I have a very fundamental question, which is at the intersection of Accounting and Econ.
Let’s say I have a company that has projected the following numbers:
Revenues : $200
Raw Material, Labor and Material : $150
Overhead : $40
Gross Profit : $10
Now, if I reduce the quantity produced by 20% then will my raw material, labor and material expenses also go down by 20%? I am not sure about this because of three reasons:
#1 - Mathematically, if A = B + C and A decreases by 8% , it doesn’t mean that C decreases by 8%. For instance, 100 = 20 + 80; If I reduce 80 by 10% then total = 20 + 72 = 92, which is 8% reduction in 100. Realistically, percentages cannot be added.
#2 - Without knowing the sensitivities (Marginal Products aka Marginal Returns), how can I say what will happen? (I am assuming that variable cost = raw material, labor and material; Fixed cost = Overhead). I believe that the sensitivity of Output wrt Fixed cost will be zero. It’s only Labor and Capital that affects the output.
#3- Given any income statement, how can I calculate Marginal product? How do Economists calculate this function from Income statement?
I would really appreciate your answer. This will help my brain to link concepts/fundamentals in Accounting with those in Economics. If there is any book that will teach me this thing, please let me know. I will try to borrow one from the public library. Our library in New Jersey is really good.
I look forward to hearing you all. I am really struggling with this. Unfortunately, google search didn’t help me at all.
Overhead costs are fixed and should be part of SG&A, not COGS.
So the Gross profit should be $50 and operating profit $10.
You are overcomplicating matters. The income statement is more simple than it looks. I think you are confusing operating leverage with “Marginal Product”. You should find more on this in the Corporate Finance book for L1.
Thanks for your reply. Very respectfully, I am not sure whether I am overcomplicating things. I believe there should be a link between Econ and Accounting, and that’s what I am trying to determine.
Others,
I would appreciate if someone could answer my questions/shed light on this. I don’t believe in robotically memorizing equations but trying to understand the concepts.
In this case - the Unit Price = Material + Labor + Overheads + Profits per Unit.
That is a largely unchanging “item” in Economics. If Quantity reduces you do not need as much labor, material, etc. etc. - so all of those will go down as well.
Accounting wise - you are “spending” cash to buy inventory, sg&a, etc. if you do not expecting to sell as much - you would reduce the amount you spend on inventory, and other “variable” items.
There is a link between accouting and economics, hence why economic profits exist.
I’ve already gave you the answer for what you need to know in terms of economies of scale. That is operating leverage.
For example, if I do not bear any fixed costs in my production line, then the amount of profits I make is a fixed unit proportion of the quantity I sell. Like a Lemonade stand business that costs me nothing to set up (let’s assume this is the case and the stand cost me nothing), only the water, lemons and sugar I buy that make the lemanode. Let’s say it costs me $9 to produce one cup, and I sell it for $10. Then the amount of profit I make is $1 per unit, gross profit is 10%, and total profits is quantity sold * profit margin. This is fixed irregardless of how many units I sell, whether that be one, or a thousand cups. I won’t be losing money if I only sell one cup per day. My DOL (degree of operating leverage) is 1 in this case, according to the equation
Let’s take another example, let’s say a burger sandwich business. It costs me $9 to make one burger and I sell it for $10, so my gross profit is also 10%. But I’ve bought small commercial space of land for $100, so that’s a fixed cost I incurr irregarldess of the amount of sales I make. If I sell 10,000 burgers, then I make a gross profit of $10,000, and total profit of $9,900. In this case, my DOL is 1.01 (10000/9900), which means a 10% increase in burger revenue I sell increases my profits by ~10.1%, more than the 10% for the lemonade stand. The higher your fixed cost, the higher the breakeven quantity of sales you need, but the more leverage you get on increasing your profit margin with additional units you sell beyond that point.
Unfortunately, google search didn’t help me at all.