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Lecture 6

BU121 Lecture Notes - Lecture 6: Fixed Cost, Variable Cost, Operating Leverage

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Laura Allan

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Entrepreneurial Finance
Cash vs Profit
Contribution Analysis
oCash Breakeven
New Venture Financing
Cash Budgeting
Cash Burn
New Venture Valuation
Strategies for Growth/Exit
Critical Success Factors
Achieving financial performance
Meeting and exceeding customer needs
Providing value (quality products at a reasonable price)
Encouraging innovation and creativity
Gaining employee commitment
Cash vs. Profit
Key Principle of entrepreneurial finance:
oWhile accounting is the language of business, cash is the currency.
Can a company that is profitable go bankrupt?
Sales Revenue – Accounts Receivable
Expenses – Accounts Payable
Depreciation/Amortization – not cash
Owners’ Equity – cash to use for business?
Survival/Cash Flow Breakeven
Some new ventures show profitability during the startup stage, but…
It is more common for a new venture to have losses – survival stage
need to know the level of sales (survival revenue) necessary to cover costs and
break even
And need to do this on a cash basis…
At survival/cash flow breakeven
oEBDAT (earnings before depreciation/amortization and taxes) = 0
oEBDAT = EBIT + depreciation - interest
We can see that the company achieved breakeven in year 2 but when? What level of
sales (survival revenue) was needed to breakeven?
At cash breakeven EBDAT = 0
oWhen EBDAT = 0, Revenues = Expenses
oExpenses can be variable (VC) or fixed (CFC)…
Two types of expenses/costs:
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Variable (VC:
Costs of directly providing a product or delivering a service – therefore total $
amount varies with sales
For example – cost of goods sold
But is constant as a % of sales revenue
Fixed (CFC):
Expected to remain constant over a range of revenues for a specific time period
because total $ amount constant - doesn’t fluctuate with volume of sales, varies as %
of revenue
For example – rent
oCash fixed costs only – not including depreciation/amortization
Let x represent the number of units of sales where total revenue = total costs
x = survival revenue (volume of sales needed to breakeven)
x = CFC = CFC _
Price – VC contribution
Breakeven/survival revenue is reached when contribution remaining from the
sale covers cash fixed costs
OR… Unit Costs are Not Available
Breakeven Drivers
Most important influence/driver on a venture’s breakeven is its variable cost
revenue ratio (VCRR)
oWhat is left over once this variable cost is covered is its contribution margin
oFor example, let’s say that in year 2, due to volume discounts, the company
could lower production costs to $60 per unit (60% of $100 revenue per unit)
vs $65
oSurvival revenue (SR) (revenue needed to breakeven)
When the VCRR goes down (65% to 60%), the contribution margin goes up (35% to
Less sales are needed, at a higher contribution, to cover the fixed costs (survival
revenue/breakeven is lower)
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