FINANCIAL EVALUATION INNOVATION AND NEW PRODUCT DEVELOPMENT - PowerPoint PPT Presentation

FINANCIAL EVALUATION INNOVATION AND NEW PRODUCT DEVELOPMENT

FINANCIAL EVALUATION Our topic includes;  Break-Even Analysis  Profit-Loss Analysis  İncremental Cash Flow  Risk Analysis

BREAK-EVEN ANALYSIS One of the most common tools used in evaluating the economic feasibility of  a new enterprise or product is the break-even analysis. The break-even point is the point at which revenue is exactly equal to costs. At this point, no profit is made and no losses are incurred. Break-even analysis is a simple and valuable forecasting technique. Business  can use break-even analysis to: estimate the levels of output they need to produce and sell to make an acceptable return on the time, Money and resources they have risked assess the impact of price changes on profit and sales assess how changes in costs impact on profits determine their margine of safety and what changes in levels of demand they can survive

BREAK-EVEN ANALYSIS  Break-even analysis is based on categorizing production costs between those which are: Fixed Cost and Variable Cost .

BREAK-EVEN ANALYSIS  Calculate break-even point numerically, a business needs to know: the level of fixed costs the selling price per unit the variable costs per unit contribution per unit= selling price (per unit) minus variable cost (per unit)

BREAK-EVEN ANALYSIS  For example; B.E.P is explained in the following example, the case of Best LTD. This company produces and sells quality pens. Its fixed costs amount to 400,000 approximately, whereas each pen costs 12 to be produced. The company sells its products at the price of 20 each.

ACTIVITY TIME

ACTIVITY TIME  There is a simple relationship between break-even and profit. If total output and sales are greater than break-even, then revenue is greater tham cost: thre business makes a profit. If total output and sales are equal to break-even, then revenue equals total costs: the business breaks even. If total output and sales are less than break-even, then revenue is less than total cost: the business makes a loss

CONSTRUCTING BREAK-EVEN CHART  Company A produces tablets. And, each tablet is sold for $500. And cost of producing per tablet is $275. And fixed cost is $12,000.

ANALYSING BREAK-EVEN CHART Break-even level of output: The point at which the total cost line crosses the  total revenue line is the break-even point. Reading down from this point can be seen that, to break even, 54 tablets must be sold. Level of profit or loss at each level of output: At levels of output below 54,  total costs are greater than total revenue, so the business is maling a loss.The level of loss is represented by the vertical distance between the two lines. The amount of loss can be read off the vertical scale. The level of profit can be found at levels of output above 54 tablets. Margin of safety: The number of units currently being produced above the  break-even level is called the margin of safety. For example; if Company A were to produce 100 tablets, the margin of safety would be : Current output - Break-even output = Margin of safety 100 units 54 units 46 units

THE EFFECTS OF CHANGING COSTS AND REVENUES ON BREAK-EVEN OUTPUT Change Impact on Break-Even Fixed or variable cost rise Total costs also rise, so more units have to be sold to cover costs. The number of units needed to break even increases. Fixed or variable costs fall Total costs also fall, so fewer units have to be sold to cover cost. The number of units needed to break- even falls. Each unit produces more revenue, so costs are Sales price rises covered more quickly. The break-even number of units decreases. Sales price falls Each unit sold earns less revenue, so it takes more units to cover costs. The break-even output point increases.

PROFIT AND LOSS ANALYSIS  The profit and loss account is a component part of the financial situations of any economic entity which synthesizes at the highest level the whole activity developed during the financial year permitting immediate comparisons at least with the indicators achieved during the previous year.  The profit and loss account presents a processing and systematization of all income and expenses recorded during the current financial year. The profit and loss account is the financial situation which measures the success and performance of a firm’s activity referring to the given period.

PROFIT-LOSS ANALYSIS  A Profit and Loss (P&L) statement measures a company’s sales and expenses during a specified period of time. The function of a P&L statement is to total all sources of revenue and subtract all expenses related to the revenue. It shows a company’s financial progress during the time period being examined.

PROFIT-LOSS ANALYSIS One reason is the P&L statement  There are two reasons to prepare a P&L statement. answers the question , “ Am I making any money ?” It is a valuable tool to monitor operations. The second reason to prepare a P&L statement is because it is required by the IRS.

PROFIT-LOSS ANALYSIS  Reading a P&L is the easiest way to tell if a business has made a profit or loss during a given month or year. The most important figure it contains is net profit — this is what is left over after expenses and taxes have been paid.

PROFIT-LOSS ANALYSIS  Companies typically issue P&Ls monthly. It's customary for the reports to include year to date figures, as well as corresponding year-earlier figures to make comparisons and analysis easier.

HOW TO PREPARE A P&L STATEMENT? The data items that you must be able to provide to construct a P&L statement are: Cost of Net Sales Goods Sold Selling and Other Income Administrative and Other Expenses Expense

HOW TO PREPARE A P&L STATEMENT? Net Sales • Net sales are the total sales during the time period being analyzed minus any allowances for returns and trade discounts. Cost of Goods Sold • Cost of goods sold is also called the cost of sales. For retailers and wholesalers it is the total price paid for the products sold during the accounting period. It is just the price of the goods. It does not include selling or administrative expenses .

HOW TO PREPARE A P&L STATEMENT? Selling and Administrative Expenses • Selling expenses are expenses incurred directly and indirectly in making sales. They include salespeople’s salaries, sales office costs, commissions, advertising, warehousing and shipping • Administrative expenses are operating expenses not directly associated with the sale of goods. Administrative expenses are commonly considered “overhead” expenses, and include rent, utilities, telephone, travel and supplies.

HOW TO PREPARE A P&L STATEMENT? Other Income and Other Expense • These are line items for any unusual income or expense items not directly related to the operations of the business. • Other income includes income from interest, dividends,rents, royalties and gains from the sale of capital assets. Other expenses is a line item to record any unexpected losses unrelated to the normal course of business.

INCREMENTAL CASH FLOW  Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project.

POSITIVE INCREMENTAL CASH FLOW  A positive incremental cash flow means that the company's cash flow will increase with the acceptance of the project. A positive incremental cash flow is a good indication that an organization should spend some time and money investing in the project.

EXAMPLE OF INCREMENTAL CASH FLOW  ABC International owns a machine that can manufacture 2,000 units per hour. An equipment upgrade can change the maximum capacity of the machine to 3,000 units per hour, which is an incremental increase of 1,000 units. The cost of this upgrade is $200,000, and the profit derived from each unit is $0.10. The machine is currently operated for 40 hours per week.

EXAMPLE OF INCREMENTAL CASH FLOW  (1,000 units per hour) x $0.10 = $100 per hour incremental cash inflow  = ($100 per hour of cash inflow) x (40 hours per week) x (52 weeks per year)  = $208,000

EXAMPLE OF INCREMENTAL CASH FLOW  So the contemplated increase in capacity will yield a net incremental cash flow increase per year of $208,000  The incremental change in cash flow represents a payback period of just over 1 year, which is highly acceptable as long as the upgraded equipment can be expected to operate for longer than the payback period.

EXAMPLE OF INCREMENTAL CASH FLOW  An alternative way to look at the sample situation is to avoid the $200,000 equipment upgrade and instead run the existing equipment for an additional shift. For example, if two machine operators can be paid $15 per hour to run the machine for an extra shift, this cost is only $62,400 per year, versus incremental cash receipts of $208,000. This alternative is considerably less expensive than the equipment upgrade option, on an incremental cash flow basis.

INCREMENTAL CASH FLOW Sunk Cost;  is a cost we have already paid or have already incurred the liability to pay. Such a cost cannot be changed by the decision today to accept or reject a project. Put another way, the firm will have to pay this cost no matter what. Based on our general definition of incremental cash flow, such a cost is clearly not relevant to the decision at hand