Income Income Statements Statements (Review) Expenditure rises to meet income. -Parkinson s Law

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1 ENGM 401 & X1 Fundamentals of Engineering Finance Fall 2010 Lecture 6: Income Statements (3) Expenditure rises to meet income. -Parkinson s Law M.G. Lipsett University of Alberta Income Income Statements Statements (Review) (Review) Bad Debt & Warranty COGS True or False: 1) Contribution = Net Revenue COGS. 2) Sales, General and Administrative (SG&A) is affected very little by the amount of sales. Gross Revenue Net Revenue Contribution SG&A Operating Income Net Income costs Ideal units Other Income MG Lipsett,

2 Example Example #3 #3 You are the marketing manager for a large plant making a chemical intermediate. In the last 12 years you have had sales exclusively in North America but your president has identified a need to diversify sales into the Pacific rim (a competitor is opening a Canadian plant in two years, which will increase North American supply above the foreseeable demand) Your plant is currently running at 80% of capacity and your COGS (including feedstock, utilities, and a maintenance allowance) is 76% Questions: What market-entry discount would you authorize without a phone call to the president? What problems might arise? MG Lipsett, Example Example #3 #3 (2) (2) What Problems can arise? Problem 1: if additional plant increases the SG &A cost, then a deeply discounted sales might not be cash positive in the company. Losing cash on a sale is rarely justified and will need high level authorization. Problem 2: If these chemical intermediates go the plant and come back as a finished chemical to the same market as lower price you are basically losing money. Problem 3: If the customers in the local market know about the discount it would be catastrophic. Treating the discount as temporary and sticking to it is important. Problem 4: Dumping is prohibitive under national treaties and international trades, the penalties are severe. MG Lipsett,

3 Example Example #4 #4 You run a compressor skid packaging business that services shallow gas wells (your units are used to compress produced gas up to pipeline pressures) Your margin has been 18 to 19.5% over the past four years and you have a stable work force (you find things for them to do during slow times, rather than lay them off) You want to expand by adding a larger sized unit to your product line, and then sell the business in a few years. Your buyer and engineer have priced all the components of the new compressor skid out at $476,000 Questions: Should you include shop floor labour in your COGS? No Why? No t variable What is the approximate price of the new unit? Price $476,000/( ) = $591,300 is the simplest pricing model, maintaining margin and ignoring SG&A What problem might occur if you sell for less? falls, making the business less valuable when you want to sell MG Lipsett, Sales, Sales, General, General, and and Administration Administration SG&A captures the cost of running a division or a company By definition, SG&A cannot be calculated by product or product line, because it includes a more general level of costing (e.g., the president and receptionist) Unambiguous examples include senior staff, corporate finance departments, corporate memberships, basic phone system charges Sales costs may be captured different ways Usually SG&A BUT can be COGS IF sales cost are strictly per product MG Lipsett,

4 Sales, Sales, General, General, and and Administration Administration (2) (2) In theory, SG&A is fixed for small changes in sales this is an accurate assumption SG&A should grow at less than the rate of growth of sales or the company has a serious problem! What happens in a long period of good times? SG&A goes up, because the business is still profitable What happens in a downturn? Ruthless cost cutting in SG&A (and cost control in COGS too) Allocation does not create marginality! If something really is an indirect cost, put it in SG&A; don t hide it in COGS MG Lipsett, More More on on is the cash left over from a sale that can contribute to covering the fixed costs (and profit) The objective: build sales to have enough margin First, reach cash break even Second, reach book breakeven Third, reach high profitability and return on investment In theory is varies proportionally (exactly) with increasing sales SG&A is truly fixed Breakeven costs Ideal costs Loss Profit units units MG Lipsett,

5 Cash More Cash on Flow Flow from from Operations Operations & Net Net Cash Cash Flow Flow Cash Flow from Operations = Operating Income + Depreciation. (typically) (this means the amount gets added back, so cash flow from operations is higher than operating income) Equivalently Cash Flow from Operations = Contribution - SG&A (excluding ) Net Cash Flow = Net Income + Depreciation + writedowns. (typically) Net Cash Flow is also called Total Cash Flow. Here we have assumed that the only Other Income is writedowns. MG Lipsett, Breakeven Cash More Breakeven on Flow from Operations & Net Cash Flow Cash breakeven is when operating income (with added back in) is zero. Cash breakeven means that you aren t making a profit, but at least you are not losing money in the short term. Book breakeven is when operating income is zero without having to add back in. Book breakeven means that not only can you cover your costs, but also you replace assets if necessary. Cash break-even thus occurs at a lower operating income than book break-even. MG Lipsett,

6 More More on on (2) (2) In theory $ Book breakeven Cash breakeven SG&A incl. SG&A excl. Sales Volume MG Lipsett, More More on on (3) (3) In the best real case: increases as you hold price and get volume discounts on your inputs SG&A growth is minor as sales increase Peace breaks out around the world MG Lipsett,

7 More More on on (4) (4) The best real case $ Cash breakeven Book breakeven SG&A incl. SG&A excl. Sales Volume MG Lipsett, More More on on (5) (5) In the investor s nightmare: SG&A (even without including ) goes up as you discover that you need more and more marketing staff to chase sales falls as you buy sales by discounting price MG Lipsett,

8 More More on on (6) (6) The investor s nightmare $ Profitability (not reached!) Book breakeven (not reached!) SG&A incl. Cash breakeven SG&A excl. Sales Volume MG Lipsett, Discussion Discussion Question Question #1 #1 Think about how many hours per year each of the following pieces of equipment operates. pump in an oil refinery telephone switch family automobile lawnmower How many hours in the total life of the piece of equipment? MG Lipsett,

9 Discussion Discussion Question Question #2 #2 Two brothers inherit $1 million each. Each brother has a job with the same pay. The conservative brother buys a 20-year bond yielding 5.5%; and so he makes $55,000 per year from the investment. The entrepreneurial brother buys two oil well service rigs; and he makes $70,000 a year in cash from the business. Fifteen years later, over a beer, the entrepreneurial brother brags that he made the better choice. Was he right? Why? MG Lipsett,