Essentials of Treasury Management, 3rd edition, Chapter 5: Financial Planning and Analysis
III. Decision Evaluation
The decision-making process of most organizations is based on a financial comparison of the costs and benefits of alternatives. Qualitative factors enter into business decisions, but this discussion is restricted to quantitative elements (i.e., those that can be expressed in numerical terms). Treasury professionals often play a central role in the financial analysis of decisions, such as product line changes, the selection of banking relationships/third-party providers, and whether to acquire or divest business units.
A. Identifying Relevant Costs and Revenues
Relevant data in evaluating decisions are the expected future cash costs and revenues among investment alternatives. There are two criteria that a cost or revenue must meet to be relevant:
- The cost or revenue must affect future cash flows. For example, if a company is considering a project using a previously purchased piece of equipment that has no alternative use, then the equipment cost is not relevant to the current decision because it does not affect future cash flows. Instead, this is referred to as a sunk cost (i.e., a historical cost that it already incurred).
- The cost or revenue must differ among the alternatives. For example, if a package delivery company is looking at acquiring new trucks, only the factors that are different between the choices are relevant to the analysis. If there are two choices available and both have the same carrying capacity, then that factor should not be part of the consideration. Instead, the analysis should focus on the items that are different (e.g., acquisition costs, fuel and maintenance costs, etc.).
Opportunity costs must also be considered when making choices. If a treasury professional decides to pay down debt that is not due, then the opportunity to invest that amount is gone. If this opportunity cost is not considered, then debt may be repaid, which costs less than the interest the company could earn from an available investment.
B. Cost/Benefit Analysis
Nearly all business decisions are based on a cost/benefit analysis, which assesses whether the relevant economic benefits of a given course of action exceed the relevant economic costs. A break-even analysis is a type of cost/benefit analysis that establishes the level of activity at which benefits and costs are equal.
A cost/benefit analysis typically attempts to measure the net benefit (i.e., benefits minus costs) of a proposed asset acquisition at a forecasted level of activity. An example of a cost/benefit analysis is a capital budgeting decision that relates the present value of cash benefits to the present value of cash costs. Other treasury decisions requiring a cost/benefit analysis include ascertaining the minimum size for a commercial paper issue, purchasing a new treasury information system and determining whether to outsource a given business process or perform it in-house.
1. Break-Even Analysis
The break-even point is the level of activity for an operation at which the costs equal the benefits. A break-even analysis is used by businesses in product decisions to determine what level of sales, at a given price, is required to cover costs. The general formula for a break-even analysis is:
If a company makes a product or delivers a service for $10 per unit, but the variable cost is only $6 per unit, then it can determine how many units it must sell to cover $10,000 of fixed costs by calculating the unit break-even point as follows:
If the company sells more than 2,500 units, then its operating profit will expand by $4 per unit because that is the amount by which the selling price exceeds the variable cost.
There are numerous applications for break-even analysis in treasury. One example is the calculation of the break-even amount of funds required to justify a wire transfer. Consider a company that usually uses an Automated Clearing House (ACH) network transfer to move funds from local field depository banks to its principal concentration bank. (Assume the local field and concentration banks are different institutions.) Because a wire transfer is more expensive than an ACH, but it results in quicker funds availability, a treasury professional should determine the quantity of funds that must be transferred to justify using the wire. (An example of this calculation is provided in Chapter 8, Cash Management and Forecasting.)