Professional Documents
Culture Documents
management
Financial Management can be defined as:
The management of the finances of a business / organisation in order to
achieve financial objectivesTaking a commercial business as the most common
organisational structure, the key objectives of financial management would be to:
Create wealth for the business
Generate cash, and
Provide an adequate return on investment bearing in mind the risks that the
business is taking and the resources invested
There are three key elements to the process of financial management:
(1) Financial Planning
Management need to ensure that enough funding is available at the right time to
meet the needs of the business. In the short term, funding may be needed to invest
in equipment and stocks, pay employees and fund sales made on credit.
In the medium and long term, funding may be required for significant additions to
the productive capacity of the business or to make acquisitions.
(2) Financial Control
Financial control is a critically important activity to help the business ensure that the
business is meeting its objectives. Financial control addresses questions such as:
Are assets being used efficiently?
Are the businesses assets secure?
Do management act in the best interest of shareholders and in accordance with
business rules?
(3) Financial Decision-making
The key aspects of financial decision-making relate to investment, financing and
dividends:
Investments must be financed in some way however there are always financing
alternatives that can be considered. For example it is possible to raise finance from
selling new shares, borrowing from banks or taking credit from suppliers
A key financing decision is whether profits earned by the business should be
retained rather than distributed to shareholders via dividends. If dividends are too
high, the business may be starved of funding to reinvest in growing revenues and
profits further.
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that
business enterprises make and the tools and analysis used to make these decisions.
The primary goal of corporate finance is to maximizeshareholder value.[1] Although
it is in principle different from managerial finance which studies the financial
decisions of all firms, rather than corporations alone, the main concepts in the study
of corporate finance are applicable to the financial problems of all kinds of firms.
The discipline can be divided into long-term and short-term decisions and
techniques. Capital investment decisions are long-term choices about
which projects receive investment, whether to finance that investment
with equity or debt, and when or whether to pay dividends to
shareholders. On the other hand, short term decisions deal with the shortterm balance of current assets and current liabilities; the focus here is on
managing cash, inventories, and short-term borrowing and lending (such
as the terms on credit extended to customers)
The terms corporate finance and corporate financier are also associated with
investment banking. The typical role of an investment bank is to evaluate the
company's financial needs and raise the appropriate type of capital that best fits
those needs. Thus, the terms corporate finance and corporate financier may be
associated with transactions in which capital is raised in order to create, develop,
grow or acquire businesses.
Project valuation
Further information: Business valuation, stock valuation, and fundamental analysis .
In general, each project's value will be estimated using a discounted cash flow
(DCF) valuation, and the opportunity with the highest value, as measured by the
resultant net present value (NPV) will be selected (applied to Corporate Finance by
Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams#Theory).
This requires estimating the size and timing of all of the incrementalcash flows
resulting from the project. Such future cash flows are then discounted to determine
their present value (see Time value of money). These present values are then
summed, and this sum net of the initial investment outlay is the NPV. See Financial
modeling.
The NPV is greatly affected by the discount rate. Thus, identifying the proper
discount rate often termed, the project "hurdle rate" [5] is critical to making an
appropriate decision. The hurdle rate is the minimum acceptable return on an
investmenti.e. the project appropriate discount rate. The hurdle rate should reflect
the riskiness of the investment, typically measured by volatility of cash flows, and
must take into account the project-relevant financing mix. Managers use models
such as the CAPM or the APT to estimate a discount rate appropriate for a particular
project, and use the weighted average cost of capital (WACC) to reflect the
financing mix selected. (A common error in choosing a discount rate for a project is
to apply a WACC that applies to the entire firm. Such an approach may not be
appropriate where the risk of a particular project differs markedly from that of the
firm's existing portfolio of assets.)
In conjunction with NPV, there are several other measures used as (secondary)
selection criteria in corporate finance. These are visible from the DCF and include
discounted payback period, IRR, Modified IRR, equivalent annuity, capital efficiency,
and ROI. Alternatives (complements) to NPV include Residual Income Valuation, MVA
/ EVA (Joel Stern, Stern Stewart & Co) and APV (Stewart Myers). See list of valuation
topics.
Valuing flexibility
Main articles: Real options analysis and decision tree
In many cases, for example R&D projects, a project may open (or close) various
paths of action to the company, but this reality will not (typically) be captured in a
strict NPV approach.[6] Management will therefore (sometimes) employ tools which
place an explicit value on these options. So, whereas in a DCF valuation the most
likely or average or scenario specific cash flows are discounted, here the flexible
and staged nature of the investment is modelled, and hence "all" potential payoffs
are considered. The difference between the two valuations is the "value of
flexibility" inherent in the project.
The two most common tools are Decision Tree Analysis (DTA)[7][8] and Real options
valuation (ROV);[9] they may often be used interchangeably:
ROV is usually used when the value of a project is contingent on the value of
some other asset or underlying variable. (For example, the viability of a
mining project is contingent on the price of gold; if the price is too low,
management will abandon the mining rights, if sufficiently high, management
will develop the ore body. Again, a DCF valuation would capture only one of
these outcomes.) Here: (1) using financial option theory as a framework, the
decision to be taken is identified as corresponding to either a call option or a
put option; (2) an appropriate valuation technique is then employed usually
a variant on the Binomial options model or a bespoke simulation model, while
Black Scholes type formulae are used less often; see Contingent claim
valuation. (3) The "true" value of the project is then the NPV of the "most
likely" scenario plus the option value. (Real options in corporate finance were
first discussed by Stewart Myers in 1977; viewing corporate strategy as a
series of options was originally per Timothy Luehrman, in the late 1990s.) See
also Option pricing approaches under Business valuation.
Quantifying uncertainty
Further information: Sensitivity analysis, Scenario planning, and Monte Carlo
methods in finance
Given the uncertainty inherent in project forecasting and valuation, [8][10] analysts will
wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions)
to the DCF model. In a typical sensitivity analysis the analyst will vary one key
factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV
to a change in that factor is then observed, and is calculated as a "slope": NPV /
factor. For example, the analyst will determine NPV at various growth rates in
annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....),
and then determine the sensitivity using this formula. Often, several variables may
be of interest, and their various combinations produce a "value-surface",[11] (or even
a "value-space",) where NPV is then a function of several variables. See also Stress
testing.
Using a related technique, analysts also run scenario based forecasts of NPV. Here,
a scenario comprises a particular outcome for economy-wide, "global" factors
(demand for the product, exchange rates, commodity prices, etc...) as well as for
company-specific factors (unit costs, etc...). As an example, the analyst may specify
various revenue growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case"
and 25% for "Best Case"), where all key inputs are adjusted so as to be consistent
with the growth assumptions, and calculate the NPV for each. Note that for scenario
based analysis, the various combinations of inputs must be internally consistent
(see discussion at Financial modeling), whereas for the sensitivity approach these
need not be so. An application of this methodology is to determine an "unbiased"
NPV, where management determines a (subjective) probability for each scenario
the NPV for the project is then the probability-weighted average of the various
scenarios. See First Chicago Method.
A further advancement is to construct stochastic[12] or probabilistic financial models
as opposed to the traditional static and deterministic models as above.[10] For this
purpose, the most common method is to use Monte Carlo simulation to analyze the
projects NPV. This method was introduced to finance by David B. Hertz in 1964,
although it has only recently become common: today analysts are even able to run
simulations in spreadsheet based DCF models, typically using a risk-analysis add-in,
such as @Risk or Crystal Ball. Here, the cash flow components that are (heavily)
impacted by uncertainty are simulated, mathematically reflecting their "random
characteristics". In contrast to the scenario approach above, the simulation
produces several thousandrandom but possible outcomes, or trials, "covering all
conceivable real world contingencies in proportion to their likelihood;" [13] see Monte
Carlo Simulation versus What If Scenarios. The output is then a histogram of
project NPV, and the average NPV of the potential investment as well as its
volatility and other sensitivities is then observed. This histogram provides
information not visible from the static DCF: for example, it allows for an estimate of
the probability that a project has a net present value greater than zero (or any other
value).
Continuing the above example: instead of assigning three discrete values to
revenue growth, and to the other relevant variables, the analyst would assign an
appropriate probability distribution to each variable (commonly triangular or beta),
and, where possible, specify the observed or supposed correlation between the
variables. These distributions would then be "sampled" repeatedly incorporating
this correlation so as to generate several thousand random but possible scenarios,
with corresponding valuations, which are then used to generate the NPV histogram.
The resultant statistics (average NPV and standard deviation of NPV) will be a more
accurate mirror of the project's "randomness" than the variance observed under the
scenario based approach. These are often used as estimates of the underlying "spot
price" and volatility for the real option valuation as above; see Real options
valuation: Valuation inputs. A more robust Monte Carlo model would include the
possible occurrence of risk events (e.g., a credit crunch) that drive variations in one
or more of the DCF model inputs.
The financing decision
Decision criteria
Working capital is the amount of capital which is readily available to an
organization. That is, working capital is the difference between resources in cash or
readily convertible into cash (Current Assets), and cash requirements (Current
Liabilities). As a result, the decisions relating to working capital are always capital
investment decisions in terms of discounting and profitability considerations; they
are also "reversible" to some extent. (Considerations as to Risk appetite and return
targets remain identical, although some constraints such as those imposed by
loan covenants may be more relevant here).
Working capital management decisions are therefore not taken on the same basis
as long term decisions, and working capital management applies different criteria in
decision making: the main considerations are (1) cash flow / liquidity and (2)
profitability / return on capital (of which cash flow is probably the most important).
The most widely used measure of cash flow is the net operating cycle, or
cash conversion cycle. This represents the time difference between cash
payment for raw materials and cash collection for sales. The cash conversion
cycle indicates the firm's ability to convert its resources into cash. Because
this number effectively corresponds to the time that the firm's cash is tied up
in operations and unavailable for other activities, management generally
aims at a low net count. (Another measure is gross operating cycle which is
the same as net operating cycle except that it does not take into account the
creditors deferral period.)
this result for the firm's shareholders. As above, firm value is enhanced when,
and if, the return on capital, exceeds the cost of capital. ROC measures are
therefore useful as a management tool, in that they link short-term policy
with long-term decision making.
Cash management. Identify the cash balance which allows for the business
to meet day to day expenses, but reduces cash holding costs.
Debtors management. There are two inter-related roles here: Identify the
appropriate credit policy, i.e. credit terms which will attract customers, such
that any impact on cash flows and the cash conversion cycle will be offset by
increased revenue and hence Return on Capital (or vice versa); see Discounts
and allowances. Implement appropriate Credit scoring policies and
techniques such that the risk of default on any new business is acceptable
given these criteria.
Raising capital via the issue of other forms of equity, debt and related
securities for the refinancing and restructuring of businesses
Raising debt and restructuring debt, especially when linked to the types of
transactions listed above
swaps; the "second generation" exotic derivatives usually trade OTC. Note that
hedging-related transactions will attract their own accounting treatment: see Hedge
accounting, Mark-to-market accounting, FASB 133, IAS 39.
This area is related to corporate finance in two ways. Firstly, firm exposure to
business and market risk is a direct result of previous Investment and Financing
decisions. Secondly, both disciplines share the goal of enhancing, or preserving,
firm value. There is a fundamental debaterelating to "Risk Management" and
shareholder value: in question is the shareholder's desire to optimize risk versus
taking exposure to pure risk (a risk event that only has a negative side, such as loss
of life or limb). The debate links the value of risk management in a market to the
cost of bankruptcy in that market. See Fisher separation theorem.
Alternate Approaches
A standard assumption in Corporate finance is that shareholders are the residual
claimants and that the primary goal of executives should be to
maximizeshareholder value. Recently, however, legal scholars (e.g. Lynn Stout[23])
have questioned this assumption, implying that the assumed goal of maximizing
shareholder value is inappropriate for a public corporation. This criticism in turn
brings into question the advice of corporate finance, particularly related to stock
buybacks made purportedly to "return value to shareholders," which is predicated
on a legally erroneous assumption.
INCOME STATEMENT
Income statement (overview)
The income statement is a historical record of the trading of a business over
a specific period (normally one year). It shows the profit or loss made by the
business which is the difference between the firms total income and its
total costs.
The income statement serves several important purposes:
Enables comparison with other similar businesses (e.g. competitors) and the
industry as a whole
Income Statement
2011
2010
'000
'000
Revenue
21,450
19,780
Cost of sales
13,465
12,680
Gross profit
7,985
7,100
Distribution costs
3,210
2,985
Administration expenses
2,180
1,905
2,595
2,210
156
120
2,439
2,090
746
580
1,693
1,510
Operating profit
Finance costs
Tax expense
Revenue
Cost of sales
Gross profit
Distribution & Operating costs and expenses that are not directly related to
administration producing the goods or services are recorded here. These would
expenses
include distribution costs (e.g. marketing, transport) and the
wide range of administrative expenses or overheads that a
business incurs.
Operating
profit
Finance
expenses
Profit before
tax
Tax
Profit
The amount of profit that is left after the tax has been accounted
attributable to for. The shareholders then decide how much of this is paid out
shareholders
to them in dividends and how much is left in the business
(retained earnings in the equity section of the balance sheet)
BALANCE SHEET
Balance Sheet (overview)
A balance sheet is a statement of the total assets and liabilities of an
organisationat a particular date - usually the last date of an accounting period.
The balance sheet is split into two parts:
(1) A statement of fixed assets, current assets and the liabilities (sometimes
referred to as "Net Assets")
(2) A statement showing how the Net Assets have been financed, for example
through share capital and retained profits.
The Companies Act requires the balance sheet to be included in the published
financial accounts of all limited companies. In reality, all other organisations that
need to prepare accounting information for external users (e.g. charities, clubs,
partnerships) will also product a balance sheet since it is an important statement of
the financial affairs of the organisation.
A balance sheet does not necessary "value" a company, since assets and liabilities
are shown at "historical cost" and some intangible assets (e.g. brands, quality of
management, market leadership) are not included.
Example Balance Sheet
The structure of a typical balance sheet is illustrated below:
Boston Learning Systems plc
Balance Sheet at 31
December
2009
2008
'000
'000
150
150
2,450
2,100
2,600
2,250
Inventories
1,325
1,475
4,030
3,800
250
190
1,340
780
ASSETS
Non-current assets
Goodwill and other intangible
assets
Property, plant & equipment
Current assets
Short-term investments
Cash and cash equivalents
6,945
6,245
2,310
2,225
Short-term borrowings
350
550
800
650
Provisions
290
255
3,750
3,680
3,195
2,565
1,200
1,450
140
140
1,340
1,590
4,455
3,225
500
500
3,955
2,725
Current liabilities
Trade and other payables
Non-current liabilities
Borrowings
Provisions
NET ASSETS
EQUITY
Share capital
Retained earnings
TOTAL EQUITY
4,455
3,225
An asset is any right or thing that is owned by a business. Assets include land,
buildings, equipment and anything else a business owns that can be given a value
in money terms for the purpose of financial reporting.
Definition of Liabilities
To acquire its assets, a business may have to obtain money from various sources in
addition to its owners (shareholders) or from retained profits. The various amounts
of money owed by a business are called its liabilities.
Long-term and Current
To provide additional information to the user, assets and liabilities are usually
classified in the balance sheet as:
- Current: those due to be repaid or converted into cash within 12 months of the
balance sheet date;
- Long-term: those due to be repaid or converted into cash more than 12 months
after the balance sheet date;
Fixed Assets
A further classification other than long-term or current is also used for assets. A
"fixed asset" is an asset which is intended to be of a permanent nature and which is
used by the business to provide the capability to conduct its trade. Examples of
"tangible fixed assets" include plant & machinery, land & buildings and motor
vehicles. "Intangible fixed assets" may include goodwill, patents, trademarks
and brands - although they may only be included if they have been "acquired".
Investments in other companies which are intended to be held for the long-term can
also be shown under the fixed asset heading.
Definition of Capital
As well as borrowing from banks and other sources, all companies receive finance
from their owners. This money is generally available for the life of the business and
is normally only repaid when the company is "wound up". To distinguish between
the liabilities owed to third parties and to the business owners, the latter is referred
to as the "capital" or "equity capital" of the company.
In addition, undistributed profits are re-invested in company assets (such as stocks,
equipment and the bank balance). Although these "retained profits" may be
available for distribution to shareholders - and may be paid out as dividends as a
future date - they are added to the equity capital of the business in arriving at the
total "equity shareholders' funds".
At any time, therefore, the capital of a business is equal to the assets (usually cash)
received from the shareholders plus any profits made by the company through
trading that remain undistributed.
CURRENT ASSETS
Current assets
This section of the balance sheet shows the assets a business owns which are either
cash, cash equivalents, or are expected to be turned into cash during the next
twelve months.
Current assets are, therefore, very important to cash flow management and
forecasting, because they are the assets that a business uses to pay its bills, repay
borrowings, pay dividends and so on,
Current assets are listed in order of their liquidity or in other words, how
easy it is to turn each category of current asset into cash.
The main elements of current assets are:
Inventories
Inventories (often also called stocks) are the least liquid
kind of current asset. Inventories include holdings of raw
materials, components, finished products ready to sell and also
the cost of work-in-progress as it passes through the
production process.
For the balance sheet, a business will value its inventories at
cost. A profit is only earned and recorded once inventories
have been sold.
Not all inventories can eventually be sold. A common problem
is stock obsolescence where inventories have to be sold
for less than their cost (or thrown away) perhaps because they
are damaged or customers no longer demand them. For these
inventories, the balance sheet value should be the amount that
can be recovered if the stocks can finally be sold.
Trade and
other
receivables
Short-term
investments
CURRENT LIABILITIES
Current liabilities
Current liabilities represent amounts that are owed by the business and which
are due to be paid within the next twelve months. Current liabilities are normally
settled from the amounts available in current assets.
The main elements of current liabilities are:
Trade and other
payables
The main element of this is normally trade creditors
amounts owed by a business to its suppliers for goods and
services supplied. A trade creditor is the reverse of a trade
debtor. A business buys from a supplier and then pays for
those goods and services some time later the period depends
on the length and amount of credit the supplier allows.
Short-term
borrowings
Current tax
liabilities
This category shows the tax liabilities that the business is still
to pay to the government. This will mainly comprise
corporation tax, income tax and VAT.
Provisions
Non-current liabilities
This category shows the longer-term liabilities that a business has. By longer-
term, we mean liabilities that need to be settled in more than one years time.
This would include bank loans which are not yet due for repayment.
RATIO ANALYSIS
Study Notes: Business Finance & Accounting
Main ratios (introduction)
In our introduction to interpreting financial information we identified five main areas
for investigation of accounting information. The use of ratio analysis in each of
these areas is introduced below:
Profitability Ratios
These ratios tell us whether a business is making profits - and if so whether at an
acceptable rate. The key ratios are:
Ratio
Calculation
Comments
Gross
Profit
Margin
[Gross Profit /
Revenue] x 100
(expressed as a
percentage
Operati
ng
Profit
Margin
[Operating Profit /
Revenue] x 100
(expressed as a
percentage)
Return
on
capital
employ
ed
Efficiency ratios
These ratios give us an insight into how efficiently the business is employing those
resources invested in fixed assets and working capital.
Ratio
Calculation
Sales
Sales / Capital
/Capital employed
Employe
d
Comments
A measure of total asset utilisation. Helps to answer
the question - what sales are being generated by
each pound's worth of assets invested in the
business. Note, when combined with the return on
sales (see above) it generates the primary ratio ROCE.
Sales or Sales or profit /
This ratio is about fixed asset capacity. A reducing
Profit /
Fixed Assets
sales or profit being generated from each pound
Fixed
invested in fixed assets may indicate overcapacity or
Assets
poorer-performing equipment.
Stock
Cost of Sales /
Stock turnover helps answer questions such as "have
Turnover Average Stock
we got too much money tied up in inventory"?. An
Value
increasing stock turnover figure or one which is
much larger than the "average" for an industry, may
indicate poor stock management.
Credit
(Trade debtors
The "debtor days" ratio indicates whether debtors
Given /
(average, if
are being allowed excessive credit. A high figure
"Debtor possible) / (Sales)) (more than the industry average) may suggest
Days"
x 365
general problems with debt collection or the financial
position of major customers.
Credit
((Trade creditors + A similar calculation to that for debtors, giving an
taken /
accruals) / (cost of insight into whether a business is taking full
"Creditor sales + other
advantage of trade credit available to it.
Days"
purchases)) x 365
Liquidity Ratios
Liquidity ratios indicate how capable a business is of meeting its short-term
obligations as they fall due:
Ratio
Current
Ratio
Calculation
Current Assets /
Current Liabilities
Comments
A simple measure that estimates whether the
business can pay debts due within one year from
assets that it expects to turn into cash within that
year. A ratio of less than one is often a cause for
concern, particularly if it persists for any length of
time.
Quick
Ratio (or
"Acid
Test"
Stability Ratios
These ratios concentrate on the long-term health of a business - particularly the
effect of the capital/finance structure on the business:
Ratio
Calculation
Comments
Gearing
Borrowing (all
Gearing (otherwise known as "leverage") measures
long-term debts + the proportion of assets invested in a business that
normal
are financed by borrowing. In theory, the higher the
overdraft) / Net
level of borrowing (gearing) the higher are the risks
Assets (or
to a business, since the payment of interest and
Shareholders'
repayment of debts are not "optional" in the same
Funds)
way as dividends. However, gearing can be a
financially sound part of a business's capital
structure particularly if the business has strong,
predictable cash flows.
Interest
cover
Operating profit
before interest /
Interest
Investor Ratios
There are several ratios commonly used by investors to assess the performance of a
business as an investment:
Ratio
Calculation
Comments
Earnings
per
share
("EPS")
Earnings (profits)
attributable to
ordinary
shareholders /
Weighted average
ordinary shares in
issue during the
year
PriceMarket price of
Earnings share / Earnings
Ratio
per Share
("P/E
Ratio")
Profitability
Financial
efficiency
Liquidity and
gearing
Shareholder
return
Valuing some assets and liabilities on the balance sheet involves subjective
judgment. For example, management has some discretion about what
provisions they need to make for trade debtors that may not pay or for
obsolete stocks.
Accounts are largely descriptive about what has occurred in the past rather
than explaining why. Publicly quoted companies are required to provide
much more detailed commentary on the financial statements in the Annual
Report. However, the vast majority of companies are not publicly quoted!
http://bizfinance.about.com/od/financialratios/f/Gross_Profit_Margin.
htm
you decrease your labor costs in this way, it could affect the quality of your
product.
You can also decrease your manufacturing costs with regard to materials. You
may want to try to find a supplier for materials that offers them at a less
expensive price. You can also try to negotiate volume discounts with your
current supplier. If you buy materials in bulk, the supplier may give you a
discount. When you are looking for a supplier offering materials for a cheaper
price, never lose sight of quality. You don't want to compromise the quality of
your product.
Fixed and Variable Costs
The Types of Expenses you Incur when you Start a Small Business
When you start a small business, you will have two types of expenses. Fixed
expenses do not change with sales volume. Variable costs, however, do
change with the volume of the product you sell. It is important to understand
the relationship between your fixed and variable expenses, your sales
volume, and your expected net profit. First, you have to understand your
costs or expenses.
Fixed Costs
Fixed costs are the costs associated with the product that have to be paid
regardless of the volume you sell. No matter how much you sell or don't sell,
you have to pay your fixed costs.
An example of a fixed cost is overhead. Overhead may include rent for the
space your company occupies such as your office space. It may also include
your weekly payroll. Another fixed expense may be the depreciation you
incur on your equipment. Those are just a few examples of expenses you
have to pay no matter what your sales volume is.
Variable Costs
Variable costs are directly related to sales. In fact, variable costs change with
sales. As sales go up, so do variable costs. As sales go down, variable costs
go down. Variable costs are costs of labor or materials that change with
sales. One way for a company to save money is to reduce its variable costs.
Sometimes, calculating variable costs is as simple as looking at your costs of
goods sold on your income statement.
Examples of variable costs are the raw materials that go into creating the
company's product and the labor the company uses. Other examples are
costs of goods sold, sales commissions, delivery charges, shipping charges,
wages and numbers of temporary or part-time employees, and bonuses to
employees. If sales decline, all of these variable costs can decline and
probably will decline.
Semi-variable costs
Some costs have components that are fixed and some that are variable. One
example is wages for your sales force. A portion of the wage for a
salesperson may be a fixed salary and the rest may be sales commission.
When calculating your fixed and variable costs, you should allocate the fixed
portion to fixed costs and the variable portion to variable costs.
Costs, Sales Volume, and Profit
A change in any of your costs can drastically affect your net profit. A change
in sales volume can also affect your net profit. Another variable that is
important is the price of your product which interacts with volume and costs.
Breakeven analysis shows the relationship between the price of the product
you sell, the volume of the product you sell, and your costs or expenses. One
of the variables you use in breakeven analysis, price, can be determined by
further dividing up fixed and variable costs in direct and indirect costs
Direct and Indirect Costs and Their Effect on Pricing your Product
How to Include Direct and Indirect Costs When Pricing your Product
Part of the process of pricing your product is including the costs of producing
that product. Those costs include the direct and indirect costs associated
with producing your product.
Direct Costs
Direct costs are costs that can be easily traced to a particular object (also
called a cost object), such as a product, the raw materials used to
manufacture a product, or the labor associated with the work to produce the
product. If your company produces a widget and a production manager is
hired to oversee production of that widget, then the production manager's
salary is a direct cost. If you own a carpet cleaning business, which is a
service organization, and you hire workers just to clean carpets, their wages
are direct costs.
Direct costs are often, but not always, variable costs. Variable costs increase
as more units of the product are manufactured. As a result, raw materials are
variable and direct costs. But, if there is a supervisor overseeing the
manufacturing of this particular product, their salary is probably the same
regardless of how much of the product is manufactured, so it is a fixed cost.
Direct Materials and Direct Labor
The most common direct costs are direct materials and direct labor. Direct
materials are the materials that can be specifically identified with the
product. If you are a furniture maker, your direct materials would be the
wood that goes into making your furniture along with the nails, varnish, and
other products that you apply specifically to making the furniture. But, you
wouldn't count the gasoline that the loggers use to drive the trucks to get to
the forest to cut down the trees as direct materials.
A method of tracking the direct cost of materials has to be chosen, generally
LIFO or FIFO.
Direct materials are all the materials required to produce a product such as
raw materials. Direct materials costs are assignable to that particular
product, such as the cost of each raw material.
Indirect Costs
Indirect costs are those which affect the entire company, not just one
product. They are costs like advertising, depreciation, general supplies for
your firm, accounting services, etc. They are services, and costs, for your
entire firm, not just one product. Indirect costs are usually called overhead.
Overhead is the ongoing cost of operating a business that can't be
associated with just one product or service.
Indirect costs can be fixed or variable costs. Often, they are fixed costs with
an example being the rent you pay on your building. Sometimes, they are
variable. An example would be your electricity or water bill which can change
monthly.
Indirect Materials and Indirect Labor
portion of the material your company uses. Indirect materials costs are
usually variable because materials are based on the level of production.
Labor costs that make production of a product or products possible but can't
be assigned to one particular product are classified as indirect costs. An
example of an indirect labor cost would be the salary of a manager as that
manager would manage the entire operation and not just one product line.
The next issue is whether indirect labor costs are fixed or variable costs. In
this case, if the salary is a monthly or annual salary and does not change
based on production, it is a fixed cost. If it is based on production, it is a
variable cost.
It is important for a business owner to correctly classify direct and indirect
costs. One reason is because overhead, your indirect costs, are taxdeductible items. Some of the overhead expenses will be in be included in
cost of goods sold, business deductions, inventory, and other categories.