Opportunity costs are profits of the best alternative (costs/profits we never incur) Multiple Product Finacial Modeling

Sunk costs are costs that have already been incurred and cannot be ameliorated by any  When a firm has multiple products, several alternatives are available to
means facilitate financial modeling

Variable costs( VC)are those costs that vary in total with changes in a cost driver, fixed Steps:
cost do not
1) Assume a weighted-average contribution margin
Direct costs can be traced to a specific cost object, indirect cannot a. To determine breakeven units, use the following formula:
FC/CM
Variable and fixed costs (direct and indirect) show up financial statements , b. Weighted average Contribution= CM per unit A* A’s sales
opportunity cost do not mix% (physical units)+ CM per unit of B* B’s sales mix%(in
terms of physical units)
Relevant Costs are expected future costs that differ among different courses of action. 2) Assume all products have the sales contribution margin
a. This can be accomplished by grouping products so they have
Incremental Costs are the differences in the total costs between two or more
equal or near equal CM
alternatives
b. This approach can be a problem when the products have
Types of Decisions substantially different CM
3) Use sales dollars as measure of volume
1) Acceptance or rejection of a special order a. B/E Sales Dollars= FC/ Weighted Average CM Ratio
2) Make or buy b. Weighted Average CM Ratio= Weighted Average CM/
3) Sell or process further Weighted Average Price= Total Cm/Total Sales Revenue
4) Add or drop a certain product line 4) Treat each product line as a separate entity
5) Utilization of scare resources a. Requires allocating indirect costs to product lines
b. To the extent allocations are arbitrary, may lead to inaccurate
Steps estimates

1) Gather all costs associated with each alternative Cost and revenue behavior is linear throughout the relevant range
2) Drop sunk costs
3) Drop those costs which do not differ between alternatives TIPS:
4) Select the best alternative based on the remaining data
GOD IS WITH YOU!!
Important Equations:
READ CAREFULLY!!!!
 Contribution Margin(CM)= Revenue – All VC
 Gross Margin(GM)+ Revenues-COGS
 CM per unit is the contribution from each unit sold to: first cover fixed cost
and then earn a profit

Steps for Maximizing Use of the Bottleneck

1) Identify bottleneck resource

2) Rank products based on profit generated per unit of the bottleneck resource
a. Find the Ranking by looking at the greatest CM per hour/min for
each product
3) Produce the highest ranked products
a. Use this to look for the optimal bundle and production plan

Financial Modeling

Financial Model is a quantitative framework with explicit causal assumptions about the
value generation process

Common saying: ‘Garbage in, garbage out’ (GIGO

A cost-volume-profit (CVP) financial model is one of the simplest financial models,

and summarizes the effects of volume changes on a firm’s costs, revenues, and income,
typically assuming piecewise linear costs and revenues:

 Rev=Q*p
 Cost= FC + Q8vc
 Inc.= Rev-cost= Q8p- (FC+ Q*vc)= Q*CM- FC

Breakeven Equations:

 Sales Revenue- VC- FC= Operating Profit

 (Sale Price-VC)* Q – FC = Operating Profit\
 Sales Dollars= FC/ CM Ratio
 QB/E= (FC + Profit)/ CM
 CM Ratio= CM/ Sales Price
 Profit in Sales Dollars= (FC+ Target Profit)/ CM Ratio

Margin of Safety- excess of projected sales unites over breakeven sales level,
calculated as follows:
Sales Unit-B/E Quantity= Margin of Safety

Step costs can be factored into CVP analysis

Operating Leverage refers to the extent to which the cost structure of an organization
has fixed versus variable costs

The higher the relative amount of FC, the higher the operating leverage, and therefore
the greater the sensitivity of operating income to the changes in sales volume.