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Unit 2: Managing a business
Finance
Using budgets
Chapter 16
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Unit 2: Managing a business
Finance
What is a budget?
A budget is an agreed plan establishing, in numerical or financial terms, the
policy to be pursued and the anticipated outcomes of that policy.
In Unit 1 the setting of budgets was discussed. The focus was on planning
a budget.
In Unit 2 the actual using of budgeting is studied. How can budgeting help
the business to improve its performance?
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Unit 2: Managing a business
Finance
Benefits and drawbacksof using budgets
Benefits
They provide direction and coordination. They can motivate staff.
They improve efficiency.
They encourage careful planning.
Drawbacks They are difficult to monitor fairly.
Allocations may be incorrect and unfair.
Savings may be sought that are not in the interests of the firm.
They may be inflexible.
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Features of good budgeting
A good budget should:
be consistent with the aims of the business
be based on the opinions of as many people as possible
set challenging but realistic targets (be SMART)
be monitored at regular intervals
be flexible
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Variance analysis
variance analysis: the process by which the outcomes of budgets are examined
and then compared to the budgeted figures. The reasons for any differences
(variances) are then found.
favourable variance: when costs are lower than expected or revenue is higher
than expected.
adverse (unfavourable) variance: when costs are higher than expected or
revenue is lower than expected.
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Unit 2: Managing a business
Finance
Calculating variances
A variance is calculated by the following formula:
variance = budget figure actual figureFor variance analysis, use F for favourable variances and A for adverse variances,
rather than positive or negative numbers.
A favourable variance would happen when:
actual income is greater than budgeted income
actual costs are below budgeted costs
An adverse (or unfavourable) variance would be shown when:
actual income is less than budgeted income
actual costs are above budgeted costs
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Unit 2: Managing a business
Finance
Calculating variances: the golden rule
The golden rule: knowing the effect a variance has on profit tells you whether it is
favourable or adverse.
A favourable variance will mean moreprofit than expected.
An adverse variance will mean lessprofit than expected.
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Finance
Example variance calculation:income budget
Income budget for XYZ Ltd, April 2009
Source ofincome
Budgetedincome ()
Actual income()
Variance () F/A
Product A 7,500 7,600 100 F
Product B 6,000 5,700 300 A
Total income 13,500 13,300 200 A
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Finance
Example variance calculation:expenditure budget
Expenditure budget for XYZ Ltd, April 2009
Item ofexpenditure
Budgetedexpenditure()
Actualexpenditure()
Variance () F/A
Raw materials 2,700 2,500 200 F
Labour costs 2,400 2,450 50 A
Administrationand other costs
4,500 4,500 0
Totalexpenditure
9,600 9,450 150 F
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Finance
Example variance calcualtion:profit budget
Profit budget for XYZ Ltd, April 2009
Item ofincome/expenditure
Budgetedprofit ()
Actual profit()
Variance () F/A
Total income 13,500 13,300 200 A
Totalexpenditure
9,600 9,450 150 F
Budgeted profit 3,900 3,850 50 A
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Finance
Interpreting the variances
1 What factors might have caused the variances for XYZ Ltd?
In small groups find:
a Two factors WITHIN the business that might have led to the variances in
the INCOME budget.
b One factor OUTSIDE the business that might have led to the variances in
the INCOME budget.
c Two factors WITHIN the business that might have led to the variances in
the EXPENDITURE budget.d One factor OUTSIDE the business that might have led to the variances in
the EXPENDITURE budget.
2 Suggest two actions the business might take to improve matters.
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Finance
Interpreting the variances:answers
Possible answers include:
1a
Successful marketing of product A.
Low-quality production of product B.
1b
Adverse media publicity concerning product B.
1c
Efficient production methods, leading to lower wastage of raw materials.
Workers being given a wage rise that was higher than expected.
1d
An unexpected shortage of raw materials, leading to higher prices being charged by suppliers.
2
Introduce new quality assurance measures for product B.
Investigate alternative suppliers or different raw materials.
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Finance
Calculating variance: income budget
Complete the variance analysis for XYZ Ltds income budget.
The budgeted income column has been provided.Actual income for XYZs two products were:
product A: 3,000 units were sold at a price of 2.70
product B: 6,400 units were sold at a price of 1.25
Income budget for XYZ Ltd, May 2009
Source of income Budgetedincome ()
Actual income()
Variance () F/A
Product A (3,200 x 2.50) 8,000
Product B (6,000 x 1.30) 7,800
Total income 15,800
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Finance
Calculating variance:expenditure budget
Complete the variance analysis for XYZ Ltds expenditure budget.
The budgeted expenditure column has been provided.Actual expenditure was as follows:
Raw materials were 25% of the actual income.
Labour costs were 25p per unit (9,400 25p).
Administration and other costs were 4,200.
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Expenditure budget for XYZ Ltd, May 2009
Item of expenditure Budgetedexpenditure()
Actualexpenditure()
Variance () F/A
Raw materials (25% of
15,800)
3,950
Labour costs (9,200 x 25p) 2,300
Administration and othercosts
4,600
Total expenditure 10,850
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Calculating variance: profit budget
Complete the variances for XYZ Ltds profit budget, based on your variances
for the income and expenditure budgets.
Profit budget for XYZ Ltd, May 2009
Item ofincome/expenditure
Budgetedprofit ()
Actual profit()
Variance () F/A
Total income 15,800
Totalexpenditure
10,850
Budgeted profit 4,950
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Finance
Income budget: answers
Income budget for XYZ Ltd, May 2009
Source of income Budgetedincome ()
Actual income()
Variance () F/A
Product A (3,200 x 25) 8,000 8,100 100 F
Product B (6,000 x 13) 7,800 8,000 200 F
Total income 15,800 16,100 300 F
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Expenditure budget: answers
Expenditure budget for XYZ Ltd, May 2009
Item of expenditure Budgetedexpenditure()
Actualexpenditure()
Variance () F/A
Raw materials (25% of15,800)
3,950 4,025 75 A
Labour costs (9,200 x 25p) 2,300 2,350 50 A
Administration and othercosts
4,600 4,200 400 F
Total expenditure 10,850 10,575 275 F
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Unit 2: Managing a business
Finance
Profit budget: answers
Profit budget for XYZ Ltd, May 2009
Item ofincome/expenditure
Budgetedprofit ()
Actual profit()
Variance () F/A
Total income 15,800 16,100 300 F
Totalexpenditure
10,850 10,575 275 F
Budgeted profit 4,950 5,525 575 F
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Unit 2: Managing a business
Finance
Interpreting the variances
What were the main factors that led to the variance in XYZs profit for May
2009?
Possible answers are:
The price increase for product A led to a small fall in demand, which led to sales
revenue increasing. (Lower volume would also have saved on variable costs.)
The price cut for product B led to a significant rise in demand and an increase in
income (but a rise in variable costs too).
There was a major cut in administration costs of almost 10%. Although variable costs rose per unit produced, they were the same as the
budget.
Conclusion: the main reason for the favourable variance in profit was the significant
saving in administration and other costs. The price changes of both products also
helped to boost income.
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Unit 2: Managing a business
Finance
Using budgets: follow-up exercise
Complete the questions in case study 1 at the end of Chapter 16.
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Unit 2: Managing a business
Finance
Chapter 17
Improving cash flow
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Unit 2: Managing a business
Finance
Causes of cash-flow problems
cash flow: the amounts of money flowing into and out of a business over a period
of time.
Firms may have shortages of cash for a variety of reasons:
seasonal demand
overtrading, arising from over-expansion
over-investment in fixed assets
credit sales
poor stock management poor management of suppliers
unforeseen change, e.g. a strike
losses or low profits
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Ways of improving cash-flowproblems (1)
There are many ways of improving cash flow. The method(s) chosen may vary
according to the cause of the cash-flow problem. The AQA specification identifies five
main ways of improving cash-flow problems. These are shown on this slide and the
next:
Bank overdraft. An agreement whereby the holder of a current account in a
bank is allowed to withdraw more money than there is in the account.
Short-term loan. This is a sum of money provided to a firm or an individual for
a specific, agreed purpose. Repayment of the loan will usually take place within2 years.
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Ways of improving cash-flowproblems (2)
Factoring. When a factoring company (usually a bank) buys the right to collect
the money from the credit sales of an organisation.
Sale of assets. This process can improve cash flow by converting an asset
(e.g. property or machinery) into cash, which can then be used to ease the
problem.
Sale and leaseback of assets. Assets that are owned by the firm are sold to
raise cash and then rented back so that the company can still use them for an
agreed period of time.The benefits and problems of using each of these five methods of improving cash
flow are discussed after the next slide.
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Unit 2: Managing a business
Finance
Ways of improving cash-flowproblems (3)
Some other ways of improving cash flow (not specified in the AQA specification) are
listed below:
Careful cash management (e.g. setting aside a contingency fund for
emergencies).
Effective debt management chasing up customers who have not paid on
time.
Stock management making sure that money is not tied up in excessively
high stock levels. Diversifying to create a range of products that sell throughout the year.
Carefulbudgeting.
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Unit 2: Managing a business
Finance
Benefits of a bank overdraft
It is easy to arrange and, once agreed, tends only to need confirming on an
annual basis.
It is very flexible, as the overdraft can be used to pay for whatever the business
requires at the time.
Interest is only paid on the level of the overdraft that is actually used.
Furthermore, interest is only paid on a daily basis.
Unlike with a bank loan, a firm that uses a bank overdraft does not need to
provide security (collateral).
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Finance
Problems of a bank overdraft
Bank overdrafts are based on flexible interest rates, so it is difficult to budget
accurately the bank may change its rate of interest.
The rate of interest charged on an overdraft is usually higher than that charged
on a short-term bank loan.
Agreements to provide an overdraft normally allow the bank to demand
immediate repayment.
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Unit 2: Managing a business
Finance
Benefits of short-term loans
Bank loans are usually at a fixed rate of interest. The interest and repayment
schedule is calculated at the time of the loan, so it easy for the business to know
whether it can afford to repay the loan and budget for repayment.
The rate of interest charged on a bank loan is usually less than that charged on
an overdraft, so it can be a cheaper solution to a cash-flow problem.
A bank loan may be set up for a long period of time, to help the firm.
2 b
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Finance
Problems of short-term loans
Interest is paid on the whole of the sum borrowed.
The business will need to provide the bank with security (collateral).
Short-term loans can often only be used for a specific, agreed purpose.
U i 2 M i b i
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Finance
Benefits of (debt) factoring
Improved cash flow in the short term.
Lower administration costs.
Reduced risk of bad debts.
Can encourage businesses to be cautious and careful with their provision of
credit, to ensure that all debts are factored.
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Finance
Problems of (debt) factoring
The main problem is the cost to the business, which will lose between 5% and
10% of its revenue.
The factoring company will charge more for factoring than it would for a loan, as
there are administrative expenses involved in chasing up the debts.
Customers may prefer to deal directly with the business that sold them the
product. An aggressive factoring company may upset certain customers, who will
blame the original seller of the product.
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Benefits of sale of assets
Selling assets can raise a considerable sum of money, particularly in the case of
a large asset such as a building.
If a particular asset is no longer helping towards the businesss overall success,
sale of the asset will not only ease the cash-flow problem, but also enhance the
overall profitability of the business.
U it 2 M i b i
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Problems of sale of assets
Assets such as buildings and machinery may be very difficult to sell quickly. A
business trying to make a quick sale usually has to accept a much lower price
than its true value.
It is a fundamental principle of business that a firm should not sell fixed assets
to improve liquidity, as the fixed assets enable it to produce the goods and
services that create its profit.
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Benefits of sale and leaseback
This will overcome a cash-flow problem by providing an immediate inflow of
cash, usually of quite a significant level.
A firm can be more flexible, as new and more efficient assets can be leased.
The ownership of fixed assets can lead to a number of costs, such as
maintenance. Sale and leaseback eliminates these costs.
Owning an asset can distract a business from its core activity because it has to
get involved with activities such as property management or organising a
transport fleet.
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Problems of sale and leaseback
In the long term, the firm will usually pay more in rent than it receives from its
sale.
As a result, sale and leaseback will also reduce the value of the firms assets that
can be used as security against future loans.
The business may eventually lose the use of the asset when the lease ends, as a
competitor may be prepared to pay a higher rental for the lease.
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Finding the causes of a cash-flowproblem: group exercise
Find three or four possible causes of the forecast cash-flow problems in the situation below.
* In quarters 2 and 3, customers will be given 6 months credit when they buy product A, to boost sales
2009 Qtr 1(000s)
2009 Qtr 2(000s)
2009 Qtr 3(000s)
2009 Qtr 4(000s)
Opening balance 0 19 16 (24)
Sales income: product A* 20 0 0 24
Sales income: product B 55 52 48 42
Total inflows 75 52 48 66
Raw material costs 22 22 20 17
Wages 34 33 42 40
Capital costs 0 0 26 0
Total outflows 56 55 88 57
Net cash flow 19 (3) (40) 9
Closing balance 19 16 (24) (15)
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Finding the causes of a cash-flowproblem: answers (1)
Possible causes:
credit given to customers of product A leading to 6 months delay in receiving
cash
steadily declining sales of product B, bringing in less income
significant increase in wage payments in quarter 3
large expenditure on capital costs in quarter 3
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Finding the causes of a cash-flowproblem: individual exercise
Find three or four possible causes of the cash-flow problem in the situation shown below.
2010 Qtr 1(000s)
2010 Qtr 2(000s)
2010 Qtr 3(000s)
2010 Qtr 4(000s)
Opening balance 0 25 10 (26)
Sales income (total inflows) 85 75 40 95
Raw material costs 27 25 25 55
Wages 33 33 27 33
Capital costs 0 0 0 0
Vehicle purchase 0 32 0 0
Loan repayment 0 0 24 0
Total outflows 60 90 76 88
Net cash flow 25 (15) (36) 7
Closing balance 25 10 (26) (19)
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Finding the causes of a cash-flowproblem: answers (2)
Possible causes:
seasonal sales dramatic fall of income in quarter 3
purchase of 32,000 vehicle in quarter 2
repayment of loan 24,000 in quarter 3
large increase in raw material costs in quarter 4 has prevented recovery
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Solving cash-flow problems (1)
In groups, discuss:
possible solutions to the cash-flow problems listed on the slide Finding
the causes of a cash-flow problem: group exercise
possible solutions to the cash-flow problems listed on the slide Finding
the causes of a cash-flow problem: individual exercise
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Finance
Solving cash-flow problems (2)
Possible answer to problems (group exercise)
Problem Possible solution
Credit given to customers of product A Debt factoring
Declining sales of product B Change marketing
Increase in wages Investigate reason
Capital costs Lease asset
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Finance
Solving cash-flow problems (3)
Possible answer to problems (individual exercise)
Problem Possible solution
Seasonal demand Broaden product range
Purchase of asset Lease asset
Repayment of loan Spread repayment over time
Raw material costs Research other suppliers
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Finance
Chapter 18
Measuring andincreasing profit
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Profit and profitability
profit: the difference between the income of a business and its total costs.
profit = revenue total costs
profitability: the ability of a business to generate profit or the efficiency of a
business in generating profit.
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Measure of profitability
Two ways of measuring profitability will be considered. Both measures investigate
how efficient a business is in terms of achieving a profit.
net profit margin: compares the profit made with the sales income of the
business/branch.
return on capital: compares the profit made with the amount of capital invested by
the entrepreneur or financial backer.
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Net profit margin
This ratio is calculated as follows:
net profit margin (%) = net profit before tax 100
sales income (turnover)
For example:
net profit = 20,000
sales income = 80,000
net profit margin (%) = 20,000
100 = 25%80,000
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Interpreting the net profit margin (1)
To assess the meaning of a net profit margin, two comparisons are usually made:
Comparison over time. Is the net profit margin increasing (suggesting
improvements in efficiency) or decreasing (implying a decline in efficiency)?
Comparison to other firms or branches/divisions. These comparisons are
useful because they look at the businesss success (or failure) relative to other
businesses. It is much easier to make high net profit margins in some
industries* than in others; this calculation avoids judgements that may be
affected by this factor.
*These industries usually sell fewer items at higher prices, so a high net profit
margin is not a guarantee of higher overall profit levels.
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Interpreting the net profit margin (2)
What conclusions can be drawn about the net profit margins of the three
companies in the table above?
Company Net profitmargin (%)
2005
Net profitmargin (%)
2006
Net profitmargin (%)
2007
Net profitmargin (%)
2008
Company A 10.3 10.9 12.0 14.0
Company B 15.2 13.8 12.4 12.1
Company C 5.6 5.5 5.8 5.6
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Interpreting the net profit margin:conclusions
With all three companies, comparisons should be made with competitors in the same
industry. This analysis assumes that the three companies are in direct competition.
Company A earns a consistent net profit that has increased steadily over the 4
years. In 2008, it recorded the highest net profit margin, so it is the company that
appears most likely to be successful in the future.
Company B has been the most successful business for 3 of the 4 years, so its
overall performance has been the best of the three companies. However, its net
profit margin has fallen each year and the trend suggests that it is unlikely to be as
successful as Company A in the future (unless there are specific, temporary reasons
for 2007 and 2008 not being such good years).
Company C has made a consistent profit each year but it has been less profitable
than the other two companies and its owners may be concerned at the relatively low
levels of profit being made. However, in some competitive industries (such as
supermarkets) Company Cs net profit margins are only slightly below the average.
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Return on capital
This ratio is calculated as follows:
return on capital (%) = net profit 100
capital invested
For example:
net profit = 20,000
capital invested = 100,000
return on capital (%) = 20,000
100 = 20%100,000
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Interpreting the return on capital (1)
To assess the meaning of the return on capital (%), three comparisons are usually
made:
Comparison over time. Is the return on capital increasing or decreasing?
Comparison with other firms or branches/divisions. Is the money invested
in this business providing a better return than the money invested in other
businesses?
Comparison with bank interest rates. The opportunity cost for many
investments is the interest that could have been gained from placing the money
in a bank account. As there is no real risk in this investment, the return on
capital invested in a business needs to be higher than the interest rate offered
by a bank.
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Interpreting the return on capital (2)
What conclusions can be drawn about the return on capital of the three
companies in the table above?
Company Return oncapital (%)
2005
Return oncapital (%)
2006
Return oncapital (%)
2007
Return oncapital (%)
2008
Company A 20.2 23.6 25.8 30.0
Company B 15.0 14.2 3.3 2.8
Company C 2.5 2.5 4.1 7.3
Bank interestrate (%)
4.5 4.75 5.75 5.5
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Interpreting the return on capital:conclusions
Company A has steadily improved and made excellent returns on capital. It is
clearly the best company in which to invest.
Company B performed well in 2005 and 2006, but its performance became
unsatisfactory in 2007 and has worsened again in 2008. Its overall return is below
the bank interest rate and it is not a good investment unless the reason for its
sudden decline can be discovered and put right.
Company C has only performed satisfactorily in one year (2008). However, it has
been improving its profitability and would seem to be a better investment for thefuture than Company B.
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Methods of improvingprofits/profitability
Many methods can be used. Three main methods are:
increasing the price
decreasing costs
increasing sales volume
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Increasing the price
Increasing the price will widen the profit margin. Therefore each product sold will
generate more profit.
This strategy will be particularly effective if the product is a necessity or has no closesubstitutes, as customers will be willing to pay the higher price.
BUTthis strategy will fail if the higher price leads to customers switching to rival
products or just giving up on buying the product.
The business must analyse the likely effect of any price increase in situations where
there are many close competitors.
It is possible that the price rise may cause such a large fall in demand that the
higher profit margin will be offset by a dramatic fall in quantity, so the overall profit
may fall.
In situations where there are many competitors, it may actually be more
profitable to cut the price.
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Price elasticity of demand
To assess the impact of price changes on profit, an understanding of price elasticity
of demand is needed. This is provided in Chapter 32.
After reading about price elasticity of demand, refer back to Chapter 18.
Price elasticity of demand will enable you to provide more sophisticated responses to
questions about price changes.
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Decreasing variable and fixed costs
Variable costs
If the firm can cut its variable costs, the profit margin will increase.This means that each product will yield more profit.
BUTif the change in costs leads to a decrease in quality (e.g. inferior raw materials)
or efficiency, the demand for the product may fall.
Fixed costsProfit will also increase if fixed costs, such as rent, are reduced.
BUTnot if the cost cutting leads to lower sales (e.g. locating the shop in a place
that is less accessible to customers).
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Increasing sales volume
If costs and price remain the same, it is still possible to increase profits by increasing
the volume of products sold.
A business can achieve this by a number of methods, such as:
increasing marketing
developing new products
improving quality
BUTall of these methods will cost money.
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Numerical example:background information
A business sells 500 units of a product at 10 each. Its fixed costs are 2,000 and
its variable costs are 3 per unit.
Calculate the profit made on this product.
Answer
TRTC= 5,000 (2,000 + 1,500) = 5,000 3,500 = 1,500
Research reveals the following:
1 An increase in price to 12 will lead to a fall in sales to 450 units.
2 Cheaper raw materials will reduce variable costs to 2.50 per unit.
3 A poster campaign costing 800 will increase sales by 10%.
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Numerical example: exercise
Will the changes on the previous slide increase or decrease the profit?
Taking each change in isolation, calculate the profit made from:
1 An increase in price to 12, which leads to a fall in sales to 450 units.
2 Cheaper raw materials, which reduce variable costs to 2.50 per unit.
3 A poster campaign costing 800, which increases sales by 10%.
Should the business make these three changes?
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Numerical example: answers 1 and 2
1 TR = 12 450 TR = 5,400
FC= 2,000 TVC= 3 450 = 1,350 TC= 3,350
Profit = 2,050
Profit increases by 2,050 1,500 = 550.
Note how some of the increase in profit has come from lower variable costs because
fewer products are made.
2 TR = 5,000 FC= 2,000 TVCfalls to 500 2.50 = 1,250
profit = TRTC= 5,000 (2,000 + 1,250) = 5,000 3,250 = 1,750
Profit increases by 1,750 1,500 = 250.
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Numerical example: answer 3and conclusion
3 Sales volume increases by 10% from 500 to 550 units. FCincreases by 800.
TR = 550 10 = 5,500 VC= 550 3 = 1,650
FC= 2,000 + 800 = 2,800
profit = 5,500 1,650 2,800 = 1,050
Profit increases by 1,050 1,500 = 450 (the businesss profits fall by 450).
Conclusion
The business should carry out actions 1 and 2 but not implement action 3.
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Extension work
Calculate the final profit if actions 1 and 2 only are implemented.
How much profit would be made if all three options were implemented?
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Other methods of improvingprofit/profitability
Some other methods of improving profits are noted below, but this is not an
exhaustive list:
investment in fixed assets product development
marketing
staff training
Note how each of the functional areas can contribute to improved profitability.
Can you add to this list?
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Distinction between cash and profit
Profit is calculated by subtracting expenditure from revenue. It is easy to assume
that a profitable firm will be cash rich, but this is not necessarily true.
Liquidity is the ability to convert an asset into cash without loss or delay.
The most liquid asset that a business can possess is cash.
Many firms will not have their profit in the form of cash, so a high profit may not
guarantee a high level of cash.
It is also possible for a firm to have low profits but high cash levels. For example, a
business that has just borrowed a large sum of money will have high cash levels,
regardless of its profit levels.
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Why a profitable firm mightbe short of cash
The firm has built up its stock levels. Its wealth will lie in stocks on shelves
rather than cash.
The firm has given credit to its customers. Its wealth will be in debtors(people who owe money to the firm).
The firm has used its profit to pay dividends to shareholders or repay long-term
loans; it may be short of cash.
The firm has purchased fixed assets, such as new machinery or vehicles.
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Measuring and increasing profit:follow-up work
Complete the questions in the case study on Cadbury at the end of
Chapter 18.
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