Basic Financial Terms for Engineers

Background

Why do engineers need to know about basic financial terms? Traditionally engineers are supposed to do engineering which is their domain of expertise. Just go a little deeper and you will find that all our actions as an engineer have a definite financial impact.

Let us understand this by an example. Consider the activities of a design engineer who makes design. If he increases the design specs on a higher side which is not required, then the cost of the product for which he has made the design will go up without adding value to it. If he makes poor design then the product may become cheaper, but the cost of warranty may go up owing to poor quality, and it may also cost brand image (intangible) because of poor quality.

Sales engineers are the ones who use the most basic financial terms after the finance department as they need to know the cost, expenses, and profit. Sales is the function that drives business in any organization.

The above analogy can be applied to all functions of an engineer irrespective of in which function he works. So let us go for the basic financial terms that come across every engineer.

Basic Financial Terms

Raw material Cost (RMC):

Basic cost of the material that goes inside the manufacturing of a product.

Labour Cost:

This is also said to be a direct cost of manufacturing that includes.

• Wages
• Overtime
• Job work
• Allied expenses
• Other manufacturing expenses (e.g. Electricity, Plant Repair and maintenance, Tools and dies)

Financial Cost:

Financial costs are the expenses incurred to execute an order. These expenses are like

• Cost of Bank Guarantees
• Cost of Credit
• Cost of warranty

Cost of Goods Sold:

Cost of goods sold = Raw material cost + Labour cost

Gross Margin:

Gross Margin=100*(Sale Price – Cost of Goods Sold)/Sale Price

It is an indicator of profitability and is calculated as a percentage.

Overheads:

This head includes.

• Administrative Expenditure
• Personnel Expenditure
• Selling and Distribution

EBITDA:

Earning before Interest, Tax, and Depreciation. It is an indicator of Cash Profit that is being generated by the company’s operations.

EBITDA = Gross Margin – Overheads

Purchase Order:

Document issued by purchaser to seller which includes all the terms of contract like

• Sale Price
• Terms of Payment
• Delivery Schedule
• Liquidated Damage (LD)
• Billing & shipping address

Bank Guaranty:

Bank Guarantees are the documents issued by the Bank on behalf of the seller to the buyer. These are of two types

• Advance Bank Guaranty – Given by the seller to take advance payment against the order from the buyer for a period till the supply of the product. Generally, it ranges between 10-20% of total order value. It can be higher or lower also.
• Performance Bank Guaranty – Given by the seller to the buyer as a guarantee against the Performance of the Product. This is usually given for a period equivalent to a warranty period.

Liquidated Damage:

A kind of penalty imposed by the buyer on the seller in case of default on a delivery commitment by the seller. Usually, it ranges from 0.5% – 1% per week and goes to a maximum of 5% – 10%. From the seller’s perspective, it must be negotiated with the buyer to be nil or kept as minimum as possible.

Most of the basic financial terms an engineer came across have been covered above. By now we must have understood how important knowledge of Basic Financial Terms for engineers is. Engineers in any function are bound to impact at least one or two financial levers listed above. Let us have a look at the below table.

Conclusion

How often do you use the Financial terms defined above? If you are a sales engineer then these are the terms you are coming across almost on a daily basis. Even if you are in another function above table gives you the idea of how your actions are impacting the financials of your organization.

When a engineering professional moving up the ladder in hirearchy, the knowledge of financial terms becomes very important. If he or she is driving the business and at the forfront of it then it becomes more important for him to understand these terms. Profitability is very important for business sustanibility. It is as important as topline of the business and without the basic knowledge of financials no one cane mange the business transactions.

Reference

https://www.investopedia.com/terms/g/gross_profit_margin.asp

If you would like to know some more basic financial terms, please let us know.

Reviewed & Edited by: Mr Neeraj Bansal, CA