Effective Profit Planning: Strategies for Resource Management and Economic Value

1. Chapter 5 Presented by Group 6 Nick Feiler Xiaohan Hu John Langsdorf Wes Matthews Steve Potts

2. Building a Profit Plan • Budget – Plan to generate or consume resources; cost center or profit center. • Profit Plan – Budgets of Profit Centers that generate profits and are accountable for both revenues and expenses.

3. Three Objectives of thePlanning Process • Translate the strategy of the business into a detailed plan to create value. • Evaluate whether sufficient resources are available to implement the intended strategy. • Create a foundation to link economic goals with leading indicators of strategy implementation.

4. Managers’ 3 Profit Plan Questions • Does the organization’s strategy create economic value? • Does the organization have the cash to fund their strategy and remain solvent? • Does the organization create enough value to attract the financial resources that it needs to fund long-term investment in new assets?

5. Three Wheels of Profit Planning • Profit Wheel • Cash Wheel • ROE Wheel

6. Three Wheels of Profit Planning Operating Cash Sales* Profit Wheel Cash Wheel Accounts Receivable Inventory Operating Expenses Investment in Assets Profits** Sales* Profits** ROE Wheel Asset Utilization Stockholders’ Equity Return on Equity

7. Profit Wheel/3Wheels • The profit plan summarizes the expected revenue inflows and expense outflows for a specified future accounting period. • Usually managers go back and forth, projecting sales, operating expenses, profits, and required investment in assets. • Then they work on the cash wheel and the ROE wheel to ensure resources will be available to implement the profit wheel.

8. Profit Wheel – 5 steps • Estimate the Level of Sales • Forecast Operating Expenses • Calculate Expected Profit • Price the Investment in New Assets • Close the Profit Wheel and Test Key Assumptions.

9. Profit Wheel – Step 1Estimate the Level of Sales • External Variables • Macroeconomic factors • Government regulations • Competitor moves • Customer demand • Internal Decisions • Product mix and pricing • Marketing programs • New Product Introduction and • Change in product quality and feature • Manufacturing and distribution capacity • Customer service levels

10. Profit Wheel – Step 2Forecast Operating Expenses • Variable costs forecast and reduction • Economic of scales • Operating efficiency • Bargaining power with suppliers • Redesigning of products • Increase price • Non-variable costs • Committed costs • Discretionary costs • Activity-based indirect costs

11. Profit Wheel – Step 3Calculate Expected Profit • Profit defined • The residual economic value after interest expense and income taxes • Calculating Profit • NOPAT: Net Operating Profit after Taxes • EBIAT: Earnings before Interest and after Taxes

12. Profit Wheel – Step 4Price the Investment in New Assets • Assets to Consider for Investment: 1) Operating Assets 2) Long-Term Assets • Most common investment evaluation technique is net present value.

13. Profit Wheel – Step 5Close the Profit Wheel and Test Key Assumptions • Perform a Sensitivity Analysis Objective: Estimate how profit might change when assumptions prove to be under- or overstated.

14. Cash Wheel • The cash wheel illustrates the operating cash flow cycle of a business. • Important as companies have limited cash reserves and borrowing capacity. • Operating cash = Cash Rec’d – Cash Paid • Direct (Short Term) & Indirect (Long Term) Methods

15. Cash Wheel – 4 Steps • Estimate Net Cash Flows from Operations • Estimate Cash Needed to Fund Growth in Operating Assets • Price the Acquisition and Divestiture of Long-Term Assets • Estimate Financing Needs and Interest Payments

16. Cash Wheel – Step 1Estimate Net Cash Flows from Operations • The calculation of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a simple technique to estimate operating cash flow. • Refer to Exhibit 2.

17. Cash Wheel – Step 2Estimate Cash Needed to Fund Growth in Operating Assets • EBITDA is a rough measure that ignores any changes in working capital needed to operate the business. • Examples include: A/R (accounts receivable), Inventory, and A/P (accounts payable). • Refer to Exhibit 2.

18. Cash Wheel – Step 3Price the Acquisition and Divestiture of Long-Term Assets • Different strategies and initiatives will require different levels of investment and cash. • Examples here are Fixed Asset purchases, such as computer equipment or machinery. • Refer to Exhibit 2.

19. Cash Wheel – Step 4Estimate Financing Needs and Interest Payments • Lastly, need to account for cash needed or generated by financing and income tax. • Examples here are dividends, interest expense, interest received, and repayment of debt principal. • Refer to Exhibit 2.

20. ROE Wheel • Return on Investment (ROI): a ratio measurement of the profit output of the business as a percentage of financial investment inputs. • Return on Equity (ROE): the appropriate internal measure of ROI for managers. • ROE = Net Income / Shareholder’s Equity

21. ROE Wheel – 3 Steps • Calculate Overall Return on Equity • Estimate Asset Utilization • Compare Projected ROE with Industry Benchmarks and Investor Expectations

22. ROE Wheel – Step 1Calculate Overall Return on Equity • ROE= (Net Income/Sales)*(Sales/Assets)* (Assets/Shareholder’s Equity) • Net Income/Sales = Profitability Ratio • Sales/Assets = Asset Turnover Ratio • Assets/Shareholder’s Equity = Financial Leverage Ratio

23. ROE Wheel – Step 2Estimate Asset Utilization • ROCE = Return on Capital Employed: Measures the effective utilization of capital and assets. = (Net Income/sales)*(Sales/Capital Employed) • Capital Employed = Assets within a manager’s direct span of control.

24. ROE Wheel – Step 2Asset Utilization Measures • Working Capital Turnover = (Sales) / (Current Assets – Current Liabilities) • Accounts Receivable Turnover = (Net Sales on Credit) / (Average Net Receivables) • Inventory Turnover = (Cost of Goods Sold) / (Average Inventory) • Fixed Asset Turnover = (Sales) / (Property, Plant, and Equipment)

25. ROE Wheel – Step 2ROCE Tree

26. ROE Wheel – Step 3Compare Projected ROE with Industry Benchmarks and Investor Expectations

27. Using the Profit Wheels to Test Strategy • Profit Wheel - Prepare profit plan • Cash Wheel - Ensure cash will be adequate • ROE Wheel - Compare each alternative

28. Chapter Summary • Profit plan describes business strategy in economic terms • Profit plan is used to assess the ability of different strategies to generate value and to estimate whether sufficient resources will be available to implement the chosen strategy