Workbook 2 Overheads

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2 Contents Highlights... 2 Quick Practice Session on Overheads... 2 Financial Quiz 2 - Overheads... 3 Learning Zone Overheads... 3 Fixed and Variable costs and Break-even analysis explained... 3 Fixed Costs... 4 Variable Costs... 4 Break-even point... 5 Talk the talk... 6 Reflection and Discussion Zone Overheads... 6 Progress test Overheads

3 Highlights 1. Learn the common overhead expense items 2. Explore the concept of Fixed and Variable costs and why the distinction is so important. 3. Calculate the break-even sales value 4. Learn what the terms accruals and prepayments mean 5. Learn about Indirect costs Quick Practice Session on Overheads Open the file saved in Buying and Selling and add the Overheads information Switch the to display the information icons Your goal is to make sure that you can understand and answer all the questions posed in Financial Quiz 2 - Overheads. Tip SAVE the file once you have added the overheads information to LOAD it again when commencing module three Overheads. Restore the original values after each question in Financial Quiz 2 Overheads 2

4 Financial Quiz 2 - Overheads # Question Your answer Correct answer If all overhead expenses were fixed (i.e. variable were zero percent) and amounted to what would the Net Profit be if Billy sold an additional 50 units for cash? In the original business model (with both fixed and variable overheads) what would the Net profit have been had Billy sold the extra 50 units for cash? What is Billy's break-even volume of sales (rounded down to the nearest unit? What is Billy's marginal cost per unit? What would the value of "Accruals" be if Billy paid only 86% of his overheads within the year? If Billy entered 110 in the "Overheads paid" box what value would appear in "Prepayments" in the Balance Sheet? Learning Zone Overheads 0verheads are indirect expenses incurred in order to administer and manage the business. Common overheads are: Salaries Rent Internet and telephone Travelling expenses Accountancy fees Light heat and power Advertising For simplicity and to keep our focus on the big picture FaBLinker combines all overheads into two generic categories - fixed and variable. Fixed and Variable costs and Break-even analysis explained When looking at the past, all costs are set done and dusted! But when forecasting, we have to be aware that not all costs respond in the same way to changes in sales volume. 3

5 A typical business will have a block of fixed costs before it even starts to sell its products or services. Then, as soon as sales begin, it incurs the variable costs as well. Identifying these Fixed and Variable costs is crucial in business, because failure to distinguish between them when budgeting and forecasting may lead to wildly inaccurate projections. They also determine an important watershed in business - the break-even point. Fixed Costs Fixed Costs are items such as Salaries and Rent which don't automatically change as volume increases. Obviously they will have to change sooner or later if the business expands to the stage where larger premises and more staff are needed. Their point is that their response to increases in volume is erratic and follows a stepped pattern such as the one illustrated below. Costs Sales Variable Costs Are costs and expenses such as Materials and Sales Commissions which will change in direct proportion to sales, as the linear pattern below illustrates. Costs Sales 4

6 Break-even point A company buys tables for 50 and sells them for 100 each. The company has fixed costs of 200,000. It will break even at 400,000 as follows: Selling Price 100 Purchase Price 50 Contribution 50 The contribution of 50 goes into the fixed costs 4000 times. Therefore our break-even units are 4,000 and our break-even sales are 400,000. The break-even point occurs when Sales finally catch up with the total costs as shown graphically below (at 400k and after 6 months). Sales Total cost 400k Variable costs 200k Fixed costs 3m 6m 9m 12m Most real business situations are, of course, more complex than our simple example. Costs don t always fit neatly into our fixed and variable categories as many expense items e.g. electricity, gas and telephones have a fixed tariff and a variable usage element. Common sense is the key when using the technique as it is a forecasting not a recording tool. Break-even analysis shows the level of sales needed for a viable business. The easier a company can reach (and sustain) its break-even point, the lower the risk to the promoters and investors. 5

7 Talk the talk Look up the following terms in the Glossary Accruals Break-even Fixed Costs Indirect expenses Marginal Cost Overheads Prepayments Revenue expenditure Variable Costs And any other item you see in Billy s business but don t understand Reflection and Discussion Zone Overheads Prompt Key learning points What did you learn about Overheads from the video? That they are expenses such as rent, insurances audit fees and so on. What are fixed and variable costs? Why is the distinction so important in planning and forecasting models? What sales would the business in our model need to do to break even i.e. deliver zero net profit. What would happen if you only paid 90% of the overheads? Or if you paid 110% of the overhead figure? What does the term Revenue expenditure mean? Why are overheads referred to as Indirect expenses Variable costs are directly To make sure that when variations in sales are explored the variable costs adjust automatically. Failing to distinguish between them would deliver misleading results. 685 is the nearest number (it yields a 30 loss) 686 would give a profit of 32 This would be shown in current liabilities as an accrual. Check the Glossary to get more information on the term accrual. Prepayment i.e. a payment in advance. This would be shown in Current assets. Check the Glossary for more information. Day to day expenditure which will appear in the Profit and Loss Account. Check the Glossary. Because they are not easy to link directly as a cost of the products or services sold. Check the glossary 6

8 Progress test Overheads Question 1: Name X in the equation "Gross Profit minus X equals Net Profit" a) Overheads b) Cost of sales c) Purchases d) Costs Question 2: Which one of the following is a revenue expense? a) The cost of acquiring a new delivery vehicle b) The cost of insuring the new vehicle c) The cost of paying a dividend to shareholders d) The regular repayments of a bank loan Question 3: Which of the following best defines "Revenue expenditure"? a) Tax payments b) Repetitive expenditure on items such as wages, goods for resale and overheads c) Expenditure that can be directly linked to sales revenue d) Large scale expenditure on fixed assets such as vehicles Question 4: Which of the following best defines a "Fixed cost"? a) A cost that never changes b) A cost that does not change in direct proportion to sales c) A cost which in aggregate changes in direct response to changes in sales volume d) A cost relating to the acquisition and maintenance of fixed assets Question 5: Which one of the following best defines an "Indirect cost"? a) A cost that cannot be directly linked to sales e.g. audit fees b) A cost which we can offset against a supplier's invoice c) A cost that changes in direct proportion to changes in sales revenue d) An unusual cost such as a parking fine incurred by an employee Question 6: Which one of the following best defines a "Variable cost"? a) A cost which changes every day b) A cost that does not change in response to sales increases c) A cost which in aggregate changes in direct proportion to changes in sales revenues d) A cost related to maintaining fixed assets 7

9 Question 7: Which one of the following best describes the meaning of "Accrual"? a) The money owed to people who have supplied good for resale b) Continually reoccurring liabilities outstanding at the end of the year c) Money owed to creditors carried forward from a previous period d) A cost related to repairs to an asset Question 8: Which of the following best defines the term "Break-even"? a) The point at which the assets and liabilities of a business are exactly even b) When sales revenues exactly match all revenue expenses c) When the cash balance in the company accounts is zero d) When cash inflows and outflows for a period are of equal value Question 9: Which of the following best defines "Marginal cost"? a) The cost of borrowing small amounts of money b) Small immaterial expenses often grouped under terms such as "Miscellaneous" c) A cost such as depreciation which does not have a cash flow impact d) The additional cost associated with selling one additional unit Question 10: Which one of the following best defines the term "Overheads"? a) All revenue expenses needed to operate and manage a business but excluding "cost of goods sold" b) A provision to replace a fixed asset c) The cost of servicing loans d) All costs associated with the business 8