Charlie Munger provided some answers to: Why did Berkshire under Buffett do so well?

1.   Why did Berkshire under Buffett do so well?

Only four large factors occur to me:

(1) The constructive peculiarities of Buffett,
(2) The constructive peculiarities of the Berkshire system,
(3) Good luck, and
(4) The weirdly intense, contagious devotion of some shareholders and other admirers, including some in the press.


I believe all four factors were present and helpful. But the heavy freight was carried by

• the constructive peculiarities, 
• the weird devotion, and 
• their interactions.

In particular, Buffett’s decision to limit his activities to a few kinds and to maximize his attention to them, and to keep doing so for 50 years, was a lollapalooza.  Buffett succeeded for the same reason Roger Federer became good at tennis.

Buffett was, in effect, using the winning method of the famous basketball coach, John Wooden, who won most regularly after he had learned to assign virtually all playing time to his seven best players. That way, opponents always faced his best players, instead of his second best. And, with the extra playing time, the best players improved more than was normal.

And Buffett much out-Woodened Wooden, because in his case the exercise of skill was concentrated in one person, not seven, and his skill improved and improved as he got older and older during 50 years, instead of deteriorating like the skill of a basketball player does.

Moreover, by concentrating so much power and authority in the often-long-serving CEOs of important subsidiaries, Buffett was also creating strong Wooden-type effects there. And such effects enhanced the skills of the CEOs and the achievements of the subsidiaries.

Then, as the Berkshire system bestowed much-desired autonomy on many subsidiaries and their CEOs, and Berkshire became successful and well known, these outcomes attracted both more and better subsidiaries into Berkshire, and better CEOs as well.

And the better subsidiaries and CEOs then required less attention from headquarters, creating what is often called a “virtuous circle.”



2.   What were the big mistakes made by Berkshire under Buffett?

Well, while mistakes of commission were common, almost all huge errors were in not making a purchase, including not purchasing Walmart stock when that was sure to work out enormously well. The errors of omission were of much importance. Berkshire’s net worth would now be at least $50 billion higher if it had seized several opportunities it was not quite smart enough to recognize as virtually sure things.



3.   The next to last task on my list was: Predict whether abnormally good results would continue at Berkshire if Buffett were soon to depart.

The answer is yes.

Berkshire has in place in its subsidiaries much business momentum grounded in much durable competitive advantage.

Moreover, its railroad and utility subsidiaries now provide much desirable opportunity to invest large sums in new fixed assets. And many subsidiaries are now engaged in making wise “bolt-on” acquisitions.

Provided that most of the Berkshire system remains in place, the combined momentum and opportunity now present is so great that Berkshire would almost surely remain a better-than-normal company for a very long time even if:

(1) Buffett left tomorrow,
(2) his successors were persons of only moderate ability, and
(3) Berkshire never again purchased a large business.

But, under this Buffett-soon-leaves assumption, his successors would not be “of only moderate ability.” For instance, Ajit Jain and Greg Abel are proven performers who would probably be under-described as “world-class.”

“World-leading” would be the description I would choose. In some important ways, each is a better business executive than Buffett.

And I believe neither Jain nor Abel would
(1) leave Berkshire, no matter what someone else offered or
(2) desire much change in the Berkshire system.

Nor do I think that desirable purchases of new businesses would end with Buffett’s departure. With Berkshire now so large and the age of activism upon us, I think some desirable acquisition opportunities will come and that Berkshire’s $60 billion in cash will constructively decrease.



4.   My final task was to consider whether Berkshire’s great results over the last 50 years have implications that may prove useful elsewhere.

The answer is plainly yes.

In its early Buffett years, Berkshire had a big task ahead: turning a tiny stash into a large and useful company. And it solved that problem by avoiding bureaucracy and relying much on one thoughtful leader for a long, long time as he kept improving and brought in more people like himself.

Compare this to a typical big-corporation system with much bureaucracy at headquarters and a long succession of CEOs who come in at about age 59, pause little thereafter for quiet thought, and are soon forced out by a fixed retirement age.

I believe that versions of the Berkshire system should be tried more often elsewhere and that the worst attributes of bureaucracy should much more often be treated like the cancers they so much resemble. A good example of bureaucracy fixing was created by George Marshall when he helped win World War II by getting from Congress the right to ignore seniority in choosing generals.



Ref:

http://www.berkshirehathaway.com/letters/2014ltr.pdf

If you are thinking of buying Berkshire shares, please read what Warren Buffett has shared here in his newsletter of 2014.

Today Berkshire possesses:

(1) an unmatched collection of businesses, most of them now enjoying favorable economic prospects;
(2) a cadre of outstanding managers who, with few exceptions, are unusually devoted to both the subsidiary they operate and to Berkshire;
(3) an extraordinary diversity of earnings, premier financial strength and oceans of liquidity that we will maintain under all circumstances;
(4) a first-choice ranking among many owners and managers who are contemplating sale of their businesses and
(5) in a point related to the preceding item, a culture, distinctive in many ways from that of most large companies, that we have worked 50 years to develop and that is now rock-solid.

These strengths provide us a wonderful foundation on which to build.



The Next 50 Years at Berkshire

Now let’s take a look at the road ahead. Bear in mind that if I had attempted 50 years ago to gauge what was coming, certain of my predictions would have been far off the mark. With that warning, I will tell you what I would say to my family today if they asked me about Berkshire’s future.


‹ First and definitely foremost, I believe that the chance of permanent capital loss for patient Berkshire shareholders is as low as can be found among single-company investments. That’s because our per-share intrinsic business value is almost certain to advance over time. 

This cheery prediction comes, however, with an important caution:

• If an investor’s entry point into Berkshire stock is unusually high – at a price, say, approaching double book value, which Berkshire shares have occasionally reached – it may well be many years before the investor can realize a profit. 
• In other words, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this truth.

Purchases of Berkshire that investors make at a price modestly above the level at which the company would repurchase its shares, however, should produce gains within a reasonable period of time.

• Berkshire’s directors will only authorize repurchases at a price they believe to be well below intrinsic value.
•  (In our view, that is an essential criterion for repurchases that is often ignored by other managements.)

For those investors who plan to sell within a year or two after their purchase, I can offer no assurances,whatever the entry price.

• Movements of the general stock market during such abbreviated periods will likely be far more important in determining your results than the concomitant change in the intrinsic value of your Berkshire shares. 
• As Ben Graham said many decades ago: “In the short-term the market is a voting machine; in the long-run it acts as a weighing machine.” Occasionally, the voting decisions of investors – amateurs and professionals alike – border on lunacy.
• Since I know of no way to reliably predict market movements, I recommend that you purchase Berkshire shares only if you expect to hold them for at least five years. 
• Those who seek short-term profits should look elsewhere.

Another warning: Berkshire shares should not be purchased with borrowed money. 

• There have been three times since 1965 when our stock has fallen about 50% from its high point. 
• Someday, something close to this kind of drop will happen again, and no one knows when. 
• Berkshire will almost certainly be a satisfactory holding for investors. But it could well be a disastrous choice for speculators employing leverage.

‹ I believe the chance of any event causing Berkshire to experience financial problems is essentially zero.

• We will always be prepared for the thousand-year flood; in fact, if it occurs we will be selling life jackets to the unprepared. 
• Berkshire played an important role as a “first responder” during the 2008-2009 meltdown, and we have since more than doubled the strength of our balance sheet and our earnings potential. 
• Your company is the Gibraltar of American business and will remain so.

Financial staying power requires a company to maintain three strengths under all circumstances:
(1) a large and reliable stream of earnings;
(2) massive liquid assets and
(3) no significant near-term cash requirements.

Ignoring that last necessity is what usually leads companies to experience unexpected problems:

• Too often, CEOs of profitable companies feel they will always be able to refund maturing obligations, however large these are. 
• In 2008-2009, many managements learned how perilous that mindset can be.

Here’s how we will always stand on the three essentials. 

1.  First, our earnings stream is huge and comes from a vast array of businesses.

• Our shareholders now own many large companies that have durable competitive advantages, and we will acquire more of those in the future. 
• Our diversification assures Berkshire’s continued profitability, even if a catastrophe causes insurance losses that far exceed any previously experienced.

2.  Next up is cash. 

• At a healthy business, cash is sometimes thought of as something to be minimized – as an unproductive asset that acts as a drag on such markers as return on equity. 
• Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent. 
• American business provided a case study of that in 2008. In September of that year, many long-prosperous companies suddenly wondered whether their checks would bounce in the days ahead. Overnight, their financial oxygen disappeared.
• At Berkshire, our “breathing” went uninterrupted. Indeed, in a three-week period spanning late September and early October, we supplied $15.6 billion of fresh money to American businesses.
• We could do that because we always maintain at least $20 billion – and usually far more – in cash equivalents. And by that we mean U.S. Treasury bills, not other substitutes for cash that are claimed to deliver liquidity and actually do so, except when it is truly needed. 
• When bills come due, only cash is legal tender. Don’t leave home without it.

3.  Finally – getting to our third point – we will never engage in operating or investment practices that can result in sudden demands for large sums.

• That means we will not expose Berkshire to short-term debt maturities of size nor enter into derivative contracts or other business arrangements that could require large collateral calls.
• Some years ago, we became a party to certain derivative contracts that we believed were significantly mispriced and that had only minor collateral requirements. These have proved to be quite profitable.
• Recently, however, newly-written derivative contracts have required full collateralization. And that ended our interest in derivatives, regardless of what profit potential they might offer. 
• We have not, for some years, written these contracts, except for a few needed for operational purposes at our utility businesses.
• Moreover, we will not write insurance contracts that give policyholders the right to cash out at their option. Many life insurance products contain redemption features that make them susceptible to a “run” in times of extreme panic. 
• Contracts of that sort, however, do not exist in the property-casualty world that we inhabit. If our premium volume should shrink, our float would decline – but only at a very slow pace.
• The reason for our conservatism, which may impress some people as extreme, is that it is entirely predictable that people will occasionally panic, but not at all predictable when this will happen. 
• Though practically all days are relatively uneventful, tomorrow is always uncertain. (I felt no special apprehension on December 6, 1941 or September 10, 2001.) 
• And if you can’t predict what tomorrow will bring, you must be prepared for whatever it does.

Ref:
http://www.berkshirehathaway.com/letters/2014ltr.pdf

Warren Buffett's actions in the 2007 - 2008 financial crisis

2007-08 financial crisis

Buffett ran into criticism during the subprime crisis of 2007–2008, part of the recession that started in 2007, that he had allocated capital too early resulting in suboptimal deals.   "Buy American. I am." he wrote for an opinion piece published in the New York Times in 2008.  Buffett called the downturn in the financial sector that started in 2007 "poetic justice".   Buffett's Berkshire Hathaway suffered a 77% drop in earnings during Q3 2008 and several of his later deals suffered large mark-to-market losses.

1. Berkshire Hathaway acquired 10% perpetual preferred stock of Goldman Sachs.  
2. Some of Buffett's put options (European exercise at expiry only) that he wrote (sold) were running at around $6.73 billion mark-to-market losses as of late 2008.   The scale of the potential loss prompted the SEC to demand that Berkshire produce, "a more robust disclosure" of factors used to value the contracts. 
3. Buffett also helped Dow Chemical pay for its $18.8 billion takeover of Rohm & Haas. He thus became the single largest shareholder in the enlarged group with his Berkshire Hathaway, which provided $3 billion, underlining his instrumental role during the crisis in debt and equity markets.

In 2008, Buffett became the richest person in the world, with a total net worth estimated at $62 billion by Forbes and at $58 billion by Yahoo, overtaking Bill Gates, who had been number one on the Forbes list for 13 consecutive years.  In 2009, Gates regained the top position on the Forbes list, with Buffett shifted to second place.

• Both of the men's values dropped, to $40 billion and $37 billion respectively—according to Forbes, 
• Buffett lost $25 billion over a 12-month period during 2008/2009.

In October 2008, the media reported that Buffett had agreed to buy General Electric (GE) preferred stock.  The operation included special incentives: 

• He received an option to buy three billion shares of GE stock, at $22.25, over the five years following the agreement, and 
• Buffett also received a 10% dividend (callable within three years). 

In February 2009, Buffett sold some Procter & Gamble Co. and Johnson & Johnson shares from his personal portfolio.

In addition to suggestions of mistiming, the wisdom in keeping some of Berkshire's major holdings, including The Coca-Cola Company, which in 1998 peaked at $86, raised questions. Buffett discussed the difficulties of knowing when to sell in the company's 2004 annual report:

• That may seem easy to do when one looks through an always-clean, rear-view mirror. 
• Unfortunately, however, it's the windshield through which investors must peer, and that glass is invariably fogged.

In March 2009, Buffett said in a cable television interview that the economy had "fallen off a cliff ... Not only has the economy slowed down a lot, but people have really changed their habits like I haven't seen". Additionally, Buffett feared that inflation levels that occurred in the 1970s—which led to years of painful stagflation—might re-emerge.

Investment philosophy of Warren Buffett

Warren Buffett's writings include his annual reports and various articles.

Buffett is recognized by communicators as a great story-teller, as evidenced by his annual letters to shareholders. He warned about the pernicious effects of inflation:

"The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation."

— Buffett, Fortune (1977)


In his article "The Superinvestors of Graham-and-Doddsville", Buffett rebutted the academic efficient-market hypothesis, that beating the S&P 500 was "pure chance", by highlighting the results achieved by a number of students of the Graham and Dodd value investing school of thought. In addition to himself, Buffett named Walter J. Schloss, Tom Knapp, Ed Anderson (Tweedy, Browne LLC), William J. Ruane (Sequoia Fund, Inc.), Charles Munger (Buffett's own business partner at Berkshire), Rick Guerin (Pacific Partners, Ltd.), and Stan Perlmeter (Perlmeter Investments).



In his November 1999 Fortune article, he warned of investors' unrealistic expectations:

Let me summarize what I've been saying about the stock market: I think it's very hard to come up with a persuasive case that equities will over the next 17 years perform anything like—anything like—they've performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate—repeat, aggregate—would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%!

— Buffett, Fortune (1999)

Index funds and active management - Warren Buffett is a vocal critic of active management.

Towards his later life, particularly following the global financial crisis of 2007-8, Buffett became an increasingly vocal critic of active management, i.e., mutual funds and hedge funds. 

Buffett is skeptical that active management and stock-picking can outperform the market in the long run, and has advised both individual and institutional investors to move their money to low-cost index funds that track broad, diversified stock market indices. 

Buffett said in one of his letters to shareholders that "when trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients."

In 2007, Buffett made a bet with numerous managers that a simple S&P 500 index fund will outperform hedge funds that charge exorbitant fees. By 2017, the index fund was outperforming every hedge fund that had made the bet against Buffett by a significant margin.

Active Management Blues (CNBC)

http://video.cnbc.com/gallery/?video=3000610137

Budgeting in different types of organization

In very large organizations, hundreds of managers may be involved in the budgeting process, and the complete budget will probably be a very thick document.


Budgeting when done well is time well spent

This involvement takes a lot of management time but, if the budgeting is done well, it is likely to be time well spent.

This is because the budget will probably be a realistic one, and because after approval the managers should feel committed to it.


Budget is approved - What happens next?

• When the budget has been approved, individual managers are responsible for their section of it.  the responsibility is like a pyramid.
• At the base of the pyramid are the most junior managers, supervising a comparatively small section, perhaps involving expenditure only.
• These junior managers should, however, have some knowledge of the overall budget and objectives.
• In the middle may be more senior managers and divisional directors, each with a wider area of responsibility for achieving the complete budget objectives.  If everyone else meets their targets they will have an easy job.

Budget must be relevant

Budgets should be designed to meet the needs of a particular organization and its managers.

For example, a large school could well have an expenditure budget of about $4 million.

• There will be little income and the budgeting emphasis will be on capital expenditure and revenue expenditure.  
• The main aims will be informed choice and value for money.

Main Principles of Budget for the Large and Small Companies

• The main principles devoted to the budget of a large company can also be used by a small organization.  
• There will be fewer managers involved, and less paper, but the same procedures should be followed.

After the budget has been approved ... what comes next?

After the budget has been approved, what comes next?  Quite possibly nothing at all.

This is a pity but it does not mean that the budgeting exercise has been a complete waste of time.

• The participants will have thought logically about the organization, its finances and its future.
• Some of the detail will remain in their minds and influence their future actions.
• Nevertheless, the budgets will be much more valuable if they are used in an active way.  

Regular performance reports should be issued by the accountants.

• These should be in the same format as the budgets.
• It should give comparable budget and actual figures.
• Variances should also be given.
• All levels of management should regularly review these figures and explain the variances.
• Significant variances will pose the question of whether corrective action needs to be taken.

Budgets do not necessarily have to be done just once a year.

They may be updated, reviewed or even scrapped and redone as circumstances dictate.

Cash Flow Forecast and the Balance Sheet Forecast

Cash-Flow Forecast

When the profit budgets are complete, it is important that a cash budget is prepared.

This is a Cash-Flow Forecast.  (click to understand this)

In practice, the profit budget and cash budget are linked.

• The profit budget cannot be completed until the interest figure is available.
• This in turn depends on the cash budget. 
• The cash budget depends partly on the profit budget.
• Dilemmas like this are quite common in budgeting.

It is usual to put in an estimated figure for interest and then adjust everything later if necessary.

This can be very time-consuming and budgeting is much simpler if it is computerized.

Several hours' work can be reduced to minutes and management is much freer to test budgets with useful "what if" questions.


Forecast Balance Sheet

Accounting rules stated that every debit has a credit.

It follows that every figure in the budgets has a forecast consequence in a future Balance Sheet.

It is normal to conclude the budgets by preparing a month-by-month forecast Balance Sheet and bankers are likely to ask for this.

It may be that some aspect of the Balance Sheet is unacceptable and a partial re-budget is necessary.

In practice, top management is likely to review and alter some aspects of the budgets several times.

The Capital Expenditure Budget

This is extremely significant in some companies, less so in others.

It will list all the planned capital expenditure showing the date when the expenditure will be made, and the date that the expenditure will be completed and the asset introduced to the business.

Major contracts may be payable in installments and the timing is important to the cash budget.

A sum for miscellaneous items is usually necessary.  For example, major projects might be listed separately and then $15,000 per month added for all projects individually less than $5,000.

Within the capital expenditure budget, timing is very important.

Expenditure affects cash and interest straight away.

Depreciation usually starts only on completion.

Revenue Expenditure Budgets

Revenue expenditure includes cost of sales (direct cost or variable cost) and overhead cost (indirect cost).

The cost of sales will consist of direct wages, items bought for resale, raw materials and others.

The Sales, Finance, and Administration Departments will make up the overhead budget.

In practice, this overhead budget is likely to be divided into three, with a different manager responsible for each section.

As with all the other budgets, each manager should submit a detailed budget for the section for which he or she is responsible.

As with the other budgets (e.g. sales budget), top management should give initial guidance on expected performance and policy assumptions.

For example, a manager might be told to assume a company-wide average pay rise of 5% on 1 January.

The Sales Budget

This should be in sufficient detail for management to know the sources of revenue.

The figures will be broken down into different products and different sales regions.

Each regional sales manager will have responsibility for a part of the sales budget.

Before the sales budget is done it would be normal for top management to issue budget assumptions concerning prices, competition, and other key matters.

The sales budget will be for orders taken.

There will usually be a timing difference before orders become invoiced sales.

The Profit Budget

There are usually several budgets and they all impact on each other.

The profit budget is arguably the most important.

There are two basic approaches to budgeting in a large organization, both having advantages and disadvantages..

1.   The "bottom up" method.  

• Proposals are taken from the lower management levels.  
• These are collated into an overall budget that may or may not be acceptable.  
• If it is not, then top management calls for revisions.

2.  The "top down" method.

• Top management issues budget targets.
• Lower levels of management must then submit proposals that achieve these targets.

In practice, there is often less difference between the two methods than might be supposed.

It is important that at some stage there is a full and frank exchange of views.

Everyone should be encouraged to put forward any constructive point of view, and everyone should commit themselves to listening with an open mind.

Top management will and should, have the final decisions.

It is a common mistake for managers to be too insular and to overlook what changes competitors are making.

All the budgets are important but in a commercial organization the overall profit budget is likely to be considered the most important.



Note the following points:

• Most budgets are for a year but this is not a requirement.  they can be for six months or for any other useful period.
• Most budget gives monthly figures, which is the most common division, but again this is not fixed.  the divisions can be weekly, quarterly or some other period.
• A summary budget is useful for a large organization.  The budgets leading up to these summarized figures will be more detailed.
• Various subsidiary budgets and calculations feed figures through to the summary budget.

Standard Costing

Standard costing involves the setting of targets, or standards, for the different factors affecting costs.

Variances from the standard are then studied in detail.


For example:

Standard timber usage per unit of production                       4.00 meters
Standard timber price                                                      $2.00 per meter
Actual production                                                                   3,500 posts
Actual timber usage                                                           14,140 meters
Actual cost of timber used                                                           $27,714


Material Price Variance is                                      $566 favourable (2%)
(14,140 x $2.00) - $27,714
= $28,280 - $27,714
= $566


Material Usage Variance is                                          $280 adverse (1%)
[(14,140 meters less 3,500 x 4.00 meters) x $2]
= [(14,140 meters less 14,000 meters) x $2]
= $280


The material price variance happens because the standard cost of the 14,140 meters used was $28,280 (at $2 per meter).  The actual cost was $27,714, a favourable variance of $566.

On the other hand, 140 meters of timber too much was used resulting in an adverse material usage variance.

Joel Greenblatt: Value Investing for Small Investors

Absorption Cost

Absorption cost takes account of all costs and allocates them to individual products or cost centers.


Direct or variable costs

Some costs relate directly to a product and this is quite straightforward in principle, although very detailed record-keeping may be necessary.

Among the costs that can be entirely allocated to individual products are

• direct wages and associated employment costs, 
• materials and bought-in components.

Indirect costs

Other costs do not relate to just one product and these must be allocated according to a fair formula.  

These indirect costs must be absorbed by each product.

There is not a single correct method of allocating overhead costs to individual products and it is sometimes right to allocate different costs in different ways.

The aim should be to achieve fairness in each individual case.  

Among the costs that cannot be entirely allocated to individual products are

• indirect wages (cleaners, maintenance staff, etc.), 
• wages of staff such as salesmen and accountants, and 
• general overheads such as rent and business rates.

Take care to allocate non-direct costs fairly

Great care must be taken in deciding the best way to allocate the non-direct costs.

There are many different ways.

The following two are common methods:

1. Production hours
2. Machine hours

Common Methods for allocating non-direct costs fairly

1.   Production hours

The overhead costs are apportioned according to the direct production hours charged to each product or cost center.

For example:

Consider a company with just two products.

Product A having 5,000 hours charged and Product B having 10,000 hours charged.  

If the overhead is $60,000.  Product A will absorb $20,000 and Product B will absorb $40,000.

2.  Machine hours

The principle is the same bt the overhead is allocated according to the number of hours that the machinery has been running.

For example:  

Consider a company that manufactures three types of jam.

Its overhead costs in January are $18,000 and it allocates them in the proportion of direct labour costs.

January Cost Statement

                                    

                                  Strawberry      Raspberry        Apricot         Total

Jars produced              26,000           60,000           87,000           173,000           

                                          $                    $                   $                      $

Costs                        

Direct labour                   2,000            4,000            6,000              12,000

Ingredients                      6,000           11,000          17,000              34,000

Other direct costs            2,000             3,000            6,000              11,000

Total Direct Costs         10,000           18,000         29,000              57,000

Overhead allocation         3,000             6,000           9,000              18,000

Total Cost                      13,000            24,000        38,000              75,000

Cost per jar                    50 sen            40 sen         43.7 sen           43.4 sen  

In the above, the direct labour is smaller than the overhead cost that is being allocated.

The trend in modern manufacturing is for direct costs and particularly direct labour costs, to reduce as a proportion of the total costs.  

If the overheads had been allocated in a different way, perhaps on floor area utilized, then the result would almost certainly not have been the same.

This increases the importance of choosing the fairest method of apportionment

Yield Curves and Breakeven Inflation

Real Yields = Nominal Yields - Breakeven Inflation

Break-even charts

In nearly all businesses, there is a close correlation between the level of turnover and the profit or loss.

The managers should know that if invoiced sales reach a certain figure the business will break even.

If invoiced sales are above that figure the business will be in profit.

The break-even point depends on the relationship between the fixed and the variable (or direct) costs.


Breakeven chart. 



The break-even point can be calculated by drawing a graph showing how fixed costs, variable costs, total costs and total revenue change with the level of output.


Fixed costs are shown as a flat line in the chart above..

The total costs are the result of adding the variable costs to the fixed costs.

The revenue is the result of sales.

The break-even point is when the total costs line crosses the revenue line.  It is at this point where these lines cross.

Profit and loss can also be read from the chart.

In practice, the relationships are rarely quite so straightforward, as some of the costs may be semi-variable.




More charts:

The uses of costing

It costs time and money to produce costing information and it is only worth doing if the information is put to good use.

The following are some of these uses.

1. To control costs
2. To promote responsibility
3. To aid business decisions
4. To aid decisions on pricing

1.  To control costs

Possession of detailed information about costs is of obvious value in the controlling of those costs.

2.  To promote responsibility

Management theorists agree that power and responsibility should go together, although often they do not do so

Timely and accurate costing information will help top management hold all levels of management responsible for the budgets that they control.

Care should be taken that managers are not held responsible for costs that are not within their control.  This does sometimes happen.

3.  To aid business decisions

Management must decide what to do about the unprofitable product.

4.  To aid decisions on pricing

We live in competitive times and the old 'cost plus' contracts are now virtually never encountered.

What the market will bear is usually the main factor in setting prices.

Nevertheless, detailed knowledge concerning costs is an important factor in determining prices.

Only in exceptional circumstances will managers agree to price goods at below cost.

They will seek to make an acceptable margin over cost.

Accurate costing is vital when tenders are submitted for major contracts and errors can have significant consequences.

Massive costing errors on the Millennium Dome at Greenwich were a spectacular example of what can go wrong.

Marginal Costing: Selling price > Variable or Direct cost ---> part of the Fixed cost is absorbed by the margin.

Marginal costing is a useful way of emphasizing the marginal costs of production and services.

This information is of great help in making pricing decisions.

If the selling price is less than the variable cost (direct cost),

• the loss will increase as more units are sold, and
• managers will only want to do this in very exceptional circumstances, such as a supermarket selling baked beans as a loss leader.

If the selling price is greater than the variable cost,

• then the margin will absorb part of the fixed cost, and,
• after a certain point profits will be made.

Why some goods are sold very cheaply at certain time?

Marginal costing explains why some goods and services are sold very cheaply.

It explains,f or example, why airline tickets are sometimes available at extremely low prices for last-minute purchasers.

• Once an airline is committed to making a flight, an extremely high part of the cost of that flight can properly be regarded as a fixed cost.  The pilot's salary will be the same whether the plane is empty or full.  
• The variable cost (direct cost) is only the complimentary meals and few other items.  
• It therefore makes sense to make last-minute sales of unsold seats at low prices.
• As long as the selling price is greater than the variable cost, a contribution is made (absorbing part of the fixed cost).