Finance for dummies and why it should matter to you

The reason I want you to go through pain of reading this blog is because I believe that agile community is missing something when it comes to the budgeting and how the business gets funded. That very often makes agile getting into collision course with higher management, but before I go further (that will be in my next blog), sorry you need to read this one first. What I learned by reading about finance is that math was not the problem, but the language that these guys use. It’s that fancy English that you hear and then your eyeballs start rolling and next second you are lost.

So, let’s start first with some simple definitions and formulas:

Revenue (R): Income for a given period.

Cost of sales (C): Manufacturing cost, or retailing cost or something like that

Gross profit (G) = Revenue – Cost of sales

Operating expenses (OE): So called overhead of the business – pay checks, water and electricity bill, rent for the office and any other administration required for running the business.

Operating profit (OP) = Cost of sales – Operating expenses

Finance expenses (FE): Interest cost of debt (like you take a loan from the bank…)

Taxation expense (TE): On every income you need to pay the tax

Net profit (P): Operating profit – Finance expenses – Taxation expense: profit or loss. Profit is either used to reinvest in the business or it gets distributed to the shareholders via dividends.

Mark up: G/C [%] (percentage of direct cost, premium added to direct cost)

Margin (m): G/R [%] (profit as percentage of sales price)

(Here is the funny thing, you may wonder how tweeter makes money – well they don’t, but this is something else. Higher the ratio between the value of the share and the actual profit share generates, higher the growth prospects investors see in the company. In case of tweeter (or facebook), private investors gave the money to the owner in return to the part of the company – indirectly telling the market how much they believe the value of the company is – once it is listed on the stock market. That also explains why sometimes good profit figures of the company still can bring the shares down – since the share is all about the belief in future earnings)

Ok, so let’s do the quick check with one example just that you get some feeling for numbers:

If you work in a corporation that sells 10 million units for price of 1 euro per unit, and your cost of sales is 8 million with operating cost of 1 million, the gross profit would be 2 million, mark-up 25% and margin 20% and finally the net profit would be .5 million.

Ok, here is the formula of the net profit impact (R1/R2) at time T1 and T2 (ignoring TE, and FE for simplicity), where N is the volume, and S the price per unit and m is the margin (hope got this one right):

R1/R2 = ((N1 * S1  – (C1+O1)*(1-m1)) * (1-m2))/ ((N2 * S2  – (C2+O2)*(1-m2)) * (1-m1)).

So, let’s assume for the moment that C, O are not changing and m is very low and volumes N very high (which is more or less true for high tech companies):

R1/R2 (C,O) is approx N1/N2 * (1-m2)/(1-m1)

What happens if another company enters the same market and brings the price down to 90 cents?

Your gross profit goes down from 2 to 1 million, your mark-up down to 12.5% and margin to 10%. If you want to sustain the same revenue of 0.5 million, you would probably need to sell now 20 million units of the same product instead of 10m.  Smaller the margin, more volume you have to produce, in order to sustain the same net profit. How are you going to do that if other guys have just cut the price? Well you can decrease it further and then you need even a bigger volume. You got the picture? Or you can just stay cool and hope your product is of a better quality. Then you better be sure that customer thinks the same – so this is why companies talk “customer first”.

Another option is to cut the cost of sales (if that is a high number), in companies that means squeezing your suppliers. If that doesn’t work, well you need to cut the operational cost – which can mean less travel, sometimes lay offs, moving to low cost sites or something like that.

So congratulations, this was your first lesson.

Things that can vary in this formula is cost of sales (which depends on whether you produce goods or not, whether you have dedicated sales channels etc.), whether the cost of sales increases with volume or not (in software that can vary from the cloud services where you need huge farms that are big original investment but can scale well or minor cost if you just download applications), operational cost, different tax regimes, and whether you reinvest or distribute profit to share holders. Each of these variations can produce new effects and that is the reason why all these finance books are thick, but remember, underlying principle is really simple.

Next to things mentioned above, very important is the concept of cash flow, ROI and stuff like that. If you really got intrigued by this blog, I suggest you read that too, it might help you next time understand quarterly results of your company.

In my next blog I will explain how budgeting process often collides with the basic principle of agile/project management and why we should consider different project management techniques for different parts of the organizations.

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