MANAGING FINANCE

Managing Finance

Managing Finance

Part 1

Today's business leaders are under enormous pressure to grow revenues, increase profits and expand the value of the business. Rather than focus on profit improvement, owners and managers should focus on improving underlying business activities and processes such as sales, production and distribution. In order to determine whether a business decision will improve profitability, you first must understand how costs are defined, as well as the relationship between cost, volume, and profitability. One of the important, yet relatively simple, tools afforded by cost/volume/profit analysis is known as contribution margin analysis. Your company's contribution margin is simply the percentage of each sales dollar that remains after the variable costs are subtracted. When you know the contribution margin, you can make better decisions about whether to add or subtract a product line, about how to price the product or service, and about how to structure any sales commissions or bonuses. (Business Owner's Toolkits, 2005).

Every business needs to cover its costs in order to make a profit. Working out the costs accurately is an essential part of working out the pricing. A business incurs fixed costs and variable costs. Fixed costs are those that are always there, regardless of how much or how little you sell, for example rent, salaries and business rates. They remain constant even if the activity level changes. Fixed costs are the costs of the investment goods used by the firm, on the idea that these reflect a long-term commitment that can be recovered only by wearing them out in the production of goods and services for sale. On the other hand, variable costs are those that rise as your sales increase, such as additional raw materials, extra labour and transport. When you set a price, it must be higher than the variable cost of producing your product or service. Each sale will then make a contribution towards covering the fixed costs - and making profits. Costs are defined by behaviour.

Variable costs increase or decrease in direct proportion to changes in the level of activity, which produce the cost. Variable costs are costs that can be varied flexibly as conditions change. (Tarantino, 2002). For instance, labour costs are variable costs. There are two categories of variable costs: direct and indirect. Direct variable costs are those that can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples. Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs.

The break-even point is defined as the point where sales or revenues equal expenses. There is no profit made or loss incurred at the break-even point. This figure is important for anyone that manages a business since the break-even point is the lower limit of profit when setting prices and determining ...