Financial Risk Management Concepts

It makes a big difference attending a class where the professor has the skillset to explain a dry and difficult concept in a relatively easy approach. This class is about Financial Risk Management concepts. But to understand how risks impact a project, we needed to go through the concepts of Cost, Break Even Point, and Contribution.

Nothing beats a nice easy mathematical equation which gives you some sort of information. But when the topic is financial management, it is not about a simple equation only. As a professional, you need to understand where the figures come from. It is not a simple 1+1=2 no matter how easy the formula looks.

My interaction with project costs has been on a small scale dealing with straight forward direct and indirect costs. Labour, material and suppliers costs to achieve the project’s outcome. If you are a new project manager, your best to start with this post first Value for Money: To Budget or not to Budget.
Today’s class took it to the next level. What made a difference is one example about a business person who wants to open a restaurant and sell all inclusive meals.

Cost, being fixed and variable, total expected sales, number of meals required to breakeven so as this business person could start making profit. So if a meal is to be sold at £40 and the fixed cost (rental and salaries) is £15,000. To produce a meal, the variable cost (raw material) is £15. How many meals does this business need to sell to break even?

So while the formulas tend to be a straight forward x – y = the total number of meals, here are few things that would put more context to this case:

Break Even Point (BEP) equals to the total fixed costs over the contribution per unit.

What is the contribution per unit? Contribution is the amount of earnings remaining after all direct costs have been subtracted from revenue (Accountingtools.com). In other words, contribution is the cost involved in producing one unit taken out of the price you will sell it for. This gives you the figure in £.

So in this case study, contribution is £25. (Selling price £40 – Cost per unit £15 = £25). At this point, we know how much the fixed costs are and how much it costs to make one meal. What is the total number of meals will the business need to sell to to break even.

Let us follow the above formula: (total fixed costs)15,000 divided by (contribution) 25 equals to 600. This business must sell 600 meals to cover all the costs before starting to make revenue. 600 meals in monetary value is £24,000.

Break Even Point
Break Even Point Diagram

Because business are not sustainable when they only product a bit over their break even point, the concept of Margin of Safety kicks in. Margin of safety is  is the reduction in sales that can occur before the break even point of a business is reached (accounting tools.com). In other words, if this business had planned to sell only 600 meals a month as part of their business plan, then you know we have a problem. Part of their feasibility study (externally and internally) they decided that their sales target should be 1000 meals per month at the cost of £40, a total of £40,000.

Margin of Safety equals to the total expected sales minus the break even point

For this restaurant to continue working successfully, their margin of safety is £16,000 (total expected sales £40,000 – break even point £24,000).

So once this business start making less than £16,000 in revenue on top of their break even point, some drastic actions must occur to maintain sustainability.

So as a project manager why is this relevant to know? In reality, as a project manager your responsibility is to produce baselines for scope, schedule and cost. Looking into the cost baseline, you need to understand that your entire plan is based on estimates. While estimates give you an idea of how you will shape up your project in a budgeting standpoint, it is essential to understand that there are factors that drive business to change their pricing factors. Remember, you could be a project manager in the context of producing a product that will be sold and thus you need to understand how you much your fixed and variable costs; or you could be a project manager who deals with suppliers that will demand different type of contracts and payments. Their pricing methods would have accounted for their fixed and variable costs. Of course, needless to say, this is only one tiny aspect of cost management.

This was only the morning morning session to help understand the basics of costs and estimates before we dove deep into the Earned Value Management (EVM); a concept that is essential for any project manager who wants to bring added value to their project by analysing the data they have and not just producing reports aimlessly.

 

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