Break-even analysis

Break-even analysis is a tool used by managers to estimate either the quantity they need to sell at a given price to cover all costs or the price they must charge to cover all costs for a given quantity of output. Break-even analysis is often used when managers are considering new INVEST-MENTs or new PRODUCTs.

Break-even quantity (BEQ) is estimated using the for­mula BEQ = FC ÷ (P – AVC), where FC is total fixed costs, P is price per unit, and AVC is average variable cost per unit. Break-even analysis assumes a manager can estimate:

- the initial fixed costs (equipment, buildings, licenses; any cost that is required to get started but does not change with the level of output),

- the average variable cost (materials, labor, energy) in the range of output being considered.

If these costs can be estimated, a manager can then deter­mine how many units must be sold at various prices to break even. For example, if FC is $1000 and AVC is $10, then at:

P = $20, BEQ = 100

P = $30, BEQ = 50

P = $40, BEQ = 33.3

Break-even analysis allows a manager to create a hypo­thetical DEMAND curve. Using the information from the BEQ analysis, managers then determine whether they think they can sell at least that quantity at a given price. Managers may then employ sales forecasting techniques to compare the results of BEQ analysis with potential market demand.

In the above formula, P–AVC is often called the con­tribution margin. For each unit produced and sold, the dif­ference between price and the average variable cost (if the difference is negative, the product should not be pro­duced) contributes to “covering” fixed costs, and when all fixed costs are covered, ultimately contributes to profit. Break-even price (BEP) is estimated using the formula BEP = (FC ÷ Q) + AVC, which says that the BEP equals average total cost. Using this same example above, if FC are $1000 and AVC is $10 then at:

Q = 50, BEP = $30

Q = 100, BEP = $20

Q = 200, BEP = $15

Managers can use BEP analysis to answer the question, “If we produce and sell 100 units, what price do we have to get in order to at least break even?”

Retail store managers frequently use break-even analy­sis when considering new products. In RETAILING, firms often “keystone” products—that is, price their products at twice the cost to the store. If a manager orders 100 spring shirts at $10 each and prices them at $20 each, then they must sell at least 50 shirts to break even.

Another way to use break-even analysis is when con­sidering ADVERTISING options. If a magazine ad costs $500, the product advertised sells for $10, and the average vari­able cost is $5, then the advertisement would need to gen­erate 100 additional sales to break even.

Request for proposal, invitation to bid

A request for proposal (RFP) solicits offers from suppliers of goods or SERVICES needed by an organization. Similar terms are invitation to bid and request for quotation. Each term is associated with a different degree of request specificity and different procedures and expectations on the part of all parties involved.

In the RFP process, the buyer typically transmits a precise statement of its requirements to several potential suppliers who are qualified to provide the goods or services required. The buyer does not develop precise specifications (e.g., military specifications) but does expect suppliers to present their own design and/or specifications, either standard or customized PRODUCTS, to fulfill the requirements. Often the successful supplier is required to provide substantial performance guarantees.

Brands, brand names

Brands are names, terms, designs, signs, symbols or some combination that identify a firm’s PRODUCTs. Brands facilitate easy recognition of a company’s products and increase consumer loyalty through repeat purchase. According to MARKET RESEARCH, consumers’ brand loyalty goes through three stages: recognition, preference, and insistence.

A marketer’s first objective is to gain brand recogni­tion—that is, consumer knowledge of a company’s brand. In ADVERTISING, marketers typically have three objectives: to inform, persuade, and remind consumers about the company’s products. Brand recognition is consistent with informing customers about a brand. Gaining brand recog­nition in a national market like the United States is expen­sive. With a large geographic area, over 280 million people, and tremendous COMPETITION from other firms, marketers have to work hard to gain brand recognition. One option used by several small firms is advertising dur­ing the Super Bowl, the most widely watched television event in the United States. Super Bowl advertising is very expensive, but several small firms have successfully used it as a way to gain national brand recognition.

Brand preference is the stage where consumers select a particular brand over competing offerings. Typically brand preference is based on past experiences with a firm’s prod­ucts. In many categories of consumer products, customers tend to be very brand-loyal. Often brand loyalty is based on what peoples’ parents purchased. For decades Sears’s strongest MARKETING STRATEGY was brand preference and insistence based on consumers’ past experiences with their tools and appliances.

Brand insistence is brand loyalty to the point where consumers refuse alternatives and seek out brands they most desire. Airlines and, more recently, hotel chains have successfully built brand loyalty through frequent-flyer/stay programs.

There are four types of brands: manufacturers, private, family, and individual. Manufacturers’ brands, also called national brands, are those owned by the manufacturer. General Motors, Kodak, and Coca-Cola are all examples of national brands. Manufacturers protect and support their brands, often using price competition with private brands and cooperative advertising and promotion with retailers to maintain and expand brand loyalty. Private brands are brand names created and marketed by WHOLESALERs and retailers. For example, Sears owns the Kenmore, Craftsman, and DieHard brand names. Sears contracts with manufacturers to make products to be sold under these private names. Traditionally manufacturers dominated brand marketing, but since World War II, retailers have greatly increased their control of DISTRIBU­TION CHANNELs and have used this market power to expand their use of private brands.

A family brand is a single brand name used to identify a group of related products. For example, Johnson & John­son offers a variety of product lines all under one brand name. Many companies market a variety of individual brands. Proctor and Gamble’s Tide is one of the longest-lasting individual brand names in cleaning products, and Crest Toothpaste is a leading brand in health products.

As previously noted, the goal of brands and brand names is to increase consumer loyalty. Marketers refer to this as gaining brand equity, which means DEMAND for a firm’s product is less elastic. Loyal consumers are more likely to continue to purchase a product even when the price is raised. Brand equity makes it infinitely easier for a firm to introduce new products, since most consumers who have had a positive experience with a company’s products are more likely to try new product offerings from that firm.

Marketers know developing effective brand equity is difficult and usually expensive. New brand names gener­ally should be easy to pronounce, recognize, and remem­ber. A brand name should also be consistent with the image a company wants to convey: status, safety, or confi­dence. TRADEMARKs are brands and brand names owned by a company.

Making an impact

Display can help make an impact. Dressing a window with drapes of fabric
or putting items on to rotating stands draws attention to a particular product
or range of products. Buying bespoke display accessories can be
expensive so learn to improvise with what you have to hand:
◆ Tins of tomatoes (with the labels removed), from the smallest up to
catering-sized and bought in your local supermarket, make shelf supports
in display cabinets.
◆ Paper clips can be twisted to create hooks to hang stock or labels from.
◆ Plant pots and wicker baskets from the local £1 shop make cheap and
effective holders for small items of stock.
Sometimes the product itself will be used to create the impact, such as in a
supermarket when one brand of baked beans is promoted by stacking the
cans to build a giant pyramid. For this type of display to be successful you
will need extra stock to sell, so make sure this product is going to be a really
big seller or you will end up with a lifetime’s supply in your stockroom.
A very good way to keep products prominent within the shop is to use display
material that has been specially produced for that product by the
manufacturer.This could be a cardboard cut out featuring an enlarged picture
of the product or a plastic moulded display stand to feature every item
in the range. Such point of sale publicity and display material is always
worth having, particularly as they are often free. They have usually been
researched and designed by marketing experts to make the best impact and
the display stands will save you many headaches in trying to display the
products to show them at their best.

board of directors

A company’s board of directors makes its strategic deci­sions, including hiring and terminating executives, direct­ing company policy, and considering proposals from outside investors or other companies to purchase or be purchased by the company. In the United States, a CORPORATION must have a board of directors elected by its SHAREHOLDERS, whose best interests the board of direc­tors is charged to represent. (Many nonprofit organiza­tions also have boards of directors providing similar functions to the organization but without responsibility to shareholders.)

A typical corporate board of directors creates at least three oversight committees: nominating, compensation, and audit. The nominating committee selects new candi­dates to be reviewed for positions on the board. The com­pensation committee determines the executive’ pay. The audit committee reviews reports from independent audit firms and internal audits. In addition, some boards of directors create a finance committee to oversee CAPITAL investment decisions.

A board of directors can be large or small. Most corpo­rate management specialists recommend that boards con­tain no more than 10 members. Larger boards allow for greater diversity but also slow decision making. Histori­cally most U.S. corporate board of directors did not aggres­sively assert the interests of shareholders but instead generally accepted the recommendations of management. In the 1990s critics, especially giant pension-fund man­agers TIAA-CREF and CALPERS challenged the status-quo “rubber stamping” by corporate boards.

The Council of Institutional Investors (CII), created in 1985, developed a set of standards for board accountabil­ity and has acted as a “watch dog” group that oversees practices by boards. The CII developed a detailed set of recommendations, including core policies, general princi­ples (shareholder rights, shareholder meeting rights, board accountability, and director and management compensa­tion for board of directors), and positions.

CORE POLICIES

Confidential ballots counted by independent tabulators should elect all directors annually.

At least two-thirds of a corporation’s directors should be independent. A director is deemed independent if his or her only non-trivial professional, familial or financial connection to the corporation, its chairman, CEO or any other executive officer is his or her directorship.

A corporation should disclose information necessary for shareholders to determine whether each director qualifies as independent.

Companies should have audit, nominating and com­pensation committees. All members of these commit­tees should be independent. The board (rather than the CEO) should appoint committee chairs and members. Committees should have the opportunity to select their own service providers.

A majority vote of common shares outstanding should be required to approve major corporate decisions con­cerning the sale or pledge of corporate assets, which would have a material effect on shareholder value.

GENERAL PRINCIPALS

A. SHAREHOLDER VOTING RIGHTS

1. Each share of COMMON STOCK, regardless of class, should have one vote. Corporations should not have classes of common stock with disparate voting rights.

2. Shareholders should be allowed to vote on unrelated issues individually. Individual voting issues, particu­larly those amending a company’s charter, BYLAWS,or anti-takeover provisions, should not be bundled.

3. A majority vote of common shares outstanding should be sufficient to amend company bylaws or take other action requiring or receiving a shareholder vote.

4. Broker non-votes and abstentions should be counted only for purposes of a quorum.

5. A majority vote of common shares outstanding should be required to approve major corporate decisions including:

a. the corporation’s acquiring, other than by TENDER OFFER to all shareholders, 5 percent or more of its common shares at above-market prices;

b. provisions commonly known as shareholder rights plans, or poison pills;

c. abridging or limiting the rights of common shares;

d. permitting or granting any executive or employee of the corporation upon termination of EMPLOYMENT, any amount in excess of two times that person’s average annual compensation for the previous three years; and

e. provisions resulting in the issuance of debt to a degree that would excessively LEVERAGE the company and imperil the long-term viability of the corporation.

6. Shareholders should have the opportunity to vote on all equity-based compensation plans that include any director or executive officer of the company.

B. SHAREHOLDER MEETING RIGHTS

Corporations should make shareholders’ expense and convenience primary criteria when selecting the time and location of shareholder meetings.

Appropriate notice of shareholder meetings, including notice concerning any change in meeting date, time, place or shareholder action, should be given to share­holders in a manner and within time frames that will ensure that shareholders have a reasonable opportunity to exercise their franchise.

All directors should attend the annual shareholders’ meeting and be available, when requested by the chair, to answer shareholder questions.

Polls should remain open at shareholder meetings until all agenda items have been discussed and shareholders have had an opportunity to ask and receive answers to questions concerning them.

Companies should not adjourn a meeting for the pur­pose of soliciting more votes to enable management to prevail on a voting item.

Companies should hold shareholder meetings by remote communication (so-called electronic or “cyber” meetings) only as a supplement to traditional in-person shareholder meetings, not as a substitute.

Shareholders’ rights to call a special meeting or act by written consent should not be eliminated or abridged without the approval of the shareholders.

Corporations should not deny shareholders the right to call a special meeting if such a right is guaranteed or permitted by state law and the corporation’s articles of INCORPORATION.

C. BOARD ACCOUNTABILITY TO SHAREHOLDERS

Corporations and/or states should not give former directors who have left office (so-called “continuing directors”) the power to take action on behalf of the corporation.

Boards should review the performance and qualifica­tions of any director from whom at least 10 percent of the votes cast are withheld.

Boards should take actions recommended in share­holder proposals that receive a majority of votes cast for and against.

Directors should respond to communications from share­holders and should seek shareholder views on important governance, management and performance matters.

Companies should disclose individual director atten­dance figures for board and committee meetings.

D. DIRECTOR AND MANAGEMENT COMPENSATION

1. Annual approval of at least a majority of a corporation’s independent directors should be required for the CEO’s compensation, including any bonus, severance, equity-based, and/or extraordinary payment.

2. Absent unusual and compelling circumstances, all directors should own company common stock, in addi­tion to any OPTIONS and unvested shares granted by the company.

3. Directors should be compensated only in cash or stock, with the majority of the compensation in stock.

4. Boards should award CHIEF EXECUTIVE OFFICERs no more than one form of equity-based compensation.

5. Unless submitted to shareholders for approval, no “underwater” options should be re-priced or replaced, and no discount options should be awarded. (Under­water means option prices below the current market price of the company’s stock.)

6. Change-in-control provisions in compensation plans and compensation agreements should be “double-triggered,” stipulating that compensation is payable only

(1) after a control change actually takes place and

(2) if a covered executive’s job is terminated as a result of the control change.

7. Companies should disclose in the annual PROXY state­ment whether they have rescinded and re-granted options exercised by executive officers during the prior year or if executive officers have hedged (by buying puts and selling calls or employing other risk-minimizing techniques) shares awarded as stock-based incentive or acquired through options granted by the company.

COUNCIL OF INSTITUTIONAL INVESTORS POSITIONS

A. BOARD SHAREHOLDER ACCOUNTABILITY

Shareholders’ right to vote is inviolate and should not be abridged.

CORPORATE GOVERNANCE structures and practices should protect and enhance accountability to, and equal finan­cial treatment of, shareholders.

Shareholders should have meaningful ability to partici­pate in the major fundamental decisions that affect cor­porate viability.

Shareholders should have meaningful opportunities to suggest or nominate director candidates.

Shareholders should have meaningful opportunities to suggest processes and criteria for director selection and evaluation.

Directors should own a meaningful position in company common stock, appropriate to their personal circumstances.

Absent compelling and stated reasons, directors who attend fewer than 75 percent of board and board-committee meetings for two consecutive years should not be renominated.

Boards should evaluate themselves and their individual members on a regular basis.

B. BOARD SIZE AND SERVICE

A board should neither be too small to maintain the needed expertise and independence, nor too large to be efficiently functional. Absent compelling, unusual cir­cumstances, a board should have no fewer than 5 and no more than 15 members.

Companies should set and publish guidelines specify­ing on how many other boards their directors may serve. Absent unusual or specified circumstances, directors with full-time jobs should not serve on more than two other boards.

C. BOARD MEETINGS AND OPERATIONS

Directors should be provided meaningful information in a timely manner prior to board meetings. Directors should be allowed reasonable access to management to discuss board issues.

Directors should be allowed to place items on board agendas.

Directors should receive training from independent sources on their fiduciary responsibilities and liabilities.

The board should hold regularly scheduled executive sessions without the CEO or staff present.

If the CEO is chairman, a contact director should be specified for directors wishing to discuss issues or add agenda items that are not appropriately or best for­warded to the chair/CEO.

The board should approve and maintain a CEO succes­sion plan.

D. COMPENSATION

Pay for directors and managers should be indexed to peer or market groups, absent unusual and specified reasons for not doing so.

An important issue in governance of a board of directors is whether the board member is independent or not. The CII defines an independent director as someone whose only nontrivial professional, familial, or financial connection to

the corporation, its chairman, CEO, or any other executive officer is his or her directorship. The CII’s position on inde­pendent directors is based on the problems of conflicts of interest for board members who are also managers; and interlocking directorships, where board members represent the interests of shareholders for different corporations.

Budgeting, capital budgeting

Budgeting is the process of developing budgets, or finan­cial plans that project a firm’s inflows and outflows for a future time period. Often budgeting results in the con­struction of pro forma statements, namely the budgeted INCOME STATEMENT and the budgeted BALANCE SHEET.Pro forma, as a matter of form, statements have generally accepted formats but are based on projections. A budgeted (pro forma) income statement is one that reflects projec­tions rather than being based on prior transactions; thus it represents expectations rather than actual data. Likewise, a budgeted (pro forma) balance sheet is one that is con­structed using projections rather than actual data. Pro-forma statements are important tools used in planning and decision-making. In banking, pro forma statements are commonly used as the basis for making loans of VENTURE CAPITAL and loans to new businesses.

Capital budgeting is the planning for a firm’s fixed ASSETS in particular. How a firm decides to use its capital is the most important of all managerial decisions, and since fixed assets represent the majority of most firms’ assets, capital budgeting is the most crucial of all budget­ing activities.

While there are infinite uses for a firm’s capital, its sources are limited, and capital budgeting determines its best uses. Payback period, net present value (NPV), and internal rate of return (IRR) are three capital-budgeting tools commonly used to determine a firm’s most profitable INVESTMENT opportunities.

Payback period, the first capital budgeting tool to be developed, is the expected number of years required for a firm to recoup its original investment in a fixed asset or project. The decision rule when using payback is that shorter payback periods are preferable over longer ones. For example, suppose Project A requires an investment of $10,000 and will generate cash inflows of $3,000 per year for the next five years. Assuming that these inflows are evenly distributed over the next five years, the payback period for Project A is $10,000/$3,000 = 3.33 years. Sup­pose Project Z costs $10,000 and will generate cash inflows of $2,000 per year for the next 10 years. The pay­back period for Project Z is $10,000/$2,000 = 5 years. If payback is used to rank these two projects, Project A is the preferred investment opportunity because of its shorter payback period.

There are two major shortcomings of payback period as a capital-budgeting tool. Only the inflows required to recoup the original investment are considered; the inflows occurring after the payback period are ignored. For Project A above, returns continue for an additional 1.67 years beyond the payback period, but they aren’t considered. For Project Z, returns continue for another five years beyond the payback period. Payback is particularly flawed when used to evaluate investment opportunities where the returns are slow for the first couple of years, but become significant in later years.

An even more serious flaw is that payback is not a dis­counted cash flow technique; it ignores the time value of money. In Project Z, for example, the $2,000 received in

Year 5 is viewed as just as valuable as the $2000 received in Year 1. Depending on the DISCOUNT RATE (cost of capital for the firm) used to determine the present value of the cash inflows, Project Z may, in reality, be a more profitable invest­ment. This makes payback period a crude tool for evaluat­ing and ranking profitable investment opportunities.

To incorporate the time value of money in capital budg­eting, NPV and IRR were developed. These are discounted cash-flow techniques and are more valid tools for decision making than payback period.

NPV is the present value of a project’s future cash inflows minus the initial cash outflow (original invest­ment) required. The decision rule is to accept the project if its NPV is positive but reject if it is negative. If projects are not mutually exclusive, those with greater NPVs are ranked more preferable than those with lower NPVs. Sup­pose a project’s NPV is +$50,000. The present value of the project’s inflows are $50,000 greater than its initial cost, and this net return accrues to the firm’s owners.

IRR, also a discounted cash-flow technique, is similar to NPV except that, while NPV is expressed in dollars, IRR is expressed in percentages. IRR is the discount rate that equates the present value of a project’s expected inflows and its cost. The decision rule to follow when using IRR is to accept projects where the IRR is greater than the firm’s cost of capital and reject those opportunities where the IRR is less than the firm’s cost of capital. For example, if a project’s IRR is 20 percent for a firm whose cost of capital is also 20 percent, undertaking and investing in the proj­ect will add nothing to the firm’s PROFITs; the project’s return exactly offsets the cost of the investment in the project. Thus the cost of capital is a “threshold” which must be exceeded when using IRR as a capital budgeting tool. If projects are not mutually exclusive, projects with higher IRRs are ranked more preferable than those with lower IRRs, and projects whose IRR is less than the firm’s cost of capital are rejected.

Bureau of Economic Analysis

The Bureau of Economic Analysis (BEA) is an agency within the Department of Commerce that produces U.S. economic statistics. Each month the BEA estimates GROSS DOMESTIC PRODUCT (GDP); gross domestic income; and industry, regional, and international economic statistics. To make important policy, INVESTMENT, and spending deci­sions, government officials, business managers, and indi­viduals use economic estimates produced by the BEA.

GDP and other important measures are usually first announced as press releases and widely quoted in the busi­ness media. GDP estimates are first released as a prelimi­nary estimate followed by a first and second revision as more data become available. Financial markets watch GDP statistics closely, and analysts watch growth (or lack thereof) in the industries in which they are involved. Regional economic statistics provide estimates of personal INCOME, population, and EMPLOYMENT by state. Interna­tional economic statistics include BALANCE OF PAYMENTS fig­ures, U.S. DIRECT INVESTMENT abroad, and foreign direct investment in the United States.

The BEA’s monthly journal, Survey of Current Business, presents detailed estimates, analyses, research, and methodology used by the agency to measure economic activity in the U.S. economy.