5.2.1 Flashcards
what is profit?
Profit – The difference between income and total costs of a business.
What is profitability?
Profitability – The efficiency of a business at generating profit in relation to the size of the business.
Difference between profit and profitability?
Profit is just a sum of money whereas profitability relates the sum to the size of the business.
What are two main ways to measure a size of a business?
Sales revenue Capital employed (all the money that has been invested in the business by owners)
What is gross and operating profit?
Gross profit – The profit made once the firm’s direct costs have been paid.
Operating profit – Profit made directly from trading (its main activities).
Profit for the year (net profit) – The profit made from all activities once all costs and income of the business have been paid and revenue received from the firm’s main and additional activities.
Gross profit margin calculation?
Formula: GPM = gross profit x 100
sales (turnover)
Example: If a business makes £100,000 gross profit from sales of £850,000 worth of goods
GPM = 100,000/850,000 x 100 = 11.76%
This could then be compared with a smaller business earning £24,000 gross profit from sales of £110,000
GPM = 16,000/100,000 x 100 = 21.82%
In this example the smaller business has better profitability but lower profit. It is therefore more efficient at converting its sales into gross profit.
Operating profit margin calculation?
Formula: OPM = operating profit x 100
sales (turnover)
Example: If a business makes £60,000 operating profit from sales of £850,000 worth of goods
OPM = 60,000/850,000 x 100 = 7.1%
This could then be compared with a smaller business earning £11,000 gross profit from sales of £110,000
OPM = 11,000/100,000 x 100 = 11%
In this example the smaller business has better profitability but lower profit. It is therefore more efficient at converting its sales into operating profit.
Profit margin for the year calculation?
Formula: PFYM = profit for the year x 100
sales (turnover)
What is a budget?
Budgets are agreed financial plans with targets set for income (revenue), expenditure (costs) and profit over a given period of time, usually a year.
What is the person responsible for a budget known as?
Budget holder.
3 types of budget?
Income budget
Expenditure budget
Profit budget
What is income budget?
Shows the budgeted income for a business and the sources
Income budget advantages?
Will help a firm to plan its workforce and operations
Will allow a firm to plan its expenditure based on requirements to meet demand, for example, order levels and staffing.
What is expenditure budget?
Shows the budgeted expenditure for a business
Profit budget calculation?
Profit budget = income budget – expenditure budget
Methods of setting budgets?
Budgeting according to company objectives
Budgeting according to competitors’ spending
Setting the budget as a percentage of sales revenue
Budgeting according to last year’s budget allocation
What is zero budgeting?
All budgets start at zero and budget holders must justify why any expenditure is necessary before it is approved. Budgets are then set based on the strength of the justification linked to company objectives.
Advantages of zero budgeting?
Encourages more thorough planning and consideration about spending
Helps to identify changes in an organisation’s needs and ensures those areas of the business that are growing and need more finance get it
Helps to save money by cutting costs where managers are unable to justify their spending
Disadvantages of zero budgeting?
It can be very time consuming for budget holders
Managers who are better at negotiating or presenting may acquire bigger budgets despite needs of other departments
Reasons for setting budgets
Helps to gain investment or finance
Financial control
Monitoring and review
Allows firms to establish their priorities
Improving staff performance and better accuracy
Assign responsibility – Budget holders can be held accountable for performance.
Problems of setting budgets
Imposed budgets – If budgets are imposed by managers further up the hierarchy with less knowledge of the department they may be unrealistic or overly optimistic. .
Research problems and accuracy – It may be difficult for firms to gain accurate and current research to inform their forecasts.
Unforeseen changes – Budgets rely on forecasts and many changes may occur such as suppliers increasing prices, falling demand, economic changes, government actions or new rivals setting up.
The time taken in setting budgets – A large amount of time may be needed to set accurate budgets. r.
Budget Benefits
They provide direction and co-ordination which may motivate staff to work towards company objectives.
Budgets can act as SMART objectives to measure performance against.
They improve efficiency by eliminating waste and overspending.
They encourage careful planning which improves company performance.
Budget drawbacks
Allocations may be incorrect and unfair – particularly if imposed.
Short-term savings may be made to meet budgets that are not in the interests of the firm in the longer term, for example, finding cheaper raw materials that may impact quality and future reputation and sales.
They are difficult to monitor fairly.
They may be inflexible.
Variance calculation
Variance = budget figure – actual figure
What is liquidity?
The ability of a firm to pay its short term debts
Explanation of fixed costs?
Costs that do not change directly with output
They must be paid even if the firm makes and sells nothing.
They may change in time but do not change by a set amount every time another unit is made.
Break even analysis (FC)
It is a straight line as fixed costs do not change directly with output and should remain constant in the short term.
Break even analysis (VC)
The variable cost line should increase by the same amount as every extra unit is made and sold.
starting from zero
Contribution per unit calculation?
Contribution per unit = Selling price – variable cost per unit
Break even calculation?
BE = Fixed costs/
Contribution per unit
TC line on graph
(fixed + variable costs). This line will always start where the fixed cost line crosses the axis as even at zero output you will still have to pay your fixed costs.
Where do you label the break even point?
Where the total revenue and total costs line cross is where they are equal and profit is therefore zero.
Margin of safety calculation?
Margin of safety = actual output – break-even output
How to change break even point?
Increase/decrease fixed costs
Increase/decrease variable costs
What is break even?
Break-even is the point at which total costs equal total revenue and neither a profit nor loss is made.
Uses and benefits of break even
Break-even charts/calculations are simple and quick to complete. Little training is needed to complete them, therefore they are useful for small businesses and inexperienced entrepreneurs.
It can show when a business will start to make a profit and what profit they will make at each output level.
It will help a firm to plan what levels of sales it will need to make to ensure a profit is made.
They can help to show the best- and worst-case scenario.
It allows a firm to investigate what will happen if prices, costs or sales volume change and carry out ‘what if’ investigations.
Limitations of break even analysis?
It can be an over-simplified model. In reality firms often sell a range of products at a range of different prices.
Break even is based on forecasted data so it may be unreliable.
It is dependant on the accuracy of forecasts made about costs and revenues. Therefore the experience of the business in the market, the stability and predictability of the market and the quality of research will all determine the quality of the forecasts and the break-even analysis.
Break even shows the short-term situation of a business and therefore cannot easily be used for long-term planning.
