Cost and Financial Models-Plus Samples

Cost and financial models are vital tools in assessing the feasibility of a potential new business. Because the success of any new venture eventually comes down to the numbers, models keep the attention focused on profits. Assuming a market exists for products or services that are being contemplated, the two essentials for profitability and long-term survivability are cost and cash management. Cost and financial models become the basis for organizing cost, pricing and marketing information so that marketing and investment decisions are made wisely.

It needs to be pointed out, however, that cost and financial models are not forecasts. Rather they provide the basis for conducting a series of “what-if” scenarios. These, then, form the basis for rigorous analysis to determine if the venture is feasible or sufficiently profitable to warrant the investment; and if feasible, what is the most advantageous strategy.

Conscientiously prepared cost and financial models reduce investment uncertainty because they:
  • prevent surprises by making certain that all costs are recognized prior to start-up – serve as a cost inclusion checklist.
  • determine the cost behavior for each of the significant cost elements, i.e., the effect of volume changes on individual cost elements.
  • match and measure the cost of various inputs (resources) with the expected revenue of each of the outputs (products or services).
  • estimate the physical quantity and cost of resources required to generate anticipated revenue.
  • identify critical performance measurement requirements and facilitate the design of performance measurement processes.
  • establish amount of initial capital investment required to operate the firm at profitable levels.
Cost and financial models are particularly useful to prospective investors and lenders as they conduct due diligence analyses of a new venture. This is especially the case if historical profit and loss and balance sheet statements are not available for review.

From the perspective of those conducting due diligence analyses, who is making the cost and financial models is as important, if not more important, than the models themselves. To be credible, the assumptions used in models will have to be made by individuals who have expertise in the type of enterprise under consideration. The expertise used must be drawn from all phases of the business: marketing, product and process technology, finance and general management. Investors and lenders will have to be convinced that the individuals who will start up and operate the enterprise have the ability to “make it happen.”

It also should be pointed out that cost and financial models may reveal that a prospective venture is not feasible, or that the potential is marginal at best. In this case, the modeling process serves an equally valuable function by preventing a bad investment.

Two types of financial models commonly used are the breakeven analyses and cash flow projections. The third type, used less often, is the input/output cost model. Breakeven analyses, explained in Section 3 of this manual, is used to determine unit and dollar sales required to cover all expenses. The cash flow projection has several uses. The main purpose is to estimate when the firm will achieve a positive cash position and to determine the amount of operating capital required.


Input/Output Model
The input/output model differs from pro forma operating statements in that physical resources (inputs) used to produce revenue are matched with the sources of revenue such as products or services (outputs). As mentioned, it gives a more accurate picture of the physical resources in terms of raw material, labor, plant and equipment utilization, etc., required to generate revenue at various levels. It is an essential step in the information-gathering process because it provides supporting data for pro-forma financial statements.

A useful tool in preparation of cost models is a process flow chart. The chart will indicate where various inputs take place in the production process until the end products/outputs are produced. The flow chart for this purpose does not have to be highly detailed or elaborate. If it indicates the major cost elements and where they occur in the production process, it should be sufficient.

The next step is to prepare input/output revenue versus cost models. The purpose of this model is to match physical units of inputs, hogs purchased and processing tasks, with the costs incurred in purchasing hogs and in each of the processing steps. To be of value, the costs of producing each product need to be matched with the revenue derived for that product. There are several ways to classify sources of revenue: by product or product category; by method of distribution (wholesale versus retail); or by specific customer (supermarket chain A versus supermarket chain B). Fortunately, present day computer systems have the capability of matching costs with revenue in many different ways, depending upon what is being analyzed at the moment.

Since it is impossible to predict future sales it is advisable to prepare several statements based upon different assumptions. Well thought-out assumptions will serve the purpose of establishing parameters, which then can be useful in analyzing the success probability of the new venture. For example, an approach might be to construct three scenarios: a conservative estimate, mid-range and an optimistic estimate. An added advantage of this approach is that it identifies the costs that will increase or decrease with volume and the capacity utilization required for each sales level.

As stated in the first paragraph, models are particularly useful in assessing the feasibility of a new venture. Market feasibility studies should indicate the potential demand for a product (outputs), and what customers would be willing to pay – particularly the price premium for a unique product. Technological feasibility will determine the physical resources (inputs), along with the costs needed to process, package and distribute the product. Financial feasibility will consolidate the information obtained from the market research and technology feasibility studies, to determine if the difference between price and cost justify risk.

With respect to developing models for a pork processing facility, examples of several worksheets are included at the end of this chapter (Exhibits 3-A through 3-E). To facilitate data gathering and revision of data as more information is accumulated, it is highly recommended that spreadsheets be developed using these worksheets as guides. Since no two operations are similar, the spreadsheet applications should be specific to the venture under consideration.


Beef Processing Feasibility Study/Business Planning Costs
In sequence of use, the first worksheet, “Beef Processing Feasibility Study/Business Planning Costs,” is designed to accumulate all costs associated with this part of the start-up process. While financial expenditures invested during this phase of the process are intangible, therefore cannot be used as collateral for financing purposes, it is still important to have this information. For one thing, it documents for potential lenders and investors the efforts that have been made in determining the feasibility of the enterprise. In other words, that the organizers have “done their homework.” It also can be useful in negotiating stock ownership share when the capital structure is determined. It is also possible these costs can be written off against future earnings (check with a tax expert as to eligibility and documentation required).

As mentioned previously, a purpose of the feasibility study/business planning worksheet is to serve as a checklist so that many costs related to this phase of business development are not overlooked. Since these costs likely will have to be paid by the enterprise organizers, this worksheet could be a useful guide in developing a budget for this phase – thus assisting in keeping cost from getting out of control.


Beef Processing Plant Start-up Costs
The next worksheet, “Beef Processing Plant Start-up Costs,” is used to gather all the costs connected with acquiring and constructing physical facilities and related prestart- up expenditures. Unlike feasibility and business planning costs, start-up costs are not likely to be incurred until equity and lending financing have been obtained or approved. It is essential that this information is available to investors, lenders and economic development agencies on a periodic basis in the form of progress reports. Again, this information is necessary for tax purposes.

Note: If custom processing is used in lieu of building or acquiring processing facilities, then the cost of custom processing per head should be used in the Revenue/Cost Model and subsequently in the pro-forma financial statements. In effect, a variable cost is being substituted for a fixed cost thereby reducing the start-up risk. Preparing the start-up cost worksheet is still a useful exercise because it identifies the cost of eventually building new facilities as well as indicating the volume that needs to be reached before building processing facilities.


Beef Processing Input/Output Model and Revenue/Cost Model

The “Beef Processing Input/Output Model” and the “Beef Processing Revenue/Cost Model” are tied together because the input/output analysis provides the necessary data for the revenue/cost model. The first step in the model preparation is to develop capacity assumptions. The models use cattle processed per day as the basis for determining capacity. However, organizers can use whatever measure make sense to them as the basis for determining capacity.

Whatever measure is used, it is strongly recommended that several capacity assumptions be used so that side-by-side comparisons can be made. It will help to identify the effect volume will have on each of the cost elements. This will assist in answering the question: “If volume increases or decreases, which of the costs will increase or decrease – both on an aggregate and on a per unit (pound) basis?”

It is important that as much cost detail as possible is included in the revenue/cost model; and that all significant sources of revenue are included – individual product sales are listed in the input/output model. Typically, processing industries have low profit margins so it is important that all revenue and costs are identified. Fortunately, personal computer spreadsheet applications make this process much less cumbersome.

The input/output model example calculates the “material margin” for each of the capacity levels. It is the difference of what is paid for the hogs, and the revenue that is likely to be received for the end products. The reason for calculating the material margin is that it provides a number that can be used to compare with historical data. For example, assume 20 percent is determined to be the minimum material margin acceptable, in terms of covering processing, selling, general and administrative costs as well as providing a sufficient return on investment. Statistical analyses can be used to determine how often that margin was 20 percent or within a given time period.

Since small processing plants are likely to be aimed at niche markets, premium prices paid to producers and premium prices paid by consumers for end products need to be taken into account when establishing revenue and cost data.

Using three capacity level assumptions was previously suggested. It is also suggested that a minimum of three separate assumptions be made in determining the material margin for as called for in the input/output model.

The basis for these assumptions could be as follows:
  • Best case (from processor’s perspective): high margins because of low prices paid to producers and high wholesale prices.
  • Most likely case: average margins over a period of time.
  • Worst case (from processor’s perspective): low margins because of high prices paid to producers and low wholesale prices.
A minimum of nine different scenarios (three revenue/cost assumptions x three capacity assumptions) should be sufficient to determine if the venture is feasible and, if feasible, the optimum size of the venture. Establishing parameters is perhaps the most practical way to deal with the infinite number of possible revenue versus cost combinations in this type of enterprise.

While the focus of any statistical analysis is on the material margin, from the investors and lenders perspective, earnings before taxes (line 13 of the revenue/cost model), is the figure they are most interested in examining. That item should also be identified for each scenario used. Calculated on the revenue cost model is the “Contribution Margin” (line 5). The contribution margin percentage can be used to calculate the breakeven point for each of the assumptions used. It is determined by dividing the nonvariable or fixed costs (indirect labor + processing machinery + facilities + selling and marketing + general and administrative) by contribution percentage x 100. In addition to dollar and unit sales required to breakeven, it can also be used to determine the percentage of capacity required to achieve that number. Breakeven calculations can be used for other purposes as well: labor required to breakeven, cash flow breakeven, etc.


Sources and Uses of Financing Worksheet
The “Sources and Uses of Financing Worksheet” is used to calculate the total capital required for the new venture and to indicate where that capital is coming from. The asset side (uses of financing) is in the same format as a balance sheet, while the sources of financing side generally follows the same sequence as the liability and net worth side. While lease and rental agreements are not part of the balance sheet, they are included here to indicate how some of the capital equipment or facilities may be financed.

Since the amount of investment required will be determined by processing capacity, a separate worksheet should be prepared for each capacity assumption. Industry statistics, such as Robert Morris Annual Statement Studies, should be consulted as guidelines. For example, data for meat processing plants could be used to determine the ratio of current assets to fixed assets, and sales to determine the amount needed for working capital.


Summary
Models, as here described, are particularly vital in judging the potential feasibility of a new enterprise. But they are only as valid as the people who construct them. Assumptions should be made by, or at least verified by, industry experts. Earnings and cost data that deviate significantly from industry norms need to be satisfactorily explained in order to be credible to vendors and lenders.

Information obtained for the models in the feasibility stage should be used as the basis for financial projections included in business plans and loan proposals. They can also be used as guides in developing performance standards and monitoring systems once the firm is in operation.

Beef Processing Feasibility Study/Business Planning Costs

(Expenditures from time of idea perception to present - include anticipated amounts)

Item Amount Comments

Project Management                      ____________ ________________________

Administrative Support                   ____________ ________________________

Consultants/Expertise                    ____________ ________________________

Engineering                                   ____________ ________________________

Laboratory Equipment                    ____________ ________________________

Facilities - Rent, Utilities, Insurance ____________ ________________________

Reference Materials                        ____________ ________________________

Data Processing/Software               ____________ ________________________

Materials                                       ____________ ________________________

Market Research/Feasibility            ____________ ________________________

Patent/Trademark                           ____________ ________________________

Product Testing                              ____________ ________________________

Travel                                             ____________ ________________________

Office Equipment                            ____________ ________________________

Telephone                                      ____________ ________________________

Insurance                                       ____________ ________________________

Miscellaneous Office Expenses       ____________ ________________________

__________________________       ____________ ________________________

__________________________       ____________ ________________________

__________________________       ____________ ________________________

__________________________       ____________ ________________________

__________________________       ____________ ________________________

TOTAL EXPENDITURES                 ____________ ________________________


Beef Processing Plant Start-up Costs

Item Amount Comments

Project Management                       ____________ ________________________

Administrative Support                    ____________ ________________________

Office Expenses                             ____________ ________________________

Land                                              ____________ ________________________

Environmental Studies                     ____________ ________________________

Building/Building Improvements        ____________ ________________________

Facilities Planning/Design               ____________ ________________________

Machinery/Equipment                     ____________ ________________________

Machinery/Equipment Installation     ____________ ________________________

Lease Deposits                              ____________ ________________________

Leasehold Improvements                 ____________ ________________________

Initial Inventory                               ____________ ________________________

Initial Working Capital                     ____________ ________________________

Legal                                             ____________ ________________________

Accounting                                     ____________ ________________________

Consultants/Architects                    ____________ ________________________

Property Insurance                          ____________ ________________________

Management Recruitment                ____________ ________________________

Workforce Recruitment                    ____________ ________________________

Workforce Training                          ____________ ________________________

Marketing/Advertising                      ____________ ________________________

Product Liability Insurance               ____________ ________________________

Other Insurance                              ____________ ________________________

Travel                                             ____________ ________________________

Telephone                                      ____________ ________________________

__________________________       ____________ ________________________

__________________________       ____________ ________________________

__________________________       ____________ ________________________

__________________________       ____________ ________________________

__________________________       ____________ ________________________

TOTAL START-UP COSTS              ____________ ________________________


Beef Processing Input/Output Model (jpg)

Beef Processing Revenue/Cost Model (jpg)

Sources and Uses of Financing Worksheet (jpg)