Costs

THE NEED FOR ACCURATE COST DATA

o Business costs are a key factor in the ‘profit equation’- profits or losses cannot be calculated without
accurate cost data. If businesses do not keep a record of their costs, then they will be unable to take
effective and profitable decisions, such as where to locate.
o Keeping cost records also allows comparisons to be made with past periods of time. In this way, the
efficiency of a department or the profitability of a product may be measured and assessed over time.
o Past cost data can help to set budgets for the future. These will act as targets to work towards for the
departments concerned. Actual cost levels can then be compared with budgets.
TYPES OF COSTS

o Direct costs

o These costs can be clearly identified with each unit of production and can be allocated to a cost centre

o The two most common direct costs in a manufacturing business are labour and materials

o The most important direct cost in a service business is the cost of the goods being sold

o Indirect costs

o These are costs that cannot be identified with a unit of production or allocated accurately to a
cost center (overheads)
o Indirect costs include utilities, office supplies, insurance costs, etc
o Fixed costs

o These are costs that do not vary with output in the short-term
o However, some fixed costs, such as rent, may change periodically but usually after a long
period.
o Variable costs

o These are costs that do vary with output, such as the materials used to make a product
o Semi-variable costs include both a fixed and a variable element, for example, the electricity
standing charge plus cost per unit used, and a salesperson’s fixed basic wage plus a
commission that varies with sales
o Marginal costs

These are the extra costs of producing one more unit of output and will be the extra variable
o
costs needed to make this extra unit
PROBLEMS IN CLASSIFYING COSTS

o Are labour costs necessarily variable, direct costs?

 o No, because when labour is unoccupied because of a lack of orders, most businesses will
still continue to employ and pay workers in the short run.
o Wages then become an overhead cost, which cannot be directly allocated to any particular
output.
o Similarly, a television presenter may be employed on a fixed-contract salary, which will not
be related to the amount of work done. In addition, the salaries of administration, selling
and other staff are always considered to be an indirect cost, probably fixed in the short run,
because these costs cannot be identified with any one of the firm’s products or services.
o Not all direct costs are variable costs.

For example, if a hotel buys a new juicing machine for the bar department, this is a direct
o
cost to that department – but the cost of the machine will not vary with the number of
orange juices being served.
BREAK-EVEN ANALYSIS

o The break-even output is the point where total revenues=total costs

o Break-even analysis can be undertaken in two ways: the graphical method and the equation method

o The graphical method- break-even chart

o The chart is usually drawn showing three pieces of information:
o Fixed costs, which, in the short term, will not vary with the level of output and
which must be paid whether the firm produces anything or not
o Total costs, which are the addition of fixed and variable costs; we will assume,
initially at least, that variable costs vary in direct proportion to output
o Sales revenue obtained by multiplying selling price by output level
o On a typical break-even chart:
o The fixed-cost line is horizontal, showing that fixed costs are constant at all
output levels.
o Sales revenue starts at the origin (0) because if no sales are made, there can
be no revenue.
o The variable-cost line starts from the origin (0) because if no goods are
produced, there will be no variable costs.
o The total-cost line begins at the level of fixed costs, the difference between
total and fixed costs being accounted for by variable costs.
o The point at which the total-cost and sales-revenue lines cross (BE) is the
break-even point. At production levels below the break-even point, the
business is making a loss; at production levels above the break-even point,
the business is making a profit
 o Margin of Safety

o The amount by which the sales level exceeds the break-even level of output- the difference
between actual level of output and break-even level of output
o A profitable business is one that operates with a positive margin of safety
o If a firm is producing below the break-even point, it is in danger- this is sometimes
expressed as a negative margin of safety.
The break-even equation

o Selling price – variable costs per unit = contribution per unit

o Further uses of break-even analysis

o The charts can be redrawn showing a potential new situation and this can then be compared
with the existing position of the business. Care must be taken in making these comparisons,
as forecasts and predictions are usually necessary.
o Examples:
o A marketing decision – the impact of a price increase
 o An operations management decision – the purchase of new equipment with lower
variable costs
o Choosing between two locations for a new factory.
o Usefulness of break-even analysis

o Charts are relatively easy to construct and interpret.

o Analysis provides useful guidelines to management on break-even points, safety margins
and profit/loss levels at different rates of output.
o Comparisons can be made between different options by constructing new charts to show
changed circumstances.
o The equation produces a precise break-even result.
o Break-even analysis can be used to assist managers when taking important decisions, such
as location decisions, whether to buy new equipment and which project to invest in.
o Evaluation of break-even analysis

o Limitations:
o The assumption that costs and revenues are always represented by straight lines is
unrealistic- not all variable costs change directly or ‘smoothly’ with output.
o Not all costs can be conveniently classified into fixed and variable costs- the
introduction of semi-variable costs will make the technique much more
complicated.
o There is no allowance made for inventory levels on the break-even chart. It is
assumed that all units produced are sold. This is unlikely to always be the case in
practice.
o It is also unlikely that fixed costs will remain unchanged at different output levels
up to maximum capacity.
TO HOME
TO AS LEVELS
TO BUSINESS 9609

Business Finance
WHY DO BUSINESSES NEED FINANCE TO START UP AND GROW?

o Business activity cannot take place without finance – or the means of purchasing the
materials and assets before the production of a good or service can take place.
o Finance decisions are some of the most important that managers have to take- inadequate or
inappropriate finance can lead to business failure
 o The range and choice of finance sources are extensive and skilled managers will be able to
match accurately the needs of their business for particular types of finance with the sources
available.
o Start-up capital- the capital needed by an entrepreneur to set up a business.
o Working capital- the capital needed to pay for raw materials, day-to-day running costs, and
credit offered to customers.
o In accounting terms working capital = current assets – current liabilities.
EXAMPLES OF SITUATIONS WHERE FINANCE IS REQUIRED

o Setting up a business will require cash injections from the owner/s to purchase essential
capital equipment and, possibly, premises. This is called start-up capital.
o All businesses need to finance their working capital – the day-to-day finance needed to pay
bills and expenses and to build up stocks.
o When businesses expand, further finance will be needed to increase the capital assets held
by the firm – and, often, expansion will involve higher working capital needs.
o Special situations will often lead to a need for greater finance- for example, a decline in
sales, possibly as a result of economic recession, could lead to cash needs to keep the
business stable.
CAPITAL EXPENDITURE AND REVENUE EXPENDITURE

o Capital expenditure- the purchase of assets that are expected to last for more than one year,
such as building and machinery.
o Typically, one-time large purchases of fixed assets that will be used for revenue
generation over a longer period of time.
o Revenue expenditure- spending on all costs and assets other than fixed assets and includes
wages and salaries and materials bought for stock.
Ongoing operating expenses, which are short-term expenses used to run the daily
o
business operations.
WORKING CAPITAL

o Finance is needed by every business to pay for everyday expenses, such as the payment of
wages and buying of stock.
o Without sufficient working capital a business will be illiquid – unable to pay its immediate
or short-term debts.
o In this case, the business either raises finance quickly – such as a bank loan – or it
may be forced into ‘liquidation’ by its creditors, the firms it owes money to.
o Sufficient working capital is essential to prevent a business from becoming illiquid and
unable to pay its debts.
 o Too high a level of working capital is a disadvantage- the opportunity cost of too
much capital tied up in inventories, accounts receivable and idle cash is the return
that money could earn elsewhere in the business
o The working capital requirement for any business will depend upon the length of this
‘working capital cycle’- the longer the time period from buying materials to receiving
payment from customers, the greater will be the working capital needs of the business.
o Liquidity- the ability of a firm to be able to pay its short-term debts.
o Liquidation- when a firm ceases trading, and its assets are sold for cash to pay suppliers and
other creditors.
SOURCES OF FINANCE

o Businesses are able to raise finance from a wide range of sources. It is useful to classify
these into:
o Internal- money raised from the business’s own assets or from profits left in the
business (retained earnings)
External- money raised from sources outside the business.
o
INTERNAL SOURCES OF FINANCE

o Profits retained in the business

o If a company is trading profitably, some of these profits will be taken in tax by the
government (corporation tax) and some is nearly always paid out to the owners or
shareholders (dividends)- if any profit remains, this is kept (retained) in the business
and becomes a source of finance for future activities
o A newly formed business or one trading at a loss will not have access to this source
of finance
o For other companies, retained earnings are a very significant source of funds for
expansion
o Once invested back into the business, these retained earnings will not be paid out to
shareholders, so they represent a permanent source of finance
o Sale of assets
o Established companies often find that they have assets that are no longer fully
employed- these could be sold to raise cash
o Some businesses will sell assets that they still intend to use, but which they do not
need to own- the assets might be sold to a leasing specialist and leased back by the
company; this will raise capital – but there will be an additional fixed cost in the
leasing and rental payment
o Reductions in working capital
 o When businesses increase stock levels or sell goods on credit to customers (trade
receivables), they use a source of finance
o When companies reduce these assets – by reducing their working capital – capital is
released, which acts as a source of finance for other uses
o However, there are risks in cutting down on working capital- cutting back on current
assets by selling inventories or reducing debts owed to the business may reduce the
fi rm’s liquidity to risky levels
o Evaluation:
o Internal sources of finance have no direct cost to the business, although if assets are
leased back once they are sold, there will be leasing charges
o Internal finance does not increase the liabilities or debts of the business, and there is
no risk of loss of control by the original owners as no shares are sold
o However, it is not available for all companies- newly formed businesses or
unprofitable ones with few ‘spare’ assets can’t make use of their internal sources of
finance
Solely depending on internal sources of finance for expansion can slow down
o
business growth, as the pace of development will be limited by the annual profits or
the value of assets to be sold- rapidly expanding companies are often dependent on
external sources for much of their finance
EXTERNAL SOURCES OF FINANCE

o Short-term sources- these methods are often used to obtain finance for a short period of
time, usually a few months up to a year
o Bank overdrafts
o A bank overdraft is the most flexible of all sources of finance- this means
that the amount raised can vary from day to day, depending on the particular
needs of the business
o The bank allows the business to ‘overdraw’ on its account at the bank by
writing cheques or making payments to a greater value than the balance in
the account
o This overdrawn amount should always be agreed in advance and always has
a limit beyond which the firm should not go
o Businesses may need to increase the overdraft for short periods of time if
customers do not pay as quickly as expected or if a large delivery of stocks
has to be paid for
o However, this form of finance often carries high interest charges
 o If a bank becomes concerned about the stability of one of its customers, it
can ‘call in’ the overdraft and force the firm to pay it back- this in extreme
cases, can lead to business failure.
o Trade credit
o By delaying the payment of bills for goods or services received, a business is
obtaining finance
o Its suppliers/creditors are providing goods and services without receiving
immediate payment from the business- it is comparable to ‘lending money’
o However, the downside to these periods of credit is that they are not free –
discounts for quick payment and supplier confidence are often lost if the
business takes too long to pay its suppliers
o Debt factoring
o When a business sells goods on credit, it creates trade receivables- the longer
the time allowed to pay up, the more finance the business has to find to carry
on trading
o One option, if it is commercially unwise to insist on cash payments, is to sell
these claims on trade receivables to a debt factor- in this way immediate cash
is obtained, but not for the full amount of the debt
o The debt-factoring company’s profits are made by discounting the debts and
not paying their full value- when full payment is received from the original
customer, the debt factor makes a profit
o Smaller firms who sell goods on hire purchase often sell the debt to credit-
loan firms, so that the credit agreement is never with the firm but with the
specialist provider
o Medium-term sources- these methods are often used to obtain fixed assets with a medium
lifespan of one to five years
o Hire purchase and leasing
o Hire purchase is when an asset is sold to a company that agrees to pay fixed
repayments over an agreed time period; that asset then belongs to that
company- this avoids making a large initial cash payment to buy the asset
o Leasing involves a contract with a leasing or finance company to acquire,
but not necessarily to purchase, assets over the medium term
o A periodic payment is made over the life of the agreement, but the business
does not have to purchase the asset at the end- this agreement allows the firm
to avoid cash purchase of the asset
o The risk of using unreliable or outdated equipment is reduced as the leasing
company will repair and update the asset as part of the agreement
 o Hire purchase or leasing is not a cheap option, but they do improve the short-
term cash-flow position of a company compared to outright purchase of an
asset for cash
o Medium-term bank loan
o Long-term sources of finance- these methods are used to obtain finance for a period of over
five years; there are two main choices of debt or equity finance
o Debt finance can be raised in two main ways:
o Long- term bank loan
o These may be offered at either a variable or a fixed interest rate-
fixed rates provide more certainty, but they can turn out to be
expensive if the loan is agreed at a time of high interest rates
o Companies borrowing from banks will often have to provide security
or collateral for the loan; this means the right to sell an asset is given
to the bank if the company cannot repay the debt
o Businesses with few assets to act as security may find it difficult to
obtain loans – or may be asked to pay higher rates of interest
o In the UK, a small business can apply to the Department of Trade and
Industry for the loan to be part of the ‘guaranteed loan scheme’-
banks will be more willing to lend if a company has been successful
in this application because it gives the bank security of repayment
o Merchant banks- these are specialist lending institutions that provide
advice as well as finance to firms engaging in expansion or
merger/takeover plans
o Debentures/long-term bonds
o Debenture- bonds issued by companies to raise debt finance, often
with a fixed rate of interest
o A company wishing to raise funds will issue or sell such bonds to
interested investors- the company agrees to pay a fixed rate of
interest each year for the life of the bond, which can be up to 25 years
o The buyers may resell to other investors if they do not wish to wait
until maturity before getting their original investment back
o Long-term loans or debentures are usually not secured on a particular
asset- when they are secured, the investors have the right if the
company ceases trading, to sell that particular asset to gain
repayment, then the debentures are known as mortgage debentures
o Debentures can be a very important source of long-term finance
 o Convertible debentures can (if the borrower requests it) be converted
into shares after a certain period of time, and this means that the
company issuing them will never have to pay the debenture back
o Equity finance
o Equity finance is permanent finance raised by companies through the sale of
shares
o All limited companies issue shares when they are first formed- the capital
raised will be used to purchase essential assets
o Both private and public limited companies are able to sell further shares – up
to the limit of their authorised share capital – in order to raise additional
permanent finance
o This capital never has to be repaid unless the company is completely wound
up as a result of ceasing to trade
o Private limited companies can sell further shares to existing shareholders-
this has the advantage of not changing the control or ownership of the
company – as long as all shareholders buy shares in the same proportion to
those already owned
o Owners of a private limited company can also decide to ‘go public’ and
obtain the necessary authority to sell shares to the wider public- this would
obviously have the potential to raise much more capital than from just the
existing shareholders; however, it comes with the risk of some loss of
control to the new shareholders
o In the UK, this can be done in two ways and these are quite typical for many
countries:
o Obtain a listing on the Alternative Investment Market (AIM), which
is that part of the Stock Exchange concerned with smaller companies
that want to raise only limited amounts of additional capital. The
strict requirements for a full Stock Exchange listing are relaxed.
o Apply for a full listing on the Stock Exchange by satisfying the
criteria of selling at least £50,000 worth of shares and having a
satisfactory trading record to give investors some confidence in the
security of their investment. This sale of shares can be undertaken in
two main ways:
o Public issue by prospectus- this advertises the company and
its share sale to the public and invites them to apply for the
new shares
o Arranging a placing of shares with institutional investors
without the expense of a full public issue- rights issue of
shares
 o Evaluations: some businesses normally use both debt and equity finance for very
large projects
o Advantages of debt finance:
o As no shares are sold, the ownership of the company does not change
or is not ‘diluted’ by the issue of additional shares
o Loans will be repaid eventually (apart from convertible debentures),
so there is no permanent increase in the liabilities of the business
o Advantages of equity finance:
o It never has to be repaid; it is permanent capital
o Dividends do not have to be paid every year; in contrast, interest on
loans must be paid when demanded by the lender
o Other sources of long-term finance
o Grants
o There are many agencies that are prepared, under certain
circumstances, to grant funds to businesses- the two major sources in
most European countries are the central government and the
European Union
o Usually grants from these two bodies are given to small businesses or
those expanding in developing regions of the country
o Grants are available to small and newly formed businesses as part of
most governments’ assistance to small businesses
o Grants often come with conditions attached, such as location and the
number of jobs to be created, but if these conditions are met, grants
do not have to be repaid
o Venture capital
o Venture capital is risk capital invested in business start-ups or
expanding small businesses that have good profit potential but do not
find it easy to gain finance from other sources
o Venture capitalists take great risks and could lose all of their money –
but the rewards can be great
Venture capitalists generally expect a share of the future profits or a
o
sizeable stake in the business in return for their investment
FINANCE FOR UNICORPORATED BUSINESSES

o Unincorporated businesses – sole traders and partnerships – cannot raise finance from the
sale of shares and are most unlikely to be successful in selling debentures as they are likely
to be relatively unknown firms
 o Owners of these businesses will have access to bank overdrafts, loans, and credit from
suppliers. They may borrow from family and friends, use the savings and profits made by
the owners and, if a sole trader wishes to do this, take on partners to inject further capital
o Lenders are often reluctant to lend to smaller businesses, which is what sole traders and
partnerships tend to be, unless the owners give personal guarantees, supported by their own
assets, should the business fail
MICROFINANCE

o Microfinance involves providing financial services for poor and low-income customers who
do not have access to banking services, such as loans and overdrafts offered by traditional
commercial banks
o Example- Muhammad Yunus founded Grameen Bank to make very small loans to poor
people with no bank accounts and no chance of obtaining finance through traditional means
o Many business entrepreneurs in Bangladesh and other Asian countries have received
microfinance to help start their business.
o In some of these countries, more than 75% of successful applicants for microfinance are
women. Women have, in some traditional societies, always found it very difficult to obtain
loans or banking services from traditional banks
o There is evidence that entrepreneurship is greater in regions with microfinance schemes in
operation – and that average incomes are rising because of more successful businesses
o However, interest rates can be quite high as the administration costs of many very small
loans is considerable
o Some economists also suggest that if a small business start-up financed by microfinance
fails, then the scheme has encouraged very poor people to take on debts that they cannot
repay
CROWDFUNDING

o Crowdfunding is the use of small amounts of capital from a large number of individuals to
finance a new business venture
o Crowd funding websites allow an individual to promote their new business idea to many
people who may be willing to each invest a small sum- for example, around $10
o There are many established websites such as Kickstarter and Crowdcube that allow
entrepreneurs to publicise their new ideas
o Through these websites, the entrepreneur will explain what the business is about, what its
objectives are and why finance is needed
o Investors can commit small sums of money to the new venture until the ‘target sum’ is
reached
o The publicity generated can also be an effective form of promotion for the new business
and its product
 o If business ventures turn out to be successful, the crowd funding investors will receive
either their initial capital back plus interest – this is sometimes known as peer-to-peer
lending, or an equity stake in the business and a share in profits
o However, entrepreneurs using crowdfunding must keep accurate records of thousands of
investors to either pay back interest and capital or a share of the profits; and another risk is
that exposing a new project idea on the Internet means that it could be copied by others
before the entrepreneur has had a chance to start the business up
FACTORS INFLUENCING THE CHOICE OF SOURCES OF FINANCE

o Cost
o Obtaining finance is never free – even internal finance may have an opportunity
cost.
o Loans may become very expensive during a period of rising interest rates
o A Stock Exchange flotation can cost millions of dollars in fees and promotion of the
share sale
o Flexibility
o When a firm has a variable need for finance – for example, it has a seasonal pattern
of sales and cash receipts – a flexible form of finance is better than a long-term and
inflexible source
o Legal structure and need to retain control
o Share issues can only be used by limited companies – and only public limited
companies can sell shares directly to the public. Doing this runs the risk of the
current owners losing some control – except if a rights issue is used
o If the owners want to retain control of the business at all costs, then a sale of shares
might be unwise.
o What the finance is required for
o It is very risky to borrow long-term finance to pay for short-term needs- businesses
should match the sources of finance to the need for it
o Permanent capital may be needed for long-term business expansion
o Short-term finance would be advisable to finance a short-term need such as to
increase stocks or pay creditors
o Amount required
o Share issues and sales of debentures, because of the administration and other costs
would generally be used only for large capital sums
o Small bank loans or reducing trade receivables’ payment period could be used to
raise small sums
o Level of existing debt
 o The higher the existing debts of a business (compared with its size), the greater the
risk of lending more- banks and other lenders will become more cautious about
lending more finance
TO HOME
TO AS LEVELS
TO BUSINESS 9609