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Presentation Transcript

Today’s Lecture

- Fixed versus Variable Costs
- Break Even Analysis
- Learn how to use the Solver in Excel

Break-Even Analysis

An important part of running a company is the determination of how the company should be financed and how the prices of the products the company sells should be set.

Clearly, in order to do this properly a sound financial analysis is necessary.

Types of costs

- It is essential to realize that there are two basic types of costs a company incurs.
- Variable Costs
- Fixed Costs
- Variable costs are roughly proportional to a company’s sales. I.e. the cost per unit remains roughly constant.
- Fixed costs remain roughly the same regardless of sales. I.e. the cost per unit is inversely proportional to sales.

Types of costs

Sales Value

Total Costs

Variable Costs

Fixed Costs

Sales

A simple graph but important to understand!

Break-Even Analysis

Commonly, the Break-even point is defined to be the level of sales where:

Revenues = Expenses

Let us have a look at a simple example.

Aunt Petunia opens a flower shop.

Break-Even Analysis

- Fixed Costs:
- Rent: 5,000
- Utilities: 300
- Helper: 1,500
- Variable Costs:
- Flowers: 40% of selling price
- So we know that:
- Selling price – cost of flowers – rent – utilities – helper = 0
- when she breaks even

Break Even Analysis

Let’s enter the last line into the spread sheet

=E6-E7-E8-E9-E10

But!!!?? I’m not a Mathematician!

How am I going to find the value for E6 so that E11 = 0?

=E6*$H$7

We learned something in the last lesson. It’s good to put the assumptions separately.

Break Even Analysis

Piece of cake! Trial and error!

Oops! Not as easy as I thought.

Especially if H7 is not a nice number like 40%.

Is there a better way?

The Solver

We could cave and write down the equation. That would, in fact not be such a bad idea since equations are really not as difficult to understand when one knows what they are supposed to mean.

But *** RELIEF *** Excel has an incredibly useful function called the solver. It will solve equations without giving it the equations!

That was close ….

The Solver

The Solver can be found in the Tools menu of Excel. If it’s not there, it can be installed by going to the “Add-ins” menu item and selecting the Solver Add-in.

This is really quite self-explanatory!

Enter the appropriate values for “Set target cell”, “Equal to” and “By changing cells”, and click Solve.

Break Even Analysis

Let try out the Solver!

The break even point is 11,333

Incredible!

Like this anyone can do Math!

An Equation

- The Solver is a fabulous tool, but really in business it is beneficial to at least be open-minded about equations.
- Let’s give it a try! We know that:
- E11=E6-E7-E8-E9-E10
- (Income = Sales – Cost – Rent – Utilities – Helper)
- At the break even point, Net Income = 0 and hence E11 = 0
- Inserting this we obtain:
- 0 = E6-E7-E8-E9-E10

An Equation

- We want to change E6 such that
- 0 = E6-E7-E8-E9-E10
- is true.
- Ah, if we just set E6 to the other values together the above equation is true. Or,
- E6 = E7+E8+E9+E10
- is the solution to our problem.
- Let’s try it and go back to the situation before we used the solver:

An Equation

May be Math isn’t as easy as I thought…

But wait, doesn’t E7 depend on E6? Yes indeed, we have defined E7 = E6 * H7 (cost of product).

Let’s put this into our equation:

E6 = E7+E8+E9+E10 => E6 = E6*H7+E8+E9+E10

Or: E6 - E6*H7 = E8+E9+E10

E6 * (1 - H7) = E8+E9+E10

E6 = (E8+E9+E10) / (1 - H7)

Break Even Analysis

Yosh! Let’s try that again.

Yatta! It works

(E8+E9+E10) / (1 - H7)

After all, this was quite easy wasn’t it?

And now we can change H7 to play out scenarios. Very useful indeed!

Break Even Analysis

If Aunt Petunia raises the price so that the cost is only 30% of sales ….

… she can break even already at 9714. Of course now she may be so expensive that no one wants to buy her flowers anymore.

The other way around

There may be times when it is betterto turn things around.

Just now, Aunt Petunia found how much she needs to sell in order to break even givencertain cost as percentage of sales. This is in general a good idea since for many products the profits are more or less set.

In order to see how feasible a business is one could also enter an expected sales amount and then see how much the cost of the product can be in order to break even.

Break Even Analysis

- With our nice equation, it’s fairly easy to accomplish this:
- E6 * (1 - H7) = E8+E9+E10
- (1 – H7) = (E8+E9+E10)/E6
- H7 = 1 - (E8+E9+E10)/E6

Cool! And I thought that Financial Analysis is only for … others

Key Points of the Day

- The Solver is a great tool
- But Math can be very useful as well
- There are two types of costs:
- Variable Costs
- Fixed Costs
- Break Even Analysis is a snap with Excel

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