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Chapter 1

PRACTICAL APPROACH TO
THE BALANCE ANALYSIS

 

by josavere

The balance analysis defined as point of profit equal to zero, constitutes an important element of planning in the short term because allows to calculate the smaller quota, or minimum of units to produce and to sell for a business does not produce loss. It is important a correct use of this tool knowing the limitation of the model.

Clearing the equation:

U:

profit

Q:

amount to produce and to sell

F:

fixed costs

V:

% of variable costs per unit

P:

unitary price

Graphically:

2. BASIC ASSUMPTIONS

a. The costs are perfectly definable like fixed or variables.
b. Variation of costs and income according to a linear function: y = mx+b
c. The sale price is constant. 
d. Production = cash sale
e. Production of goods of a single type.
f. Short term to assume that costs are fixed.

3. CRITIC

A. In the practice is very complex to classify the costs like fixed or variable. Still in the short term, very few headings can be differentiated as perfectly fixed because all the costs change based on the time, especially in an inflationary economy in regard to the technological change, the improvement of systems, etc.

 

B. The amount required of determining goods per unit depends, in many cases of an amount of variables like the mixture, batch size to produce, quality of the raw materials, its homogeneity and others. It is very difficult to find absolutely variable costs that it can be expressed in terms of a function y = f(x).
Some costs are semi-variables because change at different levels  step by step , but not in a linear way .It is the case of the supervision; probably is possible directed efficiently of 1 to 30 works but, from 31 to 60 an additional supervisor needed. The situation is similar with the public services, the maintenance, etc.

C. The curve of income by sales presents a behavior with slopes based on the offered volume and discounts, practical very common in the businesses when the plant isn't full. As far as the raw materials, usually we find changing prices based on the amounts bought. Then, a linear behavior curve happens with variable angles (A, B, C, etc.) depending on the amount to buy or to sell according to the case; no always the trade is in cash.

 

D. In many cases the demand is stationary and hardly production can be programmed that follow the same behavior. The manual labor required time for his training and incurred in expenses for storage to adapt the production to the demand.
E. The diversification principle, respected enough in finances (don´t place all eggs in the same basket) recommends the manufacture and marketing a mix of product instead of the concentration of a single line.

 

F. Generally, the businesses are constituted with indefinite life and for that reason the administrators cannot concentrate at the moment; they must think about the long term, being these most difficult aspects to handle, because it demands a great quota of forecast, responsibility and sacrifice of present results. Decisions like the system of depreciation to use, the retention of profits, the investment in publicity, the system of valuation of inventories, the motivation and training of the personnel, the refreshing of equipment, the transfer of a plant, etc., are good examples to illustrate as it is possible to be sacrificed the future of the company for an immediate result.

 

 

4. PRACTICAL RECOMMENDATIONS
The previous limitations do not imply that we must reject so important and simple tool of planning. We need to analyze the particular cases and to make the adjustments pertinent so that the analysis of balance can be used without the fear wrong decisions. Let us try to look for the solution each one of the listed limitations:

 

A. CLASSIFICATION OF COSTS: for each company in individual the careful qualification will become, after a process of discussion and analysis of each of the headings, processed by experts and with a vast knowledge of the business, try to look for the most approximate possible classification in order that one keeps the objectivity and the agreement with the system of costs of the company. In case of doubt, the behavior of the heading is due to decide on an alternative and to verify it in order to be perfect the system.

B. VARIATION OF COSTS AND INCOME: for each article is due to be studied the optimal order of production, to determine the consumption average of each of the direct incomes. The orders of raw materials must take control based on the optimal size and as far as possible, to negotiate the price for a reasonable time and if it is not obtained it, is recommended to consider a price average based on experience; the manual labor, a hiring based on produced units would be desirable, it must almost unavoidably, consider the heading as fixed and to consider the value of unit produced including the appropriations for social benefits considering the labor legislation and the collective conventions.

C. SALE PRICE:  to calculate the net sale price based in discounts and the cost of capital of the company. If use prices differentials, to define the corresponding curve of income adding the income by tributary stimuli if there is, and considering the date of the income in according to the legal rule to calculate the average price.

D. RATE OF PRODUCTION AND SALES: to balance this factor it is required to have presented the financial expenses. In case of finished product storage the functions of production and sale must be correlated, and affect the surpluses by the cost of capital of   the company.

E. PRODUCT MIXTURE: the use of a representative product like a conversion unit it is recommended to look for a factor of equivalence for other articles. Of this form it expresses the mixture of production based on that unit. The fixed costs are assigned according to the system of costs that uses the company.

 

F. SHORT TERM FOR FIXED COSTS: planning with standard costs and periodic overhaul of   the calculation bases. If a change in some of the variables appears, the balance point change because depends on the level of the fixed and variable costs and the sale price.
The balance analysis is extremely important when it defines the structure of a business. As far as possible one is due to tend to structures with very few fixed costs to reduce proportionally the risk, in the event that the result is negative, in which case   the financial leverage will operate in the same way. The idea is to look for variable structures with great flexibility is geared to face situations difficult and to respond when the difficult circumstances of the market
The balance analysis is compatible and in fact, it uses the concepts of Direct Cost and the ABC. Its great advantage in addition to simplicity rests on the graphical representation and the mathematical calculation of a budget at the different levels from production and sales.
The companies with high proportion of fix cost must introduce special programs for obtaining income. It is the case of the airlines, the theaters, the hotels. It's much recommended for sport clubs in the fixing of the value as the ticket.

 

 

5. POINT OF FINANCIAL BALANCE

 

On some occasions, especially when the situation is of crisis and a possible technical insolvency or lack of capacity to operate by insufficiency of cash, the analysis of plant closing is useful. The financial point of indifference indicates the minimum requirements of cash so that the plant can stay by itself, without injection of extra of capital.
For this analysis, take the live costs and the dead costs, following the parameters such as previous ones. Let's consider live costs those that imply expending of cash. It is the case of the purchases of raw materials, the labor payments and others.
The dead costs correspond already to cause expenses and that simply are appearing as accounting registry like depreciation and the amortizations. When the calculated affluent expectation that the company recover in a future, it is possible to be operated still losing in the activity, as long as the company generates the needs cash for its operation. It is the starting point for the analysis of the recovery   a company in critic’s conditions, aspect to analyze in another document.

Example: BALANCE POINT

Equal part of an profit to zero

Sale price

199.19

Fixed costs

175.000.000

Variable costs

20%

Variable costs in pesos 40
Q = 175,000,000 / ( 199,19 - 40 )
Q = 1.099.315 Units/Year

Example: POINT OF REVIEWED BALANCE (josavere)

sale price

199.19

cost of capital

2.19%

Term at 2 months
Reviewed Sale Price = 199.19 x 0,9565 =190.525235

FINANCIAL COST

* Raw material

Basic cost

Financial cost

 

Total cost

Cost4 (1,0225)

4

0.09

=

4.09

* Product in

 

 

 

 

Value 6.400.000

 

 

 

 

Unit / month 160.000

 

 

 

 

Cost by   unit multiplied by the percentage of product in process 40*0.5

 

 

 

 

Cost20 (1,0225)

20

0.44

=

20.44

* Finished product

 

 

 

 

Cost40 (1,0225)

40

0.88

=

40.88

Total financial cost

 

1.41

 

 

Variable costs

 

40

 

 

Total costs but financial variable costs

 

41.41

 

 

% of C.V. = 41.41 / 190.53
% of C.V. = 22%
Q Reviewed = 175,000,000 / ( 200,03 - 41,44 )
Q Reviewed = 1.173.586 Units/Year

 

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