Financial Management

Om dette eksemplar
Dette eksemplar er fremstillet af Nota til Kathrine Westh Duus

Kristensen.
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brugeren.
This textbook in financial management provides a basic, up-to-date
review of the financial issues faced by companies. It teaches students
about models and methods to:
•analyse the basic financial situations faced by companies
•analyse companies
•manage company finances, including optimisation and budgeting
•analyse investments and financing options.
The book is largely aimed at students who are studying on the mar
keting programmes, but it will also be of interest to others, including
advanced-level financial management students.
The book gives students a theoretical and practical basis from which to
build up a holistic overview of key issues in financial management and
decision-making processes.
The book and its associated, but separate, collection of exercises can be
used to support a range of types of learning, from structured courses to
independent study.
The data in the examples is available to download in Excel format from:

hansreitzel.dk. Templates and solutions to some of the assignments are
also available on the website.
h an sreitzel.d k
Dette eksemplar er fremstillet af Nota til Kathrine Westh Duus Kristensen og må ikke deles
Lone Hansen
Torben Rosenkilde Jensen
Morten Dalb0ge
FINANCIAL
MANAGEMENT
for the academy
profession programme
HANS REITZELS FORLAG
Financial Management
for the academy profession programme
1st edition, 1st print run
© the authors and Hans Reitzels Forlag, Copenhagen 2016
Translated from the 4th edition of Erhvervsokonomi til

akadem iuddannelserne
Publishing editor: Lasse W olsgard

Translator: Tam McTurk
Cover design and layout: Grethe Bruun
Typographic design: Odd Design
Type set in: Chapparal Pro and Frutiger LT Std
Printed by Grafotisak / GPS Group, Bosnia & Herzegovina
ISBN: 978-87-412-5765-5
This publication may only be reproduced in accordance with agreem ent

with Copydan Tekst & Node and the Danish Ministry of Education.
hansreitzel.dk
Contents
Preface 13
About the authors 15
Part 1
1 Introduction: Financial management - subject matter and parameters 19
1.1 Financial management and the overall financial picture 19
1.2 Types of company 20
1.3 Ownership 22
1.3.1 Groups 24
1.4 The company and its stakeholders 24
1.5 The importance of financial management and the influence of
external factors 27
1.6 The value chain and the supply chain 29
1.6.1 The value chain 29
1.6.2 The company viewed from a supply chain perspective 30
1.7 Financial management 33
1.7.1 Areas of financial management 35
1.7.2 The financial picture 36
1.7.3 Systematic management inform ation 37
2 The process of generating profit 39

2.1 Targets 39
2.2 The company and the market 40
2.2.1 Demand and sales 40
2.2.2 Controllable variables 41
2 .2.3 The product life-cycle curve and the price parameter 44
2.2.4 Sales and revenue 45
2.3 Cost factors 48
2.3.1 Variable and fixed costs 48
2.3.2 Calculating unit costs 50
2.4 Profit 51
2.4.1 Prioritisation when resources are scarce 52
2.5 Break-even analysis 54
Part 2
3 Annual reports 63
3.1 Bookkeeping 64
3.2 Income statem ents 65
3.2.1 Income 65
3.2.2 Costs 66
3.2.3 Layout and presentation of income statem ents 68
3.3 Balance sheets 70
3.3.1 Assets 72
3.3.2 Liabilities 75
3.4 The Danish Financial Statem ents Act 77
3.4.1 Readers 79
3.4.2 Adapting to international rules and regulations 79
3.4.3 Companies covered by the legislation 79
3.4.4 Supplementary reports 80
3.5 Content of annual reports 81
3.6 Basic requirements for annual reports 82
3.6.1 The true and fair picture 82
3.6.2 Basic accounting principles 83
3.7 Public access to annual reports 85
3.8 BoConcept Holding A/S 85
3.9 M anagement reports 86
3.10 Income statem ent for BoConcept 89
3.10.1 O ther examples of income statem ents 91
3.11 The BoConcept balance sheet 92
3.11.1 Assets 92
3.11.2 Liabilities 95
3.12 Cash flow statem ents 98
3.12.1 Consolidated cash flow statem ent for BoConcept 100
3.13 Independent auditor’s report 102
3.14 Summary 103
4 A nalysing company accounts 105

4.1 Background factors 106
4.1.1 External factors 107
4.1.2 Internal factors 108
4 .2 Analysing accounts 109
4 .2 .1 Internal analyses 110
4.3 Collating m aterial for analyses 110
4.4 Converting income statem ents and balance sheets for analysis
purposes 111
4.4.1 Example of converting accounts for analysis purposes 112
4.5 Analysis of the data in the income statem ent and balance sheet 114
4.6 Calculation and analysis of key financial ratios 115
4.6.1 Profitability analysis 117
4 .6 .2 Earning capacity 127
4 .6 .3 Capital adjustment 137
4.6.4 Solvency and liquidity 145
4.6.5 Stock-market ratios 151
4.7 Overall conclusion 154
4 .8 Using analyses of company accounts 154
5 Supplem entary reports 157

5.1 The background to supplementary reports 157
5.2 Quality requirements for supplementary reports 159
5.3 Knowledge resources 160
5.4 Corporate social responsibility 161
5.5 Environmental accounts/green audits 162
Part 3
6 The company in the market 165
6.1 Demand 165
6.1.1 Market knowledge 165
6.1.2 Demand and demand determ inants 166
6.1.3 The effect of price on demand 167
6.1.4 The effect of price of other products on demand 173
6.1.5 The importance of income on demand 175
6.1.6 Total m arket demand 177
6.1.7 From demand to sales 178
6.2 Types of market 179
6.2.1 The homogeneous m arket 179
6.2.2 The heterogeneous m arket 180
6.2.3 The number of companies 180
6.3 Overview of the types of m arket and competition 181
6.3.1 Perfect competition 181
6.3.2 Monopoly 183
6.3.3 Monopolistic competition - im perfect competition 185
6.3.4 Partial monopoly (price leadership) 186
6.3.5 Duopoly 186
6.3.6 Oligopoly 187
6.4 Plotting market-demand curves and sales curves 189
6.4.1 Market analysis/price analysis 189
7 Costs 193
7.1 Why are costs im portant? 193
7.2 Concepts 194
7.3 Cost trends 198
7.3.1 Trends for variable costs 198
7.3.2 The general cost trend 200
7.3.3 Variable increm ental costs 202
7.3.4 Final points about fixed and variable costs 203
7.4 Financial decision making 204
7.4.1 Relevant and irrelevant costs 204
7.4.2 Reversibility 205
7.4.3 Opportunity costs 206
7.5 Choosing between different production methods 208
8 Price optimisation 213

8.1 The optim isation challenge 213
8.2 Price optim isation - price-setter or price-taker? 216
8.2.1 Optimisation methods 216
8 .2 .2 Prerequisites for optim isation 216
8.3 Price optim isation in different types of m arket 217
8.3.1 Monopoly (price-setter) 217
8 .3 .2 Monopolistic competition 222
8 .3 .3 Perfect competition (price-taker) 222
8 .3 .4 Supply curve - lower price lim it 225
8.4 Market-based and cost-based pricing 227
8.4.1 The monopoly formula 227
8.4.2 Cost-based pricing 227
8.4.3 Competitor-based prices and retrograde calculation 233
8.4.4 Open calculations 234
8.4.5 Activity-based costing 235
8.5 The product life-cycle curve and the price param eter 238
8.6 The influence of marketing on price optim isation 238
8.7 Price differentiation 241
8.7.1 Background to price differentiation 241
8.7.2 Preconditions for differential pricing 243
8.7.3 Examples of price differentiation 244
8.7.4 Premium pricing 249
8.7.5 Discounts 249
9 Budgets and budget control 251

9.1 Budgeting as an internal management tool 251
9.2 Planning and budgeting 253
9.3 The planning and budgeting process 254
9.4 The budget model 257
9.5 Drawing up the income statem ent budget 260
9.5.1 The contribution margin budget 261
9.5.2 Budget for capacity costs 262
9.5.3 Depreciation budget 262
9.5.4 Interest budget 263
9.5.5 Tax budget 263
9.5.6 The income statem ent budget 263
9.6 The liquidity budget - the statem ent of change in financial position
model 265
9.7 The balance sheet budget 269
9.8 Budget simulation 271
9.9 Liquidity budget using cash flow budget model 271
9.10 Budget follow-up 275
9.10.1 Budget control 275
9.10.2 Causes of budget variance 276
9.11 Balanced Scorecard 280
9.11.1 The Balanced Scorecard model 280
9.12 The four perspectives as risk indicators - early warning system 285
9.13 Advantages of a Balanced Scorecard 286
9.14 Disadvantages of a Balanced Scorecard 286
Part 4
10 Investments 291
10.1 Investment projects 292
10.1.1 Investment needs 293
10.1.2 Evaluating investments 294
10.2 The financial element 294
10.2.1 Investment cash flow 294
10.3 The calculation rate 296
10.4 Evaluating investments 297
10.4.1 The capital value method 297
10.4.2 The internal rate of return method 300
10.4.3 The annuity method 302
10.5 The payback method 303
10.6 Investm ents and statem ents of changes in financial position 305
10.7 Sensitivity in investm ent analysis 306
10.7.1 Critical value for the interest rate 308
10.7.2 Critical value for annual payments 308
10.7.3 Critical value for the scrap value 310
10.7.4 Summary 310
10.8 Choosing between investm ent proposals 311
10 A ppendix A - Calculating interest 313

10A.1 The concept of interest 313
10A.2 Calculating interest in Excel 313
10A.3 Future value of a single amount 314
10A.4 Present value of a single amount 315
10A.5 The importance of interest and tim e 317
10A.6 Annuities 318
10A.7 Future value of an annuity 318
10A.8 Present value of an annuity 319
10A.9 Converting a present value into an annuity 320
10 Appendix B - Advanced investing 323

10B.1 Incorporating probability into investm ent calculations 323
10B .2 The investm ent calculation after tax 324
10B .3 Optimal life cycle 326
10B .3.1 The no-replacem ent scenario 326
10B .3.2 Identical replacement 329
10B .3.3 Replacement with a new and/or b etter version 331
11 Financing 333
11.1 W hat is financing? 333
11.2 Changes to the balance sheet 334
11.3 Balance sheet structure 335
11.3.1 The vertical balance sheet structure 336
11.3.2 The horizontal balance sheet structure 337
11.3.3 Overall evaluation 338
11.4 Evaluating financing options 339
11.4.1 Choosing between equity and borrowed capital 340
11.5 Shareholder value 341
11.5.1 Capital structure 341
11.5.2 Options as rewards for staff and management 342
11.5.3 Focus on core competencies 343
11.5.4 Open information policies and corporate governance 343
11.6 Equity 344
11.6.1 Types of company 345
11.7 Borrowed capital 347
11.7.1 Types of loan 347
11.7.2 Sources of borrowed capital 350
11.7.3 Leasing 354
11.7.4 Tax and financing 355
11.8 Choosing types of financing 355
11.9 Calculating annual costs of financing as a percentage 356
11.9.1 Calculating APR for loans with start-up costs 356
11.9.2 More interest payment dates pro anno 360
11.9.3 Overdrafts 362
11.9.4 Credit from suppliers 363
11 Appendix - Advanced financing 365

11A.1 Comparisons between buying and leasing 365
Part5
12 Business plans and marketing plans 373
12.1 The business plan 374
12.2 Bureau Festival 376
12.2.1 Basic concept and assumptions 376
12.2.2 Setup budget 377
12.2.3 Operating budget 378
12.2.4 Liquidity budget 379
12.3 Marketing plan and finances 380
12.3.1 Follow-up and controls 382
12.3.2 Break-even analysis 383
Appendices 385
Appendix 1: Types of companies in Denmark 385
Appendix 2: Definitions of financial ratios 386
Appendix 3: English-Danish glossary of accounting terms 389
Appendix 4: Frequently used financial functions in Excel 392
Appendix 5: Glossary 393
Index 397
Preface
This textbook in financial management provides a basic, up-to-date re
view of the financial issues faced by companies. It teaches students about
models and methods to:
• analyse the basic financial situations faced by companies
• analyse companies
• manage company finances, including optimisation and budgeting
• analyse investments and financing options.
The book is largely aimed at students who are studying on the marketing
programmes, but it will also be of interest to others, including advanced-
level financial management students.
This edition has been updated to take account of legislation and other
developments up to spring 2015.
The book gives students a theoretical and practical basis from which
to build up a holistic overview of key issues in financial management and
decision-making processes.
The focus is on:

• collating, understanding and processing financial data and other in
formation about companies, primarily from external sources
• processing information about demand, competition and costs, and
linking these to methods of financial optimisation, including within
the context of the value chain
• drawing up and working with budgets in a range of contexts and for
different purposes
• analysing and evaluating alternative investment and financing op
tions
• developing practical skills in the presentation of financial informa
tion.
The book and its associated, but separate, collection of assignments can
be used to support a range of types of learning, from structured courses
to independent study.
The data in the examples is available to download in Excel format from:
hansreitzel.dk. Templates and solutions to some of the assignments are
also available on the website.
The authors, autumn 2015
About the authors
Associate Professor Lone Hansen MSc Economics and Business Ad
ministration, Copenhagen Business Academy.
Teaches financial management, statistics and methodology on the ad
vanced academy profession programmes.
Associate Professor Torben Rosenkilde Jensen MSc Economics, Busi

ness Academy Aarhus.
Teaches financial management, global economics and financial services
on the advanced academy profession programmes. Previously taught man
agement and financial management at VIA University College.
Associate Professor M orten Dalboge MSc Economics and Business Ad

ministration, Business Academy Aarhus.
Teaches financial management, microeconomics, macroeconomics, busi
ness administration, statistics and methodology on the marketing man
agement programme and the bachelor programmes in economics and
information technology. Previously taught economics on the Bachelor of
Commerce programme at VIA University College.
PART 1
1 Introduction:
Financial management
- subject matter and
parameters
This chapter will teach you to:

• understand the basis for and significance of financial m anagem ent
• understand the differences betw een various types of companies
• understand the im portance of the stakeholder model
• understand the value chain and supply chain
• understand the circumstances surrounding practical financial
m anagem ent.
1.1 Financial management and the overall financial picture

Financial management is about the management challenges that every
company faces. It is the element of economic theory that deals with the
individual company, its activities and interests.
Economics is about the best possible use of resources, which can be di
vided into two categories:
• Scarce resources - which are in short supply and therefore have a price,
e.g. money, land or services
• Free resources - which are available in such abundance that they are
free, e.g. fresh air.
In the broadest sense, financial management is therefore a question of

managing resources. This is expressed in simplified form in Figure 1.1,
which shows that the production process is the value-creating link be
tween input and output.
Input comprises labour, raw materials, other materials, machinery and
buildings. Output consists of the finished products and services.
Figure 1.1 Simplified input-output model.
Managing the production process in a way that optimises resource utilisa

tion involves using all of the various financial management disciplines, i.e.:
• accounting
• business administration
• budgeting
• investments and business financing.
This book covers all four of these sub-areas:

Part 1 presents the fundamental principles behind how companies plan
their activities based on financial targets and how they achieve their re
sults.
Part 2 covers how to analyse companies, the content of published an
nual reports and accounts (both financial and non-financial), the regula
tory framework for accounts and how to conduct an overall analysis of a
company.
Part 3 covers demand and costs, optimisation models, budgeting and
the principles that underpin budgeting.
Part 4 examines methods of evaluating whether investments are worth
while, options for business financing and how to calculate different types
of borrowing costs.
The book concludes, in Part 5, with practical examples of the financial
elements of both a business plan and a marketing plan.
1.2 Types of company

According to Statistics Denmark, 301,481 companies were registered in
Denmark in 2012.1 Every single one of them exists for a different reason,
1 Source: Statistikbanken.dk.
has different objectives, and is managed and run its own unique way. Nev
ertheless, it is possible to categorise companies by type, in various ways.
In this section, companies are grouped according to type of activity,
which is also the appropriate approach to organising internal manage
ment and conducting external analyses.
In terms of activities, distinctions are often made between:
• trading companies
• manufacturing companies
• service companies.
The input into trading companies consists of goods produced by others.

The transformation process involves putting together a product range
that appeals to customers. A trading company’s activities typically include
analyses of what items can be resold, purchasing these goods and selling
them on to customers. The sales may be to private individuals (business-
to-consumer or B2C) or to other companies (business-to-business or B2B).
The input into m anufacturing companies consists of raw materials, com
ponents, labour and the use of machinery, buildings, etc. The transforma
tion process consists of planning and implementing production (business
administration). If the company makes finished products, its customers
are often trading companies, which sell the items on to the end users. If
the products consist of components or semi-finished products, the cus
tomers are other manufacturers.
The output from service companies does not consist of physical, tangi
ble items. The product may consist of a service provided at the precise
moment at which the sale is made, e.g. a telephone call or an SMS. Alter
natively, it may involve transporting goods (e.g. haulage or shipping) or
selling property (e.g. estate agents, whose product/service is the sale itself,
rather than the property). Other examples of service companies include
accountants, lawyers, consultants, travel agents and the fitness and well
ness industry.
Financial services companies, e.g. banks, building societies and insur
ance companies, are a special type of service company. The services they
provide are crucial to the day-to-day running of society as a whole and, to
ensure that they are run properly, these companies are subject to separate
legislation, special rules and ways of working that are beyond the scope of
this book.
1.3 Ownership
Companies are also categorised according to types of ownership:
• privately owned companies or sole proprietorships
• partnerships
• private limited companies
• public limited companies.
Figure 1.2 Number of companies in Denmark categorised by type of ownership, 2012.

Source: Statistikbanken.dk
“Others” includes categories such as co-operative societies, foundations,

public-sector companies, etc., none of which are covered by this book.
For sole proprietorships, both the company finances and those of the
owner are considered one and the same. This means that the owner is
liable for company debts up to the value of his or her total assets. Custom
ers, suppliers and creditors often find it reassuring that the owner is will
ing to risk everything he or she owns for the sake of the business. Among
the advantages for owners are that the legal requirements for accounts are
relatively lenient and there is no auditing requirement.
In Denmark, partnership status is denoted by the letters I/S after the
company name. A partnership consists of two or more owners. The part
ners need to have complete confidence in each other because they are
jointly and severally liable for company debt up to the full value of their
total assets. As with sole proprietorships, customers and creditors may
find this reassuring. The other advantages of this type of ownership are
the same as for sole proprietorships.
Some people choose either a sole proprietorship or a partnership be
cause there is no requirement by the Danish Business Authority for the
accounts to be made publicly available.
Private limited companies, denoted by the letters ApS after the name, are
subject to the Danish Companies Act,2 which stipulates how they must be
run. The owners are referred to as shareholders who are often few in num
ber and also often know each other. In Denmark, the minimum capital
investment to start up a private limited company is DKK 50,000.3 Large
private limited companies must have their accounts audited,4 and the Dan
ish Business Authority makes the accounts available to the public. The
advantage of the private limited company over the sole proprietorship or
partnership models is that the owners are liable only for the amount they
have invested in the company, i.e. the owners’ private assets are separate
from company assets.
Public limited companies, which have the letters A/S after the company
name, are also subject to the Danish Companies Act.5 Public limited com
panies can have many owners (shareholders). The Act stipulates how pub
lic limited companies are managed and includes provisions regarding an
nual general meetings (AGMs). All shareholders have the right to attend
the AGM, at which a board representing the shareholders is elected. The
board oversees day-to-day operations and appoints (and dismisses) the
senior management. Once the annual accounts have been finalised, the
board submits a proposal about what to do with any profit, i.e. whether
to consolidate (retain) earnings and/or pay dividends to the shareholders.
The annual accounts and this proposal must be approved by the share
holders at an AGM. The minimum share capital for public limited compa
nies in Denmark is DKK 500,000. Large public limited companies must
have their accounts audited. The Danish Business Authority makes the
accounts available to the public. The owners/shareholders are liable only
for the amount they invested in the company. The provisions in the Com
panies Act ensure that outsiders, e.g. customers and lenders, have a degree
of insight into the company.6
E ntrep ren eu r companies (IVS) operate like private limited companies, ex
cept with a more lenient requirement for start-up capital. An entrepreneur
company only requires start-up capital of DKK 1. However, a minimum of
25% of annual profits must be retained each year in a reserve, until the
2 Consolidated Act no. 322 of 11/04/2011. The Danish Act on Public and Private Limited Companies
(the Danish Companies Act).
3 Reduced from DKK 80,000 by Act no. 626 of 12/6 2013.
4 See 3.13 for further details about audits.
5 See footnote 2.
6 Appendix 1 lists the different forms of company ownership and their most important
characteristics.
share capital reaches DKK 50,000, and the company is not allowed to pay
dividends until it reaches that milestone. This gradual method of inject
ing capital directly from profits makes it easier to get the company off the
ground. In entrepreneur companies, the company’s finances and those of
the owner are separate.
1.3.1 Groups
Many companies are, in fact, a group comprising several separate com
panies, a parent company and a series of wholly or partially owned sub
sidiaries. If a company has a controlling interest, i.e. more than 50% of
the voting rights in another company, then the latter is, by definition, a
subsidiary.
Those who own the “rest” (or part of the rest) of the subsidiary are
called minority shareholders.
If a company holds between 20% and 50% of the voting rights in anoth
er company, the latter is called an associated company. The company that
owns this 20-50% stake may not control the associated company outright,
but it is able to exert influence on decision making.
1.4 The company and its stakeholders

The stakeholder model explains the company’s external and internal re
lationships. It views the company as a social system consisting of indi
viduals and groups, each of which has its own special relationship to the
company (see Figure 1.3).
The model illustrates how, in addition to the owners/shareholders,
companies consist of a range of interest groups. Staff, management, cus
tomers, suppliers, banks, public agencies and many others are important
stakeholders.
Figure 1.3 divides them into internal and external stakeholders. The
internal ones usually have the greatest interest in the company. Different
stakeholders may have identical or conflicting interests. An example of
the latter is the relationship between employees and owners - demand
for higher pay potentially lowers the level of profit, which is the primary
concern of the owners/shareholders.
Figure 1.3 Stakeholder model -the company as a coalition of internal and external stakeholders.
All stakeholders have one thing in common: they want the company to
survive and thrive, so they work together to generate more in value than
the company pays in production costs.
What are the company’s relationships with these groups of stakeholders?

• The company and its customers. The customers’ interest is in being able
to buy products that meet their needs at a reasonable price. They need
to feel that they are getting “value for money”. The company wants
to sell products at a price that covers all of its production costs, in
cluding paying the other stakeholders - staff labour costs, payments
to suppliers for materials and dividends to the owners/shareholders
from the profit generated.
• The company and its suppliers/banks. Suppliers want to keep supplying
the company and receiving their payments on time. The company is
interested in the price, quality and delivery of services, and may wish
to explore options for working more closely together in future. Banks
are suppliers of capital and payment services.
• The company and its owners/shareholders. The owners are interested in
stable profits, growth and low risk. In return, they provide the com
pany with interest-free risk capital to finance its activities.
• The company and its staff/m anagem ent. Working for the company also
fulfils a range of physical and psychological needs. The quid pro quo is
that the company asks the staff to be productive and generate profit.
This balance of interests involves the company trying to influence
parameters such as labour costs, pensions, job security, the working
environment, job satisfaction, education and training, interesting
and varied work, etc., and the staff striving to meet targets for sales,
costs and efficiency.
• The company and s ta ff associations. It is in the interests of staff as
sociations (unions) to safeguard their members’ jobs and working
conditions.
• The company and the public. Society - in the wide sense of the term -
has a range of interests in the company. It provides jobs, generates
production, pays taxes, has an impact on the environment, etc. In
terest groups include the tax authorities, the media, political parties
and grassroots groups, who raise ethical issues, e.g. about trade with
particular countries, child labour or environmental considerations.
• The company and its competitors. Companies and their competitors of
ten follow each other’s activities closely and respond to each others’
initiatives. Here too, the company seeks a balance.
All of these factors are at play in the company at all times. However, at
certain times and in specific situations, some are more clearly visible -
for example when drawing up budgets, targets are an important topic of
discussion.
As part of the budgeting process, the company defines the benefits (re
wards) that stakeholders will receive for their continued commitment to
the company. Again, this is a quid pro quo situation because the contribu
tion made by the stakeholders is a prerequisite for the company being able
to provide the rewards.
The ability to reward stakeholders is dependent upon profit. Profit is
therefore the main objective for the company and a prerequisite for its
survival.
The management’s primary task is to ensure a balance of interests be
tween all of the stakeholders that generates the maximum possible profit
for the owners/shareholders, while at the same time ensuring that the
other stakeholders - staff, customers, the public, etc. - are satisfied and
continue their relationship with the company.
Example: Corporate Social Responsibility (CSR) - the stakeholder model in
action
In recent years, increasing attention has been paid to corporate social
responsibility.
There have been numerous examples of companies that have pursued
short-term financial interests at the expense of ethical practices (use of
child labour in low-wage economies, etc.) or sound environmental policies
(emissions of heavy metals into wastewater, etc.). The long-term negative
consequences of these types of decisions include legal action, a tarnished
public image and falling sales.
For many companies, CSR is now a crucial factor (controllable variable)
in their relationships with stakeholders.
1.5 The importance of financial management

and the influence of external factors
The work they put into business-economics issues helps companies gener
ate value and improve their interaction with the rest of society. To do this
properly, both management and staff must have a degree of insight into
the planning and management of the individual activities and into the
interaction between them.
They need to be able to:

• collate and process information
• prepare and write financial reports
interpret and analyse information
• incorporate these analyses into decision-making processes.
At the same time, they must take into account the following four factors:
1. The transition from focusing on m anufacturing the company’s own prod
ucts to work that focuses on development, m arketing and services. In re
cent years, there has been a trend for companies to outsource much
of their production to other parts of the world but to retain strategy
work, development and marketing in Denmark. Consumers are not
generally aware of where a product or its components were made, but
the company’s ability to be innovative and market its products is cru
cial to its survival.
2. Increasing global competition. In recent years, globalisation has led to
low production costs on other continents, making competition even
fiercer.
Advanced communication systems (e.g. the Internet), web-based
trading and flexible distribution options place heavy demands on the
ability to adapt and remain competitive. These developments have
coincided with an increasing demand for companies to focus on the
customer.
Fiercer competition forces companies to pay close attention to fi
nancial management. To remain efficient and competitive, manage
ment needs to know how to predict the impact of its decisions on
income and expenditure. This trend also makes the ability to obtain
and interpret business information quickly a crucial parameter.
3. Technological progress. One of the fastest growing areas is e-commerce.
Business-to-business (B2B) trading via e-commerce has grown rap
idly and can bring major costs savings.
This trend places heavy demands on companies’ financial systems,
often referred to as “Enterprise Resource Planning” (ERP) systems
(e.g. SAP, Oracle, Microsoft Navision), which integrate information
from all parts of the company and communicate with suppliers and
customers.
4. Changes to business practices. The focus on efficiency and doing things
correctly without incurring unnecessary costs has led many compa
nies to rethink their business processes - a phenomenon referred
to as “Business Process Reengineering” (BPR). The focus is on cost,
quality, service, and changes in relation to the markets in which the
company operates.
Part of this trend is towards closer and more integrated co-oper
ation between companies at national and international level. This
new reality increases the need for companies to come up with viable
concepts and achievable targets and focus on product development,
marketing, technological development, financial management, etc.
The need for effective financial decision-making, management
tools and models with which to manage this new reality, has never
been greater.
Another new perspective is “Lean Thinking”, which focuses on
avoiding waste of any kind throughout the company.
Management uses business-economics models and methods to
conduct analyses and make decisions about all of these factors.
1.6 The value chain and the supply chain
1.6.1 The value chain
One model used to analyse how good companies are at meeting their tar
gets is the value chain, shown in Figure 1.4.
The value chain illustrates the various activities and how they interact
and can be viewed as an extended version of the input-output model (see
Fig. 1.1.)
Value chain analysis divides company activities up into prim ary activities
and support activities. Primary activities consist of physical processing of
raw materials and secondary materials, etc. (known as inbound logistics),
the production, sales and delivery to the customer and follow-up services.
Primary activities are only possible if various support activities are
available. Support activities include a range of overarching co-ordination
and development processes.
Companies accumulate specialist competencies and therefore the abil
ity to generate value from both primary and support activities.
Figure 1.4 The value chain.
One example of a primary activity would be a particularly efficient pro

duction process. An example of a support activity would be the ability to
develop or customise products that provide companies with a competitive
advantage, flexible ordering and delivery procedures or fast and flexible
financial management systems that make the primary activities more ef
ficient.
Companies prefer to focus on activities where they enjoy a competitive
advantage and streamline or outsource less competitive aspects of their
activities.
Value generation can be viewed in a broader perspective than just short-
term profit. Taking greater account of the customer’s needs can lead to a
long-term competitive advantage and closer links with the customer.
The example below, from the transport industry, illustrates how a car
rier and haulage contractor combine to generate greater value for an im
aginary product.
Example from the transport and haulage sector

A product's path through the supply chain extends all the way from raw
materials via the manufacturer to the consumer. Haulage companies are re
sponsible for moving raw materials, semi-finished and finished goods from
point A to point B. The activities involved are depicted in Figure 1.5.
Figure 1.5 Value creation and its cost.
The company's job is to plan, manage and run its activities in such a way
that the value generated for the customer (i.e. the services for which the
customer is willing to pay) more than covers the costs incurred by the hau
lage company, so that it is able to make a satisfactory profit.
1.6.2 The company view ed from a supply chain perspective

Companies do not operate in a vacuum. Virtually all companies form part
of a process that turns raw materials into products or services used by a
customer. This process is called the supply chain.
Figure 1.6 shows the supply chain for a pair of men’s shoes. How many
different links in the supply chain does the product go through before it
reaches the end user? The figure is an example of a well-constructed sup
ply chain:
Figure 1.6 The supply chain for a pair of men's shoes.
As Figure 1.6 shows, the supply chain is not just made up of flows o f physi
cal goods, but also the exchange of information between the links in the
chain. The flow o f information goes backwards as well as forwards. The flow
o f paym ents is mainly backwards for goods already delivered.
It is important to remember that the majority of those involved in the
supply chain act as both customers and suppliers.
If the work done by each link corresponds with market demand, then
value is added each time. In other words, leather goods and soles are only
really of any value to the end customer once they have been turned into
a pair of men’s shoes. The figure below shows how value is added to the
product at each stage of the transformation from raw materials to shoes.
It is also important to note that progressing the product along the sup
ply chain usually involves physical movement, for which a haulage con
tractor is responsible. By providing this service, the contractor adds value
to the product - shoes at a location that is nowhere near the end customer
have no practical value.
Figure 1.7 Processing and adding value (for a pair of shoes).
For the supply chain to be effective, the price the customer pays for the
shoes must cover all of the costs throughout the supply chain. This makes
financial control of each link, and of the chain as a whole, vitally impor
tant to the overall value generated. This process is known as supply chain
m anagement.
The overall market strategy is also usually a major factor in how a com
pany relates to its partners in the supply chain.
Figure 1.8 is an example of two companies in the computer industry,
each with a very different focus in terms of customer segment and product
performance.
The example illustrates the relationship between the marketing strategy
and the nature of the supply chain when it comes to choosing suppliers,
stocks, customer service and transport.
Financial management is about awareness and knowledge of the com
pany’s own financial situation and assessing the position of competitors,
suppliers and customers. This is how a company’s competitiveness is iden
tified. Basically, it means that the winner in a competitive market is the
company that supplies the customer with the greatest “utility” in the most
cost-effective way. This makes knowledge of market conditions and costs
key elements of financial management. The following section looks in
greater detail at the factors that form the basis for running a business
efficiently.
ABC Microsystems XYZ Computers
Customer segment: Customer segment:

Price-conscious customers Quality and service conscious
customers
Overall market The com pany assembles, sells and The com pany assembles, sells and
strategy provides support to price-consci provides support to PC buyers w ho
ous PC buyers w h o require good w a n t the latest and best in terms
but not exceptional performance o f both product and service and
and service. pay little attention to price.
Supply-chain Source components from the Source components from th e best

strategies cheapest suppliers w h o meet the suppliers. Price is not th e most im
minimum quality requirements. portant consideration.
Keep the lowest possible stocks to Keep enough stock to m eet even
minimise storage costs. rush orders and guarantee fast
delivery.
Hire supporters w h o provide an Employ the very best supporters

acceptable service. w h o provide superb service.
Use road transport to keep trans Use airfreight to minimise delivery

port costs down. times.
Figure 1.8 Example of the relationship between a marketing strategy and a supply chain strategy.
1.7 Financial management

Financial management is about planning future activities and meeting fi
nancial targets.
Figure 1.9 presents the process as a cycle:
Figure 1.9 The general cycle of the management process.
The management process consists of two phases:

the decision-making phase
• the implementation phase.
During the decision-making phase, a company decides what it wants to
achieve and how to go about it. If the targets prove unrealistic, they need
to be revised. This is indicated by the arrows facing in both directions.
Once the targets and action plan have been aligned, it is time to proceed
to the next phase.
The action plan outlines the route to achieving the targets. The viability
of the action plan is determined during the implementation phase.
It is important to keep monitoring and following up on progress to
wards targets. If expectations are not being met, management should ana
lyse the situation and decide whether changes need to be made. This is
known as a feedback loop.
If the nature of the budget variance suggests that the original targets
are no longer achievable, then they must be revised. This is known as a
feed-forward loop.
The circuit in Figure 1.9 is similar to a rational decision-making pro
cess. As the company goes through the process, it gains new insights and
may decide to revert to an earlier stage of the process. In this sense, the
decision-making process is a continuous learning process.
Financial management is therefore about making and implementing ra
tional decisions. Companies improve their decision-making processes and
financial management by keeping an eye on every part of the process, the
relationships between them and the situation at any given point in time.
The company must ensure that:

• it has the right amount of the right information
• it has the right methods and tools for processing the information
its decision-makers have all of the necessary decision-making skills.
Systematically checking that each step in the decision-making process is

sound improves decision making and management in general.
Companies monitor and manage many aspects of their activities via:
• financial management
• production management
• inventory management
• sales management
• materials management
• personnel management.
All of these types of management have an impact on the financial situa
tion, and the point of financial management is to quantify them in cash.
This financial data is based on action plans quantified in units, kg, hours
or other physical units.
Although all of these types of management are important and neces
sary, in different situations one can be more important than the others.
Generally, financial management is an overarching activity as it cuts
across the organisation and co-ordinates activities on the basis of the
company’s targets and, as such, covers all links in the value chain.
1.7.1 Areas of financial m anagement

Figure 1.10 shows the areas covered by financial management and the
work involved.
Figure 1.10 Financial management: Areas covered and work involved.
Activity consists of activities related to sales, production, purchasing and

stocks. The objective is to meet targets as accurately as possible given the
state of the market and the company’s production capacity and financial
wherewithal.
Capacity consists of the company’s tangible and intangible resources. The

way it deploys all of its resources - buildings, machinery, technical know
how, sales knowledge, offices, etc. - is designed to help meet its targets.
Decisions on potential investments in extra capacity are based on need
and financial strength.
Financing consists of the company’s financial holdings, which it adapts to
suit its activities, capacity needs and available options as effectively as
possible.
In Figure 1.10, the arrows indicate the relationships between the three
areas, the management of which has to be co-ordinated.
The company’s activities are multifaceted, and the problems associated
with them are often highly complex - especially where uncertainty reigns
about the future.
To keep things under control, management often groups problems,
sometimes based on particular time periods, and then co-ordinates work
on them within the periods concerned and across the company as a whole.
Example
W hat does the sales department have to do and achieve in this quarter?
This has to be co-ordinated with the production department and, in turn,
with the the stockroom and buyers.
Much of this work consists of a kind of periodisation, with the budget set
ting the parameters for day-to-day operational decisions.
1.7.2 The financial picture

The company’s accounting system serves several purposes, and differenti
ates between external and internal accounts.
External accounts
External accounts must meet certain externally determined criteria, as
well as the stakeholders’ information needs (see Figure 1.3).
The owners/shareholders, especially minority shareholders, are guar
anteed insight via the provisions in the legislation about presenting a
“true and fair” picture.
The legislation governing bookkeeping, accounting, companies and
taxation, etc. stipulates how to do the bookkeeping and keep the accounts.
This is covered in greater detail in Chapter 3.
Internal accounts
Internal accounts are management tools. The company usually bases the
decision about what form the accounts will take, on its needs.
A growing business will often focus on cash flow management; a more
stable one, on cost-effectiveness.
In the first case, the company will need frequent and comprehensive
liquidity reports. In the latter, the emphasis will be on good, detailed and
frequent cost reporting.
The main purposes of the internal accounts are:

• quantifying the results of actions - including staff performance -
and facilitating budget control via effective variance analysis
• serving as a source of information for decision-making about cus
tomers and products, based on price and profitability calculations
• acting as the basis for planning costs and managing the operational
and financial consequences of activities
• serving as a source of information on which to base tactical and stra
tegic decisions.
This is covered in Chapter 9.
1.7.3 Systematic management information

Usually, a company’s overall objective is to meet long-term profit targets.
In order to achieve this, it needs a management information system that
provides up-to-date information about every aspect of the company and
its situation.
It is also important that the company sets targets based on the factors
that are essential to achieving its long-term goals, such as customer sat
isfaction, product and process quality, employee satisfaction and devel
opment, product development, etc. Traditional financial management (in
cash) must be supplemented by non-financial benchmarks that act as in
dicators of future performance.
This makes management multidimensional, incorporating customer
satisfaction, product and process efficiency and innovation and learning,
all of which are crucial to future profits. Management information sys
tems often revolve around the Balanced Scorecard model, which is dis
cussed in Chapter 9.
The important point about any management information system is
that it must help the company meet its targets.
Sometimes, companies will have multiple options. At other times, their
options will be strictly limited. The freedom to manoeuvre, in terms of
managing their own affairs, varies according to multiple internal and ex
ternal factors. It is important that a company is always aware of, and un
derstands, the specific situation in which it finds itself, and that it makes
the best possible decisions on that basis. Previous actions and decisions
are of no direct consequence.
Management is not about the past but about the future, which the com
pany still has the chance to forge.
2 The process of
generating profit

• understand how companies set targets
• explain the background to company earnings
• understand the concept of controllable variables and the four Ps
• account for fixed and variable costs
• account for the company's profit
• analyse the contribution margin at scarce capacity
• conduct break-even analyses
2.1 Targets
For most companies, long-term survival is the main objective.
This general aim can broken down into financial and non-financial tar
gets. The classical view is that the overarching financial goal is to maxim
ise profit, supplemented by non-financial targets relating to:
• market share
• revenue growth
• return on investment
• use of technology
• customer satisfaction
• shareholder value (e.g. share-price targets).
The nature of these targets determines management decisions. For ex

ample, focus on becoming the market leader may lead to lower earnings
for a given period and increase the risk of making a loss. Or a policy of
marketing a wide range of products may entail selling certain items with
a loss.
The time factor is also important. For example, a company that markets
high-tech products will usually invest large amounts in research and de
velopment. This may reduce profit here and now but will lead to higher
profits and competitive advantage at some point in the future.
The company achieves all of these objectives via the value chain, which
generates value for customers (see Chapter 1). This makes it important to
plan its activities so that production costs are covered by the price custom
ers are willing to pay.
In other words, in order to generate revenue a company needs to know
its market and manage production as efficiently as possible so that it min
imises its costs.
2.2 The company and the market

The market is basically where buyers and sellers meet. This is where com
panies have to prove themselves by supplying products and services that
provide value at a price customers are willing to pay and which covers
costs and generates a profit.
It is crucial that the company knows its market and its customers, in
cluding what motivates them - individually and collectively - to buy.
2.2.1 Demand and sales

The ability to sell p rodu cts depends on th e dem and for th em .
As a concept, demand is defined as the number of units of a product or ser

vice people are willing to buy in a given period of time.
The market demand for a product depends on:

• price
• consumer purchasing power (disposable income)
• consumer demand
• the price of other products
• quality
• sales and marketing
• socio-economic trends.
All of the companies selling a particular product have to share the avail
able demand between them, which means there is a limit to how much
they will each be able to sell.
As a concept, sales is defined as the number of units of a product or service
people are willing to buy in a given period of time from a specific company.
The concept of sales, is therefore one that is viewed from the perspective
of the individual company.
2.2.2 Controllable variables

All companies set sales targets. They either strive to sell as many units as
possible or to generate the highest possible earnings.
In general, sales are affected by:

• product
• price
• promotion
• place.
Figure 2.1 The four Ps.
These are known as the marketing mix or the “four Ps”.1
Controllable variables are factors the company determines and that affect
sales.
The company aligns the controllable variables in a way that reflects de
mand for its products and services and maximises its earnings. Once con
1 The four Ps model was devised by American Professor Philip Kotler. It has subsequently been
expanded to the seven Ps, which are particularly relevant to service companies.
sumers prefer a particular company or brand, the way is paved for higher
prices and greater sales volume.
Once the company has analysed the demand for its products or services
and its competitors, it is ready to draw up a marketing strategy based on
the four Ps (see Figure 2.1).
Product
The most important controllable variable is the product itself. This is what
has value for the customer.
Products consist of core and peripheral services. For example, a cus
tomer buying a mobile phone does not just buy the core services (calls and
messages). They also buy a particular design and brand, a service provider,
technical service and advice from sales staff and other supplementary or
peripheral services.
Example
Product Core services Peripheral services
Mobile phone Calls, messages and internet Service provider, brand

access
Car Transport Financing options, prestige
Computer Information and IT use DVD player, speed, design
A company also has to know how its product differs from those of its com
petitors, because product design affects the production costs.
Price
Price plays a major role in all business administration. Setting the price at
the level that will maximise earnings is absolutely crucial and to do so the
company has to know what current and potential customers are willing
to pay.
Price is such an important controllable variable precisely because it is
often the key factor that drives demand. Comparing prices with the com
petitors is also relatively easy - especially if the products are very similar.
In order to make a profit, the sales price must at least cover the cost of
making the product or of buying it for resale.
Promotion
A product will only sell if people know about it. Promotion and communi
cation to current and potential customers are vitally important.
Place
Delivery and distribution play key roles in the logistics chain. The reliabil
ity of a company’s supply and distribution channels affects the availability
of its products to customers.
Companies align these four variables to influence sales of given products.

The relationships between them mean that the best result is achieved by
co-ordinating decisions about all four. For example, when planning a sale,
a shop not only cuts prices, it advertises, makes sure particular products
are available and may decide to extend its opening hours.
Example
Dansk Supermarked A/S, which includes Bilka, Fotex and Netto, buys many
of the products it sells from China and South East Asia.
Transport to Denmark by ship (place) has to be co-ordinated with the
publication of sales catalogues (promotion), i.e. distribution and marketing
have to be aligned.
If the products are not in the shops at the advertised time, the
company's reputation will take a hit.
The success of a company’s ability to affect the controllable variables is

quantified by the contribution margin, marketing contribution or profit
(see Figure 2.2). Price has a direct impact on revenue, and therefore on
the contribution margin. Product design not only affects the number of
units sold but also the variable costs for materials and labour, promotions
affect marketing costs and fixed costs depend on factors such as distribu
tion costs.
Figure 2.2 Controllable variables and profit.
2.2.3 The product life-cycle curve and the price parameter
The product life-cycle curve (PLC) depicts market penetration over time
(see Figure 2.3). Where the product is plotted on the PLC curve also affects
pricing.
Depending on the type of product, i.e. whether it is a short-term item or
a long-term investment, the curve will progress differently.
Figure 2.3 Example of product life-cycle curve (PLC curve).
Phase 1: Introduction
The product is sold by just one company, or very few, consumer awareness
of it is low. Sales are growing slowly, so the company needs to let the world
know about the product, i.e. initiate marketing.
Setting an introductory price is particularly problematic. Price skimming
involves setting a high introductory price and allowing customers who are
willing and able to pay it to do so, i.e. skimming the cream off the mar
ket. The price is then lowered to entice new customers. This method is
particularly suitable for consumer durables that customers usually only
need to buy once. While the price is high, the product is heavily advertised,
stressing the prestige associated with it. However, it can also be used to
introduce new products in other markets e.g. convenience goods.
Phase 2 : Growth
The number of suppliers increases and competition intensifies. Awareness
of the product increases, as do sales. Fiercer competition leads to initia
tives to position brands (differentiation) and build customer preference.
Phase 3: M aturity
Almost all potential customers are now aware of the product. Sales are
still growing, but slowly. Companies usually compete fiercely on price and
product development/adaptation and the amount of advertising increases.
Phase 4 : Stagnation
The number of companies remains stable and sales consist mainly of re
placements. Sales volume is stagnating. Minor adjustments and advertis
ing are the most common initiatives at this stage. The price has stabilised.
Phase 5: Decline
The product is on its way out. Little is spent on marketing.
As the product passes through the different phases, the number of cus
tomers and their characteristics, the competing products, the number of
competitors, intensity of competition, etc. all change. Companies have to
monitor these factors and take them into account whenever they take new
sales initiatives, including price setting and advertising.
2.2.4 Sales and revenue

Sales were defined above as the number of units a company sells within a
given period in a given market.
The example below shows how the quantity sold - and therefore the
revenue - varies with the price. Price is the only one of the controllable
variables shown in the example. This will be the case with most of the
business-administration examples presented throughout the book.
It is assumed that the relationship between price and sales is based on
market research and past experience.
Example
Price Sales Revenue

P X P ╟X
7 300 2,100
6 400 2,400
5 500 2,500
4 600 2,400
3 700 2,100
The company calculates that a price cut from DKK 4 per unit to DKK 3
would boost sales by 100 units per time period, but that revenue would
fall by DKK 300.
The relationships between volume and price and between volume and
turnover in the example above are depicted in the graphs in Figure 2.4.
The solid lines represent the observations in the table. The broken lines
show what would happen if the sales curve was drawn all the way from the
y-axis to the x-axis.
The general point is that if the price changes, sales move in the oppo
site direction. In other words, there is a negative or inverse relationship
between price and sales.
Figure 2.4 Graphs depicting the relationship between price, volume (sales) and turnover.
Normally, the market reacts to a price cut in one of two ways:
• Customers are under the impression that the product is cheaper than
other ones that do not change price. When this is the case, demand
usually rises. Customers replace the more expensive product with the
one that has just become cheaper. This is referred to as the substitu
tion effect.
• Customers feel better off because they can afford to buy more with
the same disposable income and they buy more of the product. This
is called the income effect.
Although the two effects usually pull in the same direction, the substitu
tion effect tends to dominate.
Note that the controllable variable is price, i.e. the sales volume is deter
mined by the product price.
Example
Figure 2.5 shows the sales curve for yoghurt from a small dairy farm.
At a price of DKK 11-15, customers are reluctant to buy the yoghurt. The
price is too high. At a price in the range DKK 4-9, sales really take off. If the
price falls any further, sales will continue to increase, albeit more slowly.
The farm can ignore the parts of the curve that it finds unattractive and
identify the relevant part of the sales curve.
Figure 2.5 Example of yoghurt sales by a dairy farm.
The relevant part of the sales curve is the part that corresponds to prices
in the range DKK 4-11 per litre. The farm needs to set its price at a point in
this range.
2.3 Cost factors
It is not enough for a company just to maximise revenue. It needs to make
a profit to survive in the long term. It has to recoup the costs of generating
the revenue. Only then does it make a profit.
Costs are defined as expenditure (in cash) on raw materials, components,

staff time, machines and premises etc. during a given period.
2.3.1 Variable and fixed costs

VARIABLE COSTS
Variable costs, change with the level of activity, i.e. the production or sales
volume.
Exampels of variable costs are labour costs and materials.
Example
The variable costs for the yoghurt-producing dairy farm consist of milk,
secondary materials and packaging. Production does not involve direct
labour, so labour costs are not a variable cost in this case.
If the milk, secondary materials and packaging cost DKK 3 per litre of
yoghurt, the variable costs for production during the period will be DKK 3
x the number of litres produced.
For example, if the dairy farm produces 100 litres of yoghurt per month,
the total variable costs will be 100 x 3 = DKK 300.
Figure 2.6 Example of variable costs.
As the example and Figure 2.6 show, variable costs rise in line with pro
duction and sales volume. If production is halted (0 litres), the variable
costs are DKK 0. If 100 litres are produced, the variable costs per month
total DKK 300.
FIXED COSTS
Companies incur fixed costs in order to have resources or capacity (e.g.
buildings, equipment, staff, IT and marketing campaigns) at their dispos
al at any given point in time. For example, costs associated with machin
ery and property do not disappear when production is halted or cut.
Fixed costs are not affected by production volume.
Example
The dairy has costs of DKK 5,000 per month on premises and leasing machi
nery.
These costs are not affected by the number of litres of yoghurt produ
ced. They are fixed costs (see Figure 2.7).
Figure 2.7 Fixed costs.
In practice, a given cost may have both variable and fixed elements.
Example
The labour costs paid to sales staff can be divided up into variable and
fixed elements.
For example, if a member of sales staff receives a fixed salary of DKK
16,000 in September topped up with 3% commission on sales of DKK
300,000, the total wage cost is DKK 25,000.
Fixed salary (fixed cost) DKK 16,000

Commission 3% of DKK 300,000 (variable cost) DKK 9,000
Total salary (total wage costs) DKK 25.000
The costs are shown in Figure 2.8.
Figure 2.8 Example of combination of fixed salary and commission.
2.3.2 Calculating unit costs

A company has to record its direct costs for materials and labour if it wants
to calculate the costs of a given product.
Information and data for this purpose are collected from lists of parts,
logs, etc. that detail the time and materials needed to produce a single
unit. This information, which is quantified in terms of physical units (e.g.
kg, units, hours, etc.), is combined with cost prices and wage rates to cal
culate the cost per unit.
Figure 2.9 shows an example of this calculation for a sofa.
Example
Unit cost - sofa
Materials Physical units Cost price Total costs

W o o d (m3) 1 200 200
Fabrics (m 2) 3 100 300
Secondary materials 1 100 100
Total materials 600
Labour costs Hours W ag e rate
Jo in er 2 200 400
Total w a g e costs 400
Total costs 1,000
Figure 2.9 Calculating the unit cost of sofa.
The example is highly simplified. In practice, unit costs are difficult to cal
culate because a whole range of different materials, secondary materials
and workflows are involved.
2.4 Profit
Once it is aware of how the company’s activities trigger costs and generate
expenditure, the next job for management is to find the optimum combi
nation of the controllable variables (price, product, promotion, place) to
meet its financial targets.
The difference between revenue and variable costs is called the contri
bution margin.
Contribution margin = Revenue - Variable costs
The contribution margin is the basis upon which companies generate

earnings. This surplus from the sale of its products has to cover its fixed
costs and provide a profit for the owners/shareholders. The bigger the con
tribution margin, the greater the profit - as long as fixed costs remain
unchanged.
Profit = Contribution margin - Fixed costs
When faced with a choice of multiple alternatives, companies choose the
one that will maximise the potential profit.
Figure 2.10 shows three alternative scenarios. In financial terms, Op
tion 2 is the best because it has the highest contribution margin (and
profit) per month. The table also shows that the fixed costs (rent, admin
istration, etc.) remain constant at DKK 70,000 per month, irrespective of
revenue and production volume.
Note that with Option 1, the contribution margin per month does not
cover the fixed costs. However, the DKK 50,000 in contribution margin
generated would cover a large proportion of them.
Example
Option 1 Option 2 Option 3
Revenue 200,000 300,000 400,000

- Variable costs -150,000 -200,000 -320,000
Contribution margin 50,000 100,000 80,000

- Fixed costs -70,000 -70,000 -70,000
Profit -20,000 30,000 10,000
Figure 2.10 Profit under different scenarios.
The example shows that, in the short term, maximising the contribution
margin per period of time should be the company’s main focus. The deci
sion-making process could be described like this:
1. W hen the contribution margin is positive, it pays to produce/sell the

product.
2. W hen there are several options, choose the one that generates the big
gest contribution margin.
These two rules apply as long as there is spare capacity, i.e. when there are
no upper limits to production and sales opportunities.
2.4.1 Prioritisation w hen resources are scarce

Production factors often limit the volume a company is able to produce.
Limited capacity, e.g. machine time, raw materials or staff, may mean that
it has to prioritise. In order to meet its financial target (i.e. maximise its
profit), scarce resources need to be utilised as well as possible.
This adds a third rule to the financial decision-making process:
3. W hen resources are scarce, prioritise production/sales according to con
tribution margin per unit of the limited (or scarce) resource.
The scarce factor may be machine hours, materials (in kg or number of

units) or staff hours.
Example
A company plans to make and sell three products - A, B and C. During the
period for which it is drawing up plans, it has a capacity of 290 hours. A
table is drawn up to illustrate the income, cost and time factors.
Product A B C
Sales (units) 50 100 40
Sales price (D KK per unit) 250 200 500
Variable costs (DKK per unit) 125 125 200
Time (hours per unit) 2 1 6
The tables below calculate the production schedule that would generate
the largest contribution margin during the period concerned.
As the number of hours available is categorised as a scarce resource, the
company needs to calculate the contribution margin per hour.
Product A B C
Sales price (DKK per unit) 250 200 500
Variable costs (D KK per unit) 125 125 200
Contribution margin (D KK per unit) 125 75 300
Time (hours per unit) 2 1 6

Contribution margin (D KK per hour) 62.50 75.00 50.00
Priority/ranking 2 1 3
Product B has the highest contribution margin per hour, so the company
makes it the first priority when it comes to scarce resources (hours avail
able). The second priority is Product A. Product C is third.
The production schedule that makes the most out of the scarce resources
(hours), and therefore provides the highest possible contribution margin,
is:
Product B: 100 units © 1 hour = 100 hours
Product A: 50 units © 2 hours = 100 hours
Product C: 15 units © 6 hours — 90 hours (residual capacity)
290
This production schedule would give the following contribution margin:
Product B: 100 units @ DKK 75 = DKK 7,500 or 100 hours @ DKK 75 = DKK 7,500
Product A: 50 units @ DKK 125 = DKK 6,250 or 100 hours © DKK 62.50 = DKK 6,250
Product C: 15 units @ DKK 300 = DKK 4,500 or 90 hours © DKK 50 = DKK 4,500
Total contribution margin DKK 18,250 DKK 18,250
If the company had prioritised the contribution margin per unit instead,
the contribution margin would only have been DKK 15,125.
Production schedule C o n trib u tio n m a rg in /u n it Total co n trib u tio n m argin Time
40 units C DKK 300 DKK 12,000 240 hours

25 units A DKK 125 DKK 3,125 50 hours
DKK 15,125 290 hours
2.5 Break-even analysis

Break-even analysis works out the exact point at which a company’s rev
enue covers its costs without making either a profit or a loss. It is a simple
tool that provides management with a solid understanding of how rev
enue, costs and profit would be affected by changes in sales volume, sales
price and variable or fixed costs.
A break-even analysis divides costs into fixed and variable costs. Varia
ble costs change with the production and sales volume. Fixed costs remain
constant, even when volume changes.
The break-even p o in t is th e exact p o in t a t w hich th e c o n trib u tio n m argin

covers fixe d costs w ith o u t th e com pany m aking e ith e r a p ro fit o r a loss.
This p o in t can be calculated fo r:

• revenue
• sales volum e
• sales price
• to ta l variable costs
• variable costs per u n it.
Break-even analysis is based on three assumptions:
1. There is a linear relationship between revenue and sales on the one hand
and variable costs and production on the other.
2. Sales price per unit and variable costs per unit remain constant throug
hout the period analysed. The same goes for the fixed costs.
3. Each period is considered in isolation. In other words, the company can
not buy or produce items to keep them in stock.
The break-even point occurs at the sales volume where the total contribu
tion margin is exactly equal to the fixed costs. In other words, revenue
must cover the sum of the variable and fixed costs. In both cases, the prof
it is zero.
Example
A company plans to sell sa te llite n avigation so ftw a re to am ateur yachts
men. The cost price is DKK 1,000 per u n it. The sales price is DKK 1,800. The
cost o f a stand at th e b oat show is DKK 40,000. Calculate h ow many units
(X) th e com pany w o u ld need to sell a t th e b oat show to reach th e break
even p o in t.
Answer
The c o n trib u tio n m argin has to cover th e fixe d costs o f a tte n d in g th e b oat
show (DKK 40,000).
Revenue - Variable costs - Fixed costs = P rofit

(Sales price · X) - (Variable costs per u n it · X) - FC = P ro fit
1,800 · X - 1,000 X -4 0 ,0 0 0 = 0
800 · X = 40,000
X = 50 units
The fo rm u la could also be w ritte n as:
The break-even p o in t is 50 units.
The break-even p o in t can also be expressed in term s o f revenue (DKK):
50 units x DKK 1,800 = DKK 90,000
This is called th e break-even revenue.
If the company sold fewer than 50 units, it would make a loss. If it sold
exactly 50, it would break even. If it sold more than 50, it would make a
profit. The break-even revenue, i.e. the point at which the costs of a stand
at the fair would be covered, is DKK 90,000.
Example continued
The company expects to sell 80 units.
How much w o u ld th e c o n trib u tio n m argin per u n it have to fa ll a t a sales
volum e o f 80 units b e fore th e com pany makes a loss?
Answer
The fixe d costs o f DKK 40,000 m ust be covered by th e c o n trib u tio n m argin
- i.e. it m ust be at least DKK 40,000.
Break-even c o n trib u tio n m argin

per u n it =
From th is it can be deduced th a t:

Break-even sales price = break-even c o n trib u tio n m argin per u n it + variable
costs per u n it = 500 + 1,000 = DKK 1,500 per un it.
Break-even cost per u n it = sales price - break-even c o n trib u tio n m argin per
u n it = 1,800 - 500 = DKK 1,300 per un it.
The break-even contribution margin per unit is DKK 500. Compared to

the original contribution margin calculated by the company, it could fall
by DKK 300 (800 - 300) without the company making a loss.
This DKK 300 per unit can be converted into a break-even sales price,
which the company can allow to fall by DKK 300 (DKK 1,800 to DKK
1,500) per unit.
Alternatively, the maximum loss can be converted into variable costs
per unit, which the company must not allow to rise by more than DKK 300
(from DKK 1,000 to DKK 1,300 per unit).
Note that when calculating the break-even point for different variables
(marketing, sales price or average variable cost), the other variables are
kept constant. It is only possible to conduct an analysis based on one vari
able at a time.
Example
A young s tu d e n t w ants to run a business on th e side and com bine it w ith
her hobby, w hich is w in d s u rfin g .
There are no dealers selling e q u ip m e n t in th e to w n w h e re she is study
ing, b u t th e re seems to be a fa irly large m arket. She decides to s ta rt selling
boards.
Based on her research, she has collated th e fo llo w in g in fo rm a tio n :
Costs
1. Cost per board fro m a German m a n u fa ctu re r = DKK 1,000
2. Sails per board fro m a Swedish m a n u fa ctu re r = DKK 700
3. O th e r e q u ip m e n t (fittin g s , fo o t straps etc.) = DKK 300 per set
4. A ll o f these prices include delivery
5. Rental o f premises in m arina suitable fo r use as a storeroom , m o u n tin g
area and sales room = DKK 14,000 per annum
6. Estimated a d m in istra tio n costs = DKK 10,000 per annum
7. Estimated sales and m arketing costs = DKK 36,000 per annum
Sales
1. Sales w ill be d ire ct fro m th e rented premises at s tip u la te d times, as w ell
as online
2. She w ill deal w ith a d m in istra tio n , sales, m o u n tin g and shipm ent herself.
Problem 1: H o w m any units can she sell and w h a t price should she demand?
She sets th e sales price per fu lly m ounted board at DKK 4,000, th e same as
a c o m p e tito r in th e nearest big to w n .
She anticipates selling 40 units p.a. in th e local area over th e ne xt fe w

years. She also expects to make o n lin e sales. Realistically, she expects to sell
50 units p.a.
Problem 2: H ow m any does she have to sell to reach break-even p o in t?
Based on the analysis shown in Figure 2.11, the break-even sales point is
30 units, i.e. this is the exact point at which the sales volume will cover
both variable and fixed costs. Only beyond that point will there be any
thing left for her (i.e. labour costs and profit).
Sales price = DKK 4,00C per u n it
Expected sales = 5C units p.a.
Average variable costs (1,000 + 700 + 300) = DKK 2,000 per u n it
CM = DKK 2,000 per u n it
Fixed costs (14,000 + 10,000 + 36,000) = DKK 60,000 p.a.
Sales Revenue VC CM FC TC Profit
0 0 0 0 60,000 60,000 -60,000
10 40,000 20,000 20,000 60,000 80,000 -40,000
20 80,000 40,000 40,000 60,000 100,000 -20,000
30 120,000 60,000 60,000 60,000 120,000 0
40 160,000 80,000 80,000 60,000 140,000 20,000
50 200,000 100,000 100,000 60,000 160,000 40,000
60 240,000 120,000 120,000 60,000 180,000 60,000
70 280,000 140,000 140,000 60,000 200,000 80,000
80 320,000 160,000 160,000 60,000 220,000 100,000
90 360,000 180,000 180,000 60,000 240,000 120,000
100 400,000 200,000 200,000 60,000 260,000 140,000
Break-even sales (units) = (FC/CM per un it) = 30 units p.a.

Break-even revenue (DKK) = (Break-even sales x sales price) = DKK 120,000 p.a.
Safety m argin (units) = (expected sales - break-even sales) = 20 units p.a.
Safety m argin (DKK) = (expected revenue - break-even revenue) = DKK 80,000 p.a.
Safety m argin (%) = (safety m argin in DKK/expected revenue) = 40 %
Figure 2.11 Break-even calculation.
If she succeeds in selling 50 units, profit for the first year will be DKK
40,000.
The safety margin shows how much she can afford to fall below this tar
get without making a loss. This is illustrated in the graph in Figure 2.12.
She does not think that an expected profit of DKK 4 0 ,0 0 0 is that much
because she also has to factor in all of the time she will spend on the pro
ject. There is also an element of risk - in the worst-case scenario, this
would amount to a deficit of DKK 6 0,000 (based on fixed costs) if she fails
to sell a single board.
Figure 2.12 The break-even p o in t as a graph.
Example (continued)
The s tu d e n t ponders her o p tio n s fo r reducing risk and m axim ising p ro fit.
If she spends a fu rth e r DKK 15,000 on advertising and sales, she expects
to sell 70 units p.a. at a price o f DKK 4,500 per un it.
The break-even revenue is still:
This has n o t changed.
Based on th is scenario, th e to ta l p ro fit is 70 x 2,500 - 7,500 = DKK 100,000.
The spreadsheet used for these calculations is available for download on

the website that accompanies this book. Try conducting simulations at a
variety of different sales prices, average variable costs and fixed costs p.a.
to see how the break-even point changes.
PART 2
3 Annual reports
• read a n n u a l re p o rts
• u n d e rs ta n d th e c o n te n t and p re s e n ta tio n o f incom e s ta te m e n ts
• u n d e rs ta n d th e c o n te n t and p re s e n ta tio n o f balance sheets
• u n d e rs ta n d th e le g is la tio n g o v e rn in g a n n u a l re p o rts
• e x p la in th e c o n te n t o f a n n u a l re p o rts
• e xp la in th e p ro visio n s c o n ta in e d in th e Danish Financial S ta te m e n ts
A c t c o n c e rn in g th e m ain ite m s in a n n u a l accounts
• u n d e rs ta n d th e p u rp o se o f a u d itin g accounts.
The purpose of an annual report is to inform stakeholders of the outcome

of a company’s actions and activities during the preceding financial year.
It shows how well the company has weathered both the general socio-eco
nomic conditions and the situation in its own industry, and how effective
its strategies are. Management uses the report to show how the results
were achieved, and to present a detailed account of the company’s finan
cial performance, including how this has affected its overall financial po
sition.
All of this information is presented in an annual report, which includes
a management report describing how the financial position progressed
during the year, an income statem ent and a balance sheet. The income
statem ent quantifies the outcome of the year’s activities (in DKK), while
the balance sheet shows the company’s financial position, i.e. its assets
and liabilities at the end of the year. Figure 3.1 illustrates the relationship
between the income statement and balance sheet.
Figure 3.1 Relationship betw een income statem ent and balance sheet.
An income statem ent shows how a profit or loss was accumulated during a
given period, e.g. a financial year.
A balance sheet shows the company’s assets and liabilities on the bal
ance sheet date, i.e. the last day of the accounting period (e.g. the year).
The closing balance is also the opening balance for the next period.
The start of this chapter provides a general introduction to income
statem ents and balance sheets. The legislation governing full annual re
ports is discussed later on.
3.1 Bookkeeping
In order to present income statem ents and balance sheets, companies
must record all of the financial transactions arising from their activities
during the period covered by the report. These entries are made in a book
keeping system.
The formal rules for bookkeeping are laid down by the Danish Book
keeping Act1 and related m inisterial orders.
Bookkeeping entries record how transactions affect financial perfor
mance (e.g. a sale is recorded as income) and holdings (e.g. whether the
customer pays in cash or receives credit).
The fundamental principle behind bookkeeping is that accounts are set
up for each and every item in the income statem ent and balance sheet, and
all transactions associated with these items are entered in the appropriate
account. Every company has a chart of accounts, i.e. a list of all of the ac
counts used for recording its financial transactions. In practice, the data
entry is done in computerised systems.
1 The Bookkeeping Act. Consolidated A ct no. 648 o f 15/06/2006.
3.2 Income statements
An income statem ent accounts for a company’s operations and transac
tions during a given period. It summarises all of the income and expendi
ture and calculates the financial performance for the period in the form
of either a profit or a loss.
Income - e x p e n d itu re = p ro fit or loss
3.2.1 Incom e
Income mainly consists of money generated from the sale of goods and/or
services. It is presented under the item net revenue and includes all revenue
generated from sales (minus discounts). Net sales are calculated ex. VAT
(value added tax, known in Denmark as MOMS). Companies levy VAT on
behalf of the tax authorities. It does not constitute a part of the company’s
operations and as such it is not included in the income statement, on ei
ther sales or purchases.
A sale (revenue) is recorded as income, irrespective of whether the cus
tomer pays right away or receives credit. If the customer pays in cash, the
item is posted in the cash balance. If credit is extended to the customer,
the company records it as a trade receivable.
Revenue consists o f income fro m th e sale o f goods, services, etc.

Payments are recorded w hen th e company receives cash o r cash equiva
lents (bank transfers, cheques, cash, etc.).
Example
On 15/12/2014, a company sold a shipm ent o f goods w o rth DKK 10,000. It
issued an invoice on th e same day. The term s and co nditions o f paym ent
fo r th e sale w ere 30 days. In e ffe c t, th e com pany has extended cre d it to
th e custom er and w ill n o t receive a cash paym ent fo r 30 days.
The sale counts as income in 2014 and is included in th e company's reve
nue fo r th e year.
The paym ent is n o t recorded u n til 2015, w hen th e m oney is actually
received.
Often, companies will also gain income from items like interest on bank
deposits, trade receivables and currency gains.
3 .2 .2 Costs
Costs consist o f th e raw materials, com ponents, s ta ff tim e , machines,

buildings, etc. used d u rin g th e period. They are q u a n tifie d in Danish kroner
(DKK) (or a d iffe re n t currency).
The costs for the period consist of the expenditure incurred to generate
the revenue (sale of goods). They are also recorded ex. VAT2 in the income
statement.
Costs are sub-divided into categories:

• Sales costs (characteristic of trading companies) - the cost of buying
the products sold during the period
• Production costs (characteristic of manufacturing companies) - the
cost of buying raw materials and components, labour and freight to
process the products sold during the period
• Marketing costs - costs incurred on sales and marketing activities
(advertising, sponsorship, market research, etc.)
• Rent, etc. - costs for buildings, light, heating and minor maintenance
• S taff costs - costs incurred on salaries, the National Labour Market
Supplementary Pension Fund (ATP) contributions and other social
costs (other pension contributions, etc.) on behalf of employees
• Administrative costs - costs incurred (in addition to labour costs) on
IT, telephones, postage, office supplies, etc.
• Vehicle costs - costs incurred running vehicles, e.g. petrol, insurance,
repairs and maintenance
• Provisions for depreciation - the estimated cost of the company hav
ing machinery, equipment etc. at its disposal during the financial
period
• Financial costs - interest paid on money borrowed from banks and
suppliers, or losses incurred on loans in foreign currencies, etc.
Costs th a t depend d ire ctly on sales volum e are called variable costs. In
o th e r w ords, th e y vary w ith th e volum e sold.
Materials, sales costs and wage costs during production are examples of
variable costs. Sales commission is also dependent on the volume of sales.
2 Certain exceptions apply, where companies are no t e n titled to a refund on pa rt or all o f the in p u t
VAT. See w w w .skat.d k.
Costs th a t do n o t depend on sales volum e are called fixe d costs (or capacity
costs). In o th e r w ords, th e y do n o t vary w ith th e volum e sold.
Examples of fixed costs include marketing, rent, administration, depre

ciation provisions, etc.
Income statem ents present the costs for the period. The difference be
tween costs, expenses and payments are as follows:
• Expenses are incurred w hen th e company assumes a fin a n cial o b lig a tio n ,
usually w hen it agree to receive goods o r services
• Costs are incurred w hen th e goods o r services are used
• Payment occurs w hen th e transaction takes place, in th e fo rm o f cash or
a bank transfer.
The majority of a company’s costs are incurred when it makes purchases,

e.g. wage costs or payments to an advertising agency. These are entered
into the company’s bookkeeping system at the amount shown on the em
ployee’s wage slip or the amount stipulated on the invoice from the agency.
Depreciation, however, is a form of cost for which no objective, exter
nally verifiable source exists. Write-downs on machinery, fixtures and fit
tings, etc. are calculated by spreading the purchase price over the number
of years during which the company expects to use the machine/fixture.
Example
In 2015, a com pany purchases fix tu re s and fittin g s costing DKK 60,000. A
deposit o f DKK 10,000 is paid on delivery. The rest is paid in 2016.
The fix tu re s and fittin g s are w ritte n o ff at th e same a m o u n t per annum
over th re e years, s ta rtin g in 2015.
The sub-division in to th e th re e categories o u tlin e d above is as follow s:
2015 2016 2017
Expense 60,000
P aym ent 10,000 50,000
Cost 20,000 20,000 20,000
For accounting purposes, the price of the fixture will be recorded in the
balance sheet as an asset worth DKK 6 0,000 at the time of the acquisi
tion (see 3.3.1 for more details about assets). The cost associated with the
company having the asset at its disposal (the depreciation provision) is
calculated as one-third of the purchase price for each of the three years
during which it is used, i.e. a cost of DKK 20,000 is entered for each year.
As well as the DKK 20,000 cost p.a., an amount for impairment is also
entered under assets. By the end of the first year, the value of the fixture
has dropped to DKK 40,000.
3 .2 .3 Layout and p re s e n ta tio n o f incom e sta te m e n ts

The most common way to present income statem ents is in the form of a
report in which data is classified either by nature or by function.3
Figure 3.2 is an example of an income statem ent in which the same com
pany’s data is presented both by nature and by function.
The column in which the data is classified by nature shows all of the
staff costs and all of the depreciation provisions combined in one number.
Other external costs consist of marketing expenses, rent, etc.
Income statem ent DKK Income statem ent DKK

BY NATURE 1,000 BY FUNCTION 1,000
N e t revenue 1,100
Sales costs 600 N et revenue 1,100
O th e r e x te rn a l costs 130 P ro d u ctio n costs 805
Gross p r o fit 370 Gross p r o fit 295

S ta ff costs 200 D is trib u tio n costs 92
D e p re c ia tio n 45 A d m in is tra tio n costs 78
O p e ra tin g p r o fit 125 O p e ra tin g p r o fit 125

N e t fin a n c ia l costs 12 N et fin a n c ia l costs 12
N et p r o fit 113 N et p r o fit 1 1 3
Figure 3.2 Example o f income statem ent by nature and by fun ction.
When the entries are classified by function, the costs are assigned to the
appropriate organisational function (department) in the company. All
costs associated with production, e.g. labour costs, maintenance costs,
rent or depreciation provisions on machinery, are assigned to production
costs. This means that staff costs and depreciation provisions, etc. are as
signed to the various parts of the company in which they are incurred.
Some general costs, e.g. rent and cafeteria costs, may be difficult to
assign to specific functions. In these cases, the company must choose a
3 Schedule 2 to the Danish Financial Statements Act contains examples o f the d iffe re n t forms of
presentation. The tem plates show the minim um requirements. Companies may alter the te x t if doing so
enhances the info rm atio n value.
reasonable algorithm with which to assign each type of general cost. For
example, rent could be assigned according to the number of square metres
in each department, canteen costs by the number of employees, etc. Note
that the same algorithm must be used every year.
In the example, costs are allocated to three functions: production, dis
tribution and administration. If a company is involved in a great deal of
product-development work, it may be in its interests to provide analysts
with a better understanding of this by adding a separate line to the income
statem ent and presenting development costs as a fourth function.
Neither method of presentation facilitates an exact breakdown into
variable and fixed costs, as per the definitions in 3.2.2.
In income statem ents classified by nature, the first subtotal, Gross
profit, comes after O ther external costs. In income statem ents classified by
function, the first subtotal, Gross profit, comes after Production costs. Both
types of presentation are outlined in the schedule to the Danish Financial
Statements Act. Note that gross profit is not the same as the concept of
the “contribution margin”, which is used in operating budgets to denote
revenue minus variable costs.
Irrespective of whether a company chooses classification by nature or by

function, its income statem ent will, as a rule, contain a subtotal called,
e.g.:
• operating profit/loss from primary operations,
• operating profit/loss from ordinary operations, or
• operating profit/loss.
This figure includes income and costs associated with production and/or
sales. Income and costs associated with financial activities, taxes and spe
cial items (if appropriate) are not included in primary (ordinary) opera
tions.
There are no rules governing what type of classification and presenta
tion companies must use. In practice, many sales and service companies
choose classification by nature, while manufacturers often choose to pre
sent their income statements by function.
Note that there is no difference between the two types of classification
and presentation for profit/loss from operations and for the bottom line
(net profit/loss).
The annual profit is the amount that the company has at its disposal.
Public and private limited companies can choose to pay this amount to
shareholders in the form of dividends or transfer it to equity. In privately
owned companies, the profit becomes part of the owner’s personal assets.
Income statem ents also include notes specifying certain items. Some
of these are statutory requirements, and as such appear in all accounts,
while others vary from company to company. Notes are used to clarify or
elaborate on important m atters that are not immediately obvious from
the income statem ent itself.
3.3 Balance sheets

Balance sheets are used to calculate the value of the company’s assets
and liabilities at the end of the financial year. The calculation date is also
called the balance sheet date or statem ent date.
Assets consist of items of value, e.g. buildings, machinery and stock,
that the company owns and has at its disposal. Assets are also referred to
as the company’s productive capital.
Liabilities are the company’s obligations, e.g. in the form of debt to
banks, suppliers and owners, at the balance sheet date. The liabilities are
also referred to as the company’s capital funding.
Assets
= productive capital = plant and resources controlled = investments.
Liabilities
= capital funding = equity and debt obligations = financing.
While the balance sheet provides a snapshot of a company’s financial po

sition or status, the income statem ent reveals how its financial situation
evolved over the period concerned.
Trends for particular balance sheet items can be identified by compar
ing with previous periods.
In the annual accounts, the balance sheet is usually presented using
what is called a horizontal layout (see Figure 3.3).4
4 The form is found in Schedule 2 to the Danish Financial Statem ents Act.
Balance Sheet
Assets Liabilities
FIXED ASSETS EQUITY

In ta n g ib le fix e d assets 70 Share cap ital 500
T a ngible fix e d assets 800 R etained e a rning s 540
Financial fix e d assets 150 Proposed d iv id e n d 40
1.020 1.080
CURRENT ASSETS
Inv e n to rie s 400 PROVISIONS 100
Trade receivables 300
Securities 60 DEBT/BORROWED CAPITAL
Cash and cash e q u iv a le n ts 100 L o n g -te rm d e b t 200
860 S h o rt-te rm d e b t 500
Total d e b t 700
TOTAL ASSETS 1.880
TOTAL LIABILITIES 1.880
Figure 3.3 Example o f a balance sheet w ith horizontal layout.
Assets are items of value that a company has at its disposal. Their current
net value is the result of past actions (e.g. buying a machine, extending
credit to a customer). Assets also form the basis for the company’s opera
tions - in other words, it’s impossible to produce goods without machines,
or to sell products without offering customers credit.
Liabilities are what the company owes to the owners or shareholders in

the form of equity and to others in the form of debt obligations. These are
current obligations that are the result of past events, e.g. equity injections
by owners or shareholders, loans taken out and raw materials bought on
credit.
The liabilities show the capital acquired, while the assets show how the
money has been spent. This means that assets and liabilities always bal
ance out.
As shown in Figure 3.3, the balance sheet is divided into two main
groups and five sub-groups:
1. Assets
• Fixed assets (long-term assets)
• Current assets (short-term assets)
2. Liabilities
• Equity
• Provisions
• Debt obligations (short-term and long-term debt)
Debt obligations consist of amounts owed to outsiders, e.g. banks, local
authorities, the government or suppliers. For this reason, debt is also re
ferred to as borrowed capital. Equity consists of the money that the own
er/shareholder have invested in the company and the amount that has ac
crued to them, i.e. the company’s “debt” to its owners. This is why equity
is listed under liabilities.
The company’s equity consists of the difference between assets and to
tal debt obligations (including provisions).
Assets - d e b t incl. provisions = e q u ity
Under both assets and liabilities, the least liquid items are listed at the
top. The least liquid is the asset or liability that would take the longest to
convert into cash or cash equivalents. Buildings are less liquid than cars,
and stocks take longer to convert into cash than trade receivables, as the
goods in the warehouse have not been sold yet. Securities and cash hold
ings are the most liquid assets, so appear at the bottom of the list. Equity
is the least liquid liability, since the owners are only allowed to withdraw
equity from the company under special circumstances. Long-term loans,
naturally, take longer to pay off than short-term loans, so appear first in
the list of debt obligations.
3.3.1 Assets
As mentioned above, assets are sub-divided into two main groups: fixed
and current. Fixed assets can be classified as long-term, current ones as
short-term.
FIXED ASSETS
Fixed (or long-term) assets are ones that the company will own for a pro
longed period and use for its own purposes. They are not intended for re
sale. Money spent on fixed assets is tied up for longer, because it takes
time for machinery, etc. to pay for itself.
Fixed assets are sub-divided into three groups:
1. Intangible fixed assets

These are assets that are not physically present. A distinction is drawn
between intangible fixed assets that companies acquire and ones that
they generate.
Intangible assets acquired by companies consist of know-how, patents,
goodwill, etc.
For example, goodwill arises when the price paid to acquire another
company is greater than the difference between the value of the assets
and the debt obligations acquired.
Example
Price paid to acquire com pany 5,000,000
- Equity (assets - d ebt) 3.500.000
= G o o d w ill5 1.500.000
The goodwill acquired in this way must be posted as an asset.
Intangible assets generated by companies consist of development projects,

rights, patents, trademarks, etc.
For a lot of companies, intangible assets make up an increasing propor
tion of their total assets.
2. Tangible fixed assets

Tangible fixed assets include physical assets such as:
• land and buildings
• plant and machinery
• other fixtures, fittings and materials used in operations.
Tangible fixed assets consists of the value of machinery, equipment used

in production, vehicles, computer equipment and office fixtures and fit
tings that the company has at its disposal.
The amount listed on the balance sheet is the acquisition cost minus
impairment (depreciation provision) since acquisition. This amount is
also referred to as the book value.
Fixed assets must be written down over their useful life on the basis of
an estimate made when they were acquired.
5 A noth er form o f go odw ill arises when a doctor takes over a medical practice. As w ell as paying fo r
the premises and equipm ent, the doctor also pays fo r the patients. If the practice has a large number of
longstanding patients, the price goes up.
Example
Asset acquired fo r DKK 1,000,000
Annual depreciation provision = cost price divided by useful life
U seful life D e p re c ia tio n B ook v a lu e a fte r 1 ye a r B ook v a lu e a fte r 3 years

p ro v is io n p.a.
5 years DKK 200,000 DKK 800,000 DKK 400,000
10 years DKK 100,000 DKK 900,000 DKK 700,000
A long depreciation period may indicate a conservative replacement pol

icy, i.e. not replacing assets until they are worn out. A short period may
signal that the company prefers to use the latest technology.
3. Financial fixed assets

Financial fixed assets include stakes (equity) in subsidiaries and associ
ated companies, as well as other securities that the company intends to
keep for a prolonged period of time.
CURRENT ASSETS
Current (short-term) assets are ones that the company does not intend to
own or use for long. These are constantly in the process of conversion into
money (liquidity).
Current assets typically include the following categories:

1. Stocks or inventories - the value of goods purchased for resale by a
trading company, or stocks of raw materials, goods for processing
and finished goods in a manufacturing company. A service company
has no stocks or only very small ones.
2. Trade receivables - the value of goods sold, i.e. the amount owed by
customers at the balance sheet date (including VAT).
3. Securities - the company’s holding of government bonds, etc., which
provide a better return on capital than current bank interest rates
but can be sold off quickly if the company needs liquidity.
4. Cash and cash equivalents - bank deposits and cash available to the
company immediately.
3 .3 .2 Liabilities
As mentioned above, liabilities are split into three broad categories: eq
uity, provisions and debt obligations.
EQUITY
The owners/shareholders are particularly interested in the amount of eq
uity in a company - be it a personally owned company, a private limited
company or a public limited company (see below).
Personally o w n e d com panies

In personally owned companies (sole proprietorships and partnerships),
the equity reflects the capital invested by the owners and the proportion
of profits not withdrawn for private use.
Example
Personally ow ned com pany (in DKK 1,000)
Equity at s ta rt o f period 100

+ annual p ro fit 250
350
- w ith d ra w n fo r private purposes 110
Equity at end o f period 24Ü
Lim ited com panies

In private and public limited companies, the equity consists of several ele
ments:
Operating capital
In public limited companies, the operating capital is called equity. In pri
vate limited companies, it is called share capital. The amount shown is the
original capital, i.e. the nominal value of the shares or equity.
Example
The nominal group share capital fo r th e pro p e rty adm inistration company
DEAS Holding is DKK 10 m illion, divided into 1,000,000 shares o f DKK 10 each.
Retained earnings or losses
Retained earnings consist of the proportion of net profit retained in the
company over the years, i.e. the proportion of annual profits not paid out
in dividends.
Proposed dividend for the financial year

The management must present its proposals for the use of the company’s
profits in the income statement. If it proposes to issue dividends, this is
shown under shareholders’ equity.
When comparing equity in different companies, it is important to take
into account the proposed dividend. Once the dividend is paid out, it is
subtracted from total equity. Payment is made immediately after the gen
eral meeting has approved the annual report.
Example
Net p ro fit fo r a public lim ite d company 113,000
Proposal fo r assigning th e p ro fit:
Transfer to e q u ity 73,000
D ividend to shareholders 40,000
Equity th e re a fte r:
Share capital 500,000
Surplus tra n sfe rre d at s ta rt o f period 467,000
+ Transferred fro m net p ro fit 73.000
Retained earnings a t year-end 540,000
Proposed dividend 40.000
Equity a t year end 1.080.000
PROVISIONS
Provisions are liabilities characterised by a degree of uncertainty about
the amount to be paid and/or the tim ing of the payment. For example, an
amount may be allocated to a director’s pension every year, but the com
pany does not know exactly when the director concerned will choose to
retire and therefore when the pension will be paid out.
DEBT O BLIG ATIO N S (BORROW ED CAPITAL)
D ebt o b lig a tio n s are characterised by th e fa c t th a t:

a) th e a m o u n t is ow ed to a p a rticu la r legal e n tity (person o r company)
b) th e a m o u n t is due a t a certain tim e
c) th e exact a m o u n t is know n.
Debt obligations are divided into long-term and short-term debts.

1. Long-term debts (non-current liabilities) are due after a year or more.
This often includes mortgage debt, i.e. debt to mortgage credit institu
tions, secured against real estate. All amounts not due for payment for
more than a year from the balance sheet date are listed as long-term
debt. Any payments due during the financial year are posted under
short-term debt.
2. Short-term debts (current liabilities) are due within a year. An overdraft

facility is a form of loan. The bank allows the company to draw on the
facility up to a pre-arranged amount. The debt is the amount the com
pany owes on the balance sheet date. Banks usually reserve the right
to withdraw an overdraft facility at short notice, so these are entered
under short-term debts.
Money owed to suppliers for goods for resale or raw materials - known as
trade payables - is also entered under short-term debt.
VAT debt is the amount owed to the Danish tax authorities (output VAT
minus input VAT).
Miscellaneous debt consists of all other debt on the balance sheet date,
e.g. employee income tax and labour market contributions, expenses such
as auditors’ fees, advertising costs, fuel bills, etc. incl. VAT.
3.4 The Danish Financial Statements Act

Company accounts are regulated because external stakeholders depend on
the reliability of the information provided. The Danish Financial State
ments Act regulates the content and format of the accounts.
All companies subject to the Financial Statements Act must publish an
annual report. The purpose of the annual report is to ensure that there
is sufficient information to make financial decisions based on the com
pany’s accounts. The company is therefore required to provide relevant
and reliable information about its current financial situation, as well as
information that provides a sound basis on which to evaluate its ability to
generate a profit.
The annual report illustrates the financial consequences of the com
pany’s decisions and actions, as well as the impact of external factors such
as legislation, socio-economic conditions, competitors, etc.
The annual report does not provide an unambiguous description of the
company. Analysts have to form their own impressions based on the gen
eral picture it presents.
The relevant legislation consists of the Bookkeeping Act, the M iniste
rial Order on Bookkeeping and the Financial Statements Act. The Finan
cial Statements Act is amended regularly to keep up to date with develop
ments in international legislation.6
FSR - Danish Auditors7 also publishes accounting standards that inter
pret and expand upon the Financial Statements Act. The Financial State
ments Act, Bookkeeping Act and the M inisterial Order are all available in
Danish from the Danish Business Authority website: www.erhvervssty
relsen.dk.
Most of the big accountancy firms also publish commentaries on the Fi
nancial Statements Act, including examples of accounts. See, for example:
www.kpmg.dk,www.deloitte.dk,www.ey.dk or www.pwc.dk.
The Financial Statements Act stipulates that annual reports must be pub
lished and that they must include a management report and accounts for
the year. Company may also produce supplements, e.g. on corporate social
responsibility (CSR), knowledge resources, employee relations, ethics and
the environment. Companies with a history of pollution are also required
to publish green audits.
The Financial Statements Act is designed to:

• to take into account a wide circle of users of the financial statements
• align Danish rules with international standards
• consolidate the rules for different types of companies
• incorporate non-financial information.
6 Financial Statements Act, consolidated act no. 1253 o f 01/11/2013 as later amended.
7 FSR - Danish A uditors, w w w .fsr.d k.
3.4.1 Readers
“Annual reports must be written in a way that helps readers make finan
cial decisions.”8
Readers/users can be defined as:9

• current and prospective participants in the company (owners)
• creditors
• staff
• customers
• alliance partners (e.g. in the supply chain)
• the local community
• official agencies.
3 .4 .2 A d a p tin g to in te rn a tio n a l rules and reg u latio ns

Internationalisation also has an impact on accounts. It is advantageous
for Danish companies that trade and/or seek to raise capital abroad to pre
sent accounts that comply with international standards, as this enables
customers and lenders abroad to read them without incurring additional
effort or costs.
Danish legislation is written - and amended regularly - so that it is
aligned with relevant EU directives. Where appropriate, national legisla
tion also complies with the International Financial Reporting Standards,10
which otherwise only apply to listed companies.
3 .4 .3 C om panies covered by th e legislation

The Financial Statements Act applies to all commercial companies except
those subject to the accounting rules set by the Danish Financial Super
visory Authority (banks, insurance companies, building societies, etc.),
those covered by the Danish State Accounting Act and those under local
authority control.
Companies are divided into five accounting classes, as per the building
block model in Figure 3.4.
8 The Danish Financial Statements Act, section 12 (2).

9 See also the stakeholder model in Figure 1.3.
10 IFRS is pa rt o f the EU's endeavours to improve the inner m arket by requiring all listed companies
to present group accounts according to the same rules. The actual standards are w ritte n by the
International Accounting Standards Board (IASB), which is a private organisation composed o f
international experts (see w w w .eogs.dk).
Figure 3.4 Size lim its in the Financial Statements A ct (the build ing-b lock model).
The requirements placed on annual reports increase in line with the com
pany’s size (class).11 A company must at least comply with the rules and
requirements for its own class and below, and may opt to comply with the
rules for a higher class. For example, a company in class C must comply
with the rules for classes A, B or C, and may volunteer to comply with
those for class D.
Companies listed on the Copenhagen Stock Exchange, the Danish Au
thorised Marketplace or a stock exchange abroad must comply with the
rules for class D.
3 .4 .4 S u p p le m e n ta ry rep o rts
Any company wishing to publish supplementary reports must include them
in its annual report, along with the rest of the standard requirements. Un
der the Financial Statements Act, supplements can include corporate social
responsibility (CSR), knowledge resources, staff terms and conditions, the
environment, ethics, etc. These supplements are subject to the same quality
requirements as the rest of the annual report.12 The point of the Financial
Statements Act is to ensure that annual reports contain information about
everything that might affect the company’s future activities. Publishing
supplements is one way of ensuring compliance with this requirement.
Supplements are covered in greater detail in Chapter 5.
11 A company changes classes if it exceeds tw o o f the lim its fo r tw o consecutive financial years. The
lim its are stipulated in the Danish Financial Statements Act, section 7 (2).
12 The Danish Financial Statements Act, section 14.
3.5 Content of annual reports
The annual report must include all of the company’s financial reporting.
The annual report covers a fixed period of 12 m onths.13 Many Danish
companies follow the calendar year, i.e. a financial year starting on 1 Ja n
uary and ending on 31 December. However, companies are free to choose
any other 12-m onth period, e.g. 1 May to 30 April.
At a general meeting of the company, a decision may be taken to publish
the annual report in English only.14 Appendix 3 at the back of this book
consists of an English/Danish reference list of the main terms used in
company accounts.
The annual report must include:

• a management report and endorsement
• income statement with notes
• balance sheet with notes
• cash flow statement (only compulsory for medium-sized and large
companies, and companies listed on the stock exchange, i.e. report
ing classes C and D).
Management reports describe main activities and trends, as well as the

overall financial situation (see 3.9).
Income statem ents show the profit or loss on activities during a certain
period (the financial year). Companies in classes A, B and medium-sized
ones in C do not have to disclose revenue - the first line in their income
statem ent can be Gross profit.15 In either its income statem ent or the man
agement report, a company must disclose how the management proposes
to allocate its profits or cover its losses.16 The rules for income statements
are covered in greater detail in 3.10.
Balance sheets show the company’s productive capital and capital fund
ing on the balance sheet date (see 3.11).
Cash flow statem ents show the effect on liquidity of activities during
the financial year, including operations, investments and other financial
activities (see 3.12).

15 The Danish Financial Statements Act, section 32 (1) and section 81.
Supplementary notes to income statements, balance sheets and cash flow
statem ents provide additional information about items contained in the
accounts. Some of these are statutory requirements, others voluntary.
Income statements, balance sheets and cash flow statem ents can be
in Danish kroner (DKK), euros (€) or any other currency relevant to the
company and its business.17 In this context, “relevant” is defined as a sig
nificant proportion of the company’s purchases and/or sales being in the
currency concerned. The bookkeeping must be in the same currency.
Example
Vestas produces w in d m ills and publishes its accounts in euros because
m ost o f its transactions - i.e. supplies and sales - are in th a t currency.
3.6 Basic requirements for annual reports

3.6.1 The tru e and fa ir picture
The Financial Statements Act’s guiding principle is that the annual report
must reflect a true and fair picture of the company.
This is stipulated in section 11 (1):
Section 11 (1). A nnual com pany and g ro u p accounts m ust provide a tru e
and fa ir pictu re o f th e com pany and group's assets and lia b ilitie s, financial
po sition and financial perform ance. The m anagem ent re p o rt must also
p rovide a tru e and fa ir account o f th e m atters covered in it.
In effect, this means that the annual report must be drawn up in a man
ner that ensures that the information about individual items is relevant
and reliable, and that the report provides the reader with a true and fair
impression of the company’s financial position and how it is developing.
The Financial Statements Act stipulates that annual reports must in
clude a section called Accounting policies,18 which describes how the compa
ny has met this requirement. Companies that comply with the IFRS rules
include this information in a note.
The principle of the true and fair picture applies to the whole of the an
nual report, i.e. it also covers the management report and any supplements.

If the more detailed provisions in the Financial Statements Act conflict
with the requirement to provide a true and fair picture, the latter takes
precedence. In cases where this applies, a note to that effect must be in
cluded.19
3.6 .2 Basic accounting principles

The rules laid down in the Financial Statements Act are designed for use
in a wide range of businesses - companies of all sizes, with all kinds of
product ranges, including trading companies, manufacturing companies,
service companies, etc.
However, it is difficult to draw up rules to cover every eventuality. The
Financial Statements Act is therefore based on a number of basic account
ing principles that are sufficiently general to apply to all businesses.20
The conceptual framework for the Act describes the purpose of annual
accounts, the basic concepts on which they are based and their context.
The idea is that the general provision about a true and fair picture should
be interpreted as uniformly as possible.
These basic requirements for annual reports are contained in sections
11-14 and Schedule 1 of the Financial Statements Act, in the Conceptual
Framework for International Accounting Standards, IAS 1 and in Regnska-
bsvejledning 1 (Danish guidelines). For more on the latter two, please refer
to more specialised literature.
The requirement for a true and fair picture includes compliance with
the following basic requirements:
Quality (clarity and substance)

The information contained in the annual accounts must be presented in a
clear and orderly manner, and must be relevant and reliable.21
All information potentially relevant to an analyst/reader must be in
cluded, and no significant information omitted. In this context, “relevant”
and “significant” are defined as information that could influence the ana
lyst’s decisions.
The information contained in the annual report must be reliable, which
in this context means that it must be reasonably easy to verify the infor
mation. There must be no omissions, errors or distortion of the facts.
19 The Danish Financial Statements Act, section 11 (3) and section 13, no. 2.
21 The Danish Financial Statements Act, section 13, no 1.
The Financial Statements Act also aims for comparability, i.e. between the
same company’s financial statem ents over time, and between different
companies.
The Act stipulates that these concerns outweigh its other, more spe
cific, rules, and that financial reporting must focus on content, substance
and financial reality rather than on form alities.22
Going concern
When annual accounts are drawn up, the assumption is that the company
concerned will continue to trade and is not facing bankruptcy. The going
concern principle implies that the accountant believes that the company
will be able to survive the next 12 months of trading.
This is important for the value of the company’s assets. Machines that
continue to be used by a company may have more value than if sold off. If
a company goes out of business, the realisable value of its assets is often
significantly lower than that recorded in its accounts.
Continuity
The company must use the same accounting policies from one year to the next
to facilitate comparisons over a period of several years (actual continuity).
The year-end balance must be identical to the opening balance the fol
lowing year (formal continuity).
Accrual
The accounts must include all income and expenditure relating to the year cov
ered by the accounts, irrespective of when the payments for them are made.
Separate valuation o f each item (gross value)

All assets and liabilities must be valued separately. They must not be offset.
Neutrality/caution
The Financial Statements Act operates with a concept of neutrality, which
states that “any change in value must be shown”, regardless of how it af
fects equity and the income statem ent.23 In practice, this means that cer
tain assets and liabilities must be shown at their current value in order
to give the most accurate possible impression of the company’s real value.
This applies, for example, to property owned by the company.
22 The Danish Financial Statements Act, section 11 (3) and section 13, no. 2.
23 The Danish Financial Statements Act, section 13, no. 5.
To a limited extent, however, the Act does allow companies to adopt a
more cautious approach, in the sense that the writing down (depreciation)
of tangible assets is compulsory, while writing up is voluntary (within the
framework of the general quality requirements).
3.7 Public access to annual reports

Following approval by a general meeting, annual reports from companies
in classes B, C and D must be submitted to the Danish Business Authority
without undue delay.
For companies in classes B and C, the deadline is a maximum of five
months after the end of the accounting year. In class D, the deadline is
four m onths.24
The Danish Business Authority is responsible for ensuring that all of
the submitted reports are made available to the public,25 so that interested
parties can study the companies’ finances.
3.8 BoConcept Holding A/S

Annual reports by BoConcept Holding A/S will serve as an example in the
following sections.
BoConcept, which is listed on the Copenhagen Stock Exchange, designs
domestic furniture. Production is largely outsourced to external suppliers.
The main sales channel consists of shops owned by franchise operators.26
In the financial year 2013/14, turnover was over DKK 1 billion, across
60 markets worldwide, and the company had an average of 627 full-time
employees.
As a listed company, BoConcept is in class D.
The review of the accounts is based on the BoConcept Group. The Group
includes a number of companies, all of which are subsidiaries (see Chapter
1). The data for each company’s revenue and costs, as well as their bal
ance sheets and cash flow statem ents, are incorporated into the Group
accounts.
BoConcept shares are shares in the Group.

25 The annual reports are published at w w w .skoda.em u.dk. Access is by subscription b u t many
educational institutions have one.
26 If you own a franchise, you own and manage the shop yourself, b u t your franchise agreem ent gives
you the rig h t and oblig ation to use th e franchise's concept fo r shop interiors, m arketing and range o f
products. The franchise op erator pays the franchise holder a fee fo r certain services. The p ro fit from
the shop goes to the franchise operator.
3.9 Management reports
Companies in class B must publish a management report in which they
account for any significant changes in their activities and financial situ
ation.27 In effect, this means that only limited requirements are placed on
management reports by companies in this class.
Companies in classes C and D are subject to stricter requirements, and
must publish a management report that provides users with an under
standing of the company.
Pursuant to section 99 of the Financial Statements Act, they must pro
vide information about the following:
M in is te ria l o rd e r on th e Danish Financial S tatem ents A ct
Section 99. The m anagem ent re p o rt must:
1. describe th e company's main activities

2. describe any uncertain factors included in calculations o r valuation,
s ta tin g am ounts w henever possible
3. describe any unusual circumstances th a t may have had an im pact on th e
calculations and valuation, sta tin g am ounts w henever possible
4. account fo r developm ents in th e com pany's a ctivities and in its fin a n cial
s itu a tio n
5. account fo r any sig n ifica n t events since th e end o f th e fin a n cial year
6. describe th e m anagem ent's expectations fo r th e company, including
any special p reconditions o r uncertain factors on w hich th e m anage
m ent has based its expectations
7. describe th e company's kn o w le d g e resources (if th e y are o f p a rticu la r
im p o rta n ce to fu tu re earnings)
8. describe any specific risks - i.e. in a d d itio n to general ones in th e rele
va n t in d u stry - including business and fin a n cial risks th a t may a ffe c t the
com pany
9. describe th e company's e ffe c t on its external e n viro n m e n t and th e m ea
sures taken to prevent, reduce o r rem edy any dam age caused
10. describe research and d e ve lop m e n t activities in and fo r th e company
11. m e n tio n any branches it has abroad.
As well as describing activities during the financial year concerned, the

management report must also describe any significant events that have
occurred since it ended. This provides the reader with the best possible
basis on which to assess the company’s financial situation at the time the
27 The Danish Financial Statements Act, section 22 and section 77.
accounts are published, which may be four or five months after the end of
the financial year.
The management report must compare the actual financial perfor
mance with the expectations set out in the previous annual report, to en
able the reader to assess the extent to which the company has met its own
targets. It must also include expectations for the coming year(s).28
The management report must also include a description of the risks
and uncertainties that the company faces. This information is critical for
any potential investor or partner seeking to evaluate the company’s future
prospects.
If necessary, in order for analysts/readers to understand developments,
big companies in classes C and D must also supplement descriptions of
their activities with information of a non-financial nature relevant to spe
cific activities, e.g. about the environment and human resources.29
Large companies in class C and companies in class D must also publish
a corporate social responsibility report30 (see Chapter 5).
Companies must provide a summary of key financial data for the past
five years.31 This allows the reader to form a quick impression of recent
trends.
Companies in class D must disclose the executive positions and/or di
rectorships their executives and directors hold in other companies.32 This
provides an overview of their experience in relation to their roles within
the company
Listed companies must also state whether - and to what extent - they
comply with stock exchange rules on corporate governance.33 This may in
volve a quite significant amount of information, so management reports
are allowed to make do with including a link to the company website (see
Chapter 11 for more details about corporate governance).
Companies are obliged to disclose all of this non-financial information
because governance issues will have a major impact on their ability to
make the most of opportunities in the future.

30 The Danish Financial Statements Act, section 99 a.
33 The Danish Financial Statements Act, section 107 b.
While the Danish requirements on management reports are fairly compre
hensive and specific, the IFRS only imposes a few general requirements.
The IFRS does, however, place greater demands on the content of notes.
The board and executive management must sign a declaration endors
ing the annual report as a whole, including the management report. The
declaration must confirm that the annual report complies with all legal
guidelines and that it provides a true and fair picture of the company’s as
sets and liabilities, financial position and financial performance.34
As mentioned above, management reports and any supplements must
comply with the requirement to provide a true and fair picture. They are
not a part of the audit. The auditor reads the management report and
checks that it is consistent with the content of the accounts (including the
income statem ent and balance sheet).35
BoConcept’s management report 2013/2014 is shown below in Figure 3.5.
R E V IE W
BoConcept in brief 2
Financial highlights and key figures 4
Financial highlights 5
Foreword 7
Strategy and business model 8
2013/2014 Financial review 14
Risk management 22
Management 26
Shareholders 28
Corporate social responsibility 30
Supervisory and executive boards 32
Figure 3.5 The con tent o f the m anagem ent re p o rt o f BoConcept 2013/14.
Source: http://w w w .boconcept.com /en-gb/investor-relations
The table of contents indicates that BoConcept has complied with the Fi
nancial Statements Act in terms of providing information about the com
pany, developments, corporate governance, risk factors, etc.
Download the BoConcept annual report 2013/14 in English from http://
www.boconcept.com/en-gb/investor-relations

3.10 Income statement for BoConcept
In real life, income statements can be more complicated than the one
shown in Figure 3.2, but the basic content is the same.
Figure 3.6, below, shows BoConcept’s income statem ent 2013/14.
The company’s financial year runs from 1 May to 30 April. It presents
its income statem ent by function.
The numbers on the left refer to notes. You can download the full re
port and read the notes from: http://www.boconcept.com/en-gb/investor
relations
For purposes of comparison, each line displays the data for the previous
year (2012/13). These comparative figures were calculated using the same
principles as the data in the accounts. This is a legal requirement.36
Figure 3.6 Consolidated income statement for BoConcept 2013/14.

Source: http://www.boconcept.com/en-gb/investor-relations
Companies in classes C (large companies) and D must list net revenue by
business segment and geographic m arket.37
Note 3 to the income statem ent covers staff costs, labour costs and av
erage number of employees. Companies in classes C and D must provide
this inform ation.38
In note 4, BoConcepts shows the amount of depreciation provisions for
the three functions included in the total costs. It also shows the deprecia
tion provisions by type of asset.
Some income statements also include an entry called Special items. This
is a catch-all term for items that are not part of ordinary operations and
are not expected to recur. Special items covers both income and expendi
ture. As a rule, the note will stipulate what items are covered by the entry.
BoConcept did not list any special items in 2012/13 or 2013/14.
After O perating profit/loss (i.e. Earnings Before Interest and Tax (EBIT)),
BoConcept lists financial items, i.e. income and expenses, including inter
est, exchange-rate adjustments and other adjustments that do not stem
from the calculations of revenue and expenditure.
If the Group has any associated companies, its share of their profit/loss
will be posted under financial items.
All companies draw up special tax accounts and base their corporation
tax calculations on them. Tax accounts differ from income statements,
including in the way they calculate depreciation provisions. Tax accounts
are not available to the public.
If the company plans to sell or close down an activity, it must (where pos
sible) include an entry showing the profit/loss from it. Where possible, the
amount that this activity contributed to Net revenue and Fixed and current as
sets should also be included.39 This information is usually presented in a note.
BoConcept had no discontinued operations to report during this period.
During financial year 2013/14, BoConcept made a loss of DKK
1 2,839,000 on a turnover of DKK 1,049,469,000.
Minority interests are the proportion of the profit, or in this case loss,
made by subsidiaries. These do not accrue to BoConcept because the com
pany was not the 100% owner of all of the subsidiaries during the finan
cial year 2013/14.
As mentioned above, the BoConcept Group made a loss of DKK 12,839,000
in 2013/14. Subsidiaries not 100% owned by BoConcept ran up losses that

38 The Danish Financial Statements Act, section 98a and section 98b.
the other owners of these subsidiaries must help to cover. As a consequence,
the owners of BoConcept Holding have posted minority interests of DKK
1,029,000. This means that the overall result for the owners of BoConcept
Holding for the year will “only” be a deficit of DKK 11,810,000. Had the sub
sidiaries made a profit, it would have been the other way round, i.e. a propor
tion of the Group’s profit would have been deducted from the net profit/loss
and transferred to the other part owners of the subsidiaries.
In BoConcept’s management report, the proposal for dividends to
shareholders is included under Investor Relations (p.28). Some companies
post their dividend proposals immediately after N et profit/loss.
3.10.1 O th e r e xa m p le s of incom e sta te m e n ts

The insulation manufacturer Rockwool is a (somewhat rare) example of
a manufacturing company with an income statement classified by type.
Its annual reports are available from www.rockwool.com/investor/results.
Matas is an example of a trading company that publishes an income state

ment classified by type. Trading companies do not have production costs.
Instead, the sales costs, i.e. the cost of goods purchased for resale, will
be relatively high. Matas publishes its accounts and other information on
www.matas.dk.
The property-management company DEAS is an example of a service com

pany that publishes an income statement classified by type. Service com
panies don’t incur costs for production or stock. Value is generated by pro
viding customers with a service, and therefore staff costs are significant.
The annual report is published at: www.deas.dk.
Coloplast is an example of a company that publishes an income statement

classified by function with development costs. Since development costs
are not directly related to future income, they must be posted as costs in
the income statement. For development projects with a documented link
to products or processes that will not yield a profit until a future date,
the costs must be entered as intangible assets by companies in classes C
(large) and D. For companies in classes B and C (medium), provided the
accounts still provide a true and fair picture, the inclusion of development
costs is optional40 (see also Section 3.11). The income statement is avail
able at http://www.coloplast.com/Investor-Relations/Annual-reports/.
3.11 The BoConcept balance sheet
Figure 3.7 below shows the BoConcept balance sheet. The structure and
comparative figures are the same as for the income statement.
The balance is calculated as per 30 April 2014 - the final day of the
company’s financial year.
3.11.1 Assets
Under IFRS rules, fixed assets are called long-term assets, while current
assets are called short-term assets.
BoConcept has three types of intangible assets. Goodwill includes the
value of acquired goodwill. Master rights endow the right to open and run
shops in a specific market. BoConcept retains some of these rights (the
ones that appear in the balance sheet), while others are sold to franchise
operators.
Although BoConcept does not incur development costs for new prod
ucts, it does have software development costs, including the value of work
done to develop new IT systems for managing corporate logistics. Compa
nies in class B and medium-sized companies in class C that incur devel
opment costs can opt to list these as intangible assets. Large companies
in class C and all companies in class D must list development costs if the
project is likely to generate future income (or savings) for the company.41
Other development costs are posted in the income statement.
41 The Danish Financial Statements Act, section 33 and section 83.
Figure 3.7 Balance sheet fo r BoConcept 30/4/2014.
Source: http://w w w .boconcept.com /en-gb/investor-relations
Intangible assets are usually written off over a maximum of 20 years.42
However, under IFRS regulations for goodwill, listed companies must in
stead conduct an impairment test. This involves the company assessing
whether the value of goodwill has diminished - and if so, posting a w rite
down. This can happen, for example, if it turns out that an acquisition
does not generate the level of additional earnings expected at the time of
the acquisition. In such cases, the goodwill is not worth as much as ex
pected and the asset is written down.
The main items under tangible fixed assets are land and buildings.
Since a large part of its production is outsourced, BoConcept does not have
much technical plant and machinery.
Notes 12, 13 and 15 show the effect of acquisition, sale, depreciation,
etc. on the respective assets.
Current assets consist primarily of stocks of goods and trade receivables,
which make up half of BoConcept’s total assets. Note 16 subdivides these
goods into raw materials and consumables, goods in progress manufac
tured goods and goods for sale.
The calculation of the stock’s value consists of two stages: counting how
many items the company has in stock; and determining the value of the
various products.
Stocks are valued (quantified) at initial price if the product is purchased,
or at cost price if the company produced it. Cost price consists of m ateri
als and labour directly attributable to the item in question.43 A number of
indirect production costs, e.g. supervisor labour costs, electricity, machin
ery costs, depreciation, etc., must also be allocated to the various products
produced during the financial year. Companies in classes C and D must
include these indirect production costs in their cost price.44
The value of the items in stock can be calculated by the FIFO method
(first in - first out) or by weighted average.
If the net realisable value is lower than the value at the balance sheet
date (based on FIFO or weighted average), the net realisable value is used.45

45 The Danish Financial Statements Act, section 45 and section 46 (2).
The valuation method can have a major impact on the company’s results
(see the example below).
Example
Based on the weighted average method, the value of the goods in stock is
DKK 150,000. Based on the FIFO method, the value is DKK 175,000.
W eigh ted average (D KK) The FIFO method (D KK)
Revenue 900,000 Turnover 900,000

- Sales costs: - Sales cost:
Stocks at start Stocks at start
of year 100,000 of year 100,000
+ cost o f aoods 600.000 + cost of aoods 600.000
700,000 700,000
- Stocks at year end 150.000 550.000 - Stocks at y ear end 175.000 525.000
Gross profit 350,000 Gross profit 375,000
The example shows that under the FIFO method, the value of the stocks at
the end of the financial year is DKK 2 5,000 higher than under the weight
ed-average method. This also means that sales costs are DKK 2 5,000 low
er, and the gross profit correspondingly higher. The gross profit and the
company’s surplus are therefore a direct result of the way in which the
company’s stocks are valued.
Companies are not allowed to change method from year to year unless
the report states the reason for the change and describes its impact on the
results.46
Trade receivables represents what customers owe the company and is de
rived from the sale of goods. Under certain circumstances, a company may
determine that particular customers will be unable to pay. In such cases,
the value of the trade receivables is written down, so that the amount list
ed in the balance sheet reflects the amount that the company expects to
receive in payments from its customers. Any write-down is entered as a
cost in the income statement.
3.11.2 Liabilities
The first item under Liabilities & equity is always share capital, which is the
least liquid form of liability. This post includes the nominal value of the
shares issued in the company.
Retained earnings has decreased because the board is proposing that the
annual loss be transferred to equity. It is proposed that there will be no
dividends payed to the shareholders.47
Any other changes to equity are disclosed in a separate equity state
ment, either in the report or in supplementary notes.48 These can be quite
complicated and are not covered in this book.
If the Group has minority interests, i.e. stakes in subsidiaries that it
does not own 100% , the value of these is shown on a separate line under
equity. The minority interests shown under liabilities consist of the share
of the value of the subsidiaries owned by parties other than the Group at
year end.
The IFRS rules require that provisions are divided into long- and short
term, and assigned to either long- or short-term debts, respectively. Bo
Concept complies with this.
BoConcept posts deferred tax under Long-term liabilities. Deferred tax
may result from different timescales in calculation depreciations in the
published accounts and the company's tax accounts.
Example
A ta n g ib le fixed asset costs DKK 1,200. In th e published accounts, it is w r it
te n o ff over six years in six equal am ounts. In ta x term s, th e asset is w ritte n
o ff as per th e reducing-balance m ethod a t 25% per year.
Value
a fte r d e
preciation
fo r ta x a Tax-
tion pur related Balance
Operational poses at declining Tax value fo r th e
straight- th e start balance A ddi o f addi item
Book line de o f the deprecia tional ta x tio nal al Deferred
Year value preciation period tion allow ance lowance ta x
1 1,200 200 1,200 300 100 25 25

2 1,000 200 900 225 25 6 31
3 800 200 675 169 -31 -8 23
4 600 200 506 127 -73 -18 5
5 400 200 380 95 -105 -26 -21
6 200 200 285 71 -129 -32 -53

The column "Additional tax allowance" is calculated as "Tax-related decli
ning balance depreciation" minus "Operational linear depreciation".
The tax value of the additional allowance is calculated as "Additional tax
allowance" multiplied by the corporate tax percentage.
The right-hand column shows how the balance for the item deferred tax
develops over the six-year period.
The example shows that in the first two years, the company posted a
bigger write-down in its tax accounts than in its income statement. As
a result, the company receives additional tax allowances and pays less in
tax than it really should - in other words, it owes tax. However, in the
subsequent years, the write-down in the tax accounts is lower than in
the income statement. A positive number after D eferred tax means that
the company owes tax, in which case, deferred tax is a liability and listed
under provisions. Companies that are expanding and investing in more
and more valuable tangible assets - and as a result, accruing greater and
greater depreciable value - will continue to list deferred tax as a liability.
Employee bonds, another item under long-term liabilities, are bonds is
sued by BoConcept and purchased by employees. In other words, employ
ees issue loans to the company for which they work. The tax rules govern
ing employee bonds used to be highly favourable. However, the employees
do run the risk of the company being unable to repay the loan.
Supplementary notes regarding the balance sheet are published on the
company website: http://www.boconcept.com/en-gb/investor-relations.
One of the statutory notes concerns contingent liabilities - conditions

that exist at the balance sheet date but have yet to be realised and are out
side of the company’s control. Since it is uncertain whether these contin
gency liabilities will ever become current, they appear in the notes instead
of the balance sheet.49
Examples of contingent liabilities include:

• legal cases, arbitration rulings, etc.
• buy-back options
• deposits and guarantees
• factoring liabilities
• option commitments.
Wherever possible, the total amount of the financial commitment should
be stipulated for each category.
It is important that analysts/readers of the accounts are able to assess
the risk of contingent liabilities becoming current, as this may affect the
company’s future performance.
BoConcept publishes details of its contingency liabilities in note 23.
3.12 Cash flow statements

Cash flow statements demonstrate the ability to generate liquidity (cash
flow). This is a significant factor when analysing a company, as it affects
the ability to repay debt and pay dividends to owners. Liquidity trends
also form the basis on which companies make investments, and as such
are crucial to growth potential.
Since, as previously described, there are differences between earnings
and payments received, and between costs and payments made, the an
nual result is rarely equal to the cash flow.
Figure 3.8 shows the main contents of a cash flow statement.
The cash flow statement cannot be deduced from the published ac
counts alone.
The cash flow statement is based on the operating profit, but also includes
depreciation - which does not have a negative impact on liquidity, as it is
not paid in cash.
When goods are paid for up front and kept in stock until sold, the com
pany has paid out before it generates income and this has a negative effect
on the cash flow. If the company extends credit to its customers, the pay
ments (the cash flow) will be delayed. This also places a strain on liquidity.
In the example, stocks have increased during the financial year, which has
had a negative impact on cash flow. Trade receivables has fallen. Less mon
ey is owed to the company by its customers. This is positive for liquidity.
Cash flo w statem en t 2014
O p e ra tin g p r o fit 125

D e p re c ia tio n 45
2013 2014
C hange t o stock levels 360 400 -40
C hange to tra d e receivables 330 300 30
C hange t o tra d e payables 300 320 20
C hange t o o th e r s h o rt-te rm d e b t 295 280 -15
In te re s t pa ym ents -12
Cash flo w from operations 153
Investments
Investm ents in m achines -150
Financing
Loan re paym e nts -25
Allocation o f profit
D iv id e n d fo r 2013 -30
Change to liquidity -52
L iq u id ity a t s ta rt o f year 152
Liquidity at year-end 100
Figure 3.8 Example o f a cash flo w statem ent.
If a company is good at negotiating (long) credit terms with its suppliers,

this has a positive effect on liquidity, because the company retains the
money (liquidity) until it makes the payment. In the example above, trade
payables have increased, which means that suppliers have made more li
quidity available to the company. Other debt has decreased but only be
cause liquidity was used for this purpose, which has a negative impact on
cash flow.
Interest payments also detract from liquidity.
In the example above, the company made an operating profit of DKK
125,000. However, payments received totalled DKK 153,000, because
there were more positive liquidity adjustments than negative ones.
When companies invest in machinery (for example), payment is often
up front at the time of the purchase. This has a negative impact on cash
flow.
When a company takes out a new loan, money is received, which has a
positive effect on liquidity. However, loan repayments represent outgoing
money/liquidity.
In the example, the company paid out DKK 30,000 in dividends during
the financial year 2014. The money to pay this dividend was earned in
financial year 2013 and earmarked for the purpose in the year-end bal
ance sheet under equity and the heading Proposed dividend for the financial
year. However, the dividend cannot be paid until the proposal has been
endorsed at the general meeting, i.e. in the following year (in this case,
2014).
3.12.1 C onsolidated cash flo w s ta te m e n t fo r BoConcept

Figure 3.9 shows BoConcept’s consolidated cash flow statem ent for
2013/14.
The statem ent is divided up into cash flow from operating activities,
investment activities and financing activities (in that order).
It starts with Cash flow from operating activities before financial items. To
arrive at this first subtotal, operating costs are deducted from revenue.
However, depreciation is added back on because it has no effect on cash
flow (it is a cost, but not a payment, see 3.2.2). An adjustment is also made
for changes in working capital - note 24 explains how this is the result of
changes in receivables, stock levels, trade payables, etc.
Financial items and tax are deducted to arrive at Cash flow from operat
ing activities.
BoConcept then lists a liquidity result for the period’s investment in
various types of assets. New assets have been acquired and others sold.
This subtotal is often called free cash flow, but BoConcept calls it Cash
flow before financing activities.
In cash flow from financing activities, new loans will be a positive num
ber, as they represent a cash injection. Repayments are negative - much
like paying out dividends, they constitute a drain on liquidity.
BoConcept calls the result of the cash flow statem ent (the net cash flow
for the year) Cash inflow/outflow for the year. The total payments received
by BoConcept in 2013/14 were DKK 3 0 ,3 5 6 ,0 0 0 lower than the payments
made.
Figure 3.9 Cash flow Statement for BoConcept 2013/14.
At the beginning of the year, net liquidity was minus DKK 888,000. This
consists of liquid assets (e.g. bank deposits) minus short-term bank debt
(e.g. overdraft facilities). Net cash flow for the year (along with a minor
rate adjustment) increased this liquidity deficit, so that liquidity at year-
end was minus DKK 31,712,000.
The liquidity deficit at year-end consists of Cash without restrictions
at DKK 16,320,000 and a short-term debt to banks of DKK 48,0 3 2 ,0 0 0
(probably including an overdraft facility).
On page 23 of its Annual Report 2013/14, BoConcept states that it has
unutilised credit facilities of DKK 68 million. This means that the com
pany has room to manoeuvre in terms of liquidity.
3.13 Independent auditor's report

The management, executive management or board presents the annual
report. The Financial Statements Act stipulates that management is re
sponsible for ensuring that the annual report is prepared in accordance
with legislation and with the company’s own articles of association.
Part 17 of the Financial Statements Act stipulates that annual accounts
for companies in classes B, C and D must be independently audited. The
management report is not subject to mandatory audit. The auditor should,
however, express an opinion as to whether the information contained in
the management report is consistent with the annual accounts.50 Smaller
companies are exempt from the audit requirement, i.e. companies that do
not exceed the following for two consecutive years:
• balance sheet of DKK 4 million

• net revenue of DKK 8 million
• average of 12 full-time employees.
However, exemption from the audit requirement may be rescinded in the

event of certain types of rulings, e.g. in criminal cases, or if irregularities
are identified in previous accounts.51
The shareholders in private limited companies elect the auditor at the
general meeting. The auditor represents the interests of the owners and
the public, and as such must be independent of the company. The auditor
has a responsibility to readers of the company accounts. In order to ensure
that the executive management is not withholding any information, the
auditor reports directly to the board.
The auditor’s report must include all m atters to which readers of the ac
counts are likely to attribute importance when making decisions. It must
indicate whether the financial reporting complies with the legislation, in
cluding whether the accounts provide a true and fair picture of the compa
ny’s assets and liabilities, financial situation and financial performance.
The auditor must date and sign the report.

51 The Danish Financial Statements Act, section 135 (1), (6) and (7).
The auditor’s report must note reservations, if:
• the accounts do not meet the requirement for a true and fair picture
of the company’s assets and liabilities, financial position and perfor
mance
• the accounts do not contain the required information
• the accounts have been affected by uncertainties concerning how
they were calculated or unusual circumstances about which insuf
ficient information is provided
• the accounts include errors or information has been omitted
• the accounts presume that the company is a going concern but the
auditor finds that it is not
• the auditor does not receive sufficient information about matters
that have an impact on the accounts
• the auditor is unable to reach a conclusion about parts of the accounts
or the accounts as a whole
• the accounts do not comply with the legislation or any other provi
sions regarding financial reporting.
If the auditor has any reservations, these must be plainly stated and ex
plained in the report. Most auditor’s reports are without reservations. If,
during the audit process, facts come to light that could give rise to reserva
tions, these are usually remedied before the accounts are presented.
BoConcept is an example of an unqualified independent auditor’s re
port. See http://www.boconcept.com/en-gb/investor-relations
Companies that are not required to present an independent auditor’s re

port may instead request that an auditor perform a “review” or “extended
review”, both of which are less comprehensive than a standard audit. This
may be an appropriate solution for companies where the cost of a tradi
tional independent auditor’s report would not be commensurate with the
benefits.
3.14 Summary
The annual report provides readers of the accounts with an overall im
pression of the company by presenting non-financial information in the
management report and supplementary reports (if any), and financial in
formation in the income statement, balance sheet, cash flow statement
and notes. In the following chapters, we will explore how to analyse all of
this material.
4 Analysing company
accounts

• understand how the accounts are the result of external and internal
factors
• convert published financial statem ents for analysis purposes
• calculate, analyse and com m ent on key financial ratios for
pro fitab ility
• calculate, analyse and com m ent on key financial ratios for earning
capacity
• calculate, analyse and com m ent on key financial ratios fo r capital
adjustm ent
• calculate, analyse and com m ent on key financial ratios fo r solvency
and cash flo w
• calculate key stock exchange ratios
• collate all of these sub-analyses into an overall analysis o f a
com pany's accounts.
The stakeholder model in Chapter 1 illustrates the range of people inter

ested in companies and their annual reports, as well as the reasons for
their interest.
Investors have a particular interest in the short-term and long-term
earnings and growth of companies in which they invest capital. Owners
of small companies have the option of more insight into and influence
on decision-making in the company. For companies listed on the stock
exchange, the individual shareholder’s insight is based on the informa
tion made publicly available and they have a chance to exert influence at
general meetings.
Banks that provide loans and credit (borrowed capital) have a particular
interest in assessing the future outlook for the company in order to ensure
repayment of current loans and credit facilities and to evaluate whether
or not to provide new ones. Banks are also interested in assets, as they are
often put up as collateral. Loans can be secured against particular fixed
assets or against current assets by means of a floating charge. Money in
vested by banks is always, by definition, borrowed capital, which means
that, under normal circumstances, the banks do not exert influence on
the way the company concerned is managed. However, their analyses of
interim accounts and budgets often means that they have good insight
into its financial position.
Customers and suppliers are interested in a company’s financial viabi
lity. In the short term, customers want to be sure that the company will
be capable of supplying them when they submit the next orders. Suppliers
want to know whether the company will be able to pay for future orders.
In the long term, both customers and suppliers may wish to assess the
potential for working more closely together as part of the supply chain.
4.1 Background factors

No m atter what their reason is for reading an annual report, analysts usu
ally focus on assessing the company’s current situation and future out
look.
It is not possible to do this properly by just looking at the annual ac
counts. Analyses must also take into account external factors, e.g. socio
economic and political factors, conditions in the industry concerned, cus
tomers and suppliers, competitors, etc.
Internal factors over and above the accounts and finances also play a
role, e.g. visions, strategies, management structure and organisation all
provide important information about the outlook for the future.
Figure 4.1 depicts the relationship between internal and external fac
tors.
Figure 4.1 Relationship between internal and external factors.
The company’s financial performance and situation are the result of:
• external factors
• company strategies
• management’s ability to implement strategies
• management’s ability to adapt new strategies when necessary.
External factors can be subdivided into socio-economic and industry/sec

toral factors. Management may not be able to affect these factors directly
but it does have to devise strategies and targets that make the most of
them.
The effectiveness of these strategies is critical to the company’s finan
cial performance, which makes it appropriate to analyse management
competencies, company structures, knowledge resources, adaptability, etc.
All of these factors affect financial performance (as reflected in the in
come statement), the value of the company and how it obtains capital (the
balance sheet). All of these factors need to be taken into consideration
when analysing accounts and key financial ratios.
4.1.1 External factors

SOCIOECONOM IC FACTORS
The direct effect of socioeconomic trends on a company depends on how
reliant it is on the Danish, European and global economies. For example,
whereas a bread factory is not particularly dependent on general trends,
companies in the fashion and luxury goods sectors are highly dependent
on the state of the economy.
Whenever there is a general upturn, most companies make bigger prof
its. In times of recession, the opposite is the case. While this indicates
that company earnings are dependent on the general direction of macro
economic travel, the degree of sensitivity clearly differs from industry to
industry.
Interest rates are highly important for companies with a relatively large
proportion of borrowed capital, while a company with a high equity ra
tio (i.e. a high degree of self-financing) is not as directly susceptible to
interest-rate variations.
INDUSTRY FACTORS
An understanding of the prevailing conditions in a particular industry or
sector is important when assessing a company’s development and earn
ings potential.
4.1.2 Internal factors
STRATEGIES
Companies base their strategies on the current state of - and future out
look for - the economy and their sector, as well as on their own strengths
and weaknesses.
If a company wants to expand, it has to draw up a growth strategy, e.g.
aimed at developing new products or markets, or increasing its market
share with current products.
A company grows by expanding its existing activities (organic growth)
or by buying other companies (acquisitions).
Example
BoConcept pursues an organic growth strategy by opening new shops and
increasing sales in existing ones. For details, see: www.boconcept.com >
Choose UK > About BoConcept > The history > Vision, mission and values.
DEAS pursues an organic growth strategy by increasing sales to existing

customers and by "consolidation in the sector", i.e. acquiring or merging
with other companies. See: www.deas.dk.
A company must decide how much of the value chain it is appropriate to

own or control, e.g. whether it manufactures its own products or outsourc
es the work (in Denmark or abroad). It must also decide whether to focus
on economies of scale and minimising costs, or on differentiated or cus
tomised products.
PRODUCTS
Choosing the product range is another strategic decision. Based on analy
ses of the development and earnings potential of both current and future
lines, a company must decide what new products to develop and which
current lines to drop.
In practice, it is difficult to surmise from a set of accounts which prod
ucts or lines generate profit. Often, the management report only conveys
a very general impression. However, analysis of these factors is crucial to
assessing a company’s overall position and future outlook.
CUSTOM ERS AND SUPPLIERS

When analysing future earnings potential, it is crucial to study whether
a company has a diverse customer portfolio or is heavily dependent on a
few big customers.
Another parameter is dependence on suppliers, i.e. has the company done
enough to guarantee the supply of items needed for production purposes?
These factors are covered in the section of the management report that
deals with risk.1
M A N A G EM EN T, O R G A N IS A T IO N , E M P LO YE E S, ETC.
Management qualifications, the company’s degree of adaptability and
knowledge resources are examples of factors that have a major impact on
financial performance.
The best way to gather information about these factors is to follow news
about the company on media outlets and other sources. Relevant infor
mation may also be found on company websites and in annual reports,
e.g. the management report, corporate social responsibility report, risk
assessment report, corporate governance report, etc.
4.2 Analysing accounts

As previously mentioned, external stakeholders - lenders, suppliers, cus
tomers, current and potential investors, etc. - may need to assess a com
pany’s future financial outlook. Analysing trends over the previous three
to five years is a useful part of this process.
Analysing accounts and key financial ratios involves:

1. Collating m aterial on which to base the analysis
2. Converting the income statem ent and balance sheet into a form suit
able for analysis
3. Analysing the data from the income statement and balance sheet
4. Calculating, analysing and evaluating relevant key financial ratios
5. Reaching an overall conclusion.
Analysts extrapolate from historical data and trends in order to assess a

company’s future prospects, i.e. whether it is financially viable and able to
continue complying with existing agreements.
The purpose of analysing accounts is to generate a methodical foundation

to assess the financial outlook for the future based on the company's past
performance.
1 This section is a statutory requirement for companies in classes C and D. See the Danish Financial
Statements Act, section 99 no. 8.
External analyses of accounts are based on the external and internal fac
tors mentioned above, as these often explain some of the trends identi
fied. The main sources of information and explanations are, of course,
annual reports, annual accounts and notes, management reports, supple
mentary reports and company websites.
Comparisons with similar companies often improve the quality of an
analysis. Information derived from industry associations, trade journals,
magazines and newspapers also helps explain the data and trends.
4.2.1 Internal analyses

Knowledge of historical trends is an important part of day-to-day finan
cial management. This usually involves drawing up budgets and compar
ing them with past accounts in order to generate inform ation (e.g. the
causes of both positive and negative deviations) on which to base future
decisions. This information is used to adapt plans and budgets. Budget
ti n g and internal analyses are covered in chapter 9.
4.3 Collating material for analyses

External analyses of accounts are, of necessity, based on published finan
cial data and other publicly available information. This often means that
analysts are unable to source as much detailed information as they would
like. It also means that external analyses differ from internal ones in sev
eral ways.
Any analysis of accounts should include key data for multiple financial
years, so that the analyst is able to assess:
• developments and the speed at which they take place
• the financial situation compared with other companies
• reasons for the trends identified.
In order to discount the possibility of random fluctuations, analyses should

take into account the previous three to five years. Annual accounts usually
only contain comparative data for the previous year. When looking further
back, it is important to check whether any changes have been made to ac
counting policies and practices that might affect the comparisons.
Some of the calculations in this chapter include average numbers for
balance sheet items. This approach is recommended by CFA Society Den
mark (Chartered Financial Analysts).2 In order to calculate averages, the
2 CFA Society Denmark: Recommendations & Financial Ratios 2010.
analyst needs to know the balance at the start of the financial year. The
balance sheet at the start of any given financial year corresponds to the
year-end balance sheet for the previous year. If this is not possible, the
average figures can be replaced with the also called ultimo data.
Companies listed on the stock exchange publish certain key financial
ratios in their annual reports based on CFA Society recommendations.
The formulas differ in certain respects from the ones shown below. For
example, they include advanced regulations not shown here, and certain
of the balance sheet items cannot be deduced directly from the published
accounts.
4.4 Converting income statements and balance

sheets for analysis purposes
To obtain a better overview of the numbers in an analysis, it is often a
good idea to merge a number of minor items in the income statem ent and
balance sheet where it is possible to do so without losing any important
information. This is a balancing act - it involves weighing up the benefits
of a better overview against any potential loss of information value. It is
important that the same approach is adopted for all of the years covered
by the analysis.
Often, it is also helpful to use DKK millions instead of DKK thousands.
Income statem ent by nature

In an income statem ent presented by nature, the costs of raw materials
and consumables are included under variable costs and are used to calcu
late the gross profit/loss.
Other external costs, staff costs and depreciation provisions can be treated
as fixed costs.
This subdivision into variable and fixed costs may not be theoretically cor
rect, but it is the best option available to external analysts.
Income statem ent by function

Income statements classified by function do not show variable costs,
which makes it impossible to calculate a contribution margin that shows
revenue minus variable costs. Instead, the gross profit/loss is calculated.3
Gross profit/loss is defined as revenue minus production costs.
Production costs include both the variable and fixed costs associated with
production. Using this method, the gross profit will be less than a contri
bution margin calculated by only subtracting variable costs from revenue.
In income statem ents by function, the sum of the distribution costs,
administration costs and any research and development costs can be clas
sified as capacity costs.
However, this total will be less than what are properly defined as capac
ity costs or fixed costs, as some of the fixed costs will be included in the
figures for production costs.
In other words, there can be differences between the cost concepts used
in internal analyses (e.g. budgeting and operating accounts) and the way
in which external analysts are able to allocate costs.
In order to ensure comparability, the same methods and principles are used
for all of the years covered in the analyses.
Special items
As well as ordinary posts, income statem ents can also include special items.
These relate to the buying and selling of fixed assets, e.g. buildings or sub
sidiaries, or major restructuring projects to do with mergers, etc. Special
items can consist of both income and costs. They are not directly linked to
operations, so do not always feature in the accounts.
Special items often have to be explained in a note. Based on this in
formation, analysts decide whether to include them when calculating key
financial ratios. For example, when comparing ordinary operations over a
period of years, analysts may want to subtract any special items from the
annual operating profits/losses.
4.4.1 Example of converting accounts for analysis purposes

The example below shows one way in which the BoConcept Group ac
counts 2013/14 can be converted for analysis use.
Like for most companies that present their income statem ents by func
tion, one is unable to separate out the variable costs for BoConcept.
Staff costs and depreciation provisions can only be studied in greater de
tail by referring to the notes, which show how the two costs are allocated
to BoConcept’s three functions.
CONVERTING THE INCOME STATEMENT

Figure 4.24 summarises BoConcept’s income statem ents from 2009/10
until 2013/14. The analysis covers five years in order to include the year
when the financial crisis started to bite. This will allow analysts to assess
how well the company has recovered from its effects.
B o Concept G roup incom e statem ents 2009/20-2013/14 in D K K m illion
09/10 10/11 11/12 12/13 13/14

Revenue 910 1,001 1,022 1,026 1,049
Production costs -539 -580 -571 -583 -601
Gross profit/loss 371 421 451 443 448
Distrubtion costs 296 -314 -338 -327 -373
A dm inistration costs, etc. -62 -71 -76 -89 -93
Other operating costs and income -1 -1 -1 -8 -4
Operating profit/loss 12 35 36 19 -22
Net financial costs -3 -5 3 -2 -2
Pre-tax profit/loss 9 30 39 17 -24
Tax -4 -10 -14 -6 11
Result before m inority interests 5 20 25 11 -13
Minority interests -3 0 0 0 -1
Net profit/loss 8 20 25 11 -12
Figure 4.2 BoConcept Group income statements 2009/10 to 2013/14, converted for analysis purposes.
The amounts are shown in DKK millions, as this provides a better over
view for analysis purposes than the DKK thousands used by BoConcept.
Other operating income and costs are included under administration
costs. This does not diminish the information value, as the amounts in
volved are small.
CONVERTING THE BALANCE SHEET

Converting the balance sheet also entails merging items to obtain a better
overview,5 as depicted in Figure 4.3.
4 The full income statements are available in the annual reports: http://www.boconcept.com/en-gb/
investor-relations
5 Full balance sheets are available in the annual reports: http://www.boconcept.com/en-gb/investor-
relations
Bo Concept G roup balance sheets 30/4 2009-30/4 2014 in D K K m illion
ASSETS 2009 2010 2011 2012 2013 2014
Intangible fixed assets 38 43 58 63 65 87

Tangible fixed assets 177 159 134 120 113 115
Other non-current assets 42 58 59 61 62 47
Total fixed assets 257 260 251 244 240 249
Inventories 140 100 108 124 106 143
Trade receivables 104 100 115 136 144 145
Other receivables 16 20 23 22 22 29
Securities and liquidity 6 30 10 15 20 16
Current assets 266 250 256 297 292 333
TOTAL ASSETS 523 510 507 541 532 582
LIA B ILITIES & EQ U ITY

Share capital 26 29 29 29 29 29
Dividend proposed 0 0 6 6 0 0
Retained earnings, etc. 120 155 165 190 199 181
Equity share, BoConcept Holding A/S shareholders 146 184 200 225 228 210
M inority interests 0 0 0 0 0 -1
Total equity 146 184 200 225 228 209
Non-current liabilities 103 109 111 101 97 90
Trade payables 60 80 79 85 90 118
Other short-term debt 214 137 117 130 117 164
Short-term debt obligations 274 217 196 215 207 282
Debt obligations 377 326 307 316 304 372
TO TAL LIABILITES AND EQUITY 523 510 507 541 532 582
Figure 4.3 BoConcept Group balance sheets 30/04/2010 to 30/4/2014, converted for use in analyses.
Like the income statement, the amounts are shown in DKK million and
certain posts have been merged where this does not detract from the in
formation value.
The balance sheet posts for 30/4/2009 are included to make it possible
to calculate the average balance and equity for 2009/10.
4.5 Analysis of the data in the income

statement and balance sheet
The main purpose of the analysis is to identify trends for the various en
tries in the income statem ent and balance sheet.
For example, activity trends are key to determining a company’s need for
various types of assets and, therefore, the different types of costs it in
curs. Activity for the year is quantified in the revenue figure.
If revenue is up, it is interesting to know whether it is due to higher
sales volume, higher sales prices or exchange-rate fluctuations. If it is due
to higher sales, then production costs and other variable costs will also be
up. If it is due to higher prices or exchange-rate fluctuations, there will be
no increase in production costs or other variable costs.
Most analysts will also be interested in the size of the annual profit or
loss.
As far as the balance sheet is concerned, owners/shareholders and lend
ers are particularly interested in equity, as it shows the value that the
owners have accumulated in the company, as well as the degree of security
available to lenders.
4.6 Calculation and analysis of key financial ratios

Key financial data (ratios) are also used to analyse accounts. This is done
by comparing and combining various entries on the income statem ent and
balance sheet. The aim is to form an impression of the company’s:
• profitability, i.e. the ability to recoup the capital invested in the com
pany
• earning capacity, i.e. the ability to make a surplus out of the revenue
generated
• capital adjustment, i.e. the ability to exploit the available capital
• solvency and liquidity, i.e. the ability to cope with losses and pay what
it owes.
Growing interest in shares in listed companies has also led to greater in
terest in stock-market ratios, which focus on the ability to generate a re
turn for current and future investors.
Financial ratios and stock-market ratios highlight developments that
are not evident from the raw numbers in the income statem ent and bal
ance sheet.
If an analyst wishes to assess a company’s financial effectiveness over
several years, the best way to do so is to look at the relative ratios. A com
pany that has an unchanged operating profit five years in a row but has
increased its investment in assets was clearly less effective in the fifth year
than in the first. The operating profit may have remained constant, but
the return on capital employed (ROCE) has fallen (see the formulas below).
The ratios also facilitate comparisons (benchmarking) between compa
nies, irrespective of size. For example, it would make no sense to compare
the operating profit for A.P. Møller - Maersk A/S with the small shipping
company Torm A/S, because the raw figures are vastly different. However,
ROCE as a percentage is a useful tool for assessing and comparing the two
companies’ effectiveness at generating earnings from invested assets.
The ratios provide relevant information about historical financial de
velopments and current capabilities. However, current trends will not
necessarily continue - to assess the future outlook, analysts have to iden
tify the internal and external factors underpinning the past and current
trends.
Analysis consists of uncovering the reasons for the trends identified by the
ratios.
These explanations are mainly found in the management report. As this

consists of information published by the company in its official annual
report, analysts should supplement it with external sources, e.g. newspa
per articles. Socio-economic and industry-specific factors also need to be
taken into account.
The more the analyst narrows the cause down to a particular develop
ment, the easier it becomes to assess its importance to the company’s fu
ture financial performance.
An analysis of the key financial ratios for BoConcept over the period
2009/10-2013/14 is conducted below (see 4.6.1). The final year illus
trates how explanations for trends and developments can be found in
management reports. However, a complete analysis would explain trends
throughout the period. The example is based on the income statements
and balance sheets converted above for analysis purposes.
The average balance is used as the denominator, as this establishes the
strongest possible relationship with the numerator. When the numerator
contains a figure from the income statement, that figure refers to activity
for the year. This is best compared with the average balance sheet total for
the year.
If the analyst does not have access to the balance sheet numbers for the
first year covered by the analysis, or wants to focus on the balance sheet
numbers that reflect the activity for the year, year-end figures from the
balance sheet can be used as the denominator.
4.6.1 Profitability analysis
Profitability is defined as a company's ability to provide a return on capital

employed (ROCE).
A profitability analysis consists of calculating and evaluating the follow

ing ratios:
• Return on capital employed (ROCE)
• Operating margin (OM)
• Rate of asset turnover (ROAT)
• Return on equity (ROE)
• Cost of Debt (CoD).
RETURN ON CAPITAL EM PLOYED (ROCE)

When you put money in the bank, you receive interest on the amount de
posited (invested). The interest is the return on the investment. The con
cept of return on invested capital is similar in that it is calculated by com
paring a company’s earnings with the capital invested in it, in the form of
the total assets.
Return on capital employed (ROCE - also known as return on invested

capital or ROIC) shows the company's ability to pay back interest on capital
invested in it (expressed as a percentage).
In other words, ROCE indicates the relationship between operating prof

it/loss and the capital invested in the company.
The formula for calculating ROCE is:
The average balance sheet total represents the capital invested in all of
the company’s assets. The balance sheet total therefore also corresponds
to the total liabilities.
ROCE is one of the key ratios in financial analysis. The numerator is
Profit/loss for operating activities, i.e. the result of ordinary operations. In
terest and tax are not included. Special items (see above) are only included
if they are classified as operating expenses or income. The average bal
ance sheet total6 used as the denominator is calculated as the average of
the balance sheet total at the start of the year and at year-end. Therefore,
ROCE shows the profitability of general operations compared to average
invested capital.
Example
ROCE for BoConcept 2013/14:
The example shows that in 2013/14, BoConcept lost 3.9% of the money
tied up in the company (the average balance sheet total). In the previous
financial year, it had reported an operating profit, and ROCE was +3.5%,
i.e. in 2012/13 the return on investment in the company’s total average
assets was 3.5%.
In order to assess ROCE, analysts draw comparisons with similar com
panies.
In certain situations, they also compare ROCE with the market rate of
interest based on bond yields. However, when drawing comparisons, ana
lysts must consider whether assets can be realised at the amounts shown
in the balance sheet. For example, they have to know whether the compa
nies used the same accounting policies. They must also take into account
the risks associated with running a business, which sometimes lead to de
mands for a ROCE higher than the market interest rate for risk-free invest
ments, e.g. bonds. This can be expressed by calculating a risk premium:
ROCE in 2012/13 3.9%

- Market interest rate 3.0%
= Risk premium 0.9%
The risk premium shows that in 2012/13 BoConcept was able to generate
a return almost 1% above the market interest rate. In other words, the
risks involved in doing business were rewarded. The opposite was the case
in financial year 2013/14.
Finally, it should be noted that ROCE reflects the impact of past ac
tions. W hether the trend will continue, rise or fall depends on the reasons
6 Average total assets is sometimes seen in the denominator. This is the same as Average balance
sheet total.
for the current level and historical trend. These reasons can be analysed in
greater depth by calculating other key financial ratios.
OPERATING MARGIN
The operating margin (OM), also referred to as the EBIT-margin, shows
how much profit a company generates as a proportion of its revenue.
The operating margin shows the relationship between income and costs.
The formula for calculating the operating margin is:
Example
Operating margin for BoConcept 2013/14:
The calculation shows that, measured as a proportion of its revenue, Bo

Concept made a loss of 2.1%. The corresponding figure in 2012/13 was a
profit of 1.9 %, i.e. the operating margin was 1.9% of revenue. These fig
ures are from operations (i.e. before interest and tax).
W hether or not the result is deemed to be satisfactory depends on the
previous years’ results and on expectations. Comparisons with other com
panies in the same industry also help indicate whether a company has ex
ploited its potential satisfactorily.
RATE OF A SSET TURNOVER
The rate of asset turnover expresses the relationship between activities and
the resources deployed to generate them.
The activities are quantified in terms of revenue, the resources as the av
erage of the company’s assets at the beginning of the year and at year-end.
ROCE and OM are expressed as percentages, ROAT as the number of times
p.a. assets are converted into earnings. The higher the rate of asset turno
ver, the better the company is at generating revenue from its assets.
Example
Rate of asset turnover for BoConcept 2013/14:
In other words, every time BoConcept invested DKK 1.00 in assets, the
company generated DKK 1.88 in revenue.
RELATIONSHIP BETWEEN RATE OF CAPITAL EMPLOYED,

OPERATING MARGIN AND RATE OF A SSET TURNOVER
The rate of capital employed depends on the operating margin and rate of
asset turnover. The formulas for these show that:7
ROCE = Operating margin • Rate of asset turnover
Example
A ROCE of 18% could be achieved in many ways.
Company A could be a manufacturer with large amounts of money tied up

in assets (machines) and therefore a low rate of asset turnover. Company
B could be a service company with few assets, but a higher rate of asset
turnover.
In the example, Company A has a better operating profit than company
B. However, the two companies achieve the same ROCE despite company A
having a lower rate of asset turnover.
Co m p an y OM ROAT = ROCE
A 12% 1.5 times = 18%
B 6% 3 times = 18%
The following can be used to double-check the mathematical calculations:
Example
BoConcept 2013/14: -2.1% 1.88 = -3.9%
(ROCE = -3.9%, as per the previous calculation)
ROCE is the key ratio for evaluating operating profit. Note that the ROCE
trend reflects the trend for either the operating margin, i.e. the relation
ship between activity (revenue) and costs, or the rate of asset turnover,
i.e. the relationship between activity (turnover) and resources (balance
sheet). It can, of course, also reflect both.
The trend for the operating margin can be studied in greater depth by
analysing the company’s earnings capacity, which focuses on the income
statement.
The rate of asset turnover can be studied in greater depth by analysing
capital adjustment, which involves relating various balance sheet entries
to the relevant entries for activities in the income statement.
The Du Pont Pyramid in Figure 4.4 illustrates these relationships.
Figure 4.4 Du Pont pyramid with data from BoConcept 2013/14.
The Du Pont Pyramid is a good way of generating a quick overview of the
main reasons for a particular trend in ROCE in a particular year.
RETURN ON EQUITY
The owners of a company are particularly interested in the return on their
investment. This is calculated as the return on equity.
Return on equity measures the percentage return on the capital that the
owners have invested in the company.
Return on equity is calculated as:
The ROE is based on net profit after tax and minority interests, i.e. the
amount that accrues to the owners/shareholders. The profit/loss made is
divided by equity minus minority interests.
Example
ROE after tax for BoConcept 2013/14:
The return on equity is often compared with bond yields because bonds
are considered an alternative investment. However, this is subject to
the same provisos outlined in the section on return on capital invested
(ROCE) above.
If you would prefer to calculate the return on equity before tax, insert
profit/loss before tax into the numerator.
Example
ROE before tax for BoConcept 2013/14:
For BoConcept, ROE before tax is lower (i.e. more negative) than after tax.
This is unusual, and reflects the fact that BoConcept had a positive bal
ance in its tax accounts for the year. In other words, the profit before tax
is lower (more negative) than the profit after tax.
C O S T O F D EB T
Cost of debt (CoD) shows the average amount the company pays in interest
on the capital provided by outside lenders.
CoD is calculated as:
Net interest8 is divided by total average debt obligations, including provi

sions.
CoD is influenced by national interest rates, bank lending rates, foreign
currency-exchange adjustments on debts and receivables and exchange
adjustments relating to securities.
As well as national interest rates, the interest paid by companies on
debt is influenced by whether the loans and credit are short- or long-term,
whether the interest rate is variable or fixed, and what the company has
put up as security. This will be illustrated later in the section on solvency
and liquidity.
In addition, if the deadline for repayment is observed, interest is not
charged on some parts of the borrowed capital, e.g. trade payables, taxes
due, VAT due and other liabilities to the public sector. If the company is
good at obtaining interest-free credit, this will also have a positive impact
on the cost of debt.
Example
CoD for BoConcept 2013/14:
BoConcept paid an average of 0.6% net interest on its debt obligations.

This is more than the company earned (or in this case, lost) on invested
capital (ROCE), which was -3.9%.
8 Gross interest costs can be inserted instead of net interest costs.
As previously mentioned, in financial year 2012/13 BoConcept had a
ROCE of 3.5% and a CoD of 0.6%. In other words, it earned more from
invested capital than it paid in interest on its debt obligations.
THE RELATIONSHIP BETW EEN RETURN ON EQUITY

AND RETURN ON CAPITAL EM PLOYED
If the cost of debt is lower than the return on capital employed, the com
pany “earns” on the former because the price (the interest rate) on the bor
rowed capital is lower than the gain made from capital employed (ROCE).
The difference accrues to the owners.
The relationship is shown by the formula below for the return on equity,
which illustrates what is called the “financial lever”. The formula uses re
turn on equity before tax.
ROE Return on equity

ROCE Return on capital employed
CoD Cost of debt
(ROCE - CoD) is the company's interest rate margin
is the company's gearing (or leverage)
The formula shows that the interest rate differential is positive (i.e. ROCE
is greater than CoD), which means that the return on equity will increase
if gearing rises.
Gearing can rise by increasing debt or reducing equity.9
9 See more about this in 11.5 on shareholder value.
Example
Because the example is clearer when the return on capital employed is
positive, the figures for BoConcept 2012/13 are used:
ROEbeforetax = ROCE + (ROCE - C o D ) •Gearing
where
ROCE = 3.5 %
CoD = 0.6 %
The results are entered:

ROEbeforetax = 3.5 + (3.5 - 0.6) -1.37 = 7.5%
Thus, this direct form of calculation also gives a result of 7.5%.
This relationship can also be shown as a supplement to ROCE:
Example
ROCE 3.5 %
+ supplement (3.5 – 0.6) • 1.37 = 4.0 %
ROE,before
, ta, x = 7.5 %'
In 2012/13, BoConcept had a positive interest rate differential. In purely

mathematical terms, higher gearing would have benefited the return on
equity. However, this would involve ROCE and CoD remaining unchanged
as gearing rises, which is not very realistic.
Cost of debt is an average based on net interest costs and includes inter
est-free credit. BoConcept might not be able to source new debt at an aver
age interest rate of 0.6%, which was the cost of debt in 2012/13. Higher
gearing would also entail a greater risk to lenders, so they would demand
a higher rate of interest. This would cause the cost of debt to rise and the
interest rate differential to fall.
An unchanged ROCE would require a company to invest in new projects
from which the pay back is at the same level as before. If the pay back is
lower, the new overall ROCE will be lower and the interest rate differential
will fall.
The analysis is static because the advantage of gearing does not remain
the same when debt is increased. However, the formula does provide an
opportunity to analyse the relationship between the company’s current
gearing and the financial return from it.
O VERA LL ANALYSIS OF PROFITABILITY 2013/14

Figure 4.5 shows BoConcept’s profitability from 2009/10 to 2013/14.
P ro fitability analysis 09/10 10/11 11/12 12/13 13/14
Return on capital employed 2.4% 6.9% 6.9% 3.5% -3.9%

Operating margin 1.4% 3.5% 3.5% 1.9% -2.1%
Rate of asset turnover (times) 1.76 1.97 1.95 1.91 1.88
Return on equity before tax 4.9% 10.4% 11.8% 4.9% -5.5%
Return on equity after tax 5.7% 15.6% 18.4% 7.5% -11.0%
Cost of debt (net) 0.9% 1.6% -1.0% 0.6% 0.6%
Figure 4.5 Profitability analysis for BoConcept 2009/10-2013/14.
BoConcept’s profitability level fluctuated considerably during the five-

year period.
Financial year 2009/10 began on 1/5/2009, which means that the fi
nancial crisis was a significant factor. Both Profit/loss for operating activi
ties and Profit/loss for the period were modest but nevertheless positive.
This led to a low return on capital employed and operating margin. The
rate of asset turnover was relatively low, because revenue was low.
In 2010/11, BoConcept corrected the relationship between revenue and
costs. Revenue rose by approximately 10%, but costs did not rise. This in
creased the operating margin. The average invested capital (balance sheet
total) was lower. Coupled with the higher revenue, this meant that the rate
of asset turnover improved. The increased operating margin and rate of
asset turnover caused the return on capital employed to rise.
In 2011/12, both the return on capital employed and the operating
margin remained at exactly the same level as the previous year. However,
the basis on which the ratios were calculated was different because rev
enue, profit/loss for operating activities and average invested capital were
all up.
In 2012/13, the return on capital employed again fell slightly, mainly
due to a lower operating margin.
In 2013/14, the profitability analysis was affected by a negative operat
ing margin and a loss for the period. ROCE, OM and ROE were all there
fore negative. Operating profit/loss fell by DKK 41 million but the profit/
loss for the period “only” fell by DKK 23 million due to tax income. The
operating margin was the cause of the negative trend.
The return on equity reflected the trend for the operating margin, as
profit/loss for the period reflects the trend for profit/loss for operating
activities. Average equity rose until 2013/14, when it fell by DKK 18 mil
lion (7.9%) due to the loss posted for the year.
The causes of a particular trend identified by a profitability analysis are
studied by looking at earning capacity, capital adjustment, solvency and
liquidity.
CFA SO CIETY DENM ARK'S RECOMMENDATIONS

CFA Society Denmark has published a booklet of recommendations about
calculating key financial ratios.10
Companies listed on the stock exchange use the CFA formulas to calcu
late the ratios shown in the five-year summary.
The CFA calculations differ from those used in this chapter in that they
are based on “adjusted results”. The adjustment relates to impairments of
goodwill, other write-downs and costs related to cases where the manage
ment (it is usually the management) are remunerated with options (share-
based payments). These factors also affect the balance sheet.
In addition, CFA does not use the average balance sheet total in its cal
culations of return on capital employed, it uses average invested capital.
Invested capital is defined as the sum of intangible and tangible operat
ing fixed assets and net working capital. Net working capital consists of
inventories plus customer receivables and other operating receivables. Op
erating debt, e.g. trade payables, is subtracted from this figure.
The CFA divides by average invested capital to achieve a better relation
ship between the numerator (operating profit/loss) and the denominator
(capital invested in operations).
Generally speaking, the workload involved in converting accounts into
a form in which they can be used to calculate the CFA’s key ratios is not
justified by an increase in information value, which is why the less compli
cated formulas are used in this book.
4.6.2 Earning capacity

The trend for the operating margin can be explained by analysing earning
capacity in greater detail.
Earning capacity is defined as the way the company aligns income and
expenditure.
In internal analyses, earning capacity is evaluated by breaking costs down

into variable and fixed costs. Variable costs are deducted from revenue to
arrive at a contribution margin. The contribution ratio (which is calcu
lated on the basis of the contribution margin and is only found in inter
nal analyses) cannot be compared with the gross profit percentage or the
gross margin (which are calculated in external analyses).
This also affects the other ratios used when analysing earning capacity,
as capacity costs in a function-based income statem ent consist of distribu
tion costs, administration costs, any other operating costs and/or devel
opment costs. In an income statem ent classified by nature, capacity costs
consist of other external costs, staff costs and depreciation provisions.
Despite this, the ratios listed below provide an acceptabel basis for de
scribing trends in earning capacity. However, it is advisable to exercise
caution when conducting comparisons across types of companies or in
dustries.
Analyses of earnings capacity can include the following:

• Operating margin (OM)
• Gross profit percentage or gross margin
• Index numbers for trends in revenue and costs
• Operational gearing
• Capacity ratio (CR)
• Break-even sales
• Safety margin
• Revenue and operating profit per employee.
O P E R A T IN G M A R G IN
The operating margin, which is calculated as part of the profitability anal
ysis, is the key element when analysing earning capacity. The other ratios
expand upon and explain the trend for the operating margin.
G R O S S PR O FIT P E R C EN TA G E/G R O SS M A R G IN
Gross profit percentage and gross margin are essentially two ways of ex
pressing the same thing – the relationship between revenue and earnings
after production costs have been deducted (for a manufacturing company)
or sales costs have been deducted (for a trading company).
Gross profit percentage/gross margin shows how the company aligns its
income with production or sales costs.
The formula is:
The concepts gross earnings and gross profit are used differently in differ
ent contexts, so it is important to know which costs are deducted when
calculating one or the other.
Example
Gross margin for BoConcept 2013/14:
This means that once the production costs have been covered, BoConcept
has 42.7% of its revenue left from which to cover capacity costs for distri
bution and administration, as well as financial items and a mark-up.
INDEX NUMBERS
Index numbers are used to illustrate trends in revenue and costs. The num
ber 100 is assigned to the first year in the period covered by the analysis.
Index numbers illustrate the extent to which the trends for different items
in the accounts are interrelated.
Index numbers are calculated as follows:
Example
The index number for BoConcept's revenue in 2013/14 using 2009/10 as the
base year:
It is a good idea to calculate index numbers for the costs of the individual
functions because they can illustrate trends in various categories com
pared to the general revenue trend and to each other. This gives a clear
picture of which costs are growing faster than revenue and which ones are
growing more slowly (see the table below).
Example
Earn in g capacity 09/10 10/11 11/12 12/13 13/14
Index for revenue 100 110 112 113 115

Index for production costs 100 108 106 108 112
Index for distribution costs 100 106 114 111 126
Index for administration costs 100 115 123 144 150
Using revenue as a measure of activity gives an impression of whether or

not the company has improved its cost efficiency in the different cost cat
egories.
Note that the choice of base year is important for both the actual index
numbers and for the relationships between them because they all relate
to it. In this example, revenue in the base year was relatively low, which
means that the index figures for the following years were relatively high.
The initial conversion to 100 makes it easier to generate an overview of
the trends. However, when analysing the index numbers, it is important
not to forget the real figures. For example, the index numbers may sug
gest a highly favourable or unfavourable trend, but if the real numbers are
small, the trend may be relatively insignificant in practice.
BoConcept’s distribution costs rose by DKK 177 million from 2009/10
to 2013/14, corresponding to an index number of 126. Administration
costs for the same period “only” rose by DKK 31 million, but this corre
sponded to an index number of 150. This is because distribution costs are
about four times as high as administration costs.
OPERATIONAL GEARING
Operational gearing assesses the relationship between the company’s ca
pacity costs and overall operating costs. This ratio provides an indication
of the company’s sensitivity to changes in the level of activity (revenue), as
capacity costs are fixed and therefore do not follow the revenue trend, no
m atter whether it is positive or negative.
Operational gearing shows the proportion of total operating costs made

up of capacity costs.
Operational gearing is calculated as follows:
Capacity costs are fixed costs. In the case of BoConcept, where the variable
costs are unknown and replaced by production costs, the capacity costs
consist of the sum of distribution costs, administration costs and other
net operating costs. If the company had incurred development costs, they
would also have been included.
In income statem ents classified by nature, the capacity costs are cal
culated as the sum of other external costs, staff costs and depreciation
provisions.
Total operating costs covers all costs incurred in relation to operations.
Financial costs and taxes are not classified as operating costs.
Operational gearing is expressed as a percentage. The higher it is, the
greater the effect of any change in revenue will be on operating profit/loss
because a large proportion of operational costs will not change with the
revenue.
Example
Operational gearing for BoConcept 2013/14:
In other words, in 2013/14 BoConcept’s capacity costs made up 43.9% of

total operating costs.
C A P A C IT Y R A TIO
The capacity ratio quantifies the degree to which gross profit/loss covers
a company’s capacity costs.
The capacity ratio shows the relationship between gross profit/loss and
capacity costs.
The capacity ratio is calculated as follows:
The capacity costs are as defined in the previous section. The capacity
ratio is not stated as a percentage, but shows how many times the gross
profit/loss covers the capacity costs. The higher the number, the better
the capacity utilisation.
Example
Capacity ratio for BoConcept 2013/14:
BoConcept’s gross profit/loss covered its capacity costs 0.95 times in

2013/14. In other words, every DKK 1 in capacity costs generates a gross
profit of 0.95. A capacity ratio of less than 1 indicates that the gross prof
it/loss was not enough to cover the capacity costs, i.e. the company made
an operating loss.
B R E A K -E V E N S A L E S (B R E A K -E V E N A N A L Y S IS )
Break-even sales calculates the revenue required for gross profit to cover
capacity costs.
It is also referred to as break-even revenue or turnover.
The capacity costs are as defined above under Operational gearing.
Example
Break-even sales for BoConcept 2013/14:
This shows that BoConcept would have needed revenue of DKK 1,101 mil
lion to break even on operations. However, this is predicated on an un
changed gross margin.
In 2012/13, the break-even sales point for BoConcept was DKK 982
million, compared to actual revenue of DKK 1,026 million. In other words,
BoConcept could have afforded to lose DKK 4 4 million (1,026 – 982) in
revenue without the operating profit becoming an operating loss.
Note that financial costs are not included in this calculation.
SA FETY MARGIN
As a supplement to break-even sales, analysts can calculate the percent
age of its revenue that a company can afford to lose before it falls below its
break-even point. This is called the safety margin.
Example
Safety margin for BoConcept 2013/14:
For 2012/13 it was:
In 2013/14, BoConcept would have had to increase revenue by 5% to cover

its capacity costs. In the previous year, it could have shed 4.3% of its rev
enue before the operating profit turned into a loss.
REVENUE AND OPERATING PROFIT/LOSS PER EMPLOYEE
One way of measuring a company’s productivity is to compare revenue or
operating profit with the number of employees. The average number of
employees during the financial year will be disclosed in a note – usually
one of the first notes to the income statem ent – or in the financial high
lights and key financial data at the start of the annual report.
BoConcept’s productivity numbers are as follows:
Example
Productivity for BoConcept 2013/2014:
On average, each employee generates revenue of DKK 1.67 million, but the
company makes a loss of DKK 35,000 per employee.
O V ERA LL ANALYSIS OF EARNING CAPACITY 2013/14

Figure 4.6 shows the operating margin and other key financial data re
lated to BoConcept’s earning capacity over a period of five years.
Earn in g capacity 09/10 10/11 11/12 12/13 13/14
Operating margin 1.4% 3.5% 3.5% 1.9% -2.1%

Gross margin 40.8% 42.1% 44.1% 43.2% 42.7%
Index revenue 100 110 112 113 115
Index production costs 100 108 106 108 112
Index distribution costs 100 106 114 111 126
Index administration costs 100 115 123 144 150
Capacity costs (D KK millions) 359 386 415 424 470
Total operating costs (D KK millions) 898 966 986 1007 1071
Operational gearing 40.0% 40.0% 42.1% 42.1% 43.9%
Capacity ratio 1.03 1.09 1.09 1.04 0.95
Break-even sales (D KK millions) 880 918 940 982 1101
Safety margin 3.3% 8.3% 8.0% 4.3% -4.9%
Revenue per employee (D KK millions) 1.72 1.73 1.76 1.75 1.67
Operating profit/loss per employee (DKK millions) 0.02 0.06 0.06 0.03 -0.04
Figure 4.6 Analysis of BoConcept's earnings capacity 2009/10-2013/14.
Revenue rose by 2.3% during the period due to negative currency fluctua
tions and higher sales in the company’s own shops and in China.11
The gross margin fell by 0.5% in 2013/14 because, relatively speaking,
production costs rose faster than revenue. Exchange rates had a negative
effect on revenue, but a positive effect on production costs. However, pro
duction costs are not affected as much as revenue. Purchases from suppli
ers (sourcing) accounted for 78% of revenue. BoConcept has suppliers in
China, Eastern Europe and Denmark.12
The operational gearing rose because capacity rose to 43.9% of total
operating costs in 2013/14, compared with 42.1% the previous year. The
rise was mainly in distribution costs. According to the company, this was
due to restructuring of the business model, optimisation and expansion
in China. It also upped its provision for bad debt to DKK 39 million from
DKK 20 million the previous year. Currency fluctuations had a positive
effect on its capacity costs.13
The average number of employees rose from 586 to 627. As a result,
revenue per employee dropped from DKK 1.75 million to DKK 1.67 m il
lion, corresponding to a fall of almost 5%. The new staff were presumably
taken on as part of the change to the business model mentioned above.
EARNING CAPACITY IN DIFFERENT TYPES OF COMPANIES

As a rule, the gross profit percentage/gross margin and the safety margin
will differ greatly depending on the type of company.
Figure 4.7 presents an analysis of three companies:
• DEAS – a service company principally involved in property manage

ment: www.deas.dk
• Matas – a trading company with retail outlets selling beauty prod
ucts, personal care and health products: www.matas.dk
• Rockwool – a manufacturing company that produces insulation
materials for the construction industry. Rockwool is one of the few
manufacturers that presents its income statement by nature www.
rockwool.dk.
11 BoConcept annual report 2013/14, pages 14 and 17.

DEAS and Matas also present their income statem ents by nature, which
makes it possible to compare ratios between the three.
M atas
Rockw ool
D E A S 2014 01/04/2013-
2014
DKK m 312/03/2014
€ m illion
DKK m
Net revenue 403 3,345 2,187

Sales costs1 18 1,803 1,108
Gross earnings 385 1,542 1,079
Other external costs, etc. 65 315 235
Staff costs 276 627 532
W rite-ups and write-downs 7 135 150
Total capacity costs 348 1,077 917
Operating profit/loss 37 465 162
Gross profit percentage 96 46 49

Operational gearing (% ) 95 37 45
Staff costs as % of revenue 68 19 24
EXA M PLE
C h a n g e in revenue (% ) -5.0 -5.0 -5.0
Net revenue 383 3,178 2,078

Sales costs 17 1,713 1,053
Gross earnings 366 1,465 1,025
Capacity costs 348 1,077 917
Operating profit/loss 18 388 108
Change in operating profit/loss, in percent -52 -17 -33
1 Rockwool includes the figure for "Delivery costs and indirect costs" as well as the figure for sales
costs because the company treats them as variable costs.
Figure 4.7 Analysis of earning capacity for different types of company.

Source: The websites mentioned above.
The numbers show that DEAS has a gross profit of 96% because its di
rect costs are very low. Its operational gearing is 95%. This high figure is
typical of service companies because their variable costs are almost non
existent or at least very small. Even if revenue falls, costs do not fall very
much, as they are mostly fixed, i.e. they are independent of the company’s
level of activity, at least in the short term. Figure 4.7 shows that, all things
being equal, a hypothetical fall in revenue of 5% would have triggered a
52% drop in operating profit.
The main cost in service companies is usually staff. DEAS spends 68% of
revenue on staff, making it highly vulnerable to increases in labour costs.
In the case of Matas, sales costs account for 54% of revenue. The opera
tional gearing is 37%. Unlike service companies, a large proportion of the
costs incurred by a trading company decrease when revenue falls. A fall
in revenue of 5% would have resulted in a fall in operating profit of only
17% – far lower than would be expected for a service company. Staff costs
represent only a small proportion of sales – in this case, 19%.
The gross profit percentage for the manufacturing company Rockwool
is 49% . The operational gearing is 45%, which is somewhere between the
levels typical of service and trading companies. At 24%, staff costs as a
percentage of revenue in Rockwool are also somewhere between DEAS and
Matas.
BoConcept’s gross margin for 2013/14 was 42.7%, its operational gear
ing 43.7% . However, the calculations were made on a very different basis
from Rockwool. Rockwool only subtracts the cost of materials from gross
profit. BoConcept subtracts all production costs, variable as well as fixed,
when calculating gross profit/loss and capacity costs. The variable wage
costs are not specified but are included in the overall staff costs. The gross
profit percentage/gross margin and operational gearing cannot therefore
be used to compare companies that present their income statem ents dif
ferently. In order to compare earning capacity, analysts must instead look
at the more general operating margin.
In 2014, Rockwool’s staff costs accounted for 24% of revenue. BoCon
cept’s total staff costs were DKK 237 million (see Note 3 to the accounts),
or 23% of revenue. However, the business models for the two companies
are very different. Rockwool manufactures its own products, while Bo
Concept purchases 78% of its goods from suppliers. Note 3 shows that
about half of BoConcept’s staff work in distribution.
4.6.3 Capital adjustment

The rate of asset turnover shows the company’s ability to generate revenue
from the assets at its disposal.
Analysing capital adjustment illustrates the relationship between activity

and the capital tied up in a company.
The rate of asset turnover can be analysed by calculating the following:

• Fixed asset turnover ratio
• Stock turnover ratio and no. of days in stock
• Debtors’ turnover ratio and no. of days of credit
• Creditors’ turnover ratio and no. of days of credit
• Index nos. for activity and capital tie-up.
Like the rate of asset turnover, these ratios are expressed in terms of the
number of times the capital is turned over. The higher the number, the
better the utilisation of the capital tied up in the company – except for
trade creditors, where a low rate of turnover is advantageous.
In external analyses, the calculations must be based on the annual ac
counts. This is important in terms of which items can be inserted into the
formulas below. Internal analysts have the possibility to access to more
detailed information.
All of the formulas in this section use the year-end figures from the bal
ance sheet in the denominator. In other words, the results represent the
position at the end of the financial year.
FIXED A SSET TURNOVER

The formulas below are used to calculate the fixed asset turnover ratio.
The rate of turnover for fixed assets and for tangible and intangible fixed
assets shows how effectively a company generates revenue from its fixed
assets.
The results quantify how much activity (revenue) companies generate

from investments in tangible and intangible fixed assets.
Example
Rate of turnover for tangible and intangible fixed assets for BoConcept
2013/14:
It can be difficult to compare the rate of fixed asset turnover in different

types of company. Companies with major investments in fixed assets (e.g.
manufacturers with a lot of machinery) will often have a lower rate of
fixed asset turnover than (for example) service companies with few fixed
assets.
The numbers can be affected by whether assets are leased, e.g. build
ings, machinery, vehicles, etc.14 Companies in classes C and D include
leased assets in the balance sheet. This facilitates comparisons between
companies that lease and companies that own their own assets. However,
as far as operational leasing is concerned, the assets do not have to be en
tered on the balance sheet. The notes must stipulate the type of assets and
quantify their book value.
Investments in intangible assets, e.g. development projects or goodwill
acquired during takeovers, also affect the rate of fixed asset turnover. For
many companies, intangible fixed assets now account for an increasing
proportion of their assets.
RATE OF STOCK TURNOVER

Many companies devote a great deal of attention to avoiding overstock
ing. As the cash flow statem ent shows,15 larger stocks impact on liquidity.
Stocks (inventories) tie up capital and cost money that could have been
earning interest if it had not been used to buy and produce goods that the
company has still to sell.
14 For further details on leasing, see 11.7.3.

15 See 3.12.
As well as tying up capital, stocks also represent a risk because they may
become out of date and decrease in value. This is particularly true of fin
ished goods.
If the value of the stocks in a manufacturing company is not sub-divid
ed into the categories raw materials, goods in progress and finished goods in
the actual balance sheet, it will be in a note.
The rate of stock turnover shows how well a company balances the amount
of capital tied up in stocks and the cost of acquiring the goods it sells.
The rate of stock turnover is, therefore, an im portant element in internal

analyses.
Most companies compile quite detailed information about rates of stock
turnover based on the current value of the different types of stocks (raw
materials, goods in progress and finished goods) – sometimes all the way
down to individual products.
Based on published accounts, analysts can work out rates of stock turn
over by comparing the total value of the stocks to the production costs (in
a function-based income statement) or the sales costs (if the income state
ment is classified by nature).
or
Days in stock = Days in the year/Rate of stock turnover
Example
Rate of stock turnover for BoConcept 2013/14:
In 2013/14, BoConcept had a rate of stock turnover of 4.20, which means
that the company’s materials, goods in progress and finished goods spent
an average of 87 days in stock.
D E B T O R S 'T U R N O V E R
The length of the period for which credit is extended is an im portant trad
ing parameter when negotiating with customers. A long period represents
a cost to the company because the money could have been earning interest
if the payment was received sooner. In other words, a long credit period
has a negative impact on liquidity. The company also runs the risk of its
customer being unable to pay when the money is due.
Comparing revenue with trade receivables provides a general impres
sion of how much capital a company has tied up in its debtors.
The debtors' turnover ratio shows how well a company balances the
amount of capital tied up in debtors compared to its revenue.
This calculation does not take into account the fact that a proportion of
the receivables includes VAT (if the customers are Danish) but this is not
included in the revenue figure. Credit on exports does not include VAT
either. This affects accuracy when calculating the debtors’ turnover ratio.
The formula shows that the ratio increases as the value of the debt falls.
Falling debt is usually due to the company offering less credit – either by
cutting the proportion of revenue on which it is offered or by reducing
the credit period. However, the number can also be reduced if a company
is forced to write down its trade receivables account because customers
are deemed incapable of paying. Obviously, this reduces the value of its
receivables and has a negative effect on profit, as the company has to post
a loss on debtors (usually under distribution costs).
Example
Debtors' turnover ratio for BoConcept 2013/14:
BoConcept’s average debtors’ turnover ratio in 2013/14 was 7.23, which

represents an average credit period to customers of 50 days.
CREDITORS' TURNOVER
Credit obtained from suppliers amounts to an interest-free source of fi
nance during the credit period. As far as tied-up capital is concerned, it
is better to owe money to suppliers than to draw on an overdraft facility.
The creditors' turnover ratio shows how good the company is at obtaining
credit from suppliers.
Suppliers provide credit on the goods purchased from them. The best way
to calculate the creditors’ turnover ratio is therefore to compare goods
purchased with trade payables. Although published accounts do not pro
vide sufficient information to conduct exact analyses of goods purchased,
the following formulas will provide an approximate value:
For income statements by nature:

Goods purchased = Sales costs + (stocks at year-end – stocks at start of year)
For income statements by function:

Goods purchased = Production costs + (stocks at year-end – stocks at start
of year)
Analysts may also deduct staff costs and write-downs from production
costs. These figures are found in the notes.
Alternatively, stocks of raw materials can be used instead of total stocks.
It is then possible to calculate the creditors’ turnover ratio:
This calculation does not take into account the fact that a proportion of
trade payables may include VAT if the suppliers are Danish, while goods
purchased are exclusive of VAT.
Example
Creditors' turnover ratio for BoConcept 2013/14:
BoConcept’s average creditors’ turnover ratio in 2013/14 was 5.41, which

represents an average credit period of 68 days. The lower the Creditors’
turnover ratio the better, as trade payables represent a free form of capital
funding.
INDEX NUMBERS
Index numbers are a useful supplement to turnover ratios. The revenue
numbers can be compared with those for fixed assets, intangible and tan
gible fixed assets and trade receivables. The production numbers can be
compared with those for inventories (stocks) and trade payables.
Calculating index numbers over a period of years provides an overview
of trends for the related entries in income statem ents and balance sheets
(e.g. activity and tied-up capital). Figure 4.8 below shows the index num
bers for BoConcept 2009/10-2013/14.
O VERALL ANALYSIS OF CAPITAL ADJUSTM ENT 2013/14

The numbers in Figure 4.8 represent BoConcept’s key financial ratios for
capital adjustment 2009/10-2013/14.
Capital adjustm ent 09/10 10/11 11/12 12/13 13/14
Rate of asset turnover (times) 1.76 1.97 1.95 1.91 1.88

Rate of fixed asset turnover (times) 3.50 3.99 4.19 4.28 4.21
Rate of intangible fixed asset turnover (times) 21.17 17.26 16.22 15.78 12.06
Rate of tangible fixed asset turnover (times) 5.72 7.47 8.52 9.08 9.12
Rate of stock turnover (times) 5.39 5.37 4.60 5.50 4.20
Days in stock 68 68 79 66 87
Debtors' turnover ratio (times) 9.10 8.70 7.51 7.13 7.23
Credit days to customers 40 42 49 51 50
Goods purchased 499 588 587 565 638
Creditors' turnover ratio (times) 6.24 7.44 6.91 6.28 5.41
Credit days from suppliers 59 49 53 58 68
Revenue index 100 110 112 113 115
Fixed asset index 100 97 94 92 96
Intangible fixed asset index 100 84 75 71 72
Debtor index 100 115 136 144 145
Production costs index 100 108 106 108 112
Stocks index 100 108 124 106 143
Creditors index 100 99 106 113 148
Figure 4.8 Analysis of BoConcept's capital adjustment 2009/10-2013/14.
In 2013/14, the rate of fixed asset turnover remained more or less un
changed, but this conceals a rise in intangible fixed assets due to buying
back master rights and goodwill.16 This was countered by a fall in financial
fixed assets due to lower deferred tax.
Expansion in China entailed higher investments in tangible fixed as
sets, which more or less corresponds with the depreciation provisions.17
The fall in the rate of stock turnover can be attributed to a low balance
at the beginning of the year, higher stock levels following the launch of a
new collection, and ownership of more shops, i.e. shops in which BoCon
cept, not a franchise operator, owns the stocks.18
The debtors’ turnover ratio has improved minimally (partly due to the
large provisions for losses). The creditors’ turnover ratio has improved sig
nificantly, i.e. fallen considerably, due to the fact that BoConcept negoti
16 BoConcept annual report 2013/14, page 18.

ated credit terms on its stocks and received down payments from custom
ers.19 In other words, its suppliers helped finance the larger stocks.
4.6.4 Solvency and liquidity

The following key data can be used to analyse solvency and liquidity:
• Equity ratio
• Gearing
• Fixed assets as proportion of the balance sheet total
• Liquidity ratio 1
• Liquidity ratio 2
• Cash flow from operating activities.
The formulas use year-end numbers from the balance sheet to assess a
company’s position at the end of the financial year.
EQUITY RATIO
Lenders, suppliers and major customers have an interest in knowing how
sensitive a company is to losses (poor financial performance, loss of as
sets, etc.). This degree of sensitivity is called solvency. A company’s sol
vency depends on the the level of equity in it.
The equity ratio shows the proportion of the capital in a company provided
by the owners.
Example
Equity ratio for BoConcept 2013/14:
At the end of 2013/14, 36.1% of the total capital in BoConcept consisted

of equity. In other words, 36.1% of the capital was provided by the owners.
This is an important piece of information for creditors. If a company
is in trouble, it has to pay its debts to creditors before the owners receive
anything. Even if BoConcept were to lose 36.1% of its assets, it would still
be able to pay off all of its creditors in full. Creditors also have the option
of securing their receivables against company assets.
The term “solvent” describes companies in which total assets outweigh
liabilities, i.e. companies with positive equity.
Working out how solvent a company is depends on how its fixed and
current assets are valued. For example, if the value of fixed assets decreas
es due to a fall in the value of a piece of property, this has a negative effect
on equity and the equity ratio. The same applies when the value of stocks
is reduced or when losses are expected on trade receivables.
GEARING
Gearing is another way of illustrating the composition of a company’s cap
ital funding (liabilities).
Financial gearing shows the amount of borrowed capital in a company per

DKK 1 of equity.
A high equity ratio gives low gearing and vice-versa.
Example
Financial gearing for BoConcept at year-end 2013/14:
As mentioned previously, high gearing gives a higher return on equity if

the return on capital employed is greater than the cost of debt. However,
high gearing also shows that a company is vulnerable to any reduction of
equity, e.g. in a year when it makes a loss. High gearing, like a low equity
ratio, can make it difficult – or expensive – to borrow from banks due to
the lack of equity cover (low equity ratio).
FIXED ASSETS A S SHARE OF BALANCE SHEET TOTAL

The equity ratio shows the proportion of the balance sheet total that con
sists of equity. The proportion that consists of fixed assets can be calcu
lated in the same way.
Fixed assets as share of the balance sheet total shows the proportion of
total assets that are fixed.
Fixed assets are also known as long-term (or non-current) assets because
converting them into revenue is not part of the company’s day-to-day op
erations. Money invested in fixed assets is tied up for a long period. Credi
tors (e.g. banks) are therefore able to take out security on them .20
Comparing fixed assets as share of the balance sheet total with the eq
uity ratio shows the extent to which capital tied up in fixed assets is cov
ered by the capital made available to the company by the owners over the
long term.
Example
Fixed assets as share of balance sheet total for BoConcept at year-end
2013/14:
At the end of financial year 2013/14, BoConcept’s fixed assets as share of

balance sheet total were 42.8% , which was 6.7%-points higher than the
equity ratio. This means that the value of the fixed assets was not covered
by the equity. However, BoConcept had long-term debt of DKK 90 million,
which helped cover its investments in fixed assets.
LIQUIDITY RATIOS
A company’s survival depends on its ability to meet all of its obligations at
any given time. If it is unable to do so, its creditors are entitled to declare
it bankrupt.
The liquidity ratio indicates the likelihood of a company being able to pay
its debts when they are due.
20 They can also demand security in current assets. This is known as a floating charge. Floating
charges can also be taken out on stocks and trade receivables.
The liquidity ratio is calculated by dividing the current assets (the most
liquid proportion of the assets) by short-term debt obligations (due within
one year). Analysts use two variants of the liquidity ratio: one with stocks
(inventories) in the numerator, and one without.
A liquidity ratio of 100 means that current assets exactly match short
term debt obligations. The more the liquidity ratio exceeds 100, the more
likely it is that the company has sufficient liquidity to pay debts when they
are due or to qualify for various types of cash discount.
If the numerator includes stocks, the ratio becomes more long-term,
since it takes time to convert stocks into liquidity. As a consequence of
this, ratio 2 has to be higher than ratio 1.
Example
The liquidity ratios for BoConcept 2013/14:
As a rule of thumb, ratio 1 should be above 100, ratio 2 at least 130. How
ever, it is difficult to set the same targets for all companies, as the m ini
mum level required depends on how liquid their current assets are and
when their short-term debts are due to be paid.
If a company has liquidity ratios close to 100, it should look at its cur
rent assets. For example, large stocks take longer to convert into cash than
goods already sold and entered under trade receivables. It can also be dif
ficult to work out when short-term debts need to be paid based purely on
the liabilities shown in the annual accounts.
Note that, in purely technical terms, bigger stocks and more debtors
normally means better liquidity and a higher liquidity ratio. In practice,
however, it is not certain that the company’s ability to pay has actually
improved.
C A S H FLO W FROM O PER A TIN G A C T IV IT IE S
Liquidity is a prerequisite for expanding via organic growth without being
dependent on borrowed capital and for paying dividends to shareholders/
owners and for repaying debt.
Earnings and liquidity are not always aligned, and this can be seen in
the cash flow statement.
Money tied up in stocks and trade receivables means that a proportion
of earnings is not available as liquidity to pay creditors.
Analysing liquidity can therefore involve comparing cash flow from op
erating activities with revenue and other data from cash flow statements.
Example
The liquidity ratios for BoConcept 2013/14:
Liquidity from operations in relation to revenue can be compared with the

operating margin. Where the operating margin shows the proportion of
revenue transformed into profit, this ratio shows the proportion of reve
nue that is turned into cash flow from operations. If liquidity from opera
tions compared to revenue is lower than the operating margin, this may
be due to the fact that the company has capital (liquidity) tied up in stocks
and debtors, and/or it has reduced its trade payables.
Liquidity from operations in relation to investments for the period,
repayments and dividends shows the relationship between the liquidity
generated and its uses. Note that liquidity from operations is not enough
to cover either the investments during the year or repayments and divi
dends, because both of these numbers are lower than 1.
The statement shows that in 2013/14, BoConcept had a total cash flow
of minus DKK 30 million, even after it took out a DKK 34 million long-
term loan. The negative liquidity was due to investments.
The ratio of debt to liquidity from operations is a measure of how many
years it would take, other things being equal, to pay off all of the com
pany’s debt with the liquidity available in the year concerned.
Any assessment of a company’s liquidity should also include inform a
tion about unutilised credit facilities.
O V ERA LL ANALYSIS OF SOLVENCY AND LIQ UIDITY 2013/14

Figure 4.9 shows key solvency and liquidity data for BoConcept 2009/10-
2013/14.
So lve n cy and liq u id ity 09/10 10/11 11/12 12/13 13/14
Equity ratio 36.1% 39.4% 41.6% 42.9% 36.1%

Gearing (times) 1.8 1.5 1.4 1.3 1.8
Fixed assets compared to balance sheet total 51.0% 49.5% 45.1% 45.1% 42.8%
Liquidity ratio 1 69 76 80 90 67
Liquidity ratio 2 115 131 138 141 118
Liquidity from operations/Revenue 11.6% 3.3% 5.2% 5.4% 0.5%
Liquidity from operations/investments (times) 3.7 1.1 2.5 1.7 0.1
Liquidity from operations/Payments and
dividends (times) 9 1.5 2.8 3.7 0.6
Debt at year-end/Liquidity from operations (times) 3 9.3 6.0 5.5 74.4
Figure 4.9 Analysis of equity and liquidity ratios for BoConcept 2009/10-2013/14.
The equity ratio has fallen to 36.1%, which is below the company’s target
range of 4 0 -5 0 % .21 The decrease is partly due to a fall in equity and a rise
in the balance sheet total.
BoConcept’s liquidity relative to revenue in 2013/14 was 0.5%. The op
erating margin was -3.9%. This is partly due to the negative impact on the
21 Annual report 2013/14, page 19.
operating margin of depreciation provisions and provisions for bad debts.
Write-downs and provisions for bad debt do not affect liquidity.22
The liquidity ratios are lower because trade payables and other short
term debt have risen more than current assets, where the main increase
was in stocks.
At the end of financial year 2013/2014, BoConcept had unutilised cred
it facilities of DKK 68 million, compared to DKK 93 million the previous
year.23
4.6.5 Stock-market ratios

As interest in investing in shares has increased, so too has interest in
stock-market ratios, which focus on the ability to generate a yield for cur
rent and future investors.
Potential investors like to compare earnings and value with the share
price. This is done by calculating the ratios P rice/Earning and Price/Book
value.
Both internal and external analysts compare these ratios with other
companies in the same industry to work out whether the share price is ex
pensive or inexpensive. The overall assessment also involves many other
company-specific factors, of course.
PRICE/EARNING
Price/Earning (P/E) shows how much investors pay at the current share
price for each DKK 1 of profit generated.
where
First, the profit per share is calculated by dividing the net profit for the
year by the number of shares.
It makes no sense to calculate profit per share when a company makes
a loss, so the calculation shown is for 2012/13. In this example, one Bo-
22 Annual report 2013/14, The cash flow statement, page 47 and note 24, page 59.
23 Annual report 2013/14, page 23.
Concept share corresponds to DKK 10 in share capital. On 30 April 2013,
there were approx. 2.9 million shares in the company, and the share price
was DKK 110.
Example
Price/Earning for BoConcept 2012/13:
In 2012/13, BoConcept earned DKK 3.80 per share. On 30 April 2013, the
price of a DKK 10 share on the stock exchange was DKK 110.
Investors paid DKK 2 8.90 for every DKK 1.00 in profit. In other words,
if nothing else changed, it would take 28.9 years to recoup their invest
ment. The high price is due to the fact that, on 30 April 2013, investors
on the stock exchange had high expectations for BoConcept’s future earn
ings, and so were willing to pay DKK 110 per share.
However, these numbers must also be seen in the context of the other
assets that share holders buy into.
PR IC E/BO O K V A LU E
Another one of the standard stock-market ratios compares share price
with book value, i.e. the equity linked to each share.
where
Example
Price/Book value for BoConcept 2012/13:
On 30 April 2013, each share in BoConcept corresponded to DKK 10 in

share capital. However, share capital is only a relatively small part of to
tal equity. Over the years, BoConcept has increased its equity, mainly by
retaining profits. As the end of the financial year 2012/13, equity of DKK
78.60 was linked to each DKK 10 share in the company.
The Price/Book value ratio of 1.4 shows that on 30 April 2013 inves
tors were willing to pay DKK 110 to own DKK 78.60 in equity. This cor
responds to a price of DKK 1.40 for DKK 1.00 in equity.
A Price/Book value ratio greater than 1 may indicate that investors be
lieve the company is worth more than the equity shown in the accounts.
For example, the accounts do not include the company’s market value or
the value of its accumulated expertise (structural capital), nor its knowl
edge resources and staff experience (human capital).24
U SIN G THE STO CK-EXCH ANG E RATIO S

Price/Earning and Price/Book value cannot be evaluated separately.
Analysts must look at them together. When buying shares, an investor
purchases both a share in the company’s profits and a share in its equity.
While Price/Earning shows the price paid to generate DKK 1.00 in profit
p.a., Price/Book value shows the price paid for DKK 1.00 of the equity ac
cumulated in the company over the years.
This means that Price/Earning can vary more than Price/Book value
because a single year with a relatively modest profit results in a high Price/
Earning ratio. At a given share price, a year with a relatively large profit
will result in a low Price/Earning ratio.
The book value, in the form of the equity, has accumulated over many
years, so a single year’s profit will not have the same impact on the book
value per share as it would have on earnings per share.
24 See Chapter 5 for further details.
Price/Earning and Price/Book value are calculated regularly throughout
the financial year. The calculations compare the profit (if any) per share
and the book value at year-end with the share price on the day.
Since Price/Earning and Price/Book value are usually higher for com
panies in growth industries with a positive outlook than for companies in
industries expecting more modest growth and earnings potential for their
products and/or services, the two ratios are often used when comparing
companies in the same industry.
4.7 Overall conclusion

Analyses of annual accounts end with an overall conclusion. For BoCon
cept, the conclusion might have been worded like this:
Analysis o f annual results for BoConcept 2 0 1 3 /1 4

BoConcept’s annual accounts 2013/14 are characterised by negative fi
nancial performance, mainly due to higher distribution costs. If BoCon
cept is able to transform the costs for concept development, opening more
of its own shops and the investment in China into higher revenue over the
next few years, it will be able to turn this around. The accounts for Qs 1 -3
in the current financial year (2014/15) indicate progress.25
In financial terms, the risk in BoConcept is relatively low, because the
equity ratio remains high even though it failed to meet the company’s own
targets.
In business terms, the risk is high, because earnings are negative.
4.8 Using analyses of company accounts

In this chapter, a range of key ratios has been reviewed and presented in
table form. Graphs are also a useful way of visualising the relationships
between the different ratios. The website that accompanies this book in
cludes examples of graphs based on the ratios in this chapter.
Analyses do not always have to include an equally in-depth look at every
one of the ratios. The purpose of the analysis will determine which ones
are particularly relevant. For example, a bank considering a request for
credit will focus on the company’s solvency (equity ratio), as this provides
an impression of the degree of security associated with the potential loan.
25 Quarterly accounts are also available on www.boconceptholding.dk.
As a rule, the bank will prefer that the owners share the risk by putting up
a significant amount of the company’s equity.
The bank will also be interested in the company’s earning capacity, as
making a profit is a prerequisite for it paying interest and instalm ents on
the debt. However, these earnings must be in the form of liquidity, so that
instalm ents can be paid when they are due.
The bank’s analysis will be conducted on this basis and focus on the
relevant ratios.
Analysing key data involves analysing past results, but there may be
many reasons why a historical trend will not continue into the future.
In addition, an analysis conducted on the basis of the publicly available
accounts does not provide a particularly deep insight into the impact of
different markets and product groups on the results.
Nevertheless, analyses based on key ratios have a role to play in com
pany analyses because – when supplemented with explanations of causal
factors and knowledge of the industry – they can identify data that can
be used (tentatively) to predict future trends. The analysis can confirm
whether or not the company is able to earn money. Finally, the results can
be compared with the company’s own targets and/or with other compa
nies or industries.
When summing up an analysis of a set of company accounts, a number of

general factors can serve as indicators of a negative trend and should trig
ger more in-depth analysis, e.g.:
• an auditor’s report with reservations
• negative or low equity ratio
• the accounts show a loss (perhaps for more than one of the years cov
ered)
• revenue falling, without costs, stocks and trade receivables following
suit
• failure to meet the company’s own targets.
Last but not least, if the company has changed accountancy principles or
auditor – especially if it has done so repeatedly over a short period – this
is worth looking into as well.
5 Supplementary reports

• account for the characteristics of supplem entary reports
• account for knowledge resources
• account for the rules governing corporate social responsibility (CSR)
reports
5.1 The background to supplementary reports

Government agencies, investors and other stakeholders are increasingly
demanding that companies publish non-financial information in order to
provide a more holistic view of their activities. The requirements placed
on this information are also growing stricter as demand for it increases.
Figure 5.1 Areas on which companies publish reports.

Source: Wivel and Sperling: Den bevidste visksomhed (The Aware Company), Bersen 2001
Many companies are also finding that their market value (the total value
of a company’s shares on the stock exchange) is significantly higher than
the value stated in their accounts (equity). One reason for this is that cer
tain aspects of a company’s value are not included in financial statements.
Chapter 3 described how it is more and more common for intangible assets
- e.g. development costs, patents and know-how – to account for a larger
and larger proportion of total assets. The knowledge and experience the
staff bring to value generation and the proficiency with which companies
conduct research and development also have significant value. None of
this is reflected in financial statements.
In order to reflect the range of different interest groups, companies pub
lish reports covering a whole range of different subjects, some of which are
shown in Figure 5.1.
A range of approaches to company reporting have emerged. One in
volves working with “the triple bottom line”, which consists of:
• the financial bottom line
• the social bottom line
• the environmental bottom line.
As discussed in Chapter 3, the parameters for financial reporting are rela

tively strictly regulated.
The purpose of social and environmental reports is not so much to ar
rive at a bottom line as to describe other im portant aspects of the com
pany’s activities.
In these reports, companies generally seek to explain:

1. what the company wants to do
2. what the company does
3. what the company gets out of its activities.
From the social perspective, companies in accounting Class C are obliged

to “... describe the company’s knowledge resources where they are of par
ticular significance for future earnings...”.1 Companies in classes C (large)
and D also have to account for their corporate social responsibility.2 As
these are relatively new types of reports, the rules and practices are not as
fixed as they are for financial reports.
Social reporting often focuses on identifying and explaining factors
that generate value. Knowledge resources include employees, innovation,
customers, quality, management, technology, processes, etc. (See 5.3).
Corporate Social Responsibility (CSR) consists of voluntarily including
considerations such as human rights, social conditions, the environment
and climate, anti-corruption initiatives, etc. in company strategies.3
1 The Danish Financial Statements Act 99 (7),

2 The Danish Financial Statements Act 99 a.
3 The Danish Financial Statements Act 99 a.
Reporting on knowledge and social responsibility is addressed later in this
chapter.
5.2 Quality requirements for supplementary reports

As mentioned previously, companies in accounting classes C and D are
subject to the rules about knowledge resources and social responsibility
laid down by the Danish Financial Statements Act.
Any other information published in supplementary reports to the an
nual report is provided on a strictly voluntary basis. However, if the com
pany does choose to publish supplementary reports then a number of
rules in the Financial Statements Act apply.
The Act does not include detailed guidelines about the content of sup
plementary reports, but section 14 contains general provisions about the
quality of the information provided.
§ 14. Supplementary reports, e.g. corporate social responsibility reports,

reports about knowledge resources, staff terms and conditions, the env
ironment, ethical targets and following up on them must give a true and
fair picture within the generally acknowledged guidelines for this type of
reporting. They must comply with the quality requirements in 12 (3) and
- with the exceptions that apply depending on the nature of the factors –
with the basic conditions set out in section 13 (1) and (2).
(2) Supplementary reports must contain details of the methods and measu
rements upon which they were based.
If an annual report contains supplementary reports, these must also com

ply with the requirement to provide a true and fair picture. The informa
tion presented must not contradict other parts of the annual report. There
is no auditing requirement on supplementary reports, but the company’s
management is responsible for ensuring that they provide a true and fair
picture.
The quality requirements referred to concern relevance, reliability and
comparability (section 12), as well as clarity, substance, significance, neu
trality, etc. (section 13).4 The quality requirements are the same for both
financial and non-financial reporting.
4 See also Chapter 3 (3.6.2).
Section 14 (2) stipulates that companies must describe the methods and
measurements used to calculate the figures and results in any supplemen
tary reports. At present, there is no generally accepted practice in this
area. Nevertheless, it is particularly important that anybody reading the
accounts has enough information about the methods used to be able to
evaluate the quality and relevance of the criteria and methods of quanti
fication.
5.3 Knowledge resources

Knowledge is an increasingly important resource, as global technological
and market trends necessitate rapid and frequent organisational changes
and product development. Knowledge is a key factor in generating growth
for customers – and therefore for the company and its owners/sharehold
ers. This means that there is a continuous internal need to manage, m ain
tain and develop knowledge resources, and to inform external stakehold
ers about this process.
Hum an capital
Human capital is defined as the knowledge possessed by individual mem

bers of staff.
A company’s stock of human capital is vulnerable to individuals chang

ing jobs, illness, etc. because the knowledge can only be deployed by the
individual concerned or, at best, by small teams. Human capital is part of
what creates and maintains the company’s image and, therefore, its ability
to attract and retain good staff.
Research-intensive companies like Novo and Novozymes are examples
of businesses that are highly dependent on staff knowledge/human capi
tal. Other examples include financial services companies, consultancies,
accountancy firms, architecture companies and IT companies.
The key characteristic of these types of company is that individual
members of staff possess the important knowledge and competencies. In
other words, the companies themselves only have a value by dint of the
contributions made by their employees.
Structural capital
Structural capital is defined as knowledge embedded in the company.
Structural capital is built up by developing the organisation and through

interaction with customers.
It consists of processes, procedures, systems and networks that bind the
organisation together internally and connect the company to its custom
ers. This knowledge can be deployed by multiple members of staff at the
same time. To keep it up to date and develop it further, it must be readily
accessible.
Companies with highly developed systems of this type include ISS A/S
(for cleaning) and Falck A/S (for security and rescue services).
Although knowledge capital – human and structural – can be a highly val

uable asset, it is not possible to include it under financial assets, so refer
ence may need to be made to it in the management report.
5.4 Corporate social responsibility

Corporate social responsibility (CSR) reports must be included in the
management report (as a supplement to the annual report) or published
on the company website. The management report must stipulate where it
can be found.
Companies that do not have CSR policies should mention this in the
management report.5
The previously mentioned reporting principles, i.e.:

• what the company wants to do
• what the company does
• what the company gets out of its activities
are expressed in the Act as follows:
5 The Danish Financial Statements Act 99 a (1).
§ 99 a (2) The report must include information about:
1. The company's corporate social responsibility policies, including any
standards, guidelines or principles the company applies.
2. How the company converts its CSR policies into action, including any
systems or procedures for this.
3. The company's assessment of what it has achieved as a result of its work
with CSR during the financial year and its expectations for the future.
Examples of the CSR guidelines or principles outlined in point 1 above

include the UN Global Compact and the UN principles for responsible in
vestm ent.6
Various awards are presented for CSR reporting. The 2013 FSR – Danish
Auditors’ CSR prize went to AP M 0ller-Maersk A/S.
From time to time, the accountants KPMG publish international analyses

of CSR reporting.7 The 2013 report ranked AP Møller-Maersk in the top
ten in the world.
5.5 Environmental accounts/green audits

In spring 2015, the Danish M inistry of Business and Growth, in collabora
tion with the M inistry of the Environment and Food, presented a bill to
abolish “green accounts”, under which companies have been required to
report on environmental issues.
Instead, environmental factors were to be written into the Financial
Statements Act section 99a (3) so that companies already under an obliga
tion to report on CSR would also have to incorporate an environmental
perspective.
For companies with more than 50 employees, these rules come into
force from financial year 2016. The transitional programme for other
companies covered by the rules means that the rule will not affect them
until 2018.
6 For further details, please refer to www.samfundsansvar.dk.

7 The KPMG Survey of Corporate Responsibility 2013.
PART 3
6 The company in the
market

• explain the relationship betw een demand and price
• explain the concept of price elasticity
• explain the relationship betw een demand and income
• explain the relationship betw een demand and sales
• explain d ifferen t types of markets and com petition, including
monopoly, oligopoly, monopolistic com petition, cartel and perfect
com petition
• account for different tools used in market analysis.
6.1 Demand
6.1.1 Market know ledge
A company proves its worth in the marketplace by supplying products
and/or services that provide its customers with something they are will
ing to pay for at a price that covers its costs and makes a profit.
In order to achieve this, it is vital that the company is fam iliar with its
customers, its market and the factors that drive it.
All companies should maximise their knowledge of the market by con
ducting regular analyses and assessments. It is important to be aware of:
• customer demand and expectations
• competitors’ actions and reactions
• mergers in the domestic and international markets
• developments in e-commerce, etc.
Customer demand is expressed in units, e.g. “expected demand for home

PCs is 20,000 units p.a.”
Markets can be parts of the country, e.g. Funen, Jutland, Denmark, Aal
borg or a cross-border region such as the 0resund Region. They can also
be demographic, e.g. specific age groups, social groups, etc.
It is important for the company, regardless of the market in which it oper
ates, to know the expected demand for its product(s). Expected demand is
the foundation of company management, purchasing decisions, produc
tion capacity, the size of the workforce, marketing activities, etc.
Note that demand is seen from the perspective of the customer, sales
from the perspective of the company. The two are not necessarily identi
cal.
In many industries, e.g. furniture and textiles, demand statistics are
calculated for a range of products and product groups. Statistics Denmark
also publishes wide-ranging statistical data, studies and other publica
tions. See http://www.danmarksstatistik.dk/en.
6.1.2 Demand and demand determinants

A range of variables determine the level of customer demand.
Demand ltemA =
F(PriceA, PriceB, Income, Need, Marketing, Social trends, etc.)
In other words, demand for a particular item is determined by the follow

ing:
• priceA– the price of ItemA
• priceB – the price of ItemB (which can be the price of a competing
product)
• income – the customer’s disposable income
• need/utility – the customer’s need for the item/the utility derived
from it
• marketing – advertising, product design, service, etc.
• socio-economic trends – the environment, the economy, culture, etc.
These factors are known as demand determinants.

Some are beyond the company’s control, e.g. the price of other products,
customers’ disposable income and general socio-economic trends. How
ever, companies set the price of their own products and services and seek
to influence customers’ perceptions of their needs via marketing, product
design, service, etc.
Demand determinants over which companies exert an influence are called

controllable variables.
These variables correspond to the four Ps (or seven Ps), referred to in sec
tion 2.2.2.
The sections below look at three of these determinants, one by one, in
partial analyses, showing how variation in one factor, e.g. the price of an
item (PriceA) affects the volume of demand (XA) while the other factors
remain constant.
The three factors concerned are:

• the effect of its price on demand for ItemA
• the effect of the price of other products on demand for ItemA
• the effect of (customer) income on demand for ItemA
6.1.3 The effect of price on demand

This section focuses solely on the demand determinant price. It is as
sumed that all other factors remain constant.
W hat happens to demand (measured in units) when the price changes?
And how does this affect the cost to the customer (in DKK) for the product
concerned?
As shown in Figure 2.5, in Chapter 2, the general rule is that when the
price falls, demand rises. Conversely, when the price rises, demand falls.
In other words, there is a negative, or inverse, relationship between price
and demand.
Figure 2.6 showed the relationship between price and demand for yo
gurt. Figure 6.1 shows a linear demand curve, which represents a rough
approximation of the yogurt curve.
Figure 6.1 Demand curve and cost curve.
The graph shows that, as the price falls, consumers buy more and more,
and total expenditure rises. However, if prices continue to fall, a point is
reached where the cost to the customer starts to fall as well because of the
falling price per unit.
Mathematically, the relationship is expressed as:
The demand function: P = 16 -1/10 •X
The cost function: C = P •X = 16X – (1/10) •X 2
where P is price per unit, and X is total demand at this price.
PRICE ELA ST IC IT Y
Price elasticity quantifies how sensitive sales of a product are to price. A
product’s price elasticity quantifies relative change in sales volume com
pared to relative change in price.
Price elasticity =
Figure 6.2 Demand curve, cost curve and price elasticity.
The sign in front of price elasticity indicates the direction in which de
mand changes when the price is changed. The number (value) indicates
how strongly this factor affects demand.
In Figure 6.2, the value of price elasticity is shown in relation to the
demand curve and the cost curve.
Example
Calculating epwhen the price falls from DKK 18 to DKK 12.
Alternative calculation o f price elasticity

For a straight-line declining sales curve, price elasticity is calculated by di
viding the lower section of the vertical axis (the y-axis) in the co-ordinate
system, by the upper section (see Figure 6.2).
The sales curve indicates an elasticity of -3 at a price of DKK 12. This num
ber can be arrived at as follows:
This formula for calculating epshows epat one point, which means that the
formula is fully in line with the principle behind calculating price elastic
ity (at infinitesim ally small price changes). This elasticity is therefore also
known as point elasticity.
Note that price elasticity changes (falls) and approaches zero as the de
mand curve falls.1
Figure 6.3 shows a series of curves with different price elasticities.
1 As the formula shows, price elasticity (ep) is conditioned by two factors, i.e. the slope (ΔP/ΔX) at
a given point in the demand curve, and the actual point (X,P), which is also the starting point for the
calculation.
Figure 6.3 Different curves and price elasticities.
Figure 6.3 C is the normal situation, where a typical decreasing demand

curve shows elasticities ranging from infinitely high to 0 as demand falls.
When ep> 1, the demand is called elastic. When ep <1, it is inelastic. When
ep = 1, the elasticity is neutral.2
The other curves are relatively unusual and show more extreme cases,
with the curves maintaining the same elasticity throughout (see Figures
6.3 A, B and D).
Price elasticity for different products

The sign in front of the price elasticity is usually negative because a falling
price increases demand. A series of factors affect the actual extent of the
elasticity. The table below provides examples of the importance of these
individual elasticities.
2 As the relationship between price and volume is generally in the opposite direction, the price
elasticity is, as a rule, negative, which is why the sign preceding it is often dropped.
Low elasticity – price change has little effect High elasticity – price change has major effect
The product is a necessity The product is a luxury item
The product is difficult to substitute The product is easy to substitute
The product makes up a small share of the The product makes up a large share of the
budget budget
A fflu en t buyers Poor buyers
Routine purchase Carefully considered purchase
Somebody else pays The customer pays personally
Note that the price elasticity of a single product can be completely differ
ent than for the product group as a whole. While price elasticity for rye
bread is generally limited, it is markedly greater for specific brands be
cause multiple substitutes are available (e.g. Kohberg wholegrain instead
of Schulstad wholegrain).
The general rule is that the price elasticity is negative. However, there
are exceptions.
Factors that can lead to positive price elasticity:

• when price is perceived as an indicator of quality
• when an expensive item signals status
• when price rises are expected.
Example
A price survey reveals the following relationship between price and de
mand for the perfume Dior Dune for a given period after a price rise.
Before price rise After price rise

Price Demand Price Demand
400 4,000 bottles 450 5,000 bottles
The formula shows that a 1% price rise leads to a 2 % increase in demand.

In other words, the actual price rise of 12.5% leads to a 25% increase in
demand.
People who buy Dior Dune clearly find the product more attractive
when they pay a premium for it. In marketing theory, this is referred to as
the Veblen effect.
The rise of ethical consumption is also affecting the traditional relation
ship between price and demand. Consumers are willing to pay a premium
for sustainably sourced and environmentally friendly products.
Examples
• Max Havelaar coffee
• Free-range eggs
• Organic food
• Furniture made from rainforest timber (replanting of felled trees)
• Cars (all parts recyclable)
6.1.4 The effect of price of other products on demand

A price change for a particular product often affects demand for several
others. This section looks at how demand for product A is influenced by
the price of product B, assuming that all other factors remain constant.
This is illustrated by cross-price elasticity, which is defined as:
i.e. the change in demand for product A when the price of product B chan
ges =
The number and the sign in front of the cross-price elasticity show the
strength and type of relationship between the two products.
The relationship between different products can be such that they ei
ther support or replace each other. These are referred to as complemen
tary or substitute (i.e. competing) items, respectively.
Complementary items are products that meet a particular need when used
together, i.e. they complement each other. Examples include music sys
tems and speakers, cinema tickets and soft drinks from the kiosk, coffee
and milk. If the price of cinema tickets goes up, fewer people buy them and
the kiosk sells fewer soft drinks. The numerator and denominator for the
two items move in opposite directions.
In this case, the cross-price elasticity is negative because the rising cost
of tickets leads to lower sales of soft drinks.
Example
Scala Cinema has observed the following relationship between the price of
its tickets, the number of tickets sold per week and the number of litres of
soft drinks it sells.
Price per Litres o f soft Price per Litres o f soft

Ticket sales Ticket sales
ticket drinks sold ticket drinks sold
D K K 100 4,000 units 1,200 litres D K K 120 3,000 units 900 litres
A = soft drinks
B = tickets
A 1% change in the price of cinema tickets changes the demand for soft
drinks by 1.25%.
The cross-price elasticity is negative, which means that when the ticket
price rises, demand for soft drinks falls (and vice versa).
Note that the price changes are always for product B.
Substitute products are products that meet the same need, as they can re
place (substitute) each other. For example, butter and margarine, pencils
and pens, brie and camembert. For example, as the price of brie rises, sales
of camembert increase, as consumers substitute the more expensive item
with the relatively less expensive one.
The cross-price elasticity in this example is positive, because the rising
price of brie leads to increased sales of camembert.
Example
The Dagligsuper chain has observed the following relationship between
the prices of brie and camembert over a given period.

Price per Gr of brie Gr of Price per Gr o f brie Gr of
gr of brie sold cam em bert sold gr o f brie sold cam em bert sold
DKK 11 700 gr 500 gr DKK 12 550 gr 575 gr
A = brie
B = camembert
A change of 1% in the price of brie changes the demand for camembert by

1.25%.
The cross-price elasticity is positive, which means that when the price of
brie goes up, demand for camembert goes up too (and vice versa).
Note that the price changes are always for product B.
Cross-price elasticities can also be calculated for products that are not
directly complementary, or which substitute each other. In principle, the
same relationship exists between products that are more distantly relat
ed. A significant rise in the price of a product that is not price-elastic leads
to a sharp rise in the price to the consumer. This means they have less
disposable income to spend on all other products, so the demand for these
is reduced. As a rule, this effect is not quantifiable, but it can sometimes
be observed, e.g. when oil and energy prices rise sharply.
6.1.5 The importance of income on demand

Each individual consumer has his or her own needs. However, the ability
to meet these needs is at least partially constrained by disposable income.
This section looks at how the demand for a product (yogurt) is influ
enced by the disposable income (purchasing power) possessed by a unit of
consumption (household/person), assuming that all other factors remain
constant.
In order to ascertain a specific functional relationship between dispos
able income and product demand, it is necessary to define the concept of
income in greater detail.
It is the unit of consumptions disposable income after tax which is rel
evant .
Figure 6.4 Demand, income and income elasticity.
Figure 6.4 indicates that it takes a certain level of income before a con
sumer begins to show an interest in the product. From that point onwards,
consumption gathers momentum. Income elasticity measures the rela
tionship between income and demand.
W here X is the volume of demand and Y is income
The importance of income elasticity – where the relative change in volume

is divided by the relative change in income – is that it expresses the per
centage change to product demand triggered by a 1% change in income.
Figure 6.4 shows how income elasticity falls as income rises. When in
come exceeds DKK 16,000 per month, consumption reaches saturation
point. Here, income elasticity is equal to zero.3
For most products, consumption increases with higher income, i.e. in
come elasticity is positive. This applies to cars, clothes, houses, leisure
products, etc. However, this effect is dependent on how the consumer de
fines the product.
3 For example, in Figure 6.4 the effect of a rise in income from DKK 7,000 to DKK 8,000 is e 1= (26-
17)/17)/ (8,000-7,000)/7,000 = 3.7. In other words, when income rises by 1%, consumption rises by 3.7%.
Example
Rising income leads to higher expenditure on cars. However, this is not
because more vehicles are purchased per household, but because people
substitute the ones they have with ones of higher quality. They move from
Skoda (Fabia) to V W (Golf) to Audi (A4) as their disposable income rises.
For many types of products, as income rises, consumers switch from

cheaper to more expensive products within the product group concerned.
This causes the demand curve to swing back, and the income elasticity
becomes negative.
Knowledge of the impact of income on customer demand is of great im
portance to company planning and budgeting. Expected consumer income
and purchasing power are significant factors when setting prices, plan
ning production and making investments.
Sources for this type of information include Statistics Denmark and
specific industry statistics. Figures for total income after tax and for car
sales, for example, are readily available and are of considerable interest to
the automobile industry.
6.1.6 Total market demand

In principle, total market demand is a horizontal sum of the individual
consumers’ demand curves, in which, for each individual price, market
demand is equal to the sum of the individual consumer’s demand at that
price.
However, adding together different consumers’ demand curves in this
way is problematic. Firstly, it requires, in principle, that there is no form
of dependency between the individual consumers.
Secondly, if it is necessary to determine the individual curves for all
consumers (which may well mean hundreds of thousands) before adding
them up, the task quickly becomes unmanageable.
In practice, companies address these problems by dividing the market
into segments, each with specific characteristics. Within these segments,
the company estimates a demand curve for the average consumer for the
product concerned.
Figure 6.5 Plotting the market demand curve.
6.1.7 From demand to sales

In section 6.1.6, the m arket’s total price demand curve was calculated on
the basis of the price/demand curves for individual consumers. This is
crucial for calculating demand per company.
Every company wants to corner the share (proportion) of total market
demand that will bring it the maximum profit. The aim is to attract con
sumer attention and purchasing power.
Several factors determine what each company can and will sell in the
market. Some of these are directly under the company’s control, e.g. price,
sales campaigns and product design. Other aspects, e.g. competitors’ pric
es, disposable income, etc., are beyond its control.
The determinants that are within the company’s control were intro
duced earlier as controllable variables (see the four or seven Ps).
Companies generate sales and profits by making the most of their control
lable variables (including price) within the externally determined fram e
works.
A product’s price-demand curve indicates the volume consumers are
willing to purchase at various prices within a specific period, while the
company’s price-sales curve shows the volume it expects to sell within a
given time period at varying prices in a given market.
If only one company is selling an item, the market-demand curve will
be the same as the company’s sales curve. This will not be the case if more
than one company is selling the item in the same market.
6.2 Types of market
Some companies have many competitors, others only a few or none. For
some, the terms and conditions for price and quality are given in advance,
so they have little room to manoeuvre. Others have a lot more flexibility
in terms of controllable variables.
Markets can be viewed systematically by dividing them up according to

two main criteria:
1. Consumer attitudes (preference and loyalty) to the company and its
products
2. Number of companies and their relative size in the market (i.e. num
ber of potential competitors) selling the same, or broadly the same,
product.
Consumer attitudes are an important factor. Do they have a neutral atti

tude to their choice of supplier? Do they prioritise good service, reliability,
quality and/or close co-operation? Or do they only prioritise the cheapest
price?
If a company is aware of consumers’ preferences, it can act accordingly.
Markets are categorised as:

• homogenous
• heterogeneous
This sub-division can be attributed to the consumers’ attitudes to the

product.
6.2.1 The hom ogeneous market

A homogeneous market is one in which individual consumers do not really
care which company’s product they buy.
The consumer considers the products/companies to be offering the same

thing. In other words, in a homogeneous market, consumers do not have
preferences.
The products sold in a homogenous market are also referred to as stand
ard items.
Standard items are products that are sold by more than one company and
which customers consider the same, no matter which company is selling
them.
Standard items include products whose prices are determined in a “mar
ketplace”, e.g. at daily commodity auctions (exchanges) ranging from co
coa, coffee, soya-bean oil, gold and other minerals (world market prices
set on the exchanges) to vegetables, fish and agricultural products, as well
as stocks and bonds. The buyers of these products have no preferences in
terms of who produces/sells the product.
In homogeneous markets, individual companies have no room to ma
noeuvre in terms of price policy. If customers consider products identical,
companies must sell them at the same price, otherwise buyers will look
elsewhere for a cheaper/better deal.
6.2.2 The heterogeneous market

A heterogeneous market is one in which the individual customer prefers
(has preferences for) individual companies and/or their products.
Consumers consider the products to be different and this creates room
for price differences between companies. This kind of preference is char
acteristic of a heterogeneous market.
Products sold in heterogeneous markets are called differentiated items.
Differentiated items are products that the customers see as different de
pending on the company selling them.
Differentiated items range from clothes brands (Armani, Boss, Dior) and
computers (Compaq, Dell) to televisions (B&O, Sony), etc. In the grocery
section, examples include Tuborg, Frisko, etc. – in short, everything that
is not a standard item.
On the business-to-business market, buyers often prefer companies
that live up to expectations in terms of reliability, quality, speed and flex
ibility.
6.2.3 The number of companies

The “number of companies” refers, quite simply, to the number of compet
ing companies selling products in the same market.
In a heterogeneous market, the products are not identical – in fact, com
panies often deliberately differentiate their products in order to increase
their visibility, which makes it difficult to define the market accurately.
The market size and number of competitors depends on how the market
is defined.
In practice, however, companies usually know their competition well.
Generally, if there is only one company in the market, it usually has con
siderable scope for making the most of the controllable variables. If there
are only a few companies and they are on an equal footing, they will usu
ally observe and react to each other. If there are a large number, they have
to adapt to the prevailing conditions and their scope for action is more
limited.
6.3 Overview of the types of market and competition

The “type of market” refers to the nature of the competition or the degree
of independence a company enjoys with regard to control variables.
The type of market is determined by customer preferences for individu
al providers and by the number of providers in the market.
The extremes vary from a single provider (monopoly) to many small
providers (perfect competition). All of the intermediate forms are referred
to as imperfect competition.
The rows in Figure 6.6 show the variation in the number of providers.
The columns show the division of the market depending on whether it is
homogeneous or heterogeneous (degree of preference). It is assumed that
the number of buyers in the market is large.
Number of 1 large 1 large + 2 Few Many

providers many small
Degree
of preference
Homogeneous M onopoly Partial Duopoly Oligopoly Perfect
market monopoly competition
Heterogeneous M onopoly Differentiated Differentiated Differentiated Monopolistic

market partial duopoly oligopoly competition
monopoly
Figure 6.6 Types of competition.
6.3.1 Perfect competition

Perfect competition is characterised by:
• many small suppliers and much small-scale demand
• a homogeneous market
• buyers with no preferences regarding individual suppliers
• a market that is organised and fully transparent in terms of supply
and demand
• no restrictions, i.e. no barriers to market entry.
In markets with many small suppliers and much small-scale demand, the
individual suppliers and buyers are too small to exert influence on either
the supply or the demand side. Both sides are of the view that the price is
determined externally.
The left-hand side of Figure 6.7 shows how rising prices trigger greater
supply while demand is falling. When conditions are relatively stable, sup
ply and demand converge around an equilibrium price. The price arrived
at will be constant (at least in the short term), which is why the company’s
sales curve on the right-hand side of the figure is horizontal.
From the manufacturer’s perspective, the market price is externally de

termined: a “take it or leave it” price. At this price, the company can sell
as much as it wants. The sales curve will therefore be a horizontal line, as
shown in Figure 6.7. In this scenario, the revenue curve rises proportion
ally. Every time sales increase by one unit, revenue increases at the (rela
tively stable) sales price.
If a company sets its price above the market rate, no one will buy its
product. Conversely, setting a price below the market rate would not be
very sensible because the entire production run could actually be sold at
the market rate.
Figure 6.7 Setting prices in perfect competition.
Under these conditions, the company that supplies the product is referred
to as a price-taker.
The company either accepts or rejects the price. If it rejects the price, it
will make no sales. If it accepts the price, it must find the production and
sales volume that will generate the maximum profit. The company’s costs
are critical to this process.
In this situation, the company can remain active in the market as long
as the additional revenue exceeds the extra production costs.
Absolutely perfect competition is rare. However, there are plentiful ex
amples of approximate situations, e.g. horticulture, fisheries, agriculture,
commodity markets.
Example
Commodity markets, e.g. global markets for coffee, cotton, oil and mink,
are examples of a situation that approaches perfect competition. These
markets have many suppliers and large numbers of buyers and standard
products, and the market is transparent because it is often well organised
and takes a form similar to an auction (commodity exchanges).
The fact that suppliers do not always like competition is reflected by the
number of cartels set up with the express purpose of avoiding it, e.g. the
powerful oil cartel OPEC.
6.3.2 M onopoly
The opposite of perfect competition is a monopoly.
In a monopoly, there is only one supplier of a given product, and there
fore the question of degrees of preference with respect to homogeneous or
heterogeneous markets becomes theoretical.
The unique feature of the monopoly is that the supplier does not have
to think about competitors. They do not exist. It also means that the m ar
ket’s demand curve is the same as the monopolist’s sales curve.
Unlike the situation under perfect competition, the monopolist deter
mines the price that is the most financially advantageous, and then lets
the market decide how many it wants to buy.
In these circumstances, the supplier of the products is referred to as a
price-setter.
Figure 6.8 shows the monopolist’s declining sales curve and the cor
responding revenue curve. Note that the revenue function is a parabola.4
4 P = aX + b and revenue = X • P = aX2 + bX
Figure 6.8 Price-sales curve and revenue curve for a monopoly. Note the different axes.
The steeper the sales curve, the stronger the monopolist’s position in
terms of price. In practice, the curve is typically non-linear (see also Fig
ure 2.6).
A monopoly can be the result of a public concession. For example, Post
Denmark still has a monopoly on the delivery of letters. Other monopolies
are based on special circumstances, such as patent rights (e.g. Tetra Pak
cartons) and/or secret production methods (e.g. the Coca-Cola recipe).
The deregulation of markets over the last 3 0 - 4 0 years has made it dif
ficult to form and m aintain monopolies. Many former public monopolies
have now been privatised, e.g. Tele Danmark and DSB.
M O N O P O L IE S A N D R E G U L A T IO N 5
If a sector is characterised by a natural monopoly, governments will of
ten seek to introduce regulation and avoid a situation where a position of
strength is exploited to extract exorbitant prices, e.g. medicines sold by
chemists.
A/S Storebaelt is an example of a natural monopoly. Building the bridge
across the Great Belt was costly, but once in use, the costs associated with
each additional car driving over the bridge are negligible.
5 See the Danish Competition and Consumer Authority: http://en.kfst.dk
6.3.3 Monopolistic competition – imperfect competition
This type of market is defined by a large number of both buyers and sell
ers. The products/services are more or less heterogeneous, i.e. consumers
have preferences for individual providers and their products.
Under imperfect competition, the sales curve falls from left to right (see
Figure 6.9). The slope of the curve, and therefore its price elasticity, are de
termined by the product’s unique selling point in relation to other, similar
products. The steeper the curve, the stronger the preference for it and the
greater the company’s room for manoeuvre in terms of pricing policy.
Compared to a true monopoly, the price-sales curve and price demand
curve will be flatter and the price elasticity will be greater, as there are
often several nearly identical competing products. The greater the num
ber of substitution options, and the more closely these products resemble
each other, the flatter and more elastic the curve.
In this type of market, companies will typically consider that the com
petitive aspects outweigh the monopoly aspects. They may have a monop
oly on their own product, but they have to compete with other products
that resemble it.
Figure 6.9 Sales curves – monopoly and monopolistic competition.
How close to each other different suppliers’ products are is quantified by

their cross-price elasticity.
Where there is a high level of cross-price elasticity, the number of sub
stitution options is high and competition at its fiercest.
Monopolistic competition is the most prevalent form of competition in
both the business-to-business and the business-to-consumer markets. In
these situations, price (differentiation) is an im portant controllable vari
able.
All of the four (or seven) Ps can be differentiated. For example, banks
differentiate on interest rates, fees, quality of advice, location, opening
hours, etc.
Example
A farmer who produces grain for bread will usually be a price-taker. He
produces the same standard product as many other farmers in a perfect
competition market.
However, the situation changes if he begins producing "Schackenborg
grain". Now, he has his own unique product and may be able to demand a
higher price. This places him in the type of market referred to as monopo
listic competition.
6.3.4 Partial m onopoly (price leadership)

This type of market form has one large provider and several smaller ones.
If the products are differentiated, it is called a differentiated partial mo
nopoly.
For example, Carlsberg dominates the Danish beer market, but there
are several smaller breweries as well – Royal Unibrew, Harboe, Thy, etc.
In this kind of market, there are no particular rules for how prices are
set. Often, price leadership consists of the large company setting a price
that the smaller ones are then expected to follow. In doing so, the large
company leaves room for the small companies’ products. In other words,
the large company is the price-setter, the smaller ones are price-takers.
The situation becomes more complicated if the small companies adopt
an independent pricing policy and undercut the large company in order to
boost their market share. This situation can often be very “painful” for
the large company, especially if the smaller ones have flexible cost struc
tures, i.e. are able to adapt their costs rapidly.
6.3.5 Duopoly
A duopoly is a market with two dominant players. If the products are ho
mogeneous (i.e. more or less the same), it is safe to assume that the market
will be divided up between them.
However, the companies will usually seek to differentiate their products
and services to attract more customers. This is referred to as a differenti
ated duopoly. The two companies will closely follow and respond to each
other’s actions.
Example
Examples of duopolies include Rockwool and Glasuld; BT and Ekstra Bladet;
and Falck and Dansk Autohjaelp.
6.3.6 O ligopoly
An oligopoly is a market dominated by a few major players. The companies
know each other and watch each other closely. In the battle for market
share, they will react to each other’s moves and protect their positions.
This is a very common type of market, and operates on both a large and
small scale. Car manufacturers and oil companies are large-scale, inter
national examples. However, in smaller towns and local markets, a lot of
local shops find themselves in the same situation.
Example
Denmark has relatively few major building societies (Nykredit, Realkredit
Danmark, Nordea Kredit and BRFkredit), which makes it an oligopoly.
Similarly, there are four major estate agents: Nybolig, Danbolig, EDC
and Home.
No single model adequately describes this type of market. In fact, several

models apply due to the fact that competitors’ reactions may vary over
time.
The various pricing models are based on different assumptions about
how the players in an oligopoly interact with each other. There are four
different models for this:
1. The co-operation model is based on the assumption that suppliers come

together in a cartel and set a price as if they were a monopoly.
Example
If a number of driving schools in a particular geographical area agree to
act as one in the market, they are able to act like a monopoly and reap the
benefits of this type of market. Changing from many suppliers and many
buyers to many buyers and a single supplier can bring major financial gains
for the members of the cartel. However, it may also have negative social
ramifications (see microeconomic theory).
An effective cartel requires unity of action in both words and deeds. Divi
sions in the cartel, which can easily arise when discussing shares in the ad
vantages of the monopoly situation, are a constant threat to its survival.
In order to be legal, a price cartel must be registered and approved by
the Competition Authority. If it is not, heavy fines and prison sentences
may be handed down.
Example
"Six banks hit by EU's biggest ever fine
Six major banks have been hit by the biggest ever EU fine (DKK 12.73 bil
lion) under anti-trust legislation.
The banks are alleged to have co-ordinated their interest rates to
restrict competition between them. On top of the huge fine, the banks
may now face civil suits for potentially far larger amounts – possibly up to
hundreds of billions."
Bø rsen online, 5 December 2013
2. K inked dem and curve is based on the assumption of asymmetric (uneven)

reaction by competitors to price rises and cuts. When a given company
cuts its price, the others will follow to preserve their market share. Con
versely, if a company puts its prices up, the others will not follow, but keep
their prices the same in anticipation of increased market share. This pat
tern leads to the company’s sales curve breaking at the current price point.
This helps explain the widespread price stability that often epitomises
this type of market (see Figure 6.10).
Figure 6.10 Price-sales curves in an oligopoly. The kinked demand curve.
The asymmetric price reaction is found by following the solid part of the
curve.
3. The conjectural model assumes that moves by one company will auto
matically trigger specific reactions from competitors, and that this has
already been taken into account.
4. The price-leadership model is based on one of the companies, usually the

biggest one, assuming a price-leadership role, which the others quietly ac
cept due to fear of price volatility.
6.4 Plotting market-demand curves and sales curves

6.4.1 Market analysis/price analysis
Theoretical marketing economics seeks to construct models that illus
trate the marketing and behavioural relationships that companies take
into consideration when making decisions. For these models to be practi
cal, companies need to be able to estimate the parameters that underpin
them.
Existing products
Methods Description/example Sources
Statistical analyses Using statistical methods, it is possible to describe Historical

Objective: the relationships between tw o variables, e.g. bet data from the
Plot the shape and ween price and sales volum e company's own
position of the sales sales statistics.
curve.
Data for the
model could
also come from
a company's
ow n pricing
experiments.
Plot the company's sales and marketing data for a

given period to reveal th e curve that best matches
the observations. The straight line in the figure
is a price-sales line, calculated using th e Excel
function Chart > Add trendline > Linear, and also
corresponds to the form ula shown. The trendline
should, o f course, be interpreted very cautiously,
as multiple variables other than price affect sales
volumes. Nonetheless, a regression like this is often
a useful starting point for further analysis.
Consumer panel A consumer panel consists of representatives Market-

Objective: selected on the basis of a range o f criteria, e.g. research
Determ ine market geography, household size, fam ily type, household companies.
size, trends, price income, etc. Inform ation about their buying habits
analysis, etc. is collated by the members systematically keeping
shopping diaries, including inform ation about pri
ces and volumes purchased.
These diaries are then subjected to statistical
analyses.
Shop panel A shop panel consists of representatives from se M arket-

Objective: lected retailers. If th e study concerns convenience research
Determ ine total food, for example, they will be representatives of companies,
sales, market trends, grocers, supermarkets, etc. e.g. A.C. Niel
com petition, price Q uantification consists of adding up stocks and sen
analysis, etc. sales data for product groups and sub-groups, all
the w ay down to individual packages.
Based on these reports, the market-research
com pany draws up reports according to th e custo
mer's specifications – e.g. covering sales, market
share, stocks, prices, etc.
Interviews/question A representative sample is selected from th e group The company's

naire surveys concerned. An interview is conducted, including ow n studies
Objective: questions about how the respondent sees a given and/or m arket-
Price comparison/ product price compared to com peting products' research
cross-price elasti prices, and the level of price rise at which the companies.
cities buyer w ould switch to other products, etc.
Statistical analyses are again applied to the
questionnaires.
N ew products
Methods Description/example Sources
Price experiments Conducting controlled experiments is difficult. Own data.

Objective: However, supermarket chains with several similar
Determ ine the price stores, for example, can use the experiment met
level hod, i.e. test parameters such as price in their dif
ferent outlets. They are then able to quantify the
effect of the various parameters on sales volumes.
The data is subjected to statistical tools such as
regression analysis.
Value analyses This type of analysis is based on the value to the Own data and
Objective: customer. calculations.
Determine the price For example, an engineering works develops a
level/max. price for new packaging machine that saves the customer
a n ew product to money has environm ental advantages. All things
replace an existing being equal, the savings that the customer makes
one by using the n ew machine rather than the current
model will justify a price premium equal to the
savings made.
This is where market research comes in. The basic aim is to quantify de
mand and plot the location and slope of the individual company’s sales
curve.
The examples in the table above consist of information gathered for the
purposes of market analysis and price analysis. The list is by no means
exhaustive, so please refer to additional literature on the subject. All of
the methods shown collate empirical (real-world) data in order to generate
knowledge about the relationship between price and sales volume, about
the total market, intensity of competition, etc.
Uncertainties about communication between respondents and inter
viewers and the degree to which the data is representative mean that the
results must be interpreted with caution.
Even greater caution is required if the results are to be used to inform
prognoses that involve time and development factors.
None of these methods of analysing markets should be used in isola
tion. Before a decision can be reached, management must evaluate a num
ber of other factors, often qualitatively.
7 Costs

• account for and d ifferentiate betw een variable and fixed costs
• calculate total costs, average costs, marginal costs and incremental
costs
• d ifferentiate betw een costs which are relevant to decision making,
sunk costs and opportunity costs
• account for choices betw een d ifferen t methods of production.
7.1 Why are costs important?

It is vital that a company pays attention to its costs. If it is to survive in the
long term, its income must be greater than its expenditure.
However, to make sure that this happens, it is important to know how
costs vary and be aware of the factors that influence them. Knowing how
much a specific activity will cost is crucial for the planning and manage
ment of:
• costs
• pricing
• other activities
• earnings and liquidity.
Knowing the costs is a prerequisite for making decisions about the feasi
bility of planned activities.
7.2 Concepts
The cost function shows how costs vary with the volume produced (X).
In general, total costs (TC) are TC = f(X). In theory, the following formula
for the cost function calculates a company's costs:
TC = FC + VC
where total costs consist of tw o parts, i.e. fixed costs (FC) + variable costs
(VC).
e.g. TC = 5,000 + 1,000
Fixed costs do not change with the production volume, e.g. rent, deprecia
tion on wages and saleries, etc.
Variable costs change with the production volume.
For example, a manufacturing company would include labour costs and

materials in its variable costs; a trading company would include sales costs
(the price it paid for the goods it sells on again).
Additional costs are defined as the difference in total to costs when a given
change is made to production volume.
Marginal costs are the amount by which total costs rise or fall when produ
ction is increased or decreased by a unit. The formula is VC (or TC)/change
in number of units.
Example (production increases by one unit)

Production Variable costs Marginal costs
volume = X (VC) (MC) (ΔX=1)
100 5,000
75
101 5,075
85
102 5,160
Example (production increases by more than one unit)
Production Variable costs M arginal costs
volum e = X (VC) (M C) (AX=1)
100 5,000
60
110 5,600
80
120 6,400
Figure 7.1 below presents the cost concepts referred to in this chapter in
table form.
Cost concept Abbreviation Description
Total costs TC Total costs for a given activity during a given period.
Q uantified as DKK per period of time.
Variable costs VC Costs that change w ith the volum e produced or sold.
Q uantified as DKK per period of time.
Fixed costs FC Costs that do not change w ith the volum e produced
or sold. Q uantified as DKK per period of time.
Average total costs AC Total costs per unit at a given volume. Q uantified as
DKK per unit. Also referred to as total unit cost.
Average variable AVC Variable costs per unit at a given volume. Quantified
costs as DKK per unit. Also referred to as variable unit cost.
Average fixed costs AFC Fixed costs per unit at a given volum e. Q uantified as
DKK per unit. Also referred to as Fixed unit cost.
Additional costs Change in Change in total or variable costs at a given change in

TC or VC the volum e produced or sold. Q uantified in DKK.
M arginal costs MC Change in total or variable costs at a change in the

volum e produced o f one unit. Q uantified as DKK per
unit.
Figure 7.1 Table of cost concepts.
Example
A company manufactures product A. The variable costs are DKK 1,000, ir
respective of the volume produced.
The product is made at a plant where interest and depreciation costs
(FC) amount to DKK 5,000 p.a.
X FC VC TC AFC AVC AC MC
FC/X VC/X TC/X
0 5,000 0 5,000 - - -
1,000
1 5,000 1,000 6,000 5,000 1,000 6,000
1,000
2 5,000 2,000 7,000 2,500 1,000 3,500
1,000
3 5,000 3,000 8,000 1,667 1,000 2,667
1,000
4 5,000 4,000 9,000 1,250 1,000 2,250
1,000
5 5,000 5,000 10,000 1,000 1,000 2,000
1,000
6 5,000 6,000 11,000 833 1,000 1,833
1,000
7 5,000 7,000 12,000 714 1,000 1,714
1,000
8 5,000 8,000 13,000 625 1,000 1,625
1,000
9 5,000 9,000 14,000 556 1,000 1,556
1,000
10 5,000 10,000 15,000 500 1,000 1,500
Figure 7.2 Table of applied cost concepts.
Note that in Figure 7.2, the marginal costs are listed in the spaces between
the production intervals.
Figure 7.3 The cost trend in graph form.
The significance of the marginal costs is that when the activity (production)
increases by a single unit, e.g. from 3 to 4, the costs go up by DKK 1,000.
Conversely, if production is reduced from 4 to 3 units, the costs fall by DKK
1.000. This is known as the marginal cost.
The concept of differential costs is used if the volume change is grea

ter than one unit.
In Figure 7.3, the total cost function (TC) is plotted on the y-axis, starting at
5.000, and this corresponds to the fixed costs (FC), whether or not anything
is produced. This type of cost is sometimes referred to as a standing cost,
i.e. a cost incurred whether or not the company actually produces any
thing.
From this starting point on the y-axis, the total cost curve increases by
an amount corresponding to the variable costs. As the variable costs per
unit are constant (DKK 1,000), the total cost function is linear. The variable
costs (VC) are plotted separately, starting at 0.0, and are also proportional
in this case.
Figure 7.4 Example of unit cost curve and marginal cost curve.
Figure 7.4 shows that average fixed costs (AFC = FC/X) fall as production
volume rises until they almost reach zero. However, the fact that they fall
does not mean that they are variable.
Average total costs (AC = TC/X) also fall as they approach the variable
costs (AVC=VC/X).
The marginal costs (MC) remain constant. In this example, they are equal
to AVC (VC/X), which also remains constant.
The website that accompanies this book includes a spreadsheet contai
ning the figures used to plot the cost curves in Figure 7.4.
The m athem atical calculations
Total costs = TC = f(X)
X = production volume in units
TC = FC + VC Total costs
FC = 5,000 (a constant) Fixed costs
VC= 1,000• X Variable costs
TC = 5,000 + 1,000 •X Total costs
AVC =VC/X =(1,000 X)/X=1,000 Average variable costs
AFC = FC/X = 5,000/X Average fixed costs
AC =TC/X =(FC + VC)/X = 5,000/X + (1,000 •X)/X
= 5,000/X + 1,000 Average total costs
7.3 Cost trends

7.3.1 Trends for variable costs
Remember that variable costs change with the level of activity.
Variable costs follow three trends:

1. Proportional costs rise and fall in direct proportion with the level of
activity. For example, production increases by 20% and costs increase
by 20%.
2. Degressive costs rise and fall at a proportionally slower rate than the
level of activity. For example, production increases by 15% but costs
only increase by 10%.
3. Progressive costs rise and fall at a proportionally faster rate than the
level of activity. For example, production increases by 15% but costs
increase by 20%.
Example
A company calculates production costs for a potential product under dif
ferent scenarios:
Example
Production/ Proportional Degressive Progressive

sales per period costs costs costs
Unit DKK DKK/unit DKK DKK/unit DKK DKK/unit
VC AVC=VC/X VC AVC=VC/X VC AVC=VC/X
0 0 0 0 0 0 0
100 300 3.00 300 3.00 300 3.00
200 600 3.00 500 2.50 700 3.50
300 900 3.00 650 2.17 1,100 3.67
400 1,200 3.00 700 1.75 1,600 4.00
Figure 7.5 Different trends for the variable costs and the average variable costs:
7.3.2 The general cost trend
The table below illustrates the trend for costs in a (fictional) manufac
turing company. Although it is a theoretical example, it contains features
common to many companies.
Example
The basic process consists of subdividing costs into the categories fixed and
variable.
The fixed costs are the costs incurred to have the capacity at the
company's disposal irrespective of whether anything is produced. These in
clude depreciation provisions for buildings and plant, administration costs,
rent, wages and saleries.
In a manufacturing company, the main variable costs are labout costs
and materials. In a trading company, the main one is sales costs.
In Figure 7.6, the left of the table shows the fixed and variable costs at
different levels of production. All of the other (derived) costs are calcu
lated on the basis of these numbers.
The graphs in Figure 7.7 are based on the data presented in table form
in Figure 7.6.
X FC VC TC AFC AVC AC MC
FC/X VC/X TC/X ΔTC/ΔX
0 2,000 0 2,000
500
1 2,000 500 2,500 2,000 500 2,500
300
2 2,000 800 2,800 1,000 400 1,400
200
3 2,000 1,000 3,000 667 333 1,000
125
4 2,000 1,125 3,125 500 281 781
135
5 2,000 1,260 3,260 400 252 652
190
6 2,000 1,450 3,450 333 242 575
300
7 2,000 1,750 3,750 286 250 536
500
8 2,000 2,250 4,250 250 281 531
750
9 2,000 3,000 5,000 222 333 556
1,200
10 2,000 4,200 6,200 200 420 620
Figure 7.6 Example of cost trends in table form.
Figure 7.7 Example o f th e cost trends in graphic fo rm (note th e tw o axes).
To find out the reasons for the trend indicated by the curves, the (fiction
al) company would have to look at technical factors relating to production.
The degressive rise in variable costs at the start is due the fact that low
production volumes make poor use of the workforce, resulting in a rela
tively high cost per unit. As the production volume increases, more staff
are taken on, work is allocated more efficiently and the opportunities to
employ specialists increase. Higher production volumes also increase the
opportunities for volume discounts.
Bit by bit, production and staff levels reach an optimum level, i.e. the
point at which the company has low constant variable average costs over a
prolonged period of production.
As production approaches the plant’s capacity limit, variable costs rise
rapidly and incrementally. Possible causes include overtime payments and
greater waste during the production process.
As the graph shows, the MC curve intersects the AVC curve and AC curve
at their minimum points. As long as the other costs that the company ex
pects to incur by producing one more unit are lower than the previous
average costs, the average will fall. Conversely, when the marginal cost is
higher than the unit costs, the average will rise. Logically therefore, if the
marginal costs are equal to the unit costs, the latter remain unchanged.
The best possible price for the company is at the AVC minimum. In oth
er words, when it is operating with the lowest possible costs per unit. How
ever, there is no guarantee that this production volume will be profitable.
The sales dimension has to be taken into consideration. In other words,
the products have to sell, which means the price has to be right. This issue
is addressed in Chapter 8.
To summarise:
Phase 1 Phase II Phase III Phase IV
T o tal costs (rig h t Total costs n o w s ta rt T o tal costs rise p ro The to ta l costs c o n ti
axis) s ta rt a t DKK to rise a lm o st p ro gressively nu e t o rise p ro g re s
2,000, c o rre s p o n d in g p o rtio n a lly sively
to fix e d costs B oth MC and AVC
AVC fa lls s lig h tly – is are n o w rising AVC, AC and MC also
The v a ria b le costs a lm o s t co n sta n t rise
rise degressively MC is h ig h e r th a n
AC co n tin u e s to fa ll AVC and p u lls it up MC is n o w also h ig
AC, AVC and MC fa ll h e r th a n AC, and
MC starts to rise b u t On th e cusp o f phase p u lls it up
MC reaches its m in i is s till lo w e r th a n IV, MC intersects AC
m u m o n th e cusp o f AVC an d AC and a t AC's m in im u m
phase II b rin g s th e m d o w n
On th e cusp o f phase
III, AVC reaches its
m in im u m
Here AVCMIN = MC
7.3.3 V a ria b le in crem ental costs

Variable incremental costs are a halfway house between fixed and variable
costs.
Variable incremental costs are subdivided into two main groups:

1. Pre-production costs, i.e. start-up costs such as cleaning and recali
brating tools and equipment before a new production run. The activ
ity is not possible without incurring pre-production costs, but no cost
is incurred if the company decides not to go ahead with the activity.
2. The term other variable increm ental costs usually refers to new ma
chinery needed to increase production volume. For example, a par
ticular piece of machinery may have a capacity of 10,000 units. In
other words, the company would have to purchase a new machine –
and therefore incur a specific cost – every 10,000 units.
The factors above make the total cost function incremental. The associ
ated marginal costs will also rise incrementally each time an incremental
increase in total costs is triggered.
Figure 7.8 shows an example of variable incremental costs.
Example
A com pany makes a p ro d u c t on a machine w ith a capacity o f 10 units per
m onth. The fixe d costs fo r interest and depreciation on th e m achinery are
DKK 10,000 per m onth. The variable p ro d u c tio n costs are DKK 1,000 per
un it.
The com pany expects to sell 3 0 -4 0 units per m onth.
Figure 7.8 shows th e cost curve.
Figure 7.8 Incremental cost trends.
7.3.4 Final points a b o u t fix e d and v a ria b le costs

Distinguishing between fixed and variable costs is important because
variable costs are included when calculating contribution margins. In the
short term, an activity is considered worthwhile if the contribution m ar
gin is positive and helps cover the fixed costs.
In the short term , only variable costs can be reduced or avoided (e.g. ma
terials and the proportion of total labour costs that varies according to
production volume). The company does not incur variable costs if it does
not produce anything and the variable costs fall if the company cuts its
production. Fixed costs, however, remain unaffected by production vol
ume in the short term.
In the slightly longer term, the company has more room to manoeuvre.
It can make office staff redundant, term inate rental and leasing contracts,
sell off some of its capacity, choose not to replace worn-out machinery, etc.
In the long term, all costs can be affected, in the sense that a company
can opt not to assume obligations and therefore avoid incurring the as
sociated costs. However, this does not mean that these costs are variable.
Example
M any companies o p t to make fixe d costs variable by outsourcing parts o f
p ro d u ctio n .
Using a subcontractor to produce its goods reduces th e company's
dependency on m achinery and o th e r e q u ip m e n t th a t incur fixe d costs. A lt
hough th e variable purchasing costs w ill increase, th e com pany o n ly needs
to buy th e required am ounts.
In th is way, th e com pany achieves g reater fle x ib ility by n o t o w n in g capa
city th a t is utilised d u rin g some periods and u n d e ru tilise d in others.
O utsourcing is, o f course, predicated on suitable subcontractors being
available a t any given tim e.
7.4 Financial decision making

7.4.1 R elevan t and irre le v a n t costs
When making decisions, companies weigh up the advantages and disad
vantages of potential scenarios.
For financial decisions, the expected changes to income and expendi
ture are among the considerations. These factors are defined as relevant.
As the process is forward looking by nature, things that have already hap
pened, including costs incurred, can be ignored.
Costs already incurred and n o t a ffe cte d by a decision are called sunk costs.
Similarly, income and expenditure not affected by the decision do not
have to be included in the considerations. These factors are defined as ir
relevant.
Example
A com pany spends DKK 1 m illio n on m arket research fo r a new project. The
results show th a t th e pro je ct w o u ld result in a to ta l c o n trib u tio n m argin o f
DKK 0.9 m illio n over th e ne xt th re e years.
The m anagem ent is n o t keen to proceed w ith a pro je ct leading to a DKK
0.1 m illio n loss.
However, if th e y do n o t proceed, th e company w ill n o t increase its re
venue by DKK 0.9 m illio n and it w ill have lost th e DKK 1 m illio n it spent on
m arket research.
Irrelevant costs are costs n o t a ffe c te d by a decision.
Relevant costs are fu tu re costs a ffe c te d by a decision.
In the example above, the company would be best advised to minimise its
losses. It is better to go ahead and lose DKK 0.1 million than lose DKK 1
million. The cost of the market research has already been incurred and is
not affected by whether or not the project goes ahead. It is a sunk cost and
as such falls into the irrelevant costs category.
7.4.2 R eversibility
Costs have degrees of reversibility, i.e. the extent to which they will revert
to their previous level if the changes made to other factors are reversed.
For reversible costs, the trend is the same whether production goes up
or down.
Differentiating between reversible and irreversible costs is particularly
important with variable incremental costs. In Figure 7.8, it is presumed
that every time production exceeds a certain volume during the given pe
riod, the company has to buy a new machine and take on new staff. This is
what triggers the sudden jumps in the cost curve. The question is whether
it is possible to get rid of these costs if production volume is reduced again.
Figure 7.9 A shows the trend for fully reversible costs, i.e. where it is
possible to get rid of these costs if production volume is reduced again.
Figure 7.9 B shows the trend for costs that are not fully reversible, i.e.
where it is not possible to return to the previous costs level when produc
tion volumes fall. The dotted line for the total cost function shows that
the costs do not return to their previous levels – in other words, the costs
are irreversible.
Figure 7.9 Trends fo r reversible and irreversible costs.
7.4.3 O p p o rtu n ity costs

The point of calculating opportunity costs is to help make decisions, un
like the other costs discussed to date, the point of which has been to quan
tify consumption (an accounting perspective).
Opportunity costs are calculated when choosing between mutually ex
clusive alternatives. They are also sometimes referred to as alternative
costs.
O p p o rtu n ity costs represent th e a m o u n t a com pany w o u ld have to pay

(including any loss o f income) by o p tin g fo r one course o f a ction o r a n o th e r
(including do in g n o th in g ).
Example
A self-em ployed blacksm ith is fru s tra te d w ith th e general business clim ate
and questions w h e th e r it is w o rth w h ile ru n n in g his ow n company.
His b u d g e t fo r th e n e xt year looks like this:
DKK 1,000
Revenue 9,800
V a ria b le costs 6,000
C o n trib u tio n m a rg in 3,800

Total fix e d costs 3,400
P rofit/loss 400
He has DKK 2,500,000 tie d up in e q u ity in th e company.
Should he keep going or sell the company and take a paid job somewhere else?
Selling th e com pany w o u ld fre e up th e e q u ity (on w hich he could be recei
ving 8% interest fro m th e bank) and he w o u ld be able to take a jo b paying
DKK 400,000 p.a.
Solution
Based on a d e fin itio n o f costs as a fa c to r th a t o n ly q u a n tifie s consum ption,
th e costs o f ru n n in g th e com pany are, as shown in th e ta b le above, DKK
9.4 m illio n (6 m + 3.4 m).
Based on th e d e fin itio n o f o p p o rtu n ity costs, th e costs o f ru n n in g th e
business are as fo llo w s:
1. Costs as pe r th e b u d g e t above DKK 9.4 m
2. Loss o f w a g e incom e DKK 0.4 m
3. Loss o f in te re s t o n e q u ity by n o t d e p o s itin g it in th e ba nk

(8% o f DKK 2.5 m) DKK 0.2 m
Total o p p o rtu n ity costs DKK 10 m
Using this d e fin itio n o f costs, revenue is DKK 9.8 m and does n o t cover
costs.
From a purely financial p o in t o f view, th e blacksm ith should sell his
business.
Example
F lo o rfix A/S makes w o o d en flo o rs. The com pany has been o ffe re d a con
tra c t w o rth DKK 200,000. The fixe d costs associated w ith th e o rd e r w o u ld
be DKK 150,000, excluding th e cost o f raw m aterials.
The com pany has th e raw m aterials it w o u ld need in stock. They o rig i
nally cost DKK 20,000. Due to recent rapid price rises fo r w o o d , th e value
o f th e raw m aterials has risen to DKK 60,000.
The company has p o te n tia l a lte rn a tive uses fo r th e raw m aterials du rin g
th e period concerned.
Should th e co m p any accept th e order?
S o lu tio n
The com pany should com pare th e a d d itio n a l costs and a d d itio n a l income
involved in accepting th e order.
The extra income am ounts to DKK 200,000.

The extra costs a m o u n t to DKK 210,000 (150,000 + 60,000).
The historic cost o f th e raw m aterials (DKK 20,000) is an irre le va n t cost.
The cost o f buying th e m again a t DKK 60,000 is th e correct one to use in
th e analysis, because it q u a n tifie s th e actual a m o u n t th e company w o u ld
have to sacrifice.
From a purely financial sta n d p o in t, F lo o rfix A/S should tu rn d o w n th e
contract, because th e a d d itio n a l costs exceed th e a d d itio n a l income by
DKK 10,000.
7.5 Choosing between different production methods

Companies often find themselves in a situation where they have to buy
new machines, e.g. when renewing old ones.
The company may have a choice between different types of machine
with different technical features, and usually also different prices and
running costs. The relationship between the machines’ variable and fixed
costs can vary considerably from machine to machine, e.g. between highly
automated machines and ones that are labour-intensive. The labour-in
tensive machine will usually be cheaper to buy and more expensive to op
erate due to high average variable costs. Conversely, the highly automated
one will be expensive to buy but will have low average variable costs.
Example
A company is in th e process o f deciding w h e th e r o r n o t to buy a machine
to produce goods fo r sale on a new m arket.
It does n o t have a clear picture o f w h a t sales to expect yet, so calculates
th e costs at various p ro d u c tio n volumes.
The com pany has received bids fro m a num ber o f suppliers. The main
data fro m th e tw o under consideration are shown in th e ta b le below.
M achine 1 M achine 2
Labour-intensive Highly autom ated
Fixed costs DKK 3 m illio n p.a. DKK 7 m illio n p.a.
V a ria b le costs
DKK 10 p e r u n it DKK 2 pe r u n it
(m ateria ls and la b o u r costs)
700,000 un its p.a. over 800,000 u n its p.a. ove r

P ro d u c tio n capacity
5-year lifespa n 5-year lifespan
Based on th e tw o o ffe rs received, th e company calculates costs at produc

tio n levels ranging fro m 0 -8 0 0 ,0 0 0 units p.a. P otential sales are expected
to be in th e range 250,000-700,000 units p.a.
Prod M achine I – labour-intensive M achine II – h igh ly autom ated
X FC VC TC AC FC VC TC AC
1,000 DKK DKK DKK DKK DKK DKK DKK DKK
units 1,000 1,000 1,000 per u n it 1,000 1,000 1,000 per u n it
0 3,000 0 3,000 7,000 0 7,000

100 3,000 1,000 4,000 40.0 7,000 200 7,200 72.0
200 3,000 2,000 5,000 25.0 7,000 400 7,400 37.0
300 3,000 3,000 6,000 20.0 7,000 600 7,600 25.3
400 3,000 4,000 7,000 17.5 7,000 800 7,800 19.5
500 3,000 5,000 8,000 16.0 7,000 1,000 8,000 16.0
600 3,000 6,000 9,000 15.0 7,000 1,200 8,200 13.7

700 3,000 7,000 10,000 14.3 7,000 1,400 8,400 12.0
800 7,000 1,600 8,600 10.8
Capacity = max. 700,000 units Capacity = max. 800,000 units
Figure 7.10 Total costs and units costs fo r tw o d iffe re n t types o f machine.
The upper part of Figure 7.10 shows the total costs for the two types of
machine. Note that if the company has a production/sales volume lower
than 500,000 units p.a., machine 1 would be cheapest. If it wants the op
tion of higher sales figures, it should choose machine 2. It will always be
best to be on the lower curve.
The lower part of Figure 7.10 shows the average total costs. Both types of
machine would lead to falling average total costs if the company increased
its production volume. Due to the relatively high fixed costs for machine 2
- the highly automated option – a relatively large volume would be needed
to achieve low unit costs.
When average total costs fall as volume increases, it is referred to as an
economy of scale.
Note
As th e com pany has n o t yet decided on one machine o r th e other, th e deci
sion w ill a ffe c t its fixe d costs.
In th is situ a tio n , th e fixe d costs are relevant costs.
8 Price optimisation

• a c co u n t fo r o p tim is a tio n
• a c co u n t fo r p ric e -s e ttin g and p ric e -ta k in g
• a cco u n t fo r and use o p tim is a tio n m e th o d s – th e to ta l m e th o d and
th e m a rg in a l m e th o d
• e x p la in th e basic assu m p tio n s th a t u n d e rp in th e m odels used fo r
analysis
• o p tim is e prices in m arkets d e s ig n a te d as m o n o p o ly , p e rfe c t
c o m p e titio n and m o n o p o lis tic c o m p e titio n
• set th e lo w e r price lim it fo r a p ro d u c t and p lo t its s u p p ly curve
• a cco u n t fo r cost-based p ric in g
• a cco u n t fo r a c tiv ity -b a s e d co stin g
• a cco u n t fo r th e p ro d u c t life -c y c le curve and its re la tio n to price
o p tim is a tio n
• e x p la in a d v e rtis in g p a ra m e te rs, in c lu d in g o p tim is a tio n and price o f
a d v e rtis in g
• a cco u n t fo r th e b a c k g ro u n d to , p re re q u is ite s fo r and typ e s o f
p re m iu m p ric in g
• o p tim is e prices fo r tw o m a rk e t segm ents.
8.1 The optimisation challenge

The “strategic triangle”, shown in Figure 8.1, provides a concise descrip
tion of a company’s overall market situation. Reference is also often made
to the three Cs – customers, competitors and costs.
All companies interact with other players in their markets.
Figure 8.1 The m arket situation. The strategic tria n g le and the three Cs.
Companies base their actions on their customers’ needs, now and, in the
future, and how best to meet them.
However, in a competitive market, this is not enough. Companies need
to monitor their competitors’ strengths and weaknesses, watch how they
are developing, and work out what they are trying to achieve.
It is also important to stand out from the crowd and focus on the type
of competitive advantages that will boost customer loyalty and justify
charging a higher price for a product or service.
In other words, the scope for adjusting its pricing policy is affected by a
company’s approach to the three Cs.
In order to make decisions that will benefit their customers and the rest of
their stakeholders, companies need a realistic picture of their own situa
tion. They also need to understand how much room they have to manoeu
vre and the constraints to which they are subjected.
The “right” price is the one that secures long-term customer loyalty and
satisfaction but also maximises profit. In practice, this price will usually
vary over time, which means that pricing must always take the following
into account:
1. The market situation (see Chapter 6), e.g.:

a. Number and size of competitors
b. Competitors’ behaviour
c. Entry and exit barriers for the product
d. Elasticity of demand and categorisation of customer segments
e. Customer perception of the product’s value compared to similar ones.
2. Production and distribution costs (see Chapter 7), e.g.:

a. Direct manufacturing costs
b. Fixed costs
c. Product life cycle and marketing needs.
The main factors on which companies are able to exert influence are prod
ucts/services, in the widest sense (also known as the product package), i.e.
a core service and a range of supplementary/accompanying services (see
Figure 8.2).
Example
A haulage co n tra cto r
Figure 8.2 The product/service package fo r a haulage contractor.
The core service consists o f tra n s p o rt fro m A to B. However, no haulage

co n tra cto r w o u ld last long if th a t was th e o nly service th e y provided.
Haulage contractors are usually p a rt o f a logistics supply chain designed
to fu lfil clients' needs fo r th e rig h t products in th e rig h t place at th e rig h t
tim e . This involves a range o f supplem entary services.
The aim is to arrive at th e rig h t sales mix – i.e. one th a t satisfies the
custom ers' needs as w ell as possible and is achievable in a cost-effective
way th a t enables th e company to optim ise its financial perform ance.
One of the cornerstones of the product package concept is the price pa
rameter, which is covered below.
Basically, companies pursue targets for financial performance/profit.
Depending on the controllable variables specified, the effect of working
toward these targets will be reflected in the contribution margin, market
ing contribution or profit.
The following section looks at price as the classic controllable variable.1
It presents examples in which the price is considered in isolation – i.e. all
other parameters remain unchanged.
A number of other controllable variables, including advertising, will be
covered later on.
1 See the fo u r Ps in Figure 2.2.
8.2 Price optimisation – price-setter or price-taker?
In this chapter, the focus is on optimising price and volume in different
types of market (see Figure 6.6).
Very often, price is a key factor in determining sales volume.
Whether a company concentrates on price or volume as the variable it has

most control over depends on its market, including the number of suppli
ers and buyers.
Sometimes the price is determined by external factors and the company
has no say in the matter. In these cases, companies have to work out the
optimum volume to sell at this price. Companies in this situation are re
ferred to as price-takers.
The opposite situation is when the company sets the price itself and
then leaves it up to the market to determine the sales volume. Companies
in this situation are called price setters.
8.2.1 O p tim is a tio n m etho d s

Companies work out optimum prices using tables, graphs or formulas ac
cording to either:
• the total method, or
• the marginal method (also known as the differential method2).
Used properly, both methods arrive at the same result, albeit using differ
ent data and different calculation techniques. What is learned is different,
however, as are the opportunities for extrapolation.
8 .2 .2 Prerequisites fo r o p tim is a tio n

Both methods are based on the following prerequisites:
• Only a single unit of a product is involved
• The aim is short-term profit maximisation
• All of the sales conditions and costs are known – i.e. the model is
exact and uncertainties are removed
• The analysis is partial – the only variables are price and volume, and
it is assumed that all other controllable variables remain constant
• Only a single time period is analysed, i.e. the model is static – any fac
tors that last longer than the period concerned are omitted
• Sales are equal with production – stocks are not factored in.
2 No distinction is made in this book between the m arginal m ethod and the d iffe re n tia tio n method,
even tho ugh in the ory the m arginal m ethod is used w hen the num ber o f units is one, w hile the
d iffe re n tia tio n m ethod is used w hen the num ber is greater than one.
8.3 Price optimisation in different types of market
The concept of marginal revenue is crucial to understanding optimisation
in different types of market.
M arginal revenue is d e fin e d as th e change in revenue trig g e re d by

changing th e sales volum e by a single u n it.
The example below shows how the marginal revenue (abbreviated to MR)
for three products (A, B and C) is calculated in the interval between the
two different figures for sales volume. The formula is:
Example
Example
Product Price per unit Sales per period Revenue MR

(DKK) (units) (DKK) (DKK per unit)
10 900 90.000
A
90 1,000 90.000
100 900 90,000

B
90 1,100 99,000
100 900 90,000

C
90 950 85,000
This table calculates marginal revenue. Marginal costs were covered in

Chapter 7.
The focus now turns to the theory behind pricing optimisation in the two
types of market forms known as monopoly and perfect competition, and
the principles for it under monopolistic competition.
8.3.1 M o n o p o ly (p rice-setter)
A company with a monopoly has noticed that its sales curve is falling and
wants to calculate the most profitable combination of price and sales. In
other words, via its pricing policy, the company wishes to set a price (the
price level) that will generate the largest profit. Companies in this situa
tion are referred to as price-setters.
Figure 8.3 shows how the company approaches this task using both the
total method and the marginal method.
Example
Total m ethod M arginal m ethod
Price Sales U n it Reve Costs C o n tri Fixed Total P ro fit MR MC M CM

costs nue of b u tio n costs costs
go ods m a rg in
P S AVC P•S VC CM FC TC Pr MR MC M CM
(DKK) (units)
12 0 4 0 0 0 500 500 -500
10 4 6
10 200 4 2,000 800 1,200 500 1,300 700
6 4 2
8 400 4 3,200 1,600 1,600 500 2,100 1,100
2 4 -2
6 600 4 3,600 2,400 1,200 500 2,900 700
-2 4 -6
4 800 4 3,200 3,200 0 500 3,700 -500
-6 4 -10
2 1,000 4 2,000 4,000 -2,000 500 4,500 -2,500
-10 4 -14
0 1,200 4 0 4,800 -4,800 500 5,300 -5,300
Figure 8.3 Price optim isation ta b le fo r a company w ith a m onopoly, using bo th th e to ta l

m ethod and th e m arginal m ethod.
THE TO TAL M E TH O D
The total method uses different combinations of price and sales to calcu
late total revenue, total costs and total profit. The combination that gen
erates the largest profit is the optimum price. The table shows that this
price is DKK 8 at a sales volume of 4 0 0 units, which results in a contribu
tion margin of DKK 1,600 and a profit of DKK 1,100.
THE M A R G IN A L M E TH O D
The marginal method arrives at the same result, as shown in the three
columns to the right above.
The principle behind the marginal method is that as long as the m ar
ginal revenue (the increase in total revenue – MR) is greater than the mar
ginal costs (increase in total costs – MC), cutting the price even further
will increase sales. This increases the contribution margin (CM).
The optimum combination using this method is therefore also a price
of DKK 8, sales of 4 0 0 units, a contribution margin of DKK 1,600 and a
profit of DKK 1,100.
The final column in Figure 8.3 shows that as long as the marginal con
tribution margin (MCM) is positive, it pays to change the price parameter
(MR – MC = MCM).
GRAPHIC PRESENTATION
Figure 8.4 addresses the same situation using a graph.
Figure 8.4 O ptim isation using the to ta l m ethod fo r price setting in graph form .
Curves for total revenue, total costs and profit have been plotted in Figure
8.4. The total method seeks to identify the actual sales volume, i.e. where
the distance between the turnover curve and costs curve is greatest. This
is also where the profit curve is at its highest.3 In this case, the figure for
optimum sales is 4 0 0 units.
3 W here the ta n g e n t fo r the revenue curve and the costs curve is parallel, the difference between the
lines is greatest – this is the optim um price.
Figure 8.5 illustrates the marginal method in graph form.4
Figure 8.5 Graphic presentation o f op tim isation fo r a price-setter using th e marginal method.
This time, the marginal costs (MC) are a straight and constant line at
DKK 4. The price-sales function and marginal revenue (MR) function are
also plotted. Note that the marginal revenue curve is twice as steep as the
price-sales curve. Mathematical presentations of the price-sales curve,
marginal revenue and marginal costs are shown below.
The optimum price is found where marginal revenue (MR) = marginal
costs (MC). Again, the optimum sales volume is 4 0 0 units, the price on the
price/sales curve is DKK 8, the contribution margin is DKK 1,600 and the
profit is a total of DKK 1,100.
4 A graphic presentation w ith linear functions shows volum e changes fo r a single unit.
Mathematical presentation
The marginal method

The price-sales fu n c tio n : P = aX + b
w here (X) is th e expected sales in units at a given price (P). A linear re la tio n
betw een price and sales is assumed.
Step 1. The price-sales function is fo u n d (Figure 8.5)

The data is derived fro m Figure 8.3, w hich shows a lte rn a tive in fo rm a tio n
a b o u t price and expected sales in ta b le form .
The slope indicates th e expected change in sales volum e fo r each DKK 1

change in th e price. In o th e r w ords, a price rise o f DKK 1 leads to a fa ll in
sales o f 100 units.
A t a given price of, e.g. DKK 10 and sales o f 200 units, th e line intersects at
th e second axis:
The m athem atical fo rm u la fo r th e price-sales curve is th e re fo re :
Step 2. O ptim u m sales volum e is fo u n d by ap p lyin g the d ecision-m aking

rule M R = M C
MR has a double curve w hen P(X). In o th e r words:
MC = AVC (average variable cost) = 4
Thus:
MR = MC
w here X = th e sales volum e th a t generates th e highest p ro fit.
Step 3. The o p tim u m price is fo u n d
The o p tim u m price is fo u n d by in se rtin g X = 400 in th e fo rm u la fo r P. In
o th e r words:
W here P = 8 th is shows th e price to set to generate sales o f 400 units.
Step 4. Calculation o f co n tribu tion m arg in a n d p ro fit fo r th e p ro d u ct

Revenue 400 x DKK 8 = DKK 3,200
- Variable costs 400 x DKK 4 = DKK 1,600
= C o n trib u tio n m argin = DKK 1,600
- Fixed costs = DKK 500
= P ro fit = DKK 1,100
An important observation to make about the marginal method is that

purely historical factors do not impact on the optimum price. Only costs
that vary with production are included. Fixed costs, which by definition
do not vary with production volume, do not influence the optimum price.
8 .3 .2 M o n o p o listic co m p e titio n
As m en tio n e d in Chapter 7, th e d e fin in g characteristic o f m o n o p o listic com

p e titio n is m u ltip le suppliers w h o d iffe re n tia te th e ir products fro m those
o f th e co m p e titio n .
This form of competition is probably the most common in practice. All of

the companies involved want consumers to think of them as special and
prefer their product(s).
The individual company faces a falling sales curve, and the situation is
similar to that of a monopoly. However, note that the sales curve is “flat
ter” (more elastic) because consumers have the option of substituting the
product with a competitors’ product.
The optimisation process is the same as for a company with a monopoly.
8 .3 .3 Perfect co m p e titio n (p ric e -ta k e r)

One of the characteristics of perfect competition is that prices are exter
nally determined. Individual companies cannot influence the price on
their own.
Under perfect competition, the sales curve is horizontal. A company tries to
sell everything it can at a given, externally determined price. The question
is how to determine the volume at which it is most advantageous to produce
and sell. Companies in this situation are referred to as price-takers.
Figure 8.6 O ptim isation under pe rfect com petition w ith free and scarce capacity.
In Figure 8.6 A, sales/production is increased to the point at which mar

ginal costs intersect with marginal revenue. Until the lines intersect, the
price and marginal revenue are higher than the marginal costs, and there
fore it will be profitable to increase production. However, production after
that point will lead to a loss. Although there is spare capacity, it would not
pay to exploit it fully.
The situation is different in Figure 8.6 B. The price and marginal rev
enue continually remain above the marginal costs, so the company is able
to produce and sell all that it can, right up to its capacity limit.
THE TOTAL M E T H O D /TH E M A R G IN A L M E TH O D

When the price is fixed (constant), the sales curve is horizontal and the
total revenue curve is a rising straight line.
If it is also assumed that the total costs follow a typical pattern, corre
sponding to the one in Figure 7.7, then optimisation using the total m eth
od will resemble figures 8 .7-8.9.
The aim is to identify the volume that generates the biggest profit at the
given price. The table (Figure 8.7) and the graph (Figure 8.8) both show
where the profit reaches its maximum point. The profit is greatest at the
peak distance between the revenue curve and the cost curve.
The optimum volume is 8 and the profit associated with it is 195.
Price Volume Rev Fixed Vari Total Profit Aver Aver Marginal Marginal Marginal
enue costs able costs age age revenue cost contri
costs total vari bution
cost able margin
cost
70 0 0 200 0 200
70 35 35
70 1 70 200 35 235 -165 235 35
70 25 45
70 2 140 200 60 260 -120 130 30
70 16 54
70 3 210 200 76 276 -66 92 25
70 9 61
70 4 280 200 85 285 -5 71 21
70 5 350 200 94 294 56 59 19 70 9 61
70 6 420 200 108 308 112 51 18 70 14 56
70 7 490 200 130 330 160 47 19 70 22 48
70 8 560 200 165 365 195 46 21 70 35 35

70 85 -15
70 9 630 200 250 450 180 50 28
70 150 -80
70 10 700 200 400 600 60 40
Figure 8.7 Perfect competition. Price-taker. The total method and the marginal method.
Figure 8.8 Perfect competition. Price-taker. The total method.
Figure 8.9 approaches the same example using the marginal method.
As the price is constant, it is also equal to the marginal turnover, both
of which appear as a single horizontal line. Also shown are the marginal
cost curve, the average variable costs (AVC) and the average total costs
(AC).
Note how marginal costs intersect with AVC and AC at their respective
minimums.
Figure 8.9 Perfect competition. Price-taker. The marginal method.
The decision-making rule is that the optimum price is the point at which
MR is equal to MC. This is because the company must continue to expand
production for as long as marginal revenue exceeds marginal costs.
However, the above rule must also be supplemented with the requirement
that the price covers the average variable costs (AVC) in the short term
and generates a positive contribution margin. In the long term, the aver
age total costs (AC) must also be covered.
The curve shows that production needs to be increased to approx. eight
units.
In certain cases, there may be multiple intersections between marginal
costs and marginal revenue. In such cases, the company must conduct a
total valuation, which usually entails a choice between producing a certain
volume or not producing anything at all.
8.3.4 Supply curve – lower price limit

In the previous section, the market price for the company’s product was
DKK 70 per unit and the optimum sales level was eight units.
This raises questions about controllable variables when companies face

exogenous price fluctuations, i.e. not of their own making.
• How far can the company lower its price, i.e. what is its lower price
limit?
• What does the company’s supply curve look like as a function of price?
LOWER PRICE LIM IT
Time is an important factor when setting the lower price limit for a prod
uct.
All of the variable costs related to production and sales have to be cov
ered in the short term. This results in a positive contribution margin and
helps cover the fixed costs. In the example, the lower price limit for the
product is therefore equal to the minimum for the average variable costs
(AVC), i.e. DKK 18.
In the long term, all of the costs have to be covered and the company
has to make a profit. In the example, the lower price limit is therefore
equal to the minimum for the average total costs (AC), i.e. DKK 46.
Figure 8.10 Lower price lim it fo r an item and th e supply curve.
SUPPLY CURVE FOR THE PRODUCT

The observations above are, therefore, important for a company’s supply
curve. In the short term, the supply curve is made up of the marginal rev
enue curve, based on the minimum AVC. In the long term, it is made up of
the marginal revenue curve, based on the minimum AC.
In Figure 8.10, the blue segment of the MR curve is therefore equal to
the supply curve.
8.4 Market-based and cost-based pricing
8.4.1 The m o n o p o ly fo rm u la
As previously mentioned, marginal revenue is equal to marginal costs at
optimum price. This can be expressed in the monopoly price formula:
W here ep is th e num erical price elasticity.
The formula shows that two factors determine the optimum price, i.e.
price elasticity (ep) and marginal costs. In other words, both the market
side and the cost side are involved in setting the optimum price.
The formula also shows that the lower the price sensitivity, the higher
the optimum price. If the elasticity is close to 1, the optimum price will be
very high. If the elasticity is high, the optimum price will be close to the
marginal costs.
The formula applies in a monopoly market, when a company effective
ly has a monopoly on its own “differentiated” product (i.e. monopolistic
competition), and the company is a price-setter.
The formula can be used to check whether the company has identified
the theoretically optimum sales price.
However, the market-based method assumes in-depth knowledge of
both the m arket’s price sensitivity and the company’s costs, and informa
tion about these factors is not always easily accessible. This is particu
larly true of new products or in markets that fluctuate greatly and are
under pressure. Under these circumstances, access to historical material
and meaningful data is limited, which means that knowledge is based on
market research and hunches.
In situations like this, companies attempt to calculate the sales price on
the basis of the costs associated with the product.
8 .4 .2 C ost-based pricing
The previous section focused on how, in theory, companies can find the
optimum price for their products. However, as mentioned in Section 8.2,
this overview was based on certain simplified assumptions, e.g. that the
company has full knowledge of its future sales figures and costs. It is es
sential to consider whether this is realistic in practice.
With regard to costs, companies usually know how much it costs to pro
duce existing products and services, but calculating the costs of producing
new ones is usually subject to a great deal of uncertainty.
Similarly, when studying sales, there will often be significant uncertainty
about volumes at alternative prices. Here too, uncertainty is greatest with
new products.
This section will now look at some of the methods used in practice to
arrive at sales prices. The methods are shown in Figure 8.11.
Figure 8.11 M ethods o f calculation.
COST PLUS PRICING

Cost plus pricing is designed to calculate a product’s average variable costs,
and thereby the sales price. It can be written like this:
In the following example, a trading company uses cost plus pricing to cal
culate its prices.
Example
Cost price 100
+ T ransport costs 10
= A cquisition cost 110
+ O th e r variable costs (commission, etc.) _24
= Average variable costs 134
+ C o n trib u tio n m argin 50
= Sales price 1M
Note that only variable costs are included.
An example from a production company would look like this:
Example
Raw m aterials 360
+ O perator's la b o ur costs 160
+ O th e r variable p ro d u c tio n costs 20
= Variable p ro d u c tio n costs per u n it 540
+ Variable sales costs (commission) _60
= Total variable costs 600
+ C o n trib u tio n m argin 150
= Sales price 750
As these examples show, cost plus pricing calculates sale prices based on
the average variable costs, i.e. how much it costs the company to produce
and sell one single unit of the product or service.
The size of the contribution margin the company adds to the variable
costs in order to reach the sales price depends on its assessment of the
product’s price sensitivity (elasticity). If the product is price-sensitive, the
company must calculate with a smaller contribution margin per unit. The
opposite would be the case for products that are not price-sensitive.
Fixed costs are not included in cost plus pricing because they are not af
fected by the volume of production and sales. The sales price that results
in the biggest total contribution margin will therefore also generate the
biggest total profit.
FULL COST PLUS PRICING

The thinking behind full cost plus pricing is that the price of products
should cover all of the product’s variable and fixed costs and generate a
certain amount of profit. This makes the price customers are charged fair
in the sense that the price reflects the production costs.
The company arrives at the product’s sales price on the basis of the total
production costs for the product (i.e. the cost of sales) plus a mark-up.
The cost of sales usually includes both variable costs and a supplement
to cover indirect variable costs and fixed costs. Finally, a mark-up is add
ed, which ideally reflects what the market will accept, i.e. it is based on the
current state of the market.
The principle behind full cost plus pricing is also referred to as the full-
cost principle because the principle is that all of the costs are assigned to
the products. In practice, this principle can be applied in a multitude of
ways. Figure 8.12 shows an example from an engineering plant.
However, full-cost calculations are not suitable for planning purposes. The
reason for this is that fixed costs are entered as an average cost per unit,
which is only valid at the level of production on which the calculation is
based. If the same cost per unit is applied at a different level of production,
the fixed costs are essentially being treated as if they were proportional to
the scale of the production – which, of course, is not the case.
Analyses of profitability should be based on the contribution margin. In

other words, when a company draws up a full-cost calculation, it should be
possible to differentiate between fixed and variable costs. This is shown in
the full cost plus pricing table in Figure 8.12 below.
The table shows that the short-term lower price limit is DKK 250 per
unit, as this amount corresponds to the sum of the variable costs for the
product. For example, a company that focuses on contribution margins
will, say, accept an offer of DKK 300 per unit because the contribution
margin is positive. A company inclined towards the full-cost approach will
reject the offer on the grounds that it does not cover all of the costs.
The question, then, is which method is best in the long term. It is not
possible to provide a general answer. In some circumstances, the responsi
ble course of action might be to accept an offer that is below the advertised
list price.
As previously mentioned, the optimum sales price cannot be deter
mined solely on the basis of cost calculations, as it is influenced by the
interaction between costs and sales. For example, it may be necessary to
consider any knock-on effects on the company’s other products.
The problem with the full-cost method is deciding on the levels for the
mark-ups. These have to be based on expectations about capacity utilisa
tion, which is price-dependent because the price determines the sales vol
ume. This makes the problem a bit of a self-perpetuating circle and means
that the method is not objective.
The example below shows a full-cost calculation that incorporates the
consequences of changes to sales volume.
Calculation: An engineering p la n t produces m easuring instrum ents o f th e typ e XX-A.
DKK per
Types o f cost Variable Fixed Total
u n it
Cost o f materials
Variable costs o f m aterials (according to the
200.00 200.00 200.00
list o f parts)
M ark-up fo r indirect materials costs derived

3% 6.00 6.00 6.00
from variable costs o f materials
Total cost o f m aterials 206.00 200.00 6.00 206.00
Pre-processing costs
Variable labour costs (as listed) 50.00 50.00 50.00
Indirect pre-processing costs derived from
variable labour costs
2% 1.00 1.00 1.00
M ark-up fo r fixed machine costs

20.00 20.00 20.00
(depreciation)
Total pre-processing costs 71.00 50.00 21.00 71.00
Total production costs 277.00 250.00 27.00 277.00
Adm in and o th e r capacity costs derived

10% 27.70 27.70 27.70
from production costs
Total costs (cost o f sales) 304.70 250.00 54.70 304.70
M ark-up/risk prem ium on cost o f sales 10 % 30.47 0.00 0.00 30.47

Sales price 335.17 250.00 54.70 335.17
Figure 8.12 Full-cost calculation.
Example
Figure 8.13 shows a m odel fo r a fu ll-c o s t calculation in th e haulage in d u stry
Figure 8.13 Full-cost calculation model in th e haulage industry.
The m odel separates vehicle costs in to th re e groups: variable costs, d ire ct

fixe d costs per vehicle and in d ire c t fixe d costs, w hich covers a d m in is tra tio n
costs, etc. The costs are calculated per kilo m e tre .
The variable costs are calculated per kilo m e tre d ire ctly on th e basis o f
th e resources used, w h ile th e fixe d costs are converted in to a u n it price
using th e num ber o f kilom etres as th e a llo ca tio n key. The exam ple presu
mes to ta l fixe d costs per vehicle o f DKK 308,800 p.a. The com pany budgets
fo r a to ta l o f 160,000 km p.a. The d ire ct vehicle costs per kilo m e tre are
th e re fo re 308,800/160,000 = DKK 1.93 per km. The in d ire c t fixe d costs per
k ilo m e tre are calculated in th e same way.
The m odel gives th e c o n tra c to r an in sig h t in to th e real costs o f haulage
and th e o p p o rtu n ity to ensure th a t th e prices cover all o f th e costs.
In the example, the average cost (price) per kilometre driven by the com
pany’s vehicles works out at DKK 8.42, at the annual budgeted total of
160,000 kilometres. If the haulage contractor uses this amount when cal
culating prices for jobs, fixed costs will be overestimated or underestimat
ed later on if the vehicles cover more or less than the budgeted 160,000
km. If they exceed the total, the contractor will have overestimated, be
cause the extra kilometres will cover more of the fixed costs, even though
the fixed costs do not rise with the increased number of kilometres. If the
vehicles cover fewer kilometres, the contractor will have underestimated.
This is illustrated in Figure 8.14.
K ilo m e tre s 160,000 200,000 120,000
DKK per D riven D riven D riven

km = budget > budget < budget
V a riab le costs 5.26 841,600 1,052,000 631,200
Fixed d ire c t ve h icle costs 1.93 308,800 386,000 231,600
In d ire c t fix e d costs 0.83 132,800 166,000 99,600
M a rk -u p 0.40 64,000 80,000 48,000
Total (= sales price) 8.42 1,347,200 1,684,000 1,010,400
P ro fit 64,000 190,400 -62,400
O v e r/u n d e re s tim a tio n 0 110,400 -110,400
Figure 8.14 Example o f o ver/underestim ating using th e full-cost m ethod.
Under the full-cost method, simplified average calculations made at a par

ticular level of activity can lead to misleading conclusions if they are ap
plied uncritically at a different level of activity.
8 .4 .3 C o m p e tito r-b a s e d prices and re tro g ra d e calculation

A company often finds itself in a situation where it knows its competitors’
prices – and therefore the price level at which it has to operate. If it tries
to charge a higher price than its competitor(s), it will lose custom. This is
known as competitor-based or market-based pricing.
In this scenario, the question is to what extent the company will be able
to cover its costs at the given price and make an acceptable profit. This is
answered with a retrograde calculation, i.e. working backwards from the
expected sales price. This is different from cost plus pricing and full cost
plus pricing, in which the calculation progresses from costs and mark-ups
until it arrives at the sales price.
Example
A company is considering outsourcing p ro d u c tio n o f surfboards to Taiwan.
The boards w ill be sold in D enm ark, w h e re th e m arket price is around DKK
1,000 per board.
The tra n s p o rt cost w o u ld be DKK 100 per board, plus expected customs
and excise duties o f DKK 50 per board. The company, w hich uses th e c o n tri
b u tio n m odel, w o u ld like a c o n trib u tio n m argin o f 40%.
D K K /unit
Sales price 1,000

- C o n trib u tio n m a rg in 40% 400
= C overage o f v a ria b le costs p e r u n it 600

- T ransp ort 100
- Customs a n d excise d u ty 50
= M a x im u m cost price 450
D uring n e g o tia tio n s w ith th e Taiwanese m anufacturer, th e com pany m ust

d e te rm in e th e m axim um cost price it is w illin g to pay. It can arrive a t this
fig u re by using th e re trog ra d e calculation above.
C annot a ffo rd th e buying price to be h ig h er th a n DKK 450 per board.
On th e o th e r hand, any price b e lo w DKK 450 w o u ld increase th e c o n tri
b u tio n m argin.
The full-cost method and the market-based method can lead to widely
varying prices and reactions. In periods during which capacity is not fully
utilised, the mark-ups in the full-cost method will push the price up if the
method is applied uncritically. In that situation, the fixed costs would be
spread across fewer products.
As the name suggests, the market-based method is based on the current
state of the market. When business is bad, prices will usually be reduced
in order to stimulate activity – the opposite of what would be required
under the full-cost method. Uncritical application of the full-cost method,
i.e. in a manner that ignores market forces, can lead to companies pricing
themselves out of the market.
8 .4 .4 O p en calculations
In many production companies, materials and components make up more
than half of total costs. As more and more of them focus on their own core
competencies, subcontractors supply more and more of the materials and
components essential to these companies. This makes agreements with
subcontractors an important factor in running a business which, from a
supply-chain perspective, makes it possible to work with open calcula
tions.
Many companies enter into binding agreements in the form of part
nerships and alliances, e.g. on the outsourcing of part shipments. These
relationships may necessitate full transparency between the parties with
regard to formulas and calculations for sales prices, costs and earnings.
This gives them deep insight into each other’s internal workings and re
quires a high degree of mutual trust.
Open calculations im ply fu ll openness betw een th e parties to th e agre

em ent a b o u t th e real costs o f buying and producing com ponents and
products in th e supply chain. This includes openness a b o u t c o n trib u tio n
margins and cost savings.
8 .4 .5 A ctiv ity -b a s e d costing

In recent years, significant changes have been made to companies’ cost
structures. Indirect fixed costs are increasingly common, as opposed to
direct variables related to production. For example, increased automation
has replaced many direct wage costs with indirect costs related to the pur
chase and maintenance of machinery.
It is difficult to control all of the indirect fixed production costs, e.g.
depreciation on machinery, labour costs, replacement costs, rent, main
tenance, etc. Establishing a direct link between these costs and the com
pany’s sales and production activities can present a challenge. As well as
the change to the cost structure, as mentioned above, price competition
has also increased. Together, these two trends place heavier demands on
internal calculations.
To be competitive, companies have a continuous need for accurate in
formation about production costs and how they are developing. Without a
reliable system for calculating prices and costs, it is not possible to run a
company efficiently. Activity-based costing (ABC), originally developed by
Professor R.S. Kaplan of Harvard University, meets these requirements.
ABC is an alternative to the contribution-margin and full-cost methods
of distributing costs. ABC is also significantly more detailed.
The purpose of the ABC method is to engender transparency about the
relationship between the resources used on the activities and the costs
associated with them. This information can be used to shed light on the
costs of a company’s products or to illustrate the costs triggered by a cus
tomer submitting an order for a product or service.
An ABC system provides management with better information on
which to make decisions about factors such as:
• product pricing
• making special offers to customers
• cost control
• computing budget projections and comparing them with actual costs
• evaluating the profitability of products and customers.
Management can also use the system for more strategic purposes, includ
ing choice of target market, product mix, distribution channels, outsourc
ing etc.
A PRACTICAL EXAMPLE
The following is a practical example of an ABC analysis at customer level.
Example
This exam ple focuses on customers A and B. It is presum ed th a t b o th o f
th e m are o n ly interested in a single p ro d u c t and in th e same a m o u n t o f it.
A t firs t glance, th e y may b oth look like equally goo d customers, and th a t
no fu r th e r analysis is necessary, b u t this is n o t always th e case.
The idea is to assign earnings and costs to in d ivid u a l customers.
Norm ally, this is fa irly easy w ith regard to earnings because invoices
show w hich products w ere sold to w hich custom ers and a t w h a t price.
However, it is considerably m ore d iffic u lt to assign costs to customers
- especially capacity costs, as these o fte n cover m u ltip le activities and are
th e re fo re d iffic u lt to allocate. For example, ho w does th e com pany a tt r i
b ute a share o f p ro m o tio n a l costs to in d ivid u a l customers?
The exam ple in Figure 8.15 b e lo w shows ho w th e ABC te ch n iq u e can
supplem ent standard c o n trib u tio n -m a rg in analysis by calculating th e
custom ers' shares o f th e various delivery services provided, w hich are n o t
usually broken dow n in th is way.
The to ta l c o n trib u tio n m argin in th e exam ple is DKK 1,657,200. Both
customers buy and c o n trib u te ju s t as much and, as such, appear to be
equally p ro fita b le fro m th e company's p o in t o f view.
Figure 8.15 Customer p ro fita b ility analysis.
Once th e to ta l costs assigned to custom ers fo r order-processing, storage,

tra n s p o rt and fin a n cing have been deducted, th e o rig in a l DKK 1,657,200
c o n trib u tio n m argin has been reduced by DKK 426,800 to DKK 1,230,400.
The question is whether the two customers draw on the DKK 4 2 6 ,8 0 0 to

the same extent.
The customers benefit from different services in connection with their
purchases. These services utilise the company’s resources and therefore
cost money. The example shows that, in one year, the company makes 12
deliveries to customer A. The driving distance to customer A is 100 km
and a m onth’s credit is extended. Customer B is based 200 km away, re
quires weekly deliveries and receives two months’ credit. In other words,
the two customers have different delivery and credit profiles. Using the
ABC system, it is possible for the company to quantify these differences.
First of all, the company identifies which activities the customer draws
on, e.g. order-processing.
Next, it identifies the cost drivers. For example, is the assignment of costs
determined by the number of orders or the size and/or tim ing of them? In
this example, it is the number of orders.
An estimate is then made of the average order-processing cost, calculat
ed as DKK 950 per order. This figure is arrived at by taking the company’s
total annual order-processing costs and dividing them by the expected
number of customer orders for the year.
As customer A receives monthly deliveries, the annual cost of customer
A is 12 x DKK 950 = DKK 11,400.
Once all of the indirect customer costs have been assigned to the two
customers, based on how much they draw on the company’s resources, it
is clear that the customer A is significantly more profitable from the com
pany’s perspective than customer B.
The example illustrates how differences in terms of orders, storage, trans

port and credit can impact on the actual profitability of particular rela
tionships with customers.
In terms of contribution margin I, customers A and B are equally profit
able. However, the situation is very different with regard to contribution
margin II.
This analysis provides management with a basis on which to evaluate
the attractiveness of individual customers. Using ABC to control costs
therefore creates greater cost transparency and generates knowledge
about how costs arise and can be influenced.
8.5 The product life-cycle curve and the price parameter

The product life-cycle curve (PLC) illustrates the different phases a prod
uct goes through (see 2.2.3, including Figure 2.3), including changes in
the state of the market – e.g. the number of customers, their characteris
tics, competing products, number and strength of competitors, etc. These
factors require observation of the specific circumstances related to sales
initiatives, including, naturally, pricing and advertising.
8.6 The influence of marketing on price optimisation

Marketing and advertising are crucial to the success or otherwise of a new
product, and for attracting and retaining certain groups of consumers.
From the company’s point of view, the purpose of marketing is to increase
sales of its products, especially when it launches new ones or variants of
existing ones.
Whenever a company wants to market and advertise its products, it
faces two obvious main questions:
♦ What resources should be earmarked for marketing and advertising?
• What media (trade fairs, websites, brochures, newspaper/magazine
ads, etc.) should be used?
To answer these questions, a company must analyse the impact of its mar
keting. A typical analysis is shown in Figure 8.16.5
Figure 8.16 The relationship betw een m arketing spend and sales volume.
The example shows that the company expects to sell a certain volume of
the item, whether or not it advertises. It also shows that there is an upper
limit on demand, irrespective of the scale of the advertising campaign.
The relationship between advertising and sales volumes is positive,
with progressive and degressive rates of increase on opposing sides of the
curve. The advertising elasticity can be used to measure the strength of
this relationship.
5 In this context, the w ord "advertising" is used to cover every form o f marketing.
A d ve rtisin g elasticity is d e fin e d as th e relative increase in sales com pared to
th e relative increase in th e advertising budget.
Measuring the effect of advertising is problematic, partly because the

causal relationship is not direct and the assumption is that all other fac
tors remain constant; and partly because the impact is often only felt over
a prolonged period.
Example
The company is considering a m arketing spend o f DKK 2,000.
The graphs below show one possible outcom e o f this in term s o f sales,
based on a price o f DKK 15 and sales o f 250 units. M a rke tin g can a ffe c t th e
position and shape o f th e sales curve in several d iffe re n t ways (see figures
8.17 and 8.18).
Figure 8.17 Examples o f sales based on d iffe re n t m arketing outcomes.6
Figure 8.18 shows that the best return on marketing spend is achieved
if the company changes the sales in the direction shown in situation III.
Situation I would be a retrograde step, but II and III are improvements.
6 Note th a t in situation 1, MR a fte r m arketing is added to the original m arketing fun ction.
The effect of the marketing spend is calculated on the basis of the market
ing contribution.
O ptim isation Starting point Situation I Situation II Situation III
Price/sales fu n c tio n
MR
MC = AVC MC = 10 MC = 10 MC = 10 MC = 10
E q u ilib riu m
O p tim u m X X = 250 X = 500 X = 500 X = 500
O p tim u m P P = 15 P = 15 P = 20 P = 22.5
Profit calculation:
R evenue (P • X) 3,750 7,500 10,000 11,250
V a ria b le costs 2,500 5,000 5,000 5,000
C o n trib u tio n m a rg in 1,250 2,500 5,000 6,250
M a rk e tin g costs 0 2,000 2,000 2,000
M arketin g
1,250 500 3,000 4,250
contribution
Figure 8.18 Example o f price op tim isation based on three d iffe re n t outcomes o f a m arketing
campaign.
8.7 Price differentiation

8.7.1 B ackground to price d iffe re n tia tio n
Price d iffe re n tia tio n is w hen th e same p ro d u c t is sold a t d iffe re n t prices ex

fa c to ry to d iffe re n t groups o f buyers.
Price differentiation is based on demand in different market segments.

In practice, it can be difficult to determine whether or not price vari
ations actually reflect differentiation or not. If the difference is due to
different costs for delivering to different groups of buyers, then it is not.
For example, a volume discount does not count if it reflects the saving a
company makes by delivering a larger amount in one go instead of multi
ple small deliveries.
Companies differentiate their prices in order to maximise profit. This
can be achieved by letting groups of buyers with low price elasticity (usu
ally those who do not look too closely at the price) pay a high price, while
groups with high price elasticity (usually those who are more price-con
scious) pay a lower price.
Figure 8.19 shows that, at a price of DKK 3 per unit for everybody, the
numerical price elasticity is 1.5 for group A and 0.5 for group B.
The company ought to increase the price for group B until the numeri
cal elasticity is greater than 1.0. It can safely do this because at the same
time as the price rises and sales fall, revenue increases and variable costs
decrease, which means that the contribution margin will rise.
By differentiating the prices for different groups of buyers, the com
pany will make more profit than if it charges all of the different groups the
same price. The disadvantage of charging everybody the same price is that
buyers who do not pay much attention to the price may obtain the prod
uct for less than they would have been willing to pay. Conversely, price
conscious customers may find the one price that everybody is charged too
high, and not buy the product.
Figure 8.19 Two groups o f buyers w ith d iffe re n t levels o f price sensitivity.
8.7.2 Preconditions fo r d iffe re n tia l pricing
Differential pricing is only possible if the following conditions apply:
C ondition 1
The seller is able to divide customers in to groups w ith d iffe re n t degrees o f
price elasticity.
If all customers have the same degree of price elasticity, there is no point
in differentiating prices. Under those circumstances, the best return is
achieved by charging everybody the same price.
C ondition 2
The seller is able to keep th e groups separated.
A company may sell the same product at different prices in an affluent

area and a low-income area. The price will be higher in the well-off area
because the company thinks that customers there pay less attention to
price. However, if the difference is too great, the company runs the risk of
some people opting to buy the product wherever it is cheapest.
C ondition 3
The com pany m ust n o t be in a position w here co m p e titio n makes it im pos
sible to d iffe re n tia te prices.
Differential pricing involves the company making more money per unit
sold in markets where the price is high than in those where it is low,
because the costs are the same regardless of the market. However, this
course of action may attract the attention of its competitors. Companies
must expect that their competitors’ attention will concentrate on markets
with low price elasticity (the high-income group), which may make effec
tive differential pricing impossible.
C o n d itio n 4
The d iffe re n tia l pricing m ust n o t appear unfair.
It may have a negative effect on the company if customers learn about the
differentiation and consider it unfair or indicative of poor business ethics.
C ondition 5
It m ust be possible to o b ta in o ffic ia l approval fo r th e d iffe re n tia tio n .
The Danish Competition and Consumer Authority will intervene if it

thinks that differential pricing is having a damaging effect on competi
tion.
8.7.3 Exam ples o f price d iffe re n tia tio n

When discussing differential pricing, it is important to underline that it
refers to the company selling exactly the same product ex factory at differ
ent prices. As mentioned previously, price differences based on differences
in costs are not a form of differential pricing.
Example
If a b o ttle o f Tuborg beer costs DKK 0.25 m ore on th e island o f A n h o lt than
in C openhagen because o f differences in tra n s p o rt costs, this is n o t price
d iffe re n tia tio n because th e price e x-fa cto ry is th e same. However, if th e
prices w ere th e same on A n h o lt and in Copenhagen, th is w o u ld be a fo rm
o f d iffe re n tia tio n based on tra n s p o rt costs.
Example
W hen Ikea Denm ark sets its prices, it does n o t look a t Ikea stores in n e ig h
b o u rin g countries. It looks a t co m p e tito rs and custom ers in D enm ark. As a
result, th e re can be a big d iffe re n ce in price b etw een, e.g. an item b o u g h t
in an Ikea store in Denm ark and th e same p ro d u c t b o u g h t in an Ikea
store in Germany. The m arket determ ines th e price. This is, th e re fo re , an
exam ple o f price d iffe re n tia tio n .
Example
Denm ark has seen cases o f parallel im p o rts o f medicines, w h e re products
e xp o rte d fro m Denm ark are re im p o rte d because th e sales price abroad is
lower. In cases like this, th e tra n s p o rt costs lim it th e size o f th e d iffe re n tia
tio n b e tw een markets.
As previously mentioned, one of the preconditions for differential pricing

is the ability to divide consumers into groups with different levels of price
elasticity and to keep them separated.
This division into groups can be based on various criteria, e.g.:
1. geography
2. characteristics
3. product use
4. time
5. sales channel.
1. Price differentiation based on geography

The preconditions for differentiation are that the level of price elasticity
varies between the areas (countries, regions, neighbourhoods) in which
the company wants to sell its product and that the groups of customers
can be kept separate. Needs, income and competition often vary from
country to country, which means companies often face different price
and sales conditions in different markets, including with regard to price
elasticity. Price differentiation is therefore common among export com
panies, which charge either higher or lower prices in their export markets
than they do in their home market. Export prices will, of course, also vary
from country to country.
The example below illustrates price differentiation between domestic
and export markets.
Example
To date, th e com pany has o n ly sold to its dom estic m arket. Its o p tim a l
situ a tio n is: sales volum e o f 4,000 units, price o f DKK 6 per u n it and a con
trib u tio n m argin o f DKK 18,000.
Due to having spare capacity, th e com pany is interested in e x p o rtin g . It
is o ffe re d an o p p o rtu n ity to e x p o rt all it can produce at a price o f DKK 4
per un it. In o th e r w ords, th e sales fu n c tio n in th e e xp o rt m arket is h o riz o
ntal.
The question is w h e th e r or n o t th e com pany should accept th e offe r,
even a lth o u g h it is fa r b e lo w th e price in its dom estic m arket. If so, how
many units should it export? A nd w h a t a b o u t th e price and sales in th e
dom estic market?
The answer is th a t th e com pany can a ffo rd to sell th e p ro d u c t abroad
as long as th e m arginal revenue is g re a te r than th e m arginal costs. This is
illu stra te d in Figure 8.20.
Figure 8.20 D iffe re n tia l pricing betw een domestic and exp ort markets.
As th e e x p o rt price remains constant, th e m arginal revenue in th e e x p o rt

m arket is equal to th e e x p o rt price. As th e com pany w ill always choose th e
highest possible m arginal revenue, th e com bined m arginal revenue cor
responds to th e d o tte d line/curve in th e fig u re . Note th a t, a t a price o f DKK
4, th is curve is identical w ith MREX.
The o p tim u m overall volum e is fo u n d at th e p o in t at w hich th e m arginal
revenue is equal to th e m arginal costs. In this case, th e o p tim a l overall sales
volum e is 12,000 units.
Sales no w have to be divided b e tw een th e dom estic m arket and th e
e x p o rt m arket in such a way th a t th e m arginal revenue fo r th e last u n it
sold in th e tw o markets is th e same. The jo in t (d o tte d ) MR = MC = 4 is the
o p tim u m s itu a tio n . The volum e in th e tw o markets is th e re fo re de te rm in ed
on th e basis o f th e ir m arginal revenue being 4. In th e fig u re above, th e
sales volum e in th e dom estic m arket is 3,000 units. The rem ainder, up to
th e o p tim u m volum e o f 12,000 units, w ill be sold in th e e x p o rt m arket. In
o th e r w ords, th e sales volum e in th e e x p o rt m arket w ill be 12,000 – 3,000 =
9,000 units.
W hen th e volum e in th e dom estic m arket falls, th e price also changes. The
o p tim u m price at a sales volum e o f 3,000 units is DKK 7, w hich brings th e
to ta l c o n trib u tio n m argin up to DKK 27,000.
The mathematical approach:
Step 1. Calculate the price and sales volumes that will generate the opti
mum profit level, as well as the total contribution margin from selling only
in the home market:
Calculate the contribution margin

Revenue for 4,000 units @ DKK 6 = 24,000
- Variable costs:
The variable costs are found in the area underneath the marginal cost
curve
Step 2. Due to the export opportunity at DKK 4 per unit, the optimum
solution is to increase total production. This is calculated as follows:
First, decide the total production volume:
MR export, = MC
7 VC is differentiated to find MC.
Then decide how to divide this production volume between the two markets:
Remainder for export = 12,000 – 3,000 = 9,000 units
Calculating the contribution margin

Revenue on domestic market 3,000 units @ DKK 7 = 21,000
Export revenue 9,000 units @ DKK 4 = 36.000
Total revenue = 57.000
- Variable costs:
= 30.000
Total contribution margin = 27.000
Compared to the starting point, the contribution margin has risen by DKK
9,000.
Note that the export opportunity affects the domestic market. When the
same production apparatus is used – and the costs are shared – one market
cannot be considered independent of the other. The two must be consid
ered in tandem. When, as in this example, the marginal costs are rising,
the company can calculate its total optimum volume by optimising its
price on the basis of the total marginal revenue. If the price is optimised
separately for the two markets, the low marginal costs are utilised twice.
2. Price differentiation based on characteristics

Age is a characteristic commonly used as a basis for differential pricing.
For example, children and pensioners often pay a lower price at museums.
This is an easy criterion to administer and the two groups are separated
quite naturally. Student discounts are another example.
In other circumstances, however, price differentiation on the basis of
characteristics can be difficult to administer and may require special con
trol checks.
3. Price differentiation based on product use

One example of this is alcohol for industrial use (surgical spirit, window
cleaner) and for drinking. Producers are able to artificially separate the
markets by using additives in surgical spirit, etc. However, in this case it
is the state, and not the company, which benefits from the differentiation
via tax and duties.
Other examples include duties on water, electricity and natural gas,
which vary depending on whether they are used in private homes or for
commercial purposes.
4. Price differentiation based on time

One example of this is the telephone companies’ policy of charging differ
ent prices during the day and in the evening. Electricity companies and
airlines apply similar policies. Differential pricing due to time considera
tions often reflects a desire to even out capacity utilisation.
5. Price differentiation based on sales channel

When the same product is sold both online and in high-street shops, but at
different prices, this is called differentiation by sales channel.
8.7.4 Prem ium pricing

Premium pricing refers to slightly different products that are sold at a
larger mark-up than is justified by their quality and cost.
For example, some products are sold in a standard version and a luxury
version. Apart from some extra features, the two products are exactly the
same. If the person who buys the luxury version is willing to pay more
than it actually cost, this could be defined as price differentiation – al
though it is more like ordinary product adjustment.
8.7.5 Discounts
In practice, it is often difficult to decide whether a price difference is due
to differentiation based on customer demand, or whether it is based on
different costs associated with sales to different groups. Where the latter
is the case, it is not a case of price differentiation.
As mentioned previously, volume discounts – which are based on cost
savings for the seller due to the large size of the purchase orders, and
which lead to a lower net price for buyers – do not constitute price differ
entiation. It is only a case of differentiation when the discount is greater
than the cost savings. If the volume discount is particularly large because
the company is very keen to retain a specific customer, then the discount
does include an element of price differentiation.
Annual discounts are a different matter, as they are usually determined
by the volume of trade between the two parties. Whether the customer
places a few large orders or many small ones is of no consequence. In this
case, it is the sales considerations that are decisive, i.e. wanting to keep
the customer. A similar discount is based on loyalty, i.e. the customer is
given a discount simply for buying from the seller. These discounts do,
therefore, constitute price differentiation.
Discounts for members of certain groups, e.g. wholesale societies, are a
very clear form of differentiation.
9 Budgets and budget
control

• account for the im portance of budgeting as a m anagem ent tool
• understand the relationship betw een planning and budgeting
• understand how to budget in practice
• draw up profit and loss budgets
• draw up a liquidity budget using the statem ent of changes in
financial position model and the cash flow budget model
• draw up a balance sheet budget
• conduct budget simulations
• follow-up on income statem ent budgets
• apply the Balanced Scorecard model
• account for risk m anagem ent.
9.1 Budgeting as an internal management tool

The budget acts as a bridge between a company’s targets and overall long
term strategies on the one hand, and daily operational activities on the
other. It links the present and future to try and keep the company on its
planned course.
A budget can be defined as a document that describes the financial con

sequences of the action plan that the company has drawn up for a given
period in the future, on the basis of its reading of certain factors.
The budget is sometimes referred to as the “accounts of the future” be

cause it is based on the same chart of accounts, and describes the expected
financial impact of plans for a particular period.
However, budgeting is more than just numbers, tables and reports. It
can consist of everything from a passive projection of last year’s results to
the active planning of future activities within the framework of the com
pany’s general targets and objectives that involve every member of staff.
Used properly, budgets fulfil multiple purposes. They can be a purely pas
sive forecasting model, as is the case with projections based on last year’s
accounts. However, they can also be a mechanism for co-ordination and
motivation, as is the case when the whole organisation is involved. Done
properly, the budgeting process and the budgets that emerge from it can
serve as important management tools.
This chapter presents a model in which both the content and the pro
cess live up to this designation – “management tool”. Figure 9.1 shows
which aspects of management the budget underpins.
Aspects of budgeting
Plan/predict developments Optimise resource utilisation
Create internal interaction Co-ordinate activities
Create m otivation Facilitate delegation
Act as forum for n ew ideas Serve as basis for monitoring progress
Comm unicate plans Act as docum entation
Form basis fo r credit rating
Figure 9.1 Aspects of management underpinned by the budget.
The way the work is organised is key to ensuring that each of these aspects
is fully addressed by the budget process. Crucially, staff at all levels must
be involved.
One option is to set up an organisational unit to promote efficiency
and generate ideas via the budget process. The chief financial officer often
chairs a steering committee made up of heads of department. Under the
steering committee, working groups prepare departmental budgets, make
suggestions and come up with ideas for new markets, products, or produc
tion and planning processes. Involving the staff means that the budget
both reflects the company’s broad knowledge base, and gives the staff a
sense of ownership that motivates them to reach the targets set.
The size of the organisational unit and the time devoted to budgeting
reflect the managers’ level of ambition for the process. The costs of draw
ing the budget up should be weighed against the advantages in terms of
company management.
9.2 Planning and budgeting
Budgets are essentially in two parts: an action plan outlining practical ac
tivities and a description of the financial consequences of those activities.
Planning and budgeting are, in other words, closely interrelated. The
planning part precedes and forms the quantitative basis for the budget.
The budget assigns values to the plans and co-ordinates them into a finan
cially feasible unified approach.
Plans are submitted by departments, divided into periods of time and
forged into a comprehensive action plan, which is then evaluated through
the budget process.
The plans and budgets both refer to the same periods(s) of time. Figure
9.2 illustrates the relationship between action plans and budgets.
Figure 9.2 Relationship between planning and budgeting.
The starting point for planning and budgeting is always the company’s
current situation and the targets it has set, as divined from the accounts
but also covering the current state of the market, products, technology
and staff.
The plans are often passive in the sense that they merely represent a
continuation of current activities, possibly with minor adjustments, e.g.
sales plans for existing products to existing customers, production using
existing facilities and/or funding from previously tapped sources, etc.
However, the process also involves active plans for new initiatives, e.g.
the sale of new products, greater capacity and new technology.
These active and passive plans are combined, co-ordinated and forged into
a comprehensive action plan designed to achieve the company’s goals.
The budget forecasts the financial consequences of the action plan. If
the plan proves unsatisfactory or impossible to implement, the framework
for it is adjusted (see the reversed arrow in Figure 9.2). For example, if the
original sales plan requires a higher level of financing than the company
is able to source, a new and more feasible plan is drawn up.
Only when the action plan and its financial consequences have been
co-ordinated in a way that meets the company’s general targets are they
approved and then implemented.
9.3 The planning and budgeting process

The finance department is usually responsible for collating and co-ordi
nating planning and budgeting work, which takes the form of dialogue:
• among management
• between management and the departments
• between the departments
• within the departments.
Figure 9.3, below, describes the workflow in more detail.
Figure 9.3 Example workflow for planning and budgeting.
The figure above presents one example of the phases involved in the budg
eting process and the order they take.
Phase 1: Analysing current situation and targets

Management analyses the company’s strategic situation internally and
externally. Internally, the analysis is based on the company’s strengths
and weaknesses, which may refer to productivity, capacity, staff, capital or
other internal factors. Externally, it is based on opportunities and threats,
e.g. competition, social aspects and industry-specific factors.
These factors are then viewed in the the light of company’s overall objec
tives. By comparing these factors, management formulates expectations
and targets for the next planning period and then draws up guidelines for
how it envisages reaching these targets. The elements of the process are
outlined in Figure 9.4, below.
Figure 9.4 The strategy model.
Phase 2: Plan and budget draft no. 1

Each department (e.g. sales and marketing, production, finance, purchas
ing/stocks, etc.) convenes a budget meeting to discuss management’s
analysis of the situation, expectations and targets.
Using this information, the departments identify budget assumptions
not included in the management’s draft proposals, e.g. for sales volume,
potential sales prices and unit costs, wage increases, new staff and mar
keting campaigns.
The departments plan and budget for the parts of the activity and capac
ity for which they are responsible within the framework of management’s
overall guidelines and targets. The budgets are entered into a budget mod
el, based on the company’s standard chart of accounts and presented in
the same way as its financial accounts.
The departments co-ordinate their work with each other, and consult
the finance department if necessary.
Phase 3: Drawing up the budget

Once each of the departments has submitted their input, the finance de
partm ent draws up sub-budgets and presents the first draft of the overall
company budget. This total budget includes an income statem ent budget,
a balance sheet budget and a liquidity budget.
Phase 4: Co-ordination and evaluation

Management compares the draft budget with the targets set for the pe
riod. If the targets are not met within the specified timescale, discussions
are held about improvements to the plan. If the targets are reached, dis
cussions are held about making the plan even better.
The work done at departmental level may identify factors that justify ad
justm ents to the initial analysis of the situation and targets, or generate
ideas for new activities, efficiencies or savings.
Management also has the option of using the initial draft budget as a
basis upon which to make decisions about activities that affect the com
pany as a whole, e.g. capacity utilisation, development work, major m ar
keting campaigns and financing.
It also has to assess the probability of sticking to the budget and the
significance of any changes made to the budget assumptions.
Elements of the first draft usually need to be revised, in which case a
second round takes place, based on the initial draft and on management’s
revised targets.
Phase 5: Plan and budget draft no. 2

Based on the new plan, the departments repeat the planning and budg
eting process, focusing on the adjustments and additions since the first
draft.
The departments then resubmit their input to the finance department,
which draws up a revised overall budget.
Phase 6: Evaluation and approval

Management reviews the new budget. If it meets the company’s require
ments, the budget is approved and plans are drawn up on that basis.
The monitoring of the budget is also discussed, including what to do in
the event of significant variances from the budget or of events having an
impact on the underlying assumptions.
Phase 7: Information m eeting

Once the second budget round has been completed, an information meet
ing is held for all members of staff, at which management informs them
of the plans, budgets and expectations for the coming year. It is important
for staff motivation that they are informed about the requirements and
expectations placed on them in the next planning period.
Phase 8 : Implementation
Once the budget has been approved, departments are able to draw on the
funds earmarked for their activities. The budget is a framework, which
management presents to the departments and to which it adheres. This
means that heads of department have a certain amount of room to ma
noeuvre.
Regular checks are made, as part of which management is able to demand
explanations for any cost overruns.
The next section looks at the actual calculations that underpin the
budget model.
9.4 The budget model

The overall budget model consists of three interdependent elements: an
income statem ent budget, a liquidity budget and a balance sheet budget.
Figure 9.5, below, shows the elements included in the income statement
budget and liquidity budget and the relationship between the two.
The liquidity budget uses the statem ent of changes in financial posi
tion model, which closely resembles the cash flow statem ents in company
financial accounts.
A liquidity budget based on the cash flow budget model is introduced in
9.5 below.
Figure 9.5 Income statement budgets and liquidity budgets.
The income statem ent budget
The income statement budget consists of the total budgeted revenue mi
nus associated costs. In the example, operating costs are divided into
variable costs, capacity costs and depreciation. The subdivision needs to
reflect the financial accounts with which the budgets will ultimately be
compared. As costs can be categorised by either nature or function, the
way they are subdivided can also vary from company to company.
The operating profit is shown in the income statem ent budget as profit
before depreciation, interest and tax. The earnings contribution also acts
as the starting point for the liquidity. The liquidity budget does not in
clude depreciation because this does not constitute a payment but a cost
calculated on the basis of fixed asset usage.
The budgeted result for the year is found by subtracting the budgeted
net interest charges and tax from the budgeted profit before interest.
The liquidity budget

In order to calculate the effect on liquidity for the period, the earnings
contribution must be regulated. The reason for this is that the company
has to wait for payment, e.g. when it sells products to customers. This
means that there will be debtors at the start of the year (or quarter or
half-year) who will pay during the year, and there will be debtors at year-
end because a proportion of the revenue for the year will not yet have been
paid for at year-end.
Example
Receivables at start of year 400
+ Turnover 2,000
2,400
- Receivables at year-end - 300
Payments by debtors 2.100
Note that debtors have been reduced from 400 to 300, which reduces the
capital tied up by 100, i.e. liquidity has improved by 100.
The earnings contribution is adjusted to take account of the expected

change in debtors. If this is expected to be higher at the end of the period
than at the beginning, more money will be tied up in customer receivables,
which will put a strain on liquidity and have a negative impact on the li
quidity budget.
The same applies to changes in stocks. If stocks are expected to grow dur
ing the period, this will tie up more of the company’s funds, which will
place a strain on liquidity. If the company reduces its stocks, liquidity is
freed up and this will have a positive impact on the liquidity budget.
Example
Stocks at year-end 800
Stocks at start of the year - 600
Stock increase 200
The increase in stocks increases the capital tied up in stocks by 200, which
has a negative effect on liquidity.
Changes in stocks and debtors are particularly challenging for start-ups.

During the early stages of its existence, a company may need to build up
stocks and extend credit to customers in order to be competitive. This en
tails tying up a relatively large amount of capital, and it is important that
the newly established company has sufficient liquidity to tide it over dur
ing this stage of its development.1
Creditors pull in the other direction. An expected increase in credit
from suppliers and/or other creditors is positive for liquidity, as the pay
ments are deferred.
Example
Cost of goods = Cost of goods for year + Stocks at year-end – Stocks at start of year
Cost of goods = 1,800 + 800 - 600
Cost of goods = 2,000
Creditors at start of year 400

+ Cost of goods for year 2,000
2,400
- Creditors at year-end 500
Payments to creditors 1.900
Note that the company has paid 100 less than the cost of goods. The sig
nificance of this is that it improves liquidity by 100 because the payment is
delayed until the next accounting period.
1 For further details of start-ups and their budgets, see Chapter 12.
Liquidity is also affected by budgeted net interest payments. In the liquid
ity budget, interest income or charges can be placed under liquidity chang
es from operations or under financial inflow and outflow.
After this, the budgeted liquidity effect of operations can be calculated.
Budgeted investments in fixed assets trigger an outflow. New loans
trigger an inflow (of capital), loan repayments an outflow.
Payments made to the company owners/shareholders can take the form
of private withdrawals (for personally owned companies) or dividends (for
limited companies). Dividends are deferred a year because they have to be
approved by an annual general meeting before they can be paid out. This
means that the dividend payment that appears in the budget is the amount
earmarked for dividends payable in the opening balance. The budget for
these items must be included along with the budgeted tax payment (the
owner’s income tax for personally owned companies, corporation tax for
limited companies) before the total liquidity for the period is calculated.
If liquidity (primo/beginning of the year) is added to the periods liquid
ity impact, it is possible to calculate the budgeted liquidity at year-end.
The item “liquid holdings” usually consists of cash holdings, bank de
posits and/or unused overdraft facility.
The purpose of the liquidity budget is to calculate the budgeted liquid
ity at year-end. However, it is also essential for liquidity management to
identify the items that impact on liquidity.
9.5 Drawing up the income statement budget

When the staff responsible for drawing up plans and budgets receive the
management’s draft proposals, they start to collate information and de
fine budget assumptions. The income statem ent budget is always based on
expected revenue/sales.
The income statement budget consists of:

• the contribution margin
• capacity costs
• depreciation
• financial items
• tax.
9.5.1 The contribution margin budget
Firstly, factors that affect the contribution margin are considered, e.g.:
• sales prices and trends
• sales factors, including total market and market share
• prices paid for materials
• wage rates
• efficient use of material and labour in production
• capacity factors, including whether the company has sufficient ca
pacity to implement its plans.
Example
Nordlys A/S is a low-tech production company with two products.
All amounts in the example are ex-VAT.
Nordlys has collated the following information for use in drawing up a
contribution margin budget for 2016:
Product A Product B
Sales (units) 1,500 1,500
Sales price (DKK per unit) 1,400 2,100
Cost of materials (D KK per unit) 530 1,025
W a g e costs (D KK per unit) 420 635
The numbers are based on the most recent data from the sales and produ
ction departments and an extrapolation based on market trends.
The sales price for item B has been increased from the previous year
because the company expects to be in a position to charge more for a new
and improved version. The price rise also presumes a higher marketing
spend.
Based on the past productivity of its machines and staff, Nordlys cal
culates that it will have sufficient capacity. The contribution margin will
therefore look like this:
Product A Product B Total

Revenue 2,100,000 3,150,000 5,250,000
Material costs 795,000 1,537,500 2,332,500
Variable wage costs 630,000 952,500 1,582,500
Contribution margin 675,000 660,000 1.335.000
Contribution margin (% ) 32.1% 21.0% 25.4%
9.5.2 Budget for capacity costs
Nordlys bases its budget for capacity costs on the previous year’s accounts.
Example cont.
The accounts for 2015 have not been finalised, so the calculations are ba
sed on estimates.
• an extra DKK 30,000 is earmarked for marketing the new version of
product B
• wages and salaries are expected to rise by 10%
• rent and miscellaneous costs are unchanged but an extra DKK 6,000 is
added to the admin budget.
In total, capacity costs are expected to rise by DKK 834,000.
Accounts 2015 Budget 2016

(Estimated)
Marketing 120,000 150,000
Rent 330,000 330,000
Wages and salaries 240,000 264,000
Administration 59,000 65,000
Misc. costs 25,000 25,000
Total 774.000 834.000
9.5.3 Depreciation budget

The depreciation budget can be based on last year’s figures, with an added
amount for depreciation on any planned new fixed assets. If the company
plans to sell off fixed assets during the period covered by the budget, this
must also be taken into account.
Example cont.
Production plant Inventory Total
Planned investment 25,000 0
Depreciation period, year 5
Last year's depreciation 99,000 15,400 114,400
Depreciation on new investments 5.000 0 5.000
Budgeted depreciation for the year 104.000 15.400 119.400
9.5.4 Interest budget
The calculations for interest income and interest charges in the interest
budget are based on the holdings on which interest is accrued and on loans
that the company expects to take out in the budget year. The interest rate
is an estimate.
Example cont.
Nordlys only pays interest on a single debt item. It is not budgeting on any
interest income.
Interest budget
Interest income 0
Interest charges 10% of long-term debt of DKK 170,000 17.000
Net interest costs 17.000
9.5.5 Tax budget

Irrespective of whether a company is personally owned or a limited com
pany, a special tax account is drawn up in order to calculate the precise
amount due in tax. For budgeting purposes, it is usually sufficient to apply
the current rate of taxation. It is particularly important to include tax in
the liquidity budget. The rate of corporation tax is 23.5% .2 In the budget,
tax is calculated on the basis of the pre-tax profit in the annual accounts.
9.5.6 The income statem ent budget

The total income statem ent budget is drawn up, and the tax is calculated
in a way that shows the net profit for the year.
Example cont.
Income statement budget for Nordlys A/S 2016
Product A Product B Total

Revenue 2 ,100,000 3,150,000 5,250,000
Cost of materials 795,000 1,537,500 2,332,500
Variable wage costs 630.000 952,500 1.582.500
Contribution margin 675.000 660,000 1.335.000
2 Corporation tax is expected to be cut to 22% in 2016.
Capacity costs:
Marketing 150,000
Rent 330,000
Wages and salaries 264,000
Administration 65,000
Misc. costs 25,000
Total capacity costs 834,000
Earnings contribution 501,000

Depreciation 119,400
Profit before net interest costs 381,600
Net interest costs 17,000
Profit before tax 364,600
Corporation tax 91,150
Profit for the year 273,450
The profit for the year for Nordlys A/S is therefore budgeted to DKK
273,450. Management now has to decide whether it is satisfied with this
budget.
Here are the key numbers for earnings capacity:
The contribution ratio is arrived at by dividing the total revenue by the

total contribution margin. To arrive at the rest of the key data, use the
formulas in Chapter 4 and Appendix 2. Note that depreciation is included
under total capacity costs.
Once the final income statem ent budget has been agreed, the company
plans how to spend the projected profit.
Example cont.
Allocation of profits:
Dividend 24% of share capital of DKK 500,000 120,000
Transferred to equity as retained earnings 153,450
273,450
The proposed dividend is shown in a separate line in the budget (and in

the accounts). The remainder of the annual profit is added to the item
called “Retained earnings” and transferred to equity.
9.6 The liquidity budget – the statement of

change in financial position model
Liquidity budgets are usually based on the statement of change in finan
cial position model. As mentioned previously, this model is based on the
same principles as cash flow statem ents in company financial accounts.
To use the statement of change in financial position model, the com
pany needs to know the opening balance at the start of the budget period.
This will often be an estimate, as the previous year’s accounts will rarely
have been finalised at this point in time.
Example cont.
Estimated balance for Nordlys A/S at year-end 2015
ASSETS LIABILITIES
FIXED ASSETS EQUITY
Production plant 487,000 Share capital 500,000
Inventory 48,200 Proposed dividend 100,000
Total fixed assets 535,200 Retained earnings 575,800
Total equity 1,175,800
CURRENT ASSETS DEBT LIABILITIES
Raw materials 165,000 Long-term debt 170,000
Work in progress 100,000
Finished products 180,000 Debt to suppliers 102,000
Debtors 465,000 Other short-term debts 132,070
Liquid holdings 134,670
Total current assets 1,044,670 Total short-term debt 234,070
TOTAL ASSETS 1,579,870 TOTAL LIABILITIES 1,579,870
The liquidity budget is based on a series of projections for current as
sets and short-term debt and on payments expected in connection with
planned investments and financing.
The expected changes in stocks, debtors and creditors, which are di
rectly dependent on trends in revenue and variable costs, can be budgeted
using the expected rates of turnover. The rates of turnover used in com
pany budgets are based on a combination of the current level and targets.
Example cont.
Budget assumptions
Rates of turnover:
Raw materials 15
Work in progress 24
Finished goods 20
Debtors 6
Creditors 24
Proportions of sales on credit 0.5

Proportion of purchases on credit 1.0
Other short-term debt 140,000
Investment and financing:

New investments 25,000
Payments for long-term debt 20,000
Dividend 24%
Unlike external analyses, the variable costs for materials and labour costs
are known. The formulas containing the rates of turnover are therefore
more detailed than the ones used in the external analyses in Chapter 4.
Formulas for calculating year-end data:
Sales on credit = Material costs + year-end stocks – stocks at start of year
The formula for raw materials only includes materials used before pro
duction. When starting to use the materials they transfer from being raw
materials to work in progress.
Work in progress consists of items that have not yet reached the end of
the production process. The formula presumes that the raw materials are
in stock throughout the production period. Labour costs are added when
appropriate. The calculation in the numerator shows the average time
during the period that the item spends in production.
Example
Average value of one unit of product A in production
Day 1 15
Cost of materials 530 530
Labour costs 0 420
Accumulated value 530 950
The rate of turnover is 24, i.e. the production time is 15 days. The average
value = 530 + 0.5 •420 = DKK 740 per unit.
Variable labour costs are added to the stocks of finished products because
the cost price for products in the stock of finished products consists of
both m aterial costs and labour costs.
Since debtors are customers who owe the company money, the formula
only includes the proportions of total sales on which credit was extended.
The amount of supplier credit also depends on the amount purchased
on credit. Purchases are calculated as the cost of materials for the period
adjusted by the change in the size of the stock of raw materials. For exam
ple, if the stock of raw materials has grown, purchases have outstripped
the use of materials.
Example cont.
The dividend to be paid in 2016 is earmarked in the opening balance as a

proposal. The numbers above are entered into the liquidity budget, along
with the rest of the information.
Example cont.
Liquidity budget 2016

Opening Year-end
Operating profit 501,000
Change to stocks of raw materials 165,000 155,500 9,500
Change to work in progress 100,000 130,156 -30,156
Change to stocks of finished products 180,000 195,750 -15,750
Change to debtors 465,000 437,500 27,500
Change to supplier credit 102,000 96,792 -5,208
Change to other short-term debt 132,070 140,000 7,930
Net interest costs -17,000
Liquidity from operations 477,816
Investment in fixed assets -25,000
Payments on long-term debt -20,000
Dividend paid (out of last year's profit) -100,000
Tax for current year -91.150
Change to liquidity for the year 241,666
Liquidity at opening 134,670
Liquidity at year-end 376,336
The liquidity budget shows that liquidity at year-end is expected to be DKK

376,336. Taken in isolation, the positive liquidity effect of operations is
DKK 477,816.
Liquidity from operations is affected positively by the expectation that
debtors and stocks of raw materials will fall, while short-term debt is ex
pected to rise.
Along with the payment of interest charges, liquidity is negatively
impacted by the expectation that work in progress and stocks of finished
products will rise and credit to suppliers will fall.
Payments for investments in new plant, payment of loan instalments,
the dividend for the previous year and tax all reduce liquidity for the year
to DKK 241,665.
9.7 The balance sheet budget

Once the income statement budget and liquidity budget have been drawn
up, all that remains in order to complete the balance sheet budget is to
calculate the fixed assets, retained earnings and dividends payable.
Example cont.
Fixed assets
Production plant Inventory

Book value at start of year 487,000 48,200
New purchases 25,000 0
512,000 48,200
Depreciation 104.000 15.400
Book value at year-end 408.000 32.800
Example cont.
Retained earnings
Transferred at start of year 575,800

Transferred from profit for the year* 153,450
Transferred at year-end 729,250
*Profit for the year is DKK 273,450 minus dividend of DKK 120,000.
Based on the opening balance and the liquidity budget, a balance sheet
budget is drawn up for year-end 2016.
Example cont.
Budgeted balance sheet for Nordlys A/S at year-end 2016
ASSETS LIABILITIES
FIXED ASSETS EQUITY
Production plant 408,000 Share capital 500,000
Inventory 32,800 Proposed dividend 120,000
Total fixed assets 440,800 Retained earnings 729,250
Total equity 1,349,250
CURRENT ASSETS DEBT LIABILITIES
Raw materials 155,500 Long-term debt 150,000
Work in progress 130,156
Finished products 195,750 Debt to suppliers 96,792
Debtors 437,500 Other short-term debts 140,000
Liquid holdings 376,336 Total short-term debt 236,792
Total current assets 1,295,242
TOTAL ASSETS 1,736,042 TOTAL LIABILITIES 1,736,042
During the budget year, the company’s balance sheet total is expected to
rise by about DKK 156,000 to approx. DKK 1,736,042.
Assets must be equal to liabilities in a balance sheet budget. If this is
not the case, something is wrong with the relationship between the in
come statem ent budget, the liquidity budget and the balance sheet budget.
Usually, the company’s stakeholders, primarily lenders, are mainly in
terested in whether the company is able to meet the conditions of the in
come statem ent budget and the liquidity budget.
The advantage of drawing up a balance sheet budget is that it accounts
for expected capital spending and capital funding during the coming
budget year. It also facilitates the calculation of profitability ratios.
9.8 Budget simulation

The Nordlys budgets above were calculated in Excel, which makes it easy
to perform budget simulations. The model is available on the website ac
companying this book. In the income statem ent budget, it is possible to
simulate the effects of changes in the number of units sold, the sales price,
material costs and/or wage costs for the two products. Changes to one or
more of these figures will trigger an immediate recalculation of the model.
In the liquidity budget, it is possible to simulate the effects of changes
to rates of turnover, amounts invested and loan repayments.
Budget simulation is an extremely useful management tool for assess
ing sensitivity to various types of changes to budget assumptions.
In the model for Nordlys, the income statement, liquidity and balance
sheet budgets are interlinked and changes to the income statement budget
or liquidity budget automatically appear in the other budgets.
9.9 Liquidity budget using cash flow budget model

If a company wants to make liquidity calculations for multiple periods, the
statement of change in financial position model is not appropriate. The
cash flow budget model is better suited for this purpose, as it shows the
payments made in each period. This provides a good overview of liquidity
- when it will be in short supply and when it will be more abundant.
Example
Fenron A/S is considering a project involving the manufacture and sale
of a new product that will give the company access to a new market. The
project requires investment in a new machine. The life cycle of the product
in the market is estimated to be four years.
To study the financial consequences of the project, management has col

lated the following data:
Year 1 Year 2 Year 3 Year 4

Sales price (DKK per unit) 100 120 110 80
Expected sales (DKK 1,000) 10 15 12 5
Cost of materials (DKK per unit) 40 40 40 40
Variable labour costs (DKK per unit) 30 20 20 20
Labour costs are higher in the first year due to training costs. The project is
feasible without increasing capacity costs (except for machinery costs, see
later).
Payment terms
Debtors: Three months' credit on all sales (rate of turnover = 4).
Creditors: One month's credit on all materials (rate of turnover = 12).
Labour costs are paid in cash.
Machine
The machine costs DKK 1,500,000 (paid outright).
After four years, it can be sold for DKK 250,000 (cash).
The repair and maintenance costs are DKK 50,000 in years 1 and 2, and
DKK 75,000 in years 3 and 4 (paid in cash).
Loan
Fenron takes out a loan to invest in the machine. It borrows 80% of the
cost.
It is a three-year serial loan (equal instalments paid each year). At the
end of each year, 10% interest is paid on the balance outstanding at the
beginning of the year.
Production factors
The company does not keep stocks. This production for the year is equal to
the sales for the year.
The lead time is also short, so there there is no work in progress.
To guard against shortages of materials, the company wants to have
enough stock for 2,000 finished units at any given time. This stock will be
purchased prior to the start of production and kept at that level until pro
duction ends, i.e. it will be used up at the end of year four.
Interest on the company's facility is 6 % p.a.
Fenron now wants to draw up budgets showing the project's contribution

margin and liquidity effect.
Budget for the contribution margin (DKK 1,000)
Year 1 Year 2 Year 3 Year 4
Revenue 1,000 1,800 1,320 400

Cost o f materials 400 600 480 200
Labour costs 300 300 240 100
Contribution margin 300 900 600 100
Liquidity budget – using the cash flow budget model (DKK 1,000)
Inflow Y e a r0 Year 1 Year 2 Year 3 Year 4 Year 5
Units sold this year 750 1,350 990 300

Units sold last year 250 450 330 100
Loan proceeds 1,200
Sale of machine 250
Total inflow 1.200 750 1.600 1.440 880 100
Outflow
M aterials bought this year 367 550 440 120

M aterials bought last year 33 50 40
Start-up stocks 80
Labour costs 300 300 240 100
Repairs and maintenance 50 50 75 75
Cost of machine 1,500
Instalments 400 400 400
Interest 120 80 40
Total o u tflow 1.500 1.317 1.413 1,245 335 0
Liquidity effect for the year -300 -567 187 195 545 100
Liquidity at start o f year -300 -902 -762 -606 -80
Liquidity at year-end -300 -867 -715 -567 -61 20
Interest on average annual balance -35 -47 -38 -19 -1
Liquidity at year-end after

interest accrual -902 -762 -606 -80 19
In the example above, the line “Units sold this year” is calculated as 9/12
of revenue for the year. Customers have three m onths’ credit, so revenue is
only generated during the first nine months of the financial year. The rest
of the revenue for the year is recorded in the accounts for the following
year under “Units sold last year”.
Revenue in year 1 was DKK 1,000,000, of which 9/12 was paid in that
year, i.e. DKK 750,000. The remainder (3/12 = 250,000) is paid in year 2.
In other words, the cash inflow in year 2 stems from revenue in years 1
and 2.
The loan proceeds are received at the start of year 1, which is the same
as the year-end figures for year 0. The payment from the sale of the ma
chine is received in year 4.
The company factors outflow for materials into the inflow from sales.
As the company receives one-month credit from suppliers, 11 m onths’ of
m aterial costs are paid in the same year, while the final month is recorded
in the accounts for the following year. However, it should be noted that
payments for materials in year 4 are affected by the stock in place at the
start of the project, which is used at the end of the project life (year 4) but
was paid for in year 1.
Labour costs and repair costs are paid in cash in the year they are in
curred.
The machine is purchased at the start of the project in year 0. Instal
ments and interest are paid during the four years it runs.
Once the total cash inflow and outflow have been calculated for each
year, the annual net liquidity effect can be calculated.
Accumulating the liquidity effects for the individual years allows the
company to trace developments in the overall project liquidity at the end
of each year.
The company covers its capital requirement by, for example, drawing on
its overdraft facility. This triggers additional interest charges. The annual
interest is calculated as the average balance – (opening liquidity + liquidity
at year-end before interest accrual)/2 – multiplied by the rate of interest.
The liquidity budget above shows that, after year 1, Fenron A/S will have
a liquidity deficit of DKK 867,000. The reason for this is that – in addition
to a capital requirement from year 0 of DKK 3 0 0 ,0 0 0 – outflow in year 1
exceeds inflow by DKK 567,000. Interest also has to be added. The interest
charges for the year will be 6% of (300+867)/2, a total of DKK 35,000. The
total liquidity at the end of year 2 will be a deficit of DKK 902,000.
After year 2, the company expects the capital requirement to fall to DKK
715,000 before interest, DKK 762,000 with interest. Only in year 5 is there
a liquidity surplus – DKK 20,000 before interest. Once interest is included,
the project ends with total liquidity surplus of DKK 19,000 after year 5.
9.10 Budget follow-up

The main purpose of the budget is to quantify plans for the future in fi
nancial terms. At the end of each period, the company has to compare the
actual results with the original budget.
This is called budget control.
9.10.1 Budget control

Budget control consists of comparing actual results with the original
budget for the same period.
The numerical differences between the actual accounts and the budget
are called budget variances. W hether positive or negative, they are im
portant to management. Understanding the causes of these variances will
improve planning for the future.
Budget control is a natural part of all financial management systems.
It is therefore important that the budget follows the same system as the
company’s financial accounts, and that it is drawn up in a way that makes
it possible to pinpoint where in the organisation responsibility for any
variances lies.
Monitoring results
The simplified example below shows how Nordlys A/S monitors its results.
Example
Income statement budget for Nordlys for a given year
Budget control reveals that the actual result is DKK 170,750 less than bud
geted. This is mainly down to capacity costs, which were DKK 241,000 over
budget. The main items were marketing (DKK 120,000) and wages and
salaries (DKK 86,000).
The increased contribution margin (DKK 139,000) was not enough to ba
lance out the extra costs.
Budget Accounts Variance
Revenue 5,250,000 5,850,000 600,000
Cost of materials 2,332,500 2,751,000 -418,500
Variable labour costs 1,582,500 1,625,000 -42,500
Contribution margin 1,335,000 1,474,000 139,000
Capacity costs:
Marketing 150,000 270,000 -120,000
Rent 330,000 320,000 10,000
Wages and salaries 264,000 350,000 -86,000
Administration 65,000 95,000 -30,000
Misc. costs 25,000 40,000 -15,000
Total capacity costs 834,000 1,075,000 -241,000

Earnings contribution 501,000 399,000 -102,000
Depreciation 119,400 150,000 -30,600
Operating profit 381,600 249,000 -132,600

Net interest costs 17,000 25,000 -8,000
Profit before tax 364,600 224,000 -140,600

Corporation tax 91,150 61,000 30,150
Profit for the year 273,450 163,000 -170,750
A plus sign in front of a number indicates that performance was better

than budgeted and had a positive effect on the result. A minus sign num
ber indicates that performance was poorer than budgeted.
9.10.2 Causes of budget variance

Budget control and management are, as mentioned previously, based on
comparisons of the budget and the actual accounts for the same period.
Figure 9.6, below, illustrates this process, and also shows the relation
ship and link between actual results and targets and strategies.
For this comparison to be effective, it is essential that the chart of ac
counts used for the budget is the same one used for the accounts. The
budget period and consumption period also have to be the same. This
helps to m aintain consistency between the budget and accounts and re
duces the number of systemic causes of variances.
Figure 9.6 Budget control process.
The typical variances can be divided into three groups:

1. Variances caused by bookkeeping errors
2. Variances caused by time differences between the budget and the
bookkeeping
3. Real variances due to changes in budget assumptions.
Ref. 1. Variances caused by bookkeeping errors

These can be eliminated by careful design of the chart of accounts used in
the budget and in the accounts.
Ref. 2. Variances caused by time differences between the budget and the bookkeeping
Nordlys A/S noted a positive variance in revenue between the budget and
the actual accounts. This may be down to a sale being brought forward and
increasing the contribution margin.
Ref. 3. Real variances due to changes in budget assumptions
Real variances occur when reality is not as expected or planned. For in
stance, higher sales may be due to the market being more positive than ex
pected, or to a marketing campaign being more successful than expected.
It is usually the job of the financial officer/controller to identify and
report these variances and ensure that the causes, i.e. the incorrect budget
assumptions, are identified.
EX A M PLE OF CONTROLLING THE CONTRIBUTION MARGIN

Budget control consists of calculating and explaining the financial conse
quences of the variances between the budget and the accounts.
Example
Budget variance for the trading company Rentos A/S, Q2 2015 (DKK 1,000)
Accounts Budget Variance Variance (% )

(DKK)
Net revenue 8,690 8,000 690 8.6
- variable costs 6,985 6,200 -785 -12.7
Contribution margin 1,705 1,800 -95 -5.3
- Capacity costs 1300 1340 40 3.0
Earnings contribution 405 460 -55 -12.0
- depreciation 275 275 0 0.0

Profit before interest 130 185 -55 -29.7
- interest costs 75 70 -5 -7.1
Profit for the year 55 115 -60 -52.2

Contribution ratio ( % ) 19.6 22.5
The table shows a positive variance of DKK 690,000 (8.6%) in revenue.

However, the variable costs were DKK 785,000 higher than expected, so
the variance in the contribution margin is minus DKK 95,000. The higher
revenue in the accounts did not improve the contribution margin because
the contribution ratio was lower than budgeted.
Overall, the profit for the year is DKK 60,000 lower than budgeted. This
is due to the aforementioned influence of the contribution margin and the
fact that the capacity costs were higher than expected.
As previously mentioned, it is important to look at why the results are

not as expected, especially in relation to the variance in the contribution
margin. A specific analysis of the variance in the contribution margin is
called for.
Contribution margin variance
These variances are grouped into three types:
1. Variances in sales
Calculated as actual sales x budget contribution margin/unit com
pared to budget sales x budget contribution margin/unit
2. Variances in sales p rices/per unit
Calculated as actual sales x actual sales price compared to actual sales
x budget sales price
3. Variances in variable costs (purchase prices/unit in trading companies or
variable production costs/unit in m anufacturing companies)
Calculated as actual sales x actual purchase price (or variable produc
tion costs) compared to actual sales x budget purchase price (or vari
able production costs).
Example
The trading company Rentos A/S wants to identify the exact reason(s) for
the aforementioned variance in the contribution margin for Q2 2015, so
conducts an analysis of the variance in the contribution margin (in DKK
1, 0 0 0 ).
Accounts Budget Variance
Revenue 8,690 8,000 690
- Variable costs 6,985 6,200 -785
Contribution 1,705 1,800 -95

margin
Sales (units) 110 100
Variance in sales Actual sales x budgeted contribution margin/unit 1,980

(11 0x 18) =
Budgeted sales x budgeted contribution margin/unit 1,800

(100 x 18) =
Variance + 180
Variance in sales Actual sales x actual sales price/unit (110 x 79) = 8,690
prices 8,800
Actual sales x budgeted sales price/unit (110 x 80) =
Variance -110
Variance in varia Actual sales x actual purchase price/unit (110 x 63,5) = 6,985
ble costs (purchase
Actual sales x budgeted purchase price/unit (110 x 62) = 6,820
prices)
Variance -165
Total variance in The sum of 180 – 110 – 165 = -95

contribution margin
Note that the total variance of DKK 95,000 is now divided into three ele
ments. This shows clearly that the lower-than-expected contribution mar
gin is mainly due to higher purchase prices. The products were also sold at
a lower sales price than assumed in the budget.
The only positive variance was in sales, which were higher than anticipa
ted in the budget.
Management now has concrete figures and relationships on which to
base its decisions when planning budgets for the future.
9.11 Balanced Scorecard

Many companies use the Balanced Scorecard model to manage and follow
up on key non-financial factors and risks.
To remain competitive in a rapidly changing world, it is im portant that
companies have a strategy for the future that is forward-looking and pro
active in terms of controlling their activities and reaching their targets.
The strategy must be visible to the staff. The goals – and what it will
take to reach them – must be followed up on so that everybody knows
what progress has been made.
"If something cannot be measured, it cannot be managed. And if it cannot

be managed, it cannot be improved, because you don't know if what you
are trying to improve actually improves."
Professor Robert Kaplan3
9.11.1 The Balanced Scorecard model
The Balanced Scorecard is a dynamic measurement tool that links long-term

strategic goals with short-term management targets in the different parts
of the company.
3 Professor Robert Kaplan developed the Balanced Scorecard model.
Figure 9.7 shows the progression from a company’s basic vision (at the top
of the pyramid) to the four key perspectives (at the bottom). What aligns
the company’s strategic objectives with short-term management needs
in the various units is series of critical success factors or areas of focus.
The critical success factors must be presented as specific benchmarks that
provide an overall picture of the company’s goals, efforts and results in
pursuit of each of the four key perspectives. The four perspectives form
the foundation of the strategy.
Figure 9.7 Relationship between vision, strategy and the four perspectives.
Based on the four perspectives, the following questions are posed:

• The financial perspective
What will it take for the company to satisfy its owners/shareholders?
This perspective is primarily related to earnings capacity, liquidity
and profit to the owner/shareholders.
• The custom er perspective
How should the company treat its customers if the overall vision is
to be realised?
This perspective is related to factors that affect customers, e.g. qual
ity, delivery service, technical service, product range, etc.
• The internal perspective
What business processes does the company have to master in order
to satisfy its owners/shareholders and customers?
This perspective measures performance related to the supply chain,
e.g. production, product development, logistics, supplier relation
ships, lead times, etc.
• Learning and grow th perspective
How should the company m aintain and enhance its ability to inno
vate, change and improve, if the overall vision is to be realised?
This perspective deals with human capital, in the form of the s ta ff’s
knowledge, motivation and commitment, as well as the company’s
ability to develop products and markets, innovate, use new technol
ogy, etc.
For each perspective, companies set their own individual critical success
factors. The benchmarks for the four perspectives are interrelated and
have to be aligned.
Once the targets and benchmarks have been set, management decides
what it needs to do to achieve its goals.
Again, three questions are posed:
1. What does the company want? (Strategies and critical success fac
tors)
2. What will the company do? (Outcomes)
3. W hat will the company get out of its efforts? (Performance measure
ments)
Example
The Volkswagen-owned car-manufacturer Skoda has been making huge
progress in recent years because it practises good company and financial
management on all levels – strategic, tactical and operational. The ma
nagement sets targets and sub-targets, including ones that are not directly
financial in nature.
Figure 9.8 shows an example of a fictional Balanced Scorecard for a Skoda

factory.
Figure 9.8 Draft Balanced Scorecard in fictional Skoda factory.
The idea behind the Balanced Scorecard is that the financial perspective
and goals need to be supplemented with targets from the other three per
spectives. Achieving the goals of the other three perspectives is the basis
upon which the financial targets will be met.
In this example, the cars’ quality, customer satisfaction and staff devel
opment are prerequisites for long-term success.
The Balanced Scorecard’s focus areas highlight the critical success fac
tors prioritised by management. The Balanced Scorecard is therefore a
communication tool for management and makes it easier for employees to
understand how their daily work contributes to strategic goals.
Example
The building society BRFkredit has a Balanced Scorecard with the following
vision, critical success factors and benchmarks. The text in italics consists of
direct translations.
Vision
- that borrowers see BRFkredit's sales and consultancy services as the
most straightforw ard in the market and its products and prices as
among the most competitive
- that bond investors know that buying BRFkredit bonds is an investment
that gives a competitive return
- that partners find BRFkredit's products easy to talk about and that they
add value to processes and customers
- that the sta ff see BRFkredit as a good and attractive workplace.
BRFkredit's vision is based on the stakeholder model, and includes speci

fic visions for each of its main groups of stakeholders. BRFkredit does not
reveal its financial success criteria and objectives in its Balanced Scorecard,
but sets overall critical success factors for each of the other three perspec
tives:
Customer perspective
Success factor: It is im portant for BRFkredit that customers perceive the
company to be modern and customer-oriented.
Target: BRFkredit aims to offer a competitive product range and a service
level that makes it easy and inexpensive for existing and new customers to
use us.
Internal factors
Success factor: BRFkredit wants to have a competitive product range. W e
develop new products to meet market demand and want to be market
leaders with new products and services in selected areas.
Target: BRFkredit's benchmarks in this area concern the product range
(loan types) and accessibility for customers, e.g. mobile banking on
smartphones.
Learning and growth

Success factor: BRFkredit's goal is to be a modern, customer-oriented
company. W e allocate a great deal of resources to the development of new
IT systems. W e support our employees' initiative, creativity and commit
ment. W e believe that modern technology and dedicated staff are pillars
of the company's continued development.
Target: The staff are BRFKredit's most important resource. The company
develops them constantly in order to ensure that it has the flexibility to
meet market demand and to attract and retain staff.
The specific benchmarks for this perspective are not immediately obvious
but relate to the development of IT systems and staff.
Source: www.brf.dk
The example shows how the targets are linked to the critical success fac
tors, so that everyone in the company is aware of what it is seeking to
achieve.
It is important to involve the staff in the various departments in the
work of defining the benchmarks and targets.
9.12 The four perspectives as risk indicators
– early warning system
The Balanced Scorecard is a management tool designed to ensure that
targets and strategies are translated into reality. Strategies often emerge
from analyses of internal strengths and weaknesses, as well as external
opportunities and threats (SWOT analysis).
In these analyses, the emphasis is on identifying and pursuing oppor
tunities but threats and risks are monitored as well. The Balanced Score
card model incorporates all of these factors, which makes it useful for risk
management.
Figure 9.9 shows examples of risk factors for the four perspectives.
These indicate areas in which trouble is brewing and management might
want to intervene. Nipping problems in the bud before they take hold is a
characteristic of good management.
Some of these indicators can only be observed internally, e.g. “High ab
sence rates”, while others can also be observed by outsiders, e.g. “Accounts
not submitted on tim e”.
Financial perspective The learning and developm ent perspective

Early w arn in g indicators Early w arning indicators
Budget overruns High rates of absence

Accounts not submitted on time M any resignations
Lack of financial control Key staff leave
Financing difficult Poor communications and team work
Customers do not pay on time M ultiple conflicts
Rising losses
Falling operating margin
The customer perspective Internal process perspective

Early w arning indicators Early w arning indicators
Falling customer satisfaction Production efficiency falls

Falling service quality Deadlines are not kept
Increasing numbers of complaints Q uality problems
Fall in demand and market share for the Increasing need repeat processes
company's main products Planning failures
Lack o f product innovation Information failures
Poor co-operation
Figure 9.9 The four perspectives as early warning indicators.

Source: ROMEIKE/Lyngaard
9.13 Advantages of a Balanced Scorecard
The targets and benchmarks set using the Balanced Scorecard make it
possible for companies to follow up whenever things are not going accord
ing to plan.
Benchmarks and targets also make it easier to provide a picture of the
company’s strategy that is understood by everybody throughout the or
ganisation. This makes it easier to delegate responsibility and decision
making to those who have direct influence on the benchmarks. It makes
it possible to create a system in which all members of staff are able to
contribute towards achieving the company’s overall objectives because the
results of their actions are directly reflected in the results for the different
individual benchmarks.
Once the system is up and running, a Balanced Scorecard provides staff
and management with continuous and rapid follow-up on each of the
benchmarks.
Used correctly, the Balanced Scorecard makes the path from strategy to
action shorter and more direct.
9.14 Disadvantages of a Balanced Scorecard

Using non-financial benchmarks as the basis for management and reports
works best for companies that mainly utilise human resources to generate
value.
The Balanced Scorecard model is epitomised by staff involvement in the
planning of financial and (in particular) non-financial targets. It is impor
tant that the whole organisation is involved in the early stages of the work
on the benchmarks. This may well be costly, time-consuming and some
what at odds with the company’s usual practice, but it should be seen as an
investment in the future, in a better understanding of company strategy
and in a greater commitment and meeting targets.
Putting in place a conceptual framework that works and can be used to
manage the company also involves a large amount of research and a sig
nificant investment in organisational development.
PART 4
10 Investments

• account for d ifferen t kinds of investments
• calculate the transactions associated w ith an investment
• use different methods to calculate how good an investment is
• analyse the sensitivity of calculations used in investment decisions.
The appendix accompanying this chapter considers the basic techniques

associated with computation of interest.
Planning of capacity is part of the company’s planning. Before decisions
are made about particular activities, the company needs to know whether
or not it has the capacity to carry them out.
Figure 10.1 shows the relationship between activities, capacity and fi
nancing needs.1
Figure 10.1 Core management and planning areas.
Activities are only possible if the fixed assets buildings, machinery, equip
ment, etc. are available at the right time and in the right quantity to cope
with the level of activity.
1 This figure is an extract from Figure 1.10.
One of the characteristics of fixed assets is that they are paid for on ac
quisition but not necessarily used right away. In fact, the benefits might
not be felt for years. They are an investment in a future competitive ad
vantage.
If investment is needed to expand capacity, the company needs to fi
nance it, and this also requires planning.
This chapter deals with investment decisions, Chapter 11 with how
they are financed.
10.1 Investment projects

Investments are made in all walks of life.
Socio-economic investments are made in infrastructure projects, e.g.
the Fehmarn Belt Link, motorways, hospitals, schools and nursing homes.
Companies invest in fixed assets such as buildings and machinery, as
well as in staff training, advertising campaigns, entering new markets,
etc.
At a private level, families and individuals invest in property, shares,
pension plans, antiques, art, etc.
An investment is characterised by:

• the expectation that the return (benefit) will be greater than the out
lay
• a delay between investment and return
• the fact that it tie up capital.
Common to all types of investment projects is that the decision-makers

expect the return to be higher than the initial outlay. However, this is only
ever an expectation. While the outlay (the investment) is usually known
at the time of investment, the future yield (return) is estimated on the
basis of certain budget assumptions, which makes it subject to the same
uncertainty as the company’s other budgets. For long-term investments
the uncertainty is, of course, greater than for short-term investments.
By definition, investments tie up capital, which stops the company from
making other investments.
This chapter focuses on business investments, not including the tax im
plications of them (see appendix 10B.2).
10.1.1 Investment needs
The Balanced Scorecard model introduced in Chapter 9 has four basic per
spectives:
• the financial perspective
• the customer perspective
• the internal perspective
• the learning and growth perspective.
The company will probably need to invest in each of these, and they are all
directly related to its vision and strategy.
1. The financial perspective

Investments related to the financial perspective include fixed assets and
current assets.
Investments in fixed assets include machinery that pays for itself via
added production capacity or savings in production costs.
Many companies also have funds tied up in current assets, in the form
of stocks and debtors. These investments in current assets are necessary
in order to meet customer demand for delivery, service and credit.
2. The custom er perspective

Investments related to the customer perspective usually consist of mar
keting spend associated with branding the company and/or product line,
gaining a foothold in a new market, launching a new product, etc.
In situations like these, the strategy is often long-term. As well as a
short-term revenue boost, the company expects a more lasting effect in
terms of customer loyalty and greater awareness of the company/product.
The costs associated with this type of marketing project must therefore
be seen in relation to both the short-term and long-term effects. While the
short-term effects on earnings/revenue can be estimated using standard
budgeting methods, it is more difficult to assess the impact on loyalty and
brand recognition and the value the company derives from these.
3. The internal perspective

In many industries, competition is fierce, so it is important to have ef
ficient production and communication processes, systems for knowledge-
sharing, etc.
Rationalisation, restructuring and reorganisation cost money, including
the costs associated with planning and implementation. The company has
to recoup this investment via additional sales and/or savings.
4. The learning and growth perspective
This perspective is all about the staff.
Companies can invest in developing and training current staff via in
ternal and external programmes. In both cases, an outlay is required to
develop in-house development programmes or to pay for training and/or
consulting fees to external suppliers. There is also an investment in terms
of staff time. All of this is expected to produce a return, in the form of
increased earnings, as the staff learn more, gain qualifications, improve
their decision-making abilities, etc.
Companies also invest in attracting new and talented staff, which is
important as it gives the company access to their knowledge and specialist
competencies (human capital).
10.1.2 Evaluating investments

Although it is not always easy to estimate the future value of investments,
companies still have to estim ate how profitable they will be. They also
have to be able to compare different investment opportunities.
For investments where it is possible to draw up a budget for the initial
outlay and the return, it is possible to work out whether an investment
will be profitable. Various methods of doing so are discussed below.
10.2 The financial element

The financial analysis of an investment (the investment calculation) is
based on the expected future return. Any such calculation is, therefore,
subject to a certain degree of uncertainty.
10.2.1 Investment cash flow

Evaluating the financial aspects of an investment starts with the transac
tions involved. The outlay and return rarely coincide nicely with earnings.
The investment calculation analyses the liquidity effect, rather than the
effect of the investment on the accounts.
The investment usually starts with an outlay, e.g. the purchase price for
a machine or the start-up costs for a project. The purchase price must in
clude all of the costs involved in making the machine ready for operation
or launching the project.
A series of transactions will be recorded during each year of the invest
m ent’s life cycle. To prevent the data set becoming too complicated, the ex
pected annual transactions are entered as a single net figure at year-end.
In some cases, the machine is sold off at the end of the investment. This
expected income is called the machine’s scrap value.
Example
Investment in new bottling machines
A microbrewery produces tw o types of beer: Black Lion Classic 4.8% and

Night Ale 6.6%. Both have been a major success in recent years, and it has
sometimes been difficult to meet growing demand.
Management has decided to invest DKK 5 million in new bottling machi
nes. After four years, the machines are expected to have a scrap value of
DKK 200,000.
Based on past experience, the management and the company ac
countant have estimated the expected improvements to revenue and the
contribution margin in the tables and figure below.
Year
1 2 3 4
Assumptions:
Sales (1,000 units) 180 220 260 300
Sales price (DKK/unit) 10 10 10 10
Variable costs (DKK/unit) 3.5 3.5 3.5 3.5
Budget:
Revenue 1,800 2,200 2,600 3,000
Variable costs 630 770 910 1,050
Contribution margin 1,170 1,430 1,690 1,950
Year Investment and Revenue Variable costs Contribution Total net

scrap value margin payment
0 -5,000 -5,000
1 1,800 630 1,170 1,170
2 2,200 770 1,430 1,430

3 2,600 910 1,690 1,690
4 200 3,000 1,050 1,950 2,150
The outlay is shown below the x-axis in the graph, the return above. The
amounts are shown in DKK 1,000 both for reasons of clarity and because it
is impossible to predict them with absolute certainty.
The tables show that the investment in the machines would be greater
than the return.
The ultimate decision on whether the investment is worth it depends on
whether the company would be able to obtain a better return by investing
the DKK 5 million in another project or alternatively depositing it in the
bank. This is shown in 10.4.1.
10.3 The calculation rate

It is impossible to calculate the effect of an investment without apply
ing an interest rate. The one companies use in investment calculations is
called the calculation rate.
The calculation rate is the company's minimum requirement for return on

investment.
The calculation rate reflects the return that the company would obtain if
it invested the amount in another project or deposited it in the bank, i.e. if
it used the money differently.
The capital invested in an asset must be financed from equity or from
borrowed capital. The calculation rate must, therefore, also reflect the in
terest rate the company paid to raise the capital.
It is not always easy to decide on a calculation rate. One option is to
apply the same net rate that the company actually pays on its overdraft
facility, because this reflects both interest paid when the company draws
on the facility and the interest saved when the account is in the black.
Alternatively, the rate can be based on the company’s return on capital
employed, which is based on the return on previous investments. Some
companies use a higher rate for investment projects if the level of risk is
particularly high. In other words, they factor in a higher return to com
pensate for the greater risk.
Since the calculation rate varies from company to company, a project
deemed not profitable by one company may well be profitable for another
company, depending on the required rate of return.
In terms of the individual company, however, it is absolutely essential
for the conclusions it reaches that the calculation rate is realistic.
10.4 Evaluating investments
Companies use a variety of methods to decide whether an investment is
profitable. This section introduces the capital value method, the internal
rate of return method and the annuity method. The payback method will
be dealt with separately later on. These methods are related. The calcu
lations all use the same five variables and arrive at the same conclusion
about the profitability of investment. The difference is in how they pre
sent the results.
The five variables are:
Variable Excel function

Investment am ount PV or NPV
The annual net payments PMT
The scrap value FV
The calculation rate IRR or RATE
Life cycle NPER
If four of the five variables are known, it is possible to calculate the fifth.
In certain cases, one of the four known variables, e.g. the scrap value or
the annual net payment, can be 0.
10.4.1 The capital value method

Once the transactions and calculation rate are known, the capital value of
the investment can be calculated.
The capital value method involves discounting all of the transactions
associated with the investment back to the point at which the investment
was made (point zero). The present value of the transactions is then com
pared to the investment amount.
In other words, the capital value is the difference between the sum of
all of the incoming and outgoing transactions associated with the invest
ment attributed to the same point in time.
An investment is profitable if the capital value is positive.
When the capital value is greater than zero, it means that the investment
- in addition to providing a return on the internal rate of return – will
make a positive contribution to the company’s earnings. This contribution
is calculated based on the value at today’s prices (the capital value).
The general mathematical formula for the calculation of the capital value
is shown below. This formula can always be used, regardless of whether
the transactions consist of annuities or different amounts at each due
date.
where: C0 = the capital value at point 0

A the purchase price
NBt = net payment at point t
i = interest per term (calculation rate)
n = life cycle of investment
Example
The capital value of the bottling machines described in 10.2.1 is calculated
in Excel as shown below. The calculation rate is 8 % . All figures are in DKK
1,000. The function "NET PRESENT VALUE (NPV)" is used.
Note that Excel discounts back all net payments from point 1 to point 4.
This gives a value of DKK 5,231,00 at point 0 for the four incoming transac
tions. From this, the investment cost at point 0 (DKK 5,000,000) is sub
tracted, giving the capital value:
Capital value = -5,000 + 5,231 = 231 (DKK 1,000).
The positive capital value indicates that the investment would be profita
ble.
Note also that the higher the calculation rate, the more the capital value
is reduced. Had the calculation rate in this example been 10% p.a., the
capital value would have been minus DKK 16,000.
When evaluating alternatives, the capital value method can be applied to
any investment proposal, whereas a range of conditions have to be met
before the other methods are applicable.
CALCULATION OF CAPITAL VALUE IF THE

TRANSACTIONS CONSIST OF ANNUITIES
If the net payments per annum consist of an annuity, Excel uses NPV (Net
Present Value) to calculate the capital value.
Example
This example assumes that the transactions for the bottling machines
consist of an initial outlay of DKK 5,000,000 plus a return of DKK 1,500,000
each year for four years, as well as a return of DKK 200,000 after year 4
(the scrap value).
An alternative method of calculating the capital value of the bottling
machines to the one in the previous example is to use the function PV in
Excel. NPV can only be used if payments are annuities. There may also be a
scrap value.
The transactions look like this:
In Excel the current value of the annuity and the scrap value are calculated
together. The calculation rate is 8% . The capital value is calculated as fol
lows:
The present value of the annuity (the net transactions including scrap
value) is a total of DKK 5,115,000. The investment cost (DKK 5,000,000) is
subtracted from this.
Capital value = -5,000 + 5,115 = DKK 115,000.
The capital value is positive, meaning that the investment would be profi
table at this calculation rate.
10.4.2 The internal rate of return method
The purpose of the internal rate of return method is to calculate the ex
pected return on the capital invested.
W hen the internal rate of return is higher than the calculation rate, the
investment is profitable.
Figure 10.2 illustrates the importance of the calculation rate to the capital
value of investments.
Bottling machines
The relationship between calculation rate and capital value
Figure 10.2 The importance of the calculation rate to the capital value of investments.
This graph uses different calculation rates to work out the capital value of
the bottling machines. The capital value falls as the calculation rate rises.
As previously worked out, the capital value is DKK 115,000 at a calcula
tion rate of 8%. In other words, the return on investment measured in %
p.a. is higher than the calculation rate.
At a calculation rate of around 9%, the capital value of the investment
would be zero.
This rate is called the investment’s rate of return or internal rate of
return.
The internal rate of return is the rate at which the transactions balance,
taking into account when they are made. It is the rate at which the invest
ment has a capital value of 0.
Example
Excel uses the IRR function to calculate the internal rate of return for the
bottling machines:
The internal rate of return is 9.01% p.a. This means that the investment
would be profitable because the internal rate of return is higher than the
calculation rate of 8 % p.a.
As this particular investment involves net transactions of the same
amount each year (an annuity), the Excel function RATE can also be used to
arrive at the internal rate of return:
The screenshot shows that the internal rate of return is 9.01% p.a.
In the example, the internal rate of return is 9%, and the calculation rate
is 8%. As the company requires a return on investment of 8% p.a., and the
investment yields a return of 9% p.a., the investment is deemed profitable.
Figure 10.2 also shows that, if the calculation rate is 0%, the capital
value would be equal to the net sum of the transactions as there would
be no loss of interest while waiting for the return on the investment to
materialise.
The internal rate of return method cannot be used to compare invest
ment opportunities unless the investment amount and life cycle are iden
tical. In practice, this is rarely the case.
10.4.3 The annuity method

This is a practical alternative in cases where the transactions include an
annuity. It compares the annual net transactions with the capital service
costs, i.e. the estimated average annual cost of depreciation and return on
investment.
The capital service costs consist of the annual average costs for interest and
depreciation associated with the investment.
The annuity method converts all of the transactions associated with the
investment into an average annual transaction.
An investment is profitable if the average annual net transaction is positive.
Example
In Section 10.4.1, it was assumed that the return on the investment for the
bottling machines consisted of an annuity, i.e. a net return of DKK 1.5 mil
lion every year.
In order to calculate the total average annual transaction, the outlay of
DKK 5 million and the scrap value of DKK 200,000 have to be converted
into average annual amounts.
Excel uses the function PMT to calculate the capital service costs for the
bottling machines:
The capital service costs are DKK 1,465,000.
Note that NPV (purchase price) and FV (scrap value) have different signs
in front of them.
The capital service costs for the bottling machines, i.e. the estimated
average annual net cost for depreciation and interest, are DKK 1,465,000.
Once the capital service costs are known, it is possible to calculate the ave
rage annual net transaction.
Average annual net return = Annual net payment - the capital service costs
Average annual net return = 1,500 - 1,465 = DKK 35,00
The average annual net figure for the bottling machines is DKK 35,000.
This means that during the four years in which the machines are in use, on
average DKK 35,000 more p.a. would be earned on top of the required 8%
(the calculation rate). The number is positive, so the investment is deemed
profitable.
10.5 The payback method

The payback method is also used to evaluate investments.
The idea is to estimate how quickly the investment will be recouped by
calculating the number of years it will take for the annual net return to
cover the initial outlay.
The calculations can be made with or without taking into account the
effect the tim ing of payments has on net interest costs. If interest correc
tion is not included in the calculations, the payback method only provides
a rough estimate.
The return on investment can also be accumulated year on year. When the
net accumulated value turns positive, it means that the annual return on
the investment has surpassed the initial outlay.
Example
An investment involves a capital outlay of DKK 1,200,000.
The annual net returns are expected to be DKK 300,000 p.a. for six
years. The calculation rate is 8 % p.a.
The figures are all in DKK 1,000.
W ithout interest correction With interest correction

Net payment Accum ulated net
Accumulated
Year Transaction Transaction discounted paym ent after
transactions
back discounting back
0 -1,200 -1,200 -1,200 -1,200 -1,200
1 300 -900 300 278 -922
2 300 -600 300 257 -665
3 300 -300 300 238 -427
4 300 0 300 221 -206
5 300 300 204 -2
6 300 300 189 187
The table shows that the accumulated net payment reaches DKK 0 in year
four. In other words, it takes four years to recoup back the initial invest
ment, if the interest effect is not included.
W ith interest correction, the payback period is just over five years. At
year five, only DKK 2,000 remains to be recouped, and in year six the re
turn on investment is DKK 189,000.
The payback method is not a particularly precise method of evaluating
the profitability of an investment. If interest correction is included, an in
vestment is considered profitable if it is recouped within its own life cycle.
The accumulated net payment at the end point are equal to the capital
value of the investment. In this example, the capital value is DKK 187,000.
The advantage of the payback method is that it shows when money invest
ed (capital tied up) again becomes liquid, which has an impact on issues
such as what other projects the company has the liquid funds to invest in.
The disadvantage of this method is that it does not take into account
the interest rate or of any returns on the investment that are not recorded
until after the end of the period covered by the payment plan.
Despite these limitations, the payback method is frequently used in
practice, as it provides a quick overview of the effect on liquidity of a pro
posed investment.
10.6 Investments and statements of
changes in financial position
Companies often find that the balances in their accounts for stocks, debt
ors, creditors, etc. change during the life cycle of an investment. If the
changes are significant from one year to the next, it is relevant to include
them in the investment calculation. The following simplified example
shows how to incorporate changes to debtors, stocks and creditors into
the calculation of the capital value and internal rate of return.
Example
Peter Sorensen has long wanted to buy a pizzeria. W hile planning the
acquisition, he draws up the following budget for the revenue, costs and
changes to the balances posted for debtors, stocks and creditors, as well as
for the investment itself. He uses a calculation rate of 8 % p.a.
Acquisition of pizzeria
Year 0 1 2 3 4 5
Unit 30,000 40,000 50,000 60,000 70,000
Unit price 50 55 60 65 70
Average variable cost 40 45 50 55 60
Revenue 1.500.000 2,200,000 3,000,000 3.900.000 4.900.000
Variable costs 1.200.000 1,800,000 2,500,000 3.300.000 4.200.000
Contribution margin 300,000 400,000 500,000 600,000 700,000
Capacity costs 275,000 275,000 275,000 275,000 275,000
Earnings contribution 25,000 125,000 225,000 325,000 425,000
Changes to balances:
Debtors (supplies to companies) -20,000 5,000 5,000 5,000 5,000
Stocks -10,000 2,500 2,500 2,500 2,500
Creditors 40,000 -10,000 -10,000 -10,000 -10,000
Changes to balances 10,000 -2,500 -2,500 -2,500 -2,500
Investment -500,000
Cash flo w from operations and

investment -500,000 35,000 122,500 222,500 322,500 422,500
Capital value DKK 338,653
Internal rate of return 24.4% p.a.
Peter arrives at a positive capital value of DKK 338,653 and an internal rate
of return of 24.4% p.a. Both figures indicate that the investment would
be profitable. Note that the calculations include the liquidity effect of the
change to the various balances.
Excel uses th e fu n c tio n NPV to calculate th e capital value (see screenshot):
The screenshot shows th a t th e present value o f th e transactions is DKK

838,653, fro m w hich DKK 500,000 is deducted, leaving a capital value o f
DKK 338,653.
Excel uses th e fo rm u la IRR to calculate th e in te rn a l rate o f re tu rn (see

screenshot):
The screenshot shows th a t th e in te rn a l rate o f re tu rn is 24.3% p.a.
10.7 Sensitivity in investment analysis

With the exception of the acquisition price, all figures for transactions as
sociated with investments are budget figures, which means that they are
subject to a certain degree of uncertainty.
In order to calculate an investment’s sensitivity to changes in budget
assumptions, companies have to calculate the critical value for each tran s
action variable, e.g. interest rates, annual net costs, life cycle, scrap value.
The critical value can only be calculated for one variable at a time. This
is called a partial analysis, and it is assumed that all of the other variables
remain constant. The critical value of a variable is the point at which the
capital value is exactly zero.
Example
A student is considering an investment in a mobile freezer in order to sell
ice cream on the beach.
The freezer costs DKK 15,000. He expects to use it during the last four
years of his studies and then sell it to a new student for DKK 5,000. His
calculation rate is 14%.
He expects to sell 800 ice creams p.a. at DKK 12 per unit. He budgets with
a cost price of DKK 6 per unit.
He wants to find out if the investment will be profitable.
The annual net costs are found by drawing up a contribution margin budget:
Revenue from 800 units @ DKK 12.00 DKK 9,600
Variable costs 800 units @ DKK 6.00 DKK 4.800
Contribution margin DKK 4.800
All payments are expected to be cash. The annual net payment are there
fore DKK 4,800 p.a.
As the net payment consist of an annuity, the Excel function PV can be

used to calculate the profitability of the investment:
The present net value of income is DKK 16,946, from which the invest
ment cost of DKK 15,000 is deducted. This makes the capital value DKK
16,946 - DKK 15,000 = DKK 1,946. The investment is profitable because
the present net value is greater than zero.
10.7.1 Critical value for the interest rate
The critical value for the interest rate has already been found. It is, of
course, the Internal Rate of Return (IRR) (see 10.4.2 above).
For an investment to remain profitable, the calculation rate must be no
higher than the internal rate of return. If the calculation rate is equal to
the IRR, the capital value of the investment is zero. If the calculation rate
is higher than the IRR, the investment is not profitable.
Example cont.
Based on the previous example, the internal rate of return can be calcu
lated by using the Excel function "INTRATE" at 19.5% p.a.
This is markedly higher than the calculation rate, so the project is profi
table.
The calculation rate could be raised to 19.5% before the student would
make a loss on the investment.
The example is also available on the website accompanying this book,

where it can be recalculated using different assumptions.
10.7.2 Critical value for annual payments

If the net payment consist of annuities, it is possible to calculate a critical
value for the annuity.
The annual net transactions must be sufficient to cover depreciation
and interest, which when converted to annual averages is also referred to
as the capital service costs.
The critical value for the net annual transactions is equal to the capital
service costs.
The example below shows how to calculate the critical value in Excel.
Example cont.
Calculating the capital service costs using the Excel function PMT:
The capital service costs - and therefore the critical value for the annual
net costs - are DKK 4,132.
Each year, the student must earn at least DKK 4,132 for the investment
to be profitable.
There may be several reasons why the annual net payments do not match
expectations, e.g. changes to unit sales, sales price or cost price.
The Company can calculate a critical value for each of these variables.
Example cont.
Annual net payments = sales ·(sales price per unit - cost price per unit)
The annual net payments must be at least DKK 4,132
The critical value for sales:
DKK 4,132 = critical sales ·(12 - 6) => critical sales = 689 units
Critical value for contribution margin per unit:
DKK 4,132 = 800 ·critical contribution margin per unit => critical contribu
tion margin per unit = DKK 5.17
It therefore follows that:

Critical value for sales price:
DKK 5.17 = (critical sales price - 6) => critical sales price = DKK 11.17 per unit
Critical value for cost price:
DKK 5.17 = (12 - critical cost price) => critical cost price = DKK 6.83 per unit.
If the annual net payments do not take the form of an annuity, it is only
possible to calculate the critical value for a single year at a time. The capi
tal value is set as 0, after which the transaction is calculated.
10.7.3 Critical value for the scrap value

The critical value for the scrap value is the minimum amount to be re
couped.
Example cont.
To calculate the critical value for the scrap value in Excel, use the function
"FV":
The screenshot shows that the critical value for the scrap value is DKK
1,713.
10.7.4 Summary
The above shows how to arrive at critical values for each variable in turn
using relatively simple calculations. Critical values are a way of quantify
ing how sensitive an investment is to changes in the original budget as
sumptions.
Calculations that involve simultaneous variation in multiple variables
require more sophisticated methods of analysis.
10.8 Choosing between investment proposals
The capital value method is used when companies have multiple invest
ment options.
It works out the capital value of the options. From a purely financial
point of view, the one with the highest capital value is the most profitable
and should be chosen. However, other factors may influence the decision:
Risk and uncertainty

Budgets for future returns on the investment may be subject to different
degrees of risk and uncertainty. For example, the degree of uncertainty is
generally less pronounced over a shorter period.
Size o f investment
The size of the investment has to be considered. If funds are limited, tying
up capital is a significant factor in decision-making.
Technology
To what extent can the company be sure that the pace of technological
change will not outstrip the asset in which it is considering making the
investment?
Life cycle
Many companies prefer investments that are recouped fairly quickly. How
ever, this cannot be the only factor in decision-making, because it fails to
take into account any return on the investment that falls after that final
date in the transaction plan.
Investment decisions affect companies’ financing needs. Chapter 11
looks at different types of financing and the factors that influence compa
nies when choosing between sources of financing.
10 Appendix A
Calculating interest
10A.1 The concept of interest

The sooner a liquid amount is available, the longer the company is able to
earn interest on it.
W hether an investment is profitable depends on how much the com
pany loses in interest income while waiting for a return on the invest
ment. This interest effect is arrived at using fairly common calculation
techniques, which make it possible to compare sums even though the pay
ments are due at different times.
Example
It is better to receive DKK 100 today than to receive DKK 100 in a year. If
the company receives it today, the DKK 100 can be deposited in the bank
and interest will accrue on it. At a rate of 7% p.a., the company will have
DKK 1.07 (100 ·1.07 = 107) at the same point the following year.
If the cash remains at the company's disposal for two years, it grows to
DKK 114.49 (100 ·1.07 ·1.07 = 114.49).
10A.2 Calculating interest in Excel

These calculations can be made in Excel. The table below shows the vari
ables used in the pre-programmed interest calculations. The interest rate
is specified as either a decimal or a percentage.
Variable Excel function
Present value NV or NPV
Annual net payments PM T
Final value FV
Interest rate RATE or IRR
Life cycle NPER
If four of the five variables are known, it is possible to calculate the final one.
10A.3 Future value1 of a single amount
At an interest rate of 7% p.a., DKK 100 becomes DKK 107 after one year
and DKK 114.49 after two years.
Example
In Excel, calculate the value of DKK 100 in a year at a rate of 7 % p.a.
The result is a future value (FV).
Enter the following:
FV becomes DKK 107, as calculated above.
Note that the result in Excel is DKK -107. This is because Excel’s calcula
tion is based on equilibrium. Effectively, this means, “Spending DKK 100
today (PV = + 100) is the equivalent of giving up DKK 107 (-107) next
year. ” 2
In other words: if the interest rate is 7% p.a., a company is in the same
financial position if it receives DKK 100 now or DKK 107 in a year.
1 Also known as accumulated value or final value.

2 If you en ter-100 in NV, then FV = 107.
Example cont.
In Excel, calculate the value of DKK 100 in two years at an interest rate of
7% p.a.
The result we are looking for is still the future value (FV).
FV is DKK 114.49 as calculated above.
Mathematically, the accumulated value of the present value (NPV) of an

amount after N payments is expressed as follows:
Kn = FV = PV · (1 + i)n
K2 = FV = 100 x (1 + 0.07)2 = DKK 114.49
The element (1 + i)n is called the interest factor.
10A.4 Present value of a single amount

Investment calculations often seek to resolve the inverse problem, i.e. find
the present value of a future amount. For example, what is the value of
receiving DKK 100 in a year? It is worth less than receiving DKK 100 now,
because if the company received it now it would earn interest for a year.
Example
W hat is the present value of DKK 100 received in a year at an interest rate
of 7 % p.a.?
The result we are looking for is the present value, i.e. NPV.
The NPV is calculated at DKK 93.46.
As above, the NPV is negative if the FV is entered as a positive.

This amount (DKK 93.46) is called the present value3 of receiving DKK
100 in a year.
If the interest rate is 7% p.a., a company is in the same position if it
receives DKK 100 p.a. in a year or DKK 93.46 right away.
Mathematically, this is expressed as follows:
PV = FV x (1 + i)-n
PV = 100 x (1 + 0 .0 7 )-1= 93.46
The element (1 + i)-n is called the discounting factor.
3 Other terms for the present value include the discounted-back value or the capitalised value.
10A.5 The importance of interest and time
Interest calculations are based on the assumption that money can be bor
rowed at the same rate throughout the period concerned. If the interest rate
goes up, the amount lost while waiting for an amount of money increases.
Example
The present value of receiving DKK 100 in a year at different interest rates:
Interest rate Value of receiving DKK 100 in a year

7% 93.46
9% 91.74
11% 90.09
Figure 10a.1 shows the effects of different rates in graph form. At 0%,
there is no loss of interest. The present value is therefore 100.
Figure 10a.1 Present value of receiving DKK 100 in a year at different interest rates
The amount lost while waiting for an amount of money increases as the
timescale expands.
Example
The present value of receiving DKK 100 in n years at 7 % p.a.:
Number of The value of receiving DKK 100 in n

years years at an interest rate of 7 % p.a.
1 93.46
2 87.34
3 81.63
Figure 10a.2 below shows the effect of time. The longer a company has to
wait for the amount, the lower the present value as the interest rate loss
increases along with the number of years.
At 0 years there is no loss of interest, and the present value is DKK 100.
Figure 10a.2 The dependence of the present value on time at a rate of 7% p.a.
10A.6 Annuities
Annuities consists of a series of payments of the same size paid at the same
regular interval.
It is possible to calculate the present value and the future (accumulated)

value of an annuity as long as the interest rate remains constant during
the period concerned and the net interest is not withdrawn or paid off.
The many examples of annuities are repayments on bank loans and
mortgages and payments into savings accounts. Certain simple rules apply
to finding the present value and the future value (final value) of an annu
ity. It is also possible to calculate the amount of the annuity if the present
or final value is known.
10A.7 Future value of an annuity

This section analyses a fixed annuity consisting of n payments dates and a
fixed interest rate. The future value is expressed as follows:
Example
DKK 5,000 is deposited in an account at year-end every year for five years.
The interest rate is 4 % p.a.
How much is in the account at the end of year five?
The result is the future value (FV).
The FV is DKK 27,081.61.
When PMT is entered as a negative number (money removed from liquid

ity), the resulting FV is positive, corresponding to the balance in the ac
count.
10A.8 Present value of an annuity

In the example of the bottling machines in 10.2.1 above, the return on the
investment for each of the four years (DKK 1,500,00 p.a.) is an annuity.
To calculate the present value of the annuity, i.e. trace the payments
back to point 0, use the method shown in the example below.
The present value of a fixed annuity over a period with n payment dates
is expressed as:
Example
The result sought is the present value (PV).
This calculates the present value of the annuity for the bottling machines
(DKK 1,500,000 return on investment p.a. for four years) at a rate of 8%
p.a.
The PNV is DKK 4,968,000.
In Excel, PV is negative when PMT is positive. In order to make DKK 1.5

million p.a. for four years at 8% interest p.a., the company is willing to
invest DKK 4.968 million right away. It is equally well placed in both sce
narios.
10A.9 Converting a present value into an annuity

Often, a company needs to be able reverse the direction of this calculation,
i.e. to allocate a present value to a series of payments of equal amounts (an
annuity) at a particular rate of interest.
This conversion of a single amount, e.g. a present value (PV), to an an
nuity (PMT), can be expressed as:
Example
W hat will the annual payments be if you borrow DKK 10,000 today and
have to pay it back over four years at 14% p.a.? The result sought is the an
nuity/payment, i.e. the function PMT in Excel.
The PMT is DKK 3,432.05.
Excel calculates the payment as DKK 3,432.05. This is the amount to be

repaid p.a. in order to receive a loan of DKK 10,000 (PV) now.
10 Appendix B
Advanced investing
10B.1 Incorporating probability into investment calculations

When budgeting with net investment costs, companies take into account
the probability of various scenarios.
Probabilities can be calculated for all of the variables in a budget.
Example
In 10.7 above, a student considers investing in a mobile freezer for selling
ice cream on the beach. The price of the freezer is DKK 15,000, with a life
cycle of four years. The scrap value is DKK 5,000 and the calculation rate is
14% p.a.
The student expects the following contribution margin:
Revenue from 800 units @ DKK 12.00 DKK 9,600

Variable costs 800 units @ DKK 6.00 DKK 4.800
Contribution margin DKK 4,800
The annual net payment are, therefore, DKK 4,800 p.a. Based on these as
sumptions, the capital value is calculated as DKK 1,946.
H o w eve r, th e sum m er w e a t h e r is crucial to th e stu d e n t's u n it sales. The
original budget was based on sales of 800 units p.a. The table below is an
overview of the probabilities for different sales figures and the associated
contribution margins.
Example cont.
Sales (units) 600 700 800 900 1000

Probability (% ) 5 10 50 30 5
Contribution margin (DKK per unit) 6 6 6 6 6
Contribution margin (DKK p.a.) 3,600 4,200 4,800 5,400 6,000
Weight in total contribution margin 180 420 2,400 1,620 300
The overall probability-weighted contribution margin is the sum of the

weighting for each of the five scenarios. In total, the expected contribu
tion margin (and therefore the return) is DKK 4,920 p.a.
The capital value with these assumptions is DKK 2,296, which is slightly
higher than the original calculation because the estimated net return is
higher.
10B.2 The investment calculation after tax

The capital value of the investment can also be calculated after tax.
The capital value of an investment after tax is calculated on the basis of

payments after tax and the calculation rate after tax.
The transactions after tax are found by calculating the tax base for the
investment for each year, i.e. earnings minus deductible expenses. The
deductible expenses are usually the investment payments plus deprecia
tion for the year. For tax purposes, the purchase price is written down by
25% p.a. using the reducing balance method. In the final year, it is written
down to the scrap value.
This is the basis on which the tax for the year is calculated. The corpora
tion tax rate is 23.5%.
The net transactions after tax are calculated as payments in minus pay
ments out (not depreciation, which is not categorised as a payment) minus
tax due.
The scrap value is added to the payment after tax in the last year of the
investment life cycle.
Example
The bottling machine introduced at the start of Chapter 9 cost DKK 5 mil
lion. The scrap value is DKK 200,000 and the annual returns on the invest
ment are DKK 1,500,000.
The payments after tax look like this (in DKK thousands):
Annual payment after tax
Purchase price and scrap

Contribution margin
Payments after tax

Year-end balance
Depriciation 25%
Tax 23.5%
Tax base
value
Year
0 5,000 -5,000 -5,000

1 3,750 1,250 1,500 250 -59 1,441 1,441
2 2,813 938 1,500 563 -132 1,368 1,368
3 2,109 703 1,500 797 -187 1,313 1,313
4 200 1,909 1,500 -409 96 1,596 200 1,796
When the tax base is positive, as in year four, the company makes a tax
loss on the project. In this example, it is because of the major write-down
to scrap value in the final year. The tax loss can be deducted from the rest
of the company’s tax base. In other words, the company enjoys a tax ben
efit (positive tax).
The calculation rate after tax is:
iaftertax = ibeforetax · (1 - t a x rate)
Example cont.
W ith a calculation rate before tax of 8 % p.a. and a tax rate of 23.5%:
Iaftertax =8 % X (1 - 0.235) = 6.12% p.3.
Using the Excel function NPV, the capital value of the investment is DKK
88,000.
Calculating the capital value after tax does not usually alter whether an
investment is profitable (or not) and it is unlikely to change the way a
company ranks alternative investment opportunities.
10B.3 Optimal life cycle

When making an investment in a project that follows a product life cycle,
or in a machine for which repair costs will increase over time, companies
must decide when to draw the project to an end or replace the machine.
This is called the life-cycle problem.
The optimal life cycle will always be less than or equal to the total tech
nical life cycle.
The optimal life cycle is determined at the start of the project or invest
ment, using financial calculations based on the budget for the investment.
If, during the life cycle, major changes occur to the assumptions on which
the budget is based, the company must repeat the calculations.
When calculating the optimal life cycle, a distinction is made between

three situations:
• The no-replacement scenario
• The identical replacement scenario
• Replace with another newer or better solution
10B.3.1 The no-replacement scenario

An investment in a product aligned with a product life cycle is usually a
one-off.
Example
A company has developed a new product, and is considering marketing it.
This would require an investment in a new machine costing DKK
400,000. The supplier is willing to buy back the machine at the scrap value
and the company budgets the annual return on the investment in the table
below.
Year Scrap value Annual net payment
1 300 245
2 200 195
3 100 135
4 0 85
The calculation rate is 10% p.a.
The optimal life cycle is determined either on the basis of the capital value
(overall consideration) or on the basis of a marginal consideration.
THE C A PITA L V A LU E C O N SID ER A TIO N
The optimal life cycle is the number of years that gives the greatest capital
value.
The transactions are plotted for each potential life cycle, i.e. one year, two
years, three years, and four years.
The payment at point 0 is the cost price of the machine (the invest
ment).
The transactions in the other years are the net payment p.a. The scrap
value is added in the final year. For example, with a life cycle of one year,
the return in year 1 would be DKK 245,000, plus DKK 3 0 0 ,0 0 0 for the sale
of the machine, resulting in a total of DKK 545,000.
Example
The table shows the transactions and the associated capital value for the
four possible life cycles.
The highest capital value (DKK 160,000) is achieved with a life cycle of
three years.
THE M A R G IN A L C O N SID ER A TIO N

The marginal consideration looks at both the net payment of the invest
ment and the costs associated with it year by year.
If the change also return on investment for the following year is higher
than the costs, the life cycle is extended by the year concerned.
The difference between the return and costs in a specific year is called the
additional cost/payment or marginal cost/payment.
Payments received for the year are the annual return on the investment.
Costs for the year consist of:
• a loss in value when keeping the machine instead of selling it. This
loss is calculated as the scrap value at start of the year (i.e. same as at
the end of the previous year) minus the scrap value at year-end.
• a loss of interest income, which arises because the company would
have received interest on the money had it sold the machine at the
start of the year. This loss is calculated as the scrap value at the start
of the year multiplied by the calculation rate.
• operational and maintenance costs.
In the example, there are no operational and maintenance costs, as they

are already included in the calculations for the project’s annual return on
investment.
Example
The table shows the calculations from the annual additional costs/
payments for each of the four years.
Loss of interest income for
Additional costs/payments
Loss of value for the year
Return on investment for

Costs for the annual net
Scrap value at year-end
for the year

payment
the year
the year
Year
0 400
1 300 100 40 140 245 105
2 200 100 30 130 195 65
3 100 100 20 120 135 15
4 0 100 10 110 85 -25
The table shows that in years one, two and three, the company receives a
positive additional payments. However, if the investment continues into
year four, it will incur additional costs (and make a loss) of DKK 25,000.
In other words, the optimal life-cycle for this investment is three years.
The two methods represent two different ways of processing the data but
they always arrive at the same result.
Calculating the capital value of the additional costs/payments will pro
duce the same result as a calculation based on the capital value considera
tion.
Example cont.
W ith a calculation rate of 10% p.a., the capital value of the additional
costs/payments for the first three years are calculated as follows:
Capital value = 105 x (1+0.10)-1 +65 x (1+0.10)-2 +15 x (1+0.10)-3 = DKK

160,000.
The Excel function NPV can also be used to calculate the capital value of
the additional payments.
10B.3.2 Identical replacement

Investment theory traditionally involves identical replacement, which
implies that the machine can be replaced on exactly the same terms and
conditions at any tim e in the future. However, in many industries, techno
logical progress now makes this unrealistic.
The theory of identical replacement is used in situations where the
same task has to be carried out in the same way every year using the same
type of machine.
Earnings are not affected by how often the machine is replaced, so it
is possible to ignore earnings when looking at the investment purely in
terms of costs.
Using identical replacement, the optimal life cycle is the number of years
that gives the lowest average annual cost.
Example
The company needs a refrigeration unit that costs DKK 1 million.
The following data is also available (DKK 1,000):
Year 1 2 3 4 5
Scrap value 750 500 400 250 0
Operating costs 200 215 250 275 325
The calculation rate is 10% p.a.
In order to calculate the average annual costs, the company first has to
work out the additional cost for each year (the marginal cost).
The annual additional costs form the basis for calculating the capital
value of the refrigeration unit for each potential year of its life cycle.
Once the company knows the capital value, it can spread it evenly across
the given number of years as an average cost.
Example cont.
The table below shows the calculations for the average annual costs.
Additional costs for the year

Operating costs for the year
Loss of interest income for
Loss of value for the year
Scrap value at year-end
Average annual cost

Capital value
the year
Year
0 1,000
1 750 250 100 200 550 500 550
2 500 250 75 215 540 946 545
3 400 100 50 250 400 1.247 501
4 250 150 40 275 465 1.564 494
5 0 250 25 325 600 1.937 511
If the refrigeration unit is replaced each year, it will cost an average of DKK
550.000 p.a. If it is replaced every four years, it will cost an average of DKK
494.000 p.a. This is the lowest possible annual cost, which means that the
optimal life cycle is four years.
10B.3.3 Replacement with a new and/or better version
If a new and/or better version comes on the market with lower annual
average costs, the company will be interested in buying the new version
instead of making an identical replacement.
Example cont.
Two years have passed since the company bought the refrigeration unit
mentioned above. The supplier is now offering a new version with the fol
lowing data:
Cost price = DKK 1,600,000

Life cycle = six years
Scrap value = DKK 300,000
Annual operating costs = DKK 120,000
The calculation rate is still 10% p.a.
The average annual costs for this new refrigeration unit are calculated as:
Average = annual operating costs + capital service costs

Average = 120 + 328 = DKK 448,000 p.a.
The capital service costs are calculated using the Excel function "PM T".
If the company buys the new type of refrigeration unit, its average cost
p.a. will be DKK 4 4 8 ,0 0 0 , which is cheaper than the old version.
In other words, identical replacement would not make sense financially.
Companies should replace their equipment with new and better ver
sions whenever the annual average costs for the new version are lower
than the annual marginal costs (additional costs) of the old version. As
long as it is cheaper to keep using old versions, companies should continue
to do so.
11 Financing
• account for a company's financing needs based on the structure of
its balance sheet
• account for the criteria applied w hen choosing forms of financing
• account for the factors involved w hen financing via equity
• account for sources of borrowed capital
• calculate APR and choose betw een loans
• draw up proposals for choosing betw een options for financing.
11.1 What is financing?

For any investment, there is a tim e lag between initial outlay and return.
During this period the company needs to have sufficient capital available
to cover its costs until it starts to receive a return on the investment. In
other words, it has a need for financing.
Investments can be long-term, e.g. in machinery and buildings, etc.,
with a long lead time before the return. Examples of more short-term
investments include stocks and debtors. Companies also invest in more
qualitative activities - staff development, branding etc. - which are more
difficult to quantify.
Companies need investment capital, which requires long-term financing,

and working capital, which requires short-term financing. Investments tie
up capital. Financing them requires procuring capital.
Investments make assets grow, while financing them makes liabilities
grow. Capital is obtained from:
• owners/shareholders
• retained earnings (self-financing)
• sale of assets (disinvestment)
• external lenders.
Equity can be obtained by owners making capital available as liquidity or

as operational funding. Self-financing consists of retaining earnings from
the previous year and transferring some, or all, of it to equity instead of
paying it out in the form of dividends. This form of self-financing is also
known as consolidation.
If an asset is sold, the capital tied up in it is released for other purposes.
This is called disinvestment. For example, a company in the process of
restructuring may sell off an entire division or a subsidiary and use the
capital this frees up to develop a different area of the business.
A prime example of disinvestment is the sale by Bang & Olufsen, in
March 2015, of its subsidiary Automotive to the speaker manufacturer
Harman for more than DKK 1 billion. Automotive makes audio equipment
for cars. The sale was part of B&O’s strategy to focus exclusively on its
core businesses while strengthening its capital base. Another form of dis
investment is when companies sell a fixed asset, a building for example,
and then rent/lease it back. This is called sale and lease-back. For example,
in 2011, TORM entered into a sale and lease-back deal for a tanker. The
proceeds of the sale ($46 million) were then available for other uses.
Capital is also raised by borrowing from external lenders, private inves
tors, banks, building societies, other types of financial institution, etc.
11.2 Changes to the balance sheet

The sum of the assets and the sum of the liabilities must always be equal.
W ithin this general framework, companies have a range of ways in which
they influence the balance sheet. The four main types of changes to the
balance sheet consist of:
1. Increasing both assets and liabilities
If the company takes out a loan and invests the proceeds in a ma
chine, or uses it as liquidity, both assets and liabilities increase.
2. Changes to assets
If the company buys a van and draws on liquidity to pay for it, there
is a shift from current assets to fixed assets without affecting the
balance sheet total.
3. Changes to liabilities
A long-term loan can be repaid by drawing on an overdraft facility.
This reduces long-term debt and increases short-term debt but the
balance sheet total remains unchanged.
4. Reducing assets and liabilities
An instalm ent on a loan is paid by drawing on liquidity. In this case,
both assets and liabilities are reduced.
The balance sheet total (total assets), along with return on capital em
ployed (ROCE), is one of the items of key data that analysts use to evaluate
companies. This means that decisions regarding changes to the balance
sheet have a direct influence on analysis of the company accounts (see
Chapter 4).
11.3 Balance sheet structure

Company management conducts regular assessments of whether a com
pany has the right balance of assets and liabilities - in particular, in rela
tion to liquidity. If the company does not have the liquid funds to cover
debts when they are due, it risks bankruptcy. However, the combination
of equity and borrowed capital is also important. This is of interest both to
the owners/shareholders in terms of return on investment and to poten
tial lenders, who will want to analyse the balance sheet before approving
any investment.
These analyses are based on one of the main subsets of the balance sheet:
Balance sheet
Assets Liabilities
Fixed assets Equity

Current assets Borrowed capital (debt)
The relationship between the main groups of liabilities is presented verti

cally on the balance sheet. The relationship between the individual groups
of assets and liabilities is presented horizontally.
Example
The following sections analyse the group balance sheet for BoConcept on
30 April 2014. The balance sheet is shown in Figure 11.1.
BoConcept 30/04/2014 (DKK million)
Balance sheet
ASSETS LIABILITIES
Total fixed assets 249 Total equity 210
Total current assets 333 Long-term debt 90
TOTAL ASSETS 582 Total short-term debt 282
Total debt 372
TOTAL LIABILITIES 582
O perating profit -22
Net financial costs -2
Profit before tax -24
Figure 11.1 BoConcept balance sheet, 30 April 2014, adapted to analyse the balance sheet
structure and selected posts from the income statement 2013/2014.
The calculations relating to the balance sheet structure below differ slight
ly from the calculations used to work out the key data in the analyses of
company accounts in Chapter 4. All figures in the analysis of the balance
sheet structure are year-end figures because the analyst is interested in a
snapshot on the balance sheet date, not an average over the year. Minority
interests and provisions are included in the debt figures.
11.3.1 The vertical balance sheet structure

Equity ratio (solvency) and financial risk are used to analyse the vertical
balance sheet structure.
Equity ratio (solvency)

The equity ratio shows the proportion of total assets financed from equity
(see also Section 4.6.4).
On 30 April 2014, BoConcept would have been able to cover all of its debts,
even if it had lost as much as 36% of its assets, i.e. 36% of its assets were
covered by equity.
Another way of analysing the composition of liabilities is the debt ratio,
which shows the proportion of borrowed capital (creditors) in relation to
total liabilities.
The calculation shows that 64% of BoConcept's liabilities are financed from
borrowed capital. W hen added to the solvency ratio they add up to 100%.
When evaluating the solvency ratio, lenders do not just look at the risk of
the company losing assets. The most important consideration is whether
the company’s earnings are sufficient to pay the principal and interest on
existing and potential loans. As a result, it is impossible to evaluate the
balance sheet structure without first assessing the company’s earnings.
Another element of the vertical balance sheet structure is the relation
ship between return on equity, return on capital employed, cost of debt
and gearing. This was also discussed in 4.6.1, which showed that, if the
cost of debt is lower than the cost of capital employed, the company earns
money on borrowed capital. Higher gearing would also improve the return
on equity.
As BoConcept has a negative interest margin of 4.5% (-3.9% - 0.6%), re
ducing the gearing would improve the company’s return on equity. In the
current financial year, BoConcept is losing money on its financing disposi
tions. Had the interest margin been positive, a higher gearing above the
current 1.8 would have improved the return on equity.
11.3.2 The horizontal balance sheet structure

The horizontal balance sheet structure focuses on the ability to pay. Com
panies must have sufficient liquidity to pay what they owe at any given
time.
Investments in fixed assets usually have a relatively long payback peri
od. They should therefore be financed by means of long-term capital such
as equity or long-term debt. Conversely, short-term debt should not be
used for long-term investments.
Example
The relationship is shown in the formula:
Fixed assets make up 83% of the long-term capital in BoConcept. As long

as this figure is under 100, it means that long-term capital is greater than
fixed assets.
BoConcept is well within this limit.
As shown in Chapter 4 (4.6.4), the liquidity ratio describes the relation

ship between short-term debt and current assets. Current assets should
be greater than short-term debt so that sufficient liquidity is available to
cover payments when they are due.
The liquidity ratio should be over 130. The exact figure depends on how
long it takes to turn debtors and stocks into liquid funds and how soon the
short-term debt has to be paid.
Approximately 43% of BoConcept's current assets consist of stocks, i.e. the

type of current asset that takes longest to turn into liquidity. A high liqui
dity ratio is therefore important.
11.3.3 Overall evaluation

An overall evaluation of the balance sheet structure provides manage
ment with a basis on which to make decisions regarding the most appro
priate way to cover its financing needs, e.g. whether the capital should be
short-term or long-term, equity or borrowed capital, etc.
Lenders are also interested in the risk of losing their investment (in the
event of insolvency) and in the risk of the borrower not having sufficient
liquidity to cover interest and instalm ents at the agreed times. Analysing
the balance sheet structure provides a snapshot of these factors.
The calculations for BoConcept show that the liquidity ratio is approach
ing 100, which could indicate a critical situation or trend. However, there
does not appear to be any need for additional financing for operations. On
the other hand, the company is losing money on its financing needs, as the
return on capital employed of -3.9% p.a. is less than the cost of debt of 0.6%
p.a. This indicates that the gearing should be reduced.
However, it can be assumed that this is not an ongoing situation. Re
turn on capital employed for the other years included in the analysis was
higher than cost of debt and this is likely to be the case again once Bo
Concept has a slightly better control over operations. The conclusion is,
therefore, that the vertical balance sheet structure (the gearing) does not
need to be changed.
11.4 Evaluating financing options

When evaluating the best way to meet financing needs, a number of fac
tors have to be considered.
The following criteria are useful:
• Costs
Borrowing costs vary widely depending on the source of the financ
ing. Taking out a loan usually involves start-up costs as well as ongo
ing costs in the form of interest payments and instalments.
Comparisons of different loans are made by calculating the effec
tive interest rate or annual percentage rate (APR).1
The different types of costs are taken into consideration when
studying financing options.
• Liquidity
Equity does not have to be paid back. Some types of loan are repay
able over five, 10 or 20 years, while an overdraft facility can be can
celled at very short notice.
It is important that the repayment plan is realistic in relation to
the company’s ongoing capital needs or the proceeds generated by
the project.
• Risk
Equity financing carries no risk.
Various types of risk are associated with borrowed capital. Vari
able rate loans are often cheaper than fixed rate loans. Variable rates
follow the market, which means they are adjusted regularly - up and
down.
1 See 11.9.
Taking out loans in a foreign currency entails a risk of adverse ex
change rate fluctuations. Various forms of currency hedging are used
to eliminate this risk.
• Security
Lenders often require some form of security for repayment of their
loans, e.g. a mortgage on the asset (building societies always take out
security on the properties for which they provide mortgages). A bank
may require security on an asset. In privately owned companies,
banks are also entitled to demand security on the owner’s personal
assets when offering an overdraft facility.
Another form of security is a guarantee. It is common for a parent
company to guarantee loans in a subsidiary. If the subsidiary is una
ble to pay, the parent company (the guarantor) becomes liable for the
debt. Owners also issue guarantees for their companies and private
individuals also issue guarantees to one another.
• Dependence
If equity is injected by a new owner of a stake in a company, the indi
vidual concerned also gains a certain degree of influence. Formally,
lenders do not usually get a decision-making role in companies to
which they lend money. However, if the company has problems mak
ing its repayments or otherwise needs to renegotiate the terms and
conditions of the loan with the lender, it may be necessary to accept
intervention in decision making.
• Flexibility
It is not always possible to predict every potential turn of events at
the start of an investment project. This makes it a good idea to agree
on options for flexible settlem ents of the loan, e.g. exceptional pay
ments or full early repayment. Some lenders charge a fee for this type
of flexibility.
For loans taken out abroad, the flexibility can consist of the option
of switching the outstanding debt into a different currency at some
point. It is also possible to hedge these loan types.
11.4.1 Choosing between equity and borrowed capital

Management’s main decision is whether the company financing needs
should be met from equity or borrowed capital. Figure 11.2 shows the dif
ference between the two options.
Equity Borrowed capital
Influence Direct via the board or indirectly None in principle
via annual general meeting
Repaym ent None Instalments as agreed
Return Dividend if there is profit Interest as agreed
Position in event If there is any money left after all Paid back before equity - perhaps
of insolvency of the creditors have been paid, it pro rata, if there is not enough
is divided up between the owners money left.
in relation to the size of their stake
in the company
Figure 11.2 Significant differences between equity and borrowed capital.
Injections of equity add capital without incurring interest payments but

they may entail a trade-off in terms of influence.
11.5 Shareholder value

The concept of shareholder value emerged from the United States but has
gained a foothold in Danish business. The principle mainly applies to list
ed companies. As the name implies, the idea is that the company should
make decisions that provide the greatest possible return for its sharehold
ers. The return can take the form of dividends or higher share prices.
Although the main aim is to look after the interests of shareholders, the
argument goes that the principle benefits everybody with an interest in
the long-term well-being of the company.
This section introduces a number of initiatives often mentioned in rela
tion to shareholder value.
11.5.1 Capital structure

Section 11.3.1 showed that higher gearing improves return on equity, if
the return on capital employed is greater than the cost of debt.
Companies that work with shareholder value will therefore be inclined
to prioritise a high debt ratio over a high solvency ratio. They will set the
debt ratio at a level where the company has just the right amount of equity
and cash funds for its current activities and those planned in the immedi
ate future.
This means that, if a company has greater liquidity at its disposal than
it needs, the debt ratio can be increased by reducing equity. This can be
done either by reducing the company’s distributable reserves (retained
earnings) via dividend payments or by reducing the equity.
DIVIDENDS
At year-end, when making decisions about dividends, the board should
always consider whether the money would be better spent on projects
that would provide a competitive return. If not, then the profit should be
shared among the shareholders, who will then decide how best to invest it.
Similarly, a company with grater accumulated liquidity than it needs
for day-to-day operations, and which does not have plans for investments
that would provide a competitive return, may choose to pay dividends.
Dividend payments reduce the distributable reserves.
BUYING UP SHARES IN THE COM PANY

In recent years, a number of listed companies have bought and then an
nulled their own shares. One example is Royal Unibrew, which in March
2015 announced that over the coming months it would acquire up to DKK
35 million of its own shares and adapt its capital structure.
This does not generate any value p er se, but it does reduce the number
of shares in circulation. In other words, the total value of the company is
divided into fewer shares, which automatically increases the price of the
shares still in circulation. Fewer shares also raises the value of key ratios
such as earnings per share and price/book value.
The advantage of this method of reducing equity is that the sharehold
ers determine when to cash in on the increased higher market value by
selling the shares, whereas the point in time at which dividend payments
are made is fixed in advance.
Reducing equity is not risk-free, however. One risk is that reserves may
be too low to withstand a number of years with poor operating results (e.g.
during a recession, increased competition, etc.).
INCREASE IN BO RRO W ED CAPITAL

The debt ratio can, of course, also be increased by raising new loans. How
ever, this exacerbates the financial risk, as the company has to bring in
sufficient liquidity at some point to repay and pay instalm ents and inter
est on the increased debt.
11.5.2 Options as rewards for staff and management

The interests of managers who receive shares and options as part of their
remuneration package coincide with those of the shareholders.
Payment in the form of options usually involves the company giving
the recipient (board member, director or employee) a right - but not an
obligation - to purchase a share in the company at any future date and at
a pre-arranged fixed price (the option exercise price).
One argument in favour of this type of remuneration package is that
it motivates the option-holder to make an extra effort to ensure that the
share price exceeds the option exercise price at the future date. This has
a financial benefit for the option-holder and shows shareholders that the
company focuses on its share price.
The disadvantage is that it may encourage the option-holder to run ad
ditional risks. This was one of the factors that led to the problems faced by
some of the banks during the financial crisis.
11.5.3 Focus on core competencies

The strategy of focusing on core competencies may not be directly related
to shareholder value, but it is often mentioned in the same context. As
well as trying to increase earnings by accumulating expertise, it implies
concentrating on a narrower range of business areas so that potential
shareholders know exactly what they are investing in. If a company has a
wide range of activities,2 investors do not have this choice.
A. P. Moller Maersk is an example of a company that has reduced diver
sity in recent years, selling off stakes in aviation, plastics and pharmaceu
ticals to concentrate on shipping, oil and gas and Danske Bank.
11.5.4 Open information policies and corporate governance

Examples abound to illustrate the fact that listed companies are now pro
viding more and more information about issues previously kept in-house,
or not quantified at all. As mentioned in Chapter 5, many companies now
publish CSR reports and/or other supplementary reports. The aim is to
convey values to current and potential shareholders that are not purely
financial and show what the company is doing to achieve them.
The recognition that investors and stakeholders read up on information
policies to m aintain and enhance confidence in their investments has led
to many listed companies setting up special departments and sections on
their websites to convey this type of non-financial information.
2 Referred to as a conglomerate.
CORPORATE GOVERNANCE
The Copenhagen Stock Exchange3 has implemented the recommendations
issued by the Committee on Corporate Governance.4
The recommendations cover nine main areas:

1. The role of the shareholders and their interaction with management
2. The role and importance of stakeholders to the company and social
responsibility
3. Openness and transparency
4. The duties and responsibilities of senior management
5. The composition and organisation of the senior management team
6. Management remuneration
7. Financial reporting
8. Risk management and internal controls
9. Auditing.
A number of sub-items are defined for each of the main areas. Please refer
to the report for a complete list.
As mentioned previously, the Copenhagen Stock Exchange recom
mends that listed companies comply with the recommendations on good
corporate governance. As several other countries have already made great
er progress in this field, it is important for foreign investment in Danish
listed companies that they provide information about these factors.
The EU is working towards a harmonisation of the rules for corporate
governance. Until the member states agree on a legal requirement for com
panies to provide information about corporate governance, the compro
mise is that companies must “comply or explain”, i.e. formally comply with
the recommendations or explain why they do not.
The Committee on Good Corporate Governance conducts regular sur
veys of compliance with the recommendations.5
11.6 Equity
The incentive for investors injecting equity into a company is usually the
expectation that the value of the company will grow. Dividend payments
are not always as important to the owners/shareholders. In both public
3 NASDAQ OMX Copenhagen A/S: www.nasdaqomxnordic.com.

4 The Committee on Good Corporate Governance: "Recommendations for good corporate
governance", August 2011, www.coprorategovernance.dk.
5 See www.coprorategovernance.dk.
and private limited companies, dividend payments reduce the amount of
capital available. If the company is good at generating a return on equity,
transferring profit to equity (retained earnings) is sometimes a better op
tion.
11.6.1 Types of company

Equity requirements vary according to company type.
Privately owned companies

In private companies and partnerships, equity is built up through profits
after withdrawals for private use. In principle, no distinction is made be
tween the company’s capital (equity) and the owner’s assets.
Private and public limited companies

The owners of a company may wish to separate its finances from their
own private assets. This is done by setting up a private or public limited
company (incorporating), which then acts as a separate financial and legal
entity.
The equity requirement for private limited companies is a minimum of
DKK 50,000. For public limited companies, the minimum is DKK 500,000.
Current or new owners/shareholders are allowed to add additional equity
at any time.
Entrepreneur companies
Since 2014, it has been possible to set up entrepreneur companies. These
are a special type of limited liability company, with a minimum start-up
equity of only DKK 1.
The equity must be built up to (at least) DKK 50,000 by transferring a
minimum of 25% from annual profits to a special reserve. Dividends may
only be paid once the total equity, in the form of reserves and company
capital, reaches DKK 50,000.
The advantage of this type of company is that the capital start-up is
only DKK 1, which helps increase the number of entrepreneurs. However,
it is safe to assume that potential creditors will make heavy demands for
security on any form of loan.
Listing on the stock exchange

A public limited liability company can be listed on the Copenhagen Stock
Exchange, which is now a part of the Nordic Exchange OMX Group, or on
a foreign exchange.
The actual listing takes the form of the company’s shares being offered
and sold to a wide range of investors. The shares concerned may be exist
ing shares, new ones or a combination of both. Trade in existing shares
does not add capital. The proceeds go directly to the seller, i.e. the previ
ous owner. Sales of new shares add new equity. A company that is already
listed has the option of generating new equity by offering new shares for
sale via the exchange on which it is listed.
If a company wants to be listed on the Copenhagen Stock Exchange,
or if an already listed company wants to issue new shares, it publishes a
prospectus consisting of financial statem ents and other information for
prospective investors. The prospectus must be approved by the Stock Ex
change.
The benefits of listing include always knowing the market price for
shares in the company6 and the degree of flexibility afforded to sharehold
ers, who are able to sell at the going rate at any time. The latter is also im
portant in companies that want to reward their staff and/or management
with shares and share options.
Listing on the Stock Exchange means a company has access to a very
wide range of investors whenever it needs to raise new equity. For many
companies, listing confers a great deal of prestige and boosts their public
profile. However, it also entails additional obligations. There are direct
costs in the form of an annual fee to the Exchange, a fee to a bank for
m aintaining a share book,7 and costs associated with printing annual ac
counts, holding the annual general meeting, etc.
Companies listed on the Copenhagen Stock Exchange must publish au
dited half-year financial statem ents and the Exchange recommends that
they also publish quarterly statements. Any other information that may
affect the share price must be immediately published via the Exchange,
e.g. information on major new orders, the acquisition of a new company,
a director’s departure, etc. The most recent of these statem ents are pub
lished on the company website or on the Exchange’s website. The Stock
Exchange also requires that listed companies comply with the recommen
dations of the Committee for Good Corporate Governance.
www.nasdaqomxnordic.com
www.euroinvestor.com
6 In practice, many shares are not liquid and are not traded every day.
7 A list of all shareholders, which is used for paying out dividends.
Venture capital
In recent years, a large number of venture-capital companies have been
set up with the purpose of investing in companies that need new capital
to realise their growth targets. The invested capital is often accompanied
by management expertise, in one form or another. Many venture-capital
companies currently focus on the pharmaceutical and IT industries. Dan
ish Kapitalanlæg (www.dankap.dk) is one example of a listed venture-cap
ital company, while others are owned by major banks, pension funds or
private individuals.
Investments by venture capital companies are often associated with a
high level of risk but also with the potential for high returns if the com
pany is successful and is later sold to another company or listed on the
stock exchange.
O ther types o f company

Other types of company include limited partnerships, co-operatives and
funds. Appendix 1 contains an overview of the types of company and their
characteristics.
11.7 Borrowed capital

Investors interested in a pre-agreed rate of return and a fixed repayment(s)
make borrowed capital available.
11.7.1 Types of loan

The investment calculation in Chapter 10 starts with an outlay, followed
by a series of payments received. The opposite is the case with financ
ing. When a loan is taken out, the company receives a payment (the loan
proceeds) and then it makes repayments (the interest and the principal)
during the loan term.
The company agrees with the lender how the loan is to be repaid. The
most important concepts referring to loans are listed in Figure 11.4.
Principal The am ount borrowed. The w h o le principal must be repaid.
Proceeds The am ount that the borrow er receives w hen the loan is paid out. The
proceeds are less than the principal am ount if expenses are incurred in the
process o f taking out the loan.
Duration The number of years it takes until the loan is repaid.
Instalments The repayments on the principal. The sum of the instalments over the en
tire loan period is equal to the principal.
Outstanding Principal minus repayments paid.

debt
Nominal inter The cost the company pays to have the loan available. The interest rate is
est rate usually expressed as a percentage o f the principal/outstanding debt.
Payment The sum of the interest and instalments for the period concerned.
Payment date The tim e at which payments are made. The date is usually annual, half-
yearly, quarterly or monthly.
Figure 11.4 Terminology used in loan calculations.
BU LLET LO ANS
Bullet loans are also known as fixed or standing loans. The whole of the
principal is repaid at the end of the loan term. During the loan term, inter
est is paid at each payment date. Figure 11.5. illustrates the servicing and
repayment profile for bullet loans.
Figure 11.5 Payments and outstanding debt for bullet loans.
SERIAL LOANS
With serial loans, the principal is paid back in equal instalments at each
payment date along with interest. The interest per instalm ent is calcu
lated on the basis of the amount owed at the start of the payment period
concerned (the outstanding debt). Figure 11.6 illustrates the servicing and
repayment profile for serial loans.
Figure 11.6 Payments and outstanding debt for serial loans.
ANNUITY LOANS
Annuity loans are paid back in equal payments at each payment date.
The amount per payment is calculated so that both the principal and the
agreed interest are paid off over the course of the loan term.
Many loans are annuity loans, as it is often convenient from the bor
rower’s perspective that all payments are equal.
Figure 11.7 Payments and outstanding debt for annuity loans.
11.7.2 Sources of borrowed capital
Companies borrow capital from a variety of sources, the most important
of which are discussed below.
BANKS
Companies can borrow both fixed and working capital from banks.
Fixed capital is often provided as long-term capital secured on the as
set for which the money is loaned. A setup/establishment fee is paid to
the lender and a registration fee to the government. The interest is either
fixed or variable and the loans are often annuity loans.
A company’s need for working capital can often be covered by an over
draft facility with an agreed maximum credit limit. A setup fee may be
charged as well as a registration fee if the bank requires security. The on
going costs can be a combination of commission and interest, or just inter
est. The commission is calculated on the basis of the size of the credit fa
cility and the interest rate on the amount drawn on it. Overdrafts without
commission have higher interest rates, of course, but this can be an advan
tage if the company only draws on a small amount of the available credit
facility. Often, the parties do not agree in advance how the overdraft will
be settled. Rather, it is an ongoing credit facility renegotiated once a year
or every two years or so.
LOANS RAISED ABROAD

Loans raised abroad are usually mediated via the company’s Danish bank,
which also guarantees that the company will make the repayments. In ad
dition to setup costs and ongoing interest payments, the company also
has to pay for this guarantee. Fluctuations in the credit currency will af
fect the interest paid and instalments. To minimise or eliminate the risks
associated with exchange fluctuations, companies can enter into hedging
agreements with their banks - for which there will also be a cost.
M ORTGAGE CREDIT INSTITUTE LOANS

Mortgage credit institutes offer fixed rate, long-term loans secured against
property. They are usually annuity loans. The mortgage credit institutes
issue bonds to finance loans. These bonds are traded on the Copenhagen
Stock Exchange. This usually leads to a capital loss, as the loan will be paid
out at a price below 100.
The extent of the capital loss depends on the interest rate on the loan.
A relatively low rate of interest leads to a large capital loss and therefore
lower loan proceeds, while a loan with a relatively high interest rate means
lower capital losses and larger loan proceeds.
When taking out loans from building societies, companies must con
sider how the borrowing costs will be spread across ongoing costs and the
capital loss, which is payable on the loan date. The tax implications also
have to be taken into account, along with any options for early redemp
tion, conversion, etc.
In addition to the capital loss at the time the loan is taken out, setup
and registration fees also have to be paid. During the loan term, the build
ing society will charge fees for administration, losses and provisions along
with its charges for interest and repayments. For more about building so
ciety loans, refer to the websites of companies like Nykredit, Totalkredit,
BRFkredit or Realkredit Denmark.
www.nykredit.dk
www.totalkredit.dk
www.brf.dk
www.rd.dk
FIXED-RATE AND ADJUSTABLE-RATE MORTGAGES

Building societies also offer loans at variable interest rates. Adjustable
rate loans are only issued against security in property. They are long-term
loans but based on short-term bonds, e.g. lasting one, two or five years.
If a company takes out a 30-year loan based on two-year bonds, the loan
has to be refinanced every two years, i.e. a total of 15 times. Each time, the
interest rate is adjusted to the current market rate for two-year bonds. If
the market rate is rising, the payments go up or the loan term is extended.
If the market rate falls, the opposite is the case.
Adjustable-rate mortgages make up a large proportion of the building
societies’ total loan portfolios, as the interest rate on short-term bonds is
usually lower than the interest rate on long-term bonds.
Example
Adjustable-rate loan
A 30-year adjustable-rate loan with an annual interest rate adjustment can
be taken out at an interest rate of 1% p.a. The price is 100. Repayments
are quarterly, which means there will be 120 repayments at an interest rate
of 1%/4 = 0.25% per quarter.
If the principal is DKK 1 million, the repayment per quarter is DKK 9,656.
Fixed rate loan

Similarly, a 3% 30-year fixed rate loan can be taken out at price of 100.
This loan also requires quarterly repayments, which again gives 120
payments at an interest rate of 3%/4 = 0.75% per quarter.
If the principal is DKK 1 million, the repayment per quarter is DKK
12,667.58.
These calculations are before tax and any administration fees, etc.
The example shows why adjustable-rate loans are popular. However, the
fact that repayments depend on interest rate trends right from the start
means there is also an inherent risk associated with them.
This risk can be minimised by capping the adjustable-rate loan. A
capped loan starts out as an adjustable-rate loan but has a built-in guar
antee that, if the interest rate rises to a specified level, the loan will auto
matically be converted into a fixed-rate loan. In other words, the borrower
assumes less risk than with an adjustable-rate loan because it knows the
maximum repayment in advance. These loans with an interest rate cap are
marketed under names like FlexGaranti (Realkredit Denmark), Guarantee
Loans (BRF) and RenteMax (Nykredit).
INTEREST-ONLY LOANS
Since 1 October 2003, building societies have been allowed to issue loans/
mortgages with an interest-only period of up to ten years. During this pe
riod, only the interest on the loan is repaid. The outstanding debt is not
reduced. These loans are also referred to as bullet loans (standing/fixed
loans), even if the interest-only period is only for ten years, rather than
for the whole loan term.
After the interest-only period, the borrower has two options: pay the
outstanding debt within the original loan term of 30 years, which means
making bigger repayments per instalment, or paying it as a lump sum at
the end of the loan term. Figure 11.8. illustrates the two options.
Figure 11.8 Outstanding debt profiles for interest-only loans. Source: www.brf.dk.
THE DANISH GROW TH FUND

The Danish Growth Fund is a public-sector body that offers risk capital to
companies with growth potential. The Fund’s website (www.vaekstfond
en.dk) provides links to venture-capital companies, etc., that also provide
investment capital.
SUPPLIERS
If they provide credit, the company’s suppliers are another source of fi
nancing. By accepting their credit, the company postpones drawing on its
own liquidity or overdraft facility.
However, accepting a supplier’s offer of credit is not always the best op
tion. Cash discounts are often an alternative. W hether or not a company
should accept a discount depends on the interest rates on its liquid hold
ings and overdraft.
11.7.3 Leasing
Leasing is a form of rental agreement for the use of an asset. The person
taking out the lease (the lessee) has the right of use on the asset, while the
person providing the lease (the lessor) has the right of ownership - and
thus the right to depreciation for tax purposes. The assets involved can
be anything from buildings and custom-built machines to cars, IT equip
ment, etc. The right of use is transferred for a fixed period, during which
the lessee makes a monthly or quarterly payment to the lessor.
If it opts to lease, a company does not have to raise capital to finance an
asset. Instead of interest and repayments, it makes lease payments. The
decision to lease or buy is a financial decision.
A distinction is made between different forms of leasing: financial and

o p eratio n al.
Financial leasing is when a lessee not only assumes the right of use but also
assumes all of the risk, including paying for any repairs, maintenance and
other running costs. Financial leasing is often chosen for custom-built as
sets such as buildings or specialised machinery. The lease period often
covers a large part of the asset’s useful life cycle, and the lessee often takes
over the asset at a predetermined price when the lease expires.
Operational leasing covers all other lease agreements. The parties can
reach different types of agreements about which one of them covers which
running costs. The assets involved are usually more standardised, e.g.
company cars, and the lease is for a shorter period. Again, the lessee often
acquires the asset at an agreed price when the lease expires. See www.nor
dania.dk for further information about leasing.
A company can also choose to sell a fixed asset (typically a building or a
machine) to a leasing company and then lease it back. This arrangement is
called sale and lease-back. It is a disinvestment but the company does not
lose the right to use the asset.
11.7.4 Tax and financing

Financing costs are included in tax calculations for individuals and com
panies. Ongoing costs -in terest rates, commission, etc.8 - are tax deduct
ible. So are exchange losses or gains related to foreign loans and set-up
costs.
For companies, the deduction is equal to the corporation tax rate of
23.5% in 2015 and 22% from 2016.
For individuals, financing costs are deducted from capital income at a
rate of approximately 30% in 2015. The rate will be reduced by 1% per an
num, reaching approximately 26% in 2019.
11.8 Choosing types of financing

The type of financing a company chooses depends very much on its strat
egy. Some prefer to be as self-sufficient as possible, others work with a
high debt ratio in order to generate a high return on equity. Some prefer to
own their assets, others prefer to lease them.
W ithin these strategic parameters, and factors such as balance sheet
structure, companies have to decide whether they prefer to add equity or
borrowed capital, with all the advantages and disadvantages associated
with both types of capital.
The choice also depends on what the money will be used for. The repay
ment profile, loan term, costs, security, risk and flexibility should all be
considered in that light.
The provider is another consideration. In the case of equity, companies
can either turn to the current owners or seek to increase the number of
owners. For borrowed capital, the choice is between the benefits associ
ated with restricting borrowing to a small group of lenders and spreading
business around in order to keep more options open.
It is also worth mentioning that companies do not always have a great
deal of choice. If a company is in a tight financial situation, it may be forced
to accept what its current creditors are willing to offer.
8 Th e D anish Tax Assessm ents A ct, 8 (3).
11.9 Calculating annual costs of financing as a percentage
The main item of interest in any loan offer is the nominal interest rate
p.a., which is the interest rate paid on the principal. However, various
other costs are often incurred - start-up costs, interest payments several
times a year, etc. This makes direct comparisons between loans on the ba
sis of the nominal interest rate alone somewhat difficult. Other borrowing
costs, the number of times interest is added per annum, etc. are taken into
consideration to provide a comprehensive picture and evaluate the true
cost of the loan.
These factors are combined in the annual percentage rate (APR), which
is also referred to as the effective interest rate.
The annual percentage rate (effective interest rate) is the rate that balan
ces out the loan transactions.
where R is the APR.
This makes the effective interest rate a tool for comparing loans. It is
translated into an annual percentage to let companies compare loan op
tions that require a different number of payments per year. (See 11.9.2).
11.9.1 Calculating APR for loans w ith start-up costs

As well as interest payments, loans taken out with a bank, Mortgage Bank
or similar often involve start-up costs such as fees to the lender, registra
tion fees to the government and, depending on the type of loan, a capital
loss. As a result, the loan proceeds (the amount paid out) may be lower
than the principal.
Prospective borrowers look at the schedule for repaying the loan and
then calculate the proceeds and the APR.
The examples below show how to calculate the APR for an annuity loan,
a bullet loan and a serial loan.
Example - Annuity loan
Assumptions
Principal DKK 100,000
Interest p.a. 4%
Interest accrued Annually
Term 10 years
Start-up costs 2 % of principal + DKK 1,000
Price 90
Calculating the APR

First, calculate the annual repayments using the Excel function PMT.
The screenshot shows that the annual repayment is DKK 12,329.09.
The loan proceeds are then calculated:

100,000 x 0.90 (the price) - 2,000 (2% of principal) - 1,000 = DKK 87,000
The APR can now be calculated using the Excel function "RATE".
The screenshot shows that the APR is 6.9%.
Example - Bullet loan
Assumptions
Interest p.a. 4%
Term 10 years
Price 90
Calculating the APR

First, calculate the annual interest as 4 % , which corresponds to DKK 4,000.
The loan proceeds are then calculated:

100,000 x 0.90 (the price) - 2,000 (2 % of principal) - 1,000 = 87,000
The APR can now be calculated using the Excel function "RATE".
The screen shows that the APR is 5.75%.
Example - Serial loan
Assumptions
Interest p.a. 4%
Term 10 years
Price 90
Calculating the APR

First, calculate the proceeds as:
100,000 x 0.90 (the price) - 2,000 (2% of principal) - 1,000 = 87,000.
Then calculate the annual repayments. As the repayments change over

time, it is necessary to draw up an amortisation table in Excel (see below).
Amortisation table
Year Proceeds Outstanding Instalments Interest Outstanding Payments

debt at start debt at
of year year-end
0 87,000 100,000 100,000 87,000
1 100,000 - 10,000 -4,000 90,000 -14,000
2 90,000 - 10,000 -3,600 80,000 -13,600
3 80,000 - 10,000 -3,200 70,000 -13,200
4 70,000 - 10,000 -2,800 60,000 -12,800
5 60,000 - 10,000 -2,400 50,000 -12,400
6 50,000 - 10,000 - 2,000 40,000 - 12,000
7 40,000 - 10,000 -1,600 30,000 -11,600
8 30,000 - 10,000 - 1,200 20,000 - 11,200
9 20,000 - 10,000 -800 10,000 -10,800
10 10,000 - 10,000 -400 0 -10,400
The ARP is then calculated with the help of the Excel function "IRR".
The screenshot shows that the APR is 7.06%.
The calculations above show that, on the same terms, the various loan
types have different APRs due to the ways in which they are paid off.
It should also be noted that the APR must not be used to compare loans
if they are very different. In such cases, the capital value method is nor
mally used.
11.9.2 More interest payment dates pro anno

For loans on which the interest is accrued several times a year, the APR is
higher than the nominal rate.
Example
The nominal interest rate on a loan of DKK 1,000 is 12% p.a. with quarterly
accrual of interest.
This means that interest is accrued at a rate per quarter of 12%/4 = 3%.
After the first year, the loan has grown as follows:

C1 = 1,000 x (1+0.03) x (1+0.03) x (1+0.03) x (1+0.03)
C1 = 1,000x(1+0.03)4
C1 = 1,000 x 1.1255 = 1,125.50
At the end of each quarter, the outstanding debt grows by 3 % of the

amount owed at the start of the quarter. In this way, the borrower pays
interest on the interest already accrued.
The outstanding debt grows to DKK 1,125.50, which corresponds to an
APR of 12.5%.
The general formula for calculating the APR based on a nominal annual
interest rate that is applied multiple times during the course of the year
looks like this:
W here R = the APR

r = the nominal interest rate p.a.
m = the number of times interest is charged p.a.
Example
Entering the numbers from the previous example produces the following
result:
Sometimes, however, companies need to spread the annual interest rate

over payment dates in a way that maintains the annual rate, e.g. if they
apply an annual calculation rate to payment periods shorter than a year.
In the example above, the interest per quarter that provides an annual
interest rate of 12% will be less than 3% per quarter.
The general formula for calculating the effective interest rate per re
payment based on a nominal annual interest rate looks like this:
r = (1 + R)1/m-1
where r = interest per instalment

R = interest rate p.a.
m = the number of times interest is charged p.a.
Example
A company wishes to convert a calculation rate of 12% p.a. to a calculation
rate per quarter.
Entering the numbers into the formula produces the following result:
r = (1 + 0.12)1/4 - 1 = 0.0287 = 2.87%
In other words, an interest rate of 2.87% per quarter corresponds to 12%

p.a., compund interest.
11.9.3 Overdrafts
Companies pay either interest and commission, or interest only, on an fa
cility.9 In both cases, the interest is always paid on the balance of the over
draft, while the commission is calculated on the maximum overdraft limit.
Interest and commission are usually added on a quarterly basis.
If a company pays both interest and commission, the annual cost as a
percentage depends on the amount it draws on the overdraft facility (uti
lisation ratio).
Example
A company has an overdraft facility with a limit of DKK 10,000, pays 10%
p.a. in interest and 2% in commission. On average, it uses DKK 7,000 of the
overdraft facility. Interest and commission are due quarterly.
where R = the effective interest rate per payment date

r = the nominal interest rate per payment date
p = commission rate per payment date
u = the average utilisation ratio
9 Some banks now only charge interest for overdrafts. This makes the rate higher, as the bank
incorporates its commission into the rate.
The interest rate is converted to an annual rate:
R = (1 + 0.0321)4 - 1 = 0.1347 = 13.47% p.a.
The formula shows that, in percentage terms, a higher utilisation ratio

results in lower annual costs. This is because commission is also paid on
the unutilised part of the overdraft facility.
11.9.4 Credit from suppliers

Companies are often able to finance their purchases by accepting credit
from suppliers. The terms and conditions vary, but this is often a relative
ly expensive form of financing, as the supplier needs to cover the interest
charges associated with extending credit, as well as the risk of incurring
losses on it.
Example
A supplier offers the company a cash discount of 2% if it pays within 15
days, or credit for 60 days.
In order to purchase goods worth DKK 100, the company has two opti
ons:
1) Take the cash discount and pay DKK 100 minus 2%, i.e. DKK 98, within
15 days.
2) Take the credit and pay DKK 100 after 60 days.
The 45-day difference can be considered a new payment date. The effec
tive interest rate per payment date is:
98 = 100 x (1 + R)-1 => R = 2.04% per payment term.

The interest rate per payment date is converted to an annual rate:
The number of payment dates per year = 360/45 = 8
R = (1 + 0.0204)8 -1 = 0.1753 = 17.53% p.a.
If the company borrows the money from the supplier, it is paying an inter
est rate of 17.53% p.a. If the APR on its overdraft facility is lower than this
figure, it would be better to pay in cash.
11 Appendix
Advanced financing
11A.1 Comparisons between buying and leasing

If a company chooses to lease fixed assets instead of buying them, they are
effectively financed by the leasing company. The company itself does not
borrow money. It pays a monthly or quarterly leasing fee during the period
covered by the leasing agreement.
As buying and leasing are treated very differently for tax purposes, the
following example is calculated both before and after tax.
The Excel spreadsheet on which the tables in the example are based is
available on the website accompanying the book.
Example
A company is considering a project that will lead to the following annual
contribution margin (DKK 1,000):
Year 1 2 3 4 5
Contribution margin 600 650 800 750 400
The project requires a machine that costs DKK 2.6 million and has a scrap
value of DKK 600,000 after five years.
The machine could also be leased for five years for an annual payment
in advance of DKK 550,000.
The calculation rate is 12%, the tax rate is 23.5%.
The pre-tax calculation
The comparison between buying and leasing is made by drawing up tables
showing the alternative transactions and calculating the capital values.
Example cont.
Buy Lease
Cost
price and
scrap Contribution Cash Contribution Cash
Year value margin flo w Year Paym ent margin flo w
0 -2,600 -2,600 0 -550 -550
1 600 600 1 -550 600 50
2 650 650 2 -550 650 100
3 800 800 3 -550 800 250
4 750 750 4 -550 750 200
5 600 400 1,000 5 400 400
Capital value = 67 Capital value = 106
The leasing payments are paid in advance. In the example, this is illustrat
ed by plotting the first payment in year zero, i.e. it constitutes the balance
at the start of year one.
The table also shows that leasing provides a capital value of DKK
106,000, compared to only DKK 67,000 for buying. In other words, leasing
is a better deal when the calculations are made before tax.
A fter-tax calculation
However, tax considerations can significantly affect the decision to buy
or lease.
If the company buys the machine, it is entitled to depreciation and tax
deductions. Depreciation (based on the declining balance method) is 25%
p.a. In year five, the depreciation is equal to the balance at the start of year
five minus the scrap value. Tax is calculated as the contribution margin
minus depreciation. The tax rate is 23.5% on the taxable amount.
Example cont.
Cash
flo w
Balance Contri Tax after Cost price All
at start Depre bution Taxable rate tax for and scrap cash
Year o f year ciation margin am ount 23.5% the year value flo w
0 -2,600 -2,600
1 2,600 650 600 -50 12 612 612
2 1,950 488 650 163 -38 612 612
3 1,463 366 800 434 -102 698 698
4 1,097 274 750 476 -112 638 638
5 823 223 400 177 -42 358 600 958
Capital value = 77
The cash flow after tax for the year are equal to the contribution m argin
m inus tax. Depreciation is not classified as a paym ent and is not included
in these transactions. The tax am ount is negative in year one. It is as
sum ed th a t th is tax deduction can be applied to other company activities.
The cost price of the m achine is included in year zero. In year five, the
scrap value is included in the annual transactions a fter tax.
The capital value after tax is calculated on the basis of the transactions
after tax. The calculation rate is also adjusted for tax.
Ia fte r tax = i pretax · (1 - th e t a x ra te )

iaftertax = 1 2 % ·(1 -0.235) = 9.18%
If the company buys the machine, the capital value after tax is DKK 77,000.
If the company opts to lease, it does not own the m achine and is not
entitled to depreciation on it. On the other hand, the annual leasing pay
m ents are tax-deductible.
Example cont.
Leasing Transactions
Contribution Leasing Taxable payments for the year
Year margin payment am ount Tax 23.5% made after tax
0 -550 -550
1 600 -550 50 -12 -550 38
2 650 -550 100 -24 -550 77
3 800 -550 250 -59 -550 191
4 750 -550 200 -47 -550 153
5 400 -550 -150 35 435
Capital value = 84
Even though the lease payments are paid in advance, the tax deductions
apply to the year to which they are assigned.
The taxable amount consists of the contribution margin minus the leas
ing payment. The rate of tax is 23.5% on the taxable amount. The calcula
tion of the annual transaction takes account of the fact that the leasing
payments are made in advance.
The calculation rate after tax is used to calculate the capital value.
The capital value after tax of leasing the machine is DKK 84,000.
The results show that when the calculations are made after tax, there
is no great financial difference between buying and leasing. The capital
value is DKK 77,000 if the company buys the machine and DKK 84,000 if
it leases.
Although leasing is still more beneficial, the difference is small enough
for other qualitative criteria to affect the decision-making.
PART 5
12 Business plans and
marketing plans

• understand a business plan in its entirety
• calculate the financial consequences of decisions set out in a
business plan
• understand a marketing plan in its entirety
• calculate the financial consequences of decisions set out in a
marketing plan.
Anybody contemplating a new business venture, no m atter what kind, has

to answer a range of questions before putting the idea into practice. For
example:
• What is my idea?
• What products do I want to sell?
• Who will be my customers?
• Who will be my competitors?
• How will I differentiate myself from the competition?
• What markets do I want to operate in?
• How will I sell my product(s)?
• How much will it cost to start up the company?
• How will I finance the start-up phase?
• What knowledge and experience do I have in this area of business?
• Do I need additional information?
• What will I do myself right from the start, and what should I out
source?
Once these questions have been answered, it is time to draw up a business

plan
12.1 The business plan
A business plan describes the basis (platform) for the new company and
how it will operate and develop. The business plan is a summary of the
information needed to start and grow a new business. Essential points to
clarify include:
• in-depth knowledge of the product/service to be sold or produced
• the market for the service or product
• marketing and distribution
• the financial aspects of the start-up and operations
• production factors.
A business plan can be divided into the following six sections:
1. Sum mary
The summary provides a quick overview of the idea, market opportunities
and the owner’s background, along with key budget data and information
about expected costs.
2. Mission
The mission is the basic idea behind the company and permeates all of its
activities. The mission indicates the path the company will take, and must
permeate everything the company does.
3. Personal data, targets and resources

In order to start a new business or take over an existing one, either as a
sole proprietor or along with others, the individuals involved must decide
whether they have the capacity and resources to turn the project into a
reality
4. M arket description and analysis o f the situation

An evaluation of the supply and demand situation has to be conducted
before the newly established company can be marketed and publicised
properly.
Figure 12.1 Model for describing the current market situation.
5. About the company

After the initial questions have been asked and answered and the deci
sion taken to set up the company, the next step is to consider how best to
organise it in practice. The company has to raise its own profile and the
profile of its product(s) or service(s). It also has to draw up policies on top
ics like:
• pricing
• discounts
• terms and conditions of payment
• guarantees
• special offers
• marketing (promotion)
• organisation and staff
• administration
• product requirements and procurement.
6. Finances
Few people who set up companies have the financial resources to do so
without raising capital in the form of loans and credit from banks or sup
pliers. This means that they have to draw up financial plans.
Based on the start-up costs, pricing and market research, prospective
owners draw up budgets for the start-up phase, for operations and for li
quidity. This documents the company’s ability to earn money and the capi
tal it will need during the start-up phase and in the first couple of years.
The aim is to avoid unpleasant surprises.
The section below features an example of the financial part of a business
plan, including:
• budget assumptions
• the start-up budget
• the operating budget
• the liquidity budget.
The example is based on the assumption that all of the other plans men
tioned above in points 1 -5 have already been drawn up.
12.2 Bureau Festival

12.2.1 Basic concept and assumptions
Bureau Festival is a start-up that aims to meet the need for effective and
creative services in the planning and running of events (company parties,
courses, theme parties, receptions, etc.).
For the first two years, the company will restrict its marketing to medi
um-sized companies in Xtown. The target client group has been selected
based on the following criteria:
1. Geographic proximity
2. Companies that hold an average of two events a year
3. Companies that employ 5 0 -2 0 0 people.
There are approximately 200 companies in the target group in the munici
pality, and approximately 450 in the surrounding region.
Analyses suggest that the market in the town is worth approximately
DKK 12 million, while the regional market is worth approximately DKK
27 million. These figures are based on companies hosting an average of
two events a year, at a cost of approximately DKK 3 0,000 each. The com
pany expects revenue in the first year of approximately DKK 5 0 0 ,0 0 0 (ex.
VAT), corresponding to a market share of about 4%. In other words, the
company expects to arrange 16 events in Xtown.
The events market in Xtown is a differentiated duopoly, i.e. there are
currently two main players.
One of the companies concentrates on renting out tents, stages and
music systems and only arranges the actual events as a peripheral ser
vice. The other company’s core business is entertainm ent, i.e. planning
nationwide tours, competitions, concerts, etc. Again, the event itself is a
peripheral service.
Neither company spends much time and money marketing to new and ex
isting customers. The competition parameters in this market are price,
quality and personal service.
Bureau Festival needs to concentrate its marketing on professionalism,
creativity and credibility and will depend heavily on direct mail and per
sonal sales to raise its profile.
OTH ER FACTORS
Bureau Festival thinks that it is vital to be known as a good and stable
supplier with “fixed” prices. Its event prices must match the market, i.e.
the price a customer would pay if it opted to do it itself. In many cases, an
argument can be made for higher prices because the customer will save
time and resources by not planning the event(s) itself.
The setup costs include equipment costing approximately DKK 20,000.
The company will also need IT equipment, mobile phones and some office
equipment, and it will also have to produce presentation brochures.
12.2.2 Setup budget
Setup budget for Bureau Festival
All prices are ex. VAT DKK

Expenditure:
Premises
2 months' rent @ DK 2,000 per month 4,000
Deposit 2,000
Interior decor 5,000
Equipm ent
Draft beer pumps and music system 20,000
Office equipm ent
Accounting software (Navision) 2,800
Smartphones 1,500
IT equipment 2,000
Supplies
Office supplies 1,000
Other items 5,000
Professional services
Accountant 6,000
M arketing
Letterhead, business cards 1,000
Presentation brochures 10,000
Other expenses
Contingencies 2,000
Total expenditure 62,300
Figure 12.2 Setup budget for Bureau Festival.
12.2.3 O p eratin g b u d g et
The company bases its revenue forecasts on m arket research. The size of
the events will vary, of course, but the average is estim ated to be DKK
24,000 (ex-VAT) per event (DKK 30,000 incl. VAT). The company expects
to be established by 1 August 2016 and organise five events in September,
three in October and eight in December.
The budgeted contribution m argin is 25%, the norm for th is industry.
O p eratin g b u d g et fo r th e p eriod s 1 A u g u st to 31 D ecem b er 2016

and 1 Ja n u a ry to 30 Ju n e 2017
Period 1 (01.08-31.12) Period 2 (01.01-30.06)
Revenue
M iscellaneo us even ts 384,000 500,000
Receptions 0 80,000
384,000 580,000
Variable costs
Sup p lier costs, 75% 288,000 435 ,0 00
Contribution margin 96,000 145,000
Capacity costs
Rent 10,000 12,000

V ehicles 6,000 9,000
O ffice supplies 2,000 3,000
Postage and fees 3 ,750 6,000

Telep ho ne 2,000 4,000
M a rketin g 7 ,500 9,000
C o m m ercial insurance 1,800 2,000

Lia b ility insurance 400 500
Sm all purchases 3 ,000 2,000

A cco u n ta n t 6,000 5,000
C on tin g en cies 2,000 3,000
44,450 55,500
Profit before depreciation and interest 51,550 89,500
D e p reciatio n 0 0
Interest
In te re st on bank loans 0 0
In te re st on o v e rd ra ft 1,200 0
O perating profit after financial items 50,350 89,500
Figure 12.3 Operating budget for Bureau Festival.
Capacity costs
• Accountancy costs of DKK 5,000 (ex VAT) will be due in March 2017
• Interest on the company’s overdraft facility is set at 10% p.a.
• Company vehicles are expected to cover 6,000 km @ DKK 2.50/km =
DKK 15,000 p.a.
• Marketing costs are expected to be DKK 1,500 per month excl. pres
entation brochures.
12.2.4 Liquidity budget

Before a liquidity budget can be drawn up, the company must decide upon
a policy for terms and conditions of payment for customers and suppliers.
Bureau Festival decides on the following:
W h en the order is placed for the event 1 0% of total price
Seven days before the event 2 5 % o f total price
On the day of/day after the event 6 5 % o f total price
Bureau Festival assumes that 50% of the events held in December will
be booked in October. Normally, events are booked approximately one
month in advance.
The 25% and 65% payments fall in the same calendar month.
Trade creditors are paid one month after delivery.
Capacity costs are paid in cash.
Figure 12.4 shows that an injection of liquidity will be required during Bu
reau Festival’s start-up phase and in November but not beyond that point.
Note, however, the large bill for suppliers (DKK 180,000, i.e. 75% of DKK
240,000) to be paid in January.
Liquidity budget period 1
(01.08-31.12.2016)
Aug Sept Oct Nov Dec

Revenue 0 150,000 90,000 0 240,000
Payments
10% on booking 15,000 9,000 24,000 0 0
2 5 % seven days before event 0 37,500 22,500 0 60,000
6 5 % at tim e of event 0 97,500 58,500 0 156,000
Total payments 15,000 144,000 105,000 0 216,000
Expenditure
Payments to creditors 0 0 112,500 63,000 0’
Setup costs 62,300
Rent 2,000 2,000 2,000 2,000 2,000
Vehicle costs 1,200 1,200 1,200 1,200 1,200
Office supplies 400 400 400 400 400
Postage and fees 750 750 750 750 750
Internet 400 400 400 400 400
M arketing 1,500 1,500 1,500 1,500 1,500
Commercial insurance 1,800
Liability insurance 400
Small purchases 2,000 1,000
Accountant 6,000
Contingencies 2,000
Net interest costs 1,200
Total expenditure 79,950 6,250 118,750 72,250 8,250
Payments - expenditure -64,950 137,750 -13,750 -72,250 207,750
Cash balance at the beginning 10,000 -54,950 82,800 69,050 -3,200

of the period
Liquidity needs -54,950 82,800 69,050 -3,200 204,550

(overdraft balance)
Figure 12.4 Liquidity budget for Bureau Festival for the period 01.08.2016-31.12.2016.
12.3 Marketing plan and finances

When drawing up a sales and marketing strategy, it is often necessary to
examine and evaluate the attractiveness of selling a product or service in
1 Goods purchased in December are paid for in January.
a given market. This requires research into the likely levels of supply and
demand in the market, potential distribution channels, opportunities for
market penetration and marketing strategy before deciding whether or
not to proceed.
It is only possible to reach a conclusion about the results of this market
research when potential earnings and profitability have been evaluated
(see the example below).
A standard market analysis consists of:

• analysis of the customer potential (demand, end-user consumption
patterns)
• competition analysis (industry analysis)
• a SWOT analysis
• a marketing plan (the four Ps)
marketing targets
market strategy in relation to competition, target group and posi
tioning
segmentation and choice of target group
• parameter mix
• financial evaluation
• timetable and plan of action.
Example
"W alter W ater" manufactures heating, ventilation and air conditioning
(HVAC) products. The company has conducted market research into the sa
les and distribution options for a particular kitchen fitting. It now conducts
a financial evaluation of the efficacy of the expected marketing strategy.
According to its market research, the total market size is estimated at
approximately 200,000 kitchen fixtures p.a., at an average production cost
of DKK 400 per unit. In other words, the total market value is DKK 80 mil
lion p.a.
The marketing plan is based on a target market share of approximately
5% by 2019. This corresponds to expected revenue of DKK 4 million. The
contribution ratio is 30%.
To achieve this target, the company must be willing to spend up to 15%
of revenue on marketing costs each year until 2019.
2017 2018 2019
Revenue from kitchen fixtures (DKK 1,000) 2,000 3,000 4,000
Annual percentage grow th in revenue 75 50 33.3
M arketing costs (DKK 1,000) 300 450 600
Figure 12.5 Marketing costs p.a. for Walter Water.
Based on the proposed parameter mix in the marketing plan and Figure
12.5, W alter W ater draws up proposals for a timetable and plan of action.
The plan can be presented in months or quarters. Here is a brief summary
for the three budget years.
Activity/year 2017 2018 2019
Sales visits to dealers 20.0002 15,000 15,000
Retraining HVAC dealers 20.0003 10,000 21,000
Four days spent attending trade fairs 40,0004 40,000 40,000
Direct mail to selected installers and wholesalers 4,0005 1,000 2,000
Advertising in various publications 125,0005 200,000 250,000
Miscellaneous PR 30.0007 30,000 30,000
Total marketing costs 239,000 296,000 358,000
Figure 12.6 Expected marketing costs.
Based on this plan and the costs in Figure 12.6, the company arrives at mar
keting contributions for the three years (see Figure 12.7 below).
2017 2018 2019

Contribution margin, 3 0 % of revenue 600,000 900,000 1,200,000
- M arketing costs 239,000 296,000 358,000
= M arketing contributions 361,000 604,000 842,000
Figure 12.7 Budgeted marketing contributions.
12.3.1 Follow-up and controls

As part of its financial management, Walter Water regularly reviews sales
progress, so it always has an idea of whether its marketing is working and
whether it needs to devote additional resources to it. Working with dealer
ships and other customers is an ongoing process that the company has to
nurture and m aintain all of the time.
Professional financial management involves evaluating individual deal
erships in terms of sales, product range, customers and other factors. The
2 Sales visits by own staff. The number is an estimate.

3 Covers course costs.
4 Total budget for a stand at a trade fair is approx. DKK 200,000, of which 20% is allocated to kitchen
fittings.
5 Estimate based on past experience.
6 Overall estimate for advertising in trade magazines and monthly publications.
7 Sports sponsorship, etc.
results are discussed and processed by the appropriate managers. As a re
sult, Walter Water always has an idea of which parameters to focus on and
which sales strategies work best.
12.3.2 Break-even analysis

Specific market data like the figures used in the example above is not al
ways available and a company will need to evaluate the cost of its mar
keting in the segment concerned by applying a break-even or zero-point
analysis. This idea is summarised below (see Chapter 2 for more detail).
Once the company knows its contribution ratio or gross margin, it can
calculate the break-even revenue that would make it profitable to market
its products in the segment concerned.
Example
The marketing costs and contribution ratio for the three years consist of
estimates based on the marketing plan.
2017 2018 2019

Expected marketing costs 500,000 750,000 1,000,000
Expected contribution ratio ( % ) 28 30 32
Break-even revenue 1,785,000 2,500,000 3,125,000
Figure 12.8 Requirements for break-even revenue.
The calculations in Figure 12.8 show that for the product in question (kit
chen fittings), W alter W ater needs to increase revenue by 75% in the three
years from 2017 until 2019.
The senior management and sales manager must assess the feasibility of
this. If they do not think it is feasible, then the company must reconsider
what to do with the planned product in the market concerned.
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A p p e n d ix 2: D efin itio n s of fin a n cia l ratios
PROFITABILITY ANALYSIS
The return on capital employed shows the ability to make a profit on invested capital
and can be broken down into the operating margin and the rate of asset turnover.
The operating margin shows the relationship between income and expenditure, i.e. the
ability to earn money.
The rate o f asset turnover shows the ability to adapt capital to levels of activity.
Return on equity shows the ability to make a profit on the capital invested by share
holders/owners. The return on equity can also be calculated pre-tax, in which case the
pre-tax profit is inserted into the form ula instead.
Shows average cost of debt (debt).
EARNINGS CAPACITY
Gross margin shows the percentage o f revenue left to cover the fixed costs and profit
after the production costs have been met.
As per gross margin, except gross profit percentage is mainly used by trading compa
nies (income statements classified by nature).
As per gross margin, except the contribution ratio is mainly used in manufacturing.
Operational gearing shows capacity costs as a proportion of total operational costs.
The gross profit has to cover fixed costs, including depreciation (capacity costs). The
point at which gross profit is just enough to cover the capacity costs is the break-even
revenue.
The safety margin shows the percentage by w hich revenue can fall before reaching
break-even revenue.
The capacity ratio shows how much each DKK 1 spent on capacity costs generates in
gross profit. In other words, it shows the extent to which a com pany "m ore than co
vers" its capacity costs.
Index numbers supplement trends identified in the data and show the speed at which
they are developing.
CAPITAL ADJUSTMENT
The rate o f fixed asset turnover shows the ability to generate revenue from fixed as
sets.
The rate of intangible fixed asset turnover shows the ability to generate revenue from
intangible fixed assets.
The rate of tangible fixed asset turnover shows the ability to generate revenue from
material fixed assets.
The rate of stock turnover shows the average num ber o f times stocks are used. For in
come statements classified by nature, sales costs are inserted instead of stocks.
The rate of debtor turnover shows how the average number of times debtors are "re
placed" p.a.
Cost of goods = sales costs + (Stocks at year-end - Stocks at start of year)

If the sales costs are not known, the production cots can be used. The rate o f creditor
turnover shows the ability to obtain credit from suppliers.
SOLVENCY AND LIQUIDITY
The equity ratio shows the percentage of assets th at can be lost before creditors suffer
losses.
Gearing shows how much debt a com pany has fo r each DKK o f equity.
Shows fixed assets as a proportion o f total assets.
Liquidity ratio I shows w h eth er a com pany is capable o f paying back short-term debt,
i.e. debt due w ithin one year. Over 100 is considered a satisfactory ratio.
The num erator in th e fraction consists of total revenue, i.e. including stocks. Liquidity
ratio II also shows the extent to which the company is capable of paying back short
term debt, i.e. debt due within one year.
STOCK EXCHANGE RATIOS
Profit per share shows how much profit is made on each individual share.
Price/earnings ratio shows how much an investor pays to make DKK 1 in profit.
Book value per share shows how much equity is linked to a single share.
Price/book value shows the price o f DKK 1 in equity.

Price/earnings and Price/book value show ho w investors foresee th e future value of the
company.
Appendix 3: English-Danish glossary of accounting terms
Income statement by function
INCOME STATEMENT RESULTATOPG0RELSE

Net sales or Revenue Nettoomsæ tning
Production costs or Cost of sales Produktionsom kostninger
Gross profit Bruttoresultat
Distribution costs Salgs- og distributionsom kostninger
Adm inistrative expenses Adm inistrationsom kostninger
Research and developm ent costs Forsknings- og udviklingsom kostninger
Other operating income Andre driftsindtægter
Other operating expenses Andre driftsom kostninger
Profit before financial items (EBIT) Resultat af primæ r drift
Income from investment in associated Resultat af kapitalandele i associerede virk-
companies somheder
Financial income Finansielle indtæ gter
Financial expenses Finansielle om kostninger
Profit before tax Resultat for skat
Tax Skat af a rets resultat
Profit for the year Arets resultat
Income statement by nature
INCOME STATEMENT RESULTATOPG0RELSE

Net sales or Revenue Nettoomsætning
Raw material costs or Cost of goods sold Produktionsom kostninger
Gross profit Bruttoresultat
Other external costs or Other expenses Andre eksterne om kostninger
Personnel costs or Staff expenses Personaleom kostninger
Depreciation, am ortisation and write-downs A f- og nedskrivninger
Operating profit (EBIT) Resultat af primaer drift
Income from investment in associated Resultat af kapitalandele i associerede virk-
companies somheder
Financial income Finansielle indtaegter
Financial expenses Finansielle om kostninger
Profit before tax Resultat for skat
Tax Skat af arets resultat
Profit for the year Arets resultat
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Appendix 4: Frequently used financial functions in Excel
Calculating capital value when the transactions are not annuities

NPV (NUTIDSVÆRDI in Danish)
Note that the transactions start at point 1
If there is a transaction at point 0, it has to be subtracted separately.
Calculating capital value when the payments are annuities

PV (NV in Danish)
Note that the transactions start at point 1.
If there is a transaction at point 0, it has to be subtracted separately.
If you choose a series of transactions with positive numbers, the result
will be negative.
Calculating internal rate of return (critical value of the interest rate) when
the transactions are not annuities
IRR (IA in Danish)
Note that the transactions start at point 0. The series of transactions
must contain a negative number (often at point 0).
Calculating internal rate of return (critical value of the interest rate) when
the transactions are annuities
RATE (RENTE in Danish)
PMT or NV must be negative. FV can be used to calculate scrap value
where appropriate.
Calculating capital service costs (critical value of net annual payments)

PMT (YDELSE in Danish)
Calculating critical value for the number of periods when the transactions
are annuities
NPER (NPER in Danish)
Calculating critical value for the scrap value when the transactions are
annuities
FV (FV in Danish)
Appendix 5: Glossary
Annuity A series of equal payments. W ith even tim eintervals.
Annual percentage rate. Total cost of a loan in percentage terms

APR
per annum.
Assets Items a com pany owns, for example machinery, stocks and cash.
If the com pany owns 20-50% o f the voting rights in another

Associated companies
company, it is defined as an associated company.
Presentation of th e accounts showing the company's values (as

Balance sheet
sets) and debt (liabilities).
M odel for setting targets and follow ing up on financial and non-
Balanced Scorecard
financial factors.
The proportion of liabilities for which capital was provided by out

Borrowed capital
siders (banks, suppliers, etc.).
The interest rate the com pany demands as a return on its invest
Calculation rate
ments.
Costs related to capacity (also fixed costs) as opposed to variable

costs, which depend on production volume. Split into cash capa
Capacity costs
city costs (rent, salaries, etc.) and depreciation on non-cash (paid)
costs.
The owners' capital injections, in the form o f cash or other assets.

In an income statem ent by nature: Sum o f other operationel costs,
Capital investment staff costs and depreciation provisions.
In an income statement by function: Sum of distribution costs and
administration costs and developm ent costs (if applicable).
The company's need for liquidity to invest in assets and operati

Capital needs
ons.
Capital use The company's assets.
The value of all payments associated w ith an investment, con

Capital value verted to "to d a y " using a particular interest rate (the calculation
rate).
Cash and cash Liquidity available to the company w ith o u t notice (cash, bank de
equivalents posits, etc.).
The calculation of how much liquidity th e company has generated

Cash flo w analysis
in a given period.
Description of th e liquidity streams during a period that has now

Cash flo w statement
concluded.
Corporate Social
The company's reporting on social responsibility.
Responsibility, CSR
Used in the valuation of fixed assets and stocks. The cost of ac
Cost price
quiring the products.
Creditor Companies or individuals to which the com pany owes money.
The value of a particular variable that balances inflow and out

Critical value flow. Minimum value of payments received/revenue. Maximum
value of payments made/costs.
Assets generated by operations (stocks, accounts receivable, cash

Current assets
and cash equivalents, etc.).
Debt Amounts owed to other individuals or companies.
Debtor A person or com pany th at owes the com pany money.
O perational depreciation shows the estimated decline in value of
fixed assets. It can also be seen as the year's expenses for using the
Depreciation fixed assets. Operational depreciation is normally linear. Tax de
preciation is used fo r tax calculations, using the declining balance
method at 2 5 % per year.
The total annual cost of a loan ( % p.a.). Also known as the annual
Effective interest rate
percentage rate or APR.
Emission Issuing and selling new shares in th e company.
The proportion o f liabilities th at is provided by the owners. Con

Equity sists o f capital injections, retained earnings (accumulated profit),
etc.
FIFO principle The first in, first out principle. Used to evaluate inventory.
Shares and bonds th at the com pany has acquired as long-term

Financial fixed assets
investments.
Financing Procuring capital.
The proportion of the assets that the com pany uses itself and
Fixed assets
which are not intended fo r resale.
The proportion of the company's costs th at do not fluctuate w ith

Fixed costs
sales or production volumes.
In connection w ith valuing assets, the assumption th a t the

Going concern
com pany will continue to operate.
Revenue minus production costs in income statements by function.

Gross profit
Revenue minus variable costs in income statements by nature.
Collective term for the com pany (the parent com pany) and its
Group
subsidiaries.
Income statem ent by Profit and loss statem ent organised according til th e function (or
function ganisational departm ent) w h ere the cost occur.
Fixed assets of a non-physical nature, e.g. developm ent costs, im

Intangible fixed assets
provements to rented premises and patent rights.
The rate at which payments in and payments out associated w ith

Internal interest rate an investment balance out. Also referred to as critical value of the
interest rate.
Investment Purchase of a fixed asset. Productive capital.
The capital th at the com pany has raised from its owners and
Liabilities
others.
Liquidity Cash or cash flow.
Description o f the (one) upcoming period's planned/expected cash

Liquidity budget
flows.
Loan types Bullet loans, serial loans and annuity loans.
The part of the company's subsidiaries owned by other sharehol

M inority interests
ders.
M ortgage debt Debt secured against real estate.
Liabilities th a t are not due w ith in the present account year, e.g.
Non-current liabilities
long term debt.
In an income statement by nature: Sum o f cost o f sales, other ope
rationel costs, staff costs and depreciation provisions.
Operational costs In an income statem ent by function: Sum of production costs, di
stribution costs and administration costs and developm ent costs (if
applicable).
Operating accounts A statem ent of the profit for the year.
Outstanding debt The part of a loan still ow ed at a given point in time.
H ow instalments and interest are paid on a bullet loan, serial loan

Paym ent profile
or annuity loan.
The value o f a future payment converted to "to d a y ", at a particu

Present value
lar interest rate.
The am ount borrowed by raising a loan. The entire principal is

Principal
repayable.
The am ount paid out w hen a loan is raised. The proceeds am ount
Proceeds
to the principal minus fees.
Used to evaluate fixed assets and stocks. The price the company
Procurement price
paid for the asset or products.
Profitability A company's ability to make money
Repaym ent o f a loan. The sum of the instalments is equal to the

Repaym ent
loan principal.
Retained earnings The sum o f the profits th at are transferred to equity.
The sales price th at a fixed asset can demand w hen the investment
Scrap value
comes to an end.
Calculations showing the impact o f changes to the original as

Sensitivity analysis
sumptions.
The part of the price th at is above the nominal value w hen the
Share premium
company issues and sells new shares.
Items in the income statement that do not relate to normal opera

Special items
tions (e.g. one-off events).
Also known as a group company. If a com pany has more than

Subsidiary 5 0 % o f th e voting rights in another company, it is by definition a
subsidiary.
Tangible fixed assets Buildings, machinery and other tangible assets.
Increasing the value o f an asset, which affects th e am ount of

W ritin g up
equity in the company.
Index
A Balance sheet structure 335

Accrual 84 Basic accounting principles 83
Activity-based costing 235 Board and executive management 88
Additional costs 1 9 4 ,1 9 5 BoConcept balance sheet 92
Advanced investing 323 Bookkeeping 64
Advantages of a Balanced Sco Bookkeeping system 64
recard 286 Book value per share 153
Advertising elasticity 240 Borrowed capital 347
After-tax calculation 366 Break-even analysis 54, 383
Alternative calculation of price Break-even calculation 58
elasticity 170 Break-even contribution margin 56
Amortisation table 360 Break-even revenue 55
Analysing accounts 109 Break-even sales (break-even
Analysing current situation and analysis) 132
targets 254 Budget control 275
Analysis of the data in the in Budget follow-up 275
come statement and balance Budget for capacity costs 262
sheet 114 Budgeting as an internal ma
Annual net payments 297 nagement tool 251
Annual percentage rate 356 Budget model 257
Annual reports 63, 81 Budgets and budget control 251
Annuities 318 Budget simulation 271
Annuity loans 349 Building-block model 80
Annuity method 302 Bullet loans 348
Areas of financial management 35 Businessplan 374
Aspects of budgeting 252 Business plans and marketing
Assets 70, 72, 92 plans 373
Auditor 88 Buying up shares in the company 342
B C
Background factors 106 Calculating annual costs of
Balanced Scorecard 280 financing as a percentage 356
Balanced Scorecard model 280 Calculating APR for loans with
Balance sheet 64 start-up costs 356
Balance sheet budget 269 Calculating interest 313
Balance sheets 70, 81 Calculating interest in Excel 313
Calculating unit costs 50 Competitor-based prices and
Calculation and analysis of key retrograde calculation 233
financial ratios 115 Competitors 26
Calculation of capital value if Complementary items 173
the transactions consist of Completely elastic 171
annuities 299 Completely inelastic 171
Calculation rate 296, 297 Concept of interest 313
Capacity ratio 132 Conjectural model 189
Capital adjustment 137 Content of annual reports 81
Capital service costs 302 Contingent liabilities 97
Capital structure 341 Continuity 84
Capital value consideration 327 Contribution margin 51
Capital value method 297 Contribution margin budget 261
Cash and cash equivalents 74 Contribution margin per unit of
Cash flow before financing acti scarce resource 53
vities 100 Contribution margin variance 279
Cash flow from operating activi Control 251
ties 1 0 0 ,1 4 9 Controllable variables 4 1 ,1 6 6
Cash flow from operating activi Converting accounts for analysis
ties before financial items 100 purposes 112
Cash flow from operations 99 Converting a present value into
Cash flow statement for BoCon an annuity 320
cept 100 Converting income statements
Cash flow statements 81, 98 and balance sheets for analy
Cash inflow/outflow for the year 100 sis purposes 111
Causes of budget variance 276 Converting the balance sheet 113
CFA Society Denmark’s re Converting the income statement 113
commendations 127 Co-operation model 187
Changes to the balance sheet 334 Corporate Governance 87, 344
Choosing between different Corporate Social Responsibility
production methods 208 (CSR) 2 7 ,1 5 8 ,1 6 1
Choosing between equity and Corporate social responsibility
borrowed capital 340 report 87
Choosing between investment Cost-based pricing 227
proposals 311 Cost factors 48
Choosing types of financing 355 Cost function 1 6 8 ,1 9 4
Clarity and substance 83 Cost of Debt (CoD) 1 1 7 ,1 2 3
Collating material for analyses 110 Costs 66, 6 7 ,1 9 3 , 339
Company and its stakeholders 24 Cost trends 198
Company and the market 40 Creditors’ turnover 142
Company in the market 165 Critical value for annual payments 308
Comparisons between buying Critical value for the interest rate 308
and leasing 365 Critical value for the scrap value 310
Cross-price elasticities 175
Cross-price elasticity 173 Effect of price on demand 167
Current assets 74, 94 Entrepreneur companies 23, 345
Customer perspective 281, 293 Environmental accounts/green
Customers 25 audits 162
Customers and suppliers 108 Equity 75, 95, 344
Equity ratio 145
D Evaluating financing options 339
Danish Business Authority 85 Evaluating investments 294, 297
Danish Financial Statements Act 77 Examples of income statements 91
Danish Growth Fund 353 Examples of price differentiation 244
Days in stock 140 Expenses 67
Debt in relation to operating Extended review 103
liquidity 149 External accounts 36
Debt obligations (borrowed capital) 77 External factors 107
Debtors’ credit days 141
Debtors’ turnover 141 F
Debtors’ turnover ratio 141 FIFO method 95
Debt ratio 337 Finances 375
Decision-making phase 33 Financial element 294
Deferred tax 96 Financial leasing 354
Degressive costs 198 Financial lever 124
Degressive variable costs 199 Financial management 35
Demand 4 0 ,1 6 5 ,1 6 6 Financial perspective 281, 293
Demand determinants 166 Financing 333
Demand function 168 Finished goods 140
Dependence 340 Fixed assets 72
Depreciation budget 262 Fixed assets as share of balance
Different production methods 208 sheet total 146
Disadvantages of a Balanced Fixed asset turnover 138
Scorecard 286 Fixed costs 4 9 ,1 9 4 ,1 9 5
Discounts 249 Fixed unit costs 195
Disinvestment 334 Flexibility 340
Dividends 342 Focus on core competencies 343
Drawing up the income state Four perspectives as risk indica
ment budget 260 tors - early warning system 285
Duopoly 186 Free resources 19
Du Pont Pyramid 1 2 1 ,1 2 2 Full-cost calculation 231
Future value of an annuity 318
E Future value of a single amount 314
Earning capacity 127
Earning capacity in different G
types of companies 135 Gearing 1 2 5 ,1 4 6
Effect of price of other products General cost trend 200
on demand 173 Going concern 84
Goods in progress 140 Internal factors 108
Graphic presentation 219 Internal perspective 281, 293
Gross profit 69 Internal rate 300
Gross profit percentage/gross Internal rate of return method 300
margin 1 2 8 ,1 2 9 International rules and regulations 79
Groups 24 Investment amount 297
Investment calculation after tax 324
H Investment cash flow 294
Heterogeneous 179 Investment needs 293
Heterogeneous market 180 Investment projects 292
Homogeneous market 179 Investments 291
Homogenous 179 Investments and statements of
Horizontal balance sheet structure 337 changes in financial position 305
Human capital 160 Investor Relations 91
Irrelevant costs 205
I Irreversible costs 206
Identical replacement 329
Implementation phase 33 K
Importance of income on demand 175 Kinked demand curve 188
Importance of interest and time 317 Knowledge resources 160
Income 65
Income elasticity 176 L
Income statement 64 Learning and growth perspective
Income statement budget 258, 263 282, 294
Income statement by function 68, 111 Leasing 354
Income statement by nature 68, 111 Liabilities 70, 75, 95
Income statement for BoConcept 89 Life cycle 297, 311
Income statements 65, 68, 81 Life-cycle 44
Incorporating probability into Limited companies 75
investment calculations 323 Liquidity 339
Increase in borrowed capital 342 Liquidity budget 2 5 7 ,2 5 8 ,2 6 5 ,3 7 9
Independent auditor’s report 102 Liquidity budget using cash flow
Index numbers 1 2 9 ,1 4 3 budget model 271
Industry factors 107 Liquidity in relation to invest
Influence of marketing on price ments 149
optimisation 238 Liquidity in relation to re
Input-output model 20 payments and dividends 149
Instalments 348 Liquidity in relation to revenue 149
Intangible assets 92, 94 Liquidity ratio 338
Intangible fixed assets 72 Liquidity ratio 1 148
Interest budget 263 Liquidity ratio 2 148
Interest-only loans 352 Liquidity ratios 147
Internal accounts 36 Listing on the stock exchange 345
Internal analyses 110 Loans raised abroad 350
Long-term debts 77 No-replacement scenario 326
Long-term financing 333
Long-term liabilities 96 O
Lower price limit 226 Oligopoly 187
Open calculations 234
M Open information policies and
Management information 37 corporate governance 343
Management, organisation, Operating budget 378
employees 109 Operating capital 75
Management process 33 Operating margin (OM) 1 1 7 ,1 1 9 ,1 2 8
Management reports 81, 86 Operating profit/loss 90
Manufacturing companies 21 Operational gearing 131
Manufacturing company 9 1 ,1 3 5 Operational leasing 354
Marginal costs 1 9 4 ,1 9 5 Opportunity costs 206
Marginal method 216, 219 Optimal life cycle 326, 327
Marginal revenue 217 Optimisation challenge 213
Market analysis/price analysis 189 Optimisation methods 216
Market-based and cost-based Options as rewards for staff and
pricing 227 management 342
Market description and analysis Other external costs 69
of the situation 374 Other variable incremental 202
Marketing plan and finances 380 Overdrafts 362
Marketing strategy and a supply Overview of the types of market
chain strategy 33 and competition 181
Market knowledge 165 Ownership 22
Minority interests 90 Owners/shareholders 25
Minority shareholders 24
Mission 374 P
Monopolies and regulation 184 Partial monopoly (price leadership) 186
Monopolistic competition 222 Partnership 22
Monopolistic competition - im Payback method 303
perfect competition 185 Payment 65, 67
Monopoly 183 Perfect competition 1 8 1 ,1 8 2
Monopoly formula 227 Perfect competition 222
Monopoly (price-setter) 217 Personal data, targets and re
More interest payment dates pro sources 374
anno 360 Personally owned companies 75
Mortgage credit institute loans 350 Place 43
Planning and budgeting 253
N Planning and budgeting process 254
Net profit/loss 91 Plotting market-demand curves
Neutral elasticity 171 and sales curves 189
Neutrality/caution 84 Preconditions for differential
Nominal interest rate 348 pricing 243
Preference and loyalty 179 Provisions 76
Premium pricing 249 Public 26
Pre-production costs 202 Public access to annual reports 85
Prerequisites for optimisation 216 Public limited companies 23
Present value of an annuity 319
Present value of a single amount 315 Q
Price 42 Quality requirements for sup
Price/Book value 1 5 2 ,1 5 3 plementary reports 159
Price differentiation 241
Price differentiation based on R
geography 245 Rate of asset turnover 119
Price differentiation based on Rate of asset turnover (ROAT) 1 1 7 ,1 2 0
product use 248 Rate of fixed-asset turnover 138
Price differentiation based on time 249 Rate of intangible fixed-asset
Price/Earning 151 turnover 138
Price elasticity 169 Rate of stock turnover 1 3 9 ,1 4 0
Price elasticity for different Rate of tangible fixed-asset
products 171 turnover 138
Price-leadership model 189 Raw materials 140
Price optimisation 213, 216 Readers 79
Price optimisation in different Relationship between rate of
types of market 217 capital employed, operating
Price parameter 44 margin and rate of asset
Price-setter 216 turnover 120
Primary activities 29 Relationship between return on
Private and public limited equity and return on capital
companies 345 employed 124
Private limited companies 23 Relevant costs 205
Privately owned companies 345 Replacement with a new and/or
Product 4 2 ,1 0 8 better version 331
Production costs 69 Requirements for annual reports 82
Product life-cycle curve 44 Resources are scarce 52
Product life-cycle curve and the Retained earnings 76
price parameter 238 Return on capital employed 117
Profit 51 Return on capital employed
Profitability analysis 117 (ROCE) 1 1 7 ,1 2 0
Profit/loss for operating activities 117 Return on equity 122
Progressive costs 198 Return on equity (ROE) 1 1 7 ,1 2 2
Progressive variable costs 199 Revenue 45, 65
Promotion 42 Revenue and operating profit/
Property-management company 91 loss per employee 134
Proportional costs 198 Reversibility 205
Proportional variable costs 199 Reversible costs 206
Proposed dividend 76 Review 103
Right price 214 Supplementary notes 82
Risk 339 Supplementary reports 8 0 ,1 5 7
Risk and uncertainty 311 Suppliers/banks 25
Supply chain management 31, 32
S Supply curve for the product 226
Safety margin 5 8 ,1 3 3 Supply curve - lower price limit 225
Sales 45 Support activities 29
Scarce resources 19
Scrap value 297 T
Securities 74 Tangible fixed assets 73, 94
Security 340 Targets 39
Self-financing 334 Tax and financing 355
Sensitivity in investment analysis 306 Tax budget 263
Separate valuation of each item 84 Technology 311
Serial loans 349 Total costs 1 9 4 ,1 9 5
Service companies 21 Total method 216, 218
Service company 135 Total method/marginal method 223
Setup budget 377 Total unit costs 195
Shareholder value 341 Trade receivables 74, 95
Short-term debts 77 Trading companies 21
Short-term financing 333 Trading company 9 1 ,1 3 5
Size of investment 311 Trends for variable costs 198
Socioeconomic factors 107 True and fair picture 82
Sole proprietorships 22 Types of company 20, 345
Solvency and liquidity 145 Types of loan 347
Sources of borrowed capital 350 Types of market 179
Special items 9 0 ,1 1 2
Staff associations 26 V
Staff/management 25 Valuation method 95
Stakeholder model 25 Value chain 29
Statement of change in financial Variable and fixed costs 48
position model 265 Variable costs 4 8 ,1 9 4 ,1 9 5
Stock-exchange ratios 153 Variable incremental costs 202, 203
Stock-market ratios 151 Variable unit costs 195
Stocks 94 Venture capital 347
Stocks or inventories 74 Vertical balance sheet structure 336
Strategies 108
Strategy model 255 W
Structural capital 161 Weighted average method 95
Subsidiaries 24, 90 What is financing? 333
Substitute products 174 Why are costs important? 193
Sunk costs 204 Working capital 333

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Om dette eksemplar

Dette eksemplar er fremstillet af Nota til Kathrine Westh Duus

Eksemplaret er personligt og må ikke deles.

Misbrug kan medføre udelukkelse fra Nota og retsforfølgelse.

Eksemplaret indeholder data, så det kan spores tilbage til

The data in the examples is available to download in Excel format from:

HANS REITZELS FORLAG

Translated from the 4th edition of Erhvervsokonomi til

Publishing editor: Lasse W olsgard

This publication may only be reproduced in accordance with agreem ent

About the authors 15

2 The process of generating profit 39

4 A nalysing company accounts 105

5 Supplem entary reports 157

8 Price optimisation 213

9 Budgets and budget control 251

10 A ppendix A - Calculating interest 313

10 Appendix B - Advanced investing 323

11 Appendix - Advanced financing 365

The focus is on:

The authors, autumn 2015

Associate Professor Torben Rosenkilde Jensen MSc Economics, Busi­

Associate Professor M orten Dalboge MSc Economics and Business Ad­

This chapter will teach you to:

1.1 Financial management and the overall financial picture

In the broadest sense, financial management is therefore a question of

Figure 1.1 Simplified input-output model.

Managing the production process in a way that optimises resource utilisa­

This book covers all four of these sub-areas:

1.2 Types of company

The input into trading companies consists of goods produced by others.

Figure 1.2 Number of companies in Denmark categorised by type of ownership, 2012.

“Others” includes categories such as co-operative societies, foundations,

1.4 The company and its stakeholders

What are the company’s relationships with these groups of stakeholders?

1.5 The importance of financial management

They need to be able to:

Figure 1.4 The value chain.

One example of a primary activity would be a particularly efficient pro­

Example from the transport and haulage sector

Figure 1.5 Value creation and its cost.

1.6.2 The company view ed from a supply chain perspective

Figure 1.6 The supply chain for a pair of men's shoes.

Customer segment: Customer segment:

Supply-chain Source components from the Source components from th e best

Hire supporters w h o provide an Employ the very best supporters

Use road transport to keep trans­ Use airfreight to minimise delivery

1.7 Financial management

Figure 1.9 The general cycle of the management process.

The management process consists of two phases:

The company must ensure that:

Systematically checking that each step in the decision-making process is

1.7.1 Areas of financial m anagement

Figure 1.10 Financial management: Areas covered and work involved.

Activity consists of activities related to sales, production, purchasing and

Capacity consists of the company’s tangible and intangible resources. The

1.7.2 The financial picture

The main purposes of the internal accounts are:

This is covered in Chapter 9.

1.7.3 Systematic management information

Associate Professor Torben Rosenkilde Jensen MSc Economics, Busi

Associate Professor M orten Dalboge MSc Economics and Business Ad

Managing the production process in a way that optimises resource utilisa

One example of a primary activity would be a particularly efficient pro

Use road transport to keep trans Use airfreight to minimise delivery

The nature of these targets determines management decisions. For ex

As a concept, demand is defined as the number of units of a product or ser