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Costs, Profits and Break-even Analysis.

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Introduction

Costs, Profits and Break-even Analysis Alas, this means coming to terms with numbers, something that seems to frighten a large proportion of Business Studies students. Before reaching the stage of actually drawing a break-even diagram we need to think what actually goes into one. First, we need to look at costs. They can be referred to in terms of output, time or product. When we speak of costs in terms of output and time we mean FIXED and VARIABLE costs. Remember fixed costs do not vary with output, whilst variable do. The TOTAL costs of a firm are its fixed and variable costs added together. We also need to remember that we borrow something from economists when we introduce time to the calculation. By this I mean the dreaded long and short run. Remember that in the short run the scale of the operation cannot be changed and any expansion in output has to come from what spare capacity may be available. In the long run the entire scale of the operation can be altered. Quite literally the company can open a new factory to meet the increase in demand for its products. When looking at the actual product we need to remember that the costs we must now calculate are the DIRECT and INDIRECT costs. Some people prefer to call indirect costs overheads. Direct costs involve all the costs that can be directly related to the product or service. An example of this would be the materials needed to make a specific product. Indirect costs are those which cannot be directly allocated to a specific product or service. This might be the postage or telephone costs, which cannot normally be allocated to just one product or service. When we add the direct and indirect costs together we get what are known as the Total costs for the product or service. We also need to make certain that we understand what is meant by the term profit. ...read more.

Middle

It is only a Profit and Loss Account that tells us about profitability of a business. But why is this? After all, many if not most of the features are the same. They both show income, they both show expenses. So why is not the bottom line on the Profit and Loss Account the same thing as the Net Cash Flow? The answer is quite simple, the figures included in each are similar but they are not identical. The table below gives details of the main differences between the two, showing how the main differences arise, and why profit and loss accounts and cash flows are in fact quite different financial animals. Cash Flow Profit And Loss Account Sales Income from sales is entered as it is received, not before. If a credit sale is made, the income is only entered when the actual bill is paid. Sales are applied to the accounting period in which the sale occurs. So a good sold in one period on credit, is entered as a sale for that period, even though the payment may not be due until the next accounting period. Expenses Entered as paid. Provision is made in accounts for expenses incurred but not yet paid, these are known as accruals. Depreciation As depreciation is a paper accounting transaction, not involving actual expenditure, this is not shown. Depreciation is shown as a business expense. Capital Inflows If a business receives a further injection of capital that has not arisen from its trading activities then this is shown as a type of income. This account will only show an inflow of capital that has arisen as a result of trading activity. Break-Even Analysis and Contribution As we have seen the figure for cost of goods sold is taken off the sales revenue to give the level of gross profit. The cost of goods sold is made up of the direct costs of production - that is the costs that can be directly attributed to the production of that particular good. ...read more.

Conclusion

If this is taken to be the optimum level of stocks it should help to minimise the firm's costs - an important pre-requisite to maximising profit. 4. Just-in-time production Because stocks cost so much to keep, another method of stock-control was developed in Japan and has now become much more common in the UK. The just-in-time method involves keeping stocks to an absolute minimum, and the raw materials are ordered only when they are needed. In other words just-in-time. This time period in some cases has been reduced to minutes or hours, and the raw materials arrive on site moments before they are needed. This can be wonderful for helping to reduce the need for working capital, but requires a very high level of organisational skill and a very close relationship with suppliers. Purchasing The aims of the purchasing department are: * to ensure the firm has the quantity and quality of goods required for efficient production * to buy at prices as competitive as possible * to get delivery as fast as possible to ensure stocks are available as required * to build a good relationship with suppliers * to ensure suppliers are prompt and reliable There is a trade-off in purchasing. The buyer will often be able to negotiate better prices if the quantity ordered is larger, but a larger quantity of stocks may mean an opportunity cost - money tied up. There are therefore various costs from stocks. Costs Of Holding Stocks If too high a level of stocks is held, there may be various costs: 1. Storage requires space, and factory space costs money. The total can be quite substantial for bulky products. 2. Suppliers like to be paid, and so if a company is holding a high level of stocks they have to pay for them. This ties up capital which could be used for other more productive purposes. 3. There may also be costs associated with keeping the stocks well to ensure they don't deteriorate. 4. Cash flow may be damaged, because (as in no.2) money is tied up in stocks ...read more.

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