Analysts may perform cost analysis using a top-down, bottom-up or hybrid approach. Gross and operating margins are positively correlated with sales levels in an industry that enjoys economies of scale.

Fixed Costs

Analysts should pay particular attention to fixed costs. This is the first step of understanding economies of scale. The greater the quantity of a good produced, the lower the per-unit fixed costs. However, fixed costs are not related to revenues but to investments in property, plant & equipment (PPE). They may be assumed to grow at their rate. If a company enjoys economies of scale, its gross and operating margin tend to increase as it produces more products.

Analysts should determine whether the company benefits from economies of scale. Economies of scale occur when average costs per unit fall as volume rises. Factors that lead to economies of scale include:

• Greater bargaining power with suppliers.
• Lower cost of capital.
• Lower per-unit advertising expenses.

Variable Costs

COGS has a direct relationship with the revenue of a company. Forecasting COGS as a percentage of sales is equivalent to forecasting gross margin percentage. Analysts should consider historical data, the impact of a company's hedging strategy, and competitors' gross margins, etc.

Selling, general, and administrative expenses (SG&A) are generally less closely linked to revenue than COGS. Companies often disclose the different components of SG&A. Selling and distribution expenses will increase as sales increase, while other general and administrative expenses are less variable.

Non-Operating Costs

Financing costs. Interest expense depends on the level of debt on the balance sheet and the interest rate associated with the debt. A company's capital structure is a key determinant when forecasting financing expenses.

Interest income is less significant to non-financial companies but a key revenue component for financial institutions such as banks and insurance companies.

Income taxes. The nature of a business, the geographic composition of profits, and the tax rate can determine income taxes. Any special tax treatment? Deferred tax assets or liabilities? Future tax changes?

Be aware of three types of tax rates:

• The statutory tax rate: This is the corporate tax rate in the company's home country.
• The effective tax rate: This tax rate is calculated as the reported income tax. It is relevant for earnings projection in the income statement.
• The cash tax rate: This is the actual tax paid divided by pre-tax income. It is used in forecasting cash flows.

Differences in tax laws and financial accounting standards result in differences between the reported taxes and cash taxes, often referred to as deferred tax assets or deferred tax liability.

Practice Question 1

Operating margin is calculated as:

A. (Net Income / Sales) * 100
B. (Operating Income / Sales) * 100
C. (Sales / Operating Income) * 100
D. (Gross Profit / Sales) * 100

Correct Answer: B

Practice Question 2

When benchmarking operating margins, it is most meaningful to compare a company's margin to:

A. Industry averages
B. Competitors with different business models
C. Historical margins of the company
D. Future projected margins

Correct Answer: A

A high operating margin indicates that the company is effective in controlling operating expenses.

Practice Question 3

Economies of scale refer to the situation where:

A. Average costs increase as production levels rise.
B. Average costs decrease as production levels rise.
C. Average costs remain constant regardless of production levels.
D. Fixed costs increase with higher production.

Correct Answer: B

The most common financial metric used to measure economies of scale is operating margin. Operating margin increases with economies of scale.

Practice Question 4

Besides production volume, what other factor can influence the realization of economies of scale?

A. Increasing fixed costs.
B. Higher variable costs.
C. Efficient use of resources.
D. Decreasing sales levels.

Correct Answer: C

Practice Question 5

Tax credits and withholding tax on dividends can cause differences between:

A. the statutory tax rate and the effective tax rate.
B. the statutory tax rate and the cash tax rate.
C. the cash tax rate and the effective tax rate.

Correct Answer: A

Practice Question 6

Which SG&A component is the most variable one?

A. Distribution expense.
B. Overhead costs.
C. R&D expense.

Correct Answer: A

It is closely linked to sales.

Practice Question 7

The first step of understanding economies of scale is to analyze:

A. fixed costs.
B. COGS.
C. different types of tax rates.

Correct Answer: A

Practice Question 8

Which type of tax rate is this? Reported tax amount on the income statement / pre-tax income.

A. Statutory tax rate.
B. Effective tax rate.
C. Cash tax rate.

Correct Answer: B

Practice Question 9

If an industry enjoys economies of scale, its ______ tend to be positively correlated with its sales levels.

I. average cost.
II. gross margin.
III. operating margin.

Correct Answer: II and III

Gross and operating margins that are positively correlated with sales provide evidence of economies of scale in an industry.

Practice Question 10

Which of the following metric is an analyst least likely to consider when forecasting financing expenses?

A. The capital structure of the company.
B. The interest rate.
C. Benefit from special tax treatment.

Correct Answer: C

Benefits from special tax treatments are more likely to affect the forecasting of corporate income taxes. Debt and interest rates are the main drivers when forecasting financing expenses.

Practice Question 11

If a company's operating margin is declining, what aspect should analysts investigate first?

A. Increase in sales levels
B. Decrease in interest expenses
C. Rising operating expenses

Correct Answer: C

A high operating margin indicates that the company is effective in controlling operating expenses.

Practice Question 12

As a company grows in size and achieves economies of scale, what is the likely trend in operating margin?

A. Operating margin decreases.
B. Operating margin increases.
C. Operating margin remains constant.

Correct Answer: B

The most common financial metric used to measure economies of scale is operating margin. Operating margin increases with economies of scale.

Practice Question 13

Economies of scale in production costs are often associated with:

A. Higher average costs.
B. Fixed costs exceeding variable costs.
C. Lower average costs.

Correct Answer: C

To sustain economies of scale over the long term, a company must continuously improve efficiency.

Practice Question 14

Which of the following is least likely a factor that leads to economies of scale?

A. Greater bargaining power with suppliers
B. Lower cost of capital
C. Fixed costs

Correct Answer: C

Fixed cost is not a factor that leads to economies of scale. Fixed costs are expenses that are not directly related to revenue, for example, investments in property, plant & equipment (PPE).

A is incorrect. Greater bargaining power with suppliers is a factor that leads to economies of scale. A company with bargaining power with suppliers can negotiate better prices with the suppliers.

B is incorrect. Lower cost of capital is a factor that leads to economies of scale. Lower cost of capital enables a company to have cheaper access to funds, lowering their overall costs.

Practice Question 15

Financial results for three major players of local grocery market in a city ($ millions):

Companies | A | B | C
Revenue | 25 | 22 | 30
Operating margin | 12% | 15% | 18%

Based on the data presented, which company most likely has economies of scale?

A. Company A.
B. Company B.
C. Company C.

Correct Answer: C

It has the highest sales and highest operating margin.

Practice Question 16

An analyst projects the cost of goods sold of a company will continue to grow at 3% per year for the next 5 years. He then makes a bit adjustment after the inflation rate is considered in his analysis. The approach this analyst takes is:

A. top-down
B. bottom-up
C. hybrid

Correct Answer: C

Bottom-up: COGS will continue to grow. Top-down: estimated inflation rate.

Practice Question 17

Which of the following items would have a tax consequence for financial accounting purposes?

I. Fines Paid for Law Violations
II. Product Warranty Liabilities
III. Life Insurance Proceeds Received (co. is beneficiary)

A. II only
B. II and III
C. I and II

Correct Answer: A

Fines paid for law violations are never deductible for tax purposes, and life insurance proceeds where the company is the beneficiary are never taxed. Therefore, these are permanent differences and do not have tax consequences. Differences due to warranty expenses, however, will create temporary differences and do have tax consequences.