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Total expenses can be grouped according to several criteria. According to their nature, total
expenses include:
• operating expenses;
• financial expenses;
• extraordinary expenses.
Operating expenses are costs associated with running the business's core operations on a daily
basis.
Financial expenses comprise the value of expenditures due to interest, fees and commissions
related to financial liabilities or to other financial operations during the reporting period.
Extraordinary expenses include expenditures that are not related to current activity (such as losses
from disasters).
Financial revenues include revenues from interests, dividends, growth of securities market value,
earnings from foreign exchange transactions.
Extraordinary revenues include revenues that are not related to current activities of the company.
Fixed costs do not vary with output, while variable costs do. Fixed costs remain constant in spite of
changes in output. Variable costs fluctuate to changes in output. Most of labour and material costs
are variable costs that increase as the volume of production increases.
Some costs are considered mixed costs. They contain elements of fixed and variable costs.
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Material costs are the costs of the raw materials used to create a product, of the utilities and the
depreciation.
Personnel expenses are the value of expenditures related to personnel, including salaries, wages,
benefits and payroll taxes (employer's funding of the social security system).
Direct costs can be accurately and directly attributed to the production of output. They can be easily
traced to a cost object (a product, a department, a project etc.). Most direct costs are variable costs.
Indirect costs are not directly related to the volume of output. They usually benefit multiple cost
objects and it is impracticable to accurately trace them to individual products, activities or
departments etc. Cost of depreciation, insurance, power is indirect costs.
The effectiveness of total expenses can be analysed with the help of the ratio total expenses-to-total
revenues:
Total Expenses
R TEx / T Re v = .
Total Re venues
A reduction of the ratio reveals a favourable situation, as the amount of money spent in order to get
a monetary unit of total revenues decreases.
Operating expenses can be grouped into four categories, corresponding to the revenues that they
generate:
− cost of goods sold;
− cost of stocked production;
− cost of capitalized production;
− cost of compensations, donations and sold assets.
The effectiveness of operating expenses is also made using the ratio operating expenses-to-
operating revenues:
Operating Expenses
R OpEx / O Re v = .
Operating Re venues
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A similar ratio can be built for analysing the effectiveness of cost of goods sold:
Cost of goods sold Σq ⋅ c
RC/S = =
Sales Σq ⋅ p
q – quantity (volume) of units sold;
p - price;
c – unit cost of goods sold.
Amortization refers to spreading an intangible asset's cost over that asset's useful life. Depreciation
refers to spreading a tangible asset's cost over that asset's life.
Both the amortization and the depreciation expenses are fixed costs. That’s why, by increasing the
volume, the cost per unit decreases.
Depreciation cost must be correlated with the output. Since depreciation cost is fixed, output
should increase at a higher rate than depreciation cost.
The effectiveness of depreciation cost can be analysed with the ratio depreciation cost-to-sales:
Depreciation cost
RD/S = .
Sales
The personnel expenses are among the most important of the operating expenses, as they usually
have a large share in the cost of goods sold.
Salary analysis can be done by decomposing them into the average number of employees and the
average annual salary:
Salary cap
Salary cap (SalCap) is the top limit on the amount of money a company can spend on salaries,
according to the dynamics of output:
SalCap = Sal0 × IOutput
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Cap space is equal to the salaries (payroll) of the current year (Sal1) minus salary cap:
Cap space = Sal1 – SalCap.
Cap space should be negative in order to get a favourable situation. This means the payroll is below
the maximum limit the company can afford to pay its employees.
It’s the cost incurred for borrowed funds (loans, bonds, lines of credit). The interest expense
depends on the level of interest rates in the economy. Interest expense will be higher during periods
of rampant inflation and lower during periods of low inflation.
The interest expense has a direct impact on profitability, especially for companies with a high debt
ratio. Heavily indebted companies may have difficulties in paying back their loans during economic
downturns. This is the reason which for managers pay a close attention to solvency ratios.
Interest expense, as absolute figure, depends on the financial liabilities and the interest rate:
Interest expenses = Financial liabilities × Interest rate .
If the financial liabilities are designated to finance the current assets, interest expense can be
analysed with the model:
Interest expenses = Current assets × R FL / CA × Interest rate =
Financial liabilities Interest rate
= Current assets × ×
Current assets Financial liabilities
The effectiveness of interest expense can be analysed using the ratio interests-to-sales:
Interest expenses Financial liabilities Interest expenses
RI/S = = × =
Sales Sales Financial liabilities
Total assets Financial liabilities Interest expenses
= × ×
Sales Total assets Financial liabilities
Marginal cost is the change in the total cost due to the increase of the quantity produced by a unit
(the cost of producing one more unit). At each level of production marginal cost includes all the
additional costs required to produce the next unit. For a specific level of production and for a time
period being considered (short time), marginal costs include all costs that vary with the level of
production.
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Marginal unit cost (MUC) can be calculated as a ratio between the change in costs (C) and the
change in quantity (Q):
∆C
MUC = .
∆Q
Marginal cost analysis allows determining the level of production for which the company has the
lowest costs. As well, the managers may decide whether to increase or not the production, by
comparing MUC with the average cost (c) and the selling price (p). The evolution of the three
indicators depending on the quantity of production (q) is shown in Figure 4.1.
c, MUC, p c
MUC
q1 q2 q3 q4 quantity
Fig. 4.1. Marginal unit cost curve
We assumed that the sale price remains constant regardless the volume of production. Hence, the
following observations can be done:
These differences are due to fixed costs, which are constant on short-term. But, while production
grows, fixed costs will occur, so MUC will increase faster than c.
If q < q1, both MUC and c decrease. For q = q1 the economic optimum level of production is
reached (MUC is minimal).
If q1 < q < q2, MUC increases, while c keeps on dropping until reaches the minimum level
for q2. This level of production is known as the technical optimum.
If q2 < q < q3, MUC is higher than c, but both are lower than p. Although unit profit falls,
total profit grows as production increases.
If q3 < q < q4, MUC is higher than p. Each additional unit produced brings losses, although c
is smaller than p.
If q > q4, c exceeds p and the activity of the company becomes unprofitable.
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