Financial

Performance
Tools
Prepared by:
Cabahug, Vankia Guiang, Genie

Caballero, Mica Quialatan, Quiarah

Cristobal, Angelo Relator, Aleah

De Leon, Jenna Luz Clarita Roxas, Jason

Espeleta, Risha Vargas, Jesica

Submitted to:
Ma’am Topacio
Financial Planning
The process of estimating the capital required and determining it’s competition. It is the
process of framing financial policies in relation to procurement, investment and administration of
funds of an enterprise.

The process of financial planning in business is designed to forecast future financial

results and determine how best to use the company’s financial resources in pursuit of the
organization’s short- and long-range objectives. Because planning involves looking well into the
future, it is a highly creative thinking process as well as an analytical one.

Companies that make a concerted effort at financial planning can grow their revenues at a
more accelerated pace than organizations that have an inefficient planning process. Financial
planning provides the numerical logic for decision making. It shows where the business should
concentrate its resources for maximum effectiveness in building revenues and managing costs.
Efficient financial management allows more funds to be available for marketing, expanding
operations and product development, which in turn brings about more growth.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:

 Determining capital requirements- This will depend upon factors like cost of current
and fixed assets, promotional expenses and long- range planning. Capital
requirements have to be looked with both aspects: short- term and long- term
requirements.
 Determining capital structure- The capital structure is the composition of capital, i.e.,
the relative kind and proportion of capital required in the business. This includes
decisions of debt- equity ratio- both short-term and long- term.

Framing financial policies with regards to cash control, lending, borrowings, etc.

A finance manager ensures that the scarce financial resources are maximally utilized in the best
possible manner at least cost in order to get maximum returns on investment.

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures, programs and
budgets regarding the financial activities of a concern. This ensures effective and adequate
financial and investment policies. The importance can be outlined as-

 Adequate funds have to be ensured.

  Financial Planning helps in ensuring a reasonable balance between outflow and
inflow of funds so that stability is maintained.
 Financial Planning ensures that the suppliers of funds are easily investing in
companies which exercise financial planning.
 Financial Planning helps in making growth and expansion programmes which helps
in long-run survival of the company.
 Financial Planning reduces uncertainties with regards to changing market trends
which can be faced easily through enough funds.
 Financial Planning helps in reducing the uncertainties which can be a hindrance to
growth of the company. This helps in ensuring stability and profitability in concern.

Function of Financial Planning

• Ensuring availability of funds:

Financial planning majorly excels in the area of generating funds as well as making
them available whenever they are required. This also includes estimation of the funds required
for different purposes, which are, long-term assets and working capital requirements.

• Estimating the time and source of funds:

Time is a game-changing factor in any business venture. Delivering the funds at the
right time at the right place is very much crucial. It is as vital as the generation of the amount
itself. While time is an important factor, the sources of these funds are necessary as well.

• Generating capital structure:

The capital structure is the composition of the capital of a company, that is, the kind
and proportion of capital required in the business. This includes planning of debt-equity ratio
both short-term and long-term.

• Avoiding unnecessary funds:

It is an important objective of the company to make sure that the firm does not raise unnecessary
resources. Shortage of funds and the firm cannot meet its payment obligations. Whereas with a surplus of
funds, the firm does not earn returns but adds to costs.
Budgeting
-Budgeting in its general sense, is the act of quantifying objectives in financial terms. Budgeting
assists managers in decision making process in an organization. It is the function of the
management accountant to provide information needed in budgeting process.

- It serves as a barometer against which the results of the daily operations of the company are
matched, coordinated, evaluated and controlled.

-A budget is basically a financial plan for a defined period, normally a year. It greatly enhances
the success of any undertaking.

-Budgeting is the basis for all business success. It helps with both planning and control of the
finances of the business.

Significance
-Budgeting plays an important role in the effective utilization of available resources in order to
achieve over all objectives of an organization.

-It generates a sense of caution and care among the line managers.

- It guides the management relating to the planning and formulation of policies

-Budgeting provides a means of controlling income and expenditure of a business. It gives a plan

for spending.

-It enables the business owner to concentrate on cash flow, reducing costs, improving profits and
increasing returns on investment.

Function
7 Functions of Budgeting:

1. FORECASTING: this entails making at calculated attempt into knowing what the
future holds. Forecasting may not be perfect as evidence has shown but it is better to
have a forecast to work with than not having any as this will help you get prepared.
There are many statistical tools developed over the years to help managers and
accountants make better forecast.

Forecasting is a complex exercise that requires you to consider many variables in the
light of; the action of competitors, government actions, economic outlook,
relationship between price and demands, etc.
2. PLANNING: generally speaking, planning depends on forecast that has been made
in the past to make decision about the future. The estimated data generated by
forecasting are used to make plans. Government agencies, for example health
authorities use forecast from estimated population to plan on the number of health
centers to open in a community and the number of beds and other health equipment
that will be put in that hospital.

Business also use forecast figure to estimate the use of materials and make plans to
ensure that they are provided as and when due

Financial models on computers makes the mixture of variables on an ‘what if’

scenario possible so that the best possible mix of variables are achieved. Spreadsheet
is one of the most popular financial models to use for planning and forecasting.

3. COMMUNICATION: budgeting in an organization acts as a communication tool in

the following ways:
3.1. Gathering information: information about a company and the activities of
its competitors are gathered during the process of making all kinds of
budget. It is quite impossible for a single individual to gather all this
information that are needed to make a functional budget. Managers and
other non-managerial staff will need to be consulted and information
obtained from them. This information will then be analyzed, challenged
and criticized in order to come up with filtered information.
3.2. Disseminating information: budgets when not acted upon are useless, so,
the budgetary system has an inbuilt information dissemination ability that
ensures that responsible managers actually got the budget which they will
work with.
Budgeting committee is usually formed to act as a forum where representatives from
different parts of the business will assemble to iron out issues that relates to resource
planning of the business.

4. MOTIVATION: motivation is the driving force that makes people to run towards
their goals rather than trudge towards it. Motivation is a relative and subjective term,
we are not here to discuss motivation but, to see how budgeting affects the motivation
of staff.

Two factors need to be considered here: how to make people follow a budget, and
setting the difficulty level of budgeting. There are two main approaches that
companies can employ to make their staff heed towards a budget, each having its
advantages and disadvantages. They are
 Authoritarian method and participatory method, these two approaches represent two
extremes. The ideal method that is actually used in practice is the one that strive to
achieve a balance between the two extremes.

Again, budgets can either be made so difficult or so easy. For a budget to motivate
staff, its level of difficulty must be somewhere around the middle of difficulty and
easiness.

5. EVALUATION: evaluation means to judge something with a sort of standard. The

budget represents that target performance which will then be compared with actual
performance. And this will then lead to corrective action being taken. Evaluation in
real life is not as easy as I have presented it here.

If not handled with, evaluation can encourage actions that will harm the organization
in the long run. Again, there are some non-quantifiable aspects of a business that is
hard to measure. Examples are; customer services, staff morale, innovation,
environmental friendliness, etc.

There are non-financial factors that have effects on investment appraisal that must be
considered before judging a manager as to whether he or she properly managed the
investment under his or jurisdiction. Other business success factors equally need to be
considered.

6. CONTROL/ CO-ORDINATION: this function budgeting is very important for an

organization to grow. Co-ordination simply means ensuring that different parts of the
business work in congruence. For example, it will be useless employing sales force
that can sell 2,000,000 units of an item when all that your company has the capacity
of producing is 1,200,000 units of that product. This is not to say that plans cannot be
made to get the remaining 800,000 units from an alternative source, in fact, this is one
of the functions of budgeting- to expose weakness so that plans can be made to cover
for it.

7. AUTHORIZATION: budgeting helps to minimize misappropriation and

embezzlement that would have characterize corporations if a system of authorization
does not exist. Through authorization, managers are made more accountable for their
spending. A manager that has been authorized to spend $5,000 dollars in a way will
be looking for trouble if she or he spends $5,001 without further authorization. In
fact, budgeting helps to prevent fraud.
 As you must have seen, we have been able to look at the functions of budget or
budgetary system in a business. And it has been revealed that much work is involved
than an ordinary person in the street would imagine.

As a manager or an accountant responsible for preparing and ensuring that budgets

are implemented, you need to always update your knowledge on budgeting.

Budgetary Control
Meaning:

Budgetary control is the process of determining various actual results with budgeted figures for
the enterprise for the future period and standards set then comparing the budgeted figures with
the actual performance for calculating variances, if any.

It is a system of procedures used to ensure that an organization's actual revenues and

expenditures adhere closely to its financial plan. The system typically involves setting personal
goals for managers that are based on the budget, along with a set of rewards that are triggered
when the goals are attained.budgets are prepared and then actual results are recorded.

Definiton:

According to Brown and Howard (2002), budgetary control is a system of controlling costs
which includes the preparation of budgets, coordinating the departments and establishing
responsibilities, comparing actual performance with the budgeted and acting upon results to
achieve maximum profitability.

On the other hand, J. Batty (1982) defines it as, “A system which uses budgets as a means of
planning and controlling all aspects of producing and/or selling commodities and services.
Welsch relates budgetary control with day-to-day control process.” According to him,
“Budgetary control involves the use of budget and budgetary reports, throughout the period to
co-ordinate, evaluate and control day-to-day operations in accordance with the goals specified by
the budget.”

According to the Institute of Cost Management Accountants, budgetary control is - “the

establishment of budgets, relating the responsibilities of executives to the requirements of a
policy, and the continuous comparison of actual with budgeted results either to secure by
individual action the objectives of that policy or to provide a basis for its revision”.
Function:

The main purpose of budgetary control is to enable the management to conduct the business in
the most efficient manner in the organisation.

 Setting up of budgets
 Policymaking
 Comparing the actual and budgeted results.
 Taking corrective steps and remedial measures, (if possible) or Revising the budgets
(if required).
 Placing responsibility when there is a failure to attain the target.

According to John Blocker, “Budgetary control is planned to assist the management the
allocation of responsibilities and authority, to aid in making estimates and plans for future, to
assist in analysis of various between estimated and actual results and to develop basis of
measurement or standards with which to evaluate the efficiency of operations.”

In other words, the budgetary control device in the organisation encompasses practically the
whole range of management activities right from planning and policy formulation to the final
function of control over various activities of the manufacturing enterprise

Specific Objectives:

1. Formalized Business Objectives - the overall aims and objectives of the business
and determining targets of performance for each section or department of the business
can be easily identified in a formal point of view. The business objectives are
formalised in the form of different types of budgets which sets targets in physical
and/or monetary values.

2. Planning - budgets are the plans to be pursued during the designed period of time to
attain certain objectives in the organisation. Budgetary control will force the
management at all levels to plan various activities well in advance in the organisation.
It helps in making and revising business policies in the organisation.

3. Control - budgetary control is an important instrument of managerial control in any

enterprise. It helps in comparing the performance of various individuals and
departments with the predetermined standards laid down in various budgets, as well
as in reporting the significant variations from the budgets to the top management in
 the organisation. Since separate budgets are prepared for each department becomes
easier to determine the weak points and the sources of waste of time, money and
resources.

4. Coordination - budgetary control involves the participation of a master budget,

which helps in bringing effective coordination among different departments of a
business enterprise in the organisation. It force the executive to make plans as a group
in the organisation. Delays involved in the red tapism and discussing matters with one
another sets procedural wrangles aside.

5. Communication - A budget is an effective means of communication between the

top-level management and the operative level. Generally, these budgets become an
important source of information regarding policies to be implemented in the
attainment of organizational goals. It brings clarity to the middle and lower levels of
management regarding the policies to be pursued.

6. Responsibility - a budget assigns managers the responsibility for the use of

designated financial resources to achieve their assigned operational objectives. The
budget is a tool by which managers compare costs and benefits of activities and select
options that allocate resources appropriately.

7. Motivation - if employees have actively participated in budget preparation and if

they are convinced that their personal interests are closely associated with the success
of organiza-tional plan, budgets provide motivation in the form of goals to be
achieved. The budgets will motivate the workers, depends purely on how the workers
have been mentally and physically involved with the process of budgeting.

8. Increase in efficiency - budgetary controls lay down the standards of production,

sales, costs and overheads taking into consideration various internal and external
factors. This compels and stimulates every department to attain maximum efficiency
over the use of men, machine, material, methods and money.

9. Determination of Policies - business policies are determined through budgetary

control, which shows the path for the future growth of the organisation, with this, the
organization can draw long range plans and policies with a fair measure of accuracy.
 10. Deviations - Ascertainments of deviations are essential to fix responsibility and
correct the deviations as far as possible. Creating a spirit of careful forethought,
assessment of what is possible and an attempt to achieve it.

Significance:
The role of budget and budgetary control has become a very vital financial control mechanism
and accountability device in the public sector and provide a formal basis for monitoring the
progress of organization as well as in the economy.

A budgetary control is a mechanism that helps senior managers ensure that spending limits are
adequate. This control is important because spending excesses have an unfavorable impact on
corporate profits. It facilitates organisation ‘control by exception’. It helps in focusing the time
and effort of the managers upon areas, which are most important for the survival of the
organisation.

It is a very effective tool to maintain financial discipline and ensure adherence to fiscal
principles. Through effective budgetary controls, which also imply vigorous planning exercise,
the organisation can ensure greater compliance with budget and financial resources management
accountability requirements.

Budgetary control within the private and public sector is an effective mechanism, the processes
of which are clearly laid out in the FRR 2001. Budgetary control or budget cycle goes through
various stages such as budget notification, budget preparation, budget approval, budget release
and execution, budget accountability, reporting and auditing.
Financial Leverage
INTRODUCTION:

A company needs financial capital to operate its business. For most companies, financial capital
is raised by issuing debt securities and by selling common stock.

Capital structure is one of the significant things for the management, since it influences the debt
equity mix of the business concern, which affects the shareholder’s return and risk. Hence,
deciding the debt-equity mix plays a major role in the part of the value of the company and
market value of the shares.

The debt equity mix of the company can be examined with the help of leverage.

LEVERAGE

Refers to furnish the ability to use fixed cost assets or funds to increase the return to
its shareholders.

James Horne has defined leverage as, “the employment of an asset or fund for which the firm
pays a fixed cost or fixed return”.

LEVERAGE RATIOS

• Used to determine the relative level of debt load that a business has incurred.
• These ratios compare the total debt obligation to either the assets or equity of a
business.

A high ratio indicates that a business may have incurred a higher level of debt than it can be
reasonably expected to service with ongoing cash flows.

Types of Leverage
The company may use finance leverage operating leverage, to increase the EBIT and EPS.

Earnings Before Income Tax (EBIT) – operating

earnings, operating profit, profit before interest and
taxes.

It is used to analyze the performance of

company’s core operations without the
costs of the capital structure and tax
expenses impacting profit

Earnings Per Share (EPS)

• Indicates how much money a company makes for each share of its stock and is
widely used metric for corporate profit.
• A higher EPS means more value because investors will pay more for a company
with higher profits

FINANCIAL LEVERAGE (Trading on Equity)

Leverage activities with financing activities is called financial leverage.

• It represents the relationship between the company’s earnings before interest and
taxes (EBIT) or operating profit and the earning available to equity shareholders.

DEFINITION:

 The ability of a firm to use fixed financial charges to magnify the effects of
changes in EBIT on the earnings per share.
 It involves the use of funds obtained at a fixed cost in the hope of increasing the
return to the shareholders.
 The use of long-term fixed interest bearing debt and preference share capital
along with share capital.
 Extent or proportion of the increase in profits as a result of the use of the money
of others in the business of the firm.
Financial leverage may be favourable or unfavourable depends upon the use of fixed cost
funds.

Favourable financial leverage (POSITIVE FINANCIAL LEVERAGE)

• When the company earns more on the assets purchased with the funds, then the fixed
cost of their use.

Unfavourable financial leverage (NEGATIVE FINANCIAL LEVERAGE)

• When the company does not earn as much as the funds cost.

Financial leverage can be calculated with the help of the following formula:
EXAMPLE:

A Company has the following capital structure:

Understanding Financial Leverage

 The borrower must have the capacity to make payments to avoid repossession.
 The leverage depends on the value of the underlying asset.
 If the asset gains value, leverage magnifies the potential profit on the property, but if the
asset loses value, leverage reduces the returns on investment. Leverage becomes
unfavorable if these two conditions are not present.

The late 1980s saw the abuse of leverage when the management of several companies, goaded on by
investors and low interest rates, took far more debts than they could repay to finance expansion and
acquisitions.

Many of these companies, including Orion Pictures, Live Entertainment, Carolco, New World
Pictures, and Cannon Group ended up filing for bankruptcy when they could not repay their toxic loans.
Most of these companies, many of which are from Hollywood, forgot that they still had to repay their
debts even if the projects they financed with the funds failed.

To use leverage successfully, a company must use realistic projections, sound management decisions,
common sense, and an unbiased appraisal of the risks.

Alternative Definition of Financial Leverage

According to Gitmar, “financial leverage is the ability of a firm to use fixed financial changes to
magnify the effects of change in EBIT and EPS”.

FUNCTIONS

Financial leverage helps to examine the relationship between EBIT and EPS.

1. Financial leverage measures the percentage of change in taxable income to the

percentage change in EBIT.
2. Financial leverage locates the correct profitable financial decision regarding capital
structure of the company.
3. Important devices which is used to measure the fixed cost proportion with the total
capital of the company.
4. If the firm acquires fixed cost funds at a higher cost, then the earnings from those
assets, the earning per share and return on equity capital will decrease.
EXAMPLE:

The earnings before interest and tax are assumed at Rs. 5,000. The tax rate is 50 %. Calculate the
EPS.

Degree of Financial Leverage

• The percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent
change in operating profit.

EXAMPLE:

If a company earned $500,000 before paying interest expenses and taxes and the company pays
interest expenses during the period equal to $40,000,
DFL = $500,000/($500,000 - $40,000)

DFL = 1.087

Interpreting Results

When DFL is greater than one, the company has financial leverage.

• Companies with greater DFLs usually have higher fixed financial costs than companies
with lower DFLs.
• Companies with low DFLs can minimize their losses when sales are low because most of
their expenses are variable and depend on the amount of sales they make.
• On the other hand, companies with high DFLs must generate more income during a
period to break even because they must pay more fixed financial costs.

SIGNIFICANCE OF FINANCIAL LEVERAGE

Financial Leverage provides the following benefits for businesses:

 Leverage is an essential tool a company's management can use to make the best financing
and investment decisions.
 It provides a variety of financing sources by which the firm can achieve its target
earnings.
 Leverage is also an important technique in investing as it helps companies set a threshold
for the expansion of business operations. For example, it can be used to recommend
restrictions on business expansion once projected return on additional investment is
lower than cost of debt.

SUMMARY:

Financial leverage is associated with financing investment activities of the company.

Financial leverage consists of operating profit of the company.

It represents the relationship between EBIT and EPS.

A percentage change in taxable profit is the result of percentage change in EBI.

Trading on equity is possible only when the company uses financial leverage.

Financial leverage depends upon operating profits.

Financial leverage will change due to tax rate and interest rate.
 OPERATING LEVERAGE

Written By: Roxas, Jason

Operating leverage is a cost-accounting formula that measures the degree to which a firm or
project can increase operating income by increasing revenue. A business that generates sales
with a high gross margin and low variable costs has high operating leverage. It is used to
measure what percentage of total costs are made up of fixed costs and variable costs in an effort
to calculate how well a company uses its fixed costs to generate profits.

The higher the degree of operating leverage, the greater the potential danger from forecasting
risk, in which a relatively small error in forecasting sales can be magnified into large errors in
cash flow projections.

Operating Leverage describes the effects that fixed costs have on changes in operating income
as changes occur in units sold and hence in contribution margin.

Formula for Operating Leverage

The formula for Operating Leverage is as follows:

Which, can be derived as:

Whereas:
Q = Unit quantity
CM = Contribution margin (price - variable cost per unit)

F.O.C. = Fixed Operating Cost

Important Key Points

 Operating leverage is a measure of how much debt a company uses to finance its
ongoing operations.
 High-operating-leverage companies must cover a larger amount of fixed costs each
month regardless of whether they sell any units of product.
 Low-operating-leverage companies may have high costs that vary directly with their
sales but have lower fixed costs to cover each month.

Calculating Operating Leverage

For example, Wonder Company sells 500,000 products for a unit price of $6 each. The
company’s fixed costs are $800,000. It costs $0.05 in variable costs per unit to make each
product.

Based on the given problem, we can say that our:

Q = 500,000
CM = (6 – 0.05)
F.O.C. = 800,000
By applying our given to the formula, we can get:
Significance of Operating Leverage

The Operating Leverage formula is used to calculate a company’s breakeven point and help set
appropriate selling prices to cover all costs and generate a profit. The formula above can reveal
how well a company is using its fixed-cost items.

Based on the computation above, if Wonder Company has an increase in revenue of 20%, their
operating income would increase as well, with a percentage of 27.4%. (.20 x 1.37) (100)

One conclusion a company can be drawn from examining operating leverage is that firms that
minimize fixed costs can increase their profits without making any changes to the selling price,
contribution margin or the number of units they sell.

Example of Operating Leverage

Most of Microsoft’s costs are fixed, such as expenses for upfront development and marketing.
With each dollar in sales earned beyond the break-even point, the company makes a profit, but
Microsoft has high operating leverage.

Conversely, Walmart retail stores have low fixed costs and large variable costs, especially for
merchandise. Because Walmart sells a huge volume of items and pays upfront for each unit it
sells, its cost of goods sold increases as sales increase. Because of this, Walmart stores have low
operating leverage.

High and Low Operating Leverage

It is important to compare operating leverage between companies in the same industry, as some
industries have higher fixed costs than others. The concept of a high or low ratio is then more
clearly defined.

Most of a company’s costs are fixed costs that recur each month, such as rent, regardless of sales
volume. As long as a business earns a substantial profit on each sale and sustains adequate sales
volume, fixed costs are covered, and profits are earned.
Other company costs are variable costs that are only incurred when sales occur. This includes
labor to assemble products and the cost of raw materials used to make products. Some companies
earn less profit on each sale but can have a lower sales volume and still generate enough to cover
fixed costs.

For example, a software business has greater fixed costs in developers’ salaries and lower
variable costs in software sales. As such, the business has high operating leverage. In contrast,
a computer consulting firm charges its clients hourly and doesn't need expensive office space
because its consultants work in clients' offices. This results in variable consultant wages and low
fixed operating costs. The business thus has low operating leverage.
Contribution Margin
The contribution margin can be stated on a gross or per-unit basis. It represents the
incremental money generated for each product/unit sold after deducting the variable portion of
the firm's costs.

The contribution margin is computed as the selling price per unit, minus the variable cost
per unit. It provides one way to show the profit potential of a particular product offered by a
company and shows the portion of sales that helps to cover the company's fixed costs. Any
remaining revenue left after covering fixed costs is the profit generated.

The Formula for Contribution Margin

The contribution margin is computed as the difference between the sale price of a product and
the variable costs associated with its production and sales process.

Contribution Margin = Sales Revenue – Variable Costs

The above formula is also used as a ratio, to arrive at an answer in percentage terms, as follows:

Contribution Margin Ratio = (Sales Revenue – Variable Costs) / Sales Revenue

Significance of Contribution Margin

Contribution margin is a product’s price minus all associated variable costs, resulting in
the incremental profit earned for each unit sold. The total contribution margin generated by an
entity represents the total earnings available to pay for fixed expenses and to generate a profit.
The contribution margin concept is useful for deciding whether to allow a lower price in special
pricing situations. If the contribution margin at a particular price point is excessively low or
negative, it would be unwise to continue selling a product at that price. It is also useful for
determining the profits that will arise from various sales levels (see the example). Further, the
concept can be used to decide which of several products to sell if they use a common bottleneck
resource, so that the product with the highest contribution margin is given preference.

The contribution margin concept can be applied throughout a business, for individual
products, product lines, profit centers, subsidiaries, distribution channels, sales by customer, and
for an entire business.

To determine the contribution margin, subtract all variable costs of a product from its
revenues, and divide by its net revenue. Product variable costs typically include, at a minimum,
the costs of direct materials and sales commissions. The calculation is:
 (Net product revenue - Product variable costs) ÷ Product revenue

For example, the Iverson Drum Company sells drum sets to high schools. In the most
recent period, it sold $1,000,000 of drum sets that had related variable costs of $400,000. Iverson
had $660,000 of fixed costs during the period, resulting in a loss of $60,000.

Revenue $ 1,000,000

Variable expenses 400,000

Contribution margin 600,000

Fixed expenses 660,000

Net loss ($60,000)

Iverson’s contribution margin is 60%, so if it wants to break even, it needs to either

reduce its fixed expenses by $60,000 or increase its sales by $100,000 (calculated as $60,000
loss divided by 60% contribution margin).

When using this measurement, be aware that the contribution margin does not account for
the impact of a product on the bottleneck operation of a company. A low contribution margin
may be entirely acceptable, as long as it requires little or no processing time by the bottleneck
operation.

Function of Contribution Margin

The contribution margin is the foundation for break-even analysis used in the overall cost
and sales price planning for products. The contribution margin helps to separate out the fixed
cost and profit components coming from product sales and can be used to determine the selling
price range of a product, the profit levels that can be expected from the sales, and structure sales
commissions paid to sales team members, distributors or commission agents.

Fixed Cost Versus Variable Cost

One-time costs for items such as machinery are a typical example of a fixed cost, that
stays the same regardless of the number of units sold, although it becomes a smaller percentage
of each unit's cost as the number of units sold increases. Other examples include services and
utilities that may come at a fixed cost and do not have an impact on the number of units
produced or sold. For example, if the government offers unlimited electricity at a fixed monthly
cost of $100, then manufacturing ten units or 10,000 units will have the same fixed cost towards
electricity.
 Another example of fixed cost is a website hosting provider that offers unlimited hosting
space to its clients at a fixed cost. Whether the client puts one or ten websites, and whether the
client uses 100 MB or 2 GB of hosting space, the hosting cost remains the same. In these kinds
of scenarios, electricity and web-hosting cost(s) will not be considered in the contribution margin
formula as it represents a fixed cost. Fixed monthly rents or salaries paid to administrative staff
also fall in the fixed cost category.

However, if the same electricity cost increases in proportion to the consumption, and the
web-host charges increase on the basis of the number of sites hosted and the space consumed,
then the costs will be considered as variable costs. Similarly, wages paid to employees who are
getting paid based on the number of units they manufacture (or any of its variations) are variable
costs. Each such item will be considered for contribution margin calculations.

Fixed costs are often considered as sunk costs that once spent cannot be recovered. These
cost components should not be considered while taking decisions about cost analysis or
profitability measures.
Time value of money (TVM)

DEFINITION

 is the concept that money you have now is worth more than the identical sum in the
future due to its potential earning capacity.
 This core principle of finance holds that provided money can earn interest, any amount of
money is worth more the sooner it is received.
 TVM is also sometimes referred to as present discounted value.
o Further illustrating the rational investor's preference
 Assume you have the option to choose between receiving $10,000 now
versus $10,000 in two years. It's reasonable to assume most people would
choose the first option. Despite the equal value at the time of
disbursement, receiving the $10,000 today has more value and utility to
the beneficiary than receiving it in the future due to the opportunity costs
associated with the wait. Such opportunity costs could include the
potential gain on interest were that money received today and held in a
savings account for two years.
o Time Value of Money Formula
Future value (FV) is the value of a current asset at a future date based on an
assumed rate of growth. The future value (FV) is important to investors and
financial planners as they use it to estimate how much an investment made today
will be worth in the future.

 Present Value of Future Money Formula

Present value (PV) is the current value of a future sum of money or stream of
cash flows given a specified rate of return.
An alternate equation would be:

 Net Present Value Example

Net present value (NPV) is the difference between the present value of cash
inflows and the present value of cash outflows over a period of time. NPV is used
in capital budgeting and investment planning to analyze the profitability of a
projected investment or project.

Below is an illustration of what the Net Present Value of a series of cash flows
looks like. As you can see, the Future Value of cash flows are listed across the top
of the diagram and the Present Value of cash flows are shown in blue bars along
the bottom of the diagram.
  Examples
o Assume a sum of $10,000 is invested for one year at 10% interest. The
future value of that money is:
FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000

o The formula can also be rearranged to find the value of the future sum in
present day dollars. For example, the value of $5,000 one year from today,
compounded at 7% interest, is:
PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) = $4,673

FUNCTION

The function of time value of money given the below:

1. Calculation of present value and future value

 we can calculate the future value of present amount and present value of the
future cash flow.

2. Determination of interest
 the interest rate of loan and deposits are determined under the concept of time
value of money.

3. Calculation of installment
 the loan is repaid at present and deposit is accumulating in future at installment
basis.

4. Determination of time period

 By time value of money, we can find the time period of certain amount at a fixed
rate of interest.
 5. Valuation of financial securities
 the process of present value that links risk and return sermons the worth of
financial securities.

6. Project appraisal
 to choice and accept the best project the time value would be helpful.

7. Decision making
 the recognition of the time value of money is extremely vital in financial decision
making.

Time value of money is a widely used concept in the:

 Literature of finance.
 Financial decision models based on finance theories basically deal with the
maximization of the economic welfare of shareholders.
 A fundamental idea in finance that money that one has now is worth more than
money one will receive in the future.

SIGNIFICANCE

The concept of time value of money contributes to this aspect to a greater extent. The
significance of the concept of time value of money could be stated as below:
 Investment Decision
o The investment decision is concerned with the allocation of capital into
long-term investment projects. The cash flow from long-term investment
occurs at a different point in time in the future. In other words, investment
decisions are concerned with the question of whether adding to capital
assets today will increase the revenues of tomorrow to cover costs. They
are not comparable to each other and against the cost of the project spent
at present. To make them comparable, the future cash flows are discounted
back to present value. As such investment decisions are concerned with
 the choice of acquiring real assets over the time period in a productive
process.

o The concept of time value of money is useful to securities investors. They

use valuation models while making an investment in securities such as
stock and bonds. These security valuation models consider the time value
of cash flows from securities.
 Financing Decision
o Financing decision is concerned with designing optimum capital structure
and raising funds from the least cost sources. The concept of time value of
money is equally useful in financing decision, especially when we deal
with comparing the cost of different sources of financing. It is concerned
with the borrowing and allocation of funds required for the investment
decisions. The effective rate of interest of each source of financing is
calculated based on the time value of money concept. Similarly, in leasing
versus buying decision, we calculate the present value of the cost of
leasing and the cost of buying. The present value of costs of two
alternatives is compared against each other to decide on an appropriate
source of financing. The objective of financial decision is to maintain an
optimum capital structure, i.e. a proper mix of debt and equity, to ensure
the trade-off between the risk and return to the shareholders.
o Besides, the concept of time value of money is also used in evaluating
proposed credit policies and the firm’s efficiency in managing cash
collection under current assets management.

 Capital budgeting decisions

o The time value of money is important in capital budgeting decisions
because it allows small-business owners to adjust cash flows for the
passage of time. This process, known as discounting to present value,
allows for the preference of dollars received today over dollars received
tomorrow. Understanding some common capital budgeting techniques that
 use the time value of money can help you understand why this concept is
so important in capital budgeting decisions.

 The time value of money is important because it allows investors to make a more
informed decision about what to do with their money. The TVM can help you
understand which option may be best based on interest, inflation, risk and return.
It can also be used to help you understand how much money to save in an account
if you have a certain goal in mind.
Distribution of Work:

1. Financial Planning - Cabahug and Relator

2. Budgeting – De Leon and Risha

3. Budgetary Control - Vargas

4. Financial Leverage - Caballero

5. Operating Leverage - Roxas

6. Contribution Margin - Cristobal

7. Time Value of Money- Guiang and Quilatan