Key determinants of operating incomeKey determinants of operating income

Purchasing and selling pricesselling prices

Sales revenue – operating costs = operating income

Structural determinants

Volumesdeterminants

Structural factorsStructural factors

i d i i• Maximum production capacity• ExperienceExperience• Specialization• Standardization• Industry• Industry• Vertical/horizontal integration• ...

2

Price levelsPrice levels

h i i• Purchasing prices– Price of inputs bought from suppliersp g pp

• Selling pricesi f ld– Price of output sold to consumers

• Both prices depend on internal factors (e.g. p p ( gpower of the firm in negotiating with suppliers or setting selling prices) and external factorsor setting selling prices) and external factors (e.g. industry trends, competition levels)

3

VolumesVolumes• For given structural determinants and cost g

structure, the operating profits is determined by volumesvolumes

• Different volumes influence operating profits by changing both total costs (via variable costs) and revenuesa d eve ues

• We use the break even point (BEP) analysis to d t d th l ti hi b t lunderstand the relationship between volumes

and operating profits• Before BEP, let’s recap the nature of costs

4

Costs CostsVolume range

being considered

Total variable costs

Total variable costs

Volumes

a. linear relationship variable costs/volumes

Volumes

b. actual relationship variable costs/volumes

5

Question: Why non-linearities?

Costs CostsVolume range

being considered

Total fixed costs

Total fixed costs

Total fixed costs

Volumes

a. linear relationship fixed costs/volumes

Volumes

b. actual relationship fixed costs/volumes

6

Question: Why step-wise increases?

A note on labor costsA note on labor costs

• If labor can be easily increased/decreased or reallocated across business units, then labor ,would be a variable cost

• However in practice labor is regulated and• However, in practice, labor is regulated and labor laws create hiring/firing costs

• In this case, labor costs are variable but they also entail some fixed cost componentalso entail some fixed cost component– In the Scaltrini solution, we classify them as semi-

variable costsvariable costs

Costs

Total costs

V i bl tVariable costs

Fixed costs

Volumes

8

120

80

100

60

80 Average unit cost cost

40

0

20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 301 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Volumes produced

• It decreases due to fixed-cost absorption economies (i.e. fixed costs distributed over more units ot output), although variable costs increase• However the shape is determined by the importance of fixed and variable costs

9

• However, the shape is determined by the importance of fixed and variable costs for the firm

Exampleh f l ld ( / l )What if only 30K pieces sold (2/3 or original projection)?

Average price per meal

Projected volume (300x150) = 45 000

16.00 Average price per meal

Projected volume (300x100) = 30 000

16.00

Projected volume (300x150) = 45,000

Total sales revenue 720,000

Variable unit cost per meal 4 00

Projected volume (300x100) = 30,000

Total sales revenue 480,000

Variable unit costs per meal 4 00Variable unit cost per meal

Projected volume = 45,000

4.00 Variable unit costs per meal

Projected volume = 30,000

4.00

Total variable costs 180,000Cost 1 expert pizza cook4 workers at average cost of 32,500

80,000130,000

Total variable costs 120,000Cost 1 expert pizza cook4 workers at average cost of 32,500

80,000130,000

Salaries and wages 210,000

Rent 60,000General Costs 70,000Depreciation 35,000

Salaries and wages 210,000

Rent 60,000General Costs 70,000Depreciation 35,000

Output sold is 1/3 lower but operating income is not just 2/3 lower but it’s negative! Why?

p ,Advertising 30,000Operating income 135,000

Depreciation 35,000Advertising 30,000Operating income -45,000

Output sold is 1/3 lower, but operating income is not just 2/3 lower but it s negative! Why? Some costs don’t drop (i.e. 5 worker is minimum number to run the restaurant), fixed costs remain unchanged

ExampleExample

(a) (b) (c) (d) (e) (f) (g)

Total and unit costs

(a) Q

(b) Variable cost (VC) per unit

(c) Total VC

(a x b)(000 €)

(d)Fixed

cost (FC)(000 €)

(e) Total costs

(c +d)000 €)

(f)Total cost per unit

(e / a)

(g)Fixed cost per unit(d / a)

25,000 4.00 100 405 505 20.20 16.20

30,000 4.00 120 405 525 17.50 13.50

45,000 4.00 180 405 585 13.00 9.0060,000 4.00 240 405 645 10.75 6.75

What can we do?What can we do?

• Variations in volumes• Variations in costsVariations in costs• Variations in selling prices

• First question to ask is what is the output that• First question to ask is, what is the output that allows the firm to generate enough revenues to

it ti t ? B k i tcover its operating costs? Break even point

Break even point (BPE)Break even point (BPE)

• Q such that Revenues (R) = Total Costs• Lets call r the selling price of each unitLets call r the selling price of each unit

• Then, r×Q = VC×Q + FC, Q Q

r×Q-VC×Q = FC

Q×(r - VC) = FC

Qbreak-even = FC / (r – VC)i ib i i= unit contribution unit

Compute the BPECompute the BPE

+ Average price per mealx Hypothetical volume (300x112.5) = 33,750

16.00Costs and revenues

Sales

= Total sales revenue 540,000+ Average cost per meal x Hypothetical Volume = 33,750

4.00

revenue

Operating profit

= Total variable costs 135,000

Salaries and wages 210,000

Rent 60,000Fixed

Total costs540,000

General costs 70,000

Depreciation 35,000

Fixed costs

Operating loss

BEPAdvertising 30,000

Operating income 0,000Volumes

BEP33,750

Break even point (BPE)Break even point (BPE)

/ ( )Qbreak-even = FC / (r – VC)= unit contribution unit (MCu)

• How much does the production and sale of each it f t t t ib t t i fi d t ?

( )

unit of output contribute to covering fixed costs?• Often, contribution margin is expressed as a

f CM(%) MC /percentage of revenues: CM(%) = MCu/r• Using this term, we can compute the revenue-

based BPE: FC/CM(%)• Useful when e.g. reasoning in quantity doesn’t g g q y

make sense (diversified firm)

Operating riskOperating risk

• Varying degree of profitability that a firm will face particularly negative or positive net income, in relation to the fluctuation in production and sales volumes

• Linked to two components of the organization's economic structure: BPE and degree of the operating leverage

• Operating leverage is the size of the differentialOperating leverage is the size of the differential between revenues and total costs above and below the break-even pointb ea eve po t

Operating riskOperating risk

Costsdand revenues Sales revenue

Operating leverage

Total costs

p g g

Fixed costs

VolumesBEP VolumesBEP

Operating riskOperating risk

• Suppose that there are exogenous changes in volume:• If a firm has very rigid cost structure, i.e. high ratio of y g g

fixed costs to total costs– The firm will react badly to drops in volumes (less room to y p (

distribute fixed costs over units of output)– But the same firm will respond positively to increases in

volumes

• The opposite is true for a firm with a flexible coststructure, i.e. low ratio of fixed costs to total costs– If volumes drop, the firm can easily reduce costs– If volumes increase, the firm experience unavoidable cost

increases

Operating riskOperating risk

Computation of operating riskComputation of operating risk

• Ratio of total variable costs and fixed costs at the BEP

• The greater the value, the greater the operating risk• Operating risk is not necessarily a bad thing: itOperating risk is not necessarily a bad thing: it

amplifies losses (as we move in the area right to the BEP), but it amplifies profits (as we move in the areaBEP), but it amplifies profits (as we move in the area left to the BEP)

• Hence the choice of e g two plants with same BEP• Hence, the choice of, e.g. two plants with same BEP but different operating risk depends on our estimate of how much volumes sold would exceed the BEPof how much volumes sold would exceed the BEP, and on the manager’s degree of risk aversion

Profit pointProfit point

• So far, we have only focused on a BEP such that revenues cover operating costs (e.g. labor, p g ( g ,equipment etc.)

• But in practice firms incur in non operating• But in practice firms incur in non-operating costs related e.g. to financial charges and taxes

• These charges are negative components that need to be taken into account in theneed to be taken into account in the determination of net income (≠ operating income)income)

Profit point: examplep pLet’s go back to the example of the restaurant (under scenario 1)

Financial charges 24,000

Non-income taxes 6,000

Income tax rate (on pre tax income) 50%

Average price per meal

Projected volume (300x150) = 45,000

16.00

Income tax rate (on pre-tax income) 50%

Target net income 75,000Total sales revenue 720,000

Variable unit cost per meal 4.00

Target operating income 24,000+6,000+150,000= 180,000

Projected volume = 45,000

Total variable costs 180,000What is the sale revenue that can allow the

firm to reach the target?

,Cost 1 expert pizza cook4 workers at average cost of 32,500

Salaries and wages

80,000130,000

210,000We use a variation of the revenue based BEP:(FC+Target operating income)

CM(%) (r-VC)/r = 12/16

Rent 60,000General Costs 70,000Depreciation 35,000Advertising 30 000

= (405,000+180,000)0.75

( )Advertising 30,000Operating income 135,000