Cost Analysis in Business Finance

Financial Forecasting for Businesses

• A BTEC Level 2 course focuses on financial forecasting for businesses
• The course begins with understanding business costs, specifically setup costs and operating costs

Business Costs

• Setup Costs (Start-up Costs): These are the initial costs needed to launch a business before generating income
  • These costs can come from savings, loans, family, or friends
  • Setup costs are usually paid only once
• Operating Costs (Running Costs): Ongoing costs required to keep a business running day-to-day
  • These costs are usually paid regularly more than once

Types of Operating Costs

• Fixed Costs (Indirect): Costs that remain the same regardless of production, sales, or customer count
  • Examples include rent, utilities, insurance, and building tax.
• Variable Costs (Direct): Costs directly related to the volume of business or sales
  • Examples include raw materials for a product (e.g., flour for a bakery), petrol for a taxi, or bags in a gift shop
• Commission: A fee paid to salespeople (brokers/agents) for enabling or completing sales transactions. This is a variable cost linked directly to sales volume

Calculating Total Costs

• Total Costs: The sum of all costs a business incurs during a specific period (e.g., month)
• Total Costs = Fixed Costs + Variable Costs
• Variable costs can vary product by product

Calculating Total Costs (Example)

• Fixed costs example:
  • Insurance: 100 JDs
  • Rent: 150 JDs
  • Wages: 200 JDs
  • Utilities: 50 JDs
• Variable costs example:
  • Material: $10 per unit (e.g., raw materials)
  • Labor: $4 per unit
  • Calculate Total Variable Costs: ($10 + $4) × 500 = $7,000
  • Calculate Total Costs: $5,500 + $7,000 = $12,500

Calculating Revenues

• Revenue: the total amount of money coming into a business (cash inflows)
• Types of revenues:
  • Sales Revenue: Money from directly selling products or services
  • Interest Revenue: Money from interest rates on deposited funds
  • Rental Income: Money from renting properties or leasing resources
  • Revenue = Unit Sale Price × Number of Units sold

Calculating Profits

• Profit: Occurs when a business's revenue exceeds its expenditures.
• Expenditures: Money spent or paid by a business. Includes fixed costs (e.g., rent, salaries), variable costs and other operating expenses.
• Profit = Revenues - Expenditures
• Types of Profits:
  • Gross Profit = Total Sale Revenue - Cost of Sale
  • Net Profit = Gross Profit - all expenditures

Ways to Maximize Profits

• Reduce Costs (e.g., using less costly materials, changing suppliers, better deals, and increasing product selling prices).
• Reduce Expenditures

Break-Even Analysis

• Break-Even Point: The stage where a business neither makes a profit nor incurs a loss.
• Break-Even Point Calculation: Fixed Costs / (Selling price per unit - Variable Cost per unit).
• This is also called "Contribution Margin"

Margin of Safety

• Margin of Safety: The difference between the break-even point and the estimated or actual sales output.
• Shows how much sales can drop before the break-even point is reached.
• Importance: A larger margin of safety means a lower risk of loss

Cash Flow Forecasting

• Estimating future sales and expenses within a specific time frame
• Cash Inflow: Money a business receives (positive cash flow)
• Cash Outflow: Money a business pays out (negative cash flow)

Advantages of Cash Flow Forecasting

• Planning tool to predict the availability of funds and decide whether to produce new goods/services, expand operations or invest in resources.
• Tracks inflows and outflows, identifying times when funds might be low thus helping to plan ahead
• Identifying causes of cash flow problems enabling you to address any issues immediately

Limitations of Cash Flow Forecasting

• Predictions might not be entirely accurate
• Poor debt collection procedures can impact accuracy

Analyzing Cash Flow Forecasting

• Closing Balance: Analyze the closing balance of a cash flow forecast to understand a business's financial health. -Positive closing balance: The business has enough money to pay its bills -Large positive: The business has extra money that can be used for investments, expansion, or risk reduction. -Negative closing balance: The business may need to borrow money to cover its expenses and might be in trouble

Deficit vs Surplus

• Deficit: Outflows exceed inflows (negative closing balance). A business might need to borrow or sell assets
• Surplus: Inflows exceed outflows (positive closing balance). Indicates the business has excess cash.