Before a business is set-up, the business will need to buy various items such as building and equipment these are called start-up costs, these costs which happens before the business can begin. These costs also occur when a business expands or decides to start a new venture.
Fixed costs are costs which usually occur when the business has begun; these costs remain the same for a period of time and do not vary on output. This means that the business needs to pay the bills whether it sold 100 units or 0 units. Fixed costs are also called indirect costs; these costs include rent and rates.
Variable costs are costs which occur once the business has been set-up. This costs varies on output and is also called direct costs, an example of this cost are the amount of hot dogs vendor requires this depends on the amount it sells.
Revenue is the amount of money received from all of the businesses activities.
The main sources of income for most businesses are its sales which include money received from its customers who buy its products or services. Business may also sell its items it no longer needs to other businesses.
Another source of income for a business is leasing which may include leasing a part of the building to another company; another is leasing equipment to other businesses.
Businesses can earn interest from the banks on an interest bearing account.
The importance of costs and revenue to profit are that costs have to be kept to a minimal and revenue high to create maximum profit.
To find out the profitability of the business you will need to calculate the total costs of the business this includes the total fixed costs and the total variable costs. Then calculate the total revenue of the business.
To find out if the business is making a loss or a profit you will need to find out the gross profit and the net profit.
The gross profit is the money left from sales income once the costs of materials are taken away.
The net profit is the gross profit minus the operating costs; the operating costs are the variable costs plus the fixed costs.
There are two ways of maximising profits, these are to increase sales or reduce operating costs.
There are a number of ways to increase sales income these include increasing prices, reduce prices to increase sales, increase advertising, sell new products to existing customers and increase scale of business.
There are a number of ways to reduce the operating costs of a business these include staff wages, property rental, cheaper suppliers and less usage.
The importance of profit to a business is to pay its owner/s wage. Profits can also be kept in the bank to use as reserves for a later time or in case of emergencies. Profits can also be used to expand the business. They can update or upgrade equipment to improve efficiency or repay any debts.
Budget
For any company to succeed, needs to have control on the income and expenditure in order to control costs. An example of this is a budget. A budget is a forecast of costs and incomes. The costs and incomes must relate to a particular purpose. Budgets may usually refer to an ongoing project, but it may equally be important when considering capital expenditure.
Individual Budgets can be based on a variety of different elements. Individual budgets are brought together into a master budget – this is the budget for the organisation as a whole.
If we look at an example of a project that did not have any budgetary controls we may see how a business can fail. A company may have a great demand for its goods and need to increase capacity. A plan to build an extension is put forward, and the plan is accepted as this is seen as affordable without the company needing to increase borrowing. The plan is approved and the project begins.
The projects hits some difficulties, but an something needs to be filled before the extension can be completed and problems with one of the suppliers means an alternative has to be found. This may be found at the same cost, but the delay adds to the costs. For the company that has not budgeted, these additional costs may be surprising, and the project will run into funding difficulties.
If the company was monitoring and controlling the budget, then the problems would be foreseen and the company may then be able to make alterative or increase the available funding.
Advantages of Budgeting
It indicates priorities. Large allocations of money can indicate the level of importance attached to a particular element of the organisation.
It provides direction guaranteeing that spending is matched to the aims of the business.
It assigns responsibility as the budget holder will be responsible for success or failure.
It should improve efficiency by comparing differences between the budget predictions and the actual achievements, problems can be identified.
Problems
Incorrect Allocation – A budget that is too generous may encourage inefficiency, with budget holders’ spending money unnecessarily, in order to obtain the same allocations in the future. An inadequate budget, where money is insufficient for essential activities, will not motivate staff and will not help the business to develop.
External factors – Changes outside the control of the organisation may affect the budget holder’s ability to keep to a plan.
Poor communication – An imposed budget may display misunderstanding of the needs of that area and be seen to be unfair, causing resentment and lower morale. A budget is that is determined solely by the manager responsible might ignore potential scope for efficiency gains and lack awareness of developments outside that are of the business.
These problems can be overcome by flexible budgeting, which allows amendments in response to changes in circumstances. However, flexible systems reduce the effectiveness of budgets as a means of control, and can lead to inefficiencies if close security is lost.
Firms can adopt zero budgeting (requires managers to justify any money allocated) in order to ensure that allocations are excessive.
Variance Analysis
A variance represents the difference between the planned standard and the actual performance.
Adverse variances – occurs when the actual performance is poor than the budgeted performance means that either the costs are higher than expected or income is lower than budgeted.
Favourable variances – exits if the variance represents a better performance than planned which means that wither lower costs than expected or higher sales revenue than anticipated.
Break-even Analysis
A break-even chart can predict whether the business is making a profit, loss or breaking even, break-even is when a business does not make a profit or a loss.
A break-even graph can be drawn to see the business profitability. This can be done by creating a graph with the y axis cost and revenue and the x axis units sold. The graph should contain a fixed cost line which is a horizontal line, total costs line which is the variable costs plus the fixed costs and a total revenue line which is the units sold times the selling price.
The break-even point in the graph is the point where the total cost line and the total revenue line intersect. This can predicted the amount of units needed to sell to break-even and the amount of sales revenue; this can also predict the profit margins.
A break-even formula can also predict the break-even point; the number of sales required to break-even can be calculated by dividing the fixed costs by the variable costs minus the selling price.
A business can check its profitable activity level by using a break-even formula as they can predicted how many units it needs to sell to break-even. It can also help owners answer key questions and help business make decisions. For example, if a business wants to expand using the break-even formula it can help the owner decide whether they can afford it and how long it will take till the business see a return in their investment.
This is an example of a break even chart and the way it should look. As you can see the lines 0A represent the variation of income of different levels of production activity. The lines OB represent the fixed costs in the business. As the output increases, the variable costs are incurred, this means that the total costs also increase.