DECA ENTREPRENEURSHIP Financial Analysis KPI's
KPI: Explain the concept of accounting.
Accounting is the language of business; it provides information to managers, owners, investors, government agencies, and others inside and outside the organization. Accounting defined is a system that measures the business's activities in financial terms, provides written reports and financial statements about those activities, and communicates these reports to decision makers and others. The accounting process performs the following functions: Analyzing: reviewing what occurred and how the business was affected. Recording: putting the information into the accounting system. Classifying: grouping all the same activities (e.g., all purchases) together. Summarizing: totaling the results. Reporting: issuing the statements to tell the results of the previous functions. Interpreting: examine the statements to determine correlation. Communication: providing reports and financial statements as needed and required.
KPI: Forecast sales.
An essential tool businesses use to avoid unforeseen cash flow problems, manage their production, staff and finances is a Sales Forecast. It can be the month-to-month projections of the level of sales the company expects to achieve and should be prepared at the beginning of the business' year. Using past figures to predict short or long term performance is a tricky business. Many factors can affect the sales forecast and future sales, such as, economic downturns, employee turnover, changing trends and fashions, increased competition, manufacturer recalls and other factors. Accurately prepared sales forecasts enable managers to be more effective. Last year's sales is the best place to begin this year's forecast. A few considerations each manager should reflect on when preparing the department's sales forecast for an existing business are: How many new customers do you gain each year? How many customers do you lose each year? What is the average level of sales you make to each customer? New businesses do not have the advantage of knowing what last year's sales were. They have to estimate what they anticipate the company can make based on market research and good judgement. Create the sales forecast by doing the following Break down sales by product, market or geographic region. If possible add individual or types of customers to the sales forecast. Estimate the conversion rate (the percentage chance of the sale happening) for each item on the sales forecast The company should specify the volume of sales in the forecast for the products they sale. For example, how many quarts of paint can be sold in one month. By knowing the volume, the business can best plan for the necessary resources in areas such as production, storage and transport. A completed sales forecast isn't just used to plan and monitor the company or department's sales efforts; It's a vital part of the cash flow.
KPI: Explain sources of financial assistance.
Any business owner would say that finances are the lifeblood of their company and knowing the necessary sources for financial assistance is imperative. With this realization, companies pursue a wide variety of strategies from government grants to investment funds to special tax breaks in order to raise the needed capital to stay in business. Even though these sources are available, the majority of businesses choose to finance their operations and new ideas through two sources: debt and equity. DebtNew business' primary source of financial assistance is through bank loans. Reports indicate that 40% of new business financing is through bank financed debt. EquityThough equity is rarer than debt as a source of financial assistance. it can have more impact. Angel investors and venture capitalists are the main source of equity financing. Reports indicate that this type of source finances less than 3% of 1% of new businesses. Additional resources a company might consider a source of financial assistance are listed below: Loan stock Retained earnings Government sources (Small Business Loans or Grants) Business expansion scheme funds Franchising
KPI: Explain the nature of balance sheets. KPI: Describe the nature of income statements. KPI: Prepare cash flow statements.
Balance SheetA financial statement that summarizes the company's assets, liabilities, and owner's equity at a specific point in time. The balance sheet is based on the following equation: Assets = Liabilities + Owner's Equity. Assets are cash or property owned by a company or individual regarded as having value.Current assets; cash or other holdings which are liquidFixed assets; not liquid e.g. property, buildings, furniture, etc. Liabilities are a company's financial debt or obligations that arise during the course of its business operations.Short-term liabilities; due within one year, e.g. accounts payable and taxesLong-term liabilities; due after one year, e.g. can include long term bank loans or notes payable to stockholders Owner's equity is the owner's investment in the company minus any withdrawals plus the business net income. Income or Profit and Loss Statement Reports a company's financial performance over a specific period of time. The period may be as short as a month or as long as one year. The income statement provides information concerning the company's ability - or lack thereof - to generate profit by increasing revenue, reducing costs, or both. Important aspect of the statement is the calculation of net profit .While gross profit equals the Total Sales - Cost of Goods Sold (COGS), net profit calculates the company's total sales minus its total expenses (not just the COGS).Net Profit Equation: Gross Profit - Total Operating Expenses = Net Profit/Loss Cash Flow StatementThis financial statement provides data regarding all cash inflow a company receives as well as all cash outflow for a given period, typically a quarter. Cash flow may be from one of three general sources: Operations, Investing, and Financing Examples of cash inflow sources: cash sales, accounts receivable, loans, investments, etc. Examples of cash outflow sources: equipment purchases, expenses paid, inventory costs, payroll, etc. The balance sheet, income statement, and cash flow statement are all interrelated. On their own, each statement provides a glimpse of the company's financial condition; but together, they provide a more complete picture. Staying consistent and diligent with maintaining financial statements results in long-term benefits for the business.
KPI: Develop company's/department's budget.
Budgets help the business manage costs, determine whether profit goals are within reach, and if the business is on the right track from month-to-month. In its simplest form, a budget is an estimate of costs, revenues, and resources over a specified period for the operation of a business or a specified project. Typically a budget is prepared every year; however, the budget should be revisited and updated each month. According to the U.S. Small Business Administration, a budget can be used to indicate one or more of the following: The funds needed for materials and/or labor Total start-up costs (for a new business) Cost of operations The revenues needed to support the business A realistic estimate of expected profits The most basic components of a budget are as follows: Sales and Other Revenues Total Costs and ExpensesFixed CostsVariable CostsSemi-variable Costs Profits Sales - Total Costs = Profit Planning and maintaining a budget can be difficult, but is necessary if the the entrepreneur wants to stay on top of business finances. Maintaining the budget, however, is key. Business is never static and the budget shouldn't be either! Unexpected events, supply chain issues, and more, can disrupt a budget. A dynamic budget should be developed and managed throughout the year. Below are tips for doing so: Update the budget monthly - The budget should be revisited monthly in order to be update based on the past month's business performance and expenses. Also research the sales forecast - do any changes need to be made? Have expenses been incurred as projected? Ask these questions each month. Make changes expected to have a positive impact - As changes are made, wait to see what impact the change has on the budget, specifically dealing with income and profits. This may take longer than one month to track, but it's important to track the impact each change has. Respond to unexpected changes as soon as possible - The budget should be used to adjust to the unexpected! For example, continued bad weather may lower demand, which will affect sales projections. Or, maybe a supplier unexpectedly raises their prices, the budget will need to be adjusted (and the business may consider selecting a different vendor, depending on the circumstances).
KPI: Explain the purposes and importance of obtaining business credit.
Business credit is important as it is the lifeline for any business and enables the company to obtain capital needed to expand, cover day to day expenses, purchase inventory, hire staff and conserve the company's cash on hand for the business owner to cover its cost of doing business. Businesses who build a strong business credit create a safety net which can help them obtain needed funding at different times during the company's life. Banks, lenders and suppliers rely on business credit reports to assess the creditworthiness of a company and whether they can trust the way the company manages its finances. A good gauge for any business' financial reputation is its business credit report. Listed below are several purposes of business credit for the business owner: It can improve the company's credit capacity. The Small Business Association (SBA) states, "businesses have 10 to 100 times greater credit capacity compared to personal credit." It can increase the value of the company. The credit score of the business is fully transferable. It protects the owner's personal credit.
KPI: Determine financing needed for business operations.
Business operations require funding, it's as simple as that. Business finance is the tool which allows a company to understand and manage financing options for the company's operations. The most frequent thought concerning financing is what is needed for the business start-up needs, but the company will face other financial decisions concerning business operations as long as it doors are open. As far as start-up funds are concerned, it's essential for the owner to obtain as much funding is possible without borrowing as it is discouraged to start the business in debt. Also asking for funding for investors, at the beginning, is discouraged due to the fact that the owner may have to give the investor partial control for the investment and that could slow the growth of the company. Lines of credit become essential as the company progresses and moves towards making a profit and in order to stay operational. Lines of credit are a source of funding which can be persistent, are available when needed, and normally are available at a good rate of interest that most businesses can afford. As the company grows and becomes successful, the time will come when the owner will have to consider launching new products or expand the current operations, which will require funding. Another option for funding besides the line of credit financing option and investors is the company's vendors. Vendors have a vested interest in the company and may be interested in being a source of revenue for the company's future growth.
KPI: Explain loan evaluation criteria used by lending institutions.
Creditworthiness Creditworthiness is defined as the individual's (or business's) current and future ability, and inclination to honor agreed upon debt obligation. Credit records include all information regarding information of how an individual has handled credit, and will be related to past and current debts and financials. Banks, credit card companies, and other lenders use credit reports as well as credit scores to evaluate the risk of lending money to a potential borrower. Credit Scores and RatingsAgain, the creditworthiness of an individual or business is determined by whether or not they will fulfill their promises to repay their debts. Lenders validate the business' creditworthiness by checking into their credit scores. A FICO Credit Score is credit scoring created by the Fair Isaac Corporation. FICO credit scoring is the most trusted method in the industry and is used by all three major credit reporting companies (Equifax, Experian and TransUnion), as well as 90% of lenders. Average personal FICO scores range from a value of 300 - 850. The higher the score, the less 'risky' the borrower. Although many lenders use a FICO credit score as a way to assess borrowers, there is no single "cutoff" score lenders use, as many have their own strategy of assessing borrowers and making lending decisions. A higher credit score indicates a higher level of creditworthiness and can lower the cost of credit for a borrower. The higher credit score will also lessen the risk for the lender. Unlike the personal credit spectrum, business FICO credit scores are much smaller, typically ranging from 0 to 100; scores at 45 and above are considered low- to medium-risk for businesses. Credit ReportsEquifax, Experian, and TransUnion are the three major credit reporting agencies. Government regulators amended the Fair Credit Reporting Act to permit consumers the ability to request a free copy of their credit report on a 12 month basis from one of the reporting agencies. This allows consumers to access three reports a year, at no cost. Regularly checking credit reports protects the consumer from fraud and empowers them to stay informed concerning their creditworthiness. The 5 C's of Credit Character/Credit History: Refers to a borrower's reputation and their record of debt repayment. Creditors find this information located on the borrower's credit reports from the four major credit bureaus; Dun and Bradstreet, Experian, Equifax and Transunion. Capacity: Measures the borrower's ability to repay by comparing the business' income against recurring debt and evaluating the borrower's debt-to-income (DTI) ratio. Also reviewed is how long the company has had its doors open for business. Capital: Refers to the amount of money the borrower is willing to put down for the potential investment. The larger the borrower's contribution the lender figures the less chance there will be for the borrower to default on the loan. Collateral: The property or other assets the borrower offers to lenders to obtain a loan with the understanding the lender will receive the collateral if the borrower defaults on the loan. Conditions: The information concerning the loan such as, the interest rate, principal amount, lender's decision to finance and the borrower's intention of how the funding will be utilized in the business venture; start-up, expansion or new product idea.
KPI: Calculate financial ratios.
CURRENT RATIOA current ratio allows the company to assess their ability to meet their financial obligations. Calculation: current assets / by current liabilities = current ratio. Assets and liabilities are "current" if they are receivable or payable within one year. A current ratio of two or higher indicates the company's current assets can likely cover their current liabilities as they come due. QUICK RATIOQuick ratios exclude any possible shares the company may have issued from the current assets and provides a more rigid view of the company's to meet short-term financial obligations. A ratio of one or higher is considered financially healthy. Calculation: current assets - the value of outstanding shares = X / by current liabilities = quick ratio. RETURN ON ASSETS (ROA)A business uses ROA to determine how much profit is being generated for each dollar the company has in assets. The higher the ratio, the more efficiently the company is generating profits from its resources. Calculation: net profit / net assets X 100 = ROA. ASSET TURNOVERAlso known as sales-to-asset (STA) ratio, this calculation refers to how efficiently the company is converting its assets into sales. The higher the ratio the better; a reading of one or higher indicates the company is generating more than $1 in sales for each $1 in assets. Calculation: company sales / total assets = STA. RETURN ON EQUITY (ROE)ROE ratio indicates how well the company is utilizing the shareholder's equity to generate profits. This ratio is tracked over time (computing the figure quarterly or yearly) to see if return on equity is increasing or decreasing. An increasing ROE is preferable as it shows the company is more efficiently using shareholder's equity to produce profits. Business owners typically want to maximize ROE to sustain or attract investors. Calculation: net income / shareholders equity = ROE. RETURN ON INVESTMENT (ROI)Return on investment or ROI is a profitability ratio that calculates the profits of an investment as a percentage of the original cost. In other words, it measures how much money was made on the investment as a percentage of the purchase price. The ROI calculation is one of the most common investment ratios because it's simple and extremely versatile. Managers can use it to compare performance rates on capital equipment purchases while investors can calculate what stock purchases performed better. Calculation: The return on investment formula is calculated by subtracting the cost from the total income and dividing it by the total cost. It is important for the business to understand that financial ratios are time sensitive; they can only present a picture of the business at the time that the ratios were prepared. For example, a retailer calculating ratios before and after the Christmas season would get very different results. In addition, calculations can be misleading when taken singly, though can be quite valuable when a business tracks them over time or uses them as a basis for comparison against company goals or industry standards.
KPI: Analyze critical banking relationships.
Choosing the right business banker can be one of the best decisions the business owner can make. Relationships between bankers and business owners are critical due to the banker's role in assisting the business when funds are needed to achieve company goals. Bankers have different roles such as assisting customers in obtaining financing, setting up company banking accounts, helping companies reach their growth goals and working as an advocate for their clients. Valuable bankers are familiar with the local economy, business environment and also with local, regional and national business. This knowledge gives them an insight which they can share with the owner to help solve business challenges and possibly prevent future problems through solid advice. The majority of bankers focus on helping their clients succeed and will go beyond their normal responsibilities, because when the company is successful, so is the bank! The business owner and the banker should work to cultivate their relationship. Open communication on both parts is essential. Communication helps the banker understand the company's needs and helps the owner to be open about the company's challenges and goals. Although bankers work to help establish the simple banking needs of the business, they must also take the time to nurture it. Bankers should strive to maximize the owner/banker relationship by investing in the business relationship, the personal relationship and the wealth management relationship.
KPI: Interpret financial statements.
Financial statements of a company, the balance statement, income statement and cash flow statement, are all interrelated. Individually, each statement provides a glimpse of the company's financial condition; but together, they provide a more complete picture. Staying consistent and diligent with maintaining financial statements results in long-term benefits for the business. Tracking day-to-day financial operations and compiling the information into data is critical for all businesses. The data collected yields invaluable financial information.This information may help a business answer the following questions: 1) Are products priced correctly?, 2) Can the business expand?, and 3) Does the business need to cut back or what is required for sustainability? Lenders and investors rely on the collected data from all sources of information to decide if the business is solid enough for investment. Businesses with correct, up-to-date data have an enhanced chance of receiving that needed loan or investment. In order to utilize this business transaction data, it must be analyzed.
KPI: File business tax returns.
How or where a business files their tax returns depends on the business type. Each type of entity requires a different tax form on which to report the business' income and expenses. Following are the steps which can be used to file business tax returns. Step 1—Collect the businesses financial records for the year for which they are reporting. Businesses which use a computer program or a spreadsheet to organize and keep track of all transactions during the year will discover it's much easier to compile the necessary calculations for filing. Step 2—Determine which tax form is required for the company to use. Step 3—Complete the form. The type of business will dictate the type and number of forms the company is required to file. Step 4—Pay attention to deadlines. Filing taxes after the required deadlines can create more expense for the company. Some of the deadlines are: March 15th: forms 1120, 1120A and 1120S April 15th: form 1065 and 1040 Schedule C Step 5—Know where to file the taxes. Tax forms normally have the address of the district each business is required to file in; find and use it. Business categories for tax filings are: Sole Proprietor, C Corporation, Partnership, S Corporation, Nonprofit Organization or Limited Liability Company. Businesses can either complete the tax filing on their own or hire an accounting firm. Due to many changing tax laws, the savvy owner(s) hire the accounting firm who is well versed in these laws. Some companies may find they are exempt from paying taxes, such as certain nonprofits. For profit companies may find that based on their income and expenses they may receive a refund instead of having to pay money into the IRS.
KPI: Verify the accuracy of business financial records.
Reconciliation of accounting records is the review mechanism in which the integrity of different parts of an accounting system are verified. This duty is normally the key responsibility of the financial manager and they can be held responsible for any irregularities. Ensuring accurate business financial records is key to a business' success. Journal entries and posting of financial transactions correctly to the company's ledger is critical. If the data entry professionals are making math errors or entering the data in the wrong accounts, even a sophisticated accounting package will not detect it. Training and random monitoring are two ways to ensure quality control in the data-entry process. An additional method to verify accuracy is to reconcile the accounting records with the company's external records, such as bank statements, supplier invoices, credit card statements and other documents The numbers should match on all documents. For example, the cash balance on the balance sheet should match the ending balance on the bank statement. The Small Business Development Center at Illinois State University recommends that business owners look for obvious errors on the balance sheet, such as a negative cash balance. One reason the reconciliation of accounting records is really important is it can prevent fraud like falsified or amended accounting records that allow unauthorized payments. Moreover, it strengthens the company's internal control, which, in turn enhances accountability and can uncover theft, ghost workers or ghost equipment. It can also make the difference of receiving the important funding needed for that all important expansion.
KPI: Determine relationships among total revenue, marginal revenue, output, and profit.
Revenue is the amount of money a firm receives from selling products at a similar price, then total revenue will equal price times quantity. Total revenue equals the amount of money received from selling the total products and services at an equal price. Calculation process for finding total revenue is multiply the amount of products and services by the price of the same products and services. Marginal revenue is what measures the change in revenue resulting from the change in the amount of sold products and services. It indicates how much revenue increases for selling an additional unit of a product or service. Calculation process for finding marginal revenue is divide the total revenues change in the quantity sold. Marginal and total revenue are directly related because it marginal measures the change in the total revenue with respect to the change in another variable. Profit is the company's reward for selling a given amount of output (products and services) which exceeds the total expenses of producing the output. Output is the quantity of products or services the company produces in a certain period. Output can be influenced by many factors such as, labor changes, natural disasters or supplier demand. These factors can increase or decrease the company's output. When output is increased the company has the potential to make more profit. When output is decreased, the company's profits are also, decreased. As seen in the aforementioned information, revenue, output and profit are related. Each one is individual, but can affect the others in a positive or negative way.
KPI: Obtain insurance coverage.
Risks can be managed by transferring the loss to another business or party. Risk transfer methods include purchasing insurance and, for the sole proprietor, transferring risk through business ownership alternatives. An insurance policy is a contract between a business and an insurance company to cover a specific business risk. The two most common forms of insurance desired are property insurance and liability insurance. Below are common types of business insurance. Professional Liability Insurance: Known as E&O (errors and omissions) insurance which does not fit into a one-size-fits-all policy. Individual industries set their own concerns which are addressed in a customized policy written for that particular business. The insurance covers a business against negligence claims due to harm which result from mistakes or performance failures. Property Insurance: Essential for all business, whether the owner owns, rents or leases their business space. Policies are written to cover the business' equipment, signage, inventory and/or furniture due to accidents, fires, theft or certain storms. Unfortunately, mass-destruction events like floods and earthquakes are generally not covered under standard property insurance policies. Businesses which are prone to these types of issues must, check with their insurer to price and obtain a separate policy. Workers' Compensation: Businesses who hire employees should purchase Workers' Compensation (WC) insurance. WC policies protect the businesses should an employee need medical treatment, become disabled or die due to the result of their working with the business. Unfortunately accidents happen; even if employees are performing seemingly low-risk work, slip-and-fall injuries or medical conditions such as carpal tunnel syndrome could result in the business having a pricey insurance claim brought against them. Product Liability: Businesses who manufacture products for sale on the general market should ensure they purchase product liability insurance. Although the business takes every measure they can to make sure they are producing safe products, they can sadly find themselves listed in a lawsuit due to damages caused by one of their products. Product liability insurance works to protect a business should a lawsuit occur, with coverage available which is tailored specifically to a specific type of product.
KPI: Make critical decisions regarding acceptance of bank cards.
Should the business accept bank cards? This is a major decision businesses have to consider related to possession utility. Several considerations to accept or not accept bank cards are listed below: The acceptance of cards means there will be a cost to the business in fees: per-transaction fees, interchange fees, incidental fees for things like chargebacks and perhaps a monthly or annual fee. While some of the fees are negotiable with the credit card processor, others are firm and must be paid. It important to understand the major players in a credit card transaction: Customer: Individual who presents a card for payment of goods or services at a merchant location or online. Merchant: Business which accepts card payments for their goods or services. Issuing bank: Bank issuing the credit or debit card used by the customer. Credit card association: The card network (card brand) that creates the cards and sets the rules for processing. (Visa, MasterCard, American Express and Discover) Acquiring bank: Also known as simply the acquirer, this is a bank or credit union that processes card payments on behalf of the merchant. Understand if accepting credit cards will help the business grow. Know which payments types should be accepted. Consider buying equipment and services which will allow for accepting the following payment processing formats: EMV chip cards Mobile payments Other NFC/contactless payments Decide which hardware and software investments the company will have to make in order to process the card payments. Debit card payments cost less than credit cards to process. Be aware it may take as long as 3 days for the money to be deposited in the business' bank account, however, the transfer is usually much quicker than check payments. Handling cash is actually less cost-effective than handling cards! A report found that there are many more hidden costs to continued cash use versus card use, which was mainly due to theft. Small businesses are particularly prone to employee cash theft because they lack the complex security systems of mega merchants. Cash is readily available and easy to access, which makes a business vulnerable to employee theft. Accepting cards, however, makes your money less liquid and also creates a digital paper trail that is much easier to follow and resolve.
KPI: Identify risks associated with obtaining business credit.
The ability for a business to obtain credit normally depends on different factors such as: how the owner(s) operate the business or whether they make on-time or early payments on their debt. To become creditworthy, a business must work hard to build their cash flow reputation. Credit RiskCredit Risk is is the probable risk of loss resulting from a borrower's failure to repay a loan or meet contractual obligations. When a debtor defaults on a loan it results in the creditor's having an interruption in their cash flow and and increase in their costs for collection of the debt. Charging interest payments to the borrower or issuer of a debt are a lender's or investor's reward for assuming credit risk. CreditworthinessThere are 5 "C's" lenders use to evaluate the ability that a borrower will repay a loan; 1) Credit history, 2) Repayment Capacity, 3) Company's Capital, 4) Collateral for the loan and 5) the Conditions of the loan. These factors determine if there is a perceived high credit risk, there will be a high demand for a higher rate of interest for their capital or they may forgo the investment or loan. If the borrower has a superior credit rating, steady income and good cash flow reputation, they are perceived a low credit risk and will normally be charged a lower interest rate. Credit BureausThere are four major credit bureaus whose business is to evaluate and score a company's creditworthiness and the risk to do business with; 1) Dun and Bradstreet, 2) Experian, 3) Equifax and 4) FICO. Each has a different process and point value they use to score businesses creditworthiness. In some cases a company can self report their financial records or the bureaus use public records as the basis for their scoring process. Businesses should work hard to ensure their credit score stays in the positive range which, in turn, can result in negotiating better terms with vendors and lower insurance premiums. Financial institutions, vendors, insurance companies and others can check the business' credit score to determine if it is a safe financial risk and choose to work with, or not to work with, the company.
KPI: Complete loan application package.
The borrower's capital loan application process begins with completing a formal credit application, which can be in a written format or online. The lender should schedule an interview with the borrower after they have received the completed application. The next step of the process involves a credit investigation which includes credit bureau reports, loan documentation and verifying company or individual current financial position. Decision on approving or not approving the loan will result in final steps which can include the following: Meeting with borrower to explain reasons for approval or non-approval of loan Contract written up Review of contract with lender and borrower Extra fees reviewed Signatures of lender and borrower on contract Open end payment dates reviewed and agreed upon Loan repayment document presented to borrower if installment loan The Loan Application When applying for a loan, the financial institution must consider many factors to determine creditworthiness and the reason for the loan. The loan application package may ask for the following information: If a startup business, is there a written business plan? If not a startup, did the business make a profit last year? Business and/or personal depository account balances (checking, savings) Current business loan accounts. Personal assets, liabilities, and sources of income. Personal loans, credit card debt, student loans, and others. Personal investments and savings in place. Personal monthly living expenses. Copies of federal tax returns (both personal and business) Business financial statements (if established business). Cash flow projections for first year (for startup business). Collateral Information This list may vary depending on the financial institution.
KPI: Describe the nature of cost/benefit analysis.
There are two points in time when you should perform a cost/benefit analysis of a decision: 1) before the decision is made and 2) during the period when the decision is in effect (assuming the decision was approved in the first place). Further analysis of these points show the costs associated with a decision are just that: costs. Any cost you incur or will incur because of a decision should be considered when making that decision. Costs are often monetary, but costs incurred by the business or physical environment (like pollution) should also be considered. One type of cost that is often the most difficult to grasp is called Opportunity Cost, which is the cost of opportunity lost as a result of accepting or rejecting a decision. For example, say you have a factory, and you have the option of producing Gadgets or Gizmos, but you cannot produce both. The opportunity cost of producing one over the other is the net profit that could have been generated by the alternative. Benefits associated with a decision can also take different forms. The most obvious of these benefits is revenue, or a change in revenue. If a decision doesn't ultimately increase your revenue, there has to be some sort of underlying benefit received, otherwise the decision would have been rejected. Sometimes, the benefit of a decision is not being fined by the government for not complying with a new regulation. It doesn't necessarily increase revenue, but it decreases expenses because the cost of not complying with the regulation could be heftier than the change required by that regulation. Consider the following example: Alice, Bart, and Clara work in a factory that produces two different products: Unit X and Unit Y. Each production worker is paid $14/hour. Unit X sells for $3 and Unit Y sells for $4. The productivity levels for each employee are illustrated in the table below. Employee Unit X per Hour Unit Y per Hour Alice 10 15 Bart 8 14 Clara 12 16 Given this information, the variable labor cost per unit can be calculated Employee Labor Cost per X Labor Cost per Y Alice $1.40 $0.93 Bart $1.75 $1.00 Clara $1.16 $0.88 Assume you can only put one person on the X line. Who do you choose? You might pick Clara, because she is the most productive at producing Unit X. However, she is also the most productive at producing Unit Y. You need to consider the cost of Clara not producing Unit Y. If Clara does not produce Unit Y, the average labor cost of each Unit Y produced is $0.96. If Clara does produce Unit Y, and you put Alice on the X line, the average cost of Unit Y becomes $0.94. The cost of your forgone alternative needs to be considered in decision-making.
