Finance explained to my mother-in-law. Chapter VI – Expenses

In this chapter you will get acquainted with 7 categories:

  1. Variable Costs
  2. Fixed Costs
  3. Operational Lever
  4. Neutral
  5. Stored costs
  6. Capitalized costs
  7. Monetary and non-monetary costs

1. Variable Costs

Variable costs are costs that vary with the level of production:

Example from Chapter IV

Usual variable costs are (non exhaustive):

  • Raw materials
  • Purchase / Resale
  • Transport
  • Energies
  • MOD
  • Subcontracting
  • Rental of production equipment

2. Fixed Costs

Fixed costs are those costs that do not vary with the change in production:

Example from Chapter IV

Usual fixed costs are (non exhaustive):

  • Personnel
  • Rents
  • Miscellaneous contracts (cleaning, maintenance, etc.)
  • Taxes
  • Warehousing
  • Mission Expenses
  • Insurance
  • Mandatory audits
  • Depreciation

3. Operational Levrage

Operating leverage corresponds to the variation in the company’s earnings as a function of a fluctuation in its turnover.

It is calculated as the ratio between the % Variable Cost Margin (Contribution Margin) and the Net Profitability (ROS = Return on Sales = Net Income / Sales).

O.L. = Contribution Margin Ratio / ROS

An operating leverage of 3 means that if sales fall by -1%, net income will fall by -3% (= -1% x 3).

EXAMPLE

O.L. = 36% / 0.5%= 72

In our example, if we increase the turnover by 1% (+1€), the impact on the result will be as follows:

(+1€ X 36%) = +0,36€

But €0.36 / €0.5 = 72%, an improvement of 72% in net income.

L.O. = Variation % of Net Income / Variation % of turnover

The lower the share of variable costs in total business costs, the higher the operating leverage, the higher the share of variable costs in total business costs the lower the operating leverage.

For variable costs which tend to zero, each additional euro of turnover will be (almost) one euro more in earnings. If, on the contrary, variable costs represent a large part of the turnover, each additional euro of turnover will leave very little of it in the result.

 CASE ACASE B
SALES100100
VARIABLE COSTS9010
FIXED COSTS1090
NET RESULT
SALES VARIATION+1+1
NET RESULT VARIATION+0,1+0,9
OPERATING LEVERAGE19

4. Break-even point

The break-even point is the level of activity, i.e. turnover, for which all revenues cover all expenses. At this level of activity, the result is therefore zero.

Break-even point = Fixed Costs / Contribution Margin Ratio

CASE OF EXAMPLE CHAPTER IV:

35.5M€ / 36% = 98.6M€.

When the blue line of sales (98,6M€) crosses the brown – total costs line that’s the breakeven point. Above it there are earnings, below it losses

OTHER SCENARIOS:

  • For 36M€ Fixed Costs / and 30% Contribution Margin = breakeven point is 120M€
  • 20M€ / 50% = 40M€
  • 36M€ / 10% = 360M€

5. Stored costs

The costs of products that are managed in the warehouse and the costs incurred in the production of multiyear orders are not included in the income statement. They are managed on the balance sheet (in “inventory”) to have an impact on the income statement only at the time of physical use in the first case, and at the time of production or final disposal in the second.

This means that if I buy 250 tons of Raw Materials with a unit value of €1,000 from supplier X in the month but do not use any of them in production in the same month, the negative impact of the purchase value in the income statement for €250,000 is balanced by the positive impact of inventory increase for the same amount.

If the following month I use 10 tons for production, the result impact will be negative for €10,000 (negative inventory change).

6. Capitalized costs

All assets that have an economic usefulness (ability to generate cash flow) beyond one year and a value of more than € 500, are potentially fixed assets. The cost of a fixed asset does not affect the income statement at the time of expenditure, but throughout the useful life of the asset.

If I buy production equipment for €4M, the impact on the income statement will not be €4M in the same year but €200K for 20 years. (Assuming a life of 20 years).
The value of the asset (4M€) will be recorded in the balance sheet.

Principle of decomposition: any machine can be broken down into elements with different life spans:

  • Chassis
  • Mechanics
  • Robotics
  • Connectics
  • and so on

When the machine is linked to a specific project, the amortization period is the life of the project.

Usual amortization periods:

  • buildings 30 years
  • fittings and furnishings 10 years
  • industrial equipment 5 – 15 years
  • furniture and equipment 5 years
  • transport equipment 5 years
  • office furniture 10 years
  • computer equipment 3 – 4 years

NBV = Net Book Value = Purchase Value – Accumulated Depreciation

EXAMPLE

Purchase value of a production equipment = 5M€.

Life span 5 years

NBV N+1 = 4M€; N+2 = 3M€; N+3 = 2M€; N+4 = 1M€.

IMPAIRMENT

Impairment is the accounting practice of “testing” the NBV of an asset against its ability to generate cash flows.

In the previous example, if at N+3, while the machine’s NBV is still 2M€, the customer announces that he is no longer interested in buying the product to which the machine is dedicated, an exceptional depreciation of 2M€ in N+3 that reduces the value of the asset to 0 will be necessary.

In accounting terms, a negative impact of 2M€ will occur on the result of N+3, instead of having one of 1M€ in N+3 and one of 1M€ in N+4.

Financially, on the other hand, the company will suffer a loss of €2M.

7. Monetary and non-monetary expenses

Monetary expenses are those expenses that need to be paid:

  • Supplier invoices
  • Expense reports
  • Salaries
  • PES Allowances
  • Investments

Non monetary expenses are those expenses that do not need to be paid:

  • Depreciation/ Amortization
  • Provision