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Chapter 5 Financial Analysis Decisions The accountant is constantly asked to conduct a variety of financial analyses regarding key management decisions. These analyses usually require a knowledge of analysis techniques well beyond the typical transaction processing and accounting presentation skills learned in college. Instead, the accountant must understand breakeven analysis, product mix analysis, how to create a what-if analysis with an electronic spreadsheet, how to create a cost variance table, how to allocate funds, and how throughput analysis can assist with a number of major decisions. This chapter provides answers to all of these issues and more. The following table itemizes the section number in which the answers to each question can be found: Section 5-1 5-2 5-3 5-4 5-5 5-6 5-7 5-8 5-9 5-10 5-11 5-12 5-13 5-14 5-15 5-16 Decision How do I calculate the breakeven point? What is the impact of fixed costs on the breakeven point? What is the impact of variable cost changes on the breakeven point? How do pricing changes alter the breakeven point? How can the product mix alter profitability? How do I conduct a ‘‘what-if’’ analysis with a single variable? How do I conduct a ‘‘what-if’’ analysis with double variables? How do I calculate cost variances? How do I conduct a profitability analysis for services? How are profits affected by the number of days in a month? How do I decide which research and development projects to fund? How do I create a throughput analysis model? How do I determine whether more volume at a lower price creates more profit? Should I outsource production? Should I add staff to the bottleneck operation? Should I produce a new product? 5-1 HOW DO I CALCULATE THE BREAKEVEN POINT? Breakeven analysis is the revenue level at which a company earns exactly no profit. It is also known as the cost-volume-profit relationship. To determine a breakeven point, add up all the fixed costs for the company or product being analyzed, and divide it by the associated gross margin percentage. This results in the sales level at which a company will neither lose nor make money—its breakeven point. The formula is shown in Exhibit 5.1. 110 5-1 How Do I Calculate the Breakeven Point? Exhibit 5.1 111 The Breakeven Formula Total fixed costs=Gross margin percentage ¼ Breakeven sales level For those who prefer a graphical layout to a mathematical formula, a breakeven chart can be quite informative. In the sample chart shown in Exhibit 5.2, we show a horizontal line across the chart that represents the fixed costs that must be covered by gross margins, irrespective of the sales level. The fixed cost level will fluctuate over time and in conjunction with extreme changes in sales volume, as noted in the next section, but we will assume no changes for the purposes of this simplified analysis. Also, there is an upward-sloping line that begins at the left end of the fixed cost line and extends to the right across the chart. This is the percentage of variable costs, such as direct labor and materials that are needed to create the product. The last major component of the breakeven chart is the sales line, which is based in the lower-left corner of the chart and extends to the upper-right corner. The amount of the sales volume in dollars is noted on the vertical axis, while the amount of production capacity used to create the sales volume is noted across the horizontal axis. Finally, Net Profit Income Taxes Sales Volume s axe eT om c n I able Vari ts Cos Variable Costs Breakeven Point v Re en Fixed Costs ue 0% 50% Percentage of Production Utilization Exhibit 5.2 Breakeven Chart 100% 112 Management Accounting Best Practices there is a line that extends from the marked breakeven point to the right and that is always between the sales line and the variable cost line. This represents income tax costs. These are the main components of the breakeven chart. It is also useful to look between the lines on the graph and understand what the volumes represent. For example, as noted in Exhibit 5.2, the area beneath the fixed costs line is the total fixed cost to be covered by product margins. The area between the fixed cost line and the variable cost line is the total variable cost at different volume levels. The area beneath the income line and above the variable cost line is the income tax expense at various sales levels. Finally, the area beneath the revenue line and above the income tax line is the amount of net profit to be expected at various sales levels. 5-2 WHAT IS THE IMPACT OF FIXED COSTS ON THE BREAKEVEN POINT? A common alteration in fixed costs is when additional personnel or equipment are needed in order to support an increased level of sales activity. As noted in the Net Profit Re In able Vari s Cost axe eT com ve nu Income Taxes e Variable Costs s Breakeven Point Fixed Costs Re 0% ve e nu 50% Percentage of Production Utilization Exhibit 5.3 Breakeven Chart Including Impact of Step Costing 100% 5-3 What is the Impact of Variable Cost Changes on the Breakeven Point? 113 breakeven chart in Exhibit 5.3, the fixed cost will step up to a higher level (an occurrence known as step costing) when a certain capacity level is reached. An example of this situation is when a company has maximized the use of a single shift, and must add supervision and other overhead costs such as electricity and natural gas expenses in order to run an additional shift. Another example is when a new facility must be brought on line or an additional machine acquired. Whenever this happens, management must take a close look at the amount of fixed costs that will be incurred, because the net profit level may be less after the fixed costs are added, despite the extra sales volume. In Exhibit 5.3, the maximum amount of profit that a company can attain is at the sales level just prior to incurring extra fixed costs, because the increase in fixed costs is so high. Though step costing does not always involve such a large increase in costs as noted in Exhibit 5.3, this is certainly a major point to be aware of when increasing capacity to take on additional sales volume. In short, more sales do not necessarily lead to more profits. 5-3 WHAT IS THE IMPACT OF VARIABLE COST CHANGES ON THE BREAKEVEN POINT? Though one would think that the variable cost is a simple percentage that is composed of labor and material costs, and which never varies, this is not the case. This percentage can vary considerably, and frequently drops as the sales volume increases. The reason for the change is that the purchasing department can cut better deals with suppliers when it orders in larger volumes. In addition, full truckload or railcar deliveries result in lower freight expenses than would be the case if only small quantities were purchased. The result is shown in Exhibit 5.4, where the variable cost percentage is at its highest when sales volume is at its lowest, and gradually decreases in concert with an increase in volume. Because material and freight costs tend to drop as volume increases, it is apparent that profits will increase at an increasing rate as sales volume goes up, though there may be step costing problems at higher capacity levels, as is the case in Exhibit 5.4. Another point is that the percentage of variable costs will not decline at a steady rate. Instead, and as noted in Exhibit 5.4, there will be specific volume levels at which costs will drop. This is because the purchasing staff can negotiate price reductions only at specific volume points. Once such a price reduction has been achieved, there will not be another opportunity to reduce prices further until a separate and distinct volume level is reached once again. In short, suppliers do not charge lower prices just because a customer’s sales volume goes up incrementally by one unit—they only reduce prices when there are increases in the volume of purchases of thousands of units. 114 Management Accounting Best Practices Net Profit Re ve e nu es Tax me Inco Variable Costs Most Expensive Level of Variable Costs Income Taxes Variable Costs Least Expensive Level of Variable Costs Breakeven Point Fixed Costs Re 0% ve nu e 50% 100% Percentage of Production Utilization Exhibit 5.4 Breakeven Chart Including Impact of Volume Purchases 5-4 HOW DO PRICING CHANGES ALTER THE BREAKEVEN POINT? A common problem impacting the volume line in the breakeven calculation is that unit prices do not remain the same when volume increases. Instead, a company finds that it can charge a high price early on, when the product is new and competes with few other products in a small niche market. Later, when management decides to go after larger unit volume, unit prices drop in order to secure sales to a larger array of customers, or to resellers who have a choice of competing products to resell. Thus, higher volume translates into lower unit prices. The result appears in Exhibit 5.5, where the revenue per unit gradually declines despite a continuing rise in unit volume, which causes a much slower increase in profits than would be the case if revenues rose in a straight, unaltered line. The breakeven chart in Exhibit 5.5 may make management think twice before pursuing a high-volume sales strategy, since profits will not necessarily increase. The only way to be sure of the size of price discounts would be to begin negotiations with resellers or to sell the product in test markets at a range of lower prices to determine changes in volume. Otherwise, management is operating in a vacuum of relevant data. Also, in some cases the only way to survive is to keep cutting prices in pursuit of 5-5 How Can the Product Mix Alter Profitability? 115 Lowest Price per Unit Net Profit Income Taxes es e Tax Incom Re ue ven s axe eT om c n I osts ble C Varia Most Expensive Level of Variable Costs Variable Costs Least Expensive Level of Variable Costs Breakeven Point ue en v Re Fixed Costs Fixed Costs Highest Price per Unit 0% 50% 100% Percentage of Production Utilization Exhibit 5.5 Breakeven Chart Including Impact of Variable Pricing Levels greater volume, since there are no high-priced market niches in which to sell. For example, would anyone buy a flat panel color television set for more than a slight price premium? Of course not; this market is so intensely competitive that all competitors must continually pursue a strategy of selling at the smallest possible unit price. The breakeven chart previously noted in Exhibit 5.5 is a good example of what the breakeven analysis really looks like in the marketplace. Fixed costs jump at different capacity levels, variable costs decline at various volume levels, and unit prices drop with increases in volume. Given the fluidity of the model, it is reasonable to periodically revisit it in light of continuing changes in the marketplace in order to update assumptions and make better calculations of breakeven points and projected profit levels. 5-5 HOW CAN THE PRODUCT MIX ALTER PROFITABILITY? Product mix has an enormous impact on corporate profits, except for those very rare cases where all products happen to have the same profit margins. To determine how the change in mix will impact profits, it is best to construct a chart, such as the one 116 Exhibit 5.6 Management Accounting Best Practices Calculation Table for Margin Changes Due to Product Mix Product Flow meter Water collector Ditch digger Evapo-Preventor Piping connector Totals Unit Sales Margin % Margin $ 50,000 12,000 51,000 30,000 17,000 160,000 25% 32% 45% 50% 15% 36% $12,500 3,840 22,950 15,000 2,550 $56,840 shown in Exhibit 5.6, that contains the number of units sold and the standard margin for each product or product line, and the resulting gross margin dollars. The resulting average margin will impact the denominator in the standard breakeven formula. For example, if the average mix for a month’s sales results in a gross margin of 40 percent, and fixed costs for the period were $50,000, the breakeven point would be $50,000/40 percent, or $125,000. If the product mix for the following month were to result in a gross margin of 42 percent, the breakeven point would shift downward to $50,000/42 percent, or $119,048. Thus, changes in product mix will alter the breakeven point by changing the gross margin number that is part of the breakeven formula. 5-6 HOW DO I CONDUCT A ‘‘WHAT-IF’’ ANALYSIS WITH A SINGLE VARIABLE? When the accountant must determine the answer to a formula where one element varies, the simplistic approach is to create a table containing all possible expected values of the variable, and calculate the answer for each one. Though workable, this approach is slow. Instead, consider using the table-fill function of Excel to more rapidly develop an answer. An example is shown in Exhibits 5.7 through 5.9. In Exhibit 5.7, we have set up a formula to determine the present value of a series of payments of $1,500 per payment, extending over eight periods. However, the interest rate could vary, so a results table has been created below the present value calculation, showing a range of possible interest rates in quarter-percent increments. Comment fields show the present value calculation in cell C8, and also show that the information appearing in cells B12 and C12 at the top of the results table are references from cells C4 and C8, respectively. All other interest rates shown in cells B13 to B32 are typed in. The main task remaining is to fill in the present value for each of the interest rates shown in the results table. We could recreate the present value calculation next to each of those interest rates, but there is an alternative approach. The alternative method is to highlight the range of cells from B12 to C32, and then access the Data, Table command in Excel. This results in the screen shown in Exhibit 5.8, where a data entry pop-up screen asks where the input value comes from (the interest rate field in cell C4), and whether we want the results to appear vertically in a column, or horizontally in a row. Since we want the present value results to appear in a 5-6 How Do I Conduct a ‘‘What-If’’ Analysis with a Single Variable? Exhibit 5.7 117 Layout of a Single-Variable Table column next to the interest rates that have already been entered in column B, we enter C4 in the ‘‘Column input cell’’ field in the pop-up screen, as shown in the exhibit. The result is shown in Exhibit 5.9, where Excel has automatically filled in the present value for each of the interest rates in the results table, ranging from a present value of $9,694.82 for a 5 percent interest rate to $8,002.39 for a 10 percent interest rate. 118 Exhibit 5.8 Management Accounting Best Practices Data Table Input for a Single-Variable Table 5-7 HOW DO I CONDUCT A ‘‘WHAT-IF’’ ANALYSIS WITH DOUBLE VARIABLES? The problem becomes more difficult when there are two variables in the formula, since the range of possible answers becomes much greater. In this case, the use of automation tools becomes more helpful to the controller, since the alternative is to manually create a large number of formulas. 5-7 How Do I Conduct a ‘‘What-If’’ Analysis with Double Variables? Exhibit 5.9 Completed Single-Variable Table 119