CHAPTER Financial Modeling for Short-Term Decision-Making PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology © 2012 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use Managerial Accounting 11E Maher/Stickney/Weil ☼ CHAPTER GOAL ☼ This chapter explains and illustrates financial modeling Financial modeling can Provide an overview of an organization’s financial activities Help managers make specific decisions Financial modeling relies on concepts of fixed and variable cost behavior LO FINANCIAL MODEL Financial Financial modeling modeling enables enables analysts analysts to to test test the the interaction interaction of of economic economic variables variables in in aa variety variety of of settings settings ItIt requires requires analysts analysts to to develop develop aa set set of of equations equations that that represents represents aa company’s company’s operating operating and and financial financial relations relations LO COST-VOLUME-PROFIT (CVP) CVP can be used to answer questions such as What effect on profit can GM expect if it builds a larger SUV? How will NBC’s profit change if ratings increase for its evening news program? How many subscribers must a Dish Network obtain to break even for the year? What happens if Verizon reduces fees charged to customers? E H D LO EXAMPLE: Early Horizons Daycare Early Horizons Daycare is a daycare center that defines a unit of output as “service provided for child for a month.” Building capacity is 30 children An accountant developed the following estimates: Price per child per month $ 600 Variable cost per child per month 200 5,000 Fixed costs per month Continued E H D LO CAPACITY and COSTS Early Horizons Daycare has a capacity of 20 units (relevant range), after which it must hire more staff  Variable costs include Snacks and food  Supplies A portion of insurance  Fixed costs include: Rent and utilities A portion of insurance Minimum staffing LO BREAK-EVEN BREAK-EVEN POINT: POINT: Definition Definition Is the point in the basic CVP model where revenues equal costs Total Revenue = Total Costs E H D LO BREAK-EVEN: Table Format Using break-even computations: Sales Revenue (12.5 X $600) $ 7,500 Less Variable costs (12.5 X $200) Contribution Margin (CM) Less Fixed costs Operating profit 2,500 $ 5,000 5,000 $ LO CONTRIBUTION CONTRIBUTION MARGIN: MARGIN: Definition Definition Is the excess of revenue over variable costs Total Revenue – Variable Costs E H D LO MANAGERS WANT TO KNOW! Can we use contribution margin to compute breakeven (BE) volume? YES! BE Volume = Fixed cost / CM per child 10 LO E H D Slope Slopeof of line lineisis variable variable cost costper per unit unit Break-even Volume = Fixed Costs / CM EXHIBIT 6.2 15 E H D LO TARGET PROFIT: CM Approach Sales revenue (20*$600) $ 12,000 Less Variable costs (20*$200) 4,000 Contribution Margin $ 8,000 Less Fixed costs 5,000 Operating profit $ 3,000 Target profit Volume = (Fixed costs + Target Profit) / CM = ($5,000 + $3,000) / $400 # children = 20 Continued 16 E H D LO TARGET PROFIT: Equation Approach Sales revenue (20 X $600) $ 12,000 Less Variable costs (20 X $200) Contribution Margin 4,000 $ 8,000 Less Fixed costs 5,000 Operating profit $ 3,000 Sales revenue – Variable costs - Fixed costs = Operating Profit ($600 - $200) × Sales volume - $5,000 = $3,000 $400*Sales volume = $8,000 Sales volume = 20 children Continued 17 E H D LO TARGET PROFIT: Reminder Sales revenue (20 X $600) $ 12,000 Less Variable costs (20 X $200) Contribution Margin 4,000 $ 8,000 Less Fixed costs 5,000 Operating profit $ 3,000 Target profit Volume = (Fixed costs + Target Profit) / CM Continued 18 E H D LO EARLY EARLY HORIZONS HORIZONS DAYCARE DAYCARE:: Sensitivity Sensitivity Analysis Analysis Base Cost EXHIBIT 6.3 Assumptions FC $500 Alt #1 VC $10 Price $60, Vol Alt #2 Alt #3 Price/child $ 600 $ 600 $ 600 $ 660 VC/child $ 200 $ 200 $ 210 $ 200 Monthly FC $5,000 $4,500 $5,000 $5,000 20 20 20 18 $ 12,000 $ 12,000 $ 12,000 $ 11,880 4,000 4,000 4,200 3,600 $8,000 $8,000 $7,800 $ 8,280 5,000 4,500 5,000 5,000 $3,000 $3,500 $2,800 $ 3,280 Children enrolled Model results: IS Sales revenue Less VC Total CM Less FC Operating profit 19 LO MARGIN MARGIN OF OF SAFETY: SAFETY: Definition Definition Is the excess of projected (or actual) sales units over Breakeven unit sales level Sales units – BE Sales units or Sales dollars – BE Sales dollars 20 LO COST COST STRUCTURE: STRUCTURE: Definition Definition Refers to the proportion of fixed and variable costs to total costs OPERATING OPERATING LEVERAGE: LEVERAGE: Definition Definition Is the extent to which an organization’s cost structure is made up of fixed costs Note: the higher the fixed costs, the higher the breakeven point 21 LO What is the contribution margin ratio? Contribution margin ratio (CMR) is the contribution amount per dollar of sales CM / Sales 22 E H D LO MANAGERS WANT TO KNOW! How can a company determine the effect of taxes will be on its profits? After tax profits = Before tax profits X (1 - tax rate) 23 LO SUMMARY OF SIMPLIFYING CVP ASSUMPTIONS  Can separate total costs into fixed and variable  Cost and revenue behavior is linear Implies the following in the relevant range Total fixed costs not change Variable costs per unit remain constant Selling price per unit remains constant  Product mix remains constant over relevant range 24 E H D LO USING ABC FOR EHD Previously, Previously, Early Early Horizons Horizons Daycare Daycare used used aa financial financial model model with with only only volume volume (number (number of of children) children) as as the the cost cost driver driver What What ifif multiple multiple cost cost drivers drivers using using the the cost cost hierarchy hierarchy are are identified identified and and used? used? 25 LO HIERARCHY OF COSTS: Reminder Activity Category Example Capacity Size limitations Building size: 30 children Customer Needs Children transported Product Production needs Field trips Batch Batch A room of children Unit Variable costs Child 26 E H D LO COST EQUATION Total Cost = (Unit-level cost × #children) + (Batch-level cost × # rooms) + (Product-level cost × #field trips) + (Customer-level cost × #children transported) + (Capacity-level costs × #facilities) Continued 27 LO EHD: EHD: ABC ABC and and Sensitivity Sensitivity Analysis Analysis Base Case Sales Unit-level costs Increase to 22 $ 12,000 $ 13,200 Decrease to 15 $ 9,000 400 440 300 2,800 3,500 2,100 Product-level costs 300 300 300 Customer-level costs 800 800 500 4,700 4,700 4,700 $ 3,000 $ 3,480 $ 1,100 Batch-level costs Facility-level costs Operating profits EXHIBIT 6.8 E H D 28 End of CHAPTER 29 ... children/month 12 LO MANAGERS WANT TO KNOW! Can we graph the relationships in CVP analysis? YES! 13 LO E H D By By graphing graphing revenues revenues and andcosts costson on same samegraph,... Definition Definition Refers to the proportion of fixed and variable costs to total costs OPERATING OPERATING LEVERAGE: LEVERAGE: Definition Definition Is the extent to which an organization’s... SIMPLIFYING CVP ASSUMPTIONS  Can separate total costs into fixed and variable  Cost and revenue behavior is linear Implies the following in the relevant range Total fixed costs not change Variable