in operating profits3. At greater levels of sales (above BEP), it takes fewer dollars of gross profits to generate a dollar of operating profits.



Unrelated Changes in DOL DOL is affected by the level of sales irrespective of the degrees of labor or capital intensity.

1. As sales increase for a given production function, the DOL will decrease.2. At the BEP, DOL = infinity

DOL = Gross Profit / Operating Profit A the BEP, Operating Profit equals zero and anything divided by zero is undefined or infinite.

3. As sales increase, gross profits increase, making operating profits increase. That results in a smaller DOL.

As sales grow infinitely large, the DOL approaches Unity (1.00)Dr. David P Echevarria


ESTIMATING DOL WHEN UNIT PRICES AND COSTS ARE KNOWN

Computing the DOL when Unit Prices, Unit Costs, and Overhead Expenses are known

1. DOL = Q (P - VC) / [Q (P - VC) - FC]2. Where:

Q = Quantity of output P = Price VC = variable cost per unit FC = fixed costs



DOL Example Suppose a particular product sells for $27.00 and has a variable cost per unit (labor and materials) of $15.00. The fixed costs associated with this process are $390,000. The company expects to sell 60,000 units in the coming year. The DOL is: DOL = (60,000*(27 - 15)) / [60,000 * (27 - 15) - 390,000] DOL = 720,000 / 330,000 = 2.18

It takes $2.18 in gross profits to generate $1 in operating profits.



SUMMARY Every owner-manager must have some ideas or knowledge about;

1. Trends in the business2. Activity by the competition3. Changes in customer behavior; tastes and preferences4. Reducing (or at least controlling) the costs incurred to do business

Planning requires some reasonable notions about the future in order to make reasonable estimates of sales and expenses (and possible profits)

Profits are partly a function of the business’s production function and its influence on the Degree of Operating Leverage


chapter 9 m arket a nalysis, f orecasting, p lanning, c ontrol b reakeven p oint a nalysis and p...

Documents

relevant market

current market

market failure

potential market

andor services target

expanding economy

business performance

types of information