Chapter 5 - building profit plan

Chapter 5 Presented by Group 6 Nick Feiler Xiaohan Hu John Langsdorf Wes Matthews Steve Potts

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Building a Profit Plan 

Budget –  Plan Budget –   Plan to generate or consume resources; cost center or profit center.

Profit Plan –  Plan –  Budgets  Budgets of Profit Centers that generate profits and are accountable for  both revenues and expenses. expe nses.

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Three Objectives of the Planning Process Translate the strategy of the business into a detailed plan to create value.  Evaluate whether sufficient resources are available to implement the intended strategy.  Create a foundation to link economic goals with leading indicators of strategy implementation. 

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Managers’ 3 Profit Plan Questions Does the organization’s strategy create economic value?  Does the organization have the cash to fund their strategy and remain solvent?  Does the organization create enough value to attract the financial resources that it needs to fund long-term investment in new assets? 

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Three Wheels of Profit Planning

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Profit Wheel

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Cash Wheel

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ROE Wheel 5

Three Wheels of Profit Planning Operating Cash

Accounts Receivable

Cash Wheel Sales*

Asset Utilization

Sales*

Inventory

Operating Expenses

Profits**

ROE Wheel Return on Equity

Profit Wheel

Investment in Assets

Profits**

Stockholders’

Equity

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Profit Wheel/3Wheels 

The profit plan summarizes the expected revenue inflows and expense outflows for a specified future accounting period.

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Usually managers go back and forth, projecting sales, operating expenses, profits, and required investment in assets.

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Then they work on the cash wheel and the ROE wheel to ensure resources will be available to implement the profit wheel. 7

Profit Wheel – 5 steps 1)

Estimate the Level of Sales

2)

Forecast Operating Expenses

3)

Calculate Expected Profit

4)

Price the Investment in New Assets

5)

Close the Profit Wheel and Test Key Assumptions. 8

Profit Wheel – Step 1 Estimate the Level of Sales  1. 2. 3. 4.

 External Variables Macroeconomic factors Government regulations Competitor moves Customer demand

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 Internal Decisions

1.

Product mix and pricing Marketing programs  New Product Introduction and Change in product quality and feature Manufacturing and distribution capacity Customer service levels

2. 3. 4. 5. 6.

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Profit Wheel – Step 2 Forecast Operating Expenses 

Variable costs forecast and reduction

1.

Economic of scales

2.

Operating efficiency

3.

Bargaining power with suppliers

4.

Redesigning of products

5.

Increase price

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 Non-variable costs

1.

Committed costs

2.

Discretionary costs

3.

Activity-based indirect costs 10

Profit Wheel – Step 3 Calculate Expected Profit  Profit defined 

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The residual economic value after interest expense and

income taxes 

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Calculating Profit  NOPAT: Net Operating Profit after Taxes EBIAT: Earnings before Interest and after Taxes

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Profit Wheel – Step 4 Price the Investment in New Assets 

Assets to Consider for Investment: 1) Operating Assets 2) Long-Term Assets

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Most common investment evaluation technique is net present value. 12

Profit Wheel – Step 5 Close the Profit Wheel and Test Key Assumptions

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Perform a Sensitivity Analysis Objective: Estimate how profit might change when assumptions prove to be under- or overstated.

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Cash Wheel 

The cash wheel illustrates the operating cash flow cycle of a business.

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Important as companies have limited cash reserves and borrowing capacity.

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Operating cash = Cash Rec’d –  Cash Paid

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Direct (Short Term) & Indirect (Long Term) Methods

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Cash Wheel – 4 Steps 1)

Estimate Net Cash Flows from Operations

2)

Estimate Cash Needed to Fund Growth in Operating Assets

3)

Price the Acquisition and Divestiture of Long-Term Assets

4)

Estimate Financing Needs and Interest Payments

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Cash Wheel – Step 1 Estimate Net Cash Flows from Operations 

The calculation of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a simple technique to estimate operating cash flow.

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Refer to Exhibit 2.

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Cash Wheel – Step 2 Estimate Cash Needed to Fund Growth in Operating Assets 

EBITDA is a rough measure that ignores any changes in working capital needed to operate the business.

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Examples include: A/R (accounts receivable), Inventory, and A/P (accounts payable).

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Refer to Exhibit 2. 17

Cash Wheel – Step 3 Price the Acquisition and Divestiture of Long-Term Assets 

Different strategies and initiatives will require different levels of investment and cash.

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Examples here are Fixed Asset purchases, such as computer equipment or machinery.

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Refer to Exhibit 2.

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Cash Wheel – Step 4 Estimate Financing Needs and Interest Payments 

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Lastly, need to account for cash needed or generated by financing and income tax. Examples here are dividends, interest expense, interest received, and repayment of debt  principal. Refer to Exhibit 2. 19

ROE Wheel 

Return on Investment (ROI): a ratio measurement of the profit output of the business as a percentage of financial investment inputs.

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Return on Equity (ROE): the appropriate internal measure of ROI for managers.

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ROE = Net Income / Shareholder’s Equity

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ROE Wheel – 3 Steps 

Calculate Overall Return on Equity

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Estimate Asset Utilization

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Compare Projected ROE with Industry Benchmarks and Investor Expectations

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ROE Wheel – Step 1 Calculate Overall Return on Equity 

ROE =

(Net Income/Sales)*(Sales/Assets)* (Assets/Shareholder’s Equity)

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 Net Income/Sales = Profitability Ratio

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Sales/Assets = Asset Turnover Ratio

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Assets/Shareholder’s Equity = Financial Leverage Ratio

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ROE Wheel – Step 2 Estimate Asset Utilization 

ROCE   =

Return on Capital Employed: Measures the effective utilization of capital and assets. = (Net Income/sales)*(Sales/Capital Employed)

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Capital Employed = Assets within a manager’s direct span of control.

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ROE Wheel – Step 2 Asset Utilization Measures 

Working Capital Turnover = (Sales) / (Current Assets –  Current Liabilities)

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Accounts Receivable Turnover = (Net Sales on Credit) / (Average Net Receivables)

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Inventory Turnover = (Cost of Goods Sold) / (Average Inventory)

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Fixed Asset Turnover = (Sales) / (Property, Plant, and Equipment)

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ROE Wheel – Step 2 ROCE Tree Sales Prof it

Return/Sales Return on Capital Employ ed

(x)

(/)

(-)

Total Expenses

COGS Selling and  Admin. Expenses

Other Expenses

Sales

Cash

Sales/Assets

(/) Total  As sets

Working Capital

(+)

Inventories  Ac counts Receivable

Productive  As sets

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ROE Wheel – Step 3 Compare Projected ROE with Industry Benchmarks and Investor Expectations ROE

Profitability

Asset Turnover 

Financial Leverage

The Limited

10.6%

2.4%

2.1

2.1

The Gap

33.7%

8.2%

1.9

2.1

Nike

25.2%

8.7%

1.7

1.7

Boston Retail

22.5%

6.4%

2.5

1.4

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Using the Profit Wheels to Test Strategy 

Profit Wheel - Prepare profit plan

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Cash Wheel - Ensure cash will be adequate

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ROE Wheel - Compare each alternative 27

Chapter Summary 

Profit plan describes business strategy in economic terms

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Profit plan is used to assess the ability of different strategies to generate value and to estimate whether sufficient resources will be available to implement the chosen strategy

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