ENGM 661 Engineering Economics for Managers Financial Statements

Cost Concepts  Life Cycle Costs the sum of all expenditures associated with an item during its entire service life  first cost machine cost, training, installation, tooling, supporting equipment  operating and maintenance costs  disposal cost (scrap vs book vs market)

Sunk Costs

Opportunity Costs

Direct vs Indirect Costs Direct Material Direct Labor Indirect Material/Labor Fixed General/Admin Selling Profit Conversion cost Selling Price Prime costs Factory Overhead Cost of goods manufactured Cost of goods sold

Fixed vs Variable  Fixed - do not vary with production general admin., taxes, rent, depreciation  Variable - costs vary in proportion to the quantity of output material, direct labor, material handling

Fixed vs Variable  Fixed - do not vary with production general admin., taxes, rent, depreciation  Variable - costs vary in proportion to the quantity of output material, direct labor, material handling TC(x) = FC + VC(x)

Fixed vs Variable TC(x) = FC + VC(x) FC TC VC

Break Even Profit = R(x) - FC - VC(x) FC TC R

Break Even Profit = R(x) - FC - VC(x) FC TC R

Break-Even Analysis SiteFixed Cost/YrVariable Cost A=Austin $20,000 $50 S= Sioux Falls60, D=Denver80,00030 TC = FC + VC * X

Break-Even (cont) Break-Even Analysis 0 50, , , , , ,0001,5002,0002,5003,0003,5004,000 Volume Total Cost Austin S. Falls Denver

Example  Company produces crude oil from a field where the basis of decision is the number of barrels produced. Two methods for production are:  automated tank battery  manually operated tank battery

Example  Automated tank battery  annual depreciation = $3,200  annual maintenance = $5,200  Other fixed & variable costs

Automated Tank Battery TC(x) = ( , ,200) X

Example  Manual Tank Battery  annual depreciation = $2,000  annual maintenance = $7,500  other costs

Manual Tank Battery TC(x) = (2, , ) X

BreakEven TC A (x) = TC M (x)

BreakEven 9, x = 9, x

BreakEven TC A (x) = TC M (x) 9, x = 9, x x = 476

BreakEven TC A (x) = TC M (x) 9, x = 9, x x = 476 x * = 145,000

Example

Average vs Marginal Cost x xTC xAC )( )(  x xTC xMC    )( )(

Example  Cost of running an automobile is TC(x) = $ x where $950 covers annual depreciation and maintenance and x is the number of miles driven per year

Example )( )(  xx xTC xAC 20.0 ).0950()( )(        x x x xTC xMC

Example Average vs Marginal Cost (Automobile) ,00020,00030,000 Miles per year cost Average Marginal

Marginal Returns

Example  Small firm sells garden chemicals. x = number of tons sold per year SP(x) = selling price per ton (to sell x tons) = $( x) TR(x) = total revenue at x tons = $( x) x TC(x) = total production cost for x tons = $(8, x)

Example TP(x) = total profit at x tons = TR(x) - TX(x) = (800x - 0.8x 2 ) - (8, x) = -0.8x x - 8,000 Compute a.x at which revenue is maximized b.marginal revenue at max revenue c.x at which profit is maximized d.average profit at max profit

Example TR(x) = -0.8x x a.max R tonsx x x xx x xTR ) 8.0( 0 )( 2       

Example TR(x) = -0.8x x b.Marginal Revenue MR(500) = -1.6(500) = $0

Example TP(x) = -0.8x x - 8,000 c.max profit )000,84008.( 0 )( 2        x x x xx x xTP

Example TP(x) = -0.8x x - 8,000 c.average profit tonAP xx x xx x /168$)250( /000, , )( 2    

Terms to define!  Bookkeeping accumulate the results of an entities financial activities  Financial Accounting external evaluation of financial statements of an entity  Managerial Accounting use of economic & financial information to plan and control activities of an entity  Cost Accounting determines product, process, or service costs; a subset of managerial accounting

Terms  Tax Accounting the preperation of income tax returns as a specialized field within accounting - tax planning  Auditing external review and evaluation of an entitys’s financial records and health internal audits government audits IRS audits

Functions of Accounting  Internal Control all measures used by an organization to guard against errors, waste and fraud  Audits of Financial Statements investigation of a company’s financial statements to determine the fairness of these statements  Annual Reports comparative financial statements enable user’s to identify trends in the company’s performance and financial position

Principles of Accounting  Principles of accounting dictate that financial statements must show  financial position at end of accounting period  earnings for the accounting period  cash flows during that period  investments by & distribution to owners

Transactions Approach  In recording economic activities, accountants focus on completed transactions - those that cause an immediate change in the financial resources or obligations of a company  purchasing raw materials  sales of finished goods  Strength - the reliability of the information that is recorded, based on past events, objectivity

Financial Statements  Balance Sheet financial position of a company indicating resources it owns, debts, and the amount of owner’s equity  Income Statement profitability of the business over the preceeding accounting period  Statement of Owner’s Equity explains changes in the amount of owner’s equity in the business  Statement of Cash Flows summarizes cash receipts and cash payments of business over the preceeding accounting period

Balance Sheet  Statement of financial position  does not show the current market value of an entity’s assests  Assets economic resources owned by a business and are expected to benefit future operations u cost principle u going concern u objectivity principle u stable dollar assumption Current Assets - convertible to cash within 1 yr.

Balance Sheet  Liabilities probable future sacrifices of economic benefits as result of current obligations Current Liabilities - must be paid within 1 yr.  Owner Equity ownership right of proprietors or stockholders Changes in OE by  investment by owner  earnings from profitable operation of business  withdrawals of cash of other assets  losses from business

Accounting Equation Owner Equity = Assets - Liabilities

Income Statement  Projects profit/loss of an entity over a period of time  Net Sales - gross sales less returns, defects, etc.  Cost-of-Goods sold - cost of raw material & direct labor  Selling, Gen, Admin - operating expenses of an entity which do not directly contribute to product (sales people, managers,...)  Interest Expense - interest paid on long/short term debt.  Net Income/share - net income (after tax) divided by outstanding shares

Changes to Owner Equity  Begin Balance - last year’s ending balance  Paid-in Capital - sold 10,000 shares at $19 /share stock par value of $10 / share. common stock = 10,000 x $10 = $100,000 addition paid in =10,000 x ($19-$10) = $ 90,000  Retained Earnings - cumulative net income which has been retained for business  Dividends - distribution of earnings to stockholders

Changes to Owner Equity Balance SheetIncome StatementBalance Sheet 8/31/96 Revenues 8/31/97 - Expenses Net Income Statement of OE A =L +OE Begin Balance Paid in capital changes Retained earnings + Net Income - Dividends Ending BalancesA = L + OE

Retained (97) = Retained (96) + $18,000 = $93,900

Statement of Cash Flows  Identify the sources and use of cash during year  Operating Activities  net income $18,000 from income statement  depreciation expense $16,400 from balance sheet added back in because it is not an actual cash outlay

You Can Go Broke Making Money!

Financial Statement Analysis  Liquidity Measures  current ratio  quick ratio  working capital  Long Term Credit Risk  debt to assets ratio  debt to equity

Financial Statement Analysis  Profitability Measures  return on assets  return on equity  net profit margin  earnings per share  Activity Ratios  accounts receivable turnover  inventory turnover

Liquidity  Working Capital 900,55 400,67300,123    sLiabilitieCurrentAssetsCurrentWC

Liquidity  Working Capital Q: Is $55,900 sufficient working capital to cover 2-3 months of expenses? 900,55 400,67300,123    sLiabilitieCurrentAssetsCurrentWC

Liquidity  Current Ratio(Industry > 2.0) ,67 300,123    sLiabilitieCurrent AssetsCurrent CR

Liquidity  Quick Ratio (Industry > 1.0) ,67 200,54300,123      sLiabilitieCurrent InventoryAssetsCurrent QR

Long Term Credit Risk  Debt to Assets (Industry < 33%) , ,193    AssetsTotal sLiabilitieTotal DA

Long Term Credit Risk  Debt to Assets (Industry < 33%) , ,193    AssetsTotal sLiabilitieTotal DA

Long Term Credit Risk  Debt to Equity Ratio (Industry 33-50%) , ,193 '    EquitysOwner sLiabilitieTotal DE

Long Term Credit Risk  Debt to Equity Ratio (Industry 33-50%) , ,193 '    EquitysOwner sLiabilitieTotal DE

Profitability Measures  Return on Assets(Industry 8-10%) ,383100, ,18     AssetsAverageTotal IncomeNet ROA

Profitability Measures  Debt to Equity(Industry 12-15%) /)900,175900,193( 000,18     EquityOwnerAverage IncomeNet ROE

Profitability Measures  Net Profit Margin(Industry 4-6%) (Industry Specific) , ,18    SalesNet IncomeNet NPM

Profitability Measures  Earnings per Share(Industry Specific) ,1,18 tan    dingOutsSharesCommon IncomeNet EPS

Activity Ratios  Accounts Receivable Turnover (Industry Specific) /)600,38800,46( 800,574 Re     ceivableAccountsAvg SalesNet ART

Activity Ratios  Inventory Turnover(Industry > 10) /)200,48200,54( 300,428     InventoryAverage SoldGoodsofCost IT

Financial Leverage

, , , ,18   ROE ROA

Financial Leverage

, , , ,14   ROE ROA

Financial Leverage , , , ,14   ROE ROA Note: ROI = 18,000/100,000