What is Financial Management and Financial Management Plans
Financial management concerns control of financial actions to achieve goals as set and financial plans is a schedule of goals and the means of funding the aims. This involves interpreting the business plan to determine the required activities and sources required e.g. equipment, systems, materials, personnel numbers, etc and reducing all these to financial amounts to reflect in various financial schedules. These schedules then become the financial plans that support the business plan. The management part requires having systems and process to aid in tracking data, information and generating reports. It also requires having policies, procedures, and manuals to guide financial management activities and ensure that they happen as desired.
Financial management is a housekeeping activity that a business owner or management of a company must constantly engage in to acquire, safeguard, measure asset values, deploy financial and other assets profitably, monitor and measure financial performance and ultimately distribute profits. It entails planning, organizing, directing, guiding, influencing and controlling the financial affairs of the business, all towards the attainment of goals most effectively and efficiently. Financial management is also about ensuring that the business has cash at all times to settle its obligations when due to avoid a situation where it is, for lack of money, not able to do business or can be put into bankruptcy for failure to honour obligations. Financial management aims to ensure that all resources that a business needs for the generation of goods and services (e.g. plant, property, equipment, tools, furniture, data gathering and communication facilities/systems and working capital) are available. The goal of financial management also is to ensure that all the resources at the disposal of the business are utilized effectively and to generate value. A business must give a fair return, must make a profit for growth/expansion or to protect erosion of the owner’s capital and the return must be good enough to attract lenders or new investors when necessary. In addition to these, stakeholders like employees, creditors, investors, and society expect the business to be properly managed and shielded from unnecessary risks. All these should be the goals of financial management.
Financial management is such a critical function that failure to engage in it in a day-to-day manner may result in poor utilization of resources and even lead to a slow death of the business. In a small business, financial management would be the work of the business owner or a capable and trusted employee or an accountant. In a large organization, this function belongs to the top management led by a designated financial planning officer or manager.
To start and run a business successfully or to make effective financial plans when preparing a business plan, it is useful to understand the elements that go into financial management. To this end, the concepts that need appreciating in the financial management arena are as follows concepts:
- Financial management concepts and principles.
- Financial controls.
- Financial management techniques and reports.
FINANCIAL MANAGEMENT TOOLS AND ACTIVITIES
Financial management is a planning and management activity that ensures that the business is properly funded and has the resources it needs to perform and achieve its set objectives. It also ensures that the resources are properly deployed, safeguarded, and generate adequate or desired returns which are then properly appropriated. One of the main benefits of tracking financial performance and operations of the business is that this activity allows you to see the trend in revenue, costs, measures, and other metrics. These trends become useful for critical actions like budgeting, detecting and preventing theft, introducing reforms and controls, and complying with laws. The activity of conducting financial management applies systems, processes, policies, procedures, and manuals to capture, control and monitor transaction as they occur and to prepare necessary reports. To conduct effective financial management, the tools and activities that are applied in this process include:
Cash Flow Management
Cash flow management entails tracking of cash inflows and outflows using a cash flow statement. Cash flow statement is a simple schedule of sources of and uses of cash in a given period. It is a statement of a business’ bank account over a period. When making business plans, it is important to prepare this statement to see in advance whether the business will generate adequate cash to meet its operations and accumulate a surplus. For an ongoing business, it is important to forecast this regularly in advance for a week, a month or a year. This forecast is necessary to plan for how to make use of surpluses or arrange to close foreseen gaps in cash needs through boosting of sales, aggressive collection of debtors, renegotiating creditor payments, borrowing, selling of assets or shares.
Categories of Cash Flow
Operating Cash Flow: This is the cash that is generated in the course of trading such as revenue, purchases of merchandise, and operating expense. Operating cash flow can be presented in a direct or indirect method. The table below shows how the two methods can be used to determine the operating cash flow. In the indirect method, non-cash flow items are added or subtracted from net income to arrive at a cash balance.
Investing cash flow: This is cash flow from investment activities such as purchasing or disposal of property, plant, and equipment i.e. buying and selling of all assets other than current assets or assets for trading activities.
Financing cash flows: These are cash flow activities involving borrowing or repaying loans, issuing and repurchasing of shares, and receipt and payment of dividends.
The data that is used to prepare a cash flow statement is derived from the business plan, the budget and the balances in the statement of financial position coupled with realistic assumptions about the amounts and the surrounding the events. Actual asset, liability, income, and expenditure balance movements are used to prepare end of year cash flow statement for reporting purposes. For the forecast cash flow statement, assumptions are made about the movements and patterns of asset, liability, income and expenditure balances in the cash flow period.
Table 1: Direct and indirect methods of computing cash flow
|Direct Method||Amount||Indirect method||Amount|
|Sales||524,500||Net income (profit)||35,450|
|Cash paid to creditors||-201,212||Depreciation||2,920|
|Cash paid to employees||-276,667||Decrease/ (increase) in accounts receivable||18,500|
|Sale commissions||-20,151||(Increase)/decrease in inventory||0|
|Directors allowances||-5,000||Increase/(decrease) in accounts payable||-35,400|
|Net Cash from Operations||21,470||Net Cash from Operations||21,470|
|Net Cash from investment activities||-500||Net Cash from investment activities||-500|
|Net Cash from financing activities||-720||Net Cash from financing activities||-720|
|Closing cash balance||20,250||Closing cash balance||20,250|
Working capital is the money needed once the business has started operating to meet recurrent expenditures such as salaries, inventory, office supplies, marketing, selling, distribution, insurances and other monthly bills that have to be paid regularly. The main components of working capital are current assets and current liabilities. Working Capital = Current Assets – Current Liabilities.
Working capital management, in effect, is nothing but cash management. Working capital management refers to the strategies that are applied to plan, utilize, monitor and balance components of working capital. This is to ensure that the business is at all times able to meet its day to day operational capital and can pay for upcoming expenses and short-term debts without tying so many funds for this purpose that could be used for other equality productive activities. This is the reason why business planning must address and include the following activities that impact on cash flow:
- How credit to customers (debtors) will be created and managed to turn them into cash as quickly as possible. This may require a credit and debtor follow-up policy.
- How inventory will be created and managed.
- How short-term debts will be created and managed.
- How creditors and employee emoluments will be generated and managed.
- Capital budgeting-this This is about the acquisition of non-trading assets such as equipment.
- Financing and investment decisions.
If working capital is zero or negative, then the business has no funds to meet its financial obligations when they fall due. Such a situation means the solvency of the business is low and there is a risk that the business can be forced by creditors to wind up and close so that other assets of the business can be sold to pay creditors.
Cash Book Management
The cashbook is the gateway through which cash enters and leaves the business. It is advisable to have a bank account to be able to pay and to be paid using cheques and electronic methods. Another important use for a bank account is that it creates an independent track record of how the business is doing financially. This record will be useful when seeking funds from a financier as a business with a bank account is viewed to be, credible, serious and organized.
A bank account should have a mirror cash account in the business’s books. Cashbook management activities should focus on having an accounting system to track cash movements and regularly produce a statement of the office cashbook that can be compared with the bank account statement regularly obtained from the bank. Policies, procedures, and manuals should require that the two accounts be reconciled regularly to promptly pick out and sort out any differences caused by time lags, errors and even fraud.
Statement of Comprehensive Income (Profit And Loss Account)
This is a statement of revenue and expenses in a given period such as a week, a month or a year. The difference between these two is a profit or a loss. The main components of this statement are gross sales, cost of goods sold, operating expenses (including depreciation), and net profit or loss. Sales or revenue is the first item on the statement of income and it pays for everything else in the business. Sales are estimated with the aid of market forecasting and sales forecasting. Revenue is divided into three main categories that include operating income, (trading income), non-operating income (e.g. disposal of assets and investment incomes), and extraordinary income (from sources that are unlikely to recur any time soon).
For a new business, a forecast statement of income for two to three years ahead is necessary to see in advance whether the business will record a profit or not, and if not, to figure out what to do at the planning stage for the business to show a profit at least in the short to medium-term. The information that is used to prepare a budget statement of income for a new business comes from the strategic plan and this is also the same information that is used to prepare the budget. For an ongoing business, the statement is prepared from actual data registered in the period covered by the statement such as a month, a quarter or a year. The main purpose of preparing an income statement for an ongoing business is to monitor the financial heartbeat of the business to ensure that the business is making a profit and if not, why and what can be done. A statement of comprehensive income is also part of the statutorily required statements for an ongoing business by, for example, tax authorities and registrar of companies. Besides, this tool contains numbers that are necessary for financial and ratio analysis to track benchmarks like sales, profit, and administration expenses to sales, etc.
Effective financial management requires accounting systems for gathering information data about sales and expenses of the business. It also requires a set of policies, procedures, and manuals to ensure that the income statement is prepared accurately and regularly or monthly to monitor the financial performance of the business.
Statement of Financial Position (balance sheet)
Statement of financial position is a snapshot of what the business owns (assets) and what it owes to other people and the owner (liabilities) in values at any one moment. Assets are tangible and intangible objects of financial value that are owned by a business or an individual such as an automobile, a premise, equipment, computer software, cash, etc. Liabilities are debts owed to another person or a business like a bank loan. Equity is the difference between assets and liabilities and is what a business owes to the owner or what the owner has invested in the business and accumulated profits. In a statement of financial position, assets = liabilities + equity. Assets and liabilities must be equal and if they are not, there is a mistake.
Effective financial management requires accounting systems for gathering data about the assets and liabilities of the business. It also requires a set of policies, procedures, and manuals to ensure that the financial position of the business is prepared accurately and regularly to monitor the financial performance of the business.
For a new business, the statement, which is a forecast or pro forma, gives a picture of the level of assets that the new business intends to acquire and liabilities that it will incur to support operations. The data that is used to prepare the statement of financial position comes from the business plan and any other assumptions that are made regarding the acquisition of assets and incurrence of liabilities for trading purposes. The data for preparing the financial position of an ongoing business comes from the data recorded in the period covered by the statement such as at the end of a month, a quarter or a year.
For an ongoing business, the main purpose of preparing the balance sheet is to monitor the assets and liabilities of the business to ensure that the net worth (assets – minus liabilities) of the business is growing and if not, why and what can be done. If liabilities are more than assets, the business is technically insolvent and this is one of the grounds that an unpaid creditor can use to petition for dissolution of the business. By looking at the financial position over time, you can, for example, tell if debtors are growing, which is a sign that debtor collection is poor and they might strain cash flow or even turn into losses. If creditor balances are increasing, this is a signal that the business is having trouble settling its obligations.
The financial position statement is also part of the statutorily required statements by mainly the tax authorities and registrar of companies. Besides, this tool contains key numbers that are necessary for financial and ratio analysis to track benchmarks like assets to liabilities, return on investment, cash ratio, etc.
A business pays and is paid regularly and this should happen smoothly and securely for both customers and the business. Payment activities should use the systems, policies, procedures, and manuals described in the operations section of this write-up to process inbound and outbound payments effectively and efficiently. The goal is to ensure that initiation and commitment of expenditure and processing of inbound and outbound payments of the business are backed by bona fide documents, checked, counter-checked, and appropriately approved and counter-approved or signed and co-signed. This is to ensure that every dollar that comes into and leaves the business is well supported and documented as cash is highly susceptible to theft.
Most expenses in business are incurred on procurement of inputs goods, services, and works which are needed to produce, market and deliver goods and services to the market. Given this level of expenditure, there should be staff or positions in a centralized procurement unit that does procurement to maximize economies of scale. This unit should use systems and follow policies, procedures and manuals to:
- Initiate purchases as required by users and have these appropriately approved in line with the budget set aside for each purchase.
- Identify and evaluate suppliers through a competitive process and contract them with the appropriate approval process.
- Receive and inspect goods, services, and works to ensure they meet the specifications, allocate these to users or place them in an inventory store, and have the values recorded in the books of accounts.
- Process the invoices relating to purchases and them approved for payment by the paying units.
Inventory is goods kept by the business, e.g. raw materials for manufacture or processing, finished goods for sale/resale or stationery or tools for use in the business, and these can for some businesses can amount to millions of USA dollars. Owing to these values, inventory management activities should have manual or automated systems and follow policies, procedures, and manuals to acquire only the inventory that is needed when needed effectively and efficiently to minimize the acquisition, handling and storage costs. Costs that can occur while inventory is in stock include theft, damage, and costs ensuing from slow-moving, expired, or obsolete stock. Inventory also requires regularly revaluation using valuation techniques such as FIFO, LIFO, or average methods for reporting and insurance purposes.
Fixed or durable assets are necessary for doing business and can form a large part of a business’s balance sheet and therefore its management is important. Fixed assets (tangible and intangible) are items that are of measurable value and are used to generate cash flow or income over a period exceeding one year. An example of a tangible asset is a car or equipment and that of an intangible asset is computer software. Given the role assets play in generating income in a business, the focus for asset management activities is to have systems like asset register software and to have and follow policies, procedures and manuals to acquire only the assets that are needed when needed effectively and efficiently to minimize the acquisition, handling and maintenance costs. Costs that can arise while assets are possessed include theft, damage, deterioration, unnecessary maintenance, obsolescence, and idleness or unproductivity. Assets also require regularly revaluation for reporting and insurance purposes.
Budget Variance Analysis
A budget is a template that is used to forecast revenue, expenses and profit or loss and it is usually prepared as part of the business plan. The template is prepared during the business planning of new or ongoing business and yearly just before the start of each year of operation for an ongoing business. It usually covers the current year and two to three years ahead. The budgetary process as a financial management tool involves the creation of an income, expenses and capital budget amount for each activity on a line-by-line fashion. Followed by comparing the actual performance of each activity, again line-by-line, with its budget regularly say monthly, scrutinizing the deviations from the budget to discover the reasons behind the deviation of the actual performance from the budgeted, taking appropriate corrective actions and reviewing of the budgets in the light of the changes in circumstances. A budget is a motivational tool too. Policies and procedures in this aspect of the budget should focus on how the operating expenses (OPEX) and capital expenditure (CAPEX) budgets are prepared and used to monitor revenue performance and spending as well as controlling the commitment of expenditure at the time of contracting suppliers.
Flexing the Budget
A budget may forecast a certain level of sales at the end of a quarter but a higher or lower level may be realized. If a higher level of sales than was budgeted is achieved at a higher cost than was budgeted, it follows that the budget should be recomputed or flexed to see what would have been the budget commensurate with the higher level of sales so that a relevant variance can be computed. Table 2 below illustrates this point more clearly.
Table 2: Flexed budget versus fixed budget
|Fixed Budget||Flexed Budget|
|US$||% to sales Budget||Actual||Budget||Variance||Actual||Budget||Variance|
Depending on the scale of operations or the nature of the item involved, any variation of ±5% and more may be investigated and necessary action taken to bring performance in line with plans. It is useful for example to ask the following questions:
- Is the profit lower or higher than last year or budget, and if higher or lower, why?
- Is the profit higher or lower than similar businesses? If lower what can be done to do as well as others?
- Is the lower profitability a short-term or long-lasting problem?
- What actions can be taken given the information being revealed by the budget analysis?
The importance of a budget as a profitability management and control tool cannot be overstated. In business, monitoring of sales and control of costs is necessary to have control over the desired profit. These two factors need close monitoring and keeping in line with the budget to get the desired returns. The thing that helps in this is the budget. The same goes for any project that is undertaken. Each project should have an income and expenditure mini-budget that is closely monitored to keep activities within plans.
Other Tools of Management
Other tools used in financial management include:
Debtors are people who owe the business money because of having bought goods and services on credit or having borrowed money from the business and for many businesses, all their sales can be on credit. Debtors can be many and each debtor tends to have numerous transaction volumes that require tracking individually for each debtor. If debts are not tracked and promptly collected when due, they can create cash flow constraints for the business and can become bad and uncollectible thereby occasioning losses for the business. The goal for debtors’ management activities is to have systems like debtors’ subsidiary ledger and policies, procedures, and manuals to ensure vetting of credit extension, accurate capture of debtor records and prompt collection of debts.
Creditors are people who the business owes money because of inward supplies to the business on credit or through borrowing by the business. Creditors are as good as moneylenders are and they ensure that you do business smoothly by promptly supplying quality goods and services when required on credit. It is therefore worth taking good care of them. If creditors are not paid or mistreated in any way, they can wind up the business. The aim for creditors’ management activities is to have systems such as creditors’ subsidiary ledger and policies, procedures, and manuals to ensure negotiating with creditors for favourable credit terms, accurate capture of creditor records and appropriate settlement of debts.
Payroll is a system and a register of employees that are used to process and pay employees every month. It contains details of employees such as name, grade, the amount payable, bank details, taxable status, deductions, and exit date and so on. Payroll management activities should apply systems such as the payroll processing and accounting software system and follow policies, procedures, and manuals to ensure changes that affect payroll are promptly captured in the payroll. These organs must also ensure that payroll byproducts are dealt with and payroll expenditure of one month is compared with the one for the previous month to detect errors or fraud early.
Reconciliations are about comparing one account balance with another that is supposed to agree but differ to reveal the reason for the differences for taking appropriate actions. Reconciliation of accounts highlights miss-postings, errors, and malpractices. The goal of reconciliation activities should be to use accounting systems to produce selected key account reports. Follow policies, procedures, and manuals to analyze and reconcile the selected accounts every month and deal with reconciling items and have the reconciliation reports to be counter-checked, and signed-off.
Account and Financial Ratio Analysis
This is about looking at the accounts (balance sheet and income statement) and comparing one balance with another or comparing the same balances over time in these statements. Doing so can reveal what is going on in the business. What is even more revealing is to compute financial ratios. A ratio is a result of dividing one measure by another measure to reveal the logical interrelationships in the form of a value or quantity. By looking at ratios, you can see how various costs are behaving and affecting the profit. For ratios to be useful they should be compared with a set standard, competitor or industry ratios or the trends of the ratios as observed over a period. All these comparisons can reveal whether the business is doing well or not. All the numbers necessary for computing ratios are in the statement of comprehensive income, statement of financial position and cash flow statement.
Computation of ratios is an important financial management activity that should focus on having systems that capture relevant data for computing the ratios. This activity should also set and apply policies, procedures, and manuals to identify ratios to compute regularly, set desired benchmarks for the ratios, maintain relevant data for the ratios, and ensure to accurately compute ratios and report them for information and decision-making.
Ratios that can be computed include net profit to sales, return on investment (ROI), current ratio, gearing ratio, and cash cover ratio. Other ratios that can be computed include earnings per share, price-earnings ratio, dividend yield, sales or profit per dollar invested, sales/profit per employee, and practically sales/profit per any activity of interest to a decision-maker.
Time Value of Money
Time Value of Money (TVM) is about the fact that money available now is worth more than the same amount in the future due to money’s potential capacity to earn money. It is also the idea that provided money can be invested to earn money; cash is worth more the moment it is received- one bird in the hand is worth two in the bush. Money deposited in a savings account will earn interest. Because of this universal fact, people would prefer to receive money today rather than the same amount in the future. For example, assuming a 5% interest rate per annum, US$100 invested today will be worth US$105 in one year (i.e. 100 multiplied by 105%). Conversely, assuming an interest of 5%, US$100 to be received one year from now is worth only US$95.24 today (i.e. 100 ÷ 105%).
Inflation and its Effects on Money
Inflation refers to the rate at which the general level of prices for goods and services is rising over a period usually a year but monitored monthly. Consequently, the purchasing power of money is falling over the same period. Owing to the effects of inflation, the value of one unit of cash today will be of lesser value a year from now in the sense that it will not be able to buy the same quantity of goods which it did before. In a world of 5% inflation every year, prices will be going up by 5% and assets will decrease in real purchasing power by the same rate. As you manage cash flow, you should be alive to the fact that money should not be left idle and that delayed receipt of money costs money. When debtors delay payment, they are reducing the value of your money. To cushion against effects of delayed payments, there is a need to apply interest penalty on unpaid balances beyond a certain agreed date. For the same reason, money should be invested at an interest rate that is higher than the rate of inflation to cushion its value against the corrosive effects of inflation.
Taxation and its effects on Profit
Businesses in most countries are required to pay various forms of taxes, the commonest ones being corporate and income tax, value-added tax (VAT) or sales tax, capital gains tax, property tax, and import duty and excise taxes. Corporate or income tax is paid on profit or income such as a salary. VAT is paid when buying goods and services. Capital gains tax is paid on the gain when a property is sold again. Property tax is paid annually as a percentage of the value of the property owned usually in urban areas mainly. Import duty and excise taxes are paid on the value of imports.
Taxes reduce income from investments. When a company makes a profit, it pays corporate income tax. A company’s net income amount is, therefore, an after-tax amount. When we say that company ABC has earnings per share (EPS) of US$15, this amount is after the company has paid its income that. When a company makes a profit, it can choose to pay all of the profit to shareholders as dividends, retain some it and pay some as dividends or retain the whole of it for reinvesting in the company. Any amount such as interest or dividend that an institution pays to an investor, that amount is after the institution has paid its tax. If you invest in ABC Company and the company pays a dividend of US$15 per share, you will pay income tax on this dividend at your tax bracket. If your tax bracket is 30%, your tax on the dividend will be US$4.5 (15 x 30%) and your net income will be US$10.5. If you are a shareholder in ABC Company, you can view the EPS of US$15 as your earnings that can be paid to you as dividends or the company is reinvesting it for you when it does not pay you dividends. If the ABC Company does not pay you the dividend of US$15 and opts to retain it, you do not have to pay the tax of US$4.5 and the effect of personal taxation is avoided.
Compounding interest is a method where interest is calculated on the initial principal and the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on principal plus interest,” This makes a deposit or loan grow at a faster rate than when simple interest is applied because the base of computation is increasing. The interest rate quoted is normally a percentage per annum (pa). If the principal amount, for example, is US$1,000 and the interest rate quoted is 12% pa, simple interest amount payable per year would be US$1,000 X (12 ÷ 100) = US$120. The interest amount payable per month would be US$120 ÷ 12 = US$10 and interest amount payable per day would US$120 ÷ 365 = 33 USA cents.
Because available resources are limited, investment projects should be selected based on their potential returns. There are three main methods of appraising potential investment projects. The first is the payback period, which simply looks at cash flow from the project and how long the project will take to return the capital outlay that funded the project. The second is a method known as discounted cash flow, which computes the present value of all the cash flows from the project using the business’ cost of capital rate and compares the total discounted cash flow with the initial outlay to determine profitability. If the discounted cash flow is more than the initial outlay, the project is likely to be profitable.
The third is the internal rate of return. This is the discount interest rate that equates the present value of future expected cash flows of a project with its initial outlay or investment. The decision rule for IRR is that only projects that have IRR that is higher than predetermined IRR or hurdle are acceptable. In other words, IRR should be higher than the cost of capital of a project to create any profit for the business. If IRR is lower than the cost of capital, the project will create no value for the business.
To undertake investment appraisal exercise effectively, it is necessary to have systems that capture, track and estimates appropriate data on costs and cash flows of potential projects. Supporting the systems are policies, procedures, and manuals that require all potential projects under consideration should undergo a financial appraisal. These organs also identify appropriate appraisal methods and set the decision rule hurdle for each method.
This is an approach for assessing and comparing the merits and demerits of available investments, projects or alternative ways of achieving desired objectives in terms of costs versus benefits and assessing which outweighs the other. This exercise has two purposes namely to confirm if the project or decision is as sound as it looks and to provide a basis of comparing alternatives. The method entails comparing the total expected cost of each intended action with their total expected benefits to gauge whether benefits significantly outweigh costs. In this process, financial and non-financial benefits and costs are expressed in monetary terms, and adjusted for the time value of money, for benefits and costs of the projects that occur at different times be presented on the same platform in terms of their net present value. The whole process involves the listing of alternative actions, identification of stakeholders, selection of measures and measurement of all costs and benefits. It also includes forecasting the outcome of costs and benefits over relevant time, translating all costs and benefits into a common currency, choosing a discount rate, calculating the net present value of each option, perform sensitivity analysis on relevant factors and, taking up the best or most responsive option.
Return On Investment (ROI)
Return on investment is the gain from an investment expressed as a percentage of the investment. The return on investment is always related to the cost of the investment. If you invest, US$1,200 and you make on profit US$90, the return 7.5% (90 ÷ 1,200 x 100). ROI is a useful tool for choosing between competing projects or investments. If one investment A is providing an ROI of 12% and investment, B provides 15%, investment B is more preferable than investment A.
A sunk cost is money already spent and permanently unavailable. Sunk costs are past costs that are irretrievable and, therefore, considered irrelevant to future decision making. In business, an example of a sunk cost may be an investment of say US$100,000 into a plant that stalls for some reason along the way and the value of the incomplete plant is of no value because resale or recovery in any way is not feasible. If the plant can be completed for an additional cost of US$50,000 or abandoned and a different but equally valuable facility can be built for US$30,000, it should be obvious that abandonment and construction of the alternative facility is the more rational decision, even though it represents a total loss of the original expenditure of US$100,000. The value of US$100,000 is sunk cost and should not count in the future decision as it is of no value.
Opportunity cost is a benefit, profit or value of something that is foregone to get something else. This arises because factors of production such as land, money etc can be used in different ways and when a choice is made to do one thing such as starting a business, this means an available alternative action will be forgone. Let us say, for example, that an investor has US$10,000 that he could use to buy shares in company ABC or place it as a deposit in a bank earning interest at the rate of 8%. If he buys company ABC shares and earns a return of 12%, the consumer’s decision to buy shares will have been beneficial because the alternative would have been less profitable. If instead, company ABC shares earn a return of 6% when the consumer could have earned 8% from a bank deposit, then the opportunity cost, in this case, is US$200 (8%-6% x 10,000). What is our point with all these? As part of active financial management, intended changes in business must undergo a cost-benefit analysis.
Cost Control and Cutting Measures
One of the main objectives of financial management in a business is cost control. If costs are out of control, they will depress profits even if sales are doing well and competing effectively will be nigh impossible. It is therefore critical for a business to set costs right from the word go and keep engaging in cost control and cost reduction from time to time as things change to keep costs under control and within set benchmarks. Cost control and reduction exercises are a search for better and more economical ways of completing an operation or delivering a product or a service. They seek to keep costs within a norm or a standard or a pre-set cost benchmark/parameter. They also aim to curb waste within an operation or an operating environment and introduce effectiveness and efficiencies in the business. Often, it involves the renegotiations of contracts with creditors and suppliers.
Policies and procedures in this area should identify what costs to regularly monitor, set appropriate benchmarks for them, define necessary data to be kept for computing the benchmarks and related actual turnout, and require regular reports about the costs to be prepared for information and decision-making. The policies and procedures should also require regular reviews of costs and processes to identify where changes have occurred and to discover new and less costly methods of doing things.
Break-even point is a level where total revenue equals total costs and the business neither makes a profit nor a loss. Any upward change in revenue at this point without a substantial accompanying fixed cost will allow the business to make a profit and create wealth. Break-even analysis is a tool for making cost, sales units and value, pricing and profit decisions. All these factors are interrelated and any change in one factor affects the other. If your business consists mainly of variable costs and very little or negligible fixed costs, then the price of your goods can be set at a level to fully cover all variable costs plus a desired return on capital invested. If your business has both variable and substantial fixed costs, then you use the formula below to compute break-even price or quantity:
PQ = F + VQ, where P represents the selling price per unit, Q represents the number of units of goods produced and sold, F stands for total fixed costs and V represents variable costs per unit. Fixed or overheads costs are costs incurred whether or not there are production and sales and cannot be assigned to any unit of sale. Variable costs are costs that vary with goods produced and can be directly associated with the number of units produced and sold. Variable costs also include costs like commissions that vary depending on the volume of sales and cannot be associated directly with any unit of sales. The above formula can also be expressed as PQ – (F + VQ) = 0. From this basic formula, the break-even point in terms of units produced can be derived from the following formula: Q = F/(P – V). The table below illustrates how to compute the break-even point in terms of units.
Table 3: Break-even point computation with both fixed and variables costs
|Selling Price/Unit (US$)||15.0||15.0||15.0||15.0||15.0||15.0||15.0||15.0|
From the data above, break-even point occurs at 2,000 units and from then on, a profit is registered up to a profit of US$15,000 at 4,000 units. Break-even point can be expressed in terms of units produced, in the percentage of plant capacity or value of sales. To compute break-even price, units are held constant while varying the price until the profit is zero. Break-even analysis can be computed for a whole business, a line of products, a single product or even a department or a unit of business.
Safety Margin in Break-even Analysis
The margin of safety is the difference between the break-even volume of sales and actual or budgeted volumes of sales. This difference indicates the level of safety the company enjoys before sales volumes fall below break-even point and incurring losses. The margin is a measure of risk and the higher this margin is the lower the risk and the better for the company. If the sales price per unit is US$50, the variable cost per unit is US$30, total fixed costs are US$7,000 and budgeted sales quantity is 500 units. Using the formula that PQ = VQ + F, where P is sales price per unit, Q represents sales and production units, V is the variable cost per unit and F is fixed costs, break-even sales volume can be computed to be 350 units or US$17,500 in value compared to actual sales of US$25,000 (500 X 50). Since the safety margin is actual sales value minus break-even sales value, the safety margin for this example works out to US$7,500 (25,000-17,500) or 30% of actual sales (7,500/25,000). When making plans, budgeted sales are used instead of actual sales to compute forecast safety margin.
Profit Goal in Break-even Analysis
The above computations do not take into account the profit goal that the business may have. To take this into account, the formula for computing break-even quantity is amended as follows:
Q = (F + PR)/(S – V), where the new variable PR represents the desired profit. If F is given as US$15,000, PR as US$30,000, S as US$15, and V as US$7.5, the break-even quantity would be 6,000 units. If it is known that the maximum capacity of the business without investment in further fixed costs is only 4,000 units, then it will not be possible to meet the profit goal without changing one or some of the variables. A balance can be achieved by reducing the profit goal, investing in further fixed costs by expanding production capacity or increasing the selling price. If for example the price is raised from US$15 to US$20 per unit, the new break-even quantity would be 3,600 units which are well within the current capacity. But the questions would be, can the market take the new price of US$20 per unit and what about competitors and their prices?