CHAPTER 5

BUILDING A PROFIT PLAN

1
Profit plans principal tools use to:
- price business & operating plans
- make trade-offs between different courses of
action
- set performance & accountability goals
- evaluate the extent to which business
performance is likely to meet the expectations
of different constituents.

2
The objectives:
To translate the strategy of the business into a
detailed pplan to create value
- agree on assumptions
- evaluate strategic alternatives
- arrive at a consensus regarding a business strategy
& its ability to satisfy the demands of different
constituencies.
constituencies
To evaluate whether sufficient resources are
available to implement the intended strategy :
- to finance current operations (operating cash),
- to invest in new assets for future growth
(investment cash).
3
To create a foundation to link economic goals with
leading indicators of strategy implementation
fi
financial
i l goals
l mustt be
b linked
li k d with
ith key
k business
b i
input, process, & measures.
To enable benchmarking with competitors &
identify areas for efficiency gains
To aid in internal communication, coordination &
education. An interactive profit planning process
sets up a motivational contract with managers &
increases knowledge of the business

4
To build a profit plan, managers need to answer three
different question:
1 Does
1. D th organizations
the i ti strategy
t t create
t economic i
value?
The strategy has to adapt to these changes if the
firm is to continue to create economic value &
survive.
2 Does
2. D the
h organization
i i have
h enoughh cash
h to fund
f d the
h
strategy & remain solvent throughout the year?
3. Does the organization create enough value to attract
the financial resources that it needs to fund long-
term investment in new assets?

5
 THE PROFIT WHEEL

Value creation is measured by profit.

Without building a profit plan,
plan managers cannot:
- evaluate whether intended strategy will generate value
for shareholders.
- estimate the economic impact of different strategic
alternatives &, as a result, lack adequate information
to decide amongg different courses of action.

The profit plan summarizes the expected revenue inflows

& expense outflows for a specified future accounting
period (typically one year).

6
 THE PROFIT WHEEL
Foundations of a Profit Plan
Step 1: Set Assumptions about the Future consensus among
managers about how various markets customer, customer supplier,
supplier &
financial will evolve in the future.
Managers consider decisions that have direct influence on sales
during the current planning period:
Mix & pricing of product categories
Marketing programs
N
New-product
d t introductions
i t d ti & product
d t deletions
d l ti
Changes in product quality & features
Manufacturing & distribution capacity
C
Customer service
i levels
l l
Managers have discretion indeed the responsibility to set these
variables to reflect the agreed strategy.
Strategy provides the criteria for consistency.

7
 THE PROFIT WHEEL
Step 2: Forecast Operating Expenses
Different categories of operating expenses must be analyzed differently.
1. Variable costs, vary proportionally with the level of sales or
production outputs estimated as a percentage of sales. Managers
must assume that the cause-&-effect relationships between inputs &
outputs are constant over the relevant range of sales.
Ways variable
i bl costs can be
b reduced
d d as a percentage off sales:
l
Taking advantage of economies of scale (e.g., installing one large
machine in place of three smaller, less-efficient machines) &
economies of scope (as combining distribution channels for different
products to eliminate redundant or underutilized resources)
Improving operating efficiencies (e.g., re-engineering or streamlining
work flows to do the same work with fewer resources)
Bargaining with suppliers to negotiate lower prices
Redesigning products to lower their cost of production
Increasinggpprices

8
 THE PROFIT WHEEL
2. Nonvariable costs, do not vary directly with the level of sales large &
have become a higher percentage of the operating expenses of most
companies in recent years.
years
Committed (or engineered) costs determined by previous
management decisions &, not subject to discretion during the current profit
planning g Depreciation depends on past planning
g period. e.g. g period ((past
investment decisions & company accounting policies), salaries of
managers, engineers, long-term employees; the cost of a long-term lease.
Discretionary costs the planned level is open to significant debate
during the planning process & subsequent adjustment during the
operating period. e.g. Advertising, employee training, & research programs.
Activity-base indirect costs cannot be traced directly to a product or
service, but change with the level of specific underlying support activities
e.g., supervision, material handling, & billing costs. They may look fixed,
especially if part of the expenses are committed, but their consumption
varies with the level of some underlying activity.

9
 THE PROFIT WHEEL

To estimate them, managers must identify indirect

cost drivers those activities that consume indirect
resources.
I
Increases i these
in th costt drivers
di (
(e.g., i
increases i
in
customer order complexity or material handling)
can be traced to growth in indirect expense levels,
levels
increased handling, setup, & shipping costs.
If cost driver activities can be decreased, then
managers can plan to save some money by using
fewer resources to perform this activity.

10
 THE PROFIT WHEEL
Step 3: Calculate Expected Profit
Expected Sales - Expected Operating Expenses the amount of
economic value that the company is expected to generate in the
profit planning period estimate NOPAT: Net Operating Profit
After Taxes, or EBIAT : Earnings Before Interest & After Taxes.
Reveal the amount of resources generated during the accounting
period that are potentially available for distribution to lenders &
owners. Lenders, like banks, have a fixed claim on the profits of the
b i
business. Receive
R i interest
i t t paymentst proportional
ti l tot the
th amountt
of financial resources that they lend to the company.
Profit, earnings or net income residual economic value after
i
interest expense & income
i taxes.
Profit is the financial measure of the economic value that is
available for distribution to the residual claimants
equity holders
or for reinvestment in the business.
11
 THE PROFIT WHEEL
Step 4: Price the Investment in New Assets
When managers agreed on expected sales, operating
expenses & profit numbers the most important part of a
expenses,
profit plan: the expected income statement.
To finish the profit plan, managers must look at the required
level of investment in new assets, including working capital
(inventory & accounts receivable) managers must decide
the levels & types
yp of investments that are required
q to support
pp
desired sales backed up by an asset investment plan.
The proposed investment in long-term productive assets is
called capital investment plan must reflect & support the
intended strategy because it often commits the company to a
limited set of strategic alternatives.

12
 THE PROFIT WHEEL
Step 5: Close the Profit Wheel & Test Key Assumptions
The feedback loopp suggests gg that the pprofit pplanningg
process is not linear. Managers must go back & forth among
the variables in the profit plan to ensure that it reflects the
strategy & is attractive from an economic point of view.
view
When managers have arrived at an acceptable expected profit,
perform a sensitivity analysis based on changes in sales or
other
h key
k profitfi plan
l variables.
i bl
The objective to estimate how profit might change when
y g assumptions
underlying p about the competitive
p environment or
other predictions embedded in the base profit plan prove to be
under- or overstated worst-case, most likely, & best-case.

13
 CASH WHEEL
Before a profit plan can be accepted as feasible,
managers
g must forecast whether the companyp y will
have enough cash to operate (cash wheel) &
whether the return to investors is sufficiently
attractive
i (ROE wheel).
h l)
The cash wheel illustrates the operating cash flow
cycle of a business: Sales of products & services to
customers generate accounts receivable, which are
eventuallyy turned into cash;; used to pproduce
inventory used to generate more sales.
Why a company may need more or less operating
cash, depending on its industry & its strategy.
14
Cash

CASH WHEEL
FIGURE 5-3 The Cash Wheel Operating
Cash

Accounts Cash Wheel Inventoryy

Receivabl
e
Sales

Operating Investment
Profit wheel
Expenses in Assets

Profits

Asset ROE Wheel Stockholders

Utilization Equity

Return on
E it
Equity

15
 CASH WHEEL
Forecasting cash needs is important for all
business because companiesp have limited cash
reserves & borrowing capacity. If managers
project that the cash needed to operate the business
exceedsd cashh reserves & maximum i b
borrowing
i
capacity, then the profit plan is not feasible & must
be reworked.
reworked
e.g., fast-growing companies need a lot of cash to
finance increases in workingg capital
p ((inventory
y&
accounts receivable) & the purchase of new
productive assets (machinery & equipment).
Existing debt may limit their borrowing capacity.
16
 CASH WHEEL
The most intuitive
Th i i i way to estimate
i cashh requirements
i i to
is
forecast cash inflows & cash outflows for each specific time
p
period.
The basic formula:
Operating cash Cash received Cash paid to suppliers
=
needed during a period from customers & operating expenses
The name of this cash flow method: the direct method,
estimate cash requirements for short periods of time a day, a
week, or a month. For each period, managers estimate cash
that will be collected (cash inflows) & cash that will be paid
out (cash outflows).

To estimate cash needs over

o er longer periods of time to tie in
with the monthly, quarterly, or yearly profit plan projections
companies generally use the indirect method 17
 CASH WHEEL
Step 1: Estimate Net Cash Flows from Operations
Use EBITDA = Earnings Before Interest, Taxes,
Depreciation, & Amortization.
Rough calculation of nonaccrual or cash based
operating earnings that can be computed readily from
an income statement.
Th calculation
The l l ti starts
t t with
ith accruall based
b d profit
fit &
adds back (1) depreciation not require an outlay of
expenses, nonoperating
cash & (2) interest & tax expenses
cash,
expenditures.

18
 CASH WHEEL

Step 2: Estimate Cash Needed to Fund Growth in

Operating Assets
EBITDA is a rough measure that ignores any
changes
g in workingg capital
p needed to operate
p the
business. e.g., cash may be used up (or provided) by
changes in inventory levels & accounts receivable
balances.
Experience in any business will provide good data
on the level of working capital needed to fund a
business.

19
 CASH WHEEL

Step 3: Price the Acquisition & Divestiture of

Long-Term Assets
Different strategies & initiatives will require
different levels of investment & cash.

Step 4: Estimate Financing Needs & Interest

Payments
The final step subtract the amount of cash
needed for (or generate by) financing & income tax.
tax
Financing demands on cash flow include dividends,
interest expense, & payment of debt principal.

20
 CASH WHEEL

The indirect method yields exactly the same results as the

direct method (compare Exhibits 5-4 & 5-5).
5-5)
The primary difference:
Indirect method can be calculated quickly from existing
monthly, quarterly, or yearly financial-statement estimates.
The direct method requires a detailed, & often laborious,
estimate of cash inflows & outflows.
Cash flow analysis will indicate the need for external funds
in the form of either debt or equity to support the proposed
profit
fit plan.
l Managers
M mustt choose
h among available
il bl source
of external financing (equity, short-term debt, long-term
debt or some combination of these instruments)) & choose
funding sources that match financial risk with business risk.
21
 CASH WHEEL
Ensuring Adequate Cash Flow
The profit plan, the time horizon is typically one year,
cash flow projections often focus on much shorter time
periods. The difference between cash inflows & cash
outflows during the operating cycle is estimated for
most businesses at least monthly.
For highly seasonal industries cash flow balances
must be calculated weekly or even daily during critical
periods when available cash may not be sufficient to
keep the business solvent
solvent. In these industries,
industries a bank
may be willing to lend the average cash requirements
for a business, but the important question is whether the
bank will advance the maximum cash shortfall that the
company needs over the business cycle. 22
 CASH WHEEL
The cash wheel highlights the fact that all businesses
have a significant amount of resources tied up in
accounts receivable, inventory, & other working capital
accounts. Managers must work diligently to accelerate
the flows around the cash wheel, thereby freeing up cash
for investment, financing, or operations growth.

23
 ROE WHEEL

Businesses that earn the most pprofit will be

better off:
- have more resources to invest in future
opportunities
- able to pay higher dividends to investors;
- stock price will be higher;
- cost of debt will be lower.

24
 ROE WHEEL
Both stock price & dividend payments depends on a
businesss ability to generate profit from the investments that
stockholders make in the business. When a stockholder
invests $100 in a firm, the managers of the firm use the $100
to purchase assets, which are then deployed to earn profit for
th benefit
the b fit off the
th stockholder.
t kh ld The Th critical
iti l measure, is
i the
th
amount of profit that managers are able to generate from the
$100 investment entrusted to them. If the business generate
$20, profit can be measured in two ways:
1). the business could report a $20 profit an absolute
measure of success.
2). managers could calculate the return on shareholders
investment by comparing the profit output ($20) with the
($100) The return on the stockholder
investment input ($100).
investment of $100 would be 20% -- a ratio.
25
 ROE WHEEL
Investors in a firm monitor their investment returns carefully &
hold top managers accountable for these returns the single most
important
p measure for investors is return on investment ((or
ROI). a ratio measure of the profit output of the business as a
percentage of financial investment inputs.
If we adoptp the pperspective
p of managers
g those entrusted byy
stockholders to generate profit then the appropriate internal
measure for return on investment is on equity (ROE).
The shareholders equity
q y pportion of the balance sheet shows the
total original investment by stockholders, plus accumulated
business profits that accrue to stockholders benefit (less, of
course, any dividends paid out).
The objective for any manager is to use the equity investment of
the firm wisely for benefit of stockholders.

26
 ROE WHEEL

Step 1 Calculate Overall Return on Equity

ROE = Net Income
Stockholders Equity

If assume that senior managers wish to maximize this

measure how senior managers cascade this measure down
to the organization hierarchy so that lower level employees
will
ill also
l workk to increase
i ROE.
ROE
To answer: Decompose ROE into its component parts.
The basic arithmetic decomposition of this measure was
devised by Donaldson Brown, developed his techniques as
chief financial officer at Dupont about 1915 & later
i
introduced
d d the
h techniques
h i to General
G l Motors.
M

27
 ROE WHEEL
ROE = Net Income
Stockholders Equity

= Net Income X Sales

Sales Shareholders Equity
Shareholders

The first term (net income sales) is a ratio measure of profitability. It

answers the q question. How much p profit will we g
generate for each
dollar of sales? Comes directly from the profit wheel.

The second term (sales stockholders equity) is a ratio measure

useful only for senior managers, because middle-& lower-level
managers do not manage stockholders equity per se.

Managers lower
M l i the
in th business
b i are allocated
ll t d funds
f d to
t acquire
i assets,
t
which in turn are used to generate sales & profits,
28
 ROE WHEEL
ROE = Net Income X Sales X Assets
Sales Assets Shareholders Equity
= y
Profitability X Asset X Financial Leverage
g
Ratio Turnover Ratio
Ratio
The first term (net income sales) remains the same a profitability
measure.
The second term (sales assets) is now a ratio measure of asset turnover.
How many sales dollars will we generate for each dollar that is invested
in assets of the business? The objective for any manager is to maximize the
sales created by the firms asset base (assuming, of course, that incremental
sales generate profits not losses).
The final term (assets stockholders equity) focuses on financial leverage
b asking,
by ki Wh t percentage
What t off total
t t l assets
t employed
l d are tot be
b funded
f d d byb
stockholders & what percentage by debt?
To the extent that the asset-to-equity ratio is greater than 1, assets will be
funded byy debt extended by y bondholders,, banks,, & other creditors of the
business.
A leveraged business is one that relies on a high percentage of debt to fund
the productive assets employed in the business. 29
 ROE WHEEL

Step 2: Estimate Asset Utilization

Within a business, unit managers (division or profit center
managers) are often accountable for a variant of ROE known
as ROCE, return on capital employed.

ROCE = Net Income X Sales

Sales Capital Employed

30
 ROE WHEEL
Capital employed refers to the assets within a managers direct
span of control. Some companies define capital employed as total
assets controlled by a manager minus noninterest-bearing liabilities
(e.g., accounts payable). These assets typically include accounts
receivable, inventory, & plant & equipment.

In other cases, some corporate-level assets, such as unamortized

ggoodwill,, are also allocated to pprofit centers to be included in the
capital that is employed to generate revenue & profit. Different
businesses define ROCE in different ways.

The detailed decomposition of ROCE provides important additional

information about the effective utilization of capital & assets. We
can decompose ROCE into a systematic view of many parts of the
businesss operations.
31
 ROE WHEEL
Sales
Working Capital Turnover = Current Assets Current Liabilities

Net Sales on Credit

Accounts Receivable Turnover = Average Net Receivables

Cost of Goods Sold

Inventory Turnover = Average Inventory

Sales
Fixed Asset Turnover = Property, Plant, & Equipment

These turnover ratios show how efficiently managers have used each
category of asset (working capital, accounts receivable, inventory, &
fixed assets) to generate sales & ultimately, profit.

32
 ROE WHEEL

Step 3: Compare Projected ROE With Industry

Benchmarks & Investor Expectations
Once overall expected ROE is calculated, managers must
compare it to some benchmark or standard to see how it
stacks
t k up againsti t competitors
tit & investor
i t expectations.
t ti
Managers are sensitive to the ROE expected by investors,
analysts, & others who monitor the financial performance
of their firm.
High returns on investment lead to high stock prices & to
the willingness to the investors to commit additional
financial resources to support the growth of the firm.
Low returns cause the opposite result.

33