13. Practical approach to the balance analysis

# Chapter 13PRACTICAL APPROACH TO THE BALANCE ANALYSIS

by josavere

The balance analysis defined as a point of profit equal to zero constitutes an important element of planning in the short term because it allows us to calculate the smaller quota or minimum of units to produce and sell for a business that does not produce a loss. It is important to correct the 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 variable.
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 practice is very complex to classify the costs as fixed or variable. Still, in the short term, very few headings can be differentiated as perfectly fixed because all the costs change based on time, especially in an inflationary economy in regard to technological change, the improvement of systems, etc.

B. The amount required of determining goods per unit depends, in many cases on a number 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 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 to direct efficiently 1 to 30 works but, from 31 to 60 an additional supervisor is needed. The situation is similar to 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, which 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; not always the trade is in cash.

D. In many cases the demand is stationary and hardly production can be programmed that follows the same behavior. The manual labor required time for his training and incurred 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 of a mix of products instead of the concentration of a single line.

F. Generally, the businesses are constituted with an 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 tools of planning. We need to analyze the particular cases and make adjustments pertinent so that the analysis of balance can be used without the fear of wrong decisions. Let us try to look for the solution to each one of the listed limitations:

A. CLASSIFICATION OF COSTS: for each company 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 deciding on an alternative and verifying it in order to perfect the system.

B. VARIATION OF COSTS AND INCOME: 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, 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 on discounts and the cost of capital of the company. I use price differentials, to define the corresponding curve of income adding the income by tributary stimuli if there is, and considering the date of the income 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 the 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 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 it 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 tending 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 geared to face situations difficult and respond to the difficult circumstances of the market.

This aspect is very important, in special circumstances, such as the one that arises to plan the recovery of the world economy from the 2020 crisis, caused by the COVID-19 or coronavirus pandemic, as far as possible, look for exponential alternatives (capable of generating results disproportionately superior to traditional ones, having technology as an ally in the structure and development of the business) to increase productivity, the most powerful tool to counteract global inflation as seen with the emergence of companies with results quite noticeable globally. According to press figures, the world's largest hotel company, Airbnb, offers more than 7 million accommodation options in more than 100,000 cities in 210 countries, without owning a single hotel and with just under 6,000 employees. The world's largest carrier, Uber manages more than 3.5 million drivers in 10,000 cities in 71 countries, without owning a single car. Nubank, one of the most valuable financial institutions in Latin America, has more than 48 million customers without having a single bank branch or safe with physical money. Tesla, founded just 20 years ago, is today the most valuable automaker in the world, with a market value of almost \$1 billion dollars, more than the following 9 automotive companies together, many of them with brands such as Mercedes Benz, Ford or Toyota with decades of existence.

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 of production and sales.
Companies with a high proportion of fixed costs must introduce special programs for obtaining income. It is the case with the airlines, the theaters, and the hotels. It's much recommended for sports clubs to fix the value of the ticket.

5. POINT OF FINANCIAL BALANCE

On some occasions, especially when the situation is of crisis and 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 the injection of extra capital.
For this analysis, take the live costs and the dead costs, following the parameters such as the previous ones. Let's consider life costs as those that imply expending of cash. It is the case of the purchases of raw materials, labor payments, and others.
The dead costs correspond already to cause expenses and that simply are appearing as accounting registries like depreciation and amortizations. When the calculated affluent expectation that the company recovers in the future, it is possible to be operated still losing 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 of a company in critic’s conditions, an aspect to analyze in another document.

Example: BALANCE POINT

An equal part of a profit to zero

Sale price =1 99.19
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 process 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