Financial Principles1. Revenue

• Single Product

R = P x Q

• Multi Product n

R = Σ PiQi i=1

2. Cost• VC vs. FC• AVC vs. AFC• MC vs. Incremental Cost• Sunk Cost• Programmed Cost• Avoidable Cost• Fungible Inputs• Opportunity Cost• Relevant Cost• Joint Cost• Accounting Allocation

3. Margins:• Gross • Trade• Net Profit

A: Gross Margin (Profit)

Total GM = R – CGS

Unit GM = P – Unit CGS

• Four Factors– Q

– P

– Cost

– Product Mix

B: Trade Margin

Mfgr Wholesaler Retailier

For a Single Channel:

Pm = P x (1 - %Discount)

Ex: Pc = $2.00

% Discount = 0.03

$1.40 = 2.00 x 0.70

Also

Pc = Cost / (1 - %Discount)

For N Channels:

Pc = Cost / (1 - %Discount)

Cost = Pc x (1 - %Discount)

C: Net Profit Margins

(before taxes)

R

-CGS_______

GPM

-Other VC

-FC_________

Net Profit Margin (NPM)

% of NPM = NPM

R

4. Contribution Analysis

BEQ = FC / (P-AVC)

% CM = (P-AVC) / P

BER = FC / %CM = BEQ x P

• NoteBER = P x BEQ

= P x FC / (P - AVC)

Divide by P P x [FC / P – AVC] = FC

P P %CM

ILLUSTRATIONChannel Unit CGS GM GM% Make-UP%Manufacturer 2.00 0.88 .306(.88/2.88) .44(.88/2.00)Wholesaler 2.88 0.72 .200(.72/3.60) .25(.72/2.88)Retailer 3.60 2.40 .400(2.40/6.00) .67(2.40/3.60)Consumer 6.00

Calc. of Prices and Margins SP = CGS x Product of Mark-UpsPrice to Consumer $6.00 = 2.00 x (1.44 x 1.25 x 1.67) = $6.00

x 0.40 CGS = SP/Product of Mark-UpsRetailer Margin 2.40 = 6.00 / 3.00 = $2.00Wholesale Price 3.60

x 0.20 Alternatively,Wholesale Margin 0.72Manufacturer Price 2.88 SP = Cost / Product (1-%D)

x 0.306 = 2.00 / (1-.4)(1-.2)(1-.306) = $6.00Manufacturer Margin 0.881 Cost = SP x Product (1-%D)Manufacturing Cost $2.00 = 6.00 x (1-.4)(1-.2)(1-.306) = $2.00

• Applications(1) Sensitivity Analysis: Vary P or

AVC or FC to determine BEQ

(2) Calculate Q to achieve Profit Objective ()

Qp = FC + P

P – AVC

Suppose objective is to achieve a profit of X% on sales

R – C = % R

PQ-AVC(Q)-FC = % PQ

Q (P-AVC) – FC = % PQ

Example: P=$25; AVC=$10; FC=$200,000; % = .20

Q(25-10) – 200,000 = .20

25Q

Q = 20,000

5. CannibalizationAssume:

• X X+

P 1.00 1.10

AVC .20 .40

CM .80 .70

• Qx = 1,000,000 if X+ is not introduced

= 5,000,000 if X+ is introduced

Qx+ = 1,000,000 if X+ is introduced

• Assume no incremental FC

Query: Should X+ be introduced?

Solution:Method AX+Gain 1,000,000 x .70 = 700,000CannibalizationLoss 500,000 x .81 = 400,000

+$300,000

Method BContr: w/o X + 1,000,000 x .80=800,000Contribution with X and X+:X 500,000 x .80 =

400,000X+ 1,000,000 x .70 = 700,000

Total Contr. Of X + X+ = 1,100,000Contr of X alone = 800,000Net Gain from Add. of X+ = 300,000

6. Financial Concepts and Ratios

A. Liquidity

• Working Capital = Current Assets – Current Liabilities

Current Assets = Cash, Accounts Receivable, Inventory, Prepaid Expenses

Current Liabilities = Accounts Payable, Income Taxes

• Operating Leverage = FC/VC

• Current Ratio = Assets Liabilities

• Quick Ratio =Assets-Inventory Liabilities

B. Asset Management

• Inventory Turnover = Sales / Inventory• Asset Utilization = Sales / Total Assets

C. Profitability Ratios

• Profit Margin in Sales = Profitability Before Taxes / Sales• Return on Assets = Profitability Before Taxes / Total Assets• Return on Investment = Net Income / Investment (Investment = Total Assets)

= Net Sales X Net Income

Investment Net Sales

= Investment Turnover x Profit Margin• ROI = f (Stockturn, ratio of CGS to Net Sales)

• Net Present Value Illustration

Cost of Capital 10%Sales from New Product $1,000,000/yrNew Equipment $700,000Useful Life of Equipment 10 yrsDepreciation 10% / yrSalvage Value $100,000Cost of Goods and Expenses $700,000Tax Rate 50%

Assumptions

Calculating Net Cash Flows

GI = Sales – CGS

= 1,000,000 – 700,000 = 300,000

Taxable Income = GI – Depreciation

= 300,000-60,000 [(700,000 – 100,000) x .10] = 240,000

Net Income = Taxable Income – Tax

= 240,000 – 120,000 (240,000 x .5) = 120,000

Net Cash Flow = Net Income + Depreciation

= 120,000 + 60,000 = 180,000

Year Net Cash Flow 10% Discount Factor PV1 $180,000 0.9091 $163,6382 $180,000 0.8264 $148,7523 $180,000 0.7513 $135,2344 $180,000 0.683 $122,9405 $180,000 0.6209 $111,7626 $180,000 0.5645 $101,6107 $180,000 0.5132 $92,3768 $180,000 0.4665 $83,9709 $180,000 0.4241 $76,33810 $280,000 0.3855 $107,940

$1,144,560