Introduction
Regardless of the direction and intended characteristics, starting your own business is associated with serious risks. Managing risks and threats is an integral part of a comprehensive planning strategy, which includes budgeting as a crucial component. Strictly speaking, budget planning involves projecting the financial component of the company, determining optimal economic indicators, and creating a vector that ensures compliance, thereby creating opportunities for quality business growth (Adrian et al., 2022).
According to Palmer (1915), the key objective of any business is to maximize profits. Therefore, companies’ management should make special efforts to achieve this objective. The scope of this report outlines the budgeting milestones for Cookie Business, a new venture that will manufacture and sell confectionery products, primarily cookies.
The analysis performed with the data collected and interpreted in this paper consists of six steps. For the Cookie Business, it is proposed to study the break-even point based on contribution margin, detailing variable costs, forecasting net profit and cash flow, evaluating the investment strategy, and analyzing variability. A comprehensive study conducted from multiple angles will provide insights into the initial conditions for launching a business. Moreover, the results will provide recommendations relevant to the Cookie Business regarding financial performance. Therefore, this report describes the findings and their interpretation in the context of a start-up business.
Contribution Margin/Break-Even
A sound financial analysis cannot be conducted without investigating the break-even point. It should be said that, terminologically, such a figure refers to the integer quantity of goods that a company must produce and sell to equalize the business’s costs and revenues (Block et al., 2019). Since Cookie Business offers the sale of three product lines — Chocolate Chip, Sugar, and Specialty — and the data has been collected, the Unit Sold/Contribution Margin was calculated for each category, and a weighted average Contribution Margin for all product lines was determined. The upwardly rounded break-even point was identified at 122,783 units — precisely the number of units that should be sold across all three product categories in the Cookie Business to achieve a zero balance.
It is essential to examine the results closely to gain a deeper understanding of the sales mix. As you can see from the data, chocolate chips generate the most profit. Still, their contribution margin per unit is the smallest, which means that the contribution to profit from selling the exact quantities of products will be uneven. On the other hand, the highest contribution margin per unit is actual for Specialty, but the projected sales of goods in this category are minimal.
Full and Variable Costing
Estimating fixed and variable costs is of practical use for budgeting as it provides insights into how cost items affect pricing, which costs prevail, and how their structure can ultimately be optimized. There are at least two methods that can be used to itemize costs, namely Absorption Costing and Variable Costing: they differ in their methodological approach to calculations (Herath & Lu, 2018).
On the one hand, in Absorption Costing, the cost of a product is calculated by considering all variable and fixed costs incurred during the production phase. This method values each unit at $2.05, with the Ending Inventory—unsold stock still held by the company—amounting to $369,000. On the other hand, Variable costing only considers variable costs, while fixed costs are not taken into account. This method enables us to determine the total cost per unit of $2.00, with an Ending Inventory of $ 360,000.
As can be seen, the two approaches produce similar but not identical results, a consequence of considering or not considering the fixed production costs. Although it makes no sense to choose the most appropriate one since they perform different essential functions, it is fair to recognize that Variable costing provides more relevant information about the final indicators, as it considers only the real costs associated with the production of products.
Special Order
Successful businesses often become so popular that customers approach management with special orders. Typically, these orders are characterized by having huge volumes of products to purchase or requesting unique one-off production options not available in the company’s product range. It can be assumed that Cookie Business will soon receive an order requesting 1,000 units of discounted confectionery products, as shown in the screenshot above. In such cases, it is appropriate to calculate the net profit to assess whether fulfilling the order as a whole is profitable.
The analysis shows that after subtracting all variable costs from the revenue, the net profit was $2.15 thousand. Notably, the calculation of the average profit for the classic line of orders (Total Profit / Total Units Sold), when converted to 1000 units, gives $973.09, which is 75.4% lower than the profit from the special order. This is natural, as a special order requires special attention and operations with unsettled processes. Overall, this order seems profitable, as it generates a positive net profit.
Internal Rate of Return
Another milestone of financial analysis is the study of the Internal Rate of Return (IRR). Strictly speaking, the IRR calculation evaluates a specific investment strategy and indicates that the Net Present Value is zero (Silva et al., 2018). The available data on the expected rate of return then allows us to compare the calculated IRR and make judgments about the profitability of investing in a given project.
For Cookie Business, there is an opportunity to invest $ 250,000 to purchase new equipment over seven years, with an expected rate of return of 9%. The analysis results shown above indicate that the calculated IRR turns out to be 8%. The calculation utilized the present value of the annuity (Purchase of new equipment divided by the expected annual increase in sales) and cash flow at the specified settings over the project’s lifespan. The fact that the IRR is lower than the required rate indicates that the purchase of new equipment will not yield the required return, and therefore, the investment strategy should be rejected.
Cash Budget
A cash budget analysis is used to determine a company’s future cash flows. It should be emphasized that this analysis is used to evaluate the dynamics of cash over time, which means finding the most effective management of the company’s liquidity. For Cookie Business, cash budget analysis is used to estimate and forecast customer cash receipts over the next three months. As the analysis results show, each month’s cash receipts are positive.
Second, the most significant portion of cash receipts occurs in February, immediately following the sales month. The exact reasons for this financial trend are unknown, but it can be assumed that it is due to increased sales during February or the fulfillment of payable transactions. Another conclusion from the analysis is that cash receipts are distributed between the current month and the following month, which means Cookie Business must effectively manage receivables to maintain a liquid business.
Material and Labor Variance
The final milestone of this financial analysis is the assessment of variation. This analysis is used to evaluate the differences between actual and standard figures, which allows conclusions to be drawn about the efficiency of material and labor consumption. A Material and Labor Variance analysis was also conducted for the Cookie Business, and the results are shown above.
As can be seen, the actual price was 3.37% higher than the standard price, which is unfavorable because more money was spent on purchasing materials than expected. On the contrary, Materials Quantity Variance was favorable as the actual quantity of materials used was lower than the standard quantity, as more materials for further use remained. For labor, the Labor Rate Variance was also calculated. For Labor Rate Variance, the calculated indicator was negative, indicating that the actual labor rate was higher than the standard labor rate; hence, higher spending on wages was observed. Finally, for Labor Efficiency Variance, the actual labor hours were also higher than the standard, indicating higher labor costs with reduced labor productivity.
Conclusions and Recommendations
This report describes and discusses the results of the financial analysis for the Cookie Business start-up, which evaluates the cost-effectiveness, profitability, and liquidity aspects of the company. The findings of the work performed showed generally acceptable conclusions. Break-even points were calculated for Cookie Business. Products with higher contribution margins were identified, and the cost of sales and Ending Inventory were determined using two strategies. Additionally, for a particular special order, the calculations were performed.
In addition, the analysis enabled us to evaluate the investment strategy and reject it, determine the distribution of budgetary revenues for the quarter, and provide an assessment of the correspondence between actual and standard (expected) labor performance. However, three of the four variation factors were unfavorable, so Cookie Business should examine operational efficiency and cash flow management more closely. Additional recommendations include revisiting the investment strategy for acquiring new equipment, developing receivables management techniques, and maintaining a commitment to rigorous financial analysis in the future.
References
Adrian, T., Ion, C., Andreea, M. P., & Florin, D. C. (2022). Information provided by management accounting through managerial decision making. Annals of ‘Constantin Brancusi’ University of Targu-Jiu. Economy Series, 4, 195-202.
Block, S. B., Hirt, G. A., & Danielsen, B. R. (2019). Foundations of Financial Management. McGraw-Hill.
Herath, H. S., & Lu, X. (2018). Inference of economic truth from financial statements for detecting earnings management: Inventory costing methods from an information economics perspective. Managerial and Decision Economics, 39(4), 389-402.
Palmer, W. B. (1915). Simplified cost accounting for manufacturers. The ANNALS of the American Academy of Political and Social Science, 61(1), 165-173.
Silva, J. L. E., Sobreiro, V. A., & Kimura, H. (2018). Prepurchase financing pool: Revealing the IRR problem. The Engineering Economist, 63(2), 158-170.