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Key determinants of operating income

Purchasing and
selling prices

Sales revenue operating costs =


operating income

Structural
determinants

Volumes

Structural factors

Maximum
i
production
d i capacity
i
Experience
Specialization
Standardization
Industry
Vertical/horizontal integration
...
2

Price levels
Purchasing
h i prices
i
Price of inputs
p bought
g from suppliers
pp

Selling prices
Price
i off output sold
ld to consumers

Both pprices depend


p
on internal factors ((e.g.
g
power of the firm in negotiating with suppliers
or setting selling prices) and external factors
(e.g. industry trends, competition levels)
3

Volumes
For ggiven structural determinants and cost
structure, the operating profits is determined by
volumes
Different volumes influence operating profits
by changing both total costs (via variable costs)
aandd revenues
eve ues
We use the break even point (BEP) analysis to
understand
d t d the
th relationship
l ti hi between
b t
volumes
l
and operating profits
Before BEP, lets recap the nature of costs
4

Costs

Costs
Volume range
being
considered

Total variable
costs

Volumes
a. linear relationship variable costs/volumes

Total variable
costs

Volumes
b. actual relationship variable costs/volumes

Question: Why non-linearities?


5

Costs

Costs
Volume range
being
considered

Total fixed costs

Total fixed costs

Volumes
a. linear relationship fixed costs/volumes

Volumes
b. actual relationship fixed costs/volumes

Question: Why step-wise increases?


6

A note on labor costs


If labor can be easily increased/decreased or
reallocated across business units,, then labor
would be a variable cost
However,
However in practice
practice, labor is regulated and
labor laws create hiring/firing costs
In this case, labor costs are variable but they
also entail some fixed cost component
In the Scaltrini solution, we classify them as semivariable costs

Costs
Total costs

V i bl costs
Variable
t

Fixed costs

Volumes
8

120
100
80

Average unit
cost cost

60
40
20
0

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Volumes produced

It decreases due to fixed-cost absorption economies (i.e. fixed costs distributed


over more units ot output), although variable costs increase
However,
However the shape is determined by the importance of fixed and variable costs
for the firm
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Example
Whatifonly30Kpiecessold(2/3ororiginalprojection)?
h f l
ld ( /
l
)
Average price per meal

16.00

Average price per meal

Projected volume (300x150) = 45,000


45 000

Projected volume (300x100) = 30,000


30 000

Total sales revenue


Variable unit cost per meal

720,000
4 00
4.00

Salaries and wages


Rent
General Costs
p
Depreciation
Advertising
Operating income

Total sales revenue


Variable unit costs per meal

Projected volume = 45,000


Total variable costs
Cost 1 expert pizza cook
4 workers at average cost of 32,500

16.00

480,000
4 00
4.00

Projected volume = 30,000


180,000
80,000
130,000
210,000
60,000
70,000
35,000
,
30,000
135,000

Total variable costs


Cost 1 expert pizza cook
4 workers at average cost of 32,500
Salaries and wages
Rent
General Costs
Depreciation
Advertising
Operating income

120,000
80,000
130,000
210,000
60,000
70,000
35,000
30,000
-45,000

Output sold is 1/3 lower


lower, but operating income is not just 2/3 lower but its
it s negative! Why?
Some costs dont drop (i.e. 5 worker is minimum number to run the restaurant), fixed costs
remain unchanged

Example
Total and unit costs
(a)
Q

(b)
Variable
cost (VC)
per unit

(c)
Total VC
(a x b)
(000 )

(d)
Fixed
cost (FC)
(000 )

(e)
Total costs
(c +d)
000 )

(f)
Total cost
per unit
(e / a)

(g)
Fixed cost
per unit
(d / a)

25,000

4.00

100

405

505

20.20

16.20

30,000

4.00

120

405

525

17.50

13.50

45,000

4.00

180

405

585

13.00

9.00

60,000

4.00

240

405

645

10.75

6.75

What can we do?


Variations in volumes
Variations in costs
Variations in selling prices
First question to ask is,
is what is the output that
allows the firm to generate enough revenues to
cover its
it operating
ti costs?
t ? Break
B k even point
i t

Break even point (BPE)


Q such that Revenues (R) = Total Costs
Lets call r the selling price of each unit
Then,, rQ
Q = VCQ
Q + FC
rQ-VCQ = FC
Q(r - VC) = FC
Qbreak-even = FC / (r VC)
= unit
i contribution
ib i unit
i

Compute the BPE


+ Average price per meal
x Hypothetical volume (300x112.5)
= 33,750
= Total sales revenue
+ Average cost per meal
x Hypothetical Volume = 33,750
= Total variable costs
Salaries and wages
Rent

16.00
Costs
and revenues

Sales
revenue

540,000
4.00

Operating
profit

135,000
210,000

Total
costs

540,000

60,000
Fixed
costs

General costs

70,000

Depreciation

35,000

Advertising

30,000

Operating income

0,000

Operating loss

BEP
33,750

Volumes

Break even point (BPE)


Qbreak-even = FC / (r
( VC))
= unit contribution unit ((MCu))

How much does the production and sale of each


unit
it off output
t t contribute
t ib t to
t covering
i fixed
fi d costs?
t?
Often, contribution margin is expressed as a
percentage off revenues: CM(%) = MC
MCu/r
/
Using this term, we can compute the revenuebased BPE: FC/CM(%)
Useful when e.g.
g reasoning
g in qquantity
y doesnt
make sense (diversified firm)

Operating risk
Varying degree of profitability that a firm will face
particularly negative or positive net income, in
relation to the fluctuation in production and sales
volumes
Linked to two components of the organization's
economic structure: BPE and degree of the operating
leverage
Operating leverage is the size of the differential
between revenues and total costs above and below the
bbreak-even
ea eve point
po t

Operating risk
Costs
and
d revenues

Sales revenue

Operating
p
g leverage
g

Total costs

Fixed costs

BEP

Volumes

Operating risk
Suppose that there are exogenous changes in volume:
g cost structure, i.e. high
g ratio of
If a firm has veryy rigid
fixed costs to total costs
The firm will react badlyy to drops
p in volumes ((less room to
distribute fixed costs over units of output)
But the same firm will respond positively to increases in
volumes

The opposite is true for a firm with a flexible cost


structure, i.e. low ratio of fixed costs to total costs
If volumes drop, the firm can easily reduce costs
If volumes increase, the firm experience unavoidable cost
increases

Operating risk

Computation of operating risk


Ratio of total variable costs and fixed costs at the
BEP
The greater the value, the greater the operating risk
Operating risk is not necessarily a bad thing: it
amplifies losses (as we move in the area right to the
BEP), but it amplifies profits (as we move in the area
left to the BEP)
Hence,
Hence the choice of,
of e.g.
e g two plants with same BEP
but different operating risk depends on our estimate
of how much volumes sold would exceed the BEP
BEP,
and on the managers degree of risk aversion

Profit point
So far, we have only focused on a BEP such
p
g costs ((e.g.
g labor,,
that revenues cover operating
equipment etc.)
But in practice firms incur in non-operating
non operating
costs related e.g. to financial charges and taxes
These charges are negative components that
need to be taken into account in the
determination of net income ( operating
income)

Profit p
point: example
p
Lets go back to the example of the restaurant (under scenario 1)
Average price per meal

16.00

Projected volume (300x150) = 45,000


720,000

Salaries and wages


Rent
General Costs
Depreciation
Advertising
Operating income

Non-income taxes

6,000

Target net income

50%
75,000

4.00
Target operating income

Projected volume = 45,000


Total variable costs
Cost 1 expert pizza cook
4 workers at average cost of 32,500

24,000

Income tax rate (on pre-tax


pre tax income)

Total sales revenue


Variable unit cost per meal

Financial charges

24,000+6,000+150,000
= 180,000

,
180,000
80,000
130,000

What is the sale revenue that can allow the


firm to reach the target?
210,000
60,000
70,000
35,000
30 000
30,000
135,000

We use a variation of the revenue based BEP:


(FC+Target operating income)
CM(%)
((r-VC)/r
) = 12/16
= (405,000+180,000)
0.75