As we saw in Part 1 of this series
of articles on Finance for the Marketing Process, forecasting is a necessary part of the decision process of what, how much and when to produce a product or a service. In this article, we will look into a useful tool that will help us with our forecasts.
Whether we like it or not, we are always faced with the so-called Business Cycle, i.e., good years reach a certain maximum and then, for some reason (to be explained in a future article, or in our FFNFP training course if you are interested in enrolling), this is followed by a decline in market activity: sales falling, incomes shrinking until (hopefully) a bottom is reached, and again the up-turn begins with demand and incomes expanding that help our sales increase again.
If we split all costs of a business into Variable v Fixed (even the discretionary costs, as we explained them in the previous article, need to be split into Variable and Fixed) then during good times when sales go up and revenues are high, we are confident that not only VC (Variable Costs) will be covered from Revenue but also our FC (Fixed Costs) will be covered, and enough will be left for profits (what three things do we need profits for? Try to guess/remember!*).
However, during bad times when we are going down in the business cycle and revenues are falling, we are at risk! And the risk is that our Revenue may not be enough to cover our FC even though these have to be paid! FC are not avoidable! Remember the rent for the factory? No matter how many units you are producing, the monthly lease has to be paid!
In fact, the ratiorepresents what we call the OPERATING GEARING which represents operating risk. The higher the FC is, the higher the risk of default!
Let’s see how this works in practice.
What is contribution? And how does it work? Have a look at our previous article on this.
Stay tuned for other, alternative Break/Even techniques that can be useful to Marketing professionals. If you have any ideas or requests on topics you'd like to see here, feel free to drop us a line - we'll be happy to hear from you!
*Reminder: What are the three things we need profits for?
1. To pay dividends;
2. To save for years where there aren't sufficient profits to pay constant dividends;
3. To save to invest for new ideas and products and markets.
The idea is that if profits go up and down, the share is perceived as risky, so dividends must not fluctuate; they must be level or, preferably, gradually rising.