Engineering Economic Analysis Chapter 17 Accounting & Engineering Economy Donald G. Newnan San Jose State University Ted G. Eschenbach University of Alaska Anchorage Jerome P. Lavelle North Carolina State University Neal A. Lewis University of New Haven Copyright Oxford University Press 2017

Chapter Outline Role of Accounting The Balance Sheet The Income Statement Traditional Cost Accounting Copyright Oxford University Press 2017

Learning Objectives Understand links between accounting & engineering economy Understand financial transactions, the objectives of accounting, & why they are important Evaluate firms with financial statements & ratios Use traditional cost accounting to calculate product costs Understand concepts of activity–based costing Copyright Oxford University Press 2017

Vignette: A Tale of Three Engineers Moving Up the Career Ladder. One was quickly promoted to project & then line management Responsible for justifying engineering decisions & project budgets. Accounting for financial performance & efficiency was required. Investing for the Future. Second used accounting for personal finances with a budget (income statement) & a balance sheet using Assets = Liabilities + Equity Student loans paid off, emergency fund established, down payment on house, & now saving for retirement Copyright Oxford University Press 2017

Vignette: A Tale of Three Engineers Engineering Entrepreneurs. Third engineer is a group of engineering students from University of California, Davis. After unexpected death of research advisor, they formed a small firm & applied for government funding Two months later, firm received award letter for over $1M Key to their success was an innovative idea, a sound technical plan & budget, & the accounting skills to manage the finances & required reporting. Copyright Oxford University Press 2017

Vignette: A Tale of Three Engineers Questions to consider: How can you develop accounting or financial analysis skills before entering the workforce? Accounting & ethics both played large roles in the last fiscal crisis & in many smaller scandals. How can knowledge of accounting help you guard against ethical lapses? Create annual budgets for next 5 years. Use to connect your current & planned assets, liabilities, & equity. Copyright Oxford University Press 2017

Role of Accounting Accounting data are used To value capital equipment To decide whether to make or buy a part To determine costs & set prices To make product mix decisions In both private & public sectors Copyright Oxford University Press 2017

Role of Accounting Accounting Eng. Economy Management About past Analyzing Summarizing Reporting Fin. indicators Economic trends Cost acquisitions Management About past & future Capital budgeting Decision making Setting goals Assessing impacts Analyzing risk Planning Controlling Record keeping Eng. Economy About future Feasibility study Collect data Analyze data Estimate Evaluate projects Recommend Audit Trade-off & const. Estimating Budgeting Copyright Oxford University Press 2017

Accounting for Business Transactions Accounting function records, analyzes, & reports business transactions Accounting function also finds, synthesizes, summarizes, & analyzes data Most accounting is done in nominal or then- current dollars Accounting function provides data for general accounting & cost accounting Copyright Oxford University Press 2017

Balance Sheet Balance sheet shows firm's financial position at a specific time = a financial “snapshot” Fundamental accounting equation: Assets = Liabilities + Equity (17-1) Copyright Oxford University Press 2017

The Balance Sheet: Assets Assets are what the company "owns" Current assets (can be converted to cash within a year) Cash Accounts receivables Securities Inventories: raw materials, work-in-progress, finished products Fixed assets Land Plant, equipment Less accumulated depreciation on plant & equipment Copyright Oxford University Press 2017

Balance Sheet: Liabilities & Equity Liabilities ≡ what firm "owes" Current liabilities (due within a year) Expenses, notes, & other payable accounts Long-term liabilities Mortgage, bonds, & loans with later due date Equity Common stock Preferred stock Retained earnings = value that balances assets with liabilities + equity Copyright Oxford University Press 2017

Balance Sheet, Engineered Industries Assets ($1000) on 12/31/2016 (left side of Fig. 17-2) Current assets Cash $1940 Accounts receivable 950 Securities (at cost) 4100 Inventories (at lower of cost or market) 1860 (minus) Bad debt provision (80) Total current assets 8770 Fixed assets Land 335 Plant & equipment 6500 (minus) Accumulated depreciation (2350) Total fixed assets 4485 Other assets Prepays/deferred charges 140 Intangibles 420 Total other assets 560 Total Assets $13,815 Copyright Oxford University Press 2017

Balance Sheet, Engineered Industries Liabilities & Equity on 12/31/2016 (left side of Fig. 17-2) Current liabilities Accounts payable $1150 Notes payable 80 Accrued expenses 950 Total current liabilities 2180 Long-term liabilities 1200 Total liabilities 3380 Equity Preferred stock 110 Common stock 650 Capital surplus 930 Retained earnings 8745 Total equity 10,435 Total liabilities & equity $13,815 Copyright Oxford University Press 2017

Financial Ratios from Balance Sheet Working Capital = Current assets – Current liabilities (17-2) Liquidity ratios measure firm’s ability to meet short-term obligations (17-3) (17-4) Copyright Oxford University Press 2017

If balance sheet a snapshot at a specific time; is a video over time Income Statement Summarizes firm’s financial performance over a period of time (usually a quarter or a year) (17-5) Operating Revenues: Sales revenues – (returns & allowances) Non-operating Revenues: Rents Interest receipts Operating Expenses: Cost of goods sold (COGS) Labor, materials, indirect cost Selling & promotion Depreciation General & administrative Lease payments Copyright Oxford University Press 2017

Engineered Industries Income Statement for 2017 (top Fig. 17-3) Operating Revenues Sales $18,900 (minus) Returns & Allowances −870 Total Operating Revenues 18,030 Operating Expenses Cost of goods sold 13,060 Labor 6,140 Materials 4,640 Indirect cost 2,280 Selling & Promotion 930 Depreciation 450 General & administrative 2,160 Lease Payment 510 Total Operating Expenses 17,110 Total Operating Income 920 Copyright Oxford University Press 2017

Engineered Industries Income Statement for 2017 (rest Fig. 17-3) Nonoperating revenues & expenses rents 20 interest receipts 300 (minus) interest payments (120) Total nonoperating income 200 Net income before taxes 1,120 Income taxes − 390 Net profit 730 Copyright Oxford University Press 2017

Financial Ratios from Income Statement (17-6) (17-7) Copyright Oxford University Press 2017

Linking Balance Sheet, Income Statement, & Capital Transactions Important links to income statement & balance sheet Overall profit / loss (from income statement) Equity, starting & ending (from balance sheet) Acquisition of capital assets Depreciation of capital assets Retained earnings Copyright Oxford University Press 2017

Example 17-1 Engineered Industries purchased $400K capital equipment & sold none; paid no dividends; What changes in 2017 balance sheet due to income statement & this transaction? Retained earnings increase by $730K profit in 2017 Plant & equipment for 2017 up by $400K Accumulated depreciation for 2017 increases by $450K depreciation shown on income statement Fixed asset2017 = Fixed asset2016 + $400K − $450K Copyright Oxford University Press 2017

Traditional Cost Accounting Cost accounting collects, analyzes, & reports operational performance data Cost accounting data are used to develop product costs to determine the mix of labor, materials, & other costs in production to evaluate outsourcing & subcontracting possibilities Copyright Oxford University Press 2017

Direct & Indirect Costs From activities directly associated with final product or service Direct material costs Direct labor costs Indirect Costs Difficult to link to specific projects, products, or services To allocate indirect costs, various cost drivers are used Direct labor hours Material costs Total direct costs Copyright Oxford University Press 2017

Example 17-2 $850K Indirect Cost Allocation by Labor Cost Standard Premium Total Annual production (units) 750 400 Unit labor cost $400 $500 Unit materials cost $550 $900 Labor cost $300,000 $200,000 $500,000 Materials cost $412,500 $360,000 $772,500 Allocate $850,000 by labor cost Total labor cost = $500,000, so overhead per labor $ = $850,000 / $500,000 = 1.7 Allocation for standard = 1.7(300,000) = $510,000 Allocation to premium = 1.7(200,000) = $340,000 Copyright Oxford University Press 2017

Example 17-2 $850K Indirect Cost Allocation by Materials Cost Standard Premium Total Annual production (units) 750 400 Unit labor cost $400 $500 Unit materials cost $550 $900 Labor cost $300,000 $200,000 $500,000 Materials cost $412,500 $360,000 $772,500 Allocate $850,000 by materials cost Total material cost = $772,500, so overhead per material $ = $850,000 / $772,500 = 1.1 Allocation for standard = 1.1(412,500) = $453,750 Allocation to premium = 1.1(360,000) = $396,000 Copyright Oxford University Press 2017

Problems with Traditional Cost Accounting Can distort product cost Direct labor content is relatively small in automation, high-tech settings Accounting data “untimely” Copyright Oxford University Press 2017

Activity-Based Costing (ABC) versus Traditional Overhead Allocation Direct Direct Overhead Labor Mat’l Machine Setup Op. Order Eng. Product Cost Copyright Oxford University Press 2017