# Analysis of profitability and capital budgeting

ANALYSIS OF PROFITABILITY AND CAPITAL BUDGETING

ACC310 module 4Case

ANALYSIS OF PROFITABILITY AND CAPITAL BUDGETING

Part I

Beautifully Fabulous Beauty Salon

The Most recent monthly statement of BFBS is as under:

TotalStore IStore II

Sales \$ 2,000,000 \$ 1,200,000 \$ 800,000

Less: Variable Expenses 1,200,000 840,000 360,000

Contribution Margin 800,000 360,000 440,000

Less: Traceable Fixed Expenses 400,000 220,000 180,000

Segment Margin 400,000 140,000 260,000

Less: Common Fixed Costs 300,000 180,000 120,000

Net Operating Income \$ 100,000 \$ (40,000) \$ 140,000

BFBS is considering to close-down Store I. In case Store I is closed,

• The one-fourth of the Traceable Fixed Costs will continue without change. Hence the traceable fixed costs will be \$ 235000 [\$ 180,000 + (\$ 220,000 x ¼)].

• The sales of Store II will be reduced to 80%.

BFBS had allocated common fixed costs on the basis of sales dollars. On closing of Store I the total common fixed costs will be allocated to Store II (Periasamy, 2010).

1 Statement showing new monthly Income Statement for the Company if Store I is closed:

CalculationStore II

Sales \$ 800,000 x 80% \$ 640,000

Less: Variable Expenses \$360,000 / \$800,000

= 45% \$ 640,000 x 45% 360,000

Contribution Margin 280,000

Less: Traceable Fixed Expenses

Store I 55,000

Store II 180,000

Segment Margin 45,000

2 On the basis of the above calculation, Closing of Store II is not recommended. The closure of the Store will lead to an overall loss of \$ 255,000 (after making adjustment for common fixed costs). The Store II segment margin is positive but the overall profits are lower by \$ 55,000 (\$ 100,000 – \$ 45,000).

3 Meaning of Relevance: A relevant cost and benefits are the ones which affect the decision making and are independent variables. Generally, variable costs are relevant and fixed costs are irrelevant while making decisions. In the given case, we are provided with two kinds of fixed costs – Traceable fixed costs and common fixed costs. Let us consider each one of them separately.

Traceable fixed costs: Such fixed costs are relevant costs as the same is directly allocated and directly attributable to the stores. The Store II will have to bear \$ 55,000 of fixed costs of Store I on closure. The total \$ 235,000 of traceable fixed costs is relevant and will reduce the profits of Store II.

Common Fixed Costs: The allocation of common fixed costs is irrelevant cost and is considered to be sunk costs for decision making. The costs are unavoidable and will remain common for any alternative.

Part II

BFBS is manufacturing two products i.e. Beauty Gloss and Cocooning Spray. Beauty Gloss is of fairly recent origin, and has developed an attempt to enter a market closely related to that of Cocooning Spray. Automated production line is used for production of Beauty Gloss. As per the forecasts of economic growth, the BFBS is considering to purchase a machine for a cost of \$ 40,000. The useful life of machine will be of 10 years with a salvage value of \$ 6,000. The machine will be depreciated on straight-line basis over the 10 years. The annual cash flows generated will be \$ 15,000 throughout the useful life. An additional working capital of \$ 3,000 will be required to maintain the machine which will be released at the end of the useful life. The tax rate of the company is 40% and the discount rate is 10%.

1 Statement showing NPV Table using the BFBS Cost Analysis:

BFBS Cost Analysis Years Amount Tax Effect (40%) After-Tax Cash Flows 10% Factor Net Present Value

Cost of asset Now -40000 -40000 1.000 -40000

Working capital needed Now -3000 -3000 1.000 -3000

Net annual cash inflows 1 to 10 15000 0.60 9000 6.1446 \$       55,301

Depreciation tax shield 1 to 10 -3400 0.40 -1360 6.1446 \$        -8,357

Salvage value 10 6000 0.60 3600 0.3855 \$         1,388

Working capital released 10 3000 3000 0.3855 \$         1,157

Net present value \$         6,489

The present value factors @ 10% for the year 1 to 10 are as under:

1 2 3 4 5 6 7 8 9 10 Total Cpvf

0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665 0.4241 0.3855 6.1446

2 Net Present Value method is the most widely used technique of capital budgeting. It takes into account the concept of time value of money. In simple words, the technique calculates the present value of all the cash inflows and outflows.

NPV = PV of Cash Inflows – PV of Cash Outflows

The result can be both positive and negative.

Statement showing the NPV Rule:

Situation Expectation Decision

NPV>0 The investment is expected to increase the shareholders wealth Accept

NPV

NPV= 0 The investment is not expected to change the shareholders wealth Indifferent

The above BFBS cost analysis table for NPV analysis provides for following elements:

• Cost of Asset: The cost of asset is the cost of machine of \$ 40,000 incurred at the start of the project (Now at T0). The same is cash outflow for which no tax shield is available. The present value factor for Year 0 is 1.000

• Working capital needed: The \$ 3000 is cash outflow incurred at T0. No Tax shield is available for the same.

• Net Annual Cash Inflows: The Salon will have an annual cash inflow for \$ 15,000 throughout the year 1 to 10. The inflows will be taxable at the rate of 40% and hence, the after tax cash flows is taken for decision making.

• Depreciation: The depreciation is calculated as under

Depreciation = Cost of Asset – Salvage Value

Useful Life

=\$ 40,000 – \$ 6,000

10

=\$ 3400

The above expense is tax deductible and hence, after-tax cash outflow is considered for decision making.

• Salvage Value: The Salvage value will be recovered for the asset at the end of year 10. The information as to sale of machine is not given and hence, it has been assumed that the \$ 6000 of salvage value will be recovered and hence, there will be no capital gain or loss recognition (Periasamy, 2010).

• Working Capital released: At the end of year 10, the working capital will be recovered and will lead to inflows for the project.

3 Thenet result of the above cash outflows and inflows is a positive NPV of \$ 6,489. Hence, it is recommended to accept the project and make investment in the new machine.

SEction 2

Part I

The consolidated statement of income had been reviewed and a proper analysis had been prepared in order to complete the requirements of the excel sheet.

The following assumptions were made in order to complete the requirements:

1. As the per unit sale price is not given thus the net sales given in the consolidated statement of income specified in the Hershey 2007 annual report is used.

2. The fixed marketing and administration cost is equal to the selling, marketing and administrative expense and the business realignment charges.

The analysis is made on the basis of following formulas:

1. Contribution margin percentage= contribution margin/ Net sales x100

2. Breakeven point in units= Fixed cost/ Contribution per unit.

3. Contribution per unit= contribution in value/ units sold

4. Sale price per unit= net sales/ units sold

5.Break even in value= breakeven point in units x sale price per unit

6. Margin of safety= Units sold- breakeven point

Requirement 1

The Hershey Company

Contribution Margin Operating Income Statements

2,007 2,006 2,005

Units Sold 2000,00,000 1004,00,000 1000,00,000

Net Sales \$ 49467,16,000.00 \$ 49442,30,000.00 \$ 48198,27,000.00

Variable Cost of Sales:

Variable Manufacturing Costs \$ 14918,16,150.00 \$ 13845,23,100.00 \$ 13305,06,900.00

Variable Marketing Costs \$ 4972,72,050.00 \$ 4615,07,700.00 \$ 4435,02,300.00

Total variable costs \$ 19890,88,200.00 \$ 18460,30,800.00 \$ 17740,09,200.00

Contribution Margin \$ 29576,27,800.00 \$ 30981,99,200.00 \$ 30458,17,800.00

Fixed Costs

Fixed Cost of Sales \$ 13260,58,800.00 \$ 12306,87,200.00 \$ 11826,72,800.00

Fixed Marketing & Administration Costs \$ 11727,42,000.00 \$ 8749,54,000.00 \$ 10095,23,000.00

Interest Expense \$ 1185,85,000.00 \$ 1160,56,000.00 \$ 879,85,000.00

Total fixed costs \$ 26173,85,800.00 \$ 22216,97,200.00 \$ 22801,80,800.00

Operating Income \$ 3402,42,000.00 \$ 8765,02,000.00 \$ 7656,37,000.00

Average Tax Rate 37% 36% 36%

Requirement 2

Contribution margin percentage 60% 63% 63%

Breakeven Net Sales \$ 43776,51,648.74 \$ 35454,73,108.11 \$ 36082,51,611.35

Breakeven quantity (units) 1769,92,237 719,96,145 748,62,679

Sales Price Per Unit \$ 24.73 \$ 49.25 \$ 48.20

Requirement 3

Margin of safety (in units) 230,07,763 284,03,855 251,37,321

Requirement 4

Units sold 1900,00,000 1010,00,000 950,00,000

Net Sales \$ 46993,80,200.00 \$ 49737,77,191.24 \$ 45788,35,650.00

Contribution margin \$ 28097,46,410.00 \$ 31167,14,334.66 \$ 28935,26,910.00

Total fixed costs \$ 26173,85,800.00 \$ 22216,97,200.00 \$ 22801,80,800.00

Operating income \$ 1923,60,610.00 \$ 8950,17,134.66 \$ 6133,46,110.00

Tax rate \$ 0.37 \$ 0.36 \$ 0.36

Net income \$ 1210,74,982.14 \$ 5708,70,544.87 \$ 3913,71,370.51

Cost of sales \$ 33151,47,000.00 \$ 30767,18,000.00 \$ 29566,82,000.00

Selling, marketing and administrative expenses \$ 8958,74,000.00 \$ 8603,78,000.00 \$ 9129,86,000.00

Business realignment charges \$ 2768,68,000.00 \$ 145,76,000.00 \$ 965,37,000.00

Provision for taxes \$ 1260,88,000.00 \$ 3174,41,000.00 \$ 2770,90,000.00

Net income \$ 2141,54,000.00 \$ 5590,61,000.00 \$ 4885,47,000.00

Part II

1. The operational budget for the year 2008 will be based on the analysis of the past year figures of the consolidated statement of income. The setting of the operational budget will require the completion of the following steps:

a. The setting of the operational budget is dependent on the analysis of the sales as sales should be break down in terms of the quarter or month and then a track needs to be prepared. The future sales must be predicted on the basis of the past year sales and changes needs to be made in regard to the profitable seasons and the percentage increase in the sales in the future year must be dependent upon the past years (The Hershey Company, 2007).

b. The similar method to predict the cost of goods sold should be used as it was used while preparing the income statement of the previous years. The cost of goods sold will be deducted from the total sales in order to arrive at the figure of the gross margin of the year. And thus the operating income can be predicted by deducting the other interest, sales and marketing expenses in order to arrive at the figure of the operating margin for the year for which the operational budget is prepared.

c. The other costs also need to be accordingly calculated on the basis  of the past analysis and thus forecasting the other costs for the year of budget also and thus making according changes to the figures of the past year in order to amend them to the required changes (Periasamy, 2010).

d. The annual taxes also need to be estimated in order to estimate the operational budget for a particular year. The taxes are deducted from the operating income in order to arrive at the net income.

e. When the actual year starts and progress starts the profits and expenses of the current year are to be compared with the figures of the operational budget and corrective action needs to be taken in order to arrive at the budgeted figures.

Hypothetical operational budget for year 2008

The Hershey Company

Contribution Margin Operating Income Statements Changes from the year 2006 to 2007 Operational budget for 2008

2,007 2,006

Units Sold 2000,00,000 1004,00,000 99% 3984,06,375

Net Sales \$ 49467,16,000.00 \$ 49442,30,000.00 \$ 98540,15,936.25

Variable Cost of Sales:

Variable Manufacturing Costs \$ 14918,16,150.00 \$ 13845,23,100.00 \$ 29718,72,666

Variable Marketing Costs \$ 4972,72,050.00 \$ 4615,07,700.00 \$ 9906,24,222

Total variable costs \$ 19890,88,200.00 \$ 18460,30,800.00 \$ 39624,96,888

Contribution Margin \$ 29576,27,800.00 \$ 30981,99,200.00 \$ 58915,19,048

Fixed Costs

Fixed Cost of Sales \$ 13260,58,800.00 \$ 12306,87,200.00 \$ 26416,64,592.19

Fixed Marketing & Administration Costs \$ 11727,42,000.00 \$ 8749,54,000.00 11727,42,000

Interest Expense \$ 1185,85,000.00 \$ 1160,56,000.00 #### 1211,69,110

Total fixed costs \$ 26173,85,800.00 \$ 22216,97,200.00 \$ 39355,75,702.15

Operating Income \$ 3402,42,000.00 \$ 8765,02,000.00 \$ 19559,43,345.82

Average Tax Rate 37% 36% 37%

Requirement 2

Contribution margin percentage 60% 63% 60%

Breakeven Net Sales \$ 43776,51,648.74 \$ 35454,73,108.11 \$ 65825,51,184.43

Breakeven quantity (units) 1769,92,237 719,96,145 2661,38,229

Sales Price Per Unit \$ 24.73 \$ 49.25 \$ 24.73

Requirement 3

Margin of safety (in units) 230,07,763 284,03,855 1322,68,145

2. The various assumptions that are being made while preparation of the operational budget for 2008 as follows:

• It is assumed that the selling price per unit is same as in 2007 as the selling price in 2007 had reduced and units sold had increased and thus no other information is available to estimate the selling price.

• Proportion of cost of sales to net sales in 2007 is 67.02% and thus it is assumed that it had remained same in 2008.

• The proportion of the variable manufacturing cost and variable marketing cost to total cost of sales is assumed to be the same as in 2007.

• It is assumed that the fixed cost in regard to selling and marketing remains constant as is the year 2007 as no hint is available in regard to its estimation.

• It is assumed that the interest expense had increased in the same proportion as they increased from the year 2006-2007.

• It is assumed that the tax rate is same as in the year 2007

References

Periasamy, P. (2010). Textbook of Financial Cost and Management Accounting, Global Media.