Principles of Managerial Finance

122 PART 1 Introduction to Managerial Finance

9. The potential returns as well as risks resulting from use of fixed (operating and financial) costs to create “lever-
   age” are discussed in Chapter 12. The key point to recognize here is that when the firm’s revenue is increasing,fixed
   costs can magnify returns.


10. The application of regression analysis—a statistically based technique for measuring the relationship between
    variables—to past cost data as they relate to past sales could be used to develop equations that recognize the fixed
    and variable nature of each cost. Such equations could be employed when preparing the pro forma income statement
    from the sales forecast. The use of the regression approach in pro forma income statement preparation is wide-
    spread, and many computer software packages for use in pro forma preparation rely on this technique. Expanded
    discussions of the application of this technique can be found in most second-level managerial finance texts.

in cost of goods sold, operating expenses, and interest expense would result. For

example, as Vectra’s sales increased by 35 percent (from $100,000 in 2003 to

$135,000 projected for 2004), we assumed that its costs of goods sold also

increased by 35 percent (from $80,000 in 2003 to $108,000 in 2004). On the

basis of this assumption, the firm’s net profits before taxes also increased by 35

percent (from $9,000 in 2003 to $12,150 projected for 2004).

This approach implies that the firm will not receive the benefits that result

from fixed costs when sales are increasing.^9 Clearly, though, if the firm has fixed

costs, these costs do not change when sales increase; the result is increased prof-

its. But by remaining unchanged when sales decline, these costs tend to lower

profits. Therefore, the use of past cost and expense ratios generally tends to

understate profits when sales are increasing.(Likewise, it tends to overstate prof-

its when sales are decreasing.) The best way to adjust for the presence of fixed

costs when preparing a pro forma income statement is to break the firm’s histori-

cal costs and expenses into fixedand variablecomponents.^10

EXAMPLE Vectra Manufacturing’s 2003 actual and 2004 pro forma income statements,

broken into fixed and variable cost and expense components, follow:

Vectra Manufacturing

Income Statements

2003 2004

Actual Pro forma

Sales revenue $100,000 $135,000

Less: Cost of good sold

Fixed cost 40,000 40,000

Variable cost (0.40 sales)  (^4)  (^0) , (^0)  (^0)  (^0)   (^5)  (^4) , (^0)  (^0)  (^0) 
Gross profits $ 20,000 $ 41,000
Less: Operating expenses
Fixed expense 5,000 5,000
Variable expense (0.05 sales)  (^5) , (^0)  (^0)  (^0)   (^6) , (^7)  (^5)  (^0) 
Operating profits $ 10,000 $ 29,250
Less: Interest expense (all fixed)  (^1) , (^0)  (^0)  (^0)   (^1) , (^0)  (^0)  (^0) 
Net profits before taxes $ 9,000 $ 28,250
Less: Taxes (0.15 net profits before taxes)  (^1) , (^3)  (^5)  (^0)   (^4) , (^2)  (^3)  (^8) 
Net profits after taxes $

7

,

6

5

0

$

2

4

,

0

1

2