As we discussed in the article about being concise, shared vocabulary is extremely important for communicating during a case.
However, when I first started doing cases I struggled immensely because I never studied business / economics / accounting (and I suspect many of my readers also don’t have business backgrounds).
So, today’s article is intended to be your cheat sheet for business vocabulary. We’re going to focus on five areas:
5. Critical Business Concepts
Costs can be broken up into two areas:
Fixed Costs – Costs that don’t vary with how much of your product or service you deliver. Examples:
1. Plant, Property, and Equipment Costs (PPE) – Land, Rent, Utilities, Equipment, Buildings, Insurance, Taxes, etc.
2. Selling, General, and Administrative Expenses – Salaries for Administrative People & Salespeople (not commission), Marketing, Promotions, and Discounts.
3. Salaried Labor
4. Research and Development (R&D)
5. Depreciation – Loss of value of assets (i.e. equipment) over time.
6. Amortization – Splitting the cost of an asset over a time period (for example, the R&D expense of a product can be split up over a 5 or 10 year period in calculations)
Variable Costs – Costs that vary with how much product or service you provide. Examples:
1. Raw Materials
4. Cost of Goods Sold (COGS) – Basically just the above 3 costs totaled up if you make the product, or the price of the product if you buy and resell it.
5. Maintenance of Equipment
6. Commissions and Hourly Wages
Synergies – A financial benefit that a corporation expects to realize when it merges with or acquires another corporation. (they often don’t materialize, however)
Synergies can be both on the revenue side and the cost side.
Revenue Synergies Examples:
1. Marketing and selling complementary products (bundling products or selling them under the same brand)
2. Cross-selling into a new customer base (selling to each other’s customers)
3. Sharing distribution channels (one company using the other’s channels)
4. Access to new markets (e.g. through existing expertise of the takeover target)
5. Reduced competition (higher prices due to eliminating unused capacity)
6. Talent Acquisition (using the company’s talent to boost the revenue of your companies)
7. Sales Force – Using one company’s large / experienced sales force to sell the other company’s product.
8. Size – Combined company can serve larger clients / contracts.
1. Headcount reduction (redundancies)
2. Elimination of surplus facilities
3. Reduced overhead (e.g. consolidate functions such as accounting, IT and marketing)
4. Increased purchasing power (greater bargaining power with suppliers due to greater combined size)
Time Value of Money – Money appreciates in value over time. $1.00 today is worth more than $1.00 in the future.
Net Present Value (NPV) – If you’re getting a consistent amount of cash from your business, the NPV is today’s value of the future cash. (remember that future cash is worth less than present day cash)
Perpetuity – A way to value financial assets. Basically, you assume that you get consistent cash flows forever and you can calculate a NPV for it (see the next section).
Rule of 72 – If you have something growing in value annually at a rate of x%, it takes 72/x years to double.
I’ve included here all of the major equations you’re likely to see.
Profit = Revenues – Costs (1)
Revenues = Price x Volume (2)
Costs = Fixed Costs – Variable Costs (3)
Variable Costs = Variable Cost / Unit x Volume (4)
another way to write (1) is to put 2, 3, and 4 into it and you get:
Profits = (Price – Variable Cost) x Volume – Fixed Cost (5)
and the break even point is defined as the number of units sold when profit = 0, so you can solve for the break even volume by rearranging the above equation:
Breakeven Volume = Fixed Cost / (Price – Variable Cost) (6)
also note that Price – Variable Cost = Contribution Margin, so
Breakeven Volume = Fixed Cost / Contribution Margin (7)
Also, there’s one more equation for profit:
Profit = Profit/Unit x Volume (8)
We can put this together with (4) to get
Profit / Unit x Volume = (Price – Variable Cost / Unit) x Volume – Fixed Cost
if you divide both sides by volume you get:
Profit / Unit = (Price – Variable Cost / Unit ) – Fixed Cost / Volume (9)
Also, some useful ratios:
Profit Margin = (Revenues – Costs) / Revenues (10)
Gross Margin = (Revenues – COGS) / Revenues (11)
Return on Invested Capital (ROIC) = Annual Profit / Capital (12)
where Capital = Equipment, Land, etc.
Return on Investment (ROI) = Annual Profit / Investment (13)
And lastly, Net Present Value
NPV for a Perpetuity = Annual Profit / Discount Rate (14)
Discount Rate can be thought of as the “interest rate” on money from an investment, you should ask for it if this comes up.
Economies of Scale – The fixed cost of an asset can be spread over the number of products it can make. In other words, in many industries as you make more your cost / unit goes down.
Depreciation – Everything loses value over time, but we often spread this equally over some arbitrary time period so we can put it on financial statements.
Time Value of Money – Money appreciates in value, but not all investments are made equally. The goal of business is to make your money appreciate at the highest rate possible with the least risk.
An investment is judged by how much it makes money increase in value (hence ROI and ROIC)
Also, money in the future is worth less than money today.
NPV, ROI, and Breakeven Point – These are the three ways to value investments for cases, but each is used in different situations.
If your NPV for an acquisition >> price, it’s a good investment from a financial perspective. Use NPV for mergers and acquisitions cases.
If your ROI > 10%, it’s a good investment from a financial perspective. Use ROI for “you are an investor, should you invest in this venture” cases.
If your Breakeven Point is less than your capacity and a reasonable portion of the market, it’s a good investment. Use this for “your company wants to introduce a new product” type cases.