This shows the company when their costs are covered and where they begin to make profit. It is usually shown in the format of a graph. It can be used to identify when prices need to be raised, fixed or dropped depending on the company’s income.
This is a very important part of financial forecasting. It involves looking forward and looking at the cash flow in and out of the company. By using this tool the company can predict how much money they will have from month to month and they can tell when an overdraft may be needed.
Brief
Lesley Jerome wants to set up her own business as a soul trader. She is very artistic and wants to design and make silk scarves, scrunchies and jewellery.
There is a large craft shoe being held near to where she lives, so she decides to rent a stand and make only scarves to sell at the show. In this way she can see if people like her ideas and will buy them. Before she goes to the show she has to do some financial planning. The first thing she needs to do is to work out the unit cost of production. This will help decide what price she will sell at.
Unit cost of production and price
Based on the following information the table below shows the cost of producing one scarf.
Fixed Costs :-
- Rental of the stand £150
- Overheads including electricity and water £60
Variable costs :-
- Silk material for the scarves is £3.00 per meter and is 90 cm wide. Each scarf is 30 cm wide by one meter long.
- Other materials including thread £15.00
- Paint 10 litres (10 different colours) @ £15.00 per litre.
- Labour – Lesley allows herself a wage of £4.00 per hour and it take an average of one hour to make one scarf.
This will help Lesley Jerome because she now has an insight into what her costs are going to be. She now knows the full extent of all of her costs and can fix a selling price that will cover them all and not leave her short or in debt.
Other things that need to be taken into consideration when fixing prices are to take notice of what the consumers are wiling to pay and what other competitors are charging for their scarves because if they are cheaper elsewhere then people will go there instead and Lesley will loose her trade.
Break even analysis
Lesley now knows the price she intends to charge. As she is only intending to make 150 scarves she needs to know how many scarves she needs to sell in order to break even. She will now have to carry out a breakeven analysis.
Break even analysis can be presented in the form of a chart or a graph. The other way of calculating the break even point is to use the contribution to fixed cost method.
Below is a table showing Lesley Jerome’s Break even point.
This is a graph showing Lesley’s Break even point.
On the next page is a hand drawn graph of Lesleys break even analysis.
Cash flow forecasting
Lesley wants to be certain that she is going to have sufficient cash to pay her bills as and when they arise. She needs to produce a cash flow forecast.
Shown below is a cash flow forecast for a 6 month period.