ENGM 661ENGM 661Engineering Economics Engineering Economics

for for ManagersManagersFinancial Financial

StatementsStatements

Cost ConceptsCost Concepts Life Cycle Costs

the sum of all expenditures associated with an item during its entire service life

first costmachine cost, training, installation, tooling, supporting equipment

operating and maintenance costs disposal cost

(scrap vs book vs market)

Sunk CostsSunk Costs

Opportunity CostsOpportunity Costs

Direct vs Indirect Direct vs Indirect CostsCosts

Direct Material

Direct Labor

Indirect Material/Labor

Fixed

General/Admin

Selling

Profit

Conversioncost

SellingPrice

Primecosts

Factory Overhead

Costof goods

manufactured

Costof goods

sold

Fixed vs VariableFixed vs Variable

Fixed - do not vary with productiongeneral admin., taxes, rent, depreciation

Variable - costs vary in proportion to the quantity of outputmaterial, direct labor, material handling

Fixed vs VariableFixed vs Variable

Fixed - do not vary with productiongeneral admin., taxes, rent, depreciation

Variable - costs vary in proportion to the quantity of outputmaterial, direct labor, material handling

TC(x) = FC + VC(x)

Fixed vs VariableFixed vs Variable

TC(x) = FC + VC(x)

FC

TC

VC

Break EvenBreak Even

Profit = R(x) - FC - VC(x)

FC

TC

R

Break EvenBreak Even

Profit = R(x) - FC - VC(x)

FC

TC

R

Break-Even AnalysisBreak-Even Analysis

Site Fixed Cost/Yr Variable CostA=Austin $ 20,000 $ 50 S= Sioux Falls 60,000 40 D=Denver 80,000 30

TC = FC + VC * X

Break-Even (cont)Break-Even (cont)Break-Even Analysis

0

50,000

100,000

150,000

200,000

250,000

0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000

Volume

To

tal

Co

st

Austin

S. Falls

Denver

ExampleExample

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

ExampleExample Automated tank battery

annual depreciation = $3,200 annual maintenance = $5,200 Other fixed & variable costs

Automated Tank Automated Tank BatteryBattery

Automatic Tank Battery OperationsFixed Cost / day Control panel power $0.15 Circulating pump 0.82 Maintenance 1.00 Meter calibration 0.40 Chemical pump power 0.32 Total $2.69 2.69/day or $982/yrVariable Cost / day Pipeline pump (5 hsp @ 50% util) $0.63 Chemical additives (7.5 qts/day) 3.75 Inhibitor (2 qts/day) 1.00 Gas (10.8 MCF/day x 0.0275/MCF) 0.30 Total $5.68 5.68/day / 500 barrels = $0.01136 / barrel

TC(x) = (982 + 3,200 + 5,200) + 0.01136 X

ExampleExample

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

Manual Tank BatteryManual Tank BatteryAutomatic Tank Battery OperationsFixed Cost / day Chemical pump power $0.16 Circulating pump 0.82 Total $0.98 0.98/day or $358/yrVariable Cost / day Chemical additives (7.5 qts/day) 3.75 Gas (10.8 MCF/day x 0.0275/MCF) 0.30 Total $4.05 4.05/day / 500 barrels = $0.00810 / barrel

TC(x) = (2,000 + 7,500 + 358) + 0.00810 X

BreakEvenBreakEven

TCA(x) = TCM(x)

BreakEvenBreakEven

TCA(x) = TCM(x)

9,382 + 0.01136 x = 9,858 + 0.0081 x

BreakEvenBreakEven

TCA(x) = TCM(x)

9,382 + 0.01136 x = 9,858 + 0.0081 x

0.0033 x = 476

BreakEvenBreakEven

TCA(x) = TCM(x)

9,382 + 0.01136 x = 9,858 + 0.0081 x

0.0033 x = 476

x* = 145,000

ExampleExample

Automatic vs Manual

8,000

9,000

10,000

11,000

12,000

- 50,000 100,000 150,000 200,000

Barrels per Year

Co

st

of

Pro

du

cti

on

Automatic

Manual

Average vs Marginal Average vs Marginal CostCost

x

xTCxAC

)()(

x

xTCxMC

)()(

ExampleExample

Cost of running an automobile is

TC(x) = $950 + 0.20 x

where $950 covers annual depreciation and maintenance and x is the number of miles driven per year

ExampleExample

20.0950)(

)( xx

xTCxAC

20.0)20.0950()(

)(

x

x

x

xTCxMC

ExampleExample

Average vs Marginal Cost (Automobile)

0.0

0.5

1.0

1.5

0 10,000 20,000 30,000

Miles per year

cost Average

Marginal

Marginal ReturnsMarginal Returns

ExampleExample

Small firm sells garden chemicals. x = number of tons sold per yearSP(x) = selling price per ton (to sell x tons)

= $(800 - 0.8x)TR(x) = total revenue at x tons

= $(800 - 0.8x) xTC(x) = total production cost for x tons

= $(8,000 + 400x)

ExampleExample

TP(x) = total profit at x tons = TR(x) - TX(x) = (800x - 0.8x2) - (8,000 + 400x) = -0.8x2 + 400x - 8,000

Computea. x at which revenue is maximizedb. marginal revenue at max revenuec. x at which profit is maximizedd. average profit at max profit

ExampleExample

TR(x) = -0.8x2 + 800x

a.max R

tonsx

x

x

xx

x

xTR

500

8006.1

)8008.0(0

)( 2

ExampleExample

TR(x) = -0.8x2 + 800x

b.Marginal Revenue

MR(500) = -1.6(500) + 800

= $0

ExampleExample

TP(x) = -0.8x2 + 400x - 8,000

c.max profit

250

4006.1

)000,84008.(0

)( 2

x

x

x

xx

x

xTP

ExampleExample

TP(x) = -0.8x2 + 400x - 8,000

c.average profit

tonAP

xx

x

xxxAP

/168$)250(

/000,84008.0

000,84008.0)(

2

Terms to define!Terms to define! Bookkeeping

accumulate the results of an entities financial activities

Financial Accountingexternal evaluation of financial statements of an entity

Managerial Accountinguse of economic & financial information to plan and control activities of an entity

Cost Accountingdetermines product, process, or service costs; a subset of managerial accounting

TermsTerms

Tax Accountingthe preperation of income tax returns as a specialized field within accounting - tax planning

Auditingexternal review and evaluation of an entitys’s financial records and health

internal auditsgovernment auditsIRS audits

Functions of Functions of AccountingAccounting 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 Principles of AccountingAccounting

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 Transactions ApproachApproach

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 StatementsFinancial 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 SheetBalance 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 cost principle going concern objectivity principle stable dollar assumption

Current Assets - convertible to cash within 1 yr.

Balance SheetBalance 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 EquationAccounting Equation

Owner Equity = Assets - Liabilities

K-Corp Consolidated Balance1997 1996

Current Assets Cash $22,300 $16,800 Accounts Receivable 46,800 38,600 Inventories 54,200 48,200 Total Current Assets $123,300 $103,600Other Assets Land 100,000 100,000 Building 85,400 94,600 Equipment 78,400 85,600

Total Assets $387,100 $383,800

Current Liabilities Accounts Payable $62,400 $55,600

Notes 5,000 20,000Total Current Liabilities $67,400 $75,600 Mortgage 125,800 132,300Total Liabilities $193,200 $207,900Owner's Equity Paid In Capital 100,000 100,000 Retained Earnings 93,900 75,900Total Liabilities & Owner Equity $387,100 $383,800

Income StatementIncome 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

K-Corp Income Statement

Net Sales $574,800Cost of Goods Sold 428,300Gross Margin 146,500Operating Expenses Sales Expenses 87,400 Depreciation Equip 7,200 Depreciation Bldg 9,200 Administrative 14,500 Utilities 4,600

Total Operating $122,900Income from Operations 23,600Taxes 5,600Net Income $18,000

Changes to Owner Changes to Owner EquityEquity

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 =

$100,000addition 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 Changes to Owner EquityEquity

Balance Sheet Income Statement Balance Sheet

8/31/96 Revenues 8/31/97 - Expenses Net Income

Statement of OEA =L +OE Begin Balance

Paid in capital changes Retained earnings + Net Income - Dividends Ending Balances A = L + OE

K-Corp Income Statement

Net Sales $574,800Cost of Goods Sold 428,300Gross Margin 146,500Operating Expenses Sales Expenses 87,400 Depreciation Equip 7,200 Depreciation Bldg 9,200 Administrative 14,500 Utilities 4,600

Total Operating $122,900Income from Operations 23,600Taxes 5,600Net Income $18,000

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

K-Corp Consolidated Balance1997 1996

Current Assets Cash $22,300 $16,800 Accounts Receivable 46,800 38,600 Inventories 54,200 48,200 Total Current Assets $123,300 $103,600Other Assets Land 100,000 100,000 Building 85,400 94,600 Equipment 78,400 85,600

Total Assets $387,100 $383,800

Current Liabilities Accounts Payable $62,400 $55,600

Notes 5,000 20,000Total Current Liabilities $67,400 $75,600 Mortgage 125,800 132,300Total Liabilities $193,200 $207,900Owner's Equity Paid In Capital 100,000 100,000 Retained Earnings 93,900 75,900Total Liabilities & Owner Equity $387,100 $383,800

Statement of Cash Statement of Cash FlowsFlows

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

K-Corp Cash Flows

Net Income $18,000Add (deduct) items Depreciation Exp 16,400 Increase in Accts Rec. -8,200 Increase in Invent. -6,000 Increase in Accts. Pay 6,800 Increase in Notes Pay -15,000Net Cash from Operations $12,000Cash from Investing 0

Cash from Financing Retire long term dept -6,500 Issue of long term dept 0 Sale of common stock 0

Payment of Dividends 0Net Increase in Cash $5,500

K-Corp Cash Flows

Net Income $18,000Add (deduct) items Depreciation Exp 16,400 Increase in Accts Rec. -8,200 Increase in Invent. -6,000 Increase in Accts. Pay 6,800 Increase in Notes Pay -15,000Net Cash from Operations $12,000Cash from Investing 0

Cash from Financing Retire long term dept -6,500 Issue of long term dept 0 Sale of common stock 0

Payment of Dividends 0Net Increase in Cash $5,500

K-Corp Consolidated Balance1997 1996

Current Assets Cash $22,300 $16,800 Accounts Receivable 46,800 38,600 Inventories 54,200 48,200 Total Current Assets $123,300 $103,600Other Assets Land 100,000 100,000 Building 85,400 94,600 Equipment 78,400 85,600

Total Assets $387,100 $383,800

Current Liabilities Accounts Payable $62,400 $55,600

Notes 5,000 20,000Total Current Liabilities $67,400 $75,600 Mortgage 125,800 132,300Total Liabilities $193,200 $207,900Owner's Equity Paid In Capital 100,000 100,000 Retained Earnings 93,900 75,900Total Liabilities & Owner Equity $387,100 $383,800

K-Corp Pro-Forma Cash Flows

Cash Flows from Ops. Feb Mar Apr May JunNet Income $250 $500 $600 $750 $900 Depreciation 50 50 50 50 50 Increase in Receivables 0 (250) (475) (600) (900) Increase in Inventory (10) (100) (300) (500) (900) Increase in Current Liab 50 75 100 150 180Net Increase/Decrease $340 $275 ($25) ($150) ($670)

Beginning Cash 250 590 865 840 690

Ending Cash $590 $865 $840 $690 $20

You Can Go Broke Making Money!

Financial Statement Financial Statement AnalysisAnalysis

Liquidity Measures current ratio quick ratio working capital

Long Term Credit Risk debt to assets ratio debt to equity

Financial Statement Financial Statement AnalysisAnalysis

Profitability Measures return on assets return on equity net profit margin earnings per share

Activity Ratios accounts receivable turnover inventory turnover

LiquidityLiquidity

Working Capital

900,55

400,67300,123

sLiabilitieCurrentAssetsCurrentWC

LiquidityLiquidity Working Capital

Q: Is $55,900 sufficient working capital to cover 2-3 months of expenses?

900,55

400,67300,123

sLiabilitieCurrentAssetsCurrentWC

LiquidityLiquidity

Current Ratio (Industry > 2.0)

83.1

400,67

300,123

sLiabilitieCurrent

AssetsCurrentCR

LiquidityLiquidity

Quick Ratio (Industry > 1.0)

03.1

400,67

200,54300,123

sLiabilitieCurrent

InventoryAssetsCurrentQR

Long Term Credit Long Term Credit RiskRisk

Debt to Assets (Industry < 33%)

50.0

100,387

200,193

AssetsTotal

sLiabilitieTotalDA

Long Term Credit Long Term Credit RiskRisk

Debt to Assets (Industry < 33%)

50.0

100,387

200,193

AssetsTotal

sLiabilitieTotalDA

1996 0.54

Long Term Credit Long Term Credit RiskRisk

Debt to Equity Ratio (Industry 33-50%)

996.0

900,193

200,193

'

EquitysOwner

sLiabilitieTotalDE

Long Term Credit Long Term Credit RiskRisk

Debt to Equity Ratio (Industry 33-50%)

996.0

900,193

200,193

'

EquitysOwner

sLiabilitieTotalDE

1996 1.182

Profitability Profitability MeasuresMeasures

Return on Assets (Industry 8-10%)

047.02

800,383100,387000,18

AssetsAverageTotal

IncomeNetROA

Profitability Profitability MeasuresMeasures

Debt to Equity (Industry 12-15%)

097.0

2/)900,175900,193(

000,18

EquityOwnerAverage

IncomeNetROE

Profitability Profitability MeasuresMeasures

Net Profit Margin (Industry 4-6%)

(Industry Specific)

031.0

800,574

000,18

SalesNet

IncomeNetNPM

Profitability Profitability MeasuresMeasures

Earnings per Share (Industry Specific)

18

000,1

000,18

tan

dingOutsSharesCommon

IncomeNetEPS

Activity RatiosActivity Ratios

Accounts Receivable Turnover (Industry Specific)

46.13

2/)600,38800,46(

800,574

Re

ceivableAccountsAvg

SalesNetART

Activity RatiosActivity Ratios

Inventory Turnover (Industry > 10)

365.8

2/)200,48200,54(

300,428

InventoryAverage

SoldGoodsofCostIT

Financial LeverageFinancial LeverageFirm with No LeverageBalance Sheet Assets $100,000

Liabilities $0 Owner Equity 100,000Total Liability & Owner Equity $100,000

Income from Operations $18,000Interest Expense 0Net Income $18,000

Financial LeverageFinancial LeverageFirm with No LeverageBalance Sheet Assets $100,000

Liabilities $0 Owner Equity 100,000Total Liability & Owner Equity $100,000

Income from Operations $18,000Interest Expense 0Net Income $18,000

18.0000,100

000,18

18.0000,100

000,18

ROE

ROA

Financial LeverageFinancial LeverageFirm with LeverageBalance Sheet Assets $100,000

Liabilities $50,000 Owner Equity 50,000Total Liability & Owner Equity $100,000

Income from Operations $18,000Interest Expense 4,000Net Income $14,000

Financial LeverageFinancial Leverage

28.0000, 50

000,14

14.0000,100

000,14

ROE

ROA

Firm with LeverageBalance Sheet Assets $100,000

Liabilities $50,000 Owner Equity 50,000Total Liability & Owner Equity $100,000

Income from Operations $18,000Interest Expense 4,000Net Income $14,000

Financial LeverageFinancial Leverage

28.0000, 50

000,14

14.0000,100

000,14

ROE

ROA

Firm with LeverageBalance Sheet Assets $100,000

Liabilities $50,000 Owner Equity 50,000Total Liability & Owner Equity $100,000

Income from Operations $18,000Interest Expense 4,000Net Income $14,000

Note: ROI = 18,000/100,000