Hi everyone, welcome to 2.2 Financial Planning. In this unit we're going to start looking at some of the real calculations in Theme 2. We're going to look at sales forecasting, sales revenue and costs, break-even and budget. So there's a whole bunch of numbers in here but I always say to students that when you're thinking about the maths side of business it's not really about the numbers, it's about what the numbers represent and what the key terms are behind the numbers.
So this is going to be fairly, I mean I'm obviously going to go through the calculations but I'm going to more talk about the theory behind them. Again, this is just an introduction kind of recap. It's not supposed to be the huge amount of depth.
We're going to go through things fairly quickly. It will require a bit more further study, but hopefully it gives you a bit of a recap as to what goes into this unit. So the first topic is sales forecasting. A sales forecast is, probably you can guess this, a weather forecast, you predict the weather. A sales forecast, you predict the sales.
And so there are a few different methods we can potentially use in order to sales forecast. This topic is quite closely linked to a topic in theme 3, 3.3.1, which is quantitative sales forecasting. I actually teach some similar things in both years just to kind of reinforce these messages.
So if some of this stuff is more the theme 3 stuff and some of the theme 3 stuff is more the theme 2 stuff, forgive me for that, but it's just how I've always taught it. Now, how do we come up with these forecasts? We might use a huge amount of data.
We're going to use past data. We're going to talk about some of the ways we can do that. We might use market data as well. so data that is available maybe through secondary market research on the market that we're operating in and we'll use this data to try and make these predictions.
The first technique we can use the first piece of data we can use is correlation between two bits of data and so the idea of correlation is it shows the relationship between two variables so it might be that one thing affects another so for example you would see a positive correlation between the temperature so the higher the temperature the more sales of flip-flops you'd get or something like that or the more sales of ice cream you'd get. Alternatively you might see that as you might see a negative correlation in terms of as temperature goes down you might see the sales of coats and scarves go up so it's just about you you might use some of that information to try and identify a trend. The second is extrapolation so this is where we base around trend our predictions for the future so if we see for example that our sales are increasing to extrapolate that data it might suggest that that pattern is going to continue so in this one for example and this is a really basic diagram of course you might be able to predict that sales would continue on that trajectory and it can be useful to a degree but only if you kind of react to it because of course you know if we're a new business and we've seen that our sales have doubled each of the last three months because we're new and we're building reputation it would be insane to assume that they're going to double for the rest of time And so it has to be taken with a pinch of salt, but it can give you an idea of trend.
It's probably more likely to be useful if you're looking at trend in the other direction. So if you're looking at sales potentially dropping, you might be able to extrapolate where you think those sales might go. You then might use that to make decisions. The last is a moving average, which smooths out fluctuations in data.
This isn't particularly useful if you have sales that go up and down quite consistently. So if you take, for example, I don't know, take the FIFA computer game. They have a spike in sales when the new one comes out. And so sales are really high for the first maybe two or three months. And then sales drop massively for the rest of the year.
And then they spike again the following October. You could say the same about the iPhone. It spikes when there's a new release. Some products spike around Christmas in quarter three and quarter four when people are buying Christmas presents. So if that is the case and your data is quite up and down, your raw sales data is up and down.
Using a moving average allows you to kind of see a trend rate over a period of time. So you might be able to then assess over a period of years whether your sales are going up or down and that might then force you to make decisions. It's worth specifying here that you could get a calculation of moving averages and they're quite complicated as well.
You effectively have to try and work out whether it's maybe a four quarter moving average, an eight period moving average and what that effectively means is four quarter means you would divide, you would add the four quarters together and divide by four. Eight period would mean you'd add the eight pieces of data, divide by eight, to get an average, basically. So it's effectively just calculating average, but the tables can be quite complicated.
What I would strongly recommend with this is have a look at past paper questions, because you'll see what they're asking for. You'll see how the tables are presented. And if you have a look at a mark scheme as well, you'll see what the answers are.
And usually you can kind of find the logic behind that, but it is something well worth having a look at, because it can be quite a scary one to see. So that's moving averages, extrapolation and correlation. That's how we get our sales forecasts. Now, sales revenue and costs.
The first thing here is to introduce this calculation. This calculation is so fundamental to everything a business does. You could argue it's kind of a magic formula, really.
That's what the lady who taught me how to teach used to always say, a lady named Hala Salit at the University of Hertfordshire. She used to always say to me and Mike, Everything needs to link back to this magic formula, revenue minus total cost equals profit. But that is too simplistic really for A-level, so we need to be able to take that a little bit further.
So let's think about how we calculate these different things. So revenue is gonna be our selling price times by our quantity sold. Obviously, how much we are selling each product for times by how many we're selling.
Our total costs can be split into two categories, fixed and variable costs. Our fixed costs are the costs that don't change as output changes. our variable costs are the costs that do change as output changes.
So we have some costs that will stay the same no matter how much we produce. If we produce, for example, rent, for example, would be the best example of this. If we have a factory that we're paying rent for, if we produce 10,000 items or we produce 15 items, we are going to pay the same amount of rent. So that is a fixed cost because no matter how much our output changes, it's going to remain the same. Whereas our variable costs could be like our material costs, where the more we produce, the more we spend on those materials.
So one thing that's really, really important, and I'm going to just kind of address this misconception here because I hear about it quite a bit, not necessarily in terms of, yeah, I guess I see it in both writing and in conversation. You've got to understand the difference between the word price and the word cost. Price is what a consumer pays.
Costs are what a business pays. So, and I get that this doesn't necessarily match to just patterns of speech because if someone came in with a new pair of trainers, I might say, how much did they cost? When really, I guess what I'm actually asking is what. price did you pay and so don't get confused with those in the in your answer don't write cost when you're talking about the price that a customer will pay so there's some calculations there in terms of revenue minus total cost equals profit we've mentioned their fixed costs don't change depending on output variable costs do change depending on output and that means we can calculate our variable costs a little bit more in detail so our variable cost per unit so how much it costs to make one unit times by the quantity sold that's the same calculation as the selling price one But obviously, instead of it being in selling price times the quantity sold, it's the variable cost times the quantity sold. We're going to talk about some of these terms again in breakeven.
So the concept of breakeven is where a business reaches a point where they no longer make a profit or a loss. So revenue equals total costs. They're making a zero pounds profit. And this is usually going to be one of the main aims for a new business because business is difficult. A lot of businesses fail.
And so you have to work really, really hard to. just get to this point of survival. If you are not making a loss, if you are breaking even, you're surviving.
You're generating enough money to run your business, you're going to be able to carry on the following year. So this is the fundamental kind of goal for any business at the beginning. For some businesses that are maybe more established but aren't doing very well, they might then switch their objective back to break even just to try and make sure that they can survive.
So we need to understand the concept of break even but also how to calculate it. So there's two calculations we need to be aware of here. The first is contribution per unit.
So selling price minus the variable cost per unit gives us our contribution per unit. What that effectively is, is that's how much we make from selling a good before we pay off our fixed costs. So for example, if we took a pair of trainers for 30 pounds and maybe we could spend 18 pounds making the trainers in terms of materials, leather, rubber, et cetera, we would receive a contribution per unit of 12 pounds. And so what is that contribution per unit? Well, that contribution per unit, each pair of trainers we sell generates 12 pounds for us.
It's not profit though, because we haven't paid off our fixed costs. So our contribution per unit contributes towards paying off those fixed costs. So if our fixed costs, if we wanna know how many contributions do we need to pay off our fixed costs, we would just do our fixed costs divided by our contribution per unit.
And that would give us the amount we need to break even. So. for example if our just to give a round number here if our fixed costs were 12,000 pounds and we make 12 pounds contribution per unit then we need 1,000 units in order to break even if we sell 1,000 units we will generate the exact same amount of revenue as we will total costs we will have made no profit no loss we live broken even if we sell 1,001 well after we've paid off our fixed costs every contribution per unit is going to be our profit so if we sell 1,001 units we're going to make 12 pounds profit 1,002 is going to be 24 pounds profit, et cetera, et cetera.
If we sell less than 1,000 units, if we sell 999, we are going to make a loss. We are going to not quite have paid off our fixed costs. So our total costs will be higher than our revenue.
So the key thing with this is to understand the concept of contribution and what it contributes to. If you understand that, the calculations are pretty straightforward. We can also see this on a graph.
So, for example, if we look at... pounds on the y-axis quantity on the x-axis you would see a series of lines on it on a break-even chart the first would be our fixed cost and our variable cost line so obviously you can see our fixed cost line as we mentioned fixed costs don't change depending on output so our fixed cost line is going to be exactly the same no matter what our quantity is Whereas our variable cost, you can see there, increases as quantity increases. The more we produce, the higher our variable costs are going to be. We can then calculate our total costs, which is going to be the exact same line as our variable cost line. But instead of starting at zero, it's going to start at whatever our fixed costs are.
Because our total costs are never going to be less than our fixed costs. Because even if we produce nothing, we still have to pay those fixed costs. So even if we produce quantity zero, our total costs are still going to be equal to our fixed costs.
And then lastly, we can calculate our revenue line doing sell and price times quantity sold. And what we're looking for here for our break-even point, we're looking for the point at which, you can see it circled there, at which our revenue and our total costs are equal. And then if you kind of extrapolate those lines down, you'll be able to see where the quantity is.
So that level, that quantity on the X-axis where you read that line down to, that would be our break-even output. And so it's just worth kind of visualizing that. And effectively, you can see there, the gap... between the green line and the red line that's our profit so to the left of our break even point where our red line is above our green line our total cost line is above our revenue line you can see that that loss is there and obviously the further left we go from our break even point the wider the bigger that loss gets on the other hand though to the right after we've reached our break even output as we mentioned anything beyond that is profit the more the further we get past our break even point the more profit we're going to make the bigger the gap between revenue and total costs get There is one other calculation in here, and that is to calculate our margin of safety. And our margin of safety is effectively just how far above our breakeven output we are.
So effectively, how safe are we from that concept of survival? So the difference between our actual sales and our breakeven output, straightforward calculation, actual output minus breakeven output equals the margin of safety. So if our breakeven output was 1,000 units, and let's just say our actual output was 1,200, then our margin of safety would be 200 units.
Quite straightforward, but it's just really, really important because that shows us how many sales we can afford to lose before we start risking making a loss. The last topic in 2.2 is budgets. A budget is effectively a target, but in this sense, a financial target. And so you might have a budget, for example, if you're going on holiday or you're planning a weekend away or a night out, you might have a budget which might be based around limitations.
But often these budgets are targets. And so you might have a target for how much you're going to spend on a weekend, but you might be able to go above that. You might go below that. You might save a bit of money. You might spend a little bit more.
For a business, these budgets come in three different forms. We've got our revenue budgets, which are our targets for how much we're going to receive in revenue. We've got our cost or expenditure budgets in terms of how much we're going to spend. And these are the most common ones that you probably have heard of. You know, for example, I run a business department.
And so we have a... We have a budget for the department, which we use to buy resources. I help run a sixth form. And so as a result, we have a budget for how much we can spend on the sixth form as a whole.
And then there's a profit budget, which is going to be linked to the revenue and cost budgets. But it's effectively a target for how much profit we are going to have. And we might give these targets, we might give these budgets to members of our staff. For example, like I said, I'm in charge or partly responsible for two budgets. And so.
my school is giving me responsibility to manage those budgets and the idea is if everyone within your organization manages their budgets effectively your entire business should work effectively. So if I manage my costs and all the other departments manage their costs then the school as a whole shouldn't overspend. These budgets can also be used as motivational tools as well so we've mentioned in 1.4.4 we've mentioned motivation financial motivation such as bonuses such as share schemes, well profit share schemes, these could be determined or performance related pay, these things could be determined by how what successfully an employee manages their budgets. So we've got two types of budgeting when we're setting budgets the following year, we can use historical budgets where we use the previous year's data to set our budget for the following year or we can use zero based budgets where we make our budgets from scratch.
Typically what we do in school is our budgets will be based around how many students we have in that course. So for example each year that will be done from scratch based around Potentially the number of students changing the more students that do a course then the more your budget would go up But some will just look at the previous year's budgets and maybe make a couple of different amendments and then and then set that budget From there. Finally, we also have variance analysis and variance analysis is where we assess how our actual performance has gone Compared to our budgets.
So the key thing here is I mean, it's effectively just subtraction you just look at how you're just comparing the two figures your actual versus your versus your budget figure but the most important thing here is we get different types of variance our variance is either going to be favorable or adverse and the key These terms probably make quite a bit of sense. Favorable is something that's good. Adverse is something that's bad.
You might have most likely heard the term adverse when you think about weather. So adverse conditions, adverse weather means it's bad weather. We need to understand, the process of calculating the revenue, expenditure, and profit variance is pretty straightforward. You're just subtracting the actual and the budget. But what does those figures mean?
So for our revenue, do we want our revenue to be favorable, as in above, or... or adverse which is below with our revenue we want our revenue to be above our target we want to make more revenue than we expected that so if it is if our revenue is above our budget revenue then we will have a favorable variance there if our revenue is below what we targeted it would be it would be adverse costs on the other hand are going to be the opposite for our costs we want our costs to be below our budget we want to save some money and so therefore if we have below you know if we have our costs being below our actual sorry if we have our costs being below our budget then we would have a favorable variance whereas if our costs are more expensive then that might be an adverse variance now it's worth bearing one thing in mind here in not not in all circumstances will saving costs be a good thing so for example if a business says or a manager says well yeah actually i was able to save five thousand pounds on material costs by finding a cheaper supplier that might have a negative impact on quality of the products which might have a long-term impact and so it's not necessarily as straightforward as saying that if we save money that's always a good thing it depends on how much of an impact it has on the product and a variety of other factors so that's just worth bearing in mind a little caveat there and then finally profit it's going to be the same as revenue we want our profit to be higher than targeted so if our profit is above target then we would be fair we would be favorable if our profit is below target that would be adverse so make sure not only can you do the calculations for those but do you know whether that is a favorable result or an adverse result? Favorable result being good, adverse being bad. Hopefully there's just an element of common sense to that. So that covers 2.2 financial planning.
We've got one more to look at in terms of in 2.3 in terms of the finance side of things and then 2.4 and 2.5 will switch to more of the operations in the external environment. Hopefully you found this useful. Have a look at some of the resources in the description and if you've got any questions let me know in the comments and I will see you next time.