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Cash Flow Analysis, Target Cost, Variable Cost

Cash flow analysis is an important tool for businesses to evaluate their liquidity and financial health. It involves analyzing cash flows from operating, investing, and financing activities to understand where money is coming from and going out. The goal is to ensure the business has enough cash flow to operate sustainably and grow over time. Key aspects of cash flow analysis include tracking cash inflows and outflows, calculating free cash flow, and analyzing trends in operating cash flow margins. Target costing and understanding variable costs are also important concepts for effective cash flow management and cost control.

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139 views29 pages

Cash Flow Analysis, Target Cost, Variable Cost

Cash flow analysis is an important tool for businesses to evaluate their liquidity and financial health. It involves analyzing cash flows from operating, investing, and financing activities to understand where money is coming from and going out. The goal is to ensure the business has enough cash flow to operate sustainably and grow over time. Key aspects of cash flow analysis include tracking cash inflows and outflows, calculating free cash flow, and analyzing trends in operating cash flow margins. Target costing and understanding variable costs are also important concepts for effective cash flow management and cost control.

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Cash Flow Analysis

Cash flow differs from profit. Cash flow refers to the


money that flows in and out of your business. Profit,
however, is the money you have after deducting your
business expenses from overall revenue.
What Is Cash Flow Analysis?
 There are three cash flow types that companies should track and
analyze to determine the liquidity and solvency of the business: cash
flow from operating activities, cash flow from investing activities and
cash flow from financing activities. All three are included on a
company’s cash flow statement.
 In conducting a cash flow analysis, businesses correlate line items in
those three cash flow categories to see where money is coming in, and
where it’s going out. From this, they can draw conclusions about the
current state of the business.
 Depending on the type of cash flow, bringing in money in isn’t
necessarily a good thing. And, spending money it isn’t necessarily a bad
thing.
Cash Flow Analysis Basics
Cash flow analysis first requires that a company generate cash statements about
operating cash flow, investing cash flow and financing cash flow.
 Cash from operating activities represents cash received from customers less
the amount spent on operating expenses. In this bucket are annual, recurring
expenses such as salaries, utilities, supplies and rent.
 Investing activities reflect funds spent on fixed assets and financial
instruments. These are long-term, or capital investments, and include
property, assets in a plant or the purchase of stock or securities of another
company.
 Financing cash flow is funding that comes from a company’s owners,
investors and creditors. It is classified as debt, equity and dividend
transactions on the cash flow statement.
Why Is Cash Flow Analysis Important?

 A cash flow analysis determines a company’s working capital—


the amount of money available to run business operations and
complete transactions. That is calculated as current assets (cash or
near-cash assets, like notes receivable) minus current liabilities
(liabilities due during the upcoming accounting period).
Preparing a Cash Flow Statement
Let’s first look at preparing the operating cash flow statement. The line items that are
factored into the company’s net income and are included on the company’s operating
cash flow statement include but are not limited to:
• Cash received from sales of goods or services
• The purchase of inventory or supplies
• Employees’ wages and cash bonuses
• Payments to contractors
• Utility bills, rent or lease payments
• Interest paid on loans and other long-term debt and interest received on loans
• Fines or cash settlements from lawsuits
There are two common methods used to calculate and prepare the operating activities
section of cash flow statements.
Cash Flow Analysis Example
 Net income adjusted for non-cash items such as depreciation expenses and
cash provided for operating assets and liabilities. Using a free public template
from the Small Business Administration (SBA), let’s say Wild Bill’s Dog Trainers
and Walkers had a net income of $100,000 to start and generated additional cash
inflows of $220,000.
 As you can see in the spreadsheet, it spent $41,000 on operating cash outflows
like hiring an additional person, buying new equipment for the dog park, paying
taxes and more. The owner paid some principal down on a loan and took a draw
of $50,000 for an ending cash balance of $127,200. Small changes in any of those
line items show the impact of hiring more people, paying more taxes, buying
more equipment and more to ensure the business has a healthy balance sheet and
doesn’t go “into the red.”
Wild Bill’s Dog Trainers and Walkers
Five Steps to Cash Flow Analysis
There are a few major items to look out for trends and outliers that can tell you a lot
about the health of the business.
 Aim for positive cash flow
When operating income exceeds net income, it’s a strong indicator of a company’s
ability to remain solvent and sustainably grow its operations.
 Be circumspect about positive cash flow
On the other hand, positive investing cash flow and negative operating cash flow
could signal problems. For example, it could indicate a company is selling off assets to
pay its operating expenses, which is not always sustainable.
 Analyze your negative cash flow
When it comes to investing cash flow analysis, negative cash flow isn’t necessarily
a bad thing. It could mean the business is making investments in property and
equipment to make more products. A positive operating cash flow and a negative
investing cash flow could mean the company is making money and spending it to grow.
 Calculate your free cash flow
What you have left after you pay for operating expenditures and capital
expenditures is free cash flow. This can be used to pay down principal, interest,
buy back stock or acquire another company.
 Operating cash flow margin builds trust
The operating cash flow margin ratio measures cash from operating
activities as a percentage of sales revenue in a given period. A positive margin
demonstrates profitability, efficiency and earnings quality.
Cash flow analysis helps your finance team better manage cash inflow and cash
outflow, ensuring that there will be enough money to run and grow the
business.

SOURCE: https://www.netsuite.com/portal/resource/articles/financial-
management/cash-flow-analysis.shtml
Target Costing
Target costing was developed independently in both USA and Japan
in different time periods.Target costing was adopted earlier by
American companies to reduce cost and improve productivity.
What is Target Costing?
Target costing is not just a method of costing, but rather a
management technique wherein prices are determined by market
conditions, taking into account several factors, such as homogeneous
products, level of competition, no/low switching costs for the end
customer, etc. When these factors come into the picture,
management wants to control the costs, as they have little or no
control over the selling price.
Target Costing = Selling Price – Profit
Margin
Why Target Costing?
In industries such as FMCG (Fast Moving Consumer Goods),
construction, healthcare, and energy, competition is so intense that
prices are determined by supply and demand in the market.
Producers can’t effectively control selling prices. They can only
control, to some extent, their costs, so management’s focus is on
influencing every component of product, service, or operational
costs.
The key objective of target costing is to enable management to use
proactive cost planning, cost management, and cost reduction practices
where costs are planned and calculated early in the design and
development cycle, rather than during the later stages of product
development and production.
Key Features of Target Costing:
 The price of the product is determined by market conditions. The company
is a price taker rather than a price maker.
 The minimum required profit margin is already included in the target selling
price.
 It is part of management’s strategy to focus on cost reduction and effective
cost management.
 Product design, specifications, and customer expectations are already built-
in while formulating the total selling price.
 The difference between the current cost and the target cost is the “cost
reduction,” which management wants to achieve.
 A team is formed to integrate activities such as designing, purchasing,
manufacturing, marketing, etc., to find and achieve the target cost.
Advantages of Target Costing:
 It shows management’s commitment to process improvements and product
innovation to gain competitive advantages.
 The product is created from the expectation of the customer and, hence, the
cost is also based on similar lines. Thus, the customer feels more value is
delivered.
 With the passage of time, the company’s operations improve drastically,
creating economies of scale.
 The company’s approach to designing and manufacturing products becomes
market-driven.
 New market opportunities can be converted into real savings to achieve the
best value for money rather than to simply realize the lowest cost.
Example:
ABC Inc. is a big FMCG player that operates in a very competitive
market. It sells packaged food to end customers. ABC can only
charge $20 per unit. If the company’s intended profit margin is 10%
on the selling price, calculate the target cost per unit.
Solution:
Target Profit Margin = 10% of 20 = $2 per unit
Target Cost = Selling Price – Profit Margin ($20 – $2)
Target Cost = $18 per unit

SOURCE:
https://corporatefinanceinstitute.com/resources/knowledge/accountin
g/target-costing/
Variable Cost
What Is a Variable Cost?
A variable cost is a corporate expense that changes in proportion to
how much a company produces or sells. Variable costs increase or
decrease depending on a company's production or sales volume—
they rise as production increases and fall as production decreases.
Examples of variable costs include a manufacturing company's costs
of raw materials and packaging—or a retail company's credit card
transaction fees or shipping expenses, which rise or fall with sales. A
variable cost can be contrasted with a fixed cost.
Understanding a Variable Cost
 The total expenses incurred by any business consist of variable
and fixed costs. Variable costs are dependent on production output
or sales. The variable cost of production is a constant amount per
unit produced. As the volume of production and output increases,
variable costs will also increase. Conversely, when fewer products
are produced, the variable costs associated with production will
consequently decrease.
How to Calculate Variable Costs

The total variable cost is simply the quantity of output multiplied by


the variable cost per unit of output:
Total Variable Cost  =  Total Quantity of Output X Variable Cost Per
Unit of Output
Example of a Variable Cost
Let’s assume that it costs a bakery $15 to make a cake—$5 for raw materials such as
sugar, milk, and flour, and $10 for the direct labor involved in making one cake. The
table below shows how the variable costs change as the number of cakes baked vary.

As the production output of cakes increases, the bakery’s variable costs also increase.
When the bakery does not bake any cake, its variable costs drop to zero.
What Are Some Examples of Variable
Costs?
Common examples of variable costs include 
costs of goods sold (COGS), raw materials and inputs to production,
packaging, wages and commissions, and certain utilities (for
example, electricity or gas that increases with production capacity).
Key Takeaways
 A variable cost is an expense that changes in proportion to
production output or sales.
 When production or sales increase, variable costs increase; when
production or sales decrease, variable costs decrease.
 Variable costs stand in contrast to fixed costs, which do not
change in proportion to production or sales volume.

SOURCE: https://www.investopedia.com/terms/v/variablecost.asp

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