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Posts Tagged ‘Finance’

Measuring company profitability with the Berry ratio

Wednesday, February 24th, 2010

Companies use profitability ratios in order to measures their ability to generate returns through effective allocation and use of available resources. KPIs in this area have often as main component profit or return. One of the most popular profitability ratios is the Berry ratio.

It was developed by Dr. Charles Berry (1930-2007), a specialist in industrial organization and applied microeconomics and professor at the Princeton University, in conjunction with a tax court case involving transfer pricing between a U.S. parent company and a foreign subsidiary. He consulted with dozens of government agencies, corporations and law firms on antitrust and regulatory matters, transfer pricing and corporate taxation before launching the ratio that carries his name.

The Berry ratio measures the ratio of a company’s gross profits to operating expenses and is used mostly by tax and transfer pricing analysts.

It is calculated by dividing $ Gross margin (which is basically the difference between $ Sales and $ Cost of goods sold) to the $ Operating expenses.

A ratio coefficient of 1 or more indicates that the company is earning a profit over and above its variable expenses; a coefficient below 1 indicates that the firm is losing money.

Although the Berry ratio is a simple profitability measure, it is probably one of the most misused ratios in analysis of transfer pricing. Due to failure in understanding its limitations, errors in interpreting it may appear. The Berry ratio cannot be applied to distributors that also perform manufacturing functions as it cannot capture the additional return earned by the manufacturing function.

Empirical studies have shown that distributors with low operating expense intensity (less than 10%-15% relative to sales ratios) show very high values of the Berry ratio when compared with distributors with higher operating expenses. Thus, an extra caution should be taken when comparing two distributors with a large gap between their operating expense intensities.

Using the Berry ratio together with other profit level indicators will provide a higher level of validity of the information.

Additional resources

smartKPIs.com library of KPIs: Finance > Profitability > # Berry ratio

Przysuski, M.,Lalapet, S. (2005), “A comprehensive look at the Berry Ratio in transfer pricing”, Tax analyst, Volume 40, Number 8, Reprinted from Tax Notes Int’l, November 21, 2005, p. 759, available at: http://www.bridging.uwaterloo.ca/mtax/documents/PrzysuskiM_BerryRatioPaper.pdf (accessed 24 February 2010)

Stevens, R. (2007), “Charles Berry, economist and ‘dedicated University citizen,’ dies”, Princeton Weekly Bulletin September 16, 2007, Vol. 97, No. 1, available at: http://www.princeton.edu/pr/pwb/07/0916/berry/ (accessed 24 February 2010)

Tags: Berry ratio, Finance, Library of KPIs, Measures, Performance Measures, Retail, Tax
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When marketing meets finance: the break-even level of sales

Tuesday, February 16th, 2010

In a previous blog post we investigated the Return on Marketing Investment, a metric that analyzes the marketing activity from a financial point of view that is more complex than the revenue from sales generated by marketing.

The current blog post aims at exploring another area where finance meets marketing: the break-even analysis. In this area, we consider that finance actually needs marketing: the break-even analysis aims at determining from which point on (i.e. volume of sales), a business begins to generate profits.

Calculating the break-even level of sales is done by following the steps below:

Calculate your fixed production costs. These include the costs to produce that do not vary upon the volume of production and generally include the administrative costs (rent, secretary etc.)
Calculate the variable unit costs. These are costs that depend on the production volume (such as: salaries for the operational employees, utilities in the plant, raw materials etc.), that are divided to the volume of production to obtain the cost per unit.
Estimate the price that will be charged for each unit of the product or service. There are various price-setting strategies, such as adding a margin to the production costs, considering competition prices and even the break-even analysis itself can be used at setting the right price.

The break-even level of sales is then calculated as:

# Break-even level of sales = $ Fixed costs / ($ Price per unit – $ Unit variable cost)

The calculation formula is derived by the equation that reflects the zero profits:

$ Total revenue = $ Total costs

The result indicates the sales volume that needs to be achieved in order to attain the break-even – at which the revenues cover the costs, but no profits are obtained. From this sales level on, the business begins to generate profits.

After having calculated the break-even level of sales based on mostly financial inputs, the marketing department can estimate when and whether these levels of sales can be achieved and in which conditions.

Thus, the contribution of the break-even level of sales is considerable in what regards several financial decisions:

Finding the optimal fixed to variable costs combination
Comparing the estimated profitability of various options for investment
Setting optimum price levels

To take the analysis a step further, finance managers can even set targets for the profits they intend to achieve and calculate the expected level of sales that would generate these profits. This is done by adjusting the break-even calculation to include the profit targets, meaning we will now calculate the level of sales that will generate an expected amount of profits, not zero profits (as in the case of the break-even level of sales):