HOW DO YOU MANAGE COSTS

the bracket. The larger this gap is, the more profit is being
achieved.
C At this level of sales, the gap between total revenue and total
costs is approximately double the size of the gap at point B. In
other words, profit being achieved at point C is double the profit
being achieved at point B. To achieve this profit increase, the sales
increase from point B to point C is only approximately 30%. This
indicates that if sales increase by 30% from point B to point C,
profit will double. Examining the reverse situation, if sales drop
from point C to point B, this results in a halving of profit.
By examining these points on the graph, we are able to identify
two very important features that are pertinent to most types of
business:
T A minimum level of sales is required to break even
A certain level of sales needs to be attained just to cover costs.
T Profit is very sensitive to changes in sales
When the break-even point is exceeded, a 10% increase in sales
will result in a more than 10% increase in profit, while a 10%
decrease in sales will result in a more than 10% decrease in profit.
The reason for these two phenomena is the existence of fixed
costs. If a business only has variable costs, the relationship between
sales and profit is far more straightforward: no sales equals no profit,
lots of sales equals lots of profit, halving the sales halves the profit,
while doubling the sales doubles the profit.
Is there an optimal cost structure for a business?
Is it better to be a primarily fixed cost or a primarily variable cost
business? Striking the balance between fixed and variable costs determines
the relationship between sales and profit. To fully appreciate the
impact of these two cost types, let’s examine two extreme cases: a
totally fixed cost business and a totally variable cost business

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How can you plan sales quickly

One of the reasons for the justifiable popularity of CVP analysis
is that it’s fast. Let us build the logic step by step. Suppose you are considering
setting up your own clothing store and what appears to be an
ideal site has just become available to rent. You estimate you will need
$750,000 at the outset to fit out the store, fill it with inventory, purchase
equipment, and cover various other initial expenses. Is this an
opportunity worth considering? The answer to this question depends
on your ability to generate sales, and this is where CVP analysis comes
to the rescue.
The most common application for CVP analysis is to help identify
a planned sales figure. In order to achieve this, the technique can
be viewed as comprising three distinct stages. The first stage involves
establishing why you want sales in the first place. In other words, how
much would you like to earn? There are only two reasons any business
wants sales:
T To pay its regular expenses
A business will incur certain expenses regardless of whether sales
take place or not. These are its fixed costs and need to be paid.
T To make a profit
Businesses need to generate a profit to provide a return to their
investors.
In your clothing business you will have to pay fixed costs such as
rent, heating and lighting, telephone, salaries, and so forth. In addition,
you will want a return on the $750,000 you are planning to
invest. Suppose you estimate that your fixed costs during the first year
of trading will be $250,000. In addition, you would like to achieve a
profit of $150,000 (which represents a 20% return on your initial
investment of $750,000). We have now established that you would like
to have enough sales to
T Pay your annual fixed costs of $250,000
T Plus provide a profit of $150,000

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HOW DO YOU CREATE A FINANCIAL PLAN

if you are able to commit some figures to paper, they will inevitably
turn out to be wrong. So why bother?
Let’s establish a key concept at the outset. If you want to run a
profitable business, you have to start with a plan. There is an adage in
the world of finance called the ‘five Ps’:
Poor Planning Produces Poor Performance
This is one of those sayings that all too frequently translates itself
into reality, so time spent planning is always time well invested. In this
chapter we are going to look at how to bring together all the financial
aspects of a business within a coherent plan that is based on
sound commercial logic.
Why have financial plans?
We have seen that shareholders invest funds in companies in
order to obtain a return on their investment. It follows that in order to
satisfy shareholders’ expectations, businesses need to coordinate
resources to ensure that they meet their targets. This is the role of
financial planning. Creating financial plans, which are more commonly
referred to as ‘budgets,’ provides a control device that can be
used to ensure that the appropriate actions are being taken. If trading
performance subsequently deviates from the budget, this will provide
a signal to management that action may be required to ensure that
commercial targets are still attained.
The bare bones
Budgets are needed to provide a control device that can
be used to ensure the attainment of commercial goals.
Do not confuse planning with forecasting – they are not the same
thing. A plan details future actions that need to be taken to achieve predefined
commercial goals, the most important of which is usually a
profit target. A forecast, by contrast, is an estimate of what is expected
to happen in the future. The distinguishing feature is the objective

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What is shareholder value

The principle of shareholder value is easy to grasp – it simply
refers to the value of the shareholders’ investment. So when companies
talk about creating shareholder value, they are talking about increasing
the value of the shareholders’ investment.
Although the concept is reasonably easy to grasp, determining
whether or not companies are creating shareholder value is somewhat
more involved.
The bare bones
Creating shareholder value means increasing the value of
the shareholders’ investment.
How do you know if a company
is creating shareholder value?
In the previous chapter we established that there are two ways to
value a company: book value and market value. Suppose shareholders’
funds, as reported in a company’s balance sheet, total $10 million. This
is its book value. If the market value is $12 million, it is evident that
additional value of $2 million has been created in excess of the funds
physically invested in the business. This premium, as we have seen, is
called goodwill. However, simply measuring the value of goodwill in a
business does not tell us how effective the management team are at
creating it. If one company has goodwill valued at $200,000 while
another company has goodwill valued at $7 million, does it follow
that the latter company is more effective at creating shareholder value?
It is impossible to say, as we might be comparing companies that vary
greatly in size.
In order to assess how good management is at creating shareholder
value a powerful measure has been developed called the
:’market to book ratio
Market price per share
 =
 Market to book ratio

Book value per share

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HOW DO YOU KNOW IF A COMPANY IS BEING WELL MANAGED

An email has just arrived in your inbox. It is the quarterly
address from your company’s chairman to the staff: ‘The
company has seen a period of sustained growth, with
sales and profits strengthening each year. As you are no doubt aware, we
have recently had a team of management consultants working with us
to assist in developing our strategy for the future. The Board of Directors
are now committed to focusing attention on creating shareholder value
and this must be the focus of attention for all managers and staff within
the organization. Everything we do must be seen to create value. We
know we have the capability to deliver on this and we are confident
each and every one of you will play your part. Good luck! Seymour
Khash, Chairman.’ You are bemused. What is shareholder value? Is it
just another way of saying make more profit? If that’s the case, why not
just say so? It sounds like just another management fad. No doubt it
will pass and in a few months’ time everything will be back to normal.
Shareholder value is definitely not a fad and it’s a concept that is
relevant to most types of business. As such, managers should be aware
of what it is and be continually trying to devise strategies to enhance
it. In this chapter we are going to see how shareholder value combines
information in financial statements with information in the
financial press to determine whether or not a company is a worthwhile
investment

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What determines share prices

The market value of a company (also known as its ‘market capitalization’)
is calculated by multiplying together two figures:
T The number of shares in issue
T The market price per share
The number of shares in issue is up to the company. What is far
more important is the amount of money it wants to raise. For example,
suppose the Gassy Beer Company wants to raise $10 million.
There are many ways in which this can be done:
T It could issue 10 million shares at $1 each
T It could issue 5 million shares at $2 each
T It could issue 2 million shares at $5 each
and so the options continue.
It is entirely up to the company which option it selects. There is
an argument, though, that the higher the price of a share the less tradable
it becomes. For example, if the Gassy Beer Company decides to
issue just two shares at $5 million each, there probably would not be
very many potential buyers! As a result, most companies like to keep
their share prices reasonably low in order to encourage trading.
Of course, once the shares have been issued, the market value of
the company will be dependent on the price that investors are subsequently
willing to pay for those shares, which will be driven by expectations
of future profits. If information comes to light that suggests the
company will make higher profits in the future than previously
expected, the value of goodwill will increase and this will be reflected
in an increased share price. Conversely, if information becomes available
that suggests that profits in the future will be lower than previously
expected, the value of goodwill will decrease, and this will be
reflected in a reduced share price

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WHAT CAN YOU LEARN FROM THE FINANCIAL PRESS

The bare bones
The book value of a business is the value of shareholders’
funds as stated in the balance sheet.
Book value is not the only method for valuing the shareholders’
investment. An alternative method is called ‘market value’ and is calculated
as follows:
Market value = Number of shares in issue x Market price per share
If the Max Spending Corporation has 5 million shares in issue
that are currently valued at $25 each, the market value would be as
follows:
Market value = 5 million shares x $25 per share
= $125 million
This is the value that investors currently place on the company.
In other words, based on the current share price, if somebody wanted
to buy the company right now they would need to pay $125 million
for it. This is very different from the book value of $75 million.
The bare bones
The market value of a company is defined as:
Number of shares in issue
multiplied by the share price
Why would anyone be willing to pay more than the value of the
business as stated in the balance sheet? If the business is indeed bought
for $125 million, the first $75 million of this is being paid for the shareholders’
funds as stated in the balance sheet. Given that shareholders’
funds are tied up in assets, it follows that this $75 million is being paid
to acquire the company’s assets such as property, equipment, inventory,
and so on. So what is the remaining $50 million buying?
The difference between the market value of a business and its
book value is called goodwill

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