paper

1. What is the difference between effective interest
rates and nominal interest rates?
Nominal interest rate is also defined as a stated interest rate. This interest works according
to the simple interest and does not take into account the compounding periods.
Effective interest rate is the one which caters the compounding periods during a payment
plan. It is used to compare the annual interest between loans with different compounding
periods like week, month, year etc.
In general stated or nominal interest rate is less than the effective one. And the later depicts
the true picture of financial payments. The nominal interest rate is the periodic interest rate
times the number of periods per year. For example, a nominal annual interest rate of 12%
based on monthly compounding means a 1% interest rate per month (compounded). A
nominal interest rate for compounding periods less than a year is always lower than the
equivalent rate with annual compounding (this immediately follows from elementary
algebraic manipulations of the formula for compound interest). Note that a nominal rate
without the compounding frequency is not fully defined: for any interest rate, the effective
interest rate cannot be specified without knowing the compounding frequency and the rate.
Although some conventions are used where the compounding frequency is understood,
consumers in particular may fail to understand the importance of knowing the effective rate.
Nominal interest rates are not comparable unless their compounding periods are the same;
effective interest rates correct for this by "converting" nominal rates into annual compound
interest. In many cases, depending on local regulations, interest rates as quoted by lenders
and in advertisements are based on nominal, not effective interest rates, and hence may
understate the interest rate compared to the equivalent effective annual rate. The term
should not be confused with simple interest (as opposed to compound interest) which is not
compounded. The effective interest rate is always calculated as if compounded annually. The
effective rate is calculated in the following way, where ie is the effective rate, r the nominal
rate (as a decimal, e.g. 12% = 0.12), and “m” the number of compounding periods per year
(for example, 12 for monthly compounding):
ie = (1 + r/m)m
- 1
The following two tables will illustrate the terminologies commonly used for ie and r.
Eeffective interest rate can be greater than or equal to nominal
interest rate but never less than nominal interest rate.If the interest
rate is compounding more than once a year then the effective
interest rate will always be greater than nominal interest rate. If it is
compounding once a year then the nominal interest rate will be
equal to effective interest rate

2. A real interest rate is an interest rate that has been adjusted to remove the effects
of inflation to reflect the real cost of funds to the borrower and the real yield to the
lender or to an investor. The real interest rate reflects the rate of time-preference for
current goods over future goods. The real interest rate of an investment is
calculated as the difference between the nominal interest rate and the inflation rate:
Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)
KEY TAKEAWAYS
 The real interest rate adjusts the observed market interest rate for the
effects of inflation.
 The real interest rate reflects the purchasing power value of the interest
paid on an investment or loan and represents the rate of time-
preference of the borrower and lender.
 Because inflation rates are not constant, prospective real interest rates
must rely on estimates of expected future inflation over the time to
maturity of a loan or investment.
Interest Rates: Nominal and Real
Understanding Real Interest Rate
While the nominal interest rate is the interest rate actually paid on a loan or
investment, the real interest rate is a reflection of the change in purchasing
power derived from an investment or given up by the borrower. The nominal interest
rate is generally the one advertised by the institution backing the loan or investment.
Adjusting the nominal interest rate to compensate for the effects of inflation helps to
identify the shift in purchasing power of a given level of capital over time.
According to the time-preference theory of interest, the real interest rate reflects the
degree to which an individual prefers current goods over future goods. A borrower
who is eager to enjoy the present use of funds shows a stronger time-preference for
current goods over future goods and is willing to pay a higher interest rate for
loaned funds. Similarly a lender who strongly prefers to put off consumption to the
future shows a lower time-preference and will be willing to loan funds at a lower
rate. Adjusting for inflation can help reveal the rate of time-preference among
market participants.
Expected Rate of Inflation
The anticipated rate of inflation is reported by the U.S. Federal Reserve to Congress
on a regular basis and includes estimates for a minimum three-year period. Most
anticipatory interest rates are reported as ranges instead of single point estimates.
As the true rate of inflation may not be known until the time period corresponding
with the holding time of the investment has passed, the associated real interest

3. rates must be considered predictive, or anticipatory, in nature, when the rates apply
to time periods that have yet to pass.
Effect of Inflation Rates on the Purchasing Power of
Investment Gains
In cases where inflation is positive, the real interest rate is lower than the advertised
nominal interest rate.
For example, if funds used to purchase a certificate of deposit (CD) are set to earn
4% in interest per year and the rate of inflation for the same time period is 3% per
year, the real interest rate received on the investment is 4% - 3% = 1%. The real
value of the funds deposited in the CD will only increase by 1% per year, when
purchasing power is taken into consideration.
If those funds were instead placed in a savings account with an interest rate of 1%,
and the rate of inflation remained at 3%, the real value, or purchasing power, of the
funds in savings will have actually decreased, as the real interest rate would be -
2%, after accounting for inflation.
Unit Economics
Unit economicsdescribesaspecificbusinessmodel'srevenuesandcostsinrelationtoan individual
unit.A unitreferstoany basic,quantifiable itemthatcreatesvalue forabusiness.Thus,unit
economicsdemonstrateshowmuchvalue eachitem—or“unit”—generatesforthe business.Foran
airline,aunitmightbe single seatsold,whereasarideshare applike Uberwoulddefine aunitasone
ride intheirvehicle.Theseunitsare thenanalysedtodeterminehow muchprofitorlossthey
individuallyproduce.Inthe case of a retail store,forinstance,itsuniteconomicsisthe amountof
revenue it’sable togenerate everymonthfromeachsingle customer.
3 Reasons Unit Economics Is Important
The data producedthroughuniteconomicsanalysiscantherefore be integral tothe short-termand
long-termfinancial planningof yourcompany.
Unit economics can help you forecastprofits. Understandinguniteconomicscanhelpyouproject
howprofitable yourbusinessis(orwhenitisexpectedtoachieve profitability),sinceitproducesa
simple,granularpicture of yourcompany’sprofitabilityonaper-unitbasis.
Unit economics can help you optimize your product. Anunderstandingof uniteconomicsisalso
helpful indeterminingthe overall soundnessof aproduct,providingevidence tosuggestwhetherit’s
overpricedorundervalued.Suchinformationcanhelpacompanyidentifyfavourablestrategiesfor
productoptimization,aswell asdeterminingwhethermarketingexpensesare worththe cost.

4. Unit economics can help you assess market sustainability. Unit economicsisalsoparticularly
adeptat analysingaproduct’sfuture potential.Forthis reason,manystart-upfoundersandco-
foundersrelyheavilyonuniteconomicsinthe earlystagesof businessdevelopmenttomeasure
theiroverall marketsustainability.
How to Calculate and Analyse Unit Economics
There are twowaysto approach calculatinguniteconomics,dependingonhow youchoose to define
a unit.
Method 1: Define Unit as “One Item Sold”
If a unitisdefinedas“one itemsold,”thenyoucandetermine uniteconomicsbycalculatingthe
contributionmargin,whichisagauge of the revenue amountfromone sale minusthe variablecosts
associatedwiththatsale.The equationisexpressedas:
Contributionmargin=price perunit – variable costspersale.
Method 2: Define Unit as “One Customer"
If you choose to define aunitas“one customer,”thenthe uniteconomicsisdeterminedbyaratio of
twodifferentmetrics:
Customer lifetime value (LTV):how muchmoneya businessreceivesfromagivencustomerbefore
the customer“churns” or stopsdoingbusinesswiththe company
Customer acquisition cost(CAC): the cost of attracting a client
Therefore,the equationthatproducesyouruniteconomicsis:customerlifetimevalue dividedby
customeracquisitioncost(UE= LTV/CAC)
How to Model Customer Lifetime Value
There are twowaysto model customerlifetimevalue:predictive LTV andflexible LTV.
Method 1: Predictive LTV
Predictive LTV helpsyouforecastthe average customerislikelytoact inthe future.The formulafor
measuringpredictive LTV is:
Predictive LTV =(T x AOV x AGMx ALT) / numberof customersfor a givenperiod
T (average number of transactions): The numberof total transactionsdividedbyagiventime span,
thusdeterminingthe average numberof transactionsinthatperiod.
AOV (average value of an order): AOV isdetermined bydividingthe total revenue bythe number
of orders,resultinginanaverage monetaryvalue of eachorder.
AGM (average gross margin): AGM iscalculatedbydeductingthe costof sales(CS) fromthe total
revenue (TR) inordertodetermine actual profit. The equationtodetermine grossmarginis:
GM = ((TR-CS) /TR) x 100.
ALT (average lifetime of a customer). ALT is equal tothe churn rate figure dividedby1.The churn
rate isdeterminedbytakingthe numberof customersatthe beginningof agivenperiod(CB) and

5. measuringitagainstthe customersleftatthe endof the period(CE).Thatequationisexpressedas:
Churnrate = ((CB-CE)/CB) x 100.
Method 2: Flexible LTV
Flexible lifetime valuehelpsyouaccountforpotential changesinrevenue.Thisisparticularlyuseful
for newbusinessesandstartups,whichare likelytoundergochangesastheygrow and develop.The
formulaformeasuringflexible LTV is:
Flexible LTV= GML x (R/(1 + D – R))
GML (average gross margin per customer lifespan): The amountof profitgeneratedbyyour
businessfromagivencustomerinanaverage lifespan.Thisismeasuredbythe equation:Gross
Margin x (Total Revenue /Numberof CustomersDuringthe Period).
D (discount rate): Discountrate measuresthe rate of returnon investment.
R (retention rate): Retentionrate isdeterminedbymeasuringthe numberof customerswho
repeatedlymade purchases(CbandCe) againstthe numberof new customersacquired(Cn),
expressedinthe equation:((Ce- Cn) /Cb) x 100.
How to Analyze the Cost of Acquiring New Customers
Everynewbusinessencountersthe hurdle of acquiringnew customers.The costof acquisition(CAC)
isan essential metricforcompanieslookingtoaccuratelydetermine how muchtheyare spendingin
orderto obtaina newcustomer.The formulais:
CAC= (salesandmarketingcosts/numberof acquiredcustomers)
Your LTV to CACratio can helpyoudetermine whetherthe buildingblocksof yourmarketingefforts
are strongor needto be adjusted.If yourCACis lessthanyourLTV, itindicatesthatyour businessis
strong.If the twometricsare equal,itlikelyhighlightsastagnantbusiness.If yourCACisgreater
than yourLTV, youare lookingata financial loss.
_________________________________________________________________
What Is the Difference Between the Different Cost
Types?
Fixed costs, total fixed costs, and variable costs all sound similar, but there are
significant differences between the three. The main difference is that fixed costs do
not account for the number of goods or services a company produces while variable
costs and total fixed costs depend primarily on that number.
KEY TAKEAWAYS:
 Fixed costs do not account for the number of goods or services a
company produces
 Variable costs and total costs depend on the number of goods or
services a company produces.

6.  Companies must consider both types of costs to ensure they are
fiscally solvent and thriving over the long term.
Understanding the Different Cost Types
As the name suggests, fixed costs do not change as a company produces more or
less products or provides more or fewer services. For example, rent paid for a
building will be the same regardless of the number of widgets produced within that
building. In contrast, variable costs do change depending on production volume. For
example, the cost of materials that go into producing the widgets will rise as the
number of widgets produced increases.
Fixed Costs
What Is a Fixed Cost?
The term fixed cost refers to a cost that does not change with an increase or
decrease in the number of goods or services produced or sold. Fixed costs are
expenses that have to be paid by a company, independent of any specific business
activities. This means fixed costs are generally indirect, in that they don't apply to a
company's production of any goods or services. Companies can generally have two
types of costs—fixed costs or variable costs—which together result in their total
costs. Shutdown points tend to be applied to reduce fixed costs.1
KEY TAKEAWAYS
 Fixed costs are expenses that have to be paid by a company,
independent of any specific business activities.
 These costs are set over a specified period of time and do not change
with production levels.
 Fixed costs can be direct or indirect and may influence profitability at
different points on the income statement.
 Companies have interest payments as fixed costs which are a factor for
net income.
 Cost structure management is an important part of business analysis
that looks at the effects of fixed and variable costs on a business
overall.
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Fixed Costs
Understanding Fixed Costs
The costs associated with doing business can be broken out by indirect, direct, and
capital costs on the income statement and notated as either short- or long-term
liabilities on the balance sheet. Both fixed and variable costs make up the total cost

7. structure of a company. Cost analysts analyze both fixed and variable costs through
various types of cost structure analysis. Costs are generally a key factor influencing
total profitability.
Fixed costs are usually established by contract agreements or schedules. These are
the base costs involved in operating a business comprehensively. Once
established, fixed costs do not change over the life of an agreement or cost
schedule.
Fixed costs are allocated in the indirect expense section of the income
statement which leads to operating profit.1 Depreciation is one common fixed cost
that is recorded as an indirect expense. Companies create a depreciation expense
schedule for asset investments with values falling over time. For example, a
company might buy machinery for a manufacturing assembly line that is expensed
over time using depreciation. Another primary fixed, indirect cost is salaries for
management.
Any fixed costs on the income statement are accounted for on the balance sheet
and cash flow statement. Fixed costs on the balance sheet may be either short- or
long-term liabilities. Finally, any cash paid for the expenses of fixed costs is shown
on the cash flow statement. In general, the opportunity to lower fixed costs can
benefit a company’s bottom line by reducing expenses and increasing profit.
Special Considerations
Fixed costs can be used to calculate several key metrics, including a company's
break-even analysis and operating leverage.
Break-Even Analysis
A break-even analysis involves using both fixed and variable costs to identify a
production level in which revenue equals costs. This can be an important part of
cost structure analysis. A company’s break-even production quantity is calculated
by:
Break-even Quantity = Fixed Costs ÷ (Sales Price per Unit – Variable Cost per Unit)
A company’s break-even analysis can be important for decisions on fixed and
variable costs. Break-even analysis also influences the price at which a company
chooses to sell its products.
Operating Leverage
Operating leverage is another cost structure metric used in cost structure
management. The proportion of fixed to variable costs influences a company’s
operating leverage. Higher fixed costs help operating leverage to increase. You can
calculate operating leverage using the following formula:
Operating Leverage = [Q(P-V)] ÷ [Q(P-V)-F]

8. Where:
 Q = number of units
 P = price per unit
 V = variable cost per unit
 F = fixed costs
Companies can produce more profit per additional unit produced with higher
operating leverage.
Fixed vs. Variable Costs
As noted above, fixed costs are any expenses that a company incurs that never
change during the course of running a business. Fixed costs are usually negotiated
for a specified period but can't decrease on a per unit basis when they are
associated with the direct cost portion of the income statement, fluctuating in the
breakdown of costs of goods sold.
Variable costs, on the other hand, are costs directly associated with production and
therefore change depending on business output. These costs can increase or
decrease with respect to production levels or sales. Variable costs are generally
associated with things like raw materials and shipping costs.2
Companies have some flexibility when it comes to breaking down costs on
their financial statements, and fixed costs can be allocated throughout
their income statement. The proportion of fixed versus variable costs that a
company incurs and its allocations can depend on its industry.
Factors Associated With Fixed Costs
Companies can associate fixed (and variable) costs when analyzing costs per unit.
As such, the cost of goods sold (COGS) can include both types of costs. All costs
directly associated with the production of a good are summed collectively and
subtracted from revenue to arrive at gross profit. Cost accounting varies for each
company depending on the costs they are working with.
Economies of scale can also be a factor for companies that can produce large
quantities of goods. Fixed costs can be a contributor to better economies of scale
because fixed costs can decrease per unit when larger quantities are produced.
Fixed costs that may be directly associated with production will vary by company but
can include costs like direct labor and rent.
Cost Structure Management and Ratios
In addition to financial statement reporting, most companies closely follow their cost
structures through independent cost structure statements and dashboards.

9. Independent cost structure analysis helps a company fully understand its fixed and
variable costs and how they affect different parts of the business as well as the total
business overall. Many companies have cost analysts dedicated solely to
monitoring and analyzing the fixed and variable costs of a business.3
The fixed charge coverage ratio, on the other hand, is a type of solvency metric that
helps analyze a company’s ability to pay its fixed-charge obligations. The fixed-
charge coverage ratio is calculated from the following equation:
EBIT + Fixed Charges Before Tax ÷ Fixed Charges Before Tax + Interest
The fixed cost ratio is a simple ratio that divides fixed costs by net sales to
understand the proportion of fixed costs involved in production.
Examples of Fixed Costs
Fixed costs include any number of expenses, including rental lease payments,
salaries, insurance, property taxes, interest expenses, depreciation, and potentially
some utilities.4
For instance, someone who starts a new business would likely begin with fixed
costs for rent and management salaries. All types of companies have fixed cost
agreements that they monitor regularly. While these fixed costs may change over
time, the change is not related to production levels but are instead related to new
contractual agreements or schedules.
What Are Some Examples of Fixed Costs?
Common examples of fixed costs include rental lease or mortgage payments,
salaries, insurance, property taxes, interest expenses, depreciation, and
potentially some utilities.
Are All Fixed Costs Considered Sunk Costs?
All sunk costs are fixed costs in financial accounting. But not all fixed costs
are considered to be sunk. The defining characteristic of sunk costs is that
they cannot be recovered.
It's easy to imagine a scenario where fixed costs are not sunk. For example,
equipment might be re-sold or returned at the purchase price.
Individuals and businesses both incur sunk costs. For example, someone
might drive to the store to buy a television, only to decide upon arrival to not
make the purchase.

10. The gasoline used in the drive is, however, a sunk cost—the customer cannot
demand that the gas station or the electronics store compensate them for the
mileage.
How Are Fixed Costs Treated in Accounting?
Fixed costs are associated with the basic operating and overhead costs of a
business. Fixed costs are considered indirect costs of production, which
means they are not costs incurred directly by the production process, such as
parts needed for assembly. But they do factor into total production costs. As a
result, they are depreciated over time instead of being expensed.
How Do Fixed Costs Differ From Variable Costs?
Unlike fixed costs, variable costs are directly related to the cost of production
of goods or services. Variable costs are commonly designated as the cost of
goods sold, whereas fixed costs are not usually included in COGS.
Fluctuations in sales and production levels can affect variable costs if factors
such as sales commissions are included in per-unit production costs.
Meanwhile, fixed costs must still be paid even if production slows down
significantly.
Variable Costs
What Is a Variable Cost?
A variable cost is a corporate expense that changes in proportion to how much a
company produces or sells. Variable costs increase or decrease depending on a
company's production or sales volume—they rise as production increases and fall
as production decreases.
Examples of variable costs include a manufacturing company's costs of raw
materials and packaging—or a retail company's credit card transaction fees or
shipping expenses, which rise or fall with sales. A variable cost can be contrasted
with a fixed cost.
KEY TAKEAWAYS
 A variable cost is an expense that changes in proportion to production
output or sales.
 When production or sales increase, variable costs increase; when
production or sales decrease, variable costs decrease.
 Variable costs stand in contrast to fixed costs, which do not change in
proportion to production or sales volume.

11. Variable Costs
Understanding Variable Costs
The total expenses incurred by any business consist of variable and fixed costs.
Variable costs are dependent on production output or sales. The variable cost of
production is a constant amount per unit produced. As the volume of production and
output increases, variable costs will also increase. Conversely, when fewer products
are produced, the variable costs associated with production will consequently
decrease.
Examples of variable costs are sales commissions, direct labor costs, cost of raw
materials used in production, and utility costs.
Variable costs are usually viewed as short-term costs as they can be adjusted
quickly.
How to Calculate Variable Costs
The total variable cost is simply the quantity of output multiplied by the variable cost
per unit of output:
Total Variable Cost = Total Quantity of Output X Variable Cost Per Unit of Output
Variable Costs vs. Fixed Costs
Fixed costs are expenses that remain the same regardless of production output.
Whether a firm makes sales or not, it must pay its fixed costs, as these costs are
independent of output.
Examples of fixed costs are rent, employee salaries, insurance, and office supplies.
A company must still pay its rent for the space it occupies to run its business
operations irrespective of the volume of products manufactured and sold. If a
business increased production or decreased production, rent will stay exactly the
same. Although fixed costs can change over a period of time, the change will not be
related to production, and as such, fixed costs are viewed as long-term costs.
There is also a category of costs that falls between fixed and variable costs, known
as semi-variable costs (also known as semi-fixed costs or mixed costs). These are
costs composed of a mixture of both fixed and variable components. Costs are fixed
for a set level of production or consumption and become variable after this
production level is exceeded. If no production occurs, a fixed cost is often still
incurred.

12. In general, companies with a high proportion of variable costs relative to fixed
costs are considered to be less volatile, as their profits are more dependent
on the success of their sales.
Example of a Variable Cost
Let’s assume that it costs a bakery $15 to make a cake—$5 for raw materials such
as sugar, milk, and flour, and $10 for the direct labor involved in making one cake.
The table below shows how the variable costs change as the number of cakes
baked vary.
As the production output of cakes increases, the bakery’s variable costs also
increase. When the bakery does not bake any cake, its variable costs drop to zero.
Fixed costs and variable costs comprise the total cost. Total cost is a determinant of
a company’s profits, which is calculated as:
A company can increase its profits by decreasing its total costs. Since fixed costs
are more challenging to bring down (for example, reducing rent may entail the
company moving to a cheaper location), most businesses seek to reduce their
variable costs. Decreasing costs usually means decreasing variable costs.
If the bakery sells each cake for $35, its gross profit per cake will be $35 - $15 =
$20. To calculate the net profit, the fixed costs have to be subtracted from the gross

13. profit. Assuming the bakery incurs monthly fixed costs of $900, which includes
utilities, rent, and insurance, its monthly profit will look like this:
Number SoldTotal Variable CostTotal Fixed CostTotal CostSales Profit
20 Cakes $300 $900 $1,200 $700 -$(500)
45 Cakes $675 $900 $1,575 $1,575 $0
50 Cakes $750 $900 $1,650 $1,750 $100
100 Cakes $1,500 $900 $2,400 $3,500 $1,100
A business incurs a loss when fixed costs are higher than gross profits. In the
bakery’s case, it has gross profits of $700 - $300 = $400 when it sells only 20 cakes
a month. Since its fixed cost of $900 is higher than $400, it would lose $500 in
sales. The break-even point occurs when fixed costs equal the gross margin,
resulting in no profits or loss. In this case, when the bakery sells 45 cakes for total
variable costs of $675, it breaks even.
A company that seeks to increase its profit by decreasing variable costs may need
to cut down on fluctuating costs for raw materials, direct labor, and advertising.
However, the cost cut should not affect product or service quality as this would have
an adverse effect on sales. By reducing its variable costs, a business increases its
gross profit margin or contribution margin.
The contribution margin allows management to determine how much revenue and
profit can be earned from each unit of product sold. The contribution margin is
calculated as:
The contribution margin for the bakery is ($35 - $15) / $35 = 0.5714, or 57.14%. If
the bakery reduces its variable costs to $10, its contribution margin will increase to
($35 - $10) / $35 = 71.43%. Profits increase when the contribution margin
increases. If the bakery reduces its variable cost by $5, it would earn $0.71 for every
one dollar in sales.
What Are Some Examples of Variable Costs?
Common examples of variable costs include costs of goods sold (COGS),
raw materials and inputs to production, packaging, wages, and commissions,

14. and certain utilities (for example, electricity or gas that increases with
production capacity).
How Do Fixed Costs Differ From Variable Costs?
Variable costs are directly related to the cost of production of goods or
services, while fixed costs do not vary with the level of production. Variable
costs are commonly designated as COGS, whereas fixed costs are not
usually included in COGS. Fluctuations in sales and production levels can
affect variable costs if factors such as sales commissions are included in per-
unit production costs. Meanwhile, fixed costs must still be paid even if
production slows down significantly.
How Can Variable Costs Impact Growth and
Profitability?
If companies ramp up production to meet demand, their variable costs will
increase as well. If these costs increase at a rate that exceeds the profits
generated from new units produced, it may not make sense to expand. A
company in such a case will need to evaluate why it cannot achieve
economies of scale. In economies of scale, variable costs as a percentage of
overall cost per unit decrease as the scale of production ramps up.
Is Marginal Cost the Same as Variable Cost?
No. Marginal cost refers to how much it costs to produce one additional unit.
The marginal cost will take into account the total cost of production, including
both fixed and variable costs. Since fixed costs are static, however, the
weight of fixed costs will decline as production scales up.
.
Total Costs
Total costs are composed of both total fixed costs and total variable costs. Total
fixed costs are the sum of all consistent, non-variable expenses a company must
pay. For example, suppose a company leases office space for $10,000 per month,
rents machinery for $5,000 per month, and has a $1,000 monthly utility bill. In this
case, the company's total fixed costs would be $16,000.
In terms of variable costs, if a company produces 2,000 widgets at $10 per unit, and
it must pay employees $5,000 in overtime to keep up with the demand, the total
variable costs would be $25,000 ($20,000 in products plus $5,000 in labor costs).

15. Consequently, the total costs, combining $16,000 fixed costs with $25,000 variable
costs, would come to $41,000. Total costs are an essential value a company must
track to ensure the business remains fiscally solvent and thrives over the long term.
A dry leaseisa leasingarrangementwherebyanaircraftfinancingentity(lessor),such
as GECAS,AerCap,orAir Lease Corporation,providesanaircraft withoutcrew,
groundstaff,etc.Dry lease istypicallyusedbyleasingcompaniesandbanks,requiringthe lessee to
put the aircrafton its own air operator's certificate(AOC) andprovide aircraftregistration.A
typical drylease lastsupwardsof twoyearsand bearscertainconditionswithrespectto
depreciation,maintenance,insurances,etc.,dependingalsoonthe geographical location,political
circumstances,etc.
A dry-lease arrangementcanalsobe made betweena major airline and a regional airline,
inwhichthe major airline providesthe aircraftandthe regional operatorprovidesflightcrews,
maintenance andotheroperational aspectsof the aircraft,whichthenmaybe operatedunderthe
majorairline'sname orsome similarname.A drylease savesthe majorairline the expenseof
trainingpersonneltoflyandmaintainthe aircraft,alongwithotherconsiderations(suchas
staggeredunioncontracts,regional airportstaffing,etc.). FedExExpressusesanarrangement
of thistype foritsfeederoperations,contractingtocompaniessuchas Empire

16. Airlines,Mountain Air Cargo, Swiftair, and othersto operate itssingle andtwin-engined
turbo-prop"feeder"aircraftinthe US. DHL hasa jointventure inthe UnitedStateswith Polar
Air Cargo,a subsidiaryof Atlas Air, to operate theirdomesticdeliveries.
A wet leaseisa leasingarrangementwherebyone airline (the lessor) providesanaircraft,
complete crew,maintenance,andinsurance (ACMI) toanotherairline orothertype of business
actingas a brokerof air travel (the lessee),whichpaysbyhoursoperated.The lesseeprovidesfuel
and coversairportfees,andanyotherduties,taxes,etc.The flightusesthe flightnumberof the
lessee.A wetlease generallylasts1–24 months.A wetlease istypicallyutilizedduringpeaktraffic
seasonsorannual heavymaintenance checks,ortoinitiate new routes.[8] A wet-leasedaircraftmay
be usedto flyservicesintocountrieswhere the lesseeisbannedfromoperating.[9] Itcan alsobe used
to replace unavailable capacityortocircumventregulatoryorpolitical restrictions.
Theycan also be consideredaformof charter wherebythe lessorprovidesminimumoperating
services,includingACMI,andthe lesseeprovidesthe balance of servicesalongwithflightnumbers.
In all otherformsof charter,the lessorprovidesthe flightnumbers.Variationsof awetlease include
a code share arrangement,ablockseatagreement,anda capacitypurchase agreement.
Wet leasesare occasionallyusedforpolitical reasons.Forinstance, EgyptAir,anEgyptian
governmententerprise,formanyyears wasnotallowedtoflyto Israel underitsownname,as a
matterof Egyptiangovernmentpolicy.Hence Egyptianflightsfrom CairotoTel Aviv were operated
by AirSinai,whichwet-leasedfromEgyptAirtocircumventthe political issue.[10] In2021 Egypt
changeditspolicyandEgyptAirstartedoperatingflightstoIsrael underitsownbanner.[11][12][13][14]
The global wetlease marketisprojectedtogrow fromUS$7.35 billionin2019 to US$10.9 billionin
2029, a CAGR of 4.1%.
What Is an Operating Lease?
An operating lease is a contract that allows for the use of an asset but does not convey
ownership rights of the asset.
KEY TAKEAWAYS
 An operating lease is a contract that permits the use of an asset without transferring
the ownership rights of said asset.
 GAAP rules govern accounting for operating leases.
 A new FASB rule, effective Dec. 15, 2018, requires that all leases 12 months and
longer must be recognized on the balance sheet.
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17. Operating Lease
How Operating Leases Work
Operating leases are considered a form of off-balance-sheet financing. This means a leased
asset and associated liabilities (i.e. future rent payments) are not included on a company's
balance sheet. Historically, operating leases have enabled American firms to keep billions of
dollars of assets and liabilities from being recorded on their balance sheets, thereby keeping
their debt-to-equity ratios low.
To be classified as an operating lease, the lease must meet certain requirements
under generally accepted accounting principles (GAAP) that exempt it from being recorded
as a capital lease. Companies must test for four criteria—known as the “bright line” test—
that determine whether rental contracts must be booked as operating or capital leases.
Current GAAP rules require companies to treat leases as capital leases if:
 There is an ownership transfer to the lessee at the end of the lease;
 The lease contains a bargain purchase option;
 The lease life exceeds 75% of the asset's economic life;
 The present value (PV) of the lease payments exceed 90% of the asset's fair market
value.
If none of these conditions are met, then the lease must be classified as an operating lease.
The Internal Revenue Service (IRS) may reclassify an operating lease as a capital lease to
reject the lease payments as a deduction, thus increasing the company's taxable income and
tax liability.1
Typically, assets that are rented under operating leases include real estate, aircraft, and
equipment with long, useful life spans—such as vehicles, office equipment, and industry-
specific machinery.
Operating Lease vs. Capital Lease
U.S. GAAP accounting treatments for operating and capital leases are different and can have
a significant impact on businesses' taxes. An operating lease is treated like renting—lease
payments are considered as operating expenses. Assets being leased are not recorded on the
company's balance sheet; they are expensed on the income statement. So, they affect both
operating and net income. Other characteristics include:
 Ownership: Retained by the lessor during and after the lease term.
 Bargain purchase option: Cannot contain a bargain purchase option.
 Term: Less than 75% of the asset’s estimated economic life.
 Present value: PV of lease payments is less than 90% of the asset's fair market
value.
 Accounting: No ownership risk. Payments are considered as operating expenses;
shown in the profit and loss statement (P&L) on the balance sheet.
 Tax: Lessee considered to be renting; lease payment treated as a rental expense.
 Risks/benefits: Right to use only. Risks/benefits remain with the lessor. Lessee
pays maintenance costs.2

18. In contrast, a capital lease is more like a long-term loan, or ownership. The asset is treated as
being owned by the lessee and is recorded on the balance sheet. Capital leases are counted as
debt. They depreciate over time and incur interest expenses. Other characteristics include:
 Ownership: Might transfer to the lessee at end of the lease term.
 Bargain purchase option: Enables lessee to buy an asset at less than fair market
value.
 Term: Equals or exceeds 75% of the asset's estimated useful life.
 Present value: PV of lease payments equals or exceeds 90% of the asset's original
cost.
 Accounting: Lease is considered an asset (leased asset) and liability (lease
payments). Payments are shown on the balance sheet.
 Tax: As the owner, lessee claims depreciation expense and interest expense.
 Risks/benefits: Transferred to the lessee. Lessee pays maintenance, insurance, and
taxes.3
Special Considerations
Effective Dec. 15, 2018, the FASB revised its rules governing lease accounting. Most
significantly, the standard now requires that all leases—except short-term leases of less than
a year—must be capitalized. Other changes include the following:
 Amends the bright-line test to help determine whether or not a lessee has the right to
control the identified asset.
 Installs a new definition of indirect costs that likely would result in fewer indirect
costs being capitalized.
 Requires the transfer of the asset to meet certain revenue recognition requirements in
order for a sale or leaseback to occur.
 Requires a significant number of new financial statement disclosures, both
quantitative and qualitative, for both parties.4
Prior to this in 2016, the Financial Accounting Standards Board (FASB) issued new
guidance requiring lessees to recognize to recognize on the balance sheet the assets and
liabilities for the rights and obligations created by operating leases.5
What Are the Key Characteristics that Define an
Operating Lease?
To be classified as an operating lease, the lease must meet certain requirements under
generally accepted accounting principles (GAAP). An operating lease is treated like
renting—lease payments are considered as operating expenses. Assets being leased are not
recorded on the company's balance sheet; they are expensed on the income statement. So,
they affect both operating and net income. It is retained by the lessor during and after the
lease term and cannot contain a bargain purchase option. The term is less than 75% of the
asset’s estimated economic life and the present value (PV) of lease payments is less than
90% of the asset's fair market value.

19. How Does GAAP Define a Capital Lease?
GAAP views a capital lease more like a long-term loan, or ownership. The asset is treated as
being owned by the lessee and is recorded on the balance sheet. Capital leases are counted as
debt. They depreciate over time and incur interest. The lessor can transfer it to the lessee at
the end of the lease term and it may contain a bargain purchase option that enables the lessee
to buy it below fair market value. The term equals or exceeds 75% of the asset's estimated
useful life. and the present value (PV) of lease payments equals or exceeds 90% of the
asset's original cost.
What Are the Advantages of an Operating Lease?
Operating leases have certain advantages. Chief amongst them is that they allow companies
greater flexibility to upgrade assets, like equipment, which reduces the risk of obsolescence.
There is no ownership risk and payments are considered to be operating expenses and tax-
deductible. Finally, risks/benefits remain with the lessor as the lessee is only liable for the
maintenance costs.
CAPITAL OR FINANCIAL LEASE
What Is Capital Lease?
A capital lease is a contract entitling a renter to the temporary use of an asset and
has the economic characteristics of asset ownership for accounting purposes.
KEY TAKEAWAYS
 A capital lease is a contract entitling a renter to the temporary use of an
asset
 A capital lease is considered a purchase of an asset, while an
operating lease is handled as a true lease under generally accepted
accounting principles (GAAP).
 Under a capital lease, the leased asset is treated for accounting
purposes as if it were actually owned by the lessee and is recorded on
the balance sheet as such.
 An operating lease does not grant any ownership-like rights to the
leased asset, and is treated differently in accounting terms.
Capital Lease
Understanding Capital Lease
The capital lease requires a renter to book assets and liabilities associated with the
lease if the rental contract meets specific requirements. In essence, a capital lease
is considered a purchase of an asset, while an operating lease is handled as a true

20. lease under generally accepted accounting principles (GAAP). A capital lease may
be contrasted with an operating lease.
Even though a capital lease is technically a sort of rental agreement, GAAP
accounting standards view it as a purchase of assets if certain criteria are met.
Capital leases can have an impact on companies' financial
statements, influencing interest expense, depreciation expense, assets, and
liabilities.
To qualify as a capital lease, a lease contract must satisfy any of the following four
criteria:
1. the life of the lease must be 75% or greater for the asset's useful life.
2. the lease must contain a bargain purchase option for a price less than the market
value of an asset.
3. the lessee must gain ownership at the end of the lease period.
4. the present value of lease payments must be greater than 90% of the asset's market
value.
In 2016, the Financial Accounting Standards Board (FASB) made an amendment to
its accounting rules requiring companies to capitalize all leases with contract terms
above one year on their financial statements. The amendment became effective on
December 15, 2018, for public companies and December 15, 2019, for private
companies.1
Accounting treatments for operating and capital leases are different and can
have a significant impact on businesses' taxes.
Capital Leases Vs. Operating Leases
An operating lease is different in structure and accounting treatment from a capital
lease. An operating lease is a contract that allows for the use of an asset but does
not convey any ownership rights of the asset.
Operating leases used to be counted as off-balance sheet financing—meaning that
a leased asset and associated liabilities of future rent payments were not included
on a company's balance sheet in order to keep the debt to equity ratio low.
Historically, operating leases enabled American firms to keep billions of dollars of
assets and liabilities from being recorded on their balance sheets.
However, the practice of keeping operating leases off the balance sheet was
changed when Accounting Standards Update 2016-02 ASU 842 came into effect.
Starting Dec. 15, 2018, for public companies and Dec. 15, 2019, for private
companies, right-of-use assets and liabilities resulting from leases are recorded on
balance sheets.1
To be classified as an operating lease, the lease must meet certain requirements
under generally accepted accounting principles (GAAP) that exempt it from being

21. recorded as a capital lease. Companies must test for the four criteria, also known as
the “bright line” tests, listed above that determine whether rental contracts must be
booked as operating or capital leases. If none of these conditions are met, the lease
can be classified as an operating lease, otherwise, it is likely to be a capital lease.2
The Internal Revenue Service (IRS) may reclassify an operating lease as a capital
lease to reject the lease payments as a deduction, thus increasing the company's
taxable income and tax liability.3
Accounting for Capital Leases
A capital lease is an example of accrual accounting's inclusion of economic events,
which requires a company to calculate the present value of an obligation on its
financial statements. For instance, if a company estimated the present value of its
obligation under a capital lease to be $100,000, it then records a $100,000 debit
entry to the corresponding fixed asset account and a $100,000 credit entry to the
capital lease liability account on its balance sheet.
Because a capital lease is a financing arrangement, a company must break down its
periodic lease payments into an interest expense based on the company's
applicable interest rate and depreciation expense. If a company makes $1,000 in
monthly lease payments and its estimated interest is $200, this produces a $1,000
credit entry to the cash account, a $200 debit entry to the interest expense account,
and an $800 debit entry to the capital lease liability account.
A company must also depreciate the leased asset that factors in its salvage
value and useful life. For example, if the above-mentioned asset has a 10-year
useful life and no salvage value based on the straight-line
basis depreciation method, the company records an $833 monthly debit entry to
the depreciation expense account and a credit entry to the accumulated
depreciation account. When the leased asset is disposed of, the fixed asset is
credited and the accumulated depreciation account is debited for the remaining
balances.