TLIP5035A Presentation 4

PRESENTATION 4: DEFINITIONS OF TERMS AND DATA

PRESENTATION 4 OUTLINE

The following areas are covered in this presentation:

• Budgeting for Costs, Revenues and Profits

• Translating CVP into Accounting Language

• Profit and Loss Statement

• Linking CVP to the P&L Statement

BUDGETING FOR COSTS, REVENUES AND PROFITS

Profit

• A simple but sensible assumption - the aim of most commercial

businesses is to MAXIMISE PROFITS.

• Note that not all organisations have this aim e.g. public sector

agencies, voluntary and not-for profit associations. These

organisations have different aims.


Profit

• Total Revenue (TR) refers to

the total income the

business receives from the

sales of its goods and

services

Formula 1PROFIT = TOTAL REVENUE – TOTAL COST or Pr = TR - TC


Profit

• For a simple business selling just one product at one price:

• TR (like total costs) increases as more products and services are

produced and sold.

• Total cost (TC) refers to the sum of all the money spent by the

business purchasing the inputs to produce its goods or services.

These costs will include:

Total Revenue = Price X Quantity

• raw materials• wages and salaries• rent• electricity, telephones etc.

• even the tea bags for the office kitchen

• More about the various types of costs later


Profit

• Fixed costs are those costs that do not change as the

business’s volume of products and services change

Example:

• A company rents a

warehouse at the Port of

Brisbane

• It does not matter how many

customers they have or how

many staff are employed

• The rent does not change

• The rent is a fixed cost


Profit

• Variable costs are those costs that do change with the quantity

of products or services produced by the business

Example:

• As the number of customers

at a restaurant grow and

more and more meals need

to be prepared more and

more ingredients (or inputs)

e.g. meat, seafood,

vegetables, salads and wine

need to be purchased


Profit

• If the business is aiming to

maximise its profits, it will

need plans to do so

• Such plans will include

budgeting for:

− sales revenues

− costs, and

− profit

Graphically, Total Cost is shown as:

Total Cost = Fixed Cost + Variable Cost


Cost Volume Profit Analysis

• Can be used to plan for future sales, revenue, cost and profit

targets. Examines the relationship between costs, revenues and

profits (or losses) the firm will have at various levels (or volume)

of production

• Allows business to calculate the level of output and sales it must

achieve to avoid a loss – this is called the BREAKEVEN POINT

BUDGETING FOR COSTS, REVENUES AND PROFITSContribution Margin

• The contribution margin refers to how much the sale of a single product

contributes to profit. It is calculated as the price less the variable cost (per

unit) of the product. It is called the contribution margin because this

margin contributes:

1. To paying off the

fixed costs (and

reducing loss)

2. Then, once the

breakeven point is

reached, towards

profit

TRANSLATING CVP INTO ACCOUNTING LANGUAGE• The accounting profession has developed different terms to describe

fixed and variable costs e.g. variable costs, direct costs, cost of

goods sold, fixed costs, indirect costs, overhead.

Cost of Goods Sold (COGS)

• COGS is the costs that go into creating the products (and services)

that a company sells. The only costs included are those that are

directly tied to the production of the products.

For example:

• The COGS for an automaker would include the material costs for the

parts that go into making the car plus the labour costs used to put

the car together.

• The cost of sending the cars to dealerships and the cost of labour

used to sell the car would be excluded.

TRANSLATING CVP INTO ACCOUNTING LANGUAGE

Overheads

• In business, overhead or an overhead expense refers to an

ongoing expense of operating a business.

• Also known as Operating Expenses e.g. rent, gas/electricity,

administrative wages, etc.

• The term overhead is usually used to group together expenses

that are necessary for the continued functioning of the business

but cannot be immediately associated with the products/services

being offered

• Overhead expenses do not directly generate profits


Allocating Wages and Salaries

A distinction can be drawn between:

1. The wages of staff employed directly in the production of goods and

services

2. The wages and salaries of staff employed in managerial and

administrative positions

− Q. Which of these would you consider to be a variable cost?

− Q. And which would you consider to be a fixed cost?

• The numbers of staff involved directly in production are likely to

increase and decrease with changing levels of production. Therefore,

they are likely to be variable costs and are reported as part of the

COST OF GOODS SOLD in the profit and loss statement.


Allocating Wages and Salaries

• The numbers of staff involved in managerial and administrative

positions are less likely to vary with changes in the scale of

production

• Therefore, they are likely to be considered as fixed costs and are

reported as part of the business’s OPERATING COSTS or

OVERHEADS in the profit and loss statement

• Note: This is particularly true in the contemporary Australian

context where there has been a great increase in the use of casual

labour. Increasingly, casual labour is used specifically because it

constitutes a variable cost of production


Gross, Operating and Net Profit

We now understand that:

Profit = Total Revenue – Total Cost

Total Cost = Variable Cost + Fixed Cost

But accountants talk about:

• Gross Profit

• Operating Profit or EBIT (i.e. earnings before interest and taxes

• Net Profit or Net Income


Gross Profit (or Sales Profit)

• The difference between revenue and the cost of making a product

or providing a service (before deducting overhead, payroll,

taxation and interest payments)

• This is like saying: Gross Profit = Total Revenue – Variable costs.

Gross Profit = Sales – Cost of Goods Sold


Operating Profit

• Profit earned from a firm's normal core business operations

• This value does not include:

− any profit earned from the firm's investments (e.g. earnings

from other firms in which the company has partial interest),

and

− the effects of interest and taxes

• Also known as ‘earnings before interest and tax’ or simply EBIT.


Net Profit

• Represents the number of sales dollars left after all cost of goods,

operating expenses, interest, taxes and preferred stock dividends

(but not common stock dividends) have been deducted from a

company's total revenue

• Net profit is also referred to as the bottom line, net income, or net

earnings

• This is like saying: Gross Profit = Total Revenue – Variable costs.

Net Profit = TR – COGS – Operating Expenses – other financial costs

PROFIT AND LOSS STATEMENTTotal Revenue $100,000

Cost of Goods Sold ($20,000)

Gross Profit $80,000

Operating Expenses/Overheads

Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000

Total Operating Expenses ($30,000)

Operating Profit/EBIT $50,000

Interest Expense ($10,000)

Taxes ($10,000)

Net Profit $30,000

TOTAL REVENUE is the revenue the company

receives from the sale of its product or service





Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

COST OF GOODS SOLD are the direct costs of

producing the goods or services sold. These are also the variable costs of

production.Cost of goods sold will

include the cost of buying raw materials,

parts used in making the product, the wages of staff employed directly

in manufacturing or service delivery etc.





Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

GROSS PROFIT = SALES - COGS





Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

The OPERATING EXPENSES or

OVERHEADS refer to the indirect costs of the

company’s operations.These can be thought of

as fixed costs of production as they do

not vary with the number of products

produced.However, that does not mean that they can not

change for other reasons!





Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

The OPERATING PROFIT is the profit earned from

a firm’s normal core business operations.

Operating Profit = Total Revenue – COGS –

Overheads

Sometimes referred to as EBIT (Earnings Before

Interest and Taxes)





Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

INTEREST PAYMENTS made (for example on money borrowed from

the bank) can be substantial, but they

relate to how the company is financed rather than its day to day operations and

production of goods and services





Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

TAXES are significant too, but these are taken

into account after operating profit as they do not relate directly to

the core activities or running the business or

producing goods and services for sale.





Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

NET PROFITS or NET EARNINGS is what we

often call:

“THE BOTTOM LINE”

This is what the owner(s) get after all expenses,

interest and taxes have been deducted from

sales revenue.

LINKING CVP TO THE P&L STATEMENTTotal Revenue $100,000




Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

TR = P X Q





Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

TR = P X Q

COSTS OF GOODS SOLD ARE THE VARIABLE COSTS





Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

TR = P X Q


The OPERATING EXPENSES or OVERHEADS are

equivalent to fixed costs





Salaries $10,000

Rent $10,000

Utilities $5,000

Depreciation $5,000




Taxes ($10,000)

Net Profit $30,000

TR = P X Q


The OPERATING EXPENSES or OVERHEADS are

equivalent to fixed costs

OPERATING PROFITPROFIT = TR- TC

PROFIT = TR – (VC+FC)(… but not counting interest

and tax)

Education

TLIP5035A Presentation 4