ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 1 OUTLINE Questions? News? Chapter 2 – Financials Chapter 8 - Costs

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 2 Why study financials?

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 3 Chapter 2 – Understanding Financial Statements If someone gave you $100,000, what would you do with it?

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 4 CHAPTER 2 - FINANCIAL STATEMENTS ACCOUNTING - KEEPING TRACK OF MONEY FISCAL PERIOD - A 12 MONTH PERIOD SELECTED FOR ANALYSIS INCOME STATEMENT - HOW MUCH PROFIT (LOSS)? STATEMENT OF RETAINED EARNINGS - WHAT DID YOU DO WITH THE PROFIT? STATEMENT OF CASH FLOWS - HOW MUCH CASH WAS GENERATED? BALANCE SHEET - WHERE DO YOU STAND FINANCIALLY? STOCK PRICE DEPENDS ON WHAT PEOPLE THINK OF THE COMPANY’S FUTURE

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 5 Things to do with profits?

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 6 Things to do with profits Buy back stock Expand product line Pay investors dividends Profit sharing and raises Research Hire more labor Acquisitions Infrastructure Retire loans

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 7 How is the price of a stock determined? (08/16/05)

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 8 How do stocks look in the aggregate? (8/16/05)

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 9

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 10 CHAPTER 2 - FINANCIAL STATEMENTS (CONTINUED) USING RATIOS TO MAKE DECISIONS ABSOLUTE NUMBERS OFTEN ARE NOT MEANINGFUL - e.g. YOUR SCORE ON THE EXAM HAS ONLY MEANING WITHIN THE CONTEXT OF HOW IT COMPARES TO YOUR EXPECTATIONS AND THE PERFORMANCE OF OTHERS PERCENTAGES ARE THE MOST COMMON RATIOS THE BOOK LISTS 12 RATIOS THAT ARE USED FREQUENTLY

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 11 CHAPTER 2 - CATEGORIES OF RATIOS DEBT MANAGEMENT - HOW DO YOU GET YOUR CAPITAL? LIQUIDITY - CAN YOU PAY YOUR DEBTS? ASSET MANAGEMENT- INVENTORY AND RECEIVABLES MARKET VALUE - HOW REALISTIC IS THE VALUE OF THE STOCK? PROFITABILITY - HOW WELL ARE YOUR INVESTMENTS GENERATING PROFITS?

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 12 CHAPTER 2 - DEBT MANAGEMENT DEBT RATIO = TOTAL DEBT / TOTAL ASSETS HAVE YOU BORROWED TOO LARGE A PART OF YOUR ASSETS? TIMES INTEREST EARNED RATIO = EARNINGS BEFORE INTEREST AND INCOME TAXES / INTEREST EXPENSE CAN YOU EARN ENOUGH TO PAY THE INTEREST?

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 13 CHAPTER 2 - LIQUIDITY CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES DO YOU OWE MORE THAN YOU HAVE? QUICK RATIO = (CURRENT ASSETS - INVENTORIES) / CURRENT LIABILITIES HOW FAST CAN YOU PAY YOUR DEBTS?

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 14 CHAPTER 2 - ASSET MANAGEMENT INVENTORY TURNOVER = SALES / AVERAGE INVENTORY BALANCE ARE YOU MOVING YOUR INVENTORY FAST ENOUGH? ACCOUNT RECEIVABLE TURNOVER (DAYS SALES OUTSTANDING) = RECEIVABLES / DAILY SALES ARE YOU COLLECTING FROM YOUR CUSTOMERS? TOTAL ASSET TURNOVER = SALES / TOTAL ASSETS ARE YOUR ASSETS GENERATING SALES?

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 15 CHAPTER 2 - MARKET VALUE PRICE EARNING RATIO = STOCK PRICE / ANNUAL EARNINGS PER SHARE LIKE INTEREST (JUST A LOT LOWER) BOOK VALUE PER SHARE (TOTAL STOCK HOLDER EQUITY - PREFFERED STOCK) / SHARES OUTSTANDING USUALLY MUCH LOWER THAN THE STOCK PRICE

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 16 CHAPTER 2 - PROFITABILITY PROFIT MARGIN ON SALES = NET INCOME / SALES HOW EFFECTIVE ARE YOUR SALES IN GENERATING INCOME? RETURN ON TOTAL ASSETS = NET INCOME + TAXED INTEREST EXPENSE) / AVERAGE TOTAL ASSETS ARE YOUR INVESTMENTS GENERATING ENOUGH INCOME?

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 17 Is any of this applicable to personal finances?

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 18 CHAPTER 8 - COSTS IMPORTANT TERMS: –MANUFACTURING COSTS »DIRECT MATERIALS »DIRECT LABOR »INDIRECT LABOR »OVERHEAD MATERIAL REGULAR –SALES AND ADMINISTRATIVE COSTS –RESEARCH, DEVELOPMENT, DESIGN COSTS

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 19 CHAPTER 8 - COSTS INVENTORY –RAW –WORK IN PROCESS (WIP) –FINISHED GOODS (FG) –TRANSIT –EXCESS AND CANCEL

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 20 CHAPTER 8 - COSTS COSTS –FIXED (Independent of the volume of production) –VARIABLE (Increase as volume increases) »Generally linear –MIXED COSTS - Ignore

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 21 CHAPTER 8 - COSTS UNIT COSTS = UNITS PRODUCED / TOTAL COST VOLUME - NUMBER OF UNITS PRODUCED BREAK EVEN VOLUME – VOLUME NEEDED TO RECOVER INVESTMENT COSTS MAKE OR BUY SUNK COSTS - CAN’T BE RECOVERED MARGINAL COSTS - COST TO PRODUCE THE NEXT UNIT

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 22 Break Even Volume Initial investment = $20M Fixed operating cost per year = $5M Unit cost to manufacture = $50 Selling price = $200 Expected Life 4 years Ignoring the time value of money and assuming equal volumes per year, how many units per year must I make in order to break even 20M + 5M(4) +4(50)v = 200(4)v v= 66,667

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 23 Adding up the costs (example) A plant generates 270,000 earned hours (established by standards for each of the products produced). 85% efficiency is assumed. The cost of an hour of labor, including benefits, is $30 Indirect labor totals $30M Materials cost $70M Material overhead costs are $4M What is the cost of a product containing 0.8 hours of standard labor and $20 of material? We first calculate the total labor rate as (30,000, ,000*30/0.85)/270,000=$146.40/hour

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 24 Adding up the costs (example continued) Material overhead = $4M/$70M= 5.7% Direct and indirect labor =0.8* $146.40=$ Material=$20.00 Material Overhead= 0.057*20=$1.14 Total Cost =$ We can separate the direct and indirect labor into: Direct labor = 0.8*30=$24 Indirect=$93.12 And you can see why everyone attacks overhead If you are independent, the profit would add another 10% or so. It is very dependent on the industry and level of investment

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 25 Cost Distribution

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 26 Make or Buy If a supplier bid $130 on the product from the last example, how would you decide whether to make it yourself or buy it from the supplier?

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 27 Adding up the costs (Second example) Labor = 0.2 hours, material = $200 Direct and indirect labor =0.2* $146.40=$29.28 Material=$ Material Overhead= 0.057*200=$11.40 Total Cost =$ We can separate the direct and indirect labor into: Direct labor = 0.2*30=$6 Indirect=$23.28 And you can see why everyone attacks Material Costs If you are independent, the profit would add another 10% or so. It is very dependent on the industry and level of investment

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 28 Cost Distribution (second example)

ENGINEERING ECONOMICS ISE460 SESSION 2 CHAPTER 2, May 28, 2015 Geza P. Bottlik Page 29