Posted on

IndependentCritical Evaluation of a Financial Planning Model

Nameof Student

IDNumber

UGB317.1

Table of Contents

Cost-Volume-Profit Analysis Model 3

Pros 3

Cons 3

The Merchant Navy 4

Case Study Excel 5

Income Statement 5

Formula View 6

Sensitivity Analysis 6

Modeling the Sensitivity Analysis Tool 7

Observations, Projections and Recommendations 9

Strengths of the Sensitivity Analysis 11

Weaknesses of the Sensitivity Analysis 11

Assumptions 12

Recommendation of Application of the Model 12

Conclusion 12

IndependentCritical Evaluation of a Financial Planning Model

Cost-Volume-ProfitAnalysis Model

Acost-volume profit analysis is a method in managerial accounting thatis focused on the impact of product costs and sales volume on thebusiness’ operating profit. It deals with the different ways bywhich alterations in variable costs, selling price per unit, andfixed costs may impact operating profit. Assumptions undercost-volume-profit analysis are as follows:

  1. Cost can be classified as fixed or variable.

  2. Total fixed cost, variable cost per unit, and sales price per unit are constant

  3. All units generated are sold.

Pros

Acost-volume profit analysis is simple to apply. It makes use of astandard formula that functions well in all forms of analysistechniques. A cost-volume profit analysis is also easy to understandbecause of its simple terminologies.

Cons

Acost-volume profit analysis is not always accurate. This methodassumes that the entire costs incurred by the company are completelyvariable or fixed. A cost-volume profit analysis is inflexible. Thismeans that the CVP analysis believes that a company is selling asingle product or if it is selling various products, the equivalentproportion of the quantity of each product sold remains constant.

Inits application to Merchant Navy, CVP analysis is very usefulparticularly in making short term decisions and in identifyingwhether the company has enough funds to pay their members theirbenefits.

TheMerchant Navy

Formany years, the shipping industry existed without schemes that aim atbenefiting shipping officers and their families. The Merchant NavyOfficers Pension Fund (MNOPF) started in 1938 with the aim ofproviding pensions on retirement and protection on death for officersin the UK mercantile marine [ CITATION mno14 l 1033 ]. MNOPF is divided into two sections – the old section and the newsection. The new section was set up after closing the old section in1978. However, the new section also closed up to new membership in1996.Other than having members in the new or old section, there aremembers that are registered in both sections and therefore, benefitfrom both.

Tomeet the fund obligations, contributions are made by the officers’employers. The fund pays benefits to members on retirement or death,or to dependents approved by the Board of Directors. The benefitsrepresent a long obligation and it is unlikely to know whatcontributions to the fund are needed to ensure sufficient moneyavailable to pay the benefits in the future [CITATION mno141 p 14 l 1033 ]. From this, it can be confirmed that the objective function tooptimize would be fund contributions by employers.

CaseStudy Excel

Fromthe case study on the Merchant Navy Officers Pension Fund in 2012 [CITATION eng14 l 1033 ],the following information wasestablished:

Old section (b£)

New section (b£)

Funding position (%)

2008

assets

1.3

2

96

81

active members

1200

Inthis case study, the Chief Executive Officer, Andrew Waring indicatedthat they had a clear journey plan and targeted full settlement ofliabilities within the next 10 years. Therefore, it is clear thatdeficit is a variable that needs to be addressed in decision making. The association will not meet its objectives if the number ofdefaulters grows with time.

IncomeStatement

Theinformation below has been extracted from the Summary Annual Report-2013 of the Merchant Navy Officers Pensions Fund as at 31stMarch 2013 [ CITATION mno142 l 1033 ].

Table1: Income Statement

old section (m£)

new section (m£)

total (m£)

opening balance as at 31st march 2012

1329.9

2169.2

3499.1

income during the year

90.6

90.6

less

expenses during the year

-90.5

-114.9

-205.4

plus

net return on investment

126.6

261.6

388.2

equals

1366

2406.5

3772.5

FormulaView

Total costs= fixed costs + (unit variable cost * number of units)

Total revenue = sales price * number of units

TC = TFC + V * X

TR = P * X

Where:

TC = Total Cost

TR = Total revenue

TFC = Total fixed costs

V = Unit variable cost or variable cost per unit

X = Number of units

P = Unit or sale price

SensitivityAnalysis

Inconducting a sensitivity analysis for the Merchant Navy, thefollowing are possible parameters to consider:

  1. Contributions from employers

  2. Deficit/surplus

  3. Membership

  4. Investments

  5. Time in years

Theanalysis in this case will be used for decision making anddevelopment of recommendations for decision makers [CITATION Pan14 p 2 l 1033 ]. It can also be used in identifying critical values, thresholds orbreak-even values where the optimal strategy changes identifyingsensitive or important values and developing flexible recommendationsdepending on circumstances.

Modelingthe Sensitivity Analysis Tool

Contributionsto the pension fund are made by members in the two sections throughtheir employers. Table 2 shows the total number of members at theend of March 2013.

Table2: Membership

old section

new section

both

total

Membership as at 31st march 2013

22096

10125

16786

49009

Inthe case study, Farrand quotes Waring, the Chief Executive Officer ofMNOPF, saying that the idea behind the MNOPF was to provide aconsistent pension scheme for officers in the Merchant Navy whochanged employment regularly [CITATION eng14 l 1033 ]. Table 3 showsthe amounts needed to pay the officers their benefits in 2012 and2013 financial years.

Table3: Estimated amounts needed to provide benefits

Estimated amount needed to provide benefits

Old section (m£)

New section (m£)

Total(m£)

as at 31st march 2012

1302

2626

3928

as at 31st march 2013

1330

2805

4135

estimated funding level as at 31st march 2013

100%

85%

Paymentof benefits depends on funds available at the end of the financialyear. This will be a surplus if they exceed amounts to be paid outfor benefits and a deficit if the amount to be paid out for benefitsexceeds the total funds available.

Table4 shows the net funds available from employer contributions andreturn on investments.

Table4: Assets/ total funds at the end of the given financial years

year

assets (m£)

2013

3772.5

2012

3499.1

2011

3305.7

2010

3108.2

2009

2659.2

Theseare values that should be optimized in the operations of the pensionfund. Figure 1 below shows the relationship given by these valuesover a period of five years. Financial models are usually built withthe x-axis serving as the time and the y-axis breaking down theresults by line-item [ CITATION Sim12 l 1033 ]. The sensitivity analysis in this case has been built on the x, y -plane as shown in figure 1.

Figure1: Relationship between total funds and time in years.

Observations,Projections and Recommendations

Fromthe graph, there is a steady increase in total funds contributed tothe merchant navy officers’ pension fund. The annual increase isapproximately £250 million. If this scenario is maintained, then in2016, the total funds expected to be collected will be £4500million. The contributions are made from employers and investmentsreturns undertaken by the officers’ pension fund. Since the oldand new section is closed to new membership, it means thatcontributions from employers relative to the membership remainsconstant or drops due to deficits. This is on the assumption thatthere is 100% payment of contributions.

However,other employers may fail to remit their contributions in time or someemployers may dissolve their companies hence rendering the employeesjobless and failing to remit their contributions. These conditionswill reduce total contributions to the pension fund hence resultingin a deficit. For the association to meet the deficits, an investmentplan should be mooted to generate income or profits to the group. Such profits can then be used to clear the deficits in a givenperiod.

Thedeficits will result from the need to meet the obligations of thegroup in paying benefits to the members. It has been noted that theamount needed to provide benefits has been increasing with time. Forexample, in 2013, the estimated amount needed to pay for the benefitsin all sections was £4135 million which is up by £207 millioncompared to that of 2012. At the end of the financial year 2012, theoverall asset was £3499.1 million. The contribution margin ratio isonly 85% of the estimated amount needed to provide benefits. Thisimplies that the overall asset in 2012 is not enough to provide thebenefit. Merchant Navy incurred a 15% deficit.This implies thatthe old section is able to meet its obligations in payment ofbenefits to its members and will have a surplus. But the new sectioncannot meet the payment of benefits to the members and incurs adeficit.

Anotherway of checking on the deficit is to revise the contribution level ofthe employers so as to meet the deficit. This could be a necessaryaction if the investment conditions are unfavorable. The total amountneeded to pay benefits in both sections was £4135 million on 31stmarch 2013. This shows that there was an overall deficit. If thisamount remains constant for the next three years to 2016, then theassets projected for the year 2016 would be able to cover thebenefits obligations of the pension fund. However, if the estimatedamount needed to pay for benefits increases at the same rate as theincrease in total funds paid, then the pension fund will not be ableto meet its benefits payment obligations. Since the deficits areemanating from the new section, it is recommended that factorscontributing to the shortfalls should be addressed immediately so asto remove the deficit and even generate a surplus. The breakevenpoint for the new section can be met by the end of the financial year2014 if the amount to be used for paying benefits remains fairlyconstant.

Strengthsof the Sensitivity Analysis

Theobservations, projections and recommendations mentioned are based onthe sensitivity analysis meant to optimize assets or contributions tothe pension fund now and in future. The critical factor in this caseis the total contribution at the end of each financial year. Thegraph and tables give a projection of the fund in three years timefrom a base of 2013. It is easy to make such observations using thesensitivity analysis by considering two aspects at a time. In thiscase, it is clear that contributions to the fund are sensitive tochanges in other parameters over a given period of time. Consequently, sensitivity analysis is easy to undertake, easy tounderstand, communicate, and apply in financial models and decisionmaking

Weaknessesof the Sensitivity Analysis

Theanalysis becomes more complex to analyze and interpret if manyfactors are considered at a go. This limits the analysis in scopeand makes it more favorable when dealing with one parameter orseveral factors grouped together. Samuels and Wilkes explained thatsensitivity analysis does not make decisions of itself. It is apracticable procedure that presents derived information in arevealing way [CITATION Sam82 p 236 l 1033 ]. Therefore, the decision rests with the management and implementersof the project in question.

Assumptions

Itis assumed that the project will only run for life if Merchant Navywould be able to remedy the deficit through a break-even point [ CITATION McM141 l 1033 ].

Recommendationof Application of the Model

Sensitivityanalysis is a good financial model and can easily be applied to manysituations. Repeated considerations of the objective function withother parameters either singly or grouped together ultimately yieldsmore accurate results that would allow for better decisions to bemade.

Conclusion

Financialmodels must be used in financial plans to make informed decisions. Sensitivity analysis should be prioritized in financial modeling.

Reference/Bibliography

Accounting4management.com.2014.&nbspContributionMargin Ratio-(CM Ratio).[online] Available at:http://www.accounting4management.com/contribution_margin_ratio.htm[Accessed: 16 Mar 2014].

bpg.com. (n.d.). How to write a financial plan. Retrieved march 3, 2014, from business plans guide website: http://www.business-plans-guide.com/financial-plan.html

Farrand, F. (2011, november 17). Case Study: The Merchant Navy Officers` Pension Fund. Retrieved march 4, 2014, from Engaged Investor: http://www.engagedinvestor.co.uk/case_study_the_merchant_navy-Offi…

McMorran, J. (n.d.). Financial modeling and forecasting. Retrieved march 4, 2014, from Postlethwaite &amp Netterville web site: http://www.pncpa.com/admin/files/resources/financial-modeling-and-forecasting.pdf

mnopf. (n.d.). MNOPF summary. Retrieved march 5, 2014, from Merchant Navy Officers Pension Fund web site: http://www.mnopf.co.uk/pdf/49232_MNOPF_Summary_RA_Interactive.pdf

mnopf.co.uk. (n.d.). MNOPF Summary. Retrieved march 5, 2014, from Merchant Navy Officers Pensions Fund web site: http://www.mnopf.co.uk/pdf/49232_MNOPF_Summary_RA_Interactive.pdf

mnopf.co.uk. (n.d.). Welcome to Merchant Navy Officers Pension Fund. Retrieved march 5, 2014, from The Merchant Navy Web site: http://www.mnopf.co.uk

Pannell, D. J. (n.d.). Sensitivity Analysis: strategies, methods, concepts examples. Retrieved march 3, 2014, from dpannell web site: http://www.dpannell.fnas.uwa.edu.au/dpap971f.htm

Samuels, J., &amp Wilkes, F. (1982). Management of Company Finance (3rd Edition). Frome: Butler &amp Tanner Ltd.

Simpson, S. D. (2012, august 10). Financial models you can create with Excel. Retrieved March 4, 2014, from Investopedia web site: http://www.investopedia.com/financial-edge/0812/financial-models