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Subject 2. Income Statement Modeling: Costs PDF Download

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.

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