Innovative thinker (group 3)

Product Pricing ManagementFinancial Analysis

Learning objectives Introduce basic financial arithmetic. Understand cost calculation. Recognize how breakeven analysis, how its used and

what are its shortcoming. Understand the role of costs. Analyses performance. Recognize the need for financial ratio and

performance metrics.

Basic financial Arithmetic

Definition: Financial arithmetic is dynamic estimation of the value of money. The fundamental assumption of financial arithmetic is the certainty that the nominal value of money in circulation increases with time.

Types of Interest Rates Simple interest

Compound interest

Nominal and Effective Interest Rates

Real Interest Rates

Geometric Rates of Return

Simple interest

Definition:Interest is calculated on the original sum invested. Typically used only for a single time period. Formula

Interest Principal periods rateP t r

1S P Ptr P rt

1SPrt

Compound interest

Definition:Compounding involves accumulating interest on previous interest payments, which will generate further interest. Formula• The sum or future value accumulated after n periods is:

The present value of a future sum is: 1 nS P i

1 n

SPi

Compound interest cont.….The backbone of many time-value calculations are the present value (PV) and future value (FV) based on compound interest.

Present Value PV = FV (1+r) n

Future Value FV = PV (1+r) n

Note: The PV and FV formulas are the inverse of each other!

Nominal and Effective Interest Rates

• Is when interest is compounded over a period different from that expressed by the interest rate, e.g. more than once a year.

Formula1 1

mjim

where: nominal rate per period

number of compounding periods which occur during a single nominal period

jm

Real Interest Rates

• The real interest rate is the interest rate after taking out the effects of inflation.

• The nominal interest rate is the interest rate before taking out the effects of inflation.

Formulawhere:

* real interest rate nominal interest rate expected inflation rate

iip

1* 11iip

Geometric Rates of Return

The rate of return between two dates, measured by the change in value divided by the earlier value.

The average of a sequence of geometric rates of return is found by a process that resembles compounding.

Average geometric rate of return is also referred to as the average compound rate of return.

Formula

0

where: final value or price initial value or price number of periods

nPPn

1

0

1n

nPiP

Cost Calculation

Definition: All payments made by a firm in the production of a good or service are called the cost of production.

Types of Cost Opportunity cost Fixed cost Variable cost Total cost Average cost Average Fixed cost Average Variable cost Marginal cost

Opportunity cost

Definition:The value of the next best alternative that must be sacrificed when one makes a choice.

Fixed cost (FC)

Definition: Are those costs that do not vary with the quantity of output produced.FormulaTotal Fixed Cost = Total Cost – Total Variable Cost

ORAverage Fixed Cost x Quantity

Variable cost (VC)

Definition:Are those costs that do vary with the quantity of output produced.FormulaTotal Variable Cost = Total Cost – Total Fixed Cost

ORAverage Variable Cost x Quantity

Total cost (TC)

Definition: the market value of the inputs a firm uses in production.

FormulaTotal Cost = Total Fixed Cost + Total Variable CostORTotal Cost = Average Cost x Quantity

Average cost

Definition:Average costs can be determined by dividing the firm’s costs by the quantity of output it produces.

FormulaAverage Cost = Average Fixed Cost + Average Variable Cost

Total Costor Average Cost = ----------

Quantity

Average Fixed Cost This is the fixed cost per unit of output. AFC steadily

decreases as more of a good is produced.Formula Total Fixed Cost

Average Fixed Cost = --------------- Quantity

Average Variable Cost This is the variable cost per unit of output. AVC will

decrease, reach a minimum and then increase as more of a good is produced. The curve is U-shaped.

Formula Total Variable Cost

Average Variable Cost = --------------- Quantity

Marginal cost (MC)

Definition:Cost of producing one extra unit of output.

Formula

MC = Change in Total costChange in Quantity

ActivityOutput

(Q)

Total fixed cost

N$

Total variable

cost

N$

Total cost

 

N$

Average fixed cost

N$

Average variable cost

N$

Average (total) cost

N$

Marginal cost

 

N$

0     50 - - - -

3     88        

4     100        

9     150        

10     158        

16     200        

17     205        

BREAKEVEN ANALYSISDEFINITION

• The break even point is the point where the gains equal the losses. The point defines when an investment will generate a positive return. The point where sales or revenues equal expenses. The point where total costs equal total revenues. There is no profit made or loss incurred at the break even point. It is the lower limit of profit when prices are set and margins are determined.

Breakeven analysis

FormulaBreak even point:

= (fixed cost)/(contribution per unit)

Where,Contribution = selling cost – variable costFixed cost = Contribution - profit

Application of break-even analysis in market conditions

Fixed Cost

Monthly Rental $100

Insurance(600 per year, so 600/12 = 50 ) $50

TOTAL MONTHLY FIXED COST $150

Variable Cost

Materials $3

Labor $4

TOTAL VARIABLE COST $7

Selling Price $10

BREAK-EVEN POINT CALCULATIONBreak-Even Point Fixed Cost / (Selling cost – Variable Cost)

Break -Even Point = $150 / ($10 - $7) = 50

To break-even the company must sell 50 units per month.If the Company just broke even, then its Profit and Loss Statement would look like the following:

Monthly Profit and Loss Statement

SalesGross Sales ($10 per unit times 50 units) $500Less Cost of Goods Sold ($7 per unit times 50 units) $350Net Sales $150

ExpensesRent $100Insurance $50Total Expense $150

Net Profit $0

SALES

UNITS SOLD

Activity 2Mountain view is small, romantic bed and breakfast hotel located near Grahamstown, The charge of R500 per double room is for one night’s accommodation excluding breakfast. (Patrons can walk across the road to an independent coffee shop for a delicious breakfast) The retired couple who own and manage the hotel estimate that the variable cost per room is N$200 per day. This includes cost such as electricity, laundry, cleaning and utilities. The hotel’s fixed cost, which include council rates, water rates and land taxes, total R420 000 per year. The hotel has 10 double rooms. The hotel charges per room and a couple sharing a room will pay the same rate as a single person per room.

Required: Contribution margin per unit of service (a unit of service is one night’s

accommodation per room). Contribution margin ratio Annual breakeven point in units of service and in Rands of service revenue The number of units of service required to earn a target net profit of R600 000

for the year (ignore income taxes)

SolutionContribution margin per unit of service

= nightly charge/room – variable cost/room= R500 – R200= R300

Contribution margin ratio = Contribution margin per unit/nightly room charge= R300/R500= 0.60

Annual break even point in units of service = fixed cost/contribution margin per unit= R420 000/R300= 1400 nights of accommodation

Uses of B/E Break-even analysis provides a quick estimate of how much the firm

must sell to break even and how much profit can be earned if a higher sales volume is obtained.

Helps the business to determine the cost structures, and the number of units that needs to be sold in order to cover the cost or make a profit.

Help determine how practical the business idea is, and whether or not it is worth pursuing.

It is useful to see what can be done to reduce costs or increase sales.

LIMITATIONS OF BREAKEVEN ANALYSIS

Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at various prices.

It assumes that fixed costs (FC) are constant

It assumes average variable costs (VC) are constant per unit of output, at least in the range of likely quantities of sales.

It is difficult in determining whether a cost is fixed or variable using a breakeven. Additionally, break-even analysis ignores demand.

Role of CostDefinition:Cost is the value of money that has been used up to produce something. Cost is part of Cost management which is an activity of managers related to planning and control of costs.

Managers have to take decisions regarding use of materials, processes, product designs and have to plan costs or expenses to support the operating plan for their department or section.

It provides a variety of data for many day-to-day decisions as well as essential information for longer-range decisions.

To charge whatever they want for their products. The manager need cost price to decide the price.

Performance analysis

Examination of various financial performance indicators(such as return on assets and return on equity) in comparison with the results achieved by the competing firms of about the same size.

It also looks at the human resource managements, examination of the performance of current employees to determine if training can help reduce performance problems such as low outputs, uneven quality, excessive waste.

Performance analysis can also be analyzed more into details by looking at activity analysis, job analysis and task analysis.

Performance analysis cont.….. It can also be analyzed as the process by which a

manager or consultant examines and evaluate an employees work behavior by comparing it with preset standards, documents are results of the comparison and uses the results to provide feedback to the employees to show were improvements are needed and why.

Performance appraisals are employed to determine who needs what training and who will be promoted, demoted or retained.

Tools to assess Financial performance

Financial Ratio Are ratio that can be extracted from the financial statement. It

can be used to compare your firms performance during different time period.

Benchmarking Is a way of measuring your product, services and processes

against those of other organizations, in the same industry sector. This help the manager to assess the company’s performance.

Financial ratios Profitability Ratios

Activity Ratios

Liquidity Ratios

Productivity Ratios

Profitability Ratios Profit on sales = net profit / net sales (how much does each $ of

revenue contribute to profit, so if Profit on Sales = 12% this means that 12cents in each $ of revenue goes to profit)

Return on assets = net profit / total assets (how much is each $ of assets contributing to profit)

Return on net worth = net profit / net worth

Activity Ratios

Inventory turnover = cost of goods sold / average inventory at cost (number of times in the year when average amt. Of inventory

is completely sold out)

Asset turnover = net sales / average total assets (are all assets being efficiently used to generate sales?)

Receivables turnover = net sales / average accounts receivable (length of time it takes for customers to pay)

Liquidity Ratios Current ratio = current assets / current liabilities

Current liabilities to inventory = current liabilities / inventory

NB Liquidity ratio help companies answer the question of

whether they will able to meet their debts?

Productivity Ratios Space productivity

= net sales / square foot of selling space

Personnel productivity = selling expense / net sales

Accounts payable to sales = accounts payable / net sales

Operating Performance Ratios

Fixed-Asset Turnover

Sales/Revenue Per Employee Operating Cycle

Debt Ratio

Overview of debts

Debt Ratio

Debt-Equity Ratio

Capitalization Ratio

Interest Coverage Ratio

Cash Flow To Debt Ratio

Investment Valuation Ratios

Per Share Data Price/Book Value Ratio Cash Flow Coverage Ratio Price/Earnings Ratio Price/Earnings To Growth Ratio Price/Sales Ratio Dividend Yield Enterprise Value Multiple

Cash Flow Indicator Ratios

Operating Cash Flow/Sales Ratio

Free Cash Flow/Operating Cash Ratio

Cash Flow Coverage Ratio

Dividend Pay-out Ratio

Financial metrics Liquidity metrics

Efficiency metrics

Leverage metrics

Profitability metrics

Valuation metrics

Growth Metrics

References • Charles T., (2000). Cost Accounting: Managerial Emphasis (10th

ed.). New Jersey: Prentice Hall

• Varian, H., R. (2010). Intermediate microeconomics: A modern approach (8th Ed.). New York: W. W. Norton & Company.

• Solution Matrix Limited (2015). Financial Metrics Explained. Retrieved from https://www.business-case-analysis.com/financial-metrics.html

• Lot, R. (2015). Financial Ratio Tutorial. Retrieved from http://www.investopedia.com/university/ratios/