Financial Planning in an Engineering Business

Financial planning is a dynamic process that deals with allocation of various financial resources in order to meet strategic goals and objectives of the business. Financial planning involves planning for finance and planning for operations. Operation managers are concerned with sales and production whereas financial planners are interested in financing the operations nevertheless financial planning is considered to be one single process that encompasses both operations and financing.

The Financial Planning process starts with strategic planning. Various strategic decisions have financial implications and therefore it is imperative that there is a strong correlation between strategic plan and budgeting. Strategic planning encompasses a process of establishing goals and objectives over short term as well as the long run. Strategic objectives and corresponding goals are developed based on a very thorough assessment of the organization and the external environment. Strategic plans are implemented by developing an Action Plan.

Financial Plans (Budgets) Þ Operating Plan & THORN; Strategic Plan Þ Action Plan

In this assignment we will study financial planning process in a hypothetical company (VALUEFONES) manufacturing low cost sub £ 50 Cell phones. VALUEFONES will assemble various components parts to make cell phones. The company is incorporation with head office in London. CEO Dave who is also the Chief Finance Officer (CFO) heads the company. For this new hypothetical company VALUEFONES market research is undertaken to analyse existing market conditions. A PESTEL analysis, Porter’s five-force analysis and a SWOT analysis have already been conducted and now the CEO is preparing a detailed financial planning process for the company.

Financial Planning Process:

The financial plan starts with enlisting various items showing the capital costs and set up costs involved in the business. The list should include expenditure such as alterations to buildings, improvements, roads, planning and legal costs and equipment costs. This will help in determining how much capital is required to initiate the business and how the business can be funded. It would also help to determine if any over draft or loans are needed.

The Cash Flow Forecast

The cash flow is a useful tool for reflecting potential sales and contains details of all the income and expenditure of the business over a fixed period of time. It is used to evaluate the timing of incoming and outgoing money. A cash flow forecast can be budgeted on a monthly, quarterly or yearly basis. As the first year is the most critical for any new business venture, the first year’s cash flow would typically be set out on a monthly basis.

The Sales Forecast

Sales are the most important financial activity therefore; the Sales Forecast is made first in order to estimate sales. In order to arrive a reasonable sales forecast the past sales trend as well as various factors that influence sales are studied in details. Once all the relevant information has been collected and analyzed the finance manager can estimate sales volumes for the planning period. It is important that the estimates are correct and reasonable since this estimate will be used for several other estimates in the budgets. The Sales Forecast has to take into account what the firm is selling and at what sales price. Following sales forecast are arrived at based on previous trends.

Product Units sold Price Total Sales

Cell Phones 16,000 £ 45.00 £ 720,000

Percent of Sales

Next step in the financial planning is to predict account changes because of estimated sales. One way to estimate and forecast certain account balances is with the Percent of Sales Method. By looking at past account balances and past changes in sales, one can establish a percentage relationship. For example, all variable costs and most current assets and current liabilities will vary as sales change. In our hypothetical case the past trends in similar cell phone producing companies its been shown that accounts receivable runs around 30% of sales. Therefore for estimated annual sales of £ 1800,000 the account receivable will be £ 1800,000 x 0.30 = £ 600,000.

Preparing a Detailed Budget:

1. Budgeted Income Statement involves preparation of several budgets. For VALUEFONES based on estimated monthly sales of 16,000 units the Production Department will need to budget for materials, labor, and overhead based on what the company expect to sell and what the company expect in inventory.

PRODUCTION BUDGET

(Units)

Planned Sales 16,000

Desired Ending Inventory 1,500

Total Units 17,500

Less Beginning Inventory (3,000)

Planned Production 14,500

2. Next step is to prepare a Materials Budget. The Materials Budget attempts to forecast the level of purchases required, taking into account materials required for production and inventory levels. Materials to be purchased is summarize as:

Materials Purchased = Materials Required + Ending Inventory – Beginning Inventory

Assumptions:

– Total Component Material required for producing 14500 units = 3625 units.

– Average cost per unit material = £ 5.

MATERIALS BUDGET

Particulars Units

Materials Required for Production 3,625

Desired Ending Inventory 375

Total Materials 4,000

Less Beginning Inventory -500

Total Materials Required 3,500

Unit Cost for Materials 5

Total Materials Purchased £17500

3. Labour Budget:

VALUEFONES need to forecast its labor needs based on expected production. The Labor Budget arrives at expected labor cost by applying an expected labor rate to required labor hours.

Assumptions:

– It takes 0.5 hours to assemble one unit.

– Therefore 14,500 units x 0.5 = 7250 hours.

– The expected hourly labor rate is £12.00.

Labour cost

Estimated Production Hours 7,250

Hourly Labor Rate (£) 12

Total Labor Costs (£) 87000

4.Overhead Budget:

As production moves up or down, support services and other costs related to production will also change. These overhead costs represent the third major costs of production. Each item that comprises overhead may warrant independent analysis so that VALUEFONES can determine what drives the specific cost. For example, production rental equipment may be driven by production orders while levels of capital investment spending drive depreciation.

Overhead Budget

(£)

Indirect Labor Costs 12000

Utilities 5000

Depreciation 3000

Maintenance 1000

Insurance and Taxes 4000

Total Overhead Costs 25000

5.Once all the production costs (direct materials, direct labor, and overhead) have been budgeted, VALUEFONES can work these numbers into its beginning inventory levels for Direct Materials, Work In Progress, and Finished Inventory. Beginning inventory levels are actual amounts from the last reporting period. VALUEFONES need to apply its costs based on what they want ending inventory to be. The end-result is a Budget for Cost of Goods Sold, which VALUEFONES will use for their Forecasted Income Statement.

Cost Of Good Sold Budget

Direct Material WIP Inventory Finished Inventory

(£) (£) (£)

Beginning Inventory 2500 16000 46000

Purchases 7500

Less Ending Inventory -1875

Materials Required 18125

Direct Labor 87000

Overhead 25000

Total Manufacturing Costs 130125 130125

Total Work in Progress 146125

Less Ending Inventory -12000

Cost of Units Manufactured 134125 134125

Cost of Units Available for sell 180125

Less Ending Inventories -36000

Cost of Units Sold 144125

6. Marketing Budget

Marketing budget is made as per the estimates made by the marketing division:

Marketing Budget

(£)

Marketing Personnel 75000

Advertising & Promotion 42000

Marketing Research 12000

Travel & Personal Expenses 6500

Total Marketing Expenses 135500

7. Other operating expenses involve the administrative costs, which is estimated based on past trends. Following are the trends observed for the similar kind of production units in this area.

General and Administration Budget

(£)

Management Personnel 110,000

Accounting Personnel 55,000

Legal Personnel 40,000

Technology Personnel 45,000

Rent & Utilities 25,000

Supplies 15,000

Miscellaneous 7,500

Total G & A Expenses 297,500

Financial Statements

Based on various budgets made as above VALUEFONES can now prepare a Budgeted Income Statement. To the above items A few items are added to account for non-operating items, such as income received on investments and financing costs. The Budgeted Income Statement puts together all revenue and expense estimates from the previously prepared detail budgets.

BUDGETED INCOME STATEMENT

(£)

Revenues 720,000

Less Cost of Goods Sold 144,125

Gross Profit 575,875

Less Marketing 135,500

Less G & A 297,500

Operating Income 142,875

Less Interest on Debt 8000

Income Before Taxes 134,875

Taxes @ 37.5% 50,578

Net Income 84,297

The net income estimated for first years is £ 84297. Next year VALUEFONES plans to launch another model of Cell phones targeted at high-end customers. The CFO obtains the following information.

1. Planned sales are 50,000 units

2. Unit price is $110.00 per unit.

3. Beginning Inventory consists of 5,000 units at a cost of £60.00 per unit.

4. Planned production is 55,000 units with the following production cost:

5. Direct Materials are £ 18.50 per unit

6. Direct Labor required is 4 hours per unit @ £ 12.00 per hour

7. Overhead is estimated at 20% of Direct Labor Cost

8. Desired Ending Inventory = 6,000 units. (LIFO Method).

9. Marketing Expenses are budgeted at £ 350,000

10. General & Administrative Expenses are budgeted at £ 400,000

Budgeted Income Statement

(£) (£)

Sales (50,000 x £ 110) 5,500,000

Less Cost of Goods Sold:

Beginning Inventory (5,000 x £ 60.00) 300,000

Direct Materials (55,000 x £ 18.50) 1,017,500

Direct Labor (55,000 x 4 hours x £ 12.00) 2,640,000

Overhead (£ 2,640,000 x .20) 528,000

Cost of Available Sales 4,485,500

Less Ending Inventory (1) 380,500

Cost of Goods Sold 4,105,000 4,105,000

Gross Profits 1,395,000 1,395,000

Less Operating Expenses:

Marketing Expenses 350,000

General & Administrative 400,000

Net Income 645,000

Under LIFO, last costs in are:

£1,017,500 + £ 2,640,000 + £ 528,000 =

£ 4,185,500 / 55,000 =

£ 76.10 x 5,000 =

£ 380,500.

Based on this Budgeted Income Statement, VALUEFONES can prepare a Budgeted Balance Sheet, which will give an estimate of how much external financing is required to support their estimated sales. The main link between the Income Statement and the Balance Sheet is Retained Earnings. Therefore, preparation of the Budgeted Balance Sheet starts with an estimate of the ending balance for Retained Earnings. In order to estimate ending Retained Earnings, VALUEFONES needs to project future dividends based on their existing dividend policies and what management expects to pay in the next planning period.

Estimated Retained Earnings

Beginning Balance £270,000

Budgeted Net Income £ 84,297

Less Estimated Dividends -55,000

Ending Retained Earnings £ 299,297

Acquisition of Fixed Assets:

Next, VALUEFONES needs to account for the acquisition of fixed assets. VALUEFONES needs to purchase a new machinery such decisions are taken by the upper management.

CAPITAL EXPENDITURES BUDGET

£

Purchase New Office Equipment 16,000

Replace Machinery 8,500

Total Capital Expenditures 24500

Based on the beginning balance in assets and the budget for capital assets VALUEFONES can estimate an ending asset balance for the Budgeted Balance Sheet.

CHANGE IN FIXED ASSETS

£

Beginning Balance 886000

New Acquisitions (Exhibit 11) 24500

Less Depreciation for the Year -33500

Ending Fixed Assets 877000

· Assuming all liabilities and interest expense will remain the same. VALUEFONES needs to analyze trends and ratios in order to ascertain accounts that do not fluctuate with sales.

· Since the Balance Sheet is a year-end estimate, it assumes that all other estimates have been met.

· The Budgeted Balance Sheet will show either a surplus (excess financing over assets) or a deficit (additional financing needed to cover assets). This difference is derived from the Accounting Equation: Assets = Liabilities + Equity.

BUDGETED BALANCE SHEET

(£)

Cash 36,000 5% of Sales

Accounts Receivable 86,400 12% of Sales

Inventory 50,400 7% of Sales

Prepaid Expenses 11,000 5 year trend analysis

Fixed Assets 877,000

Total Assets 1060800

Accounts Payable 79,200 11% of Sales

Current Portion of LT Debt 6,000 Principal Paid

Long Term Debt 60,000 Subject to Revision

Total Liabilities 145,200

Common Stock 450,000 Unchanged

Retained Earnings 299,297

Total Equity 749,297

Total Liability & Equity 894,497

External Financing Required 166,303

After the budgeted financial statements are prepared, it is very important to carefully review these statements with management. The major draw back of an annual budget is that many unplanned events can take place during the year therefore; financial planning is often improved by simply forecasting on a monthly or quarterly basis as opposed to an annual basis.

Short term Financial Planning:

A good example of short-term financial planning is the Cash Budget, which is an estimate of future cash inflows and outflows. A Cash Budget is prepared based on the projections made previously. VALUEFONES can prepare a Cash Budget by using stable cash flow patterns, such as accounts receivable, accounts payable, payroll, etc. It also has several predictable transactions, such as insurance payments, loan payments, etc.

CASH BUDGET FOR JANUARY

(£)

Beginning Cash Balance 28,000

Cash Collections on Sales (60 day lag) 47,000

Sold old machine in January 3,000

Investment Revenues 2,000

Total Cash Inflows 52,000

Disbursements for Manufacturing (30 day lag). 12,400

Marketing Expenses 10,000

General & Administrative Expenses 26,000

Capital Expenditures – 0 –

Repayments on Debt 750

Debt Interest Payments 450

Dividend Payments – 0 –

Taxes Paid – 0 –

Total Cash Outflows 49,600

Net Cash Inflow (Outflow) 2,400

Ending Cash Balance 30,400

Minimum Desired Cash Balance 10,000

Cash Surplus or (Deficit). $20,400

Predicting Future Financial Performance and uncertainties:

One can improve forecasting by using several forecasting techniques. Forecasting relies on past relationships and existing historical information. If these relationships change, forecasting becomes increasingly inaccurate. Since forecasting can be inaccurate due to uncertainty, financial planner should consider developing several forecast under different scenarios. It is possible to assign probabilities to each scenario and arrive at expected forecast.

Factors affecting the forecast:

In order to increase reliability in forecasting, one should consider a shorter planning period. The planning period depends upon how often existing plans need to be evaluated. This will depend upon stability in sales, business risk, financial conditions, etc. Forecasting of large inter-related items is more accurate than forecasting a specific itemized amount. When a large group of items are forecast together, errors within the group tend to cancel out. For example, an overall economic forecast will be more accurate than an industry specific forecast.

Quantitative and Qualitative Techniques

Quantitative techniques of forecasting are best used when changes are infrequent. In today’s world of rapid change, quantitative techniques tend to be of little use. Qualitative techniques include surveys, interviews with people who are “in the know”, market reports, articles, and other information sources that allow us to make a better judgment.

Smoothing out the Numbers

One simple approach to forecasting is to setup a model that relies on averages from past historical data. For example, one can take an average of the last five years. As one moves forward to the next planning period, a new moving average is calculated and used as the forecast for the next planning period. Exponential smoothing can be used whereby one may place more weight on the most recent set of actual numbers. This can be important where changes have occurred, making older data less reliable.

Regression Analysis

A statistical approach can be used for forecasting. This relies on the average relationships between a dependent variable and an independent variable. Simple regressions look at one independent variable, whereas multiple regressions consider two or more variables. Regression analysis is very popular for forecasting sales since it helps us find the right fit over a range of observations.

Working Capital Management

Management of Working Capital

This involves setting and implementing working capital policy. The goal in managing working capital is to strike a balance between the costs and benefits.

· Cost of investment in accounts receivable is the interest that could have been earned if customers had paid their bills earlier.

· Cost of idle cash is the money foregone by not investing the cash in marketable securities.

· Cost of holding inventory includes the opportunity cost of capital, storage, insurance costs, and the risk of spoilage.

Importance of Managing Working Capital

· In order to record a firm’s transactions, one needs to understand cash conversion cycle and management of inventory, accounts receivable, and receipts and disbursement.

· One needs to understand cash conversion cycle and management of inventory, accounts receivable, and receipts and disbursements in order to design financial information systems that enhance effective short-term financial management.

· One needs to understand management of working capital and current assets in order to decide whether to finance the firm’s funds requirements aggressively or conservatively.

· One needs to understand credit selection and monitoring because sales will be affected by the availability of credit to purchasers, sales will also be affected by inventory management.

· One needs to understand cash flow conversion cycle because one is responsible for reducing the cycle through management of inventory levels and costs.

· Cash budget is a forecast of cash inflows and cash outflows.

Cash Conversion Cycle Model

This model focuses on the length of time between when a company makes payments and when it receives cash inflows. A firm’s goal should be to shorten the cash conversion cycle as much as possible without hurting operations.

Algebraically, the cash conversion cycle is expressed as

· Cash conversion cycle = inventory period + accounts receivable period – accounts payable period.

· The cash conversion cycle may also expressed as

· Cash conversion cycle = cash inflow delay – payment delay = net delay

· Inventory conversion period = average inventory/(sales/360)

Zero Working Capital

Under this concept, working capital = inventories + accounts receivable – accounts payable.

1. Suppliers can finance inventories through accounts payable.

2. Every pound sterling freed up by reducing inventories or accounts receivable results in a one-time contribution to cash flow.

3. A movement towards zero working capital raises a company’s earnings.

4. The most important factor in moving toward zero working capital is increasing speed; companies can produce items as they are ordered rather than having to forecast demand and then build up large inventories.

Case Study:

PRINTSCAN Ltd has developed a new printer scanner with great potential the company has to develop its own delivery, recruit staff and purchase vehicles. Therefore it is necessary to budget the investment amount and analyze available finance sources to invest this project. Moreover, with the aid of investment appraisal, managers should make a decision whether to invest the project and anticipate the profits and risk.

Investment Budget of Fixed Asset

The fix asset investment includes plant constructing, vehicles purchasing and staff training.

The table below shows the composition of fix asset investment:

Item Amount () Percentage in total fixed asset investment (%)

Constructing 1,500,000 50%

Vehicles purchasing 100,000 33.3%

Staff training 40,000 13.3%

Provision 10,000 3.3%

Investment on fixed asset 3,000,000 100%

Investment Budget of working capital

“Working capital is defined as the difference between current assets and current liabilities.”(Jaffe, Ross and Westerfield, 1998) It must maintain an investment in working capital. The calculation of working capital adopts subentry calculation method. According to the forecast of production, inventory, sales, and referring to the average working capital in the printer industry, the working capital of this project is approximately 1, 000,000.

Total Investment Budget

Total investment = Investment of Fixed Asset + Investment of working capital

= 3, 000,000 + 1, 000,000 = 4, 000,000

Finance of the Project

There are various sources of finance for the company. The source of finance should be chosen according to the situation and features of the project. Four sources of finance can be adopted for PRINTSCAN Ltd Ltd. These are retained profit, bank loan, ordinary shares and venture capital.

Internal sources of finance

Retained profits are the main source of finance for the company. “The reinvestment of profits rather than the issue of new ordinary shares can be a useful way of raising equity capital. There are no issue costs associated with retaining profits, and the amount raised is certain, once the profit has been made.” (Atrill and McLaney, 1998) Moreover, retained profits are owned by the company, it is can be used without waiting for receiving funds. In the fierce competitive business environment, time is valuable for a new product. Successful companies always lead their competitors. PRINTSCAN Ltd retained profits are1, 000,000, which is not enough to support this project, but it is can act as start-up funds. Meanwhile the company should seek for other finance sources.

External sources of finance

Bank loans- short-term finance

“The simplest and most common source of short-term finance is an unsecured loan from a bank. The firm can borrow and repay whenever it wants so long as it does not exceed the credit limit.”(Brealey, Marcus and Myers, 1991) The line of credit of PRINTSCAN Ltd is 1, 000,000. According to Atrill and McLaney (1998), “Bank overdrafts represent a very flexible form of borrowing. The size of an overdraft can (subject to bank approval) be increased or decreased according to the financing requirements of the business. It is relatively inexpensive to arrange, and interest rates are often very competitive, the rate of interest charged on an overdraft will vary, however, according to how creditworthy the customer is perceived to be by the bank. It is also fairly easy to arrange- sometimes an overdraft can be agreed by a telephone call to the bank. In view of these advantages, it is not surprising that this is an extremely popular form of short-term financing.

Ordinary shares- long-term finance

“Ordinary shares form the backbone of the financial structure of a business” (Atrill and McLaney, 1998) “when the firm borrows, it promises to repay the debt with interest. If it doesn’t keep its promise, the debt holders may force the firm into bankruptcy. However, no such commitments are made to the equity holders. They are entitled to whatever is left over after the debt holders have been paid off.” (Brealey, Marcus and Myers, 1991)

“From the business’s perspective, ordinary shares can be a valuable form of financing, at times, it is useful to be able to avoid paying a dividend. In the case of new expanding business or one in difficulties, the requirement to make cash payment to investors can be real burden. Where the business is financed totally by ordinary shares, this problem need not occur.” (Atrill and McLaney, 1998) On the other hand, shareholders have the control over the business’s affairs. When companies make decision or take action, they should receive the shareholder’s approval. For example, shareholders have right to vote on appointments of the board directors.

A public issue of shares may be costly, but it would benefit the company’s long-term goal- maximizing the shareholder’s wealth. For PRINTSCAN Ltd the right offering is suggested in this situation. A right offering is “an issue of common stock to existing stockholders.” (Jaffe, Ross and Westerfield, 1998) Shareholders can maintain their rights or sell them. Apparently, the new price of the company’s stock will lower after the rights offering. However, our shareholder would not suffer this loss. PRINTSCAN Ltd can obtain 1, 700,000 through right offering.

Venture capital- long-term finance

“Venture capital is long-term capital provided by certain institutions to help business exploit profitable opportunities.” (Atrill and McLaney, 1998) The venture capital investment is high-risk investment. “It is not passive portfolio investment but involves a close working relationship between the venture capital company and the company receiving the funds.”(Brayshaw, Samuels and Wilkes, 1995) Usually, the venture capital company will appoint a representative in the broad of directors so as to monitor the investment.

PRINTSCAN Ltd new product has a great market potential. It might give high return to the shareholders. This is a most attraction for the venture capitalists that are usually looking for an average return of 35% per annum on their investment. (Brayshaw, Samuels and Wilkes, 1995) Furthermore, venture capital company usually interested in the small or medium size business. Therefore this project might receive funds from the venture capitalist. This project may probably receive 300, 000 investment from the venture capitalist.

Investment Appraisal

The investment decision is crucial to the success of the company. “Investment involves making an outlay of something of economic value, usually cash, at one point in time that is expected to yield economic benefits to the investor at some other point of in time.”(Atrill and McLaney, 1998) In order to help PRINTSCAN Ltd making decision to invest in the new printer project, some method of appraisal is set out “which can be applied equally to the whole spectrum of investment decisions and which should, in terms of the decision structure so far outlined, help to decide whether any particular investment will assist the company in maximizing shareholder wealth.”(Lumby, 1991) there are various methods for the company to evaluate investment opportunities. They are accounting rate of return (ARR), payback period (PP), and net present value (NPV),

Accounting rate of return (ARR) (Atrill and McLaney, 1996)

“This method takes the average accounting profit which the investment will generate and expresses it as a percentage of the average investment in the project as measured in accounting terms. ARR is regarded as one of main method of investment appraisal because of its two advantages.

1. It is a holistic approach to evaluate the performance of investment.

2. Second, “ARR is also a measure of profitability that many believe is the correct way to evaluate investments, and it produces a percentage figure of return which managers understand and feel comfortable with.” (Atrill and McLaney, 1996) But it is necessary to point out that ARR ignores the time factor, which is more important factor for the investment decision.

ARR= Average annual profit division Average investment to earn that profit ×100% “

After calculating ARR of the new printer project, the comparison should be made with a minimum require rate set by the PRINTSCAN Ltd. The evidence shows this project is far exceeded the minimum rate. According to Atrill and McLaney, “where there are competing project that all seem capable of exceeding the minimum rate, the one with the highest ARR would normally be selected.”

Payback period (PP)

“The payback period for an investment is the number of years required for the undiscounted sum of the returns at least to equal the initial outlay- in other words to pay it back.” (Brayshaw, Samuels and Wilkes, 1990) “In times of cash shortage this may be of vital importance to the business.”(Searle, 2000)

PP method is easy and quick way to calculate. The payback period can be obtained by calculating the cumulative cash flow. For this project we can see the cumulative cash flows become positive by the end of the third year. Thus the project’s PP is 3 years. Compared with the company’s minimum PP that is 3.5 years. This project is acceptable. “The PP method is not concerned with the profitability of project”, but it “does at least provide a means of dealing with the problems of risk and uncertainty.” (Atrill and McLaney, 1996)

Net present value (NPV)

“A more reliable method is to consider the project’s net present value. The net present value is arrived at by ‘discounting’ all the cash flows associated with the project.”(Hatherly, 1993) NPV “takes accounts of all the costs and benefits of each investment opportunity and that also makes a logical allowance for the timing of those cost and benefits.” (Atrill and McLaney, 1996)

There are four steps to calculate the NPV (Brealey, Marcus and Myers, 1991):

Step 1. Forecast the project cash flow.

Step 2. Estimate the opportunity cost of capital.

Step 3. Use the opportunity cost of capital to discount the future cash flow.

Step 4. Go ahead with the project if the present value of the payoff is greater than the investment.

NPV=PV- required investment

In this project, the discount rate is 10%. Therefore after calculating NPV is greater than zero. The positive NPV indicates that the investment would increase shareholder’s wealth. Therefore it would be acceptable.

Absorption costing principles

1. An absorption costing system allocates or apportions a share of all costs incurred by a business to each of its products/services. This is done to establish whether, in the long run, each product/service makes a profit.

2. An absorption costing system traditionally classifies costs by function. Sales less production costs (of sales) measures the gross profit (manufacturing profit) earned. Gross profit less costs incurred in other business functions establishes the net profit (operating profit) earned.

3. Using an absorption costing system, the profit reported for a manufacturing business for a period will be influenced by the level of production as well as by the level of sales.

4. This is because of the absorption of fixed manufacturing overheads into the value of work-in-progress and finished goods stocks. If stocks remain at the end of an accounting period, then the fixed manufacturing overhead costs included within the stock valuation will be transferred to the following period.

Marginal costing principles

1. The marginal costing system emphasises the behavioural, rather than the functional, characteristics of costs.

2. The focus is on separating costs into variable elements and fixed elements

3. Marginal costing information can be very useful for short-term planning, control and decision-making, especially in a multi-product business.

4. In a marginal costing system, sales less variable costs measures the contribution that individual products/services make towards the total fixed costs incurred by the business.

5. The fixed costs are treated as period costs and, as such, are simply deducted from contribution in the period incurred to arrive at net profit.

Examples of various factors affecting financial performance:

General Motors and the Ford Motor Company are two automotive giants, whose success can be measured by analyzing a few important goals of management, the company’s solvency, liquidity, and profitability. In the past many factors and various strategic decisions taken can affect the financial performance of these two giants.

Liquidity

Moody’s Investor Service reported that Ford’s liquidity remains very strong, with $23 billion in cash, securities, and short-term voluntary employee beneficiary association balances. GM’s liquidity is positioned at $32 billion in balance sheet debt, $3 billion in present value of leases, and about $9 billion in un-funded pension liabilities. According to Moody’s Investor Services estimates GM’s balance sheet debt should mature within 19 years with only about $3 billion maturing over the next five years.

Profitability

Ford Motor Company is claiming the higher prices for gasoline, raw materials and health care, among other things, when describing why its 2005 earnings fell to the tune of 35 percent when compared with the previous year. It also said it no longer expects to post annual pre-tax profits of $7 billion as early as 2006, blaming “vastly different market and business conditions.” Ford has taken very aggressive steps to cut costs, including plant closings, job reductions, and a cut in its annual dividend. Over the past three years, it has reduced expenses by $4 billion. Ford is also planning a new round of early-retirement offers to cut an estimated 1,000 additional U.S. white-collar posts in the upcoming months. Falling U.S. sales, an unfavorable product mix and escalating health care costs slammed General Motors resulting in its 2005 profits plunging as much as 80 percent as compared to previous years.

Solvency

According to GM’s company data, their salaried employees are responsible for about 27% of their health care costs, and the hourly employees are responsible for about 7%. Interesting enough salaried employees also pay deductibles and monthly premiums for their health care coverage. In an effort to lower those costs GM is expanding on its LifeSteps program they launched in 1996. The program encourages employees against smoking, drinking alcohol, and eating unhealthy foods. Under the program the company also added gyms and health care seminars to some of their manufacturing plants.

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