0264 · 6.1.2Effects of government policy

Policy effects on business profit

0:00Tolworth Cycles sells bicycles. Its managers could keep the same prices and offer the same products, yet decisions outside the business could change its results. Customers might have less money available, borrowing could become more expensive, or new government orders could create opportunities. By the end of this video, you will understand these connections and how businesses can respond. Government policy includes decisions about taxation and public spending that influence businesses and their customers.

0:25Changes in interest rates also affect business decisions, although central banks often set the main rate independently. The useful starting point is to trace where money moves. A policy change can affect customers’ spending, business costs or the funds available for expansion. Revenue is the income a business receives from selling goods or services, while profit is total revenue minus total costs. These definitions give us two routes through which policy can affect performance.

0:51Customers buying fewer products can reduce revenue, while more expensive borrowing raises costs. A tax charged on profits affects how much remains after that payment. A useful explanation follows a chain from the policy change to its business outcome. Start with the person or organisation directly affected. Then follow the change through spending, costs or available finance. Finish with the consequence for the particular business. This approach helps you understand the effect and choose a response that addresses its cause.

1:19A tax on business profits is a compulsory payment to government based on the amount earned after costs. For companies, this is commonly called corporation tax. If the rate increases, a larger proportion goes to the government. With profit before tax unchanged, the company has less remaining to keep within the business or pay to its owners. Retained profit is profit kept in the business after tax and payments to owners.

1:41Tolworth Cycles might use this finance to open another outlet. A higher tax rate leaves less available for that project, so managers may delay expansion. Alternatively, owners could accept smaller payments so that more funds remain available for the planned opening. A lower rate of tax on profits leaves a business with more after the payment, assuming its earnings before tax stay unchanged. Managers could use the additional funds to purchase equipment or improve the premises.

2:07Owners might receive more instead. The tax reduction creates an opportunity, while the eventual benefit depends on how the money is used.

Income tax and government spending

2:14Income tax is a compulsory payment to government based on a person’s earnings. The income remaining after direct taxes have been deducted is called disposable income. An increase in income tax reduces this amount if earnings before deductions stay unchanged. Customers then have less available for purchases or saving, so businesses may experience weaker demand. A luxury product is something customers regard as desirable but unnecessary. An expensive leisure bicycle could fit this description for someone who already has suitable transport.

2:43When disposable income falls, that customer may postpone the purchase. Spending on basic food is usually harder to reduce substantially, so the effect differs between businesses and their products. With a lower income tax rate, customers keep more of their earnings if other deductions remain unchanged. Some customers may spend part of that increase at Tolworth Cycles, which could raise revenue. Others may save the additional money or repay existing debts.

3:07The effect on sales therefore depends on customers’ choices and the products they want. Businesses can respond to lower disposable income by launching cheaper products or changing the customers they target. Tolworth Cycles could offer a simpler model for essential journeys. This gives buyers an affordable option while preserving a reason to purchase. Managers would still need to check that its selling price covers the relevant costs and supports profit.

3:30Government spending is money paid by the state for goods, services and public projects. Brackley Masonry constructs buildings and roads. An increase in public spending on schools could create new contracts for this business. Its suppliers may also receive more orders for materials. Those payments create opportunities beyond the firm that wins the construction contract. To complete additional projects, Brackley Masonry may recruit more employees or increase purchases from suppliers.

3:56Newly recruited employees receive earnings that they can spend in local shops and cafés. This creates an indirect benefit for other businesses. The original spending therefore affects both the organisations receiving contracts and businesses serving the households whose incomes rise. Government spending can also improve the conditions under which businesses operate. Better roads may shorten delivery journeys and reduce transport costs. Investment in schools can improve future employees’ knowledge and skills over time.

4:23These benefits develop at different speeds, so a business should distinguish immediate orders from improvements that support its activities over a longer period. Cuts in government spending can reduce contracts for construction firms and their suppliers. Businesses losing orders may reduce recruitment or purchase fewer materials. Lower household earnings can then weaken demand for nearby shops and cafés. The effect depends on how closely a business relies on public contracts and the spending of those connected to them.

Interest rates and borrowing costs

4:50Interest is the payment made for borrowing money. An interest rate expresses the cost of borrowing, or reward for saving, as a percentage over a stated period. Higher rates make new borrowing more expensive. Businesses with variable-rate loans may also face larger charges on existing debt when their lender changes the rate. An overdraft is an arrangement allowing a business to spend more than the balance available in its bank account, up to an agreed limit.

5:13A higher rate increases the cost of using that facility. Loans with fixed rates keep their agreed charges during the fixed period. Managers therefore need to check their borrowing arrangements before predicting the effect. Lindale Fields grows vegetables for local retailers. It has a loan of one hundred thousand dollars, with the full amount outstanding throughout the year. We will compare annual interest at five per cent and eight per cent.

5:34Assume there are no fees or repayments during this period, so the comparison isolates the effect of the rate change. Annual interest equals the amount borrowed multiplied by the annual interest rate divided by one hundred. One hundred thousand dollars divided by one hundred gives one thousand dollars for one per cent. Multiplying one thousand dollars by five gives five thousand dollars in annual interest. At eight per cent, one thousand dollars multiplied by eight gives eight thousand dollars.

6:00Eight thousand dollars minus five thousand dollars gives an increase of three thousand dollars per year. With revenue and every other cost unchanged, the higher charge reduces profit by that amount. The business also needs additional money available when interest is payable. Managers must consider both the effect on earnings and their ability to make the payment. More expensive borrowing can make a planned expansion less attractive. Lindale Fields might delay purchasing additional equipment because the loan would cost more to service.

6:27Using retained profit could avoid the additional borrowing charge if sufficient funds are available. Managers would still need to preserve enough money for everyday payments such as wages and materials.

Interest rates and business responses

6:38Credit allows a customer to receive a product now and pay later. Higher interest rates can increase the total cost of purchases financed this way. Customers may postpone buying expensive items such as cars or houses. At the same time, a greater reward for saving encourages some people to set money aside, which can further reduce current spending. When rates rise, a business can face pressure from two directions. Its borrowing charges may increase while customers reduce purchases.

7:02Falling sales can weaken revenue at the same time that costs rise. Businesses selling expensive products commonly bought on credit are particularly exposed to this combination, especially when they also rely heavily on loans. When rates fall, new loans, overdrafts and variable-rate loans become cheaper. Businesses may bring forward expansion because financing equipment or premises costs less. Customers could also find credit purchases more affordable, while saving offers a smaller reward.

7:29These changes can support sales, although managers still need evidence of sufficient demand before committing to expansion. Possible responses include changing prices, cutting costs, adjusting expansion plans, using retained profit, launching cheaper products and targeting different customers. Each action addresses a particular pressure. A business with rising borrowing charges may focus on finance and operating costs. When customers have less disposable income, affordable products or a different target group may offer a stronger response.

7:58Changing prices involves a trade-off between earnings per sale and the quantity customers purchase. A higher price may help cover increased costs, but some buyers may choose alternatives. Cutting prices could encourage purchases when household spending is weak. Managers must judge whether the additional sales would compensate for receiving less from each customer. Cost reductions can help protect profit after borrowing becomes more expensive. A business might reduce wasted materials or negotiate better supplier terms.

8:24Managers should preserve the features customers value, because poorer products could weaken future sales. Targeting customers whose spending is less affected offers another possibility, provided the business can meet their needs profitably.

Exam chains and recap

8:36A tax on business profits directly changes the amount a business keeps after the payment. Income tax works through customers instead, by changing their disposable income. Revenue falls when customers buy less, while profit also falls when costs such as interest rise. For borrowing, establish whether the agreement allows its rate to change before predicting a larger charge on existing debt. Both Paper One Short Answer and Data Response and Paper Two Case Study can use business information to test these relationships.

9:04For the command word explain, set out purposes or reasons, say why and how, supported with relevant evidence. Use the situation in the question to choose the relevant chain. Finish with the requested business outcome. Penrose Joinery makes desks for government schools. It has a variable-rate loan used to purchase machinery. An exam-style question asks you to explain how higher interest rates and lower government spending could affect this business’s profit.

9:29The loan detail supports a borrowing-cost explanation, while the customer information connects public spending to orders. Higher interest rates increase the charge on Penrose Joinery’s variable-rate loan when its lender applies the change. This raises borrowing costs and reduces profit if revenue and other costs remain unchanged. Lower spending on school equipment could reduce orders for desks, so revenue falls. Each lost desk sale removes its price from revenue but saves only the materials used to make it, so profit falls.

9:55Government policy reaches businesses through the money available to customers, the orders placed by the state and the funds firms can keep. Interest rate changes affect borrowing charges, saving decisions and purchases on credit. Responses work best when they address the pressure faced by that particular business. Trace the cause, follow the money and connect the result to a suitable action.