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Test Your Knowledge Answers

 Chapter 4 - The Breakeven Point and Profit Projection

 Problem 1 - A business has a contribution margin of 40% and monthly fixed costs of $52,000.  What is the breakeven point of the business?

 To find the breakeven point of a business, divide the fixed costs for the period by the contribution margin percent.  In this case, that would be: 

  • $52,000 fixed costs / 40% contribution margin = $130,000 sales breakeven point.

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 Problem 2 - A business has monthly sales of $90,000 and variable costs of $54,000, with monthly fixed costs of $30,000.  What is the breakeven of the company?  What is the profit at $90,000 net sales?

 As with the answer to problem 1 above, the breakeven will be the fixed costs divided by the contribution margin percent.  However, in this case we need to find the contribution margin.  The contribution margin can be calculated by subtracting variable costs from sales and then dividing that amount by the sales figure. 

  • In this case that is:  $90,000 -  $54,000 = $36,000 / $90,000 = 40% contribution margin. 
  • You then calculate the breakeven as:  $30,000 fixed costs / 40% contribution margin = $75,000 sales breakeven point.

 The profit is calculated by subtracting fixed costs from the contribution margin.  The contribution margin has already been calculated above as $36,000 and your fixed costs are given in the problem as $30,000. 

  • The profit is calculated as:  $36,000 contribution margin - $30,000 fixed costs = $6,000 profit.

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 Problem 3 - A business has a contribution margin of 30%, monthly fixed costs of $30,000 and a product sales price of $5.  What is the monthly breakeven point in units?

Like the two other breakeven calculation, breakeven is calculated by dividing fixed costs by the contribution margin percent. 

  • To calculate the breakeven in units, divide the breakeven by the price of the unit.  In this case that calculation is:  $30,000 fixed costs / 30% contribution margin = $100,000 breakeven point. 
  • The breakeven in units is calculated as:  $100,000 breakeven / $5 unit cost = 20,000 units to breakeven. 
  • This can be calculated more efficiently as:  $30,000 / 30% / $5 = 20,000.

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Chapter 5 - The Profit Impact of Pricing, Investment and Marketing Decisions

 Problem - You own a business with $50,000 per month in sales with $15,000 per month is fixed costs.  You sell your product for $5 and have a contribution margin of 45%.  As in the previous examples, you have three strategy choices; to keep the price the same, increase prices and lose customers, or lower prices and gain customers.  This is how you view your choices:

  1. Keep pricing and volume the same.
  2. Increase prices 5% which you believe will decrease unit volume by 5%.
  3. Lower prices 5% which you believe will increase unit volume 5%.

 

Problem 1 - Given these choices, which strategy should be more profitable?

 The calculation to see which of the pricing scenarios is most profitable, the profit projection is calculated as:

 Option 1. 

We have to do some pre-work on this:

  • $50,000 sales / $5 unit costs = 10,000 units sales.
  • $5 unit cost * 45% contribution margin = 2.25 unit contribution margin.
  • $5 unit cost - $2.25 contribution margin = $2.75 variable cost per unit.
  • A simpler way to calculate variable cost per unit is $5 * (1-.45) = $5 * .55 = $2.75 .

 Now that we have all that pre-work we will use in the rest of the scenarios calculated, the first profit is easy.  It is: 

  • $50,000 sales * 45% contribution margin = $22,500 contribution margin - $15,000 fixed costs = $7,500 profit.

 Option 2. 

This profit is calculated as: 

  • ($5 unit cost * 1.05 reflecting 5% price increase) * (10,000 units *.95 reflecting 5% unit decrease) = 5.25 new price * 9,500 new units = $49,875 in sales.
  • The contribution margin per unit is $5.25 price - $2.75 unit cost = $2.50per unit  contribution margin.

Profit can be calculated 2 ways from here:

  • 9,500 units * 2.50 contribution margin per unit = $23,750 contribution margin - $15,000 fixed costs = $8,750 profit.
  • (9,500 units * 5.25 unit price) - (9,500 units * $2.75 unit variable cost) = $49,875 sales - $26,125 variable cost = $23,750 contribution margin - $15,000 fixed costs = $8,750 profit.

 Option 3.

This profit is calculated as:

  • ($5 unit cost *.95 reflecting 5% price decrease) * (10,000 units * 1.05 reflecting 5% unit increase) = $4.75 new price * 10,500 new units = $49,875 in sales.
  • The contribution margin per unit is $4.75 price - $2.75 unit cost = $2.000 per unit contribution margin.

 Profit can be calculated two ways from here:

  • 10,500 units * $2.00 contribution margin per unit = $21,000 contribution margin - $15,000 fixed costs = $6,000 profit.
  • (10,500 units * $4.75 unit price) - (10,500 units * $2.75 unit variable cost) = $49,875 sales - $28,875 variable costs = $21,000 contribution margin - $15,000 fixed costs = $6,000 profit.

 The end result is:

  • Option 1 keeping price and volume the same  yielded $7,500 in profit.
  • Option 2 raising prices 5% causing a 5% decrease in volume yielded $8,750 in profit.
  • Option 3 lowering prices causing a 5% increase in volume yielded $6,000 in profit.

 Under this set of scenarios, option B raising prices with less volume was more profitable.  As an aside, I calculated these profits several  ways because we each see problems a little differently.

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 Problem - Your business is currently selling $120,000 per month at a 45% contribution margin and $45,000 per month in fixed costs.  You would like to lease a machine for $1,200 per month.  You would also like to hire a person to run the machine at a cost for wages and benefits of $3,500 per month.  Consider both of these additional expenses and fixed operating costs.

 Problem 1 - What is your current monthly profit?

 The current monthly profit for this business can be calculated as: 

  • $120,000 sales * 45% contribution margin = $54,000 contribution margin - $45,000 fixed costs = $9,000 profit.

 Problem 2 - What would be the additional sales volume necessary to achieve equal profitability to your current profits?

 To calculate the new fixed costs:

  • New fixed costs = $45,000 current fixed costs + $1,200 lease expense + $3,500 employee = $49,700 new fixed costs.

 To achieve equal profitability:

  • ($49,700 new fixed costs + $9,000 old profit) / 45% = $58,700 / 45% =$130,444 in sales to equal the old profit.

To confirm:

  • $130,444 * 45% = $58,700 contribution margin - $49,700 new fixed costs = $9,000 profit.

 So to equal the same profitability with the new machine and employee, the business would need to consistently add $10,444 in sales per month.

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 Problem - Assume your company spent $4,000 on an ad spend to increase sales.  Sales improved $40,000 with a 47% contribution margin.  Fixed costs stayed the same.

  Problem 1 - What is the additional sales volume necessary to breakeven on the ad spend?

 The additional sales volume necessary to breakeven on the add spend is:

  • $4,000 ad spend / 47% contribution margin = $8,511 in additional sales to breakeven on the ad spend.

 Problem 2 - What is the additional profit generated by the $4,000 ad spend that created the $40,000 in additional sales?

 The additional profit that can be inferred from this ad spend can be calculated as:

  • $40,000 new sales * 47% contribution margin = $18,800 contribution margin - $4,000 cost of the ad spend = $14,800 in additional profit generated by the ad spend.

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 Chapter 7 - Ratios that Measure Risk, Efficiency and Profitability

 Problem - Assume your company has the following on its balance sheet:

 

  • $50,000 in cash.
  • $50,000 in accounts receivable.
  • $200,000 in total current assets.
  • $110,000 in total current liabilities.

 What is the current ratio?  

  • $200,000 current assets / $110,000 current liabilities = 1.82:1 current ratio. 

 What is the current quick/acid test ratio?

  • $50,000 cash + $50,000 accounts receivable = $100,000 quick current assets / $110,000 current liabilities = .91:1 quick ratio.

 

As a rule of thumb, should you happy with the results of your calculations?  Why?

  • As a general rule of thumb, the current ratio should be greater that 2:1 and the quick ratio greater than 1:1.  Both of the calculations were below target, and so possibly problematic.  No reason to be happy with these ratios.

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Problem - Assume your business has the following on its income statement and balance sheet:

  • $500,000 in sales.
  • 55% cost of goods sold.
  • $50,000 in accounts receivable.
  • $40,000 in accounts payable.
  • $80,000 in inventory.

 What is the average daily sales?

  • $500,000 sales / 360 (or 365) = $1,389 average daily sales. 

 What is the average daily cost of goods sold?

  • $500,000 sales * 55% COGS = $275,000 COGS / 360 = $764 average daily COGS.

 What is the average collection period?

  • $50,000 accounts receivable / $1,389 average daily sales = 36 average days to turn a receivable into cash.

 What is the average days of inventory on hand?

  • $80,000 inventory / $764 average daily COGS = 104.7 average days inventory on hand.  Typically, this many days inventory on hand is a problem and this business has too much cash tied up in inventory.

 

In your opinion, are any of these ratios problematic?  Why?

  • Yes.  Typically I would like to see 30 days or less to collect receivables and something like 15 - 45 days of inventory on hand.  Both of these are general rules and could vary by situation and industry.

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Chapter 8 - The Cash Flow Statement and Creating a Cash Flow Budget

 Does an increase in accounts receivable increase cash or decrease cash?

  • An increase in accounts receivable decreases cash as you are making sales and booking profit (hopefully) but not collecting cash as evidenced by the increase in receivables.

 Does a decrease in inventory increase cash or decrease cash?

  • A decrease in inventory increases cash as you are making sales and booking profit but not spending cash.  That is, you are turning your inventory into cash as evidenced by the decrease in inventory.  Cash was already spent to build the inventory. 

 Does an increase in accounts payable increase cash or decrease cash?

  • An increase in accounts payable increases cash as you have booked an expense which decreased profit but haven't paid for it with cash as evidenced by the increase in payables.

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 Chapter 9 - 50+ Ways to Improve Cash Flow

 Problem - What are the eight ways to improve your cash flow?

As the name of the chapter implies, there are 50+ ways, and a great deal more than that, to improve your cash flow.  My list was hardly exhaustive.  However, you might consider these:

 

  1. Raise your prices.  Think of ways to implement this in ways the upset your customers the least.
  2. Have a firm credit policy and run credit on ALL new customers.  If late pay, no pay, or BK, collect up front.  With a credit card if necessary.  Also, limit the amount of receivables new customers can run up until they have a track record with you.
  3. If a customer is late, send out a friendly late payment reminder the next cycle.  If the bill is still unpaid, make friendly calls.  Work it out with them ASAP.  Do not wait to address these kinds of receivables problems.
  4. Bill customer the DAY the product ships or the service is performed.  Every day you wait is a day's worth of sales you have to invest in your business.
  5. If you are paying cash for your merchandise, materials and supplies, negotiate with your suppliers to sell to you on terms and bill you.  Better yet, negotiate to pay with a credit card after 30 days.  That may give you another 20 days to pay your bill on top of the usual 30 day terms.
  6. If you have the cash on hand, take the discount for early payment.  If your supplier doesn't offer discount for early payment, negotiate one with them.  A discount taken on 2%, Net 30 has a roughly 36% ROI on what is in effect a short term loan to your supplier.
  7. Renegotiate your lease.  Use the best deals on the market for space like that which you occupy as leverage.  Along the same lines, renegotiate every major expense item you have.  Look for competitive offers as leverage.  Be ruthless in getting the best deal you can.  It's your money.
  8. Sell high margin companion products and services with your normal products or services. Think bottle of wine at the restaurant or service contract with the appliance.  Along those lines, up sell your customers on higher value, higher margin products and services.  Incentivize your sales team to sell what makes you the most money.  Also, find ways to add value to your products and charge a premium for them.  Or, value engineer your products to take costs out of them.  Your suppliers can be of value here.