How Much Does Your Company Cost?

An introduction to profit, cost and EBITDA

Disclaimer: I am not an Economics expert. If you really want to learn more about the subject of Economics as a whole, I suggest you attend college.

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Introduction

Welcome to Economics 101.

Today I will attempt to explain to all of you, with no economic knowledge, about the basic concepts of profit, cost and EBITDA. Why is this important? These three concepts are crucial in making any economic decision, or any decision involving choice. Understanding these concepts and applying them in daily life makes your decision making process much easier.

Let’s get started.

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What exactly is profit, cost and revenue?

Lesson 1.

What are these three concepts and how do they relate to one another? The best place to start would be the system of supply and demand.

Supply and demand is one of the fundamentals of Economics. Supply refers to the amount of product, labour or land available and demand refers to how much is wanted for purchase.

Supply and demand on its own is an entirely different concept which I could go on for a while in a different article, but for purposes of this article, demand is the want for purchase of the supply which generates revenue.

Revenue is the total earnings from the business. However, not all of it is yours to keep. Before we do anything with this money, we first have to subtract the total cost from our revenue to keep the cost value at $0, otherwise we’d have made a loss.

Cost is a very important and complex topic as there are so many kinds of it. The first kind is the cost of goods sold.

Costs of goods sold is the cost for any resources needed to make a product. It’s essentially a materials cost. This is always the first cost taken out of the revenue as this is the indicator of profit margin, which, to be brief, is a measure of profitability. This cost is proportional to the amount of units produced and sold. To categorise it, this is known as variable cost, as it changes depending on the unit count.

The next cost is the operating cost. This is a fixed cost. It is the cost for operating the business. This could be a labor cost, or a land cost. A common operating cost is rent - the cost for selling the product on a certain space. The cost won’t change no matter how many units you sell.

Aside from a few other costs, any remaining revenue now becomes your gain, also known as profit.

Profit is your total gain from the business, aside from paying some of it as tax which I’ll elaborate on later, you can freely use it to buy anything you want (which by doing so gives the person you’re buying from revenue of which some will become profit to them).

As you can see, these cycles of supply and demand as well as profit, cost and revenue are all interconnected and will continue to complete each other until the business in question breaks down. What do I mean? If one of these fails, the rest of them fail. There is no supply without cost. There is no fulfilled demand without supply. There is no revenue without demand. There is no profit or repaid cost without revenue.

Everything arrives full circle.

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Explaining EBITDA

Lesson 2.

EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation. What does this big, long acronym mean?

• Interest is paying back money owed to a money lender or bank that loaned you funds.

• Tax is money being paid to the government as part of governing business policies.

• Depreciation is the allocation of tangible (physical) assets over a period of time.

• Amortisation is the allocation of intangible (non-physical) assets over a period of time.

It’s actually just more cost - but they’re special costs. They can be referred to as non-operating costs, as they are costs outside the business’ product manufacturing and sales. These also differ from other costs because the company can actually strategically operate to optimise their ITDA portfolio.

• The company can decide how much money they want to borrow and from who considering interest rates and financial alternatives. (Interest)

• The company can decide where geographically they would like to operate considering different countries’ tax laws and how much they are likely to take from you. (Tax)

• The company can decide the best tangible asset to depreciate, or pay back in even amounts (Tractor A vs Tractor B). (Depreciation)

• The company can decide how much they would like to acquire a company and its workers for depending on how much they are likely to give returns. (Amortisation)

If all that is ITDA, then EBITDA is obviously the operating earnings before taking off ITDA.

Why do we split up these different costs?

By splitting them up, it is easier to observe whether the company is doing well in its sales and profit margins versus their investment strategy and capital structure.

Takeaways:

Interest: Capital Structure

Tax: Geographic Location

Depreciation: Investment Strategy

Amortisation: Acquisition History

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How would this be applied practically? (Calculating the cost of your company)

Group Activity.

If I were really teaching, I’d ask the class to get into small groups and discuss how we could use the above to calculate how much it would cost to purchase Apple.

Assuming/pretending we have all the statistics and data we need, and that Apple is solely earned by either one person or a small group of people, this is how you would do it.

Firstly, we would need to figure out roughly how much Apple is making in revenue. This is from total sales of products.

Next, we need to find the total cost that Apple has built up. This would be all the variable costs, all the fixed costs and all of the ITDA.

Thirdly, we subtract all costs from the revenue to get our profit - this is how much the current owner(s) would be giving up. The number wouldn’t be accurate as Apple makes different profit every year, but a rough estimate would do. We must remember to take off all the different costs and use our net income value (the final profit value).

Then, we would have to give an extra compensation (amortization fee) to the owners which is different depending on the company being acquired. In our case with Apple, it would be a big one.

Finally, we either continue to run Apple under our ownership or we dissolve the company and pay off all the shareholders and bondholders.

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Conclusion

Obviously this version of profit, cost, revenue, supply, demand, interest, tax, depreciation and amortization is incomplete, brief and somewhat crude. There would be no way I could fit the entire detailed version into one article, it would easily take up one or more whole series(’). The aim of this article is to open you, the reader, to the world of economics and accounting and hope that you take an interest in it and will read up on it by yourself.

For those of you who do find it interesting, classes in Economics, Accounting and Business will all be of great interest and value to you. For those who didn’t, I hope it was a good read for you guys anyway.