Investopedia

Reviewed by Ebony Howard
Fact checked by Suzanne Kvilhaug

Jersey is a 45-square-mile island located in the English Channel, off the coast of France. It is a British Crown Dependency, which means that although it is not part of the United Kingdom, it is a possession of the British Crown. Jersey maintains full political and financial autonomy, allowing it to operate independently of the UK. Known for its low taxes, Jersey has long been considered a tax haven, particularly for wealthy individuals and corporations looking to reduce their tax liabilities. Let’s discuss why.

Key Takeaways

• Jersey has been considered a tax haven since the 1920s.
• The island has a maximum 20% personal income tax rate, with no wealth, inheritance, or capital gains taxes.
• Jersey’s corporate tax rate is zero for most businesses, except for financial services (10%) and certain utilities, rentals, and development projects (20%).
• Jersey’s tax structure has made it an attractive destination for international financial services and high-net-worth individuals.

Jersey Tax History

Jersey first gained a reputation as a tax haven in the 1920s, when wealthy British citizens began moving to the island, or, in many cases, simply transferring their wealth there, in order to benefit from the absence of wealth and inheritance taxes.

In 1928, Jersey introduced a 2.5% income tax, which was later raised to 20% during the German Occupation of the Channel Islands in World War II. Since then, the island has maintained a 20% income tax rate, and it still does not impose inheritance, wealth, or capital gains taxes.

As deposits from wealthy individuals filled the nation’s coffers, the revelation that almost any tax could be avoided in Jersey brought the banking business to roost on the island. That gave birth to one of the most popular offshore destinations for U.S. dollars, rubles, yen, and other global currencies.

Note

Jersey became a location for international smuggling in the 17th century. In the early 18th century, the merchant Jean Martel, whose Cognac brandy is prized to this day, smuggled Jersey knitted stockings to France as his brandy was smuggled to England.

Financial Regulation

No registration of offshore trust accounts is required by the companies that administer individual financial accounts on the island. While the Jersey Financial Services Commission (JFSC) insists that trusts face strict regulation of fund sources, ownership, beneficiaries, and anti-money laundering provisions, large degrees of privacy surround the accounts.

JFSC officials who entered into cooperative agreements fostering disclosure with the United States and the United Kingdom contend that the confidentiality associated with the trusts equates with standards afforded to any other financial accounts.

To combat tax fraud or money laundering, banks require significant documentation regarding the source and nature of deposits, such as sales contracts from real estate or business transactions and proof of income from employers.

Individual Income Taxes

A maximum income tax rate of 20% applies to people who establish residency in Jersey. Those prospective residents who are high-net-worth individuals must meet and sustain a minimum income of £1,250,000, or about $1,617,875 as of March 2025. Income that exceeds the minimum is subject to an additional 1% tax. Compared to the UK, where the top income tax rate is 45%, Jersey provides significant tax savings for those meeting the residency requirements.

Corporate Tax Structure

In 2008, Jersey introduced a landmark tax policy by eliminating corporate taxes for most companies operating on the island. The only exceptions to this are financial services firms, which are taxed at 10%, and businesses in the utilities, rental, and development sectors, which face a 20% tax rate.

As of 2025, there were 20 banks, with deposits of over $160 billion, licensed to operate in Jersey. Among the banks that conduct business in Jersey are Citibank, the U.S. consumer division of Citigroup Inc., and UBS AG.

Other Taxes

While no taxes are levied against capital gains or capital transfers, a 5% tax on goods and services was implemented in June 2011. Additionally, a stamp duty of up to 0.75% applies to the transfer of immovable property within the nation’s borders, and its individual parishes collect property taxes.

Jersey offers a VAT-free environment, meaning goods and services are not subject to value-added taxes, unlike in the UK and much of Europe, where VAT rates can reach 20% or more. This tax advantage significantly reduces the cost of living and business operations, making the island particularly attractive to high-net-worth individuals, luxury shoppers, and companies looking to minimize consumption tax burdens. 

What Makes Jersey’s Taxes Attractive?

What makes Jersey’s taxes attractive is the fact that they’re low for individuals (20% maximum tax rate) and nonexistent for many corporations or relatively low for the exceptions, such as financial services firms (10%).

Which Taxes Does Jersey Not Levy?

Jersey does not charge taxes on wealth, inheritance, or capital gains. This makes it an attractive place for individuals and corporations seeking to minimize their tax liabilities.

When Did Jersey’s Income Tax Rate Go to 20%?

During the Second World War and the German Occupation of Jersey, the rate was raised from 2.5% to 20%, where it has stayed to this day.

The Bottom Line

The largest Channel Island, Jersey is home to a tax structure that for years has attracted new financial accounts, residents, and corporations.

Known as a tax haven, its 20% income tax rate has been in place since the 1940s. And, with some exceptions (e.g., banks and other financial services companies), it eliminated corporate taxes in 2008.

Reviewed by Andy Smith
Fact checked by Yarilet Perez

Net present value (NPV) assesses the profitability of an investment on the basis that a dollar in the future isn’t worth the same as a dollar today.

NPV calculations are useful when you’re evaluating investment opportunities but the process is by no means perfect. It’s a useful starting point but it’s not a definitive metric that an investor can rely on for all investment decisions.

Key Takeaways

• Net present value (NPV) is a calculation that discounts a future stream of cash flows back into the present day.
• The NPV calculation helps investors decide how much they would be willing to pay today for a stream of cash flows in the future.
• A disadvantage of using NPV is that it can be challenging to accurately arrive at a discount rate that represents the investment’s true risk premium.
• Another disadvantage is that a company may select a cost of capital that’s either too high or too low leading it to miss a profitable opportunity.

Net Present Value (NPV)

Money loses value over time due to inflation but a dollar today can be invested and earn a return. Its future value could possibly be higher than a dollar received at the same point down the road.

NPV seeks to determine the present value of future cash flows of an investment above its initial cost. The discount rate element of the formula discounts the future cash flows to the present-day value. The investment is considered worthwhile if subtracting the initial cost of the investment from the sum of the cash flows in the present day is positive.

An investor could receive $100 today or a year from now. Most investors wouldn’t be willing to postpone receiving $100 today but what if they could choose to receive $100 today or $105 in one year? The 5% rate of return (RoR) for waiting one year might be worthwhile unless another investment could yield a rate greater than 5% over the same period.

An investor would choose to receive $100 today, not $105 in a year with the 5% rate of return if they knew they could earn 8% from a relatively safe investment over the next year. The 8% is the discount rate in this case.

Important

An alternative to net present value (NPV) is the payback period or payback method. More attractive investments generally have shorter payback periods.

Disadvantages of Net Present Value (NPV)

There are some disadvantages to using the NPV calculation.

Selecting a discount rate

Accurately pegging a percentage number to an investment to represent its risk premium isn’t an exact science. If the investment is safe with a low risk of loss, 5% might be a reasonable discount rate to use. But what if the investment harbors enough risk to warrant a 10% discount rate? NPV calculations require the selection of a discount rate so they can be unreliable if the wrong rate is used.

The investment won’t have the same level of risk throughout its entire time horizon, either, and this makes matters even more complex.

Let’s go back to our example of a five-year investment. How should an investor calculate NPV if the investment had a high risk of loss for the first year but a relatively low risk for the last four years? The investor could apply different discount rates for each period but this would make the model even more complex and require the pegging of five discount rates.

Determining the cost of capital and cash flows

The cost of capital is the rate of return required to make an investment worthwhile. It helps determine whether the return on the investment is worth the risk.

A company must set an appropriate cost of capital when it decides whether to invest. It may determine that an investment isn’t worth the risk and miss and opportunity if it aims too high. It may be making investment decisions that aren’t worthwhile, however, if the cost of capital is too low.

It can be difficult to determine the cash flows from an investment when it doesn’t have a guaranteed return. This can sometimes be the case for companies that invest in new equipment or decisions that are based on business expansion. A company can estimate the kind of cash flows these investment decisions may have but there’s a chance they could be off by a significant percentage.

Investment size

A higher NPV doesn’t necessarily mean a better investment. The NPV will be higher for a project if there are two investments or projects up for decision and one project is larger in scale because NPV is reported in dollars. A larger outlay will therefore result in a larger number. It’s important to assess the returns from an investment in percentage terms to get an accurate picture of which investment provides a better return.

How Does Inflation Work?

Inflation involves a consistent escalation of prices, particularly for consumer goods, over an extended time. A $500 purchase in December 2024 might require $525 out of pocket in June 2025. It’s referred to as disinflation when increases pause. Deflation is a drop in prices that’s steady on ongoing like inflationary increases.

What Is a Payback Period?

The payback period is the amount of time it takes for an investor to reach the breakeven point and recover their initial investment cost.

How Is Cash Flow Measured?

Cash flow is the difference between money coming into a business or account and money leaving the business or account as it’s spent. The difference can be positive or negative. Negative cash flow isn’t sustainable indefinitely. Positive cash flow can be reduced by investments into growth or other opportunities.

The Bottom Line

Net present value calculates the value of future cash flow into the present day. It can be a tool for investors to help determine how much they’re willing to pay now for cash inflows in the future. Basing your investment decisions on NPV comes with some risks, however, particularly if you’re only considering this one factor. It can be tricky to calculate and can be affected and skewed by a company’s cost of capital.

Always seek expert help if you’re uncertain about an investment rather than rely too heavily on this metric.

Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.

Find profits in these types of companies that do well during recessions

Reviewed by Michael J Boyle
Fact checked by Kirsten Rohrs Schmitt

During a recession, equities markets are usually hammered as companies’ earnings take a hit from reduced consumer demand. But there are companies that do well in bad times. Knowing which types of companies do well even when the economy is in poor health can help shield your investment from the worst of a market downturn, and it may offer the opportunity to find profit even as the broader market languishes.

Key Takeaways

• Investors can safeguard their portfolios, and potentially even make money, during a market downturn by identifying recession-resistant companies.
• Recession-resistant companies generally deliver stable revenue regardless of economic conditions.
• Most of these companies sell consumer essentials, provide critical repair services, manufacture proprietary products, or provide required services that consumers cannot easily eliminate.

How to Spot a Recession-Resistant Company

When looking to minimize downside risk during a recession, investors should look for companies that sell products or offer services consumers cannot easily cut. These include companies such as utilities, insurance, healthcare, consumer essentials and food. Discounters also fare well as consumers look for bargains.

Inelasticity of Demand

What all recession-proof companies have in common is that demand for their products and services is relatively inelastic. Customers have little flexibility even when budgets are tight.

1. Enjoys Inelastic Demand

Many recession-resistant companies sell products and services that are relatively inelastic. That is, customers have little flexibility about buying their products or services, even when budgets are tight.

Utility companies are one good example. They provide gas for heating and cooking, electricity and water. These companies generally fare well during recessions as consumers cannot easily stop consuming those services.

Their prices also do not come under pressure the way consumer products do if demand weakens, as most utility rates are set by agreement with various government agencies.

To get a sense of how this stability translates into share price, we can look at the Great Recession (2007-2009), when stock values took a beating. The Dow Jones Industrial Average slid more than 35% from 12,650 in early January 2008 to 8,000 one year later. It did recover somewhat by early 2010, but regained less than half its losses, crawling back to 10,000 in early January 2010.

But utilities held their value even as the market imploded. Some even made money for investors.

Pacific Gas and Electric Company (PCG), for example, was trading at about $25 in early January 2008. One year later, while the broader market lost about 35%, PCG was trading slightly higher at just over $26 per share.

American Water Works (AWK) was similarly trading at around $21 in early 2008, climbed slightly to just below $22 by the end of the year and further still to $23 by January 2010.

These may not look like stellar performances, but given that the broader market was in steep decline, holding steady is an accomplishment. It also shows that these companies tend to enjoy fairly stable earnings regardless of what is happening in the economy.

2. Provides Critical Repair Services

Companies that provide nonessential services are typically the first to suffer in a recession. A consumer can choose to cut their own grass or paint their own house, for example.

But some companies provide critical services that cannot be easily cut.

Waste management is one example: It takes more than a recession for people to cancel garbage collection and just let uncollected trash pile up.

So it’s not surprising that shares in Waste Management Inc (WM) also held firm during the 2008 recession, and even gained ground. In early 2008, WM shares were trading at about $29, but then climbed to nearly $34 by the end of the year even as the market lost over a third of its value.

Auto repair and parts companies are another example: Consumers generally have no choice to repair their cars if they break down, even if it’s financially challenging to do so.

AutoZone, Inc. (AZO) also fared well during the 2008 recession. The company’s share price was around $120 in early January 2008, before the recession hit in earnest. One year later, it had climbed to $132, and then further to $155 by January of 2010.

3. Sells Proprietary or Specialized Products

Pharmaceutical and healthcare companies with drug patents also enjoy relatively inelastic demand for their products. Consumer buying habits remain stable regardless of price, especially if the product is something they have to buy.

Insulin is a good example. Diabetics who need insulin to survive have no choice but to pay, whatever the cost.

Indeed, the S&P Pharmaceuticals Select Industry Index did take a hit at the onset of the 2008 crisis, slipping just 8% from 1,660 in early January 2008 to 1,530 one year later, but by January of 2010 the index had not only recovered but jumped to over 1,900.

4. Sells Discounted Products

In tough economic times, discounters also do better as people look for bargains.

Before the 2008 recession, Dollar Tree Inc (DLTR) was trading at $9.24, but by January of 2009 its share price had climbed some 54% to $14.24, and a further 16.5% to $16.50 by January of 2010.

How are Companies Negatively Impacted by Recessions?

For most companies, tough economic times mean slowing or even negative earnings growth as consumers spend less, resulting in less demand for the goods and services companies sell. This falling demand may prompt businesses to cut spending, which may impact companies they buy goods and services from, which in turn have to cut their own costs.

In some cases, cost-cutting measures may mean layoffs, which feeds the cycle as laid-off employees have less money to spend, further decreasing demand.

How Do Companies Manage During a Recession?

When consumers cut spending, companies earn less and may have to cut their own spending. This can include reducing or cancelling investments, slowing new hiring or even cutting costs through layoffs.

What Kinds of Companies Are Recession-Resistant?

While most companies are hurt by recessions, some can weather them better than others. Companies that are most likely to fare better during recessions are those that provide an essential product or service to consumers such as gas, electricity, heat and healthcare. Also, companies producing consumer essentials such as toothpaste and toilet paper tend to hold up better during recessionary times.

The Bottom Line

While most companies are negatively impacted by recessions as consumers cut spending, there are companies that weather tough times better than others. Consumers can easily cut spending in many areas, but there are some things consumers cannot easily eliminate from their budgets.

Companies that provide goods and services that people need tend to do well regardless of economic conditions. These include utilities (as people need to heat and power their homes), insurance (car insurance, for example, is required) and healthcare (such as insulin: a diabetic cannot simply stop taking it even if the price creates financial hardship). These companies offer a safe haven to shield investors from the worst of a downturn, and may even offer positive returns.

Fact checked by Vikki Velasquez

What Is a Traditional IRA?

A traditional individual retirement account (IRA) is a retirement savings account that lets you invest pre-tax income to save for retirement. The key feature of this account is its tax advantages: contributions to a traditional IRA are tax-deductible, meaning you don’t pay taxes on the money you contribute in the year you make the deposit. Taxes are paid when you withdraw funds during retirement, ideally when you’re in a lower tax bracket.

You don’t need to be sponsored by an employer to open a traditional IRA. It’s an individual account that you can open with various financial institutions such as Vanguard, Fidelity, or Charles Schwab.

Key Takeaways

• Traditional IRAs allow you to invest pre-tax income toward your retirement.
• Contributions to a traditional IRA may be tax-deductible.
• Taxes are paid upon withdrawal of funds, typically during retirement.
• Early withdrawals may be subject to penalties, with some exceptions.
• Alternatives to traditional IRAs include Roth IRAs, SIMPLE IRAs, and SEP-IRAs.

How Traditional IRAs Work

Traditional IRAs allow you to direct your contributions to a variety of investment options such as stocks, bonds, or mutual funds. These investments grow tax-deferred, meaning you won’t owe any taxes on dividends, interest, or capital gains as long as the funds remain in the account.

Once you reach your retirement age and begin to withdraw funds, they are subject to ordinary income taxes. If you withdraw money before age 59½, you’ll typically incur a 10% early withdrawal penalty, in addition to paying the relevant income taxes on the distribution.

Tax Treatment of Traditional IRAs

Contributions to a traditional IRA are made from pre-tax income. In some cases, contributions may be tax-deductible. Typically, investors without access to employer-sponsored retirement plans are more likely to be able to deduct contributions to a traditional IRA.

Contribution Limits for Traditional IRAs

If you are under age 50, you may contribute a total of $7,000 to traditional and Roth IRAs in 2024 and 2025. If you are age 50 and above, you may contribute an additional $1,000 in catch-up contributions for a total of $8,000 per year. These limits include all contributions, meaning that the total contribution to all IRA accounts cannot exceed $7,000 or $8,000, depending on your age.

Note

In 2024, you may make IRA contributions until April 15, 2025.

Early Withdrawals: Rules, Penalties, and Exceptions

Traditional IRA withdrawals are subject to income tax for the year in which they are disbursed. Additionally, the IRS levies a 10% early withdrawal penalty for investors who take a distribution before age 59½.

There are exceptions for which the 10% penalty tax does not apply. These include but are not limited to:

• Birth or adoption expenses for a new child (up to $5,000)
• Death or disability of the account holder
• Expenses for recovery from a federally recognized disaster (up to $22,000)
• Cases of domestic abuse
• Qualified higher education expenses
• Emergency family expenses (typically up to $1,000 per year)
• First-time homebuying expenses (up to $10,000)
• Unreimbursed medical expenses equal to greater than 7.5% of the taxpayer’s AGI
• Health insurance costs while unemployed

Required Minimum Distributions

The IRS requires investors to take regular distributions from traditional IRAs once they reach a certain age. If you turn 72 before Dec. 31, 2022, you’ll need to take these required minimum distributions (RMDs) by age 72; if you turn 72 after that date, you’ll need to take RMDs by age 73.

Tip

The amount of these minimum withdrawals is calculated based on the account balance at the end of the previous year and your life expectancy.

Having a Traditional IRA and a 401(k)

If you have an employer-sponsored retirement plan like a 401(k), you may also invest in IRAs. However, if you have a 401(k) as well as an IRA, depending on your income, you may be unable to deduct IRA contributions.

Pros and Cons of Contributing to a Traditional IRA

Benefits of a Traditional IRA

• Ability to set up a traditional IRA separate from (and in addition to) employer-sponsored retirement accounts like 401(k)s
• May provide tax advantages at retirement if you expect to be in a lower tax bracket then than you are now
• Contributions may be tax-deductible

Drawbacks of a Traditional IRA

• Lower annual contribution limit compared to 401(k) accounts
• Must pay taxes on distributions in the year they are made
• Early withdrawal penalties in most cases for individuals under 59½ 

Traditional IRAs vs. Other IRAs

Traditional IRA vs. Roth IRA

Traditional and Roth IRAs are very similar, except that Roth IRAs make use of post-tax income for contributions. This means that Roth IRA distributions are generally not taxed. The 10% early withdrawal penalty tax is only levied on distributions of Roth IRA earnings; investors may typically withdraw their contributions without penalty so long as the fund has been active for at least five years.

Traditional IRA vs. SIMPLE IRA

SIMPLE IRAs allow both employees and employers to contribute. These accounts are offered by employers who may be unable to provide other retirement plans.

Traditional IRA vs. SEP-IRA

Simplified Employee Pension Plan IRAs (SEP-IRAs) function similarly to traditional IRAs, except they provide employers a way to contribute toward an employee’s retirement. The contribution limits are higher for a SEP-IRA than a traditional IRA, but typically only employers are allowed to make contributions.

Here’s a comparison of how the four main types of IRAs compare with one another: 

	Traditional IRA	Roth IRA	SIMPLE IRA	SEP-IRA
Account holders are…	Individuals	Individuals	Employees	Employees (or self-employed individuals)
Contributions come from…	Pre-tax income	Post-tax income	Pre-tax income	Pre-tax income
Annual contribution limits (2024 and 2025)	$7,000	$7,000	$16,000 (for 2024) $16,500 (for 2025)	$69,000 or 25% of compensation up to $345,000 (for 2024) $70,000 (or 25% of their compensation up to $350,000 (for 2025)
Income cap	None	2024 phaseout range: single filers, $146,000-$161,000; joint filers, $230,000-$240,000 2025 phaseout range: single filers, $150,000-$165,000; joint filers, $236,000-$246,000	None	None
Who is eligible?	Anyone earning at least the contribution amount	Anyone earning at least the contribution amount	Employers not offering other retirement accounts	Individuals 21+ earning at least $750 annually from a business they’ve worked for during at least 3 of the previous 5 years

How To Open a Traditional IRA

Opening a traditional IRA is a straightforward process:

1. Select an IRA provider. Major providers include TIAA, Vanguard, Fidelity, and more.
2. Apply through the provider. You’ll need to provide personal information and financial details and specify the type of IRA you want to open.
3. Fund the account. Make a contribution from an existing bank account or set up a rollover from a previous retirement account.
4. Select investment options. Specify any investments you would like the account to target. This may mean particular stocks, mutual funds, bonds, and so on, or it may be a broader breakdown of stocks vs. bonds.

Is a Traditional IRA Right for You?

Traditional IRAs are a good option if you’re looking to contribute pre-tax dollars to a retirement account separate from an employer-sponsored plan. They are particularly appropriate if you anticipate being in a lower tax bracket at the time of retirement when you will pay taxes on distributions.

What Happens if I Contribute More Than the Annual Limit to a Traditional IRA?

Over contributing to a traditional IRA incurs a 6% penalty tax. In order to correct the situation, you must withdraw any excess contributions or apply them to the next year’s limit.

How Much Tax Will I Pay on a Traditional IRA?

The amount of tax you pay on a traditional IRA depends on your income tax bracket when you withdraw the funds. Contributions to a traditional IRA are made with pre-tax income, and taxes are deferred until you begin taking distributions. At the time of withdrawal, the amount you take out is taxed as ordinary income. If you withdraw funds before age 59½, you may face a 10% early withdrawal penalty.

At What Age Can You No Longer Open a Traditional IRA?

There is no maximum age for opening a traditional IRA. As long as you have earned income (such as from a job or self-employment), you can contribute to a traditional IRA at any age.

The Bottom Line

Traditional IRAs are individual-directed retirement accounts that use pre-tax dollars for investment. They have lower contribution limits than 401(k)s but do not require employer sponsorship. While investors can direct how their contributions are invested, often the best approach is to determine an appropriate level of risk, target a broad range of assets through a mutual fund or similar option, and hold for the long term.

Reviewed by Ebony Howard
Fact checked by Vikki Velasquez

408(k) Plan vs. 401(k) Plan: An Overview

408(k) and 401(k) are sections of the Internal Revenue Code that outline employer-sponsored retirement plans. Both sections provide guidelines for plans that give employees a means of saving for retirement in a special account.

That’s where these two retirement savings plans diverge. While section 401(k) has become synonymous with a widely available retirement savings vehicle, section 408(k) sets the guidelines for what is called the simplified employee pension (SEP) IRA.

Key Takeaways

• 408(k)s and 401(k)s are retirement savings plans.
• Employee contributions are not permitted as part of the 408(k) contribution limits.
• An SEP is available to companies of any size and self-employed individuals.
• Up to 25% of an employee’s pay may be contributed to an SEP.
• 401(k)s are the most common type of plan.

408(k)s

A simplified employee pension plan is an individual retirement account and/or annuity that meets the contribution requirements set by the Internal Revenue Code. It can be created by a business of any size. Only the employer can contribute to the plan, and every employee receives the same percentage of their earnings as contribution amounts.

Those who are self-employed may contribute to SEP IRAs. Employers can also make tax-deductible contributions on behalf of eligible employees—including the business owner—to their SEP IRAs. The employer is allowed a tax deduction for plan contributions that do not exceed the statutory limit.

401(k)s

A 401(k) is the most common type of retirement savings account offered. It is an employer-sponsored savings plan in which the employer and employee can make contributions. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings in a 401(k) plan accrue on a tax-deferred basis in traditional 401(k)s and a potentially tax-free basis in a Roth 401(k).

Important

401(k) plans are slightly more complex than 408(k)s, as they generally contain several investment options chosen by the employer. In an SEP IRA, employees choose their investments.

Key Differences

Here are some features that distinguish the 408(k) SEP IRA from the 401(k):

• In general, only employers can contribute to an SEP IRA: Unlike a 401(k), employee contributions are not permitted as part of SEP contribution limits.
• Some SEP IRAs permit separate, personal IRA contributions: If your company’s SEP IRA plan permits it, employees can make non-SEP IRA contributions to the same account, up to $7,000 for 2025 (and 2024), plus an additional $1,000 for those age 50 or older.
• Employer contributions under an SEP IRA must be equal: Each eligible employee must get the same percentage of the salary contributed to the plan.
• Employees, not employers, manage an SEP account: Overall, 401(k) plans are a bit more complex than SEPs, with many investment options set up by the employer (or its plan managers), including mutual funds that contain stocks, bonds, and commodities. With an SEP IRA, the employer does not set up investment options. Instead, the employee manages the SEP IRA, choosing their investments. Employers essentially put money (not real property, which is forbidden) into employee individual retirement accounts (IRAs). This saves the employer from paying administration costs as they would with a 401(k).
• Self-employed contributions are tax-deductible: Only self-employed participants can deduct a certain amount of their contributions to their retirement funds.
• 408(k)s have minimum earnings for eligibility: The minimum compensation threshold is $750 for 2025 and 2024.

Similarities

• Maximum allowable compensation: No matter how much an employee earns, the annual compensation limit for determining contributions is $350,000 in 2025.
• Contribution limits: Employers can contribute as much as 25% of an employee’s salary but no more than $70,000 for 2025 ($69,000 for 2024). However, no catch-up contributions are allowed in SEP IRAs, as they are funded only with employer contributions.
• Contributions are not taxed: Employer contributions to your plans are not taxed. You pay taxes on withdrawals.
• Eligibility: SEP IRAs are available for employees of companies of any size or those who are self-employed and would typically not have access to a retirement plan.
• Contribution deadlines follow IRA deadlines. For example, 2025 contributions to an SEP IRA may be made until April 15, 2026. With a 401(k), the deadline is the calendar year (i.e., Dec. 31) for individual contributions, but April 15 for employer contributions.
• Penalty for early withdrawal. Both accounts are inaccessible without a penalty until the account holder reaches the qualifying age of 59½.

What Is a 408(k) Withdrawal Plan?

A 408(k) plan is an SEP IRA. If you have an SEP IRA, it’s best to make a withdrawal plan that meets your financial needs and accounts for paying any taxes on the withdrawals. You aren’t required to take distributions until age 73. After you turn 73, you must begin taking withdrawals that meet or exceed the required minimum distribution amounts.

Is a 408(a) the Same as a Traditional IRA?

A 408(a) is commonly known as a Roth IRA, so it is not a traditional IRA. This individual retirement account lets you make post-tax contributions and tax-free distributions after 59½.

What Are the 2 Types of 401(k) Plans?

The types of IRAs are traditional, Roth, SIMPLE, and Safe Harbor IRAs.

The Bottom Line

408(k) and 401(k) plans are both retirement savings plans, but they have significant differences and similarities. Differences include who can contribute, who manages the account, and whether catch-up contributions are allowed.

Reviewed by Charlene Rhinehart
Fact checked by Suzanne Kvilhaug

What Is a Liquidity Ratio?

A liquidity ratio is a measurement of a company’s ability to pay off its current debts with its current assets.

There are various types of liquidity ratios, including the current ratio and the quick ratio. Usually, a liquidity ratio greater than 1 is a positive sign. But a very high liquidity ratio isn’t necessarily a good thing.

Companies can increase their liquidity ratios quickly in a few different ways, including using sweep accounts, cutting overhead expenses, and paying off liabilities.

Read on to learn more about liquidity ratios and how a company can increase them.

Key Takeaways

• Ways in which a company can increase its liquidity ratios include paying off liabilities, using long-term financing, optimally managing receivables and payables, and cutting back on certain costs.
• Liquidity ratios measure the ability of a company to pay off its short-term obligations with its current assets.
• Two of the most common liquidity ratios are the current ratio and the quick ratio.
• A higher liquidity ratio indicates a company is in a better position to meet its obligations, but can also indicate that a company isn’t using its assets efficiently.
• A satisfactory ratio can differ depending on the ratio type.

Understanding Liquidity Ratios

A company calculates a liquidity ratio by dividing its current assets by its short-term liabilities.

A liquidity ratio can be a valuable metric for market analysts and potential investors. That’s because it can help them to determine if a company is financially healthy enough to pay off its short-term debts and other current liabilities.

A low liquidity ratio could signal a company that is in financial trouble. However, a very high liquidity ratio may show that a company is too focused on liquidity, to the detriment of efficiently utilizing its capital to grow and expand its business.

The Current and Quick Ratios

As mentioned above, two commonly reviewed liquidity ratios are the current ratio and the quick ratio.

Current Ratio

The current ratio provides a good indication of a company’s ability to cover its short-term liabilities. It’s a measure of all current assets that can be turned into cash quickly and used to pay all short-term obligations.

For this ratio, current assets include cash, cash equivalents, inventory, marketable securities, and certain other short-term investments.

Quick Ratio

The quick ratio refines the current ratio, measuring the most liquid assets a company has to cover liabilities, including cash, receivables, and marketable securities.

As a result, it is more conservative than the current ratio because it excludes inventory and some other current assets from the calculation.

As you might imagine, liquidity ratios can differ somewhat depending on which assets are used in the ratio formula.

Important

Creditors analyze liquidity ratios when deciding whether or not to extend credit to a company.

Increasing Liquidity Ratios

• One way to quickly improve a company’s liquidity ratio is to use sweep accounts that transfer funds into higher interest rate accounts when they’re not needed, and back to readily accessible accounts when necessary.
• Paying off liabilities also quickly improves the liquidity ratio. So does cutting back on short-term overhead expenses such as rent, labor, and marketing.
• A company can also increase its liquidity ratio by using long-term rather than short-term financing to acquire inventory or finance projects. Removing short-term debt from the balance sheet allows a company to save some liquidity in the near term and put it to better use.
• To increase a company’s liquidity ratio for the long term, take a look at accounts receivable and payable. Ensure that you’re invoicing customers as quickly as possible, and that they’re paying on time. When it comes to accounts payable, you’ll want to ensure the opposite—longer pay cycles are more beneficial to a company that’s trying to improve its liquidity ratio. You can often negotiate longer payment terms with certain vendors.

Why Do Liquidity Ratios Matter?

They matter because they give management and potential investors a way to gauge how easily and quickly a company could meet its short-term obligations, and without having to borrow money to do so. It’s a sign of a company’s short-term financial health. A company with solid liquidity, as demonstrated by liquidity ratios, should be able to weather periods when the economy weakens. It may also use some quickly available cash to take advantage of opportunities for growth.

When Is a Liquidity Ratio Too High?

It’s not an exact science, but a ratio that’s way above 1, for example 4, means that a company has enough in current assets to pay off its immediate obligations four times over. Some companies may feel that one time over is enough. In that case, it may be that cash isn’t being used properly and opportunities to grow value are missed.

How Do Liquidity Ratios Clarify a Company’s Potential for Default?

The more easily that a company can pay all of its short-term liabilities, the less chance there is that the company will default on them. Measuring how quickly current assets can be sold and the cash used to pay all of these bills is the role of liquidity ratios. By presenting a metric, such ratios demonstrate whether there’s a risk of default. A liquidity ratio of 1 indicates that all short-term debts can be covered by current assets.

The Bottom Line

Liquidity ratios, which measure a firm’s capacity to pay its short-term financial obligations with current assets, can be increased by paying off some liabilities, reducing costs, using long-term financing, and efficiently managing receivables and payables.

That said, a liquidity ratio that’s overly high does not always indicate stronger financial health, as it could mean that a company is not using its assets effectively to grow the value of the business.

Reviewed by Michael J Boyle
Fact checked by Kirsten Rohrs Schmitt

Though it can be difficult to invest in a stock when its price is falling, there are certain individuals who have a knack for doing so. In this article, we’ve outlined five investors who demonstrated remarkable timing by making big investments during the 2007-2009 financial crisis, eventually generating big gains as a result.

Key Takeaways

• The 2007–09 financial crisis saw markets fall, erasing trillions of dollars of wealth around the world.
• Savvy investors recognized a unique buying opportunity, with many companies’ shares for sale at deep discounts.
• Once markets recovered from the Great Recession, these investors realized tremendous gains from their assertive maneuvers.

The Crisis

You can’t really understand the philosophies and actions of successful investors without first getting a handle on the financial crisis. What happened in the lead-up to the crash and the Great Recession that followed afterward remains stamped in the memories of many investors and companies.

The financial crisis of 2007–09 was the worst to hit the world since the stock market crash of 1929. In 2007, the subprime mortgage market in the United States collapsed, sending shock waves throughout the market. The effects were felt around the globe, and even caused the failure of several major banks, including Lehman Brothers.

Panic ensued, with people believing they would lose more if they didn’t sell their securities. Many investors saw their portfolio values drop by as much as 30%. The sales resulted in rock-bottom prices.

Important

During the crisis, while many people were selling, there were others who saw this as a chance to increase their positions in the market at a big discount.

1. Warren Buffett

In October 2008, Warren Buffett published an article in the op-ed section of The New York Times, declaring he was buying American stocks during the equity downfall brought on by the credit crisis. As he once said, investors should “be fearful when others are greedy, and be greedy when others are fearful.”

His buys included the purchase of $5 billion in perpetual preferred shares in Goldman Sachs (GS) that paid him a 10% interest rate and included warrants to buy additional Goldman shares. Goldman also had the option to repurchase the securities at a 10% premium. This agreement was struck between Buffett and the bank in 2008. The bank ended up buying back the shares in 2011.

Buffett did the same with General Electric (GE), buying $3 billion in perpetual preferred stock with a 10% interest rate and redeemable in three years at a 10% premium. He also purchased billions in convertible preferred shares in Swiss Re and Dow Chemical (DOW), all of which required liquidity to get them through the tumultuous crisis. As a result, Buffett not only made billions for himself, but also helped steer these and other American firms through an extremely difficult period.

2. John Paulson

Hedge fund manager John Paulson reached fame during the crisis for a spectacular bet against the U.S. housing market. This timely bet made his firm, Paulson & Co., an estimated $20 billion during the crisis.

Paulson quickly switched gears in 2009 to bet on a subsequent recovery and established a multibillion-dollar position in Bank of America (BAC) as well as approximately two million shares in Goldman Sachs. He also bet big on gold at the time and invested heavily in Citigroup (C), JP Morgan Chase (JPM), and a handful of other financial institutions.

Paulson’s 2009 overall hedge fund returns were decent. He also posted huge gains in the big banks he invested in. The fame he earned during the crisis also helped bring in billions in additional assets and lucrative investment management fees.

3. Jamie Dimon

Jamie Dimon used fear to his advantage during the crisis, making huge gains for JP Morgan. At the height of the financial crisis, Dimon used the strength of his bank’s balance sheet to acquire Bear Stearns and Washington Mutual, which were two financial institutions brought to ruins by huge bets on U.S. housing.

JP Morgan acquired Bear Stearns for $10 a share, or roughly 15% of its value, in March 2008. In September of that year, it also acquired Washington Mutual. The purchase price was also for a fraction of Washington Mutual’s value earlier in the year. From its lows in March 2009, shares of JP Morgan more than tripled over the next 10 years and made shareholders and its CEO quite wealthy.

4. Ben Bernanke

As the former head of the Federal Reserve (Fed), Ben Bernanke was at the helm of what turned out to be a vital period for the U.S. central bank. The Fed’s actions were ostensibly taken to protect both the U.S. and global financial systems from meltdown, but brave action in the face of uncertainty worked out well for the Fed and underlying taxpayers.

A 2011 article detailed that profits at the Fed came in at $82 billion in 2010. This included roughly $3.5 billion from buying the assets of Bear Stearns and AIG, $45 billion in returns on $1 trillion in mortgage-backed security (MBS) purchases, and $26 billion from holding government debt. The Fed’s balance sheet tripled from an estimated $800 billion in 2007 to absorb a depression in the financial system, but appears to have worked out nicely in terms of profits now that conditions have returned to normal.

5. Carl Icahn

Carl Icahn is another legendary fund investor with a stellar track record of investing in distressed securities and assets during downturns.

His expertise is in buying companies and gambling firms in particular. In the past, he acquired three Las Vegas gaming properties during financial hardships and sold them at a hefty profit when industry conditions improved. Icahn sold the three properties in 2007 for approximately $1.3 billion—many times his original investment. He began negotiations again during the crisis and was able to secure the bankrupt Fontainebleau property in Las Vegas, Nevada, for approximately $155 million, or about 4% of the estimated cost to build the property. Icahn ended up selling the unfinished property for nearly $600 million in 2017 to two investment firms, making nearly four times his original investment.

What Was the 2007–09 Global Financial Crisis?

The global financial crisis began with cheap credit and lax lending standards that fueled a housing bubble. When the bubble burst, banks were left holding trillions of dollars of worthless investments in subprime mortgages. The Great Recession that followed cost many their jobs, their savings, and their homes.

Who Is Warren Buffett?

Warren Buffett is a legendary value investor in Nebraska who turned an ailing textile mill into a financial engine that powered what would become the world’s most successful holding company, Berkshire Hathaway. Known as the “Oracle of Omaha” for his investment prowess, Buffett has amassed a personal fortune in excess of $162 billion, according to Forbes.

What Is the U.S. Federal Reserve System?

The Federal Reserve System is the central bank of the United States. Often called the Fed, it is arguably the most influential financial institution in the world. It was founded to provide the country with a safe, flexible, and stable monetary and financial system.

The Bottom Line

One key differentiating factor for these investors is their ability to stay calm during a crisis. They are examples of how to take advantage of the market when it is in a panic. When more normalized conditions return, savvy investors can be left with sizable gains, and those who are able to repeat their earlier successes in subsequent downturns can end up quite wealthy.

Generally speaking, a low P/S ratio is better

Reviewed by Andy Smith
Fact checked by Vikki Velasquez

The price-to-sales (P/S) ratio is a profitability analysis tool used to compare companies and discover undervalued securities. P/S ratios can vary significantly between industries and companies so it’s important to view a company’s P/S ratio in comparison to similar companies within the same industry.

An investment is generally more attractive when it has a lower P/S ratio calculation.

Key Takeaways

• The P/S ratio measures how much equity received from investors is necessary to deliver $1 of revenue.
• The P/S compares the company’s market capitalization to its revenue from the last 12 months.
• The ratio is most useful when comparing similar companies in similar industries.
• You can calculate the ratio on a per-share basis or a company-wide basis.
• A company with a lower P/S ratio will typically be a more favorable investment when comparing similar companies.

The Price-to-Sales Ratio

The P/S ratio is an investment valuation ratio that shows a company’s market capitalization divided by its sales for the previous 12 months. It’s a measure of the value investors are receiving from a company’s stock by indicating how much equity is required to deliver $1 of revenue.

The metric is also referred to as the revenue multiples or sales multiples.

Analysts prefer to see a lower number. A ratio of less than 1 indicates that investors are investing less than $1 for every $1 the company earns in revenue.

When to Use the Price-to-Sales Ratio

The ratio should only be used when comparing similar companies within similar industries against each other. The P/S ratio of one industry may vary greatly from the ratio of another because different entities and different sectors have varying capital requirements.

The P/S ratio is also useful when analyzing companies with similar financing structures, especially considering companies that don’t carry debt. Two companies earning the same total revenue can have different P/S ratios if one is highly leveraged while the other relies heavier on share offerings because the P/S ratio doesn’t consider debt financing.

Price-to-Sales Formula(s)

The metric can be calculated based on aggregate totals or a per-share basis:

• Price-to-Sales Ratio = Total Company Market Capitalization / Total Company Sales
• Price-to-Sales Ratio = Market Value per Share / Sales per Share

The P/S ratio can be a particularly good metric for evaluating companies in cyclical industries that may not show an actual net profit every year. The P/S ratio considers a company’s past 12 months of revenue so it absolves any cyclicality or seasonality. It’s not as useful when analyzing young emerging companies, however, because the metric doesn’t consider future growth potential.

The P/S ratio is also useful when analyzing companies with negative earnings or negative cash flow. It only looks at a company’s revenue and not its operating expenses or profit margin. Companies may not be profitable but the P/S ratio analyzed over time can detect revenue growth and emerging efficiencies in operations before the company ends up turning a profit.

What Does a High Price-to-Sales Ratio Indicate?

Higher P/S ratios may indicate that a company isn’t efficiently using investor funds to drive revenue. Lower P/S ratios are more favorable when comparing similar companies across similar industries.

What’s the Average Price-to-Sales Ratio?

Each industry has its own average P/S ratio. What might be an average P/S for one sector may be considered a very high or very low ratio for another.

How Do You Analyze a Price-to-Sales Ratio?

A P/S is analyzed by comparing it against similar companies or industries. Investments with lower P/S ratios are generally more attractive as this indicates the company is generating more revenue for every dollar investors have put into the company.

The Bottom Line

Less usually means more with P/S ratios. A lower ratio is often a sign of a good investment but all metrics come with caveats and cautions. The P/S ratio is most reliable when it compares similar companies in the same industry because they typically have similar capital requirements and face the same sorts of challenges. Be sure you have a handle on all its implications before you rely on it for your investment decisions.

Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.

Reviewed by Ebony Howard
Fact checked by Vikki Velasquez

Online marketplaces have become an important part of many people’s lives, and both businesses and customers have embraced online sales as a cheaper and more convenient way to shop. Still, just like anything associated with the internet, there are benefits and dangers associated with shopping online. Read on to learn how to protect yourself when you use this handy resource.

Key Takeaways

• Due to the high cost of college, students and parents rely on the Internet to acquire and sell textbooks at affordable prices.
• Online shopping is a large section of the retail industry.
• Most brick-and-mortar stores offer online shopping via their websites.
• Many stores offer a virtual customer service experience to their customers.
• Buying and selling online can be very convenient and fun, but make sure to protect your financial information when shopping online.

How Does Online Buying Work?

Shopping online is just like heading out to the store. You can often buy the same products online as available in a brick-and-mortar store and can sometimes score better sales.

Finding a Product

When you shop online, you have to start by searching for a product. This can be done by visiting a store’s website, or if you are not aware of any store that has the particular item you are looking for, or you’d like to compare prices between stores, you can always search for the items with a search engine and compare the results.

On major retail websites, companies will have pictures, descriptions, and prices. If a company or individual does not have the means to create a website, some sites like Amazon and Etsy make it possible for them to display products or build their own online stores for a monthly fee.

Important

Who is responsible when defective products sold through websites cause injuries? Faced with lawsuits about third-party products, Amazon announced that, starting Sept. 1, 2021, if “a defective product sold through Amazon.com causes product damage or personal injury,” it “will directly pay customers for claims under $1,000,” when they can’t reach an agreement with the seller. It also “may step in to pay claims for higher amounts if the seller is unresponsive or rejects a claim we believe to be valid.” Amazon also offers Insurance Accelerator, a product to help their sellers buy insurance, through Marsh.

Other websites like eBay provide an auction format in which sellers can display items for a minimum price, and buyers can bid on these items until the listing ends or the seller chooses to award it to a buyer. Most stores also have placed virtual customer service centers on their websites, so you can either call, email, or chat with a live customer service representative if you have questions.

Buying and Receiving the Product

After selecting a product and adding it to the customer’s shopping cart, the webpage usually has a “checkout” option. When you check out, you are often given a list of shipping and payment options. Shipping options include standard, expedited, or overnight shipping. Depending on the shipping company and your location, standard shipping usually takes seven to 21 business days, and expedited shipping can take anywhere from two to six business days.

Items that are left in an online cart and never purchased are eventually considered abandoned. The abandon rate is an important metric for online retailers.

There are typically various payment options available. Common payment options are explained in greater detail below.

E-Check

This payment option is just like paying directly from your bank account. If you choose to pay by electronic check, you must enter your routing and account numbers. Once this is done, the amount is taken directly from your bank account.

Credit Card

When you pay by credit card, instead of swiping your card as you would at a brick-and-mortar store, you type the required credit card information into the provided fields. Required information includes your credit card number, expiration date, type of card (Visa, MasterCard, etc.), and verification/security number, usually the last three digits on the back of the card above the signature.

Payment Vendors

Payment vendors or payment processing companies, such as PayPal, are e-commerce businesses that provide payment exchange services. They allow people to transfer money to one another without sharing financial information safely. Before you purchase through a payment vendor, you’ll need to set up an account first to verify your credit card or financial institution information.

Advantages of Online Trading

There are a lot of benefits gained from buying and selling online. These include the following:

• Convenience: It is very convenient to shop from where you are located.
• Cost savings: With ever-increasing gas prices, shopping online saves you the cost of driving to stores, as well as parking fees. You will also save time by avoiding standing in line, particularly around the holidays, when stores are busy and packed with customers.
• Variety: The Internet provides sellers with unlimited shelf space, so they are more likely to offer a wider variety of products than they would in brick-and-mortar stores.
• No pressure: No salesperson is hovering around and pressuring you to purchase in a virtual or online store.
• Easy comparison: Shopping online eliminates the need to wander from store to store comparing prices.

Disadvantages of Online Trading

There are also disadvantages to buying and selling online. These include the following.

Increased Risk of Identity Theft

When paying for your goods online, it can be straightforward for someone to intercept sensitive information, such as credit card numbers, home address, phone, and other account numbers.

Vendor Fraud

If the vendor/seller is fraudulent, they might accept your payment and either refuse to send you your item or send you the wrong or a defective product. Trying to rectify an incorrect order with a vendor through the Internet can be a hassle.

Pros

• Online stores have a greater variety of products, and it is easier to compare products across stores than visiting in person

• Shoppers can save time and money by shopping from home, rather than driving to a store

• Convenience—Online stores allow you to shop from home.

Cons

• Higher risk of identity theft

• May be difficult to return incorrect or defective products.

Protecting Yourself While Shopping Online

Overall, the advantages of shopping online outweigh the disadvantages. That said, it is important to note that while they might be smaller in number, the disadvantages can be a major hardship.

While shopping online, it is essential to protect yourself and your information. Below are some tips that can help you take care of yourself.

Invest in Technology

It is a great idea to install antivirus and anti-phishing programs on your computer. An antivirus program will protect your computer from viruses. An anti-phishing program will attempt to protect you via cybersecurity from illegitimate sites that are designed to look like legitimate sites but actually collect your personal information for illegal activities.

Be Careful

Vendors do not have the right to ask for certain information. If a website requests your Social Security number, it is probably a scam. You will need to research the company requesting the information or exit that site as quickly as possible.

Note

U.S. consumers can report fraud, abuse, and incidents of identity theft with the Federal Trade Commission (FTC).

Research

If you are searching for an item using search engines, and you encounter a store or a website you have not heard about, check the bottom of the pages for a TLS logo.

TLS is a standard security technology for establishing an encrypted link between a web server and a browser. To create a TLS connection, a web server requires an TLS certificate.

Shipping Check

Always read shipping policies posted on the seller’s website or beneath the product listing. Some sellers allow you to return an item within a specific period of time, while other vendors never accept returns.

How Do You Create an Online Store?

There are several convenient tools to create a store for online sales. Sites like Shopify and Squarespace allow anyone to create an online storefront, list items for sale, and start accepting orders. Once a storefront is created, it can be linked from the vendor’s website or other online presence. It is also possible to make sales through other sites, such as eBay.

How Do You Stay Safe When Shopping Online?

You can avoid most dishonest sellers by sticking to reputable websites with clear buyer protections. It also helps to read the seller’s reviews and the terms of service: If there are no buyer protections or right to make returns, you may be better off shopping somewhere else.

What Is the Safest Payment Method for Shopping Online?

Online payment apps, such as PayPal, are generally safer than using cards, because the recipient does not receive your credit card numbers and cannot misuse them. If you do need a card, credit cards have better protections than debit cards, meaning that you will have greater recourse in the event of a dishonest seller. Gift cards and cryptocurrencies have the fewest protections and should be avoided if possible.

The Bottom Line

Buying and selling online can be very convenient and rewarding, but you always have to protect yourself. If a deal looks too good to be true, it usually is. If you don’t feel 100% secure on a particular site, leave it, and find something else.

Also, make sure that your computer is well protected before you begin any transaction that involves sensitive information. Many scams on the internet can negatively affect your credit score and cost you money, so be proactive in your research to get the most out of shopping online.

Reviewed by Julius Mansa
Fact checked by Vikki Velasquez

What Is the Cost Accounting Method?

The cost accounting method, which assesses a company’s production costs, comes in a few broad styles and cost allocation practices. However, cost accounting comes with advantages and disadvantages over other types of accounting methods.

Key Takeaways

• The cost accounting method is an internally focused, firm-specific system used to estimate cost control, inventory, and profitability.
• It can be much more flexible and specific when compared to general accounting methods.
• The complexity of cost accounting, however, means that it can be costly in a number of ways.

Understanding Cost Accounting

Cost accounting was originally developed in manufacturing firms, but financial and retail institutions have adopted it over time.

Contrasted with general accounting or financial accounting, the cost accounting method is an internally focused, firm-specific system used to estimate cost control, inventory, and profitability. Cost accounting can be much more flexible and specific, particularly when it comes to the subdivision of costs and inventory valuation. Unfortunately, this complexity-increasing auditing risk tends to be more expensive and its effectiveness is limited to the talent and accuracy of a firm’s practitioners.

The main difference between cost accounting and financial accounting is the intended audience and level of detail. Cost accounting provides in-depth, detailed information primarily for internal use by management to aid in decision-making. Financial accounting is designed to provide a high-level view of a company’s financial health. Let’s now take a look at reasons why cost accounting may or may not be the better of the two, depending on a given situation.

Advantages of Cost Accounting

Easier to Adapt/Change

Managers appreciate cost accounting because it can be adapted, tinkered with, and implemented according to the changing needs of the business. Unlike the Financial Accounting Standards Board (FASB)-driven financial accounting, cost accounting need only concern itself with internal eyes and internal purposes.

Note

Activity-Based Costing (ABC) is a more refined method of cost allocation that assigns costs based on the activities that consume resources. Though it may cost a lot to implement, a company can get access to tremendous insights and information.

Easier to Monitor and Control Costs

Labor costs are easier to monitor and control through cost accounting. Depending on the nature of the business, wage expenses can be taken from orders, jobs, contracts, or departments and sub-departments. This means management can pick and choose how it determines efficiency and productivity. This is very important when estimating the marginal productivity of individual employees.

Can View Data in Different Ways

Cost accounting can be thought of as a sort of three-dimensional puzzle. Accounts, calculations, and reports can be manipulated and viewed from different angles. Management can analyze information based on criteria that it values, which guides how prices are set, resources are distributed, capital is raised, and risks are assumed. It’s a crucial element in management discussion and analysis.

Enhances Decision-Making

Cost accounting supports decision-making by providing the financial data needed to evaluate different options. Whether deciding on production methods, investment opportunities, or cost-cutting measures, businesses can rely on cost accounting to weigh the financial implications and provide back-up to the choices that can be made.

Useful for Comparing Different Options

Cost accounting can also be used to help make capital investment decisions by analyzing potential returns on investment. By examining the costs associated with purchasing new equipment, expanding facilities, or launching new products, businesses can assess the financial feasibility of investments. Whereas financial accounting might require each of these potential projects to conform to one set of analytical rules, cost accounting allows each of these options to be analyzed specific to its own details, meaning decision-makers can potentially compare their options more effectively.

Disadvantages of Cost Accounting

May Require Capital Investment

Implementing cost accounting systems can come with significant initial setup costs. For small businesses, the need for specialized software, training, and staff may make it difficult to justify the investment. The ongoing maintenance and updates to the system can also be costly.

May Complicate Decision-Making Analysis

Cost accounting can add complexity to a business’s financial reporting system. The detailed tracking of direct and indirect costs, along with the need for multiple allocation methods, may require sophisticated software, additional personnel, and more time. This complexity can sometimes overwhelm smaller businesses or organizations without the necessary resources to implement and manage it effectively.

Cost accounting is useful not only for reporting actuals but for making future plans. By analyzing past cost behavior, businesses can predict future costs and set more realistic budgets or forecasts.

May Require Additional Steps to Verify Accuracy

Even if the rigidity of financial accounting creates some inherent disadvantages, it does remove the uncertainty and misapplication of accounting guidelines of cost accounting. Uncertainty equals risk, which always comes at a cost. This means additional—and often more vigorous—reconciliation to verify accuracy.

May Have Overreliance on Highly-Skilled Talent

Higher-skilled accountants and auditors are likely to charge more for their services. Employees have to receive extra training and must sufficiently cooperate with data input. Non-cooperation can render ineffective an otherwise beautifully constructed system.

May Overemphasize Short-Term Decisions

Cost accounting might encourage a business to prioritize cost-cutting measures that are not sustainable in the long run. For example, efforts to reduce labor costs or use cheaper materials could compromise the quality of products or services, leading to customer dissatisfaction or reputational damage. Short-term cost reductions, therefore, might be the suggested option when looking at cost accounting reports though this may not actually be what’s best for the company long-term.

What Is Cost Accounting?

Cost accounting is a branch of accounting that focuses on tracking, analyzing, and controlling the costs associated with the production of goods or services. It helps businesses understand the costs incurred in manufacturing and operating, breaking down expenses into fixed, variable, and semi-variable costs.

What Are the Main Types of Costs in Cost Accounting?

In cost accounting, costs are typically classified into three main types: fixed costs, variable costs, and semi-variable (or mixed) costs. Fixed costs remain constant regardless of production levels, such as rent or salaries. Variable costs fluctuate with production output, like raw materials and labor. Semi-variable costs are a combination, having both fixed and variable components, such as utilities or maintenance.

How Is Cost Accounting Different from Financial Accounting?

While cost accounting focuses on internal decision-making, financial accounting is concerned with creating standardized reports for external stakeholders. Cost accounting provides detailed insights into the cost structure of a business to help with pricing, budgeting, and cost control. Financial accounting prepares overall financial statements that provide an overview of a company’s financial health for investors, creditors, and regulators.

Why Is Cost Accounting Important?

Cost accounting is important because it helps businesses track and manage their expenses. By understanding where and how money is being spent, companies can make informed decisions that improve profitability, reduce waste, and optimize where they decide to put their resources.

The Bottom Line

The repeated trade-off in any accounting method is accuracy versus expediency. Cost accounting reflects this more dramatically than other accounting methods because of its pliability. Every business needs to find its own balance between the ability to analyze data and the requirements to wrangle it.