Specialized Tools of financial analysis (1)
14/02/2019
Besides financial ratio analysis, cross-sectional analysis, time-series analysis, common-size analysis etc. there are specialized tools and techniques applied to special purpose studies and other cases. Such studies depend on different aspects such as insurance coverage, the seasonality of the business, segment data, foreign operations, concentration of sales within a small number of customers, unusual events affecting the company, and the effect of inventory method (LIFO, FIFO) and depreciation methods on financial statements.
Breakeven analysis
These tools disclose relationships between revenue and patterns of cost behavior for fixed and variable expenses. Different managers within a company use breakeven analysis because it is important when beginning a new activity, such as starting a new line of business, expanding an existing business, or introducing a new product or service.
Break-even analysis is a method widely used in production and management. The main idea of this tool is that total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume or sales dollars (other currency), at which the business does not make a profit or a loss ("break-even point").
Formula
Break even point in units = Fixed costs / Contribution margin per unit
Break event point in USD = Sales price per unit * Break even point in units
Example of break-event analysis
IndicatorCalculations (USD)
Sales
Price per unit15.00
Units sold500
Costs
Variable costs3,400.00
Fixed costs1,100.00
Revenue
Unit margin8.20
Gross margin4,100.00
Break even point
In units134
In currency2,010.00
Problems and restrictions of the breakeven analysis
It is important to understand what the results of your breakeven analysis suggests. If the calculation demonstrates that you break even when you sell 500 units, your next step is to decide whether this seems achievable.
If you do not think you can manage to sell 500 units within a reasonable time period, in accordance with your financial situation, patience and personal expectations, then this method of analysis may not be useful for you. It may not be fast enough profitable for your business to stay alive. If you think that 500 units is possible, but it will take a little time, try decreasing the price and calculate a new breakeven point. You can also look at your fixed and variable costs to determine areas which you could cut.
Finally, it should be understood that the breakeven analysis is not a predictor of demand. If you go to the market with the wrong product or the wrong price, it can be difficult to reach the breakeven point.
Contribution margin analysis
Contribution margin analysis is a structured approach to understanding the extent to which observed consequent are the result of a particular activity, unlike other factors. A margin analysis examines the residual margin after deducting variable costs from revenue. This analysis is used to compare the amount of money allocated by various products and services, so that management can determine which of them should be sent to customers through extended marketing campaigns and commission plans. The total amount of margin created can also be compared with the total fixed costs payable in each period so that management can see if the current pricing structure and costs of the company can generate any profit.
The margin contribution is revenue minus all variable costs. Then the result is divided by revenue to get the percentage contribution margin.
Formula
Contribution margin ratio = (Sales - Variable expenses) ÷ Sales
Example of contribution margin analysis
IndicatorCalculations (USD)
Total revenue500,000
Cost of goods sold200,000
Shipping and labor expenses150,000
Contribution margin150,000
Contribution margin ratio30%
Number of units sold50,000
Contribution margin per unit sold3
This analysis can also be used to examine proposals for acquisition objectives as part of a due diligence process to determine if the company allocates enough money to be worth buying. If not, those who research the enterprise must decide whether the costs of the target company can be changed sufficiently to generate increased income.
The main problem of such an analysis is that it does not take into account the influence of products and services on the company's restrictions, which is a bottleneck preventing a business from receiving higher profits. If a product with a high margin of contributions uses an excessive amount of time restriction, the result may be a decrease in the total amount of profit received by the business. The reason is that the restriction has too little time to process other products. This problem can be solved by expanding the analysis of the marginal contribution, which also includes the use of the marginal contribution per minute limit time. Those products and services that generate the most profit per minute should be prioritized in sales.