Cost and Profit Planning

By : Solomon Blay
Introduction
• This lecture is focuses on two analytical tools for determining the cost and pro t
performance of the company.
• This chapter will be devided into three sections:

• Basic Planning Concept - outlines a typical nancial planning process, the

planning variables, types of decisions and bene t of planning

• Break-even Analysis - presents a fundamental tool for assessing likely cost

and pro ts at di erent levels of business volume. It discusses techniques for
determining xed and variable costs. It cautions analysts on the limitations of
break-even analysis in cash planning for a company

• Leverage Analysis - Discusses a tool for assessing the implications of the

level of xed costs and use of debt on the earnings of a company’s
stockholders. It introduces the concept of operation leverage and nancial
leverage. Total leverage is the combination of the two concepts.
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1. BASIC PLANNING CONCEPT

Planning is one of the key functions of managers. It involves thinking out the possible
consequences of decisions. It requires a company to have a clear idea of where it wants to be
in the future. A company will not achieve its goals if it is unprepared to face unfavorable
conditions in the future.

By understanding basic planning concepts, a manager could improve the quality of his
planning outputs. These concepts are:

a. the planning process,

b. planning variables,

c. types of decisions

d. bene ts of planning

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a. The Planning Process
A Plan is a manager’s proposal on how to achieve an intended result

The planning process starts with the setting of an overall goal that will guide all
components of the plan. Stockholders, represented by the board or the chief
executive o cer, set goals. Maximizing the stock price, ensuring a return on equity
and sales growth are just some of the goals set by stockholders.

In this way, plans start in a "top-down" manner.

Given the goals, operating managers, including the nance manager, prepare the
strategies that will enable them to support those goals. Each operating manager is in
charge of a speci c area whose results are expected to contribute to achievement of
the goals. A plan is a manager's proposal to achieve the intended result. The
organization ensures that work is divided to enable each manager to plan and control
a speci c area and that the divided work is coordinated by higher level managers
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 Operating managers lay out detailed plans for the business. The chief operating
o cer coordinates the plans of operating managers. The chief executive o cer
(CEO) reviews the plan. If any aspect of the plan is not acceptable, the CEO sends
it back to the operating managers for revision. A plan may not be acceptable to
higher management for various reasons, some of which are as follows

• The plan is based on strategies that are too di cult to implement or risky to
implement.

• The company could not raise the funds required to implement the plan.

• The likely result of the operating plan falls short of the overall corporate goal.

In the revision stage, operating managers conduct re-planning activities to address

issues raised by the CEO. The plan, once approved, would guide the company's
future decisions and operations.

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b. Planning Variables

An operating manager prepares plans based on his expectations about future

conditions. These variables in the planning process are classi ed according to their
nature and controlment by the manager, as follows:

a) External or internal variables

b) Noncontrollable or controllable variables

External variables are factors that are a part of the environment of the company. The
success of strategies depends on the conditions that exist in the environment.
Examples of external factors are the economy, interest rates, foreign exchange
rates, industry and technology and an operating manager should understand the
external variables faced by the company and should estimate the likely impact of
each major environment variable on his/her plan.

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External factors could make plans a
risky proposition. With risk comes the
possibility that actual results may
deviate from the plan. All plans carry
some risk because companies
operate in an industry and in an
economy. A manager partly addresses
risk by spreading his projects in
several areas. Any remaining risk is
unavoidable.
some internal problems that prevent
Internal variables are factors that are
within the in uence of the company.
manager addresses these concerns
Examples of internal variables are the
level of inventory, customer credit
policy. volume of production, and
amount of debt nancing.
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While management can control
internal factors, there are other
internal problems that could hamper
the attainment ofplans. Many
companies are so large and
complicated that it is di cult to
coordinate managers and their
operations. Some units may be
working at cross purposes. There are
the coordination of operations, for
example, poor information systems. A
by improving his decision making,
support systems and coordination
with other managers
Noncontrollable variables refer to those factors not within the company's
control. Most external factors are not controllable by a company. In the
Philippines, howeker, companies can in uence some external factors. For
example, companies can try to in uence the government's trade, investment
and incentives policies, especially when the latter consults with the former on
these issues. By collectively taking a position on issues, companies can
somehow in uence government policies and, thus, their external environment.
At the same time, some internal factors may be non-controllable. For example, a
company may nd its production capacity being constrained by an old
technology, so much so that managers could not increase production or shift to
new products

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Controllable variables are those factors within the company's
control. Most of the internal variables are controllable. The
degree of control by a manager depends on his position in the
organization. What is controllable to a production manager may
not be controllable to a plant manager.
 Type of Decisions
The key performance variables that are within the control of operating managers involve three decisions:

(a) the volume of sales or business activity.

(b) the sources of nancing, and

(c) the investment in xed assets.

The sales volume will determine the level of activity of a company.

Management gears the company's resources to meet the target sales volume, as well as plans the production of
goods or capacities to o er the service corresponding to the desired sales volume. Management answers such
questions as:

-What should the volume of production be?

-How much should be invested in xed assets?

-What credit terms should be given to customers?

-How much inventory should be kept as stock?

-How many employees should be hired?

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 A Decisions concerning the sales volume a ect all aspects of the business. Factory operations and administration
will depend on the sales volume. The company would need new investments in xed assets for production and
marketing as sales increase. It should nd new nancing to pay for the required investments and expenditures for
operations.

nance manager plans the amount and sources of nancing, and it matters very much whether such nancing
comes from owners or from creditors. Eventually, the company will have to pay back those funds, and
management would want repayment to come from successful business opera-tions.

The nance manager balances his funding equity and debt sources in order to bene t from the features of each
source. In choosing the nancing, he resolves such questions as:

• What funds are required?

• What funding sources are available?

• How much nancing should be sought from each source?

• What compensation would funding sources require?

• Would operations be capable of supporting the required repayment of nancing?

Planning for long-term investments requires a di erent form of analysis called capital budgeting which is
discussed in Chapter 15.

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Bene ts of Planning

Plans enable management to perform the following:

a) Communicate the goal of the company and coordinate decisions from all units

b) Measure performance and provide incentives

c) Require managers to think out aspects of their future operations

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Communication and coordination. Top management announces its overall
goals at the start of the planning process. The heads of di erent units then
determine their respective goals. If there are issues regarding goals, the
planning process the main avenue for discussing and reconciling con icts
between top management and lower unit's goals. Plans focus the attention of
every manager and employee to the priorities of the company.

Coordination of decisions is made possible by plans. Every manager can see

the impact of his actions on other units and on the overall goals.Without plans,
every unit will only see the consequences of its own actions.With plans, units
can support each other, provide resources to others when needed, and move
together in the same direction for best results. This reduces con icts and builds
a satisfying professional environment.

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Incentives for performance. Plans provide a standard for measuring the
degree of actual achievement. Actual results show whether managers attained
the goals of the company as re ected in the plans. Managers gain a better
understanding of why actual performance exceeded or did not meet planned
levels. By comparing actual performance with plans, managers are able to
isolate the successful units ofthe business from the unsuccessful ones.

This also enables them to understand the underlying reasons for the company's
operating performance

A company provides incentives to successful managers based on actual

performance relative to plans which spell out a clear standard of performance.
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The di erence between actual performance and plans is a signal to a manager
that he should make further assessments. He should address this signal through
any of the following actions :

• Attend to a possible problem area

• Exploit a potential opportunity to further increase revenues or reduce costs

• Revise the plan because it is unrealistic

Comprehensive assessment. Plans show interrelationships among actions by

all key units ofthe business. Managers think out the impact oftheir actions on
the entire operations ofthe business. The planning process starts with clear
mandates on what areas are covered and which among them are critical. It ends
with top management asking the question: What can go wrong in the plans?
Planning requires a comprehensive thinking on the part of managers.
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A plan is an evidence that a company has thought out all aspects of the
business from the viewpoint of operations, organization and business functions
Operations involve purchasing, asset stewardship, production, and
merchandising. Organizational matters involve top management, lower man-
agement, and the rank and le. Business functions include operations,
administration, investment and nancing.
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 2. Break-even Analysis
Plans have nancial or non nancial elements. Non nancial plans cover
production level, personnel deployment, maintenance schedules, training, and
marketing approaches. Financial plans have to do with budgets. There are
budgets for nancial performance, nancial poStion, amount and timing of cash
ows, and xed asset expenditures. Because management monitors nancial
plans through the nancial reporting system, plans follow the nancial statement
formats, such as:

- Budgeted income statement

- Budgeted balance sheet

- Cash budget

- Capital expenditure budget

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 Break-even analysis is a technique for integrating the nancial performance and
production plans of a business. Break-even analysis shows the likely costs, revenues
and pro ts at di erent levels of production and sales. It shows the di erent levels of
operation at which the business loses money, recovers its full cost, or makes money.

The break-even point is the precise level of operation at which the business revenues
equal total costs. At the break-even point, the business earns zero pro t, hence the
name. In itself, the break-even point is not interesting to the manager of a business. It
is not an objective of the manager to achieve zero pro t. Break-even point is only a
renerence for the entire analysis. Below break-even volume, the company incurs
losses. Above the break-even point, the business enjoys pro ts. In break-even
analysis, management considers the likelihood that actual business operations will be
pro table by how much higher its volume exceeds the break-even point.
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Break-even analysis concepts vary according to these perspectives:

1) As to presentation and solution method

a) Graphical method

b) Algebraic method

2) As to cost and revenue assumption

a) Linear

b) Not linear

Graphical Method for Break-even Analysis

Break-even analysis lends itself easily to graphical analysis. The graph in this instance
could represent two lines: total cost and total revenues. The intersection of these two
lines represents the break-even point.
To use the graphical analysis, the analyst classi es costs in two, namely:

a) Fixed costs. These are costs that remain the same regardless of the level of
operation. There are numerous costs related to the setting up of production capacity
and management of the business.

Examples of xed costs are:

• Depreciation

• Rent

• Insurance

• Salaries of managers

Figure 14-1 represents total xed cost as a horizontal line at P20,000,000.

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b) Variable costs. These are costs that change with the level of operation. At the zero level
ofthe operation, variable cost is also zero. Assuming that costs are linear functions of volume,
variable costs increase in a xed proportion relative to the level ofoperation.

Examples of variable costs are:

• Wages o actory workers. • Raw materials • Sales

commissions

• Supplies • Maintenance

• Component parts • Fuel

In the graph, total variable cost per unit is P180 or a total of P18 million at 100.000 units.
Starting at the vertical axis at the xed cost level of P20 million, the total cost line is extended
to cover all levels of operation. This approach is the same as taking the sum of total xed
cost and total variable cost at each level of operation. For example, total cost is P38 million
at 100,000 units, representing total variable cost of P18 million and xed cost of P20million.
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The graph plots revenues
beginning at zero and increasing at
a rate ofP260 per unit. For
example, at 100,000 units, total
revenues are P26 million

Total revenue is a straight line

between and through these two
points beginning at zero.
The break-even point is where the total revenue line intersects
the total cost line. Its signi cant in two ways, namely:

1. Break-even point is a minimum goal.

The break-even point, which represents a volume of operation

that recovers all costs, should be the minimum goal of
management

2. The break-even point de nes the whole range of possibilities

for a business company.
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The break-even point divides the operating volume of a company in two
parts. Below the break-even point, the company incurs a loss. Above the
break-even point, the company is pro table. In the graph, pro ts are
equal to the area between the total revenues and total costs lines.
Computer spreadsheet programs can easily provide graphical
representations of the break-even point.

The graphical method is useful especially for presentations and as an

initial basis for analysis.

The break-even point is a minimum goal. It is useful as a reference in

determining the pro t possibilities for a company.
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Algebraic Method

A more precise way of analyzing the break-even point is via the

algebraic method. The analyst classi es costs into xed and
variable costs before using the algebraic method. The estimate of
the break-even point of the algebraic method would be accurate if
cost analysis were also accurate.

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The algebraic method calculates the break-even point by dividing the total xed costs by the contribution margin, as
shown in equation 14-1

14-1(a) Break-even = Fixed cost + Desired pro t.

sales (units). Contribution margin per unit

where:

Contribution margin = Selling price - variable cost per unit

The desired pro t is zero at break-even point.

14-1(b) Break-even = Fixed cost + Desired pro t.

sales (Pesos). Contribution margin percent

where:

Contribution margin percent = Sales - Variable cost.

Sales

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The mathematical logic is simple. The numerator focuses on xed cost.The goal
is to recover xed cost. The denominator says that revenues should rst recover
variable costs. The remaining revenue after recovery of the variable cost is the
contribution margin per unit. The target pro t amount is added to the xed cost.
The company requires operations to recover this amount.

The algebraic method is simple and precise compared to the graphical method.
Its disadvantage lies in its inability to show management an overall appreciation
of the potential pro ts and losses that a graphical presentation might show. It
does not help management understand whether an alternative volume of
operation is highly pro table or not. For example, if sales are 12,000 units,
would this volume represent high pro ts? Further calculations using the
algrbraic formula will give a precise answer. The graphical approach gives a
more general answer because the graph shows the slope of the total cost line in
relation to the revenue line.
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Variations on the Basic Model*

Break-even analysis is a basic model that can accommodate aspects of actual

business realities. The most common problem under actual business conditions is
determining whether costs are xed or variable in the rst place.

Many costs are neither xed nor variable. Others behave unpredictably. The following
types of costs require further analysis

1. Semi-variable costs

2. Costs with random behavior

Break-even analysis uses the results of the analysis of these costs. The analysis
involves estimates of xed and variable components oftotal costs.

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Semi-variable costs. Not all costs areeiter xed or variable. The basic break-even analysis
requires the analyst to know the total xed costs and variable costs per unit regardless of the
accounting classi cation in the nancial statements. When an analyst reviews each cost item
for classi cation into xed or variable, he will nd many cost items that are hard to classify in
either category. Examples are:

• Power

• Advertising

• Repairs

• Auditing and other professional fees

The analyst reviews each cost item and breaks it up into a xed cost component and a variable
cost component. A semi-variable cost consists of a component which is incurred regardless of
the level of operation and another that varies with volume. For example, electricity charges
consist of a xed base charge and a consumption charge. As another example, auditors' fees
consist ofa xed fee and a time charge that varies with the working hours spent.
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There are two methods ofbreaking up a semi-variable cost into its xed and
variable components, namely: the "high-and-low-point" method and the
statistical regression technique. The "high-and-low point" method derives the
variable cost element by comparing the change in cost to the change in volume
as shown in equation 14-2.

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a) Not all costs are semi-variable.

In the illustrative example, the estimate of the xed cost was at P1,128,000
while variable cost per unit was at P120 regardless of the volume of production.

In fact, the choice of the pair of points as inputs to equations 14.2 and 14.3
severely a ects the estinfated xed and variable costs estimates will be arrived .
at. It is not common to nd many examples of truly semi-variable costs.
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In most cases, the estimated amount of xed cost depends on the selection of
production volumes in the calculation of the variable cost per unit. The "high-
and-low point" method prescribes these two points in the estimate but it is not
necessarily the most accurate estimate.

b). The estimate may lead to a "negative xed cost."

The "high-and-low point" method mayresult in an estimate of a xed cost that is

a negative amount. A negative xed cost has no basis in reality. The method
aims to estimate total cost rather than xed and variable costs per se.Only the
accuracy of the forecast total cost matters. The analyst should disregard the
negative xed cost and focus on total cost.

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Costs with rand&m behavior. Many costs are not entirely within the control of
management. For these costs which behave randomly, management cannot
identify their xed and variable components. The task is to determine the total cost
using statistical analysis. The previous chapter presented the statistical regression
technique as a way of estimating total cost given the volume ofbusiness activity.

The statistical regression technique breaks up the total cost into an average xed
cost component, the alpha estimate, or the constant of the regression, and the
estimate of variable cost per unit or beta component.

(14-5). Estimated = alpha + (beta x Volume of business)

total cost

The alpha and beta correspond to statistical estimates of total xed cost and
variable cost per unit, respectively. Statistical estimates are subject to estimation
errors. The degree of t of the regression equation relative to actual historical data
cautions the analyst about the degree of accuracy of the regression estimate.
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Using a standard computer-based regression package like Lotus 1-2-3 the
statistical regression estimate is:

Total cost = 911.2 + (0.15 x Production volume)

with R 0.72, a high degree of t.

The graph of the regression estimate is shown in Figure 14.3.

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Break-even Point and Cash Position*

The break-even point formula shows an important limitation. It ignores the cash
or noncash nature of revenues and expenses. The formulas use the de nition of
revenues and expenses under accrual accounting. The implications regarding
the relationship, or lack of it, between the break-even point and the cash
position of a company are as follows:

1. When sales exceed the break-even point, cash is not necessarily generated
from operations. There are many reasons for this. Revenues may still be in the
form of accounts receivable, and expenses may have been prepaid.

2. When sales fall below the break-even point, cash is not necessarily lost in
operations. This is because some expenses do not entail the use of cash, like
depreciation, and other expenses do not have to be paid yet, like accrued taxes.

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There are cases when management wants to know whether a business can achieve a sales
level that will enable it to support its own cash requirements For example, management might
require a project to stand on its own from an income and cash ow perspective. It is tempting
to develop a "cash break-even point formula" that would respond to such a question. No such
theoretically correct formula exists. For example, it would be incorrect to estimate a "cash
break-even point" by excluding non-cash expenses in the break-even point formula. Such an
approach is incorrect and misleading because it does not completely analyze every revenue
and expense item from a cash ow prespective.

The correct approach for relating sales volume to cash position is to prepare a cash budget
using methods shown in the previous chapter. The cash budget enables the analyst to vary the
sales volume relative to the break-even point and to observe the impact on the expected cash
position of the company.Each operating cash in ow or out ow that varies with the sales level
is analyzed.
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 3. Leverage Analysis

The net income of a company is partly determined by the way its management
con gures the company's operating costs and nances operations.

Interest expense reduces income. Planning for the net pro t requires planning
for the level of xed operating costs and of debt. Operating leverage is the use
of xed costs to make operations more e cient. It magni es the sensitivity of
operating income to sales. Financial leverage is the use of debt to nance the
business. It magni es the sensitivity of net income to changes in sales. This
section analyzes the impact of the two types of leverage on the income of a
company.
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Operating Leverage

Management sets up the operations of the business. The operating setup

determines the level of xed costs relative to variable costs. Fixed costs magnify
the sensitivity of operating income to changes in sales. When a company is set-
up as a capital assets-intensive operation, its variable costs are low but its plant
costs are high. A slight increase in sales results in a large increase in operating
pro ts. The concept of operating leverage pertains to the set-up costs of a
business. Operating leverage is the ratio of a company's level of xed costs to
total costs at di erent levels of sales or activity. A company has a high operating
leverage if its costs consist mainly of xed costs.

For example, a capital-intensive plant has a high operating leverage. Another

company may choose to set up its plant as a high labor, low capital plant. Such
a company has a low operating leverage.
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The measure of operating leverage is the degree of operating leverage

(DOL). DOL is the percentage change in pro t for each percentage change in output. Equation 14-6shows the formula
for DOL

(14-6) Degree of operating = Percent change in pro t.

leverage. Percent change in output

= Contribution margin

EBIT

= Sales - total variable cost.

Sales - total variable cost - total xed costs

DOL depends on the level of output.

DOL is the counterpart of the concept of elasticity in basic economics. It measures the responsiveness of pro ts to a
change in the level of output. Since xed cost does not change with output, DOL will have values at di erent volumes
ofoutput, as follows: (a) positive above the break-even sales volume,(b) negative below the break-even sales volume,
and (c) zero at zero sales volume. DOL decreases as the volume of output increases
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Financial Leverage

The degree of nancial leverage (DFL) is the percentage change in net income for any
percentage change in income before interest and taxes. It is equal to the ratio of income before
interest and taxes to income after interest but before taxes. Equation 14.7 shows the formula for
DFL.

(14-7) Degree of Financial = Percent change in operating income

Leverage Percent change in operating income - interest expense

= EBIT

EBIT - 1

= Total contribution margin - xed cost

Total contribution margin - xed cost - interest expense

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 DFL is equal to one if the company has zero debt; it rises in proportion to
arise in the interest expense. If the ratio is negative, nancial leverage
would be so high that operating income would not be su cient to cover
the interest expenses.

The concept of nancial leverage is one of the most important in

corporate nance. Financial leverage involves the use of debt to generate
income that exceeds the cost of nancing. Such excess increases the
income of the owners of the business. DFL measures the impact of
nancial leverage on the income of the business. Such impact is in the
way debt expands the potential of the business for earnings or losses.
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The mathematical derivation of equation 14-7 is beyond the scope
of this book. Instead, an intuitive explanation of DFL is o ered

From equation 14-7, a company with zero debt has a DFL of one
because any percentage change in operating earnings will accrue
to the owners as the same percentage change in net income.
When debt nances the business, interest expenses will make a
percentage change in operating income yield a larger percentage
change in net income of the company.
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 Total Leverage

Total Leverage is the combination of the operating and nancial leverage of a

company. Operating leverage concerns the capacity of a company to recover its
xed costs without nancing costs. Financial leverage concerns the capacity of
operating income to pay for nancing expenses. The combined e ect ofthese
two factors is called the degree of total leverage (DTL), shown in equation 14-8.
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There are several interpretations regarding total leverage, as follows:

a) High degrees of operating and nancial leverage magnify the level of total leverage.

b) Toreduce leverage risk, management should reduce DOL or DFL.

c) When DOL due to production technology is high, management can reduce total
leverage by avoiding debt.

d) When DFL is high, for example, due to a shortage in equity capital, management can
reduce total leverage by avoiding xed costs.

e) If DFL is negative, total leverage is also negative. This signals the need for
management either to reduce xed cost (without reducing the contribution margin) or to
reduce debt.
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SUMMARY

Planning is one of the most important functions of a manager.

A manager plans cost and pro ts by thinking through the consequences of

future decisions, events and levels of activity of the business. A planner should
consider the impact of external and internal factors on the costs and pro ts of
the business.

External factors determine the succes or failure of management decisions. The

planner should try d predict these external factors.
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 SUMMARY

Operating, nancing or investing decisions are the responsibilities of a nance

manager. Operating and nancing decisions have an immediate e ect on costs and
pro ts. A useful tool for the analvsis of the operating decision is the break-even point
analysis.

The break-even point is the level of operations at which the company fully recovers
its operating costs. It is useful as a guide for management in controlling costs and
the business volume in order to attain its target pro ts. In applying the technique,
there is a need to segregate costs into xed and variable components.

When costs are neither xed nor variable, two techniques are suitable for segregating
costs: the "high-and-low point" method and statistical regression analysis.

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 SUMMARY

Operating leverage is the degree of importance of xed costs relative to total costs of a
company. It determines the responsiveness of operating pro ts to a change in volume.

Financial leverage has an impact on planning outputs.

Planning for the net pro t of a company requires a nance manager to plan for the level
of xed operating costs and of debt.

The concepts of operating and nancial leverage are useful in this regard. Operating
leverage is the sensitivity of operating pro ts to a change in sales. Operating leverage is
about the use of xed assets. Financial leverage is the sentivity of net income to a
company's borrowing activities. It concerns the use of debt.

Total leverage analysis shows the combined impact of operating and nancial leverage
on pro tability
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