Finance- understanding cost, revenue and profit for a business Essay Example

Finance Finance- understanding cost, revenue and profit for a business Essay Finance- understanding cost, revenue and profit for a business Essay In accounting, costs are the monetary value of expenditures for supplies, services, labour, products, equipment and other items purchased for use by a business or other accounting entity. Here are some of the costs a business needs to know: * Fixed * Start-up cost : * Variable * Total * Marginal * Semi-fixed costs * Direct costs * Indirect costs * Average * Operating costs Fixed costs These costs do not change however many units of a product are made. Factory rent, insurance premiums and administration salaries stay the same, whether the factory is working at full capacity or producing nothing. The owner of the business may have taken out a loan to buy equipment or refurbish a building. The loan will have to be repaid whether or not the business has customers. Variable costs Variable costs change as output changes. For example, the amount of raw materials needed varies as the levels of output go up or down. Piece-work wages also fluctuate, depending on the employees efficiency and the demand for the companys products. Start- up costs These are incurred before a business begins to operate, such as the purchase of land, building and equipments. Total costs The fixed costs and the variable costs are added together to establish the total costs. The fixed costs remain constant, but the variable costs increase in direct proportion with output. Marginal costs Using marginal cost is a way of measuring how much more it will cost a company to make one more individual item. Semi-fixed costs Semi-fixed costs are costs which only change when there is a large change in output. For example, costs associated with buying a new machine to cope with increased production. Also telephones and electricity for instance have a fixed and variable element: a standard line rental and then a charge for each call/unit of electricity after that. Direct costs Direct costs are costs which can be identified directly with the production of a good or service; e.g. raw materials. Indirect costs Indirect costs are costs which cannot be matched against each product because they need to be paid whether or not the production of good or services takes place; e.g. rent on the premises. Classification of costs help allocate costs to right parts of the profit and loss account and also helps analysis of the break even point of the business. Average costs The example of the CD shows the benefits of economies of scale, where mass production results in a lower unit cost. The reason is that the fixed costs do not change and are spread across a greater level of output. Finding out the average cost of production helps a firm to monitor its progress, and makes it easier to set prices. It is calculated by dividing total cost by total output. Using the example of the compact disc firm above: Total costs / Total output = Average cost of production à ¯Ã‚ ¿Ã‚ ½1,000 / 100 CDs = à ¯Ã‚ ¿Ã‚ ½10 per CD This might seem expensive, but if the firm produces another hundred units at a marginal cost of à ¯Ã‚ ¿Ã‚ ½1.00 per CD, its average cost will fall radically: Total costs / Total output = Average cost of production à ¯Ã‚ ¿Ã‚ ½1,100 / 200 CDs = à ¯Ã‚ ¿Ã‚ ½5.50 per CD The firm can use this information to decide whether it is worth accepting a new order for goods. Operating costs Variables costs and fixed costs added together are known as operating or running costs since they are both incurred when a business is running. Revenue In business, revenue or revenues is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. Sales these are the main source of revenue for most organisations because customers pay for the goods or services they buy. Leasing a part of a building to another business can also provide a source of income. Some businesses specialise in leasing cars or equipment to other organisations. Interest this earned when a business has no money in an interest bearing accounts at the bank. Calculating total revenue To do this we need two items of information: * The selling price * The number sold We then need use the following formula: Profit Profit generally is the making of gain in business activity for the benefit of the owners of the business. Profit is the difference between the income of the business and all its costs/expenses. It is normally measured over a period of time. Profit is important in three ways: 1. It rewards the business people who have taken risks to run it 2. It provides the funds to develop the business further 3. It is a source of cash, which allows the business to meet its debts Gross profit This is the difference between sales income and the direct costs of making those products. Gross profit is used as a performance indicator to help the business make decisions over its pricing policies and use of materials. In the example, the business had sales of à ¯Ã‚ ¿Ã‚ ½18,000 over the year. Its cost of sales was à ¯Ã‚ ¿Ã‚ ½4,850 and its gross profit, therefore, was à ¯Ã‚ ¿Ã‚ ½13,150. Trading Account for Filling Snacks for year ended 31 December, 2000 à ¯Ã‚ ¿Ã‚ ½ à ¯Ã‚ ¿Ã‚ ½ Sales 18,000 less Cost of Sales Opening Stock 750 Purchases 5000 Closing Stock (900) (4,850) Gross Profit 13,150 Net profit Net profit represents gross profit less all expenses associated with the normal running of the business. Net profit shows how well the business performs under its normal trading circumstances. It is used to calculate the primary efficiency ratio. Net profit is the final profit of the business. It is the amount of profit made by the owners of the business at the end of the period. In this Example when we take expenses into account, we can see that what was a gross profit of à ¯Ã‚ ¿Ã‚ ½13,150 is now a net loss of à ¯Ã‚ ¿Ã‚ ½1,650. Trading and Profit Loss Account for Filling Snacks for year ended 31 December, 2000 à ¯Ã‚ ¿Ã‚ ½ à ¯Ã‚ ¿Ã‚ ½ Sales 18,000 less Cost of Sales Opening Stock 750 Purchases 5,000 Closing Stock (900) (4,850) Gross Profit 13,150 less Expenses Rent 10,000 Interest Payments 1,800 Light Heat 1,500 Advertising 500 Other 1,000 (14,800) Net Profit (1,650) Retained profit Retained profit is the profit left over after the shareholders have been paid their dividends. Retained profit is normally reinvested in the business. Profit is important to a business because it is a reward to the owners of the business. They have taken risks with their money and time. If there was no profit, then there would be little point in starting up or putting more money into the business, they might as well put the money into a bank or building society Profit maximization Profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenue total cost method relies on the fact that profit equals revenue minus cost. There are two basic ways of improving profits: * Increasing sales income * Reducing running costs Increasing sales income There are different ways of trying to achieve this. They all have risks as shown in the charts. Methods Risks Increase prise Sales could fail Reduce prices to increase sales Not enough extra sales would be made to compensate Reducing operating costs We already know that cost fall in to two variables and fixed. Many business have operating cost like bills, labours, raw materials etc. An example of reducing operating profit is given below, a valeting business have a list which begins: Staff wages à ¯Ã‚ ¿Ã‚ ½200,000 Property rental à ¯Ã‚ ¿Ã‚ ½50,000 And end with Ball pens à ¯Ã‚ ¿Ã‚ ½20.00 Paper clips à ¯Ã‚ ¿Ã‚ ½4.50 Method of reducing costs falls into main categories: * Minimising usage * Finding the best purchase deal Item Use less Reduce purchase price Labour Reduce staff levels by increasing number of automated or computerised operations Increase productivity sub-contract work to cheapest bidder Raw materials Use fewer materials in product Look for a cheaper supplier Gas, water and electricity Replace older item with efficient ones, e.g. Energy- saving bulbs, light which turn off automatically. Switch utility company if this would reduced costs Consumable items, e.g. stationary Send documents by e-mail rather than by post. Shop around for cheaper suppliers and investigate online source The importance of profit After tax is paid the business can spend the remaining money in several ways. If the business is a limited company with shareholders, some of the profits will be paid as dividends. These are the rewards paid to shareholders for investing their money- similar to the interest you if you save money in the bank.