Enjoy HAPPY LEARNING today…

Let’s go ahead with our

learning about
Financial Modeling
Any question before we proceed further?
Let’s move to our next item of Agenda.

C-V-P ANALYSIS UNDER

RISK AND UNCERTAINTY
Please look at the following:(Black flat line
represent Break-Even-Point)
Is there any relation between

BEP and Risk?

Higher Break-Even-Point
means higher operating risk.
Margin of Safety and Risk
▪It is the units sold or expected to be sold above the break-even
sales.

Margin of Safety = Actual (Expected) Sales – BEP Sales

▪It shows to what extent decrease in sales can be allowed before it

starts resulting in losses.

▪It is a crude measure of risk.

Angle of Incidence
▪This is an angle which the total costs line makes with sales line. It is also an Indicator of
risk – higher this angle, higher the operating risk.

450,000

400,000 Break-even Total sales

350,000 point
Angle of
300,000
Incidence
250,000

200,000
Total expenses
150,000

100,000

50,000
Fixed expenses
-
- 100 200 300 400 500 600 700 800
Please look at the following…and try to understand.
Perform – Sensitivity Analysis and
Scenario Analysis
▪Sensitivity Analysis - It is a quantitative process to perform “what if” analysis. It
starts with some change in some variable's)/parameter(s) and studies the consequent
impact on the variable(s) of the interest. The usual practice is to change the sales
volume/capacity utilization and then study its impact on Break-Even-Point or Profit.
▪Such an analysis can be performed either by changing the variables by some percentage or by
an absolute amount.

▪Scenario Analysis - It is similar to Sensitivity Analysis. In it, a number of variables

are changed in some or other combination of different values of variables of interest.
▪Such an analysis can be performed normally by consider three scenarios – BEST, MOST
LIKELY and WORST.
Sensitivity Analysis… Go to EXCEL
Scenario Analysis…

Scenario Summary SCENERIOS

Current Values: BEST MOST LIKELY WORST
Changing Cells:
ACTUAL_QUANTITY_SOLD 5,000 6,000 5,100 4,000
PRICE Rs.100 Rs.120 Rs.102 Rs.85
VARIABLE_COST Rs.50 Rs.45 Rs.49 Rs.55
FIXED_COST Rs.1,00,000 Rs.80,000 Rs.99,000 Rs.1,20,000
Result Cells:
CONTRIBUTION Rs.50.00 Rs.75.00 Rs.53.00 Rs.30.00
PROFIT Rs.1,50,000 Rs.3,70,000 Rs.1,71,300 Rs.0
Break_Even_Point 2,000 1,067 1,868 4,000
MARGING_OF_SAFETY 3,000 4,933 3,232 0
 Scenario Analysis…
CONTRIBUTION PROFIT
SCENARIO ANALYSIS SCENARIO ANALYSIS
80 Rs.4,00,000

70 75 Rs.3,50,000 Rs.3,70,000
60 Rs.3,00,000

50 Rs.2,50,000
53
50
40 Rs.2,00,000

30 Rs.1,50,000 Rs.1,71,300
30 Rs.1,50,000
20 Rs.1,00,000

10 Rs.50,000
Rs.0
0 Rs.0
Current Valu es BEST MOST LIKELY WORST Current Valu es BEST MOST LIKELY WORST
Any question???
WHAT NEXT?
Leverage
What is LEVERAGE?

▪First an Idea about Leverage:

◦ Strategic advantage;

◦ power to act effectively;

◦ Helps in lifting heavy objects, which may not be otherwise possible;

◦ Magnifies the force applied

◦ an increase means of accomplishing purpose

Leverage establishes relation between
TWO VARIABLES!
LEVERAGE…

▪One leverages "X" to do "Y".

▪When somebody leverages X to do Y, Y must be something which could be

done without X. And having X must make Y a whole lot easier. If having X
doesn’t make Y easier, it’s not leverage.

▪Formally, the Leverage Y with respect to X can be defined as…

 Y  Y / Y
L  =
 X  X / X
Leverage in Y with respect to x is - Percentage
Change in Y to a given Percentage Change in X
Let’s visualize
Leverage
Leverage and the Income Statement

Sales
• Leverage means use of “fixed
- Variable costs cost” items in the process of
- Fixed costs magnifying earnings.
EBIT
- Interest
PBT
- Taxes
PAT
Presence of Fixed Cost …

▪…Leads to OPERATING LEVERAGE.

▪Fixed operating costs may be rent, depreciation, etc.

Presence of Interest Cost …

▪…Leads to FINANCIAL LEVERAGE.

▪Fixed financial costs may be Interest Costs from debt.

BALANCE SHEET AND LEVERAGE …

Balance Sheet
LIABILITIES ASSETS

FINANCIAL OPERATING
LEVERAGE LEVERAGE
OPERATING LEVERAGE …

▪Leverage associated with asset acquisition or investment activities is

referred to as the operating leverage.

▪It refers to the firm’s ability to use fixed operating costs to magnify
the effect of changes in sales on its operating profits (EBIT) and
results in more than a proportionate change (±) in EBIT with change
in the sales revenue.
Operating Leverage and
Business Risk …
Leverage is a double-edged sword!!!

▪It magnifies profits as well as losses.

▪Remember that NOTHING COMES FREE OF COST IN FINANCE!!!

▪If Leverage provides an opportunity to EARN MORE with less

efforts, it provides the same at the cost – and it is RISK!!!!
Operating Leverage is RISKY!!!

▪An aggressive or highly leveraged firm has high fixed costs (and a
relatively high break-even point)

▪A conservative or non-leveraged firm has low fixed costs (and a

relatively low break-even point)
Operating Leverage leads to Operating Risk
Can we quantify the LEVERAGES?

▪YES, we can.

▪That’s the next thing we are going to discuss.

What is Degree of Operating Leverage? … A Challenge
to Measure Operating Leverage

▪Degree of Operating Leverage is defined as-

Percentage Change in EBIT divided by Percentage Change in Sales Volume.

▪ Degree of Operating Leverage (DOL):

% CHANGE IN OPERATING INCOME

DOL =
% CHANGE IN UNIT VOLUME
Degree of Operating Leverage (DOL)

▪It is also equal to …

%EBIT
DOL =
%Sales

▪If we assume that Selling Price per unit is constant, Variable Cost per is constant, and
the total fixed cost is constant, then DOL can be calculated as -

Total Contribution at Base Level

DOL =
EBIT at Base Level
Determine Degree of Operating Leverage

INPUT DATA
SELLING PRICE Rs. 25.00

VARIABLE COST Rs. 15.00

FIXED COST Rs. 1,00,000.00

QUANTITY SOLD 20,000.00

OUTPUT DATA
SALES Rs. 5,00,000.00
LESS: VARIABLE COST Rs. 3,00,000.00
CONTRIBUTION Rs. 2,00,000.00
LESS: FIXED COST Rs. 1,00,000.00 Degree of Operating Leverage
PROFIT Rs. 1,00,000.00 = 2,00,000/1,00,000 = 2
Example…

▪A Company produces and sells 10,000 units of a product. The selling price per
unit is Rs. 500, variable cost per unit Rs. 200 and fixed cost Rs. 25,00,000.
A. Calculate Operating Leverage.

B. If sales goes up by 10%, then what is percent change in EBIT?

 ANSWER:
ANSWER ANSWER
ACTUAL QUANTITY SOLD 10,000 PARTICULARS EXISTING AFTER CHANGE DIFFERENCE
PRICE Rs.500 QUANTITY SOLD 10,000 11,000.00 1,000
PRICE Rs.500 Rs.500
TOTAL SALES Rs.50,00,000
LESS: VARIABLE COST Rs.20,00,000
TOTAL SALES Rs.50,00,000 Rs.55,00,000 Rs.5,00,000
CONTRIBUTION Rs.30,00,000
LESS: VARIABLE COST Rs.20,00,000 Rs.22,00,000 Rs.2,00,000
LESS: FIXED COST Rs.25,00,000
EBIT Rs.5,00,000 CONTRIBUTION Rs.30,00,000 Rs.33,00,000 Rs.3,00,000
LESS: FIXED COST Rs.25,00,000 Rs.25,00,000
DEGREE OF OPERATING EBIT Rs.5,00,000 Rs.8,00,000 Rs.3,00,000
6.00
LEVERAGE
PERCENT CHANGE IN SALES 10%
PERCENT CHANGE IN EBIT 60% PERCENT CHANGE IN EBIT 60%
-50.00
-40.00
-30.00
-20.00
-10.00
10.00
20.00
30.00
40.00
50.00

0.00
0
300
600
900
1200
1500
1800
2100
2400
2700
3000
3300
3600
3900
4200
4500
4800
5100
5400
5700
6000
6300
DEGREE OF OPERATING LEVERAGE

6600
6900
7200
7500
7800
Understanding Behaviour of DOL

8100
8400
8700
9000
9300
9600
9900
That’s all about Leverage!!!
ANY QUESTIONS…?
What NEXT?
A Case about Multi-Product Break-Even-Point
Assume that you are doing internship in a company and you have been
provided the following information and have been asked to fine the Break-
Even-Point. How will you do that?
Production (in Units)

Total Cost A B C D

20,37,941 1,117 1,035 1,040 906

Delete Conents of
20,45,905 1,299 1,146 1,066 1,026 BASIC INPUT DATA
20,51,448 1,442 1,263 1,283 1,116
Particulars A B C D
20,57,439 1,529 1,280 1,317 1,345

Proportion in
20,64,352 1,624 1,405 1,565 1,507 30% 25% 25% 20%
Product Mix
20,69,367 1,742 1,601 1,650 1,440
Selling Price Rs.30.00 Rs.15.00 Rs.25.00 Rs.10.00
20,76,101 1,851 1,696 1,828 1,799

20,81,602 2,040 1,973 1,839 1,909

Think how can you

20,87,859 2,117 2,010 2,044 1,891

20,93,191 2,324 2,106 2,144 2,006

21,03,814 2,420 2,165 2,318 2,114

estimate the
21,07,205 2,541 2,360 2,445 2,185
Break-Even-Point?
21,12,828 2,647 2,506 2,511 2,339

21,20,733 2,725 2,672 2,674 2,645

21,26,604 2,881 2,832 2,678 2,643

Go to
21,29,759 3,075 2,860 2,860 2,845
EXCEL.
21,36,402 3,111 2,944 3,080 2,950

21,43,246 3,237 3,051 3,203 2,947

Another Problem of Product-Mix under
constraints – ONLY ONE constraint
Consider the following problem…

Particuars A B C D
If the management
Selling Price Rs.48 Rs.45 Rs.38 Rs.31 inform you that the
Costs : supply of the material
Material Rs.15 Rs.12 Rs.18 Rs.9 is restricted and it is
limiting factor.
Direct Labour Rs.12 Rs.10 Rs.4 Rs.2

Fixed Overheads* Rs.9 Rs.8 Rs.3 Rs.2

Total Cost Rs.36 Rs.30 Rs.25 Rs.13

Net Profit Rs.12 Rs.15 Rs.13 Rs.18

(* Based on 50% of Direct Labour).

Go to
Material Consumption (Per Unit i EXCEL.
5 4 6 3
n Kgs)
Labour Hours (Per Unit in Hours) 6 5 2 1
Answer: Please understand the concept of
Limiting Factor
Particuars A B C D

Selling Price Rs.48 Rs.45 Rs.38 Rs.31

Costs :

Material Rs.15 Rs.12 Rs.18 Rs.9

Direct Labour Rs.12 Rs.10 Rs.4 Rs.2

Total Variable Cost Rs.27 Rs.22 Rs.22 Rs.11

Contribution Margin Rs.21 Rs.23 Rs.16 Rs.20

Less Fixed Overheads Rs.9 Rs.8 Rs.3 Rs.2

Net Profit Rs.12 Rs.15 Rs.13 Rs.18

Contribution Margin per Kg of Material Rs.4.20 Rs.5.75 Rs.2.67 Rs.6.67

Another Problem of Product-Mix under
constraints – MORE THAN ONE constraints
Consider the following problem…

Particulars A B C D If the management

Selling Price Rs.48 Rs.45 Rs.38 Rs.31 inform you that the
supply of the material
Costs :
as well as that of the
Material Rs.15 Rs.12 Rs.18 Rs.9 Labour is
Direct Labour Rs.12 Rs.10 Rs.4 Rs.2 RESTRICTED.
Fixed Overheads* Rs.9 Rs.8 Rs.3 Rs.2

Total Cost Rs.36 Rs.30 Rs.25 Rs.13 In such a case, use

Net Profit Rs.12 Rs.15 Rs.13 Rs.18 Linear
(* Based on 50% of Direct Labour). Programming.

Material Consumption (Per Unit i

n Kgs)
5 4 6 4 Go to
Labour Hours (Per Unit in Hours) 6 5 2 3 EXCEL.
What Next ?
NOTHING MORE IN THIS SESSION.
 NEXT TIME

Thank You Very Much