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AccountingAccountingfor Non-Accountantsfor Non-Accountants
Dr. Joyce S. WendamLecturer
I - Basic Accounting: I - Basic Accounting: Concepts, Techniques Concepts, Techniques
and Conventionsand Conventions
Definition of AccountingDefinition of Accounting
AccountingAccounting is the art of is the art of recordingrecording, , classifyingclassifying and and summarizingsummarizing in a in a significant manner and in terms of significant manner and in terms of money, transactions and events which money, transactions and events which are, in part at least, of a financial are, in part at least, of a financial character and character and interpretinginterpreting the results the results thereof.thereof.
Functions of AccountingFunctions of Accounting
Functions of accounting:Functions of accounting:
1.1. Recording of dataRecording of data
2.2. Classifying of dataClassifying of data
3.3. Summarizing of dataSummarizing of data
4.4. Interpreting the resultsInterpreting the results
Major users of accounting Major users of accounting informationinformation
1. owners of the business1. owners of the business 2. management of the business2. management of the business 3. banks or creditors of the business 3. banks or creditors of the business 4. the government or its agencies4. the government or its agencies 5. prospective investors5. prospective investors 6. consumers6. consumers 7. employees of the business7. employees of the business 8. the general public8. the general public
2 – The Elements of 2 – The Elements of AccountingAccounting
The Accounting ElementsThe Accounting Elements
AssetsAssets Owner’s EquityOwner’s Equity LiabilitiesLiabilities RevenueRevenue ExpensesExpenses
AssetsAssets
Assets are items of worth owned by the Assets are items of worth owned by the business organization in conducting its business organization in conducting its operations.operations.
Examples: cash, receivables, stock, Examples: cash, receivables, stock, landland
Types of AssetsTypes of Assets
1. Current assets1. Current assets – those assets which – those assets which are are readilyreadily converted into cash within a converted into cash within a twelve-month period or within the normal twelve-month period or within the normal operating cycle of a business.operating cycle of a business.
As a guide – non-monetary assets that As a guide – non-monetary assets that are convertible to cash within a year or are convertible to cash within a year or the normal operating cycle of a business the normal operating cycle of a business are categorized as current assets.are categorized as current assets.
2.2. Non-current assetsNon-current assets - those which are not - those which are not readily convertible into cash within a twelve-readily convertible into cash within a twelve-month period or within the normal operating month period or within the normal operating cycle of a business and, thus, it has a long-cycle of a business and, thus, it has a long-term nature. Also known as long-term term nature. Also known as long-term assets.assets.
These assets are mostly not intended to be These assets are mostly not intended to be sold by the business entity. Ex. - land, sold by the business entity. Ex. - land, building, machinery, motor vehicles, building, machinery, motor vehicles, equipment and furniture. equipment and furniture.
LiabilitiesLiabilities
Amounts owed by the business entity to Amounts owed by the business entity to outside parties other than its owner and outside parties other than its owner and as such these are seen as “debts” and as such these are seen as “debts” and obligations of the business.obligations of the business.
Examples – accounts payable, notes Examples – accounts payable, notes payable, loans, salaries payablepayable, loans, salaries payable
a. Current Liabilitiesa. Current Liabilities
Current LiabilitiesCurrent Liabilities - debts and - debts and obligations which should be paid within a obligations which should be paid within a twelve-month period or within the normal twelve-month period or within the normal operating cycle of a business. operating cycle of a business.
Examples are creditors, accounts Examples are creditors, accounts payable, salaries payable. payable, salaries payable.
b. Non-current b. Non-current LiabilitiesLiabilities
Non-current LiabilitiesNon-current Liabilities – debts and – debts and obligations which will be paid over more obligations which will be paid over more than a twelve-month period and, thus, it than a twelve-month period and, thus, it has a long-term nature. Also known as has a long-term nature. Also known as long-term liabilities.long-term liabilities.
Examples – mortgage loan or long-term Examples – mortgage loan or long-term notes payable notes payable
Owner’s EquityOwner’s Equity
Also known as owner’s contribution, Also known as owner’s contribution, investment, proprietorship, net worth or investment, proprietorship, net worth or capital to the business. capital to the business.
Outstanding claim of the owners in the Outstanding claim of the owners in the assets of a business after satisfying the assets of a business after satisfying the claims of the creditors.claims of the creditors.
Revenue & ExpensesRevenue & Expenses
RevenueRevenue - amount made or earned by - amount made or earned by the business entity as a result of its the business entity as a result of its operations.operations.
ExpensesExpenses – expenditures associated – expenditures associated with earning revenue. These are with earning revenue. These are generally utilized in the period in which generally utilized in the period in which they incurred.they incurred.
Profit/Loss calculationProfit/Loss calculation The primary objective of most business The primary objective of most business
organizations is organizations is to make earnings or profitsto make earnings or profits.. To calculate a profit or loss, we only need to To calculate a profit or loss, we only need to
subtract expenses from revenues. subtract expenses from revenues. If revenue is greater than expenses, a profit is If revenue is greater than expenses, a profit is
made and consequently, a loss is made when made and consequently, a loss is made when revenue is less than expenses.revenue is less than expenses.
In Accounting, a loss is generally shown with In Accounting, a loss is generally shown with parentheses around it ( a negative numerical parentheses around it ( a negative numerical figure). figure).
Accounting EquationAccounting Equation
The Fundamental Accounting Equation:The Fundamental Accounting Equation:
Assets = Liabilities + Owners’ EquityAssets = Liabilities + Owners’ Equity
The accounting equation may also be The accounting equation may also be expressed in two other forms:expressed in two other forms:
(1)(1) OWNER’S EQUITY = ASSETS – LIABILITIESOWNER’S EQUITY = ASSETS – LIABILITIES(2)(2) LIABILITIES = ASSETS – OWNER’S EQUITYLIABILITIES = ASSETS – OWNER’S EQUITY
Expanded Accounting Expanded Accounting EquationEquation
A = L + OE (C + R – E – D)A = L + OE (C + R – E – D)
Where: Where: A = assetsA = assets L = liabilitiesL = liabilities OE = Owner’s EquityOE = Owner’s Equity C = CapitalC = Capital R = RevenueR = Revenue E = ExpensesE = Expenses D = DrawingsD = Drawings
DOUBLE-ENTRY DOUBLE-ENTRY BOOKKEEPINGBOOKKEEPING
Phases of AccountingPhases of Accounting Recording PhaseRecording Phase Classifying PhaseClassifying Phase Summarizing PhaseSummarizing Phase Interpreting PhaseInterpreting Phase
Recording Phase Recording Phase – – refers to the procedure of methodically and refers to the procedure of methodically and chronologically documenting businesschronologically documenting business transactions in the appropriate accounting books. transactions in the appropriate accounting books. Classifying Phase -Classifying Phase - refers to the procedure of sorting accounting refers to the procedure of sorting accounting entries and grouping them into same type such entries and grouping them into same type such as asset accounts, liability accounts, owner’s as asset accounts, liability accounts, owner’s equity accounts, revenue accounts and expense equity accounts, revenue accounts and expense
accounts.accounts.
Summarizing Phase –Summarizing Phase – refers to the procedure of abridging orrefers to the procedure of abridging or summing up of accounting entries thatsumming up of accounting entries that were classified in the classifying were classified in the classifying phase into phase into
more more useful financial statements.useful financial statements. Interpreting Phase –Interpreting Phase – refers to the procedure of analyzing the financial refers to the procedure of analyzing the financial statements done in the summarizing phase to statements done in the summarizing phase to provide answers to major users of financial provide answers to major users of financial information.information.
Principles of Double-Principles of Double-Entry Bookkeeping Entry Bookkeeping SystemSystem
(1)(1) Each business transaction involves a Each business transaction involves a worth received and a worth given away;worth received and a worth given away;
(2)(2) The balance of the accounting equation The balance of the accounting equation should always be conserved, that is, the should always be conserved, that is, the accounting equation should still be accounting equation should still be balance after each business balance after each business transaction.transaction.
Debit and Credit EntryDebit and Credit Entry
Double-entry bookkeeping system always Double-entry bookkeeping system always records a transaction using two entries:records a transaction using two entries:
Debit entry deals with the worth received Debit entry deals with the worth received (things-of-value received) by the (things-of-value received) by the business entity.business entity.
Credit entry deals with the worth given Credit entry deals with the worth given away (things-of-value given away) by the away (things-of-value given away) by the business entity.business entity.
For you to understand further the double-entry For you to understand further the double-entry bookkeeping system, study the following business bookkeeping system, study the following business transactions:transactions:
1.1. The business purchase a motor vehicle for P500,000 The business purchase a motor vehicle for P500,000 from David Car Sales paid in cash.from David Car Sales paid in cash.
worth received: motor vehicle worth P500,000worth received: motor vehicle worth P500,000 worth given away: cash of P500,000worth given away: cash of P500,000 What is the accounting entry?What is the accounting entry? Debit entry – transportation equipment worth Debit entry – transportation equipment worth
P500,000P500,000 Credit entry – cash-on-hand of P500,000 Credit entry – cash-on-hand of P500,000
Rules of Debit and CreditRules of Debit and Credit
Rule 1: An asset is increased by a debit entry.Rule 1: An asset is increased by a debit entry. Rule 2: An asset is decreased by a credit Rule 2: An asset is decreased by a credit
entry.entry. Rule 3: A liability is increased by a credit entry.Rule 3: A liability is increased by a credit entry. Rule 4: A liability is decreased by a debit Rule 4: A liability is decreased by a debit
entry.entry. Rule 5: An owner’s equity is increased by a Rule 5: An owner’s equity is increased by a
credit entry.credit entry.
Rule 6: An owner’s equity is decreased by a Rule 6: An owner’s equity is decreased by a debit entry.debit entry.
Rule 7: A revenue is increased by a credit Rule 7: A revenue is increased by a credit entry.entry.
Rule 8: A revenue is decreased by a debit Rule 8: A revenue is decreased by a debit entry.entry.
Rule 9: An expense is increased by a debit Rule 9: An expense is increased by a debit entry.entry.
Rule 10: An expense is decreased by a credit Rule 10: An expense is decreased by a credit entry.entry.
3. FINANCIAL ACCOUNTING 3. FINANCIAL ACCOUNTING REPORTS REPORTS
Financial StatementsFinancial Statements
Summarized reports of accounting transactionsSummarized reports of accounting transactions Two-fold purpose: to communicate to users:Two-fold purpose: to communicate to users: - the effect of operating activities during a - the effect of operating activities during a
specified period of time; and,specified period of time; and, - the business’ financial position at the end of - the business’ financial position at the end of
the periodthe period Types of financial statements:Types of financial statements:
Income Statement Income Statement Balance SheetBalance Sheet
Statement of Cash FlowStatement of Cash Flow
Balance SheetBalance Sheet
Reports the financial position of a Reports the financial position of a business at a specific point in timebusiness at a specific point in time
Often called the “statement of financial Often called the “statement of financial position”position”
Equation: Assets = Liabilities + Owners’ Equation: Assets = Liabilities + Owners’ EquityEquity
Balance SheetBalance Sheet
Assets – economic resources that are Assets – economic resources that are expected to benefit future activitiesexpected to benefit future activities
Equities – claims against, or interests in, the Equities – claims against, or interests in, the assetsassets
Liabilities – entity’s economic obligations to Liabilities – entity’s economic obligations to non-ownersnon-owners
Owners’ equity – excess of the assets over the Owners’ equity – excess of the assets over the liabilitiesliabilities
For a corporation, the owners’ equity is called For a corporation, the owners’ equity is called the stockholders’ equity.the stockholders’ equity.
Pro Forma Balance Sheet
XYZ Co.Balance Sheet
December 31, 20xx
ASSETSCurrent Assets Cash xxx Marketable Securities xxx Accounts Receivable xxx Merchandise Inventory xxx Other Current Assets xxx .
Total Current Assets xxx
Fixed Assets Land xxx Building xxx
Furniture & Fixture xxx Office Equipment xxx . Total xxx Less: Accumulated Depreciation xxx .
Total Fixed Assets xxx .TOTAL ASSETS xxx
.
LIABILITIES & STOCKHOLDERS’ EQUITYLIABILITIES Current Liabilities: Notes and Accounts Payable xxx Taxes Payable xxx Other Current Liabilities xxx .
Total Current Liabilities xxx Long-term Liabilities xxx .
Total Liabilities xxx .
STOCKHOLDERS’ EQUITY Capital Stock xxx Retained Earnings xxx .
Total Stockholders’ Equity xxx .TOTAL LIABILITIES & STOCKHOLDERS’ EQUITY xxx
.
Income StatementIncome Statement
Measures the operating performance of Measures the operating performance of the corporation by matching its the corporation by matching its accomplishments (revenue from accomplishments (revenue from customers, which is usually called sales) customers, which is usually called sales) and its efforts (cost of goods sold and and its efforts (cost of goods sold and expenses).expenses).
Measures performance for a span of timeMeasures performance for a span of time Also known as Profit and Loss StatementAlso known as Profit and Loss Statement
Revenues - inflows of assets either from the Revenues - inflows of assets either from the sale of goods or the performance of servicessale of goods or the performance of services
Expenses - outflows or other uses of assets to Expenses - outflows or other uses of assets to produce revenues over expensesproduce revenues over expenses
Net income (sometimes referred to as earnings Net income (sometimes referred to as earnings or profit) is the excess of revenues over or profit) is the excess of revenues over expenses, including tax expenseexpenses, including tax expense
ABC Corporation ABC Corporation
Income StatementsIncome StatementsFor Year Ended December 31, 2008For Year Ended December 31, 2008
(in thousands of pesos)(in thousands of pesos)
Sales 3,280 Sales 3,280 Less: Cost of Sales Less: Cost of Sales 2,120 2,120 Gross Income Gross Income 1,160 1,160 Less: Operating Expenses Less: Operating Expenses Selling 350 Selling 350 Administrative Administrative 420 420 Total Operating Expenses Total Operating Expenses 770 770 Income from Operations 390 Income from Operations 390 Less: Interest Expense Less: Interest Expense 30 30 Income before tax 360 Income before tax 360 Less: Income Tax Less: Income Tax 126 126 Net Income 234 Net Income 234 ==== ====
Statement of Cash FlowsStatement of Cash Flows
Prepared by analyzing changes in balance Prepared by analyzing changes in balance sheet amounts and the data in the income and sheet amounts and the data in the income and retained earnings statements.retained earnings statements.
The financing (i.e. obtaining financial The financing (i.e. obtaining financial resources) and investing (i.e. using financial resources) and investing (i.e. using financial resources) activities of a company are of resources) activities of a company are of considerable interest to users of financial considerable interest to users of financial information because those activities change information because those activities change the financial position of the businessthe financial position of the business
C. Pro forma Cash Flow Statement
XYZ EnterpriseXYZ EnterpriseCash Flow ProjectionsCash Flow Projections
For the Period Ending _________For the Period Ending _________
Opening BalanceOpening Balance xxxxxx
Cash ReceiptsCash Receipts xxxxxx Collection of ReceivablesCollection of Receivables xxxxxx Cash SalesCash Sales xxxxxx Sale of Temporary InvestmentsSale of Temporary Investments xxxxxx Sale of EquitySale of Equity xxxxxx Short-Term BorrowingShort-Term Borrowing xxxxxx Long-Term BorrowingLong-Term Borrowing xxxxxx InvestmentsInvestments xxx . xxx .
Total ReceiptsTotal Receipts xxxxxx
Cash DisbursementsCash Disbursements
Payments for Raw Materials PurchasesPayments for Raw Materials Purchases xxxxxx Payments for LaborPayments for Labor xxxxxx Manufacturing Overhead and ExpensesManufacturing Overhead and Expenses xxxxxx Selling ExpensesSelling Expenses xxxxxx General and Administrative ExpenseGeneral and Administrative Expense xxxxxx Payment for Fixed AssetsPayment for Fixed Assets xxxxxx Interest PaymentsInterest Payments xxxxxx Loan RepaymentsLoan Repayments xxxxxx Payments on Real Estate MortgagePayments on Real Estate Mortgage xxxxxx Payment on Income TaxesPayment on Income Taxes xxxxxx Other Taxes and AssessmentsOther Taxes and Assessments xxx . xxx .
Total DisbursementsTotal Disbursements (xxx) . (xxx) .
End BalanceEnd Balance xxx xxx ==============
MANAGEMENT ACCOUNTINGMANAGEMENT ACCOUNTING
II -II - INTRODUCTIONINTRODUCTION Management Accounting -Management Accounting - Management Accounting – the application of appropriate techniques and concepts in Management Accounting – the application of appropriate techniques and concepts in
processing the historical and projected economic data of an entity to assist processing the historical and projected economic data of an entity to assist management in establishing a plan for reasonable economic objectives and in the management in establishing a plan for reasonable economic objectives and in the making of rational decisions with a view towards achieving these objectives.making of rational decisions with a view towards achieving these objectives.
Management Accounting defies attempts at comprehensive, concise definition; it changes Management Accounting defies attempts at comprehensive, concise definition; it changes constantly to adapt to technological changes, changes in manager’s needs, and new constantly to adapt to technological changes, changes in manager’s needs, and new approaches to other functional areas of business – marketing, production, finance, approaches to other functional areas of business – marketing, production, finance, organizational behavior, and corporate strategy.organizational behavior, and corporate strategy.
An indispensable part of the system that provides information to managers – the people An indispensable part of the system that provides information to managers – the people whose decisions and actions determine the success or failure of an organization.whose decisions and actions determine the success or failure of an organization.
Definition of Definition of Management AccountingManagement Accounting
Management Accounting includes the methods Management Accounting includes the methods and concepts necessary for effective planning, and concepts necessary for effective planning, for choosing alternative business actions and for choosing alternative business actions and for control through the valuation and for control through the valuation and interpretation of performance (The interpretation of performance (The
American Accounting Association).American Accounting Association). The essential aim of management accountant The essential aim of management accountant
is to assist management in decision making is to assist management in decision making and control (Brown and Howard).and control (Brown and Howard).
Financial Accounting and Managerial AccountingFinancial Accounting and Managerial Accounting
Major Differences:Major Differences:
1.1. They serve different audiencesThey serve different audiences
- Financial Accounting – serves persons outside - Financial Accounting – serves persons outside the firm the firm such as such as creditors, customers,creditors, customers,
government units and investors.government units and investors.
- Managerial - insiders- Managerial - insiders
2.2. Differ in source and natureDiffer in source and nature
- Financial Accounting reports are developed from - Financial Accounting reports are developed from
the basic accounting system , which captures the basic accounting system , which captures
data about completed transactions. data about completed transactions.
Financial Accounting and Managerial Financial Accounting and Managerial AccountingAccounting
-- Managerial - reports incorporate information that is not found Managerial - reports incorporate information that is not found in the financial in the financial accounting system; such information accounting system; such information might relate to expected future transactions (such as budgeted might relate to expected future transactions (such as budgeted sales and costs) or alternatives to past sales and costs) or alternatives to past transactions (such as transactions (such as showing what income would have been if we had sold more showing what income would have been if we had sold more units at a lower price)units at a lower price)
3.3. As to purposeAs to purpose
-- Financial accounting reports are general purpose. Financial accounting reports are general purpose.
- Managerial accounting reports are specifically - Managerial accounting reports are specifically
designed for a particular user or a particular decision.designed for a particular user or a particular decision.
Financial Accounting and Managerial AccountingFinancial Accounting and Managerial Accounting
4.4. Financial accounting reports concentrate on the Financial accounting reports concentrate on the results of past decisions.results of past decisions.
Managerial accounting reports often concentrate on Managerial accounting reports often concentrate on what is likely to happen in the future.what is likely to happen in the future.
5. Managerial accounting has no external restrictions 5. Managerial accounting has no external restrictions such as the generally accepted accounting principles such as the generally accepted accounting principles (GAAP) while financial accounting has to adhere to (GAAP) while financial accounting has to adhere to GAAP.GAAP.
Managerial Functions and their Managerial Functions and their Relationship to AccountingRelationship to Accounting
1.1. planning – setting goals and developing strategies and planning – setting goals and developing strategies and
tactics to achieve themtactics to achieve them 2. decision making - use of analytical techniques2. decision making - use of analytical techniques 3.3. control - determining whether goals are being met, control - determining whether goals are being met,
and if not, what can be done.and if not, what can be done.
4.4. performance evaluation - how well operations are performance evaluation - how well operations are being controlled being controlled
Objectives of Management Objectives of Management AccountingAccounting
Main objective – to supply the required data to perform the internal managementMain objective – to supply the required data to perform the internal management functions.functions.The ff. are some of the functions:The ff. are some of the functions:- Collection of data – for preparation of plansCollection of data – for preparation of plans- Evaluation of plans – ascertaining the defects if any and brought to the notice of Evaluation of plans – ascertaining the defects if any and brought to the notice of
the managers immediately.the managers immediately.- Observing the performance – comparing the actual with the standardsObserving the performance – comparing the actual with the standards- Observing the reports – analyzing the uses of various types of statements in the Observing the reports – analyzing the uses of various types of statements in the
organization and suggesting for their improvement.organization and suggesting for their improvement.- Coordination among persons – showing organizational relaitons among peopleCoordination among persons – showing organizational relaitons among people- Financial analysis Financial analysis - Timely decisionsTimely decisions- Peaceful atmospherePeaceful atmosphere- CoordinationCoordination- Submission of reports – for performance evaluation Submission of reports – for performance evaluation
Role of Managerial Accounting within an OrganizationRole of Managerial Accounting within an Organization
Boeing – “ Less transactional and more decision-support type of Boeing – “ Less transactional and more decision-support type of work. More analytical, more . . . option analysis”work. More analytical, more . . . option analysis”
US West – “ From a historical role to a much more collaborative US West – “ From a historical role to a much more collaborative business partner, doing a lot more analysis, saying here’s what business partner, doing a lot more analysis, saying here’s what we need to do in the business. A business partner. It’s how do we need to do in the business. A business partner. It’s how do we run the business and what are the financial impacts of doing we run the business and what are the financial impacts of doing that.”that.”
Caterpillar - “Accountants evolve to become more of a team Caterpillar - “Accountants evolve to become more of a team player and being involved in major projects and being looked to as player and being involved in major projects and being looked to as a business advisor or consultant to help leverage our expertise on a business advisor or consultant to help leverage our expertise on profitability of certain products or outsourcing decisions and then profitability of certain products or outsourcing decisions and then helping the team develop strategy and focus the team all the way helping the team develop strategy and focus the team all the way through recommendation and implementation.” through recommendation and implementation.”
Source: Counting More , Counting Less: Transformation in the Mangament Accosunting Profession, Institute of Managmeent Accosutning, 1999.Source: Counting More , Counting Less: Transformation in the Mangament Accosunting Profession, Institute of Managmeent Accosutning, 1999.
Activities of Managerial AccountantsActivities of Managerial Accountants
Assist in the design of the organization’s Assist in the design of the organization’s information systeminformation system
Ensuring that the system performs Ensuring that the system performs adequatelyadequately
Periodically reporting information to Periodically reporting information to interested managersinterested managers
Undertaking special analysesUndertaking special analyses
III - Profit PlanningIII - Profit Planning
Cost-Volume-Profit Analysis – a systematic examination of the Cost-Volume-Profit Analysis – a systematic examination of the relationships among costs, activity levels or volume, and profit.relationships among costs, activity levels or volume, and profit.
Cost – refers to amount of resources given up in exchange for Cost – refers to amount of resources given up in exchange for some goods or servicessome goods or services
Classification of costClassification of cost 1. fixed – remain the same in total over a wide range of volume1. fixed – remain the same in total over a wide range of volume
2. variable – change in total in direct proportion to changes in 2. variable – change in total in direct proportion to changes in volumevolume
Profit PlanningProfit Planning
Example:Example:
Exeter CompanyExeter Company
Selling price of backpacks Selling price of backpacks P20.00P20.00
Cost of backpacks from manufacturers P10.00Cost of backpacks from manufacturers P10.00
Variable cost to pack and ship 1.00Variable cost to pack and ship 1.00
Sales commission at 5% of P20.00 Sales commission at 5% of P20.00 1.00 1.00
Total Variable Cost Total Variable Cost P12.00P12.00
Fixed Costs (rent, salaries, insurance, etc.) Fixed Costs (rent, salaries, insurance, etc.) P40,000P40,000
Contribution MarginContribution Margin
Contribution Margin – the difference between selling price per Contribution Margin – the difference between selling price per unit and variable cost per unitunit and variable cost per unit
Contribution margin percentage – per-unit contribution margin Contribution margin percentage – per-unit contribution margin divided by selling pricedivided by selling price
CM/unitCM/unit
CM percentage = ___________CM percentage = ___________
Selling PriceSelling Price
a) In our example, how much is the contribution margin per a) In our example, how much is the contribution margin per unit and what is the contribution margin percentage?unit and what is the contribution margin percentage?
b)b) What is the total cost? What is the total cost?
Total costs = fixed costs + (variable cost per unit x unit Total costs = fixed costs + (variable cost per unit x unit volume)volume)
(Assume units sold, 6000 units)(Assume units sold, 6000 units)
c)c) Determine profit:Determine profit:
Profit = (selling price x unit sales) - total variable Profit = (selling price x unit sales) - total variable
costs – total fixed costscosts – total fixed costs
Achieving Target ProfitsAchieving Target Profits
Break-Even Point Break-Even Point – – the point at which profits are zero because the point at which profits are zero because
total revenues equal total coststotal revenues equal total costs
BEP = Total sales = Total costs = 0 ProfitBEP = Total sales = Total costs = 0 Profit
Finding the BEPFinding the BEP
A. A. In units In units
Total Fixed CostsTotal Fixed Costs
Q (break even sales, in units) = --------------------------Q (break even sales, in units) = --------------------------
CM per unitCM per unit
= P40,000= P40,000
----------------------------------
P20 – 12P20 – 12
= P 40,000= P 40,000
------------------------------
8 8 = 5,000 backpacks = 5,000 backpacks
Finding the BEPFinding the BEP
B.B. In PesosIn Pesos
Total Fixed Costs + P 0Total Fixed Costs + P 0
Break-even sales = -------------------------------Break-even sales = -------------------------------
CM %CM %
= P40,000= P40,000
----------------------------------
40%40%
= P100,000= P100,000
Target ProfitTarget Profit
At the BEP, total contribution margin equals total fixed costs. We canAt the BEP, total contribution margin equals total fixed costs. We cantherefore find the volume required to achieve a target profit by finding therefore find the volume required to achieve a target profit by finding the sales required to earn total contribution margin equal to the sum the sales required to earn total contribution margin equal to the sum of total fixed costs and the target profit.of total fixed costs and the target profit.Formula:Formula: Fixed costs + target profitFixed costs + target profitSales in units to achieve target profit = ---------------------------------------Sales in units to achieve target profit = --------------------------------------- Contribution margin per unit Contribution margin per unit Problem: Problem:
Suppose Exeter wishes to earn a profit of P5,000 per month. Suppose Exeter wishes to earn a profit of P5,000 per month. How many backpacks must it sell?How many backpacks must it sell?
= P40,000 + 5,000= P40,000 + 5,000 -------------------------------------------------- 20 – 1220 – 12 = 45,000= 45,000 ------------------------ 88
= 5,625 units= 5,625 units
B.B. Sales, in pesos, to achieve target profitSales, in pesos, to achieve target profit
total fixed costs + target profittotal fixed costs + target profit
Sales, in pesos, to achieve = ------------------------------------------------Sales, in pesos, to achieve = ------------------------------------------------
target profit contribution margin percentagetarget profit contribution margin percentage
P40,000 + 5,000P40,000 + 5,000
= ---------------------------= ---------------------------
40%40%
= P112,500= P112,500
Target Return on Sales (ROS)Target Return on Sales (ROS)
Formula:Formula: fixed costsfixed costsSales, in pesos to = __________________________Sales, in pesos to = __________________________achieve target ROS CM percentage – target ROSachieve target ROS CM percentage – target ROS
Problem:Problem:Suppose that Exeter wishes to earn a 15% ROS.Suppose that Exeter wishes to earn a 15% ROS.
P40,000P40,000 = _________________ = _________________ 40% - 15%40% - 15%
P40,000 P40,000 = _______________ = P160,000= _______________ = P160,000 25% 25%
To check:To check:
Pesos PercentagesPesos Percentages
Sales 160,000 100%Sales 160,000 100%Variable costs (60% of sales) Variable costs (60% of sales) 96,000 96,000 60% 60%CM 64,000 40%CM 64,000 40%Fixed costs Fixed costs 40,000 40,000 25% 25%Income 24,000 15%Income 24,000 15%
====== ============ ======
Target Selling PricesTarget Selling Prices
Formula:Formula:
total fixed costs + target profittotal fixed costs + target profit
Price = ___________________________ + unit variable costPrice = ___________________________ + unit variable cost
unit volumeunit volume
Problem:Problem:
Exeter’s target is P10,000 per month and it expects to sell 6,000 Exeter’s target is P10,000 per month and it expects to sell 6,000 backpacks per month. Remember that Exeter’s variable costs backpacks per month. Remember that Exeter’s variable costs are P10.00 to purchase a backpack and P1.00 for packing and are P10.00 to purchase a backpack and P1.00 for packing and shipping and a 5% sales commission. Thus, per unit variable cost shipping and a 5% sales commission. Thus, per unit variable cost is P11.00 plus 5% of selling price. is P11.00 plus 5% of selling price.
Target Selling PricesTarget Selling Prices
P40,000 + P10,000P40,000 + P10,000
Price = _____________________ + P11.00 + (5% x price)Price = _____________________ + P11.00 + (5% x price) 6,0006,000
= P8.33 + P11.00 + 5%Price= P8.33 + P11.00 + 5%Price
95% Price = P8.33 + P11.0095% Price = P8.33 + P11.00
= P19.33/.95= P19.33/.95
Price = P20.35 roundedPrice = P20.35 rounded
Target CostingTarget Costing
Some companies use a planning technique called Some companies use a planning technique called target costingtarget costing to help decide whether to enter a new market or bring out a new to help decide whether to enter a new market or bring out a new product.product.
The essence of target costing is to determine how much the The essence of target costing is to determine how much the company can spend to manufacture and market a product, given company can spend to manufacture and market a product, given a target profita target profit
The price and volume are estimated first, then the costsThe price and volume are estimated first, then the costs
Target costing is useful especially in deciding whether to enter an Target costing is useful especially in deciding whether to enter an established market where selling prices are relatively stable.established market where selling prices are relatively stable.
Target CostingTarget Costing
For instance, if the managers agree on a target profit of P300,000 For instance, if the managers agree on a target profit of P300,000 and that unit volume of 100,000 is achievable at a P20.00 price, the and that unit volume of 100,000 is achievable at a P20.00 price, the total allowable cost is:total allowable cost is:
Revenue (100,000 x P20 ) P2,000,000Revenue (100,000 x P20 ) P2,000,000 Target profit 300,000Target profit 300,000 Total allowable cost P1,700,000Total allowable cost P1,700,000
If managers expect total fixed costs to be P1,200,000, total variable If managers expect total fixed costs to be P1,200,000, total variable costs can be P500,000 or P5.00 per unit. The P5.00 along with the costs can be P500,000 or P5.00 per unit. The P5.00 along with the P1,200,000 fixed cost, becomes an objective for the managers P1,200,000 fixed cost, becomes an objective for the managers responsible for designing and manufacturing the product.responsible for designing and manufacturing the product.
Uses of Target CostingUses of Target Costing
To illustrate, consider Cruz Co. Its managers decide to To illustrate, consider Cruz Co. Its managers decide to introduce a new product. They expect to sell 20,000 introduce a new product. They expect to sell 20,000 units at P10.00. They can make the product in either units at P10.00. They can make the product in either two manufacturing processes: two manufacturing processes:
Process A uses a great deal of labor and has Process A uses a great deal of labor and has variable cost of P7.00 per unit and annual fixed costs variable cost of P7.00 per unit and annual fixed costs of P40,000.00.of P40,000.00.
Process B uses more machinery, with unit Process B uses more machinery, with unit variable costs of P4.00 and annual fixed costs of variable costs of P4.00 and annual fixed costs of P95,000.00. P95,000.00.
Income StatementIncome Statement
Process A Process BProcess A Process B
Sales (20,000 x 10) P200,000 P200,000Sales (20,000 x 10) P200,000 P200,000
Variable cost at P7 & P4 Variable cost at P7 & P4 140,000 140,000 80,000 80,000
Contribution margin atContribution margin at
P3 and P6 60,000 120,000P3 and P6 60,000 120,000
Fixed costs Fixed costs 40,000 40,000 95,000 95,000
Profit 20,000 25,000Profit 20,000 25,000
======== ================ ========
Given the above income statements, what will Given the above income statements, what will you choose? Process A or Process B? Why?you choose? Process A or Process B? Why?
1. Finding the BEP1. Finding the BEP
BEP = Fixed Costs/CM per unitBEP = Fixed Costs/CM per unit
Process A = P40,000/3 = 13,333 unitsProcess A = P40,000/3 = 13,333 units
Process B = P40,000/6 = 15,833 unitsProcess B = P40,000/6 = 15,833 units
The higher the break-even, the riskier. Managers The higher the break-even, the riskier. Managers often express risk by referring to the Margin of often express risk by referring to the Margin of Safety (MOS).Safety (MOS).
2. Margin of Safety2. Margin of Safety
= the decline in volume from the expected = the decline in volume from the expected level of sales to the break-even point level of sales to the break-even point
is called the margin of safety (MOS).is called the margin of safety (MOS).
Formula:Formula:
MOS = Expected level of sales - BE (units)MOS = Expected level of sales - BE (units)
Finding the MOSFinding the MOS
Process A Process A MOS = 20,000 units (expected) –13,333 units (BE)MOS = 20,000 units (expected) –13,333 units (BE) = 6,667 units or P66,670 (6,667 x P10.00)= 6,667 units or P66,670 (6,667 x P10.00) or 33.33% (6,667/20,000)or 33.33% (6,667/20,000)
Process BProcess B MOS = 20,000 units (expected) –15,833 units (BE)MOS = 20,000 units (expected) –15,833 units (BE) = 4,167 units or P41,670 (4,167 x P10.00)= 4,167 units or P41,670 (4,167 x P10.00) or 20.8% (4,167/20,000)or 20.8% (4,167/20,000)Generally the higher the MOS, the lower the risk.Generally the higher the MOS, the lower the risk.
3. Indifference Point3. Indifference Point
= the level of volume at which total costs and, = the level of volume at which total costs and,
hence profits, are the same under both hence profits, are the same under both
structures.structures.
= at unit volumes below the indifference point, the = at unit volumes below the indifference point, the alternative with the lower fixed cost gives higher profits; alternative with the lower fixed cost gives higher profits; at volumes above the indifference point, the alternative at volumes above the indifference point, the alternative with the higher fixed cost is more profitable. with the higher fixed cost is more profitable.
Formula for Indifference PointFormula for Indifference Point
Total Cost for Process A = Total Cost for Process BTotal Cost for Process A = Total Cost for Process B
Fixed Cost + Variable Cost = Fixed Cost + Variable CostFixed Cost + Variable Cost = Fixed Cost + Variable Cost
P40,000 + P7Q = P95,000 + P4QP40,000 + P7Q = P95,000 + P4Q
P3Q = P55,000P3Q = P55,000
Q = 18,333 roundedQ = 18,333 rounded
At volume below 18,333 units, Process A gives lower totalAt volume below 18,333 units, Process A gives lower total
costs (and higher profits); above 18,333 units, Process B costs (and higher profits); above 18,333 units, Process B
gives higher profits.gives higher profits.
Cruz’s managers have no correct answer in theirCruz’s managers have no correct answer in their
choice of cost structure. Analytical tools such as thechoice of cost structure. Analytical tools such as the
indifference point, margin of safety, and CVP graph help indifference point, margin of safety, and CVP graph help
them evaluate alternatives, but the decision depends ofthem evaluate alternatives, but the decision depends of
their attitudes about risk and return. their attitudes about risk and return. If they want to avoid risk, they will choose Process A If they want to avoid risk, they will choose Process A
foregoing the potential for higher profits from Process B. foregoing the potential for higher profits from Process B.
If they are venturesome, they probably will be willing to If they are venturesome, they probably will be willing to
take some risk for the potentially higher returns and take some risk for the potentially higher returns and
choose Process B. choose Process B.
Assumptions and Limitations of CVP AnalysisAssumptions and Limitations of CVP Analysis
Assumptions:Assumptions:First:First: The company sells only one product orThe company sells only one product or The sales of each product in a multiproduct company The sales of each product in a multiproduct company
are a constant percentage of total sales.are a constant percentage of total sales.Second:Second: Relevant only to manufacturing companies,not to Relevant only to manufacturing companies,not to
merchandising and service companies.merchandising and service companies.
Assumptions and Limitations Assumptions and Limitations Underlying CVP AnalysisUnderlying CVP Analysis
All costs are classifiable as either fixed or variable.All costs are classifiable as either fixed or variable. Fixed costs remain constant within the relevant range.Fixed costs remain constant within the relevant range. The behavior of total revenues and total costs will be linear over The behavior of total revenues and total costs will be linear over
the relevant range i.e. will appear as a straight line on the BE the relevant range i.e. will appear as a straight line on the BE chart. chart.
In case of multiple-product companies, the selling prices, costs In case of multiple-product companies, the selling prices, costs and proportion of units, (sales mix) sold will not change. and proportion of units, (sales mix) sold will not change.
There is no significant change in the inventory levels during the There is no significant change in the inventory levels during the period under review. period under review.
Unit selling prices will remain constantUnit selling prices will remain constant Unit variable cost will not changeUnit variable cost will not change There will be no change inefficiency and productivityThere will be no change inefficiency and productivity The design of the product will not change The design of the product will not change
Uses of Cost-Volume-Profit AnalysisUses of Cost-Volume-Profit Analysis
- Planning – CVP Analysis is useful tool for planning - Planning – CVP Analysis is useful tool for planning future operations. future operations.
- Control – CVP Analysis may be used to control - Control – CVP Analysis may be used to control operations. Actual results are studied, analyzed and operations. Actual results are studied, analyzed and compared with the projected or planned data.compared with the projected or planned data.
- Analysis – both projected and actual data may be - Analysis – both projected and actual data may be analyzed using CVP relationships. analyzed using CVP relationships.
IV - Short-Term Decisions and IV - Short-Term Decisions and Accounting InformationAccounting Information
Making decisions is choosing among alternatives. Should Making decisions is choosing among alternatives. Should
we raise the price of our product, lower it, or leave itwe raise the price of our product, lower it, or leave it
alone? Should we drop a product (or product line) or alone? Should we drop a product (or product line) or
keep it? Should we add a new product? Should we keep it? Should we add a new product? Should we
make a component of our product in our factory or buy it make a component of our product in our factory or buy it
from another company? from another company?
Managers continually evaluate such sets of alternatives.Managers continually evaluate such sets of alternatives.
The Criterion for Short-Term DecisionsThe Criterion for Short-Term Decisions
The economic criterion for making a short-term decision is The economic criterion for making a short-term decision is simple. Take the action that you expect will give the simple. Take the action that you expect will give the organization theorganization the highest income highest income (or lowest loss). (or lowest loss).
Two subrules are often helpful:Two subrules are often helpful:1.1. The only revenues and costs that are relevant in The only revenues and costs that are relevant in
making decisions are the expected future revenues making decisions are the expected future revenues and costs that will differ among the available choicesand costs that will differ among the available choices(differential revenues and costs)(differential revenues and costs)
2. Revenues and costs that have already been earned or 2. Revenues and costs that have already been earned or incurred are irrelevant in making decisions. incurred are irrelevant in making decisions.
Sunk cost – one that has already been incurred Sunk cost – one that has already been incurred and therefore will be the same no matter which and therefore will be the same no matter which alternative a manager selects. alternative a manager selects.
Opportunity cost – the benefit lost by taking one Opportunity cost – the benefit lost by taking one action as opposed to another.action as opposed to another.
Example:Example:
Compu Sales recently manufactured 100 Compu Sales recently manufactured 100
specialized workstation monitors for a customerspecialized workstation monitors for a customer
that has since gone bankrupt. A rival companythat has since gone bankrupt. A rival company
has offered to buy the monitors for P12,000. The has offered to buy the monitors for P12,000. The
cost to manufacture the monitors was P17,000. cost to manufacture the monitors was P17,000.
The President says he’d rather throw them away The President says he’d rather throw them away
than sell them at a loss of P5,000. Is his than sell them at a loss of P5,000. Is his
reasoning sound?reasoning sound?
Make or Buy DecisionsMake or Buy Decisions
Suppose XYZ Co now makes a component for its majorSuppose XYZ Co now makes a component for its majorproduct. A manager has prepared the following product. A manager has prepared the following estimates of costs at the normal volume of 20,000 units.estimates of costs at the normal volume of 20,000 units.
Materials at P2/unit P40,000Materials at P2/unit P40,000Direct labor at P5/unit 100,000Direct labor at P5/unit 100,000Variable overhead at P3/unit 60,000Variable overhead at P3/unit 60,000Allocated indirect fixed costs (buildingAllocated indirect fixed costs (building depreciation, heat and light, etc. depreciation, heat and light, etc. 120,000 120,000 Total cost P320,000Total cost P320,000
An outside supplier offers to supply the component at An outside supplier offers to supply the component at P14/unit or P280,000 for 20,000 units. Should XYZ accept the P14/unit or P280,000 for 20,000 units. Should XYZ accept the offer?offer?
Make or Buy DecisionMake or Buy Decision
DecisionsDecisions
Make BuyMake Buy
Materials 40,000 -0-Materials 40,000 -0-
Direct labor 100,000 -0-Direct labor 100,000 -0-
Variable overhead 60,000 -0-Variable overhead 60,000 -0-
Purchase price Purchase price -0- -0- 280,000280,000
Total 200,000 280,000Total 200,000 280,000
======= ============= ======
Temporary Shut DownTemporary Shut Down
Mr Rene Yap operates a snack counter selling sandwiches and Mr Rene Yap operates a snack counter selling sandwiches and softdrinks. Each unit sale is composed of a sandwich and a cup softdrinks. Each unit sale is composed of a sandwich and a cup of softdrinks which is sold at a lot price of P15.00. Variable cost of softdrinks which is sold at a lot price of P15.00. Variable cost amounts to P8.00 per unit. Under normal conditions, Mr. Yap amounts to P8.00 per unit. Under normal conditions, Mr. Yap sells an average of 3,000 units per month, during which he incurs sells an average of 3,000 units per month, during which he incurs the following fixed costs:the following fixed costs:
Rent - P3,000Rent - P3,000 Allocated cost of utilities - 2,000Allocated cost of utilities - 2,000 Salary of sales clerk 1,500Salary of sales clerk 1,500 Janitor’s salary 1,000Janitor’s salary 1,000 Security agency’s billing Security agency’s billing 2,500 2,500 Total P10,000 Total P10,000
A joint strike of teachers and students decreased the sales of Mr. A joint strike of teachers and students decreased the sales of Mr. Yap to only 800 units. Accordingly the strike would last for a Yap to only 800 units. Accordingly the strike would last for a month. Mr. Yap is considering of shutting down his business for a month. Mr. Yap is considering of shutting down his business for a month to avoid incurring losses due to the reduced sales volume. month to avoid incurring losses due to the reduced sales volume. He noted that if he shut down his operations, cost of allocated He noted that if he shut down his operations, cost of allocated utilities would be reduced to P500.00 and he could avoid incurring utilities would be reduced to P500.00 and he could avoid incurring salary of the sales clerk who would be asked to take a forced salary of the sales clerk who would be asked to take a forced leave without pay while the snack counter is closed. All the other leave without pay while the snack counter is closed. All the other fixed costs would be incurred despite of the discontinuance of fixed costs would be incurred despite of the discontinuance of operations. operations.
Should the snack counter be shut down for one month?Should the snack counter be shut down for one month?
Solutions:Solutions:Continue:Continue:Unit sales price P15.00Unit sales price P15.00Less Variable cost 8.00Less Variable cost 8.00CM /unit 7.00CM /unit 7.00X Sales in units 800.00X Sales in units 800.00Total CM 5,600.00Total CM 5,600.00Less: Fixed Costs 10,000.00Less: Fixed Costs 10,000.00Loss under continued Loss under continued operations P 4,400.00operations P 4,400.00
Shut Down:Shut Down:CM P -CM P -Less: Shut down costs:Less: Shut down costs: Rent P3,000Rent P3,000 Cost of utilities 500Cost of utilities 500 Janitor’s salary 1,000Janitor’s salary 1,000 Security agency’sSecurity agency’s billing 2,500 7,000billing 2,500 7,000Loss if operations were Loss if operations were shut down P7,000shut down P7,000
V - BudgetingV - Budgeting
Budget - a plan, expressed in quantitative terms, on how to acquire and use Budget - a plan, expressed in quantitative terms, on how to acquire and use the resources of an entity during a certain future period of time.the resources of an entity during a certain future period of time.
Uses/Advantages of BudgetingUses/Advantages of Budgeting Budgeting compels periodic planning.Budgeting compels periodic planning. Budgeting enhances coordination, cooperation, and communication.Budgeting enhances coordination, cooperation, and communication. Forces quantification of plans and proposalsForces quantification of plans and proposals Provides a framework for performance evaluationProvides a framework for performance evaluation Enables members of the organization to be aware of business costsEnables members of the organization to be aware of business costs Satisfies some legal and contractual requirementsSatisfies some legal and contractual requirements Directs the firm’s activities toward the achievement of organizational Directs the firm’s activities toward the achievement of organizational
goals.goals.
Comprehensive BudgetsComprehensive Budgets
A comprehensive budget or a masterA comprehensive budget or a masterbudget is a set of financial statements and budget is a set of financial statements and other schedules showing budgeted, other schedules showing budgeted, expected, or pro forma results for a future expected, or pro forma results for a future period. period.
Represents the overall plan of the organization for a Represents the overall plan of the organization for a given budget period.given budget period.
Normally contains an income statement, a balance Normally contains an income statement, a balance sheet, a cash budget (statement of cash receipts and sheet, a cash budget (statement of cash receipts and disbursements), and schedules of production, disbursements), and schedules of production, purchases, and fixed-asset acquisitions.purchases, and fixed-asset acquisitions.
Two Major Parts of the Master BudgetTwo Major Parts of the Master Budget
Operating Budget – budgeted income statement for a Operating Budget – budgeted income statement for a certain budget periodcertain budget period
Financial budget – includes the budgeted balance Financial budget – includes the budgeted balance sheet as of the end of a certain budget period, sheet as of the end of a certain budget period, budgeted statement of changes in financial position, budgeted statement of changes in financial position, capital expenditure budget, and all other budgets capital expenditure budget, and all other budgets required in financial management.required in financial management.
Sales ForecastingSales Forecasting
Sales forecast is the foundation for the comprehensive budget.Sales forecast is the foundation for the comprehensive budget.
Factors Considered in Making a Sales ForecastFactors Considered in Making a Sales Forecast- company’s past sales volume- company’s past sales volume- economic and political conditions- economic and political conditions- conditions in the industry to which the company belongs- conditions in the industry to which the company belongs- competition- competition- market research studies- market research studies- pricing policies of the firm as well as those of the competitors- pricing policies of the firm as well as those of the competitors- government control and regulations affecting the company- government control and regulations affecting the company- company’s own sales force and its planned advertising and promotional - company’s own sales force and its planned advertising and promotional activitiesactivities- company’s productive capacity and other limitations affecting production- company’s productive capacity and other limitations affecting production- change in demand for the product due to seasonal variations- change in demand for the product due to seasonal variations
Expense BudgetExpense Budget
Each manager in an organization is Each manager in an organization is responsible for specific tasks and their responsible for specific tasks and their costs. So managers should have budget costs. So managers should have budget allowances, or expense budgets, stating allowances, or expense budgets, stating the limits for costs they may incur in the limits for costs they may incur in accomplishing their tasks.accomplishing their tasks.
Budgeting in Not-For-Profit EntitiesBudgeting in Not-For-Profit Entities
Not-for-profit (NFP) entities, especially governmental Not-for-profit (NFP) entities, especially governmental
units, use budgets in different ways from profit-seekingunits, use budgets in different ways from profit-seeking
companies.companies.
- NFPs are likely to budget only for cash flows (receipts - NFPs are likely to budget only for cash flows (receipts
and expenditures), not for revenues and and expenditures), not for revenues and expensesexpenses
- the process is more likely to begin with expenditures - the process is more likely to begin with expenditures
rather than receiptsrather than receipts
Zero-Based Budgeting Zero-Based Budgeting
Zero-based budgeting – starts with the assumption Zero-based budgeting – starts with the assumption
that zero will be spent on each activity.that zero will be spent on each activity.
Tries to help management answer the question, Tries to help management answer the question, “Supposing we are to start our business from scratch, “Supposing we are to start our business from scratch, on what activities would we spend our money and to on what activities would we spend our money and to what activities would we give the highest priority?”what activities would we give the highest priority?”
Advantages of Zero Base Budgeting:Advantages of Zero Base Budgeting:1.1. Not based on incremental approach, so it promotes operational Not based on incremental approach, so it promotes operational
efficiency because it requires managers to review and justify efficiency because it requires managers to review and justify their activities or the funds requested.their activities or the funds requested.
2.2. Most appropriate for the staff and support areas Most appropriate for the staff and support areas 3.3. Considers alternative ways of performing the same jobConsiders alternative ways of performing the same job4.4. Focuses management process on analysis and decision Focuses management process on analysis and decision
makingmaking5.5. Helpful to the management in making optimum allocation of Helpful to the management in making optimum allocation of
scarce resources scarce resources 6.6.
Program BudgetingProgram Budgeting
Program budgeting – requires that a Program budgeting – requires that a budget indicate not only how the budget indicate not only how the requested funds are to be spent, requested funds are to be spent,
but also why the funds are to be spent in but also why the funds are to be spent in those ways.those ways.
VI - Analysis of Financial VI - Analysis of Financial StatementsStatements
Horizontal AnalysisHorizontal Analysis
- Involves comparing figures shown in the - Involves comparing figures shown in the financial statements of two or more financial statements of two or more consecutive periods. The difference consecutive periods. The difference between the figures of the two periods is between the figures of the two periods is calculated, and the percentage change calculated, and the percentage change from one period to the next is computed, from one period to the next is computed, using the earlier period as the base.using the earlier period as the base.
Horizontal AnalysisHorizontal AnalysisCompare Corporation Compare Corporation
Income StatementsIncome StatementsFor Years Ended December 31For Years Ended December 31
(in thousands of pesos)(in thousands of pesos)
2008 2007 Increase (Decrease)2008 2007 Increase (Decrease) Amount PercentAmount PercentSales 3,280 2,950 330 11%Sales 3,280 2,950 330 11%Less: Cost of Sales Less: Cost of Sales 2,120 2,120 1,917 1,917 203 203 11 11Gross Income Gross Income 1,160 1,160 1,033 1,033 127 127 12 12Less: Operating Expenses Less: Operating Expenses Selling 350 100 250 250Selling 350 100 250 250 Administrative Administrative 420 420 480 480 ( 60) ( 60) (13) (13)Total Operating Expenses Total Operating Expenses 770 770 580 580 190 190 33 33Income from Operations 390 453 (63) (14)Income from Operations 390 453 (63) (14)Less: Interest Expense Less: Interest Expense 30 30 25 25 5 5 20 20Income before tax 360 428 (68) (16)Income before tax 360 428 (68) (16)Less: Income Tax Less: Income Tax 126 126 149.8 149.8 (23.8) (23.8) (16) (16)Net Income 234 278.2 (44.20) (16)Net Income 234 278.2 (44.20) (16) ==== ===== ====== ======== ===== ====== ====
Horizontal AnalysisHorizontal Analysis
Formula for Percentage Change:Formula for Percentage Change:
Percentage = Percentage = Most Recent Value - Base Period ValueMost Recent Value - Base Period Value
Change Base Period ValueChange Base Period Value
= = 3,280 – 29503,280 – 2950
2,9502,950
= .11 or 11%= .11 or 11%
Vertical AnalysisVertical Analysis
- process of comparing figures in the financial process of comparing figures in the financial statements of a single period.statements of a single period.
- involves converting the figures in the statements to a involves converting the figures in the statements to a common base. common base.
- accomplished by expressing all the figures in the accomplished by expressing all the figures in the statements as a percentage of an important item, such statements as a percentage of an important item, such as total assets (in the balance sheet) and total or net as total assets (in the balance sheet) and total or net sales (in the income statement).sales (in the income statement).
- all the figures in the statements would be expressed all the figures in the statements would be expressed not in peso but in percentage terms.not in peso but in percentage terms.
- these converted statements are called common-size these converted statements are called common-size statements, 100 percent statements or component statements, 100 percent statements or component statements.statements.
Compare Corporation Compare Corporation Income StatementsIncome Statements
For Years Ended December 31For Years Ended December 31(in thousands of pesos)(in thousands of pesos)
20082008 Percent Percent 20072007 Sales 3,280 100.0% 2,950 Sales 3,280 100.0% 2,950 Less: Cost of Sales Less: Cost of Sales 2,120 2,120 64.6% 64.6% 1,917 1,917Gross Income Gross Income 1,160 1,160 35.4% 35.4% 1,0331,033Less: Operating Expenses Less: Operating Expenses Selling 350 10.7% 100Selling 350 10.7% 100 Administrative Administrative 420 420 12.8% 12.8% 480 480Total Operating Expenses Total Operating Expenses 770 770 23.5% 23.5% 580 580Income from Operations 390 11.9 453Income from Operations 390 11.9 453Less: Interest Expense Less: Interest Expense 30 30 1.0 1.0 25 25Income before tax 360 10.9% 428Income before tax 360 10.9% 428Less: Income Tax Less: Income Tax 126 126 3.8% 3.8% 149.8 149.8Net Income 234 7.1 278.2Net Income 234 7.1 278.2 ==== ========= =====
Ratio AnalysisRatio Analysis
Ratios are categorized based on their uses:Ratios are categorized based on their uses:1.1. Tests of liquidityTests of liquidity - Current ratio- Current ratio - Acid test ratio- Acid test ratio - Turnovers- Turnovers2.2. Tests of SolvencyTests of Solvency - Number of times interest earned ratio- Number of times interest earned ratio - Debt-equity ratio- Debt-equity ratio - Debt ratio- Debt ratio - Equity ratio- Equity ratio
Ratio AnalysisRatio Analysis
3.3. Tests of ProfitabilityTests of Profitability - Return on sales- Return on sales - Return on total assets- Return on total assets - Return on owner’s equity- Return on owner’s equity - Earnings per share- Earnings per share4.4. Market TestsMarket Tests - Price-earnings ratio- Price-earnings ratio - Dividend yield- Dividend yield - Dividend payout- Dividend payout
Tests of LiquidityTests of Liquidity
1.1. Current Ratio – also called the working Current Ratio – also called the working capital ratio or banker’s ratio, measures capital ratio or banker’s ratio, measures the number of times that the current the number of times that the current liabilities could be paid with the liabilities could be paid with the available current assets.available current assets.
Current AssetsCurrent Assets CURRENT RATIO =CURRENT RATIO = Current Current
LiabilitiesLiabilitiesStandard – 1.5:1 - the higher, the betterStandard – 1.5:1 - the higher, the better
2. Acid Test Ratio2. Acid Test Ratio
- Also called as quick ratio; only those Also called as quick ratio; only those assets that are cash or “near cash” (or assets that are cash or “near cash” (or assets that can be converted to cash assets that can be converted to cash quickly) are included so that the resulting quickly) are included so that the resulting ratio can indicate the firm’s paying liability ratio can indicate the firm’s paying liability in the very, very near term.in the very, very near term.
- Similar to the current ratio except that the Similar to the current ratio except that the inventories and prepayments are inventories and prepayments are excluded from the numerator. excluded from the numerator.
Acid test ratioAcid test ratio
Quick AssetsQuick Assets
Quick Ratio = Current LiabilitiesQuick Ratio = Current Liabilities
oror
= = Cash + Marketable Securities+ ReceivablesCash + Marketable Securities+ Receivables
Current LiabilitiesCurrent Liabilities
Standard = 1:1 - the higher, the betterStandard = 1:1 - the higher, the better
Illustration:Illustration:
Let us first compute Compare Let us first compute Compare Corporation’s quick or liquid assets:Corporation’s quick or liquid assets:
19891989 19901990Cash 120 150Cash 120 150Marketable securities 45 15Marketable securities 45 15Accounts receivable (net)Accounts receivable (net) 210 210 180180Total Quick Assets 375 345Total Quick Assets 375 345 === ====== ===
Current Liabilities:Current Liabilities:
19891989 19901990
Notes & Accounts Payable - P125 169Notes & Accounts Payable - P125 169
Taxes Payable 85 107Taxes Payable 85 107
Other Current Liabilities Other Current Liabilities 82 - 82 -
Total CL P292 276Total CL P292 276
===== ========= ====
Solution:Solution:
Acid Test Ratio = Acid Test Ratio = Quick AssetsQuick Assets
Current LiabilitiesCurrent Liabilities
2007 = 2007 = 375 375
292 = 1.28 to 1292 = 1.28 to 1
2008 = 2008 = 345345
276 = 1.25 to 1276 = 1.25 to 1
Working Capital Activity Working Capital Activity RatiosRatios
Both the current ratio and acid test ratio fail to Both the current ratio and acid test ratio fail to provide answers to the following questions:provide answers to the following questions:
1.1. How long can the firm expect to realize cash How long can the firm expect to realize cash from its receivables and inventories?from its receivables and inventories?
2.2. When should the firm pay its various current When should the firm pay its various current liabilities?liabilities?
To answer these 2 important questions, analysts To answer these 2 important questions, analysts can use the 3 working capital activity ratios: can use the 3 working capital activity ratios: accounts receivable turnover, inventory accounts receivable turnover, inventory turnover and accounts payable turnover. turnover and accounts payable turnover.
Receivables TurnoverReceivables Turnover
- the time required to complete one - the time required to complete one collection cycle – from the time collection cycle – from the time receivables are recorded, then collected, receivables are recorded, then collected, to the time new receivables are recorded to the time new receivables are recorded again; the faster the cycle is completed, again; the faster the cycle is completed, the more quickly receivables are the more quickly receivables are converted into cash.converted into cash.
Formula for Receivables Formula for Receivables TurnoverTurnover
Receivables = Receivables = Net SalesNet Sales
Turnover Average ReceivablesTurnover Average Receivables
Average Average Receivables = Receivables = Beg. Balance + Ending BalanceBeg. Balance + Ending Balance 2 2 Standard: 20 – 60 days - the lower, the betterStandard: 20 – 60 days - the lower, the better
Inventory TurnoverInventory Turnover
Measures the number of times that inventory is Measures the number of times that inventory is replaced during the period.replaced during the period.
Inventory = Inventory = Cost of Goods SoldCost of Goods Sold Turnover Ave. Merchandise Turnover Ave. Merchandise InventoryInventoryAve Mdse Invty - Ave Mdse Invty - Beg Bal + Ending Bal Beg Bal + Ending Bal 22Standard – 180 days - the lower the betterStandard – 180 days - the lower the better
Net Working CapitalNet Working Capital
Net Working Capital = Net Working Capital =
Current Assets - Current LiabilitiesCurrent Assets - Current Liabilities
Standard = PositiveStandard = Positive
Remarks = PositiveRemarks = Positive
Tests of SolvencyTests of Solvency
Solvency refers to the company’s ability Solvency refers to the company’s ability to pay all its debts, whether such to pay all its debts, whether such liabilities are current or noncurrent.liabilities are current or noncurrent.
Net Income before Net Income before Interest Interest Expense Expense
Times Interest Earned = -----------------------Times Interest Earned = ----------------------- Interest ExpenseInterest ExpenseStandard - 2x - the higher, the betterStandard - 2x - the higher, the better
Debt RatioDebt Ratio
- indicates the percentage of total assets indicates the percentage of total assets provided by creditors.provided by creditors.
Total LiabilitiesTotal Liabilities
Debt Ratio = --------------------- x 100Debt Ratio = --------------------- x 100
Total AssetsTotal Assets
Standard - 50% - the lower, the betterStandard - 50% - the lower, the better
Debt-Equity RatioDebt-Equity Ratio
Debt-Equity = Debt-Equity = Total LiabilitiesTotal Liabilities
EquityEquity
Standard = 4:1 - the lower, the betterStandard = 4:1 - the lower, the better
Tests of ProfitabilityTests of Profitability
Gross Profit MarginGross Profit Margin
Gross Profit Margin = Gross Profit Margin = Gross ProfitGross Profit
Net SalesNet Sales
Standard = 10 – 15% Standard = 10 – 15%
The higher, the betterThe higher, the better
Net Profit MarginNet Profit Margin
Net Profit Margin = Net Profit Margin = Net ProfitNet Profit
Net SalesNet Sales
Standard = 2 – 20%Standard = 2 – 20%
The higher, the betterThe higher, the better
Return on EquityReturn on Equity
Return on Equity = Return on Equity = Net ProfitNet Profit
EquityEquity
Standard = 5 – 25%Standard = 5 – 25%
The higher, the betterThe higher, the better
Return on Total AssetsReturn on Total Assets
Return on Total Assets = Return on Total Assets = Net ProfitNet Profit
Total AssetsTotal Assets
Standard = 10%Standard = 10%
The higher, the betterThe higher, the better
Return on InvestmentReturn on Investment
Rate of Return Rate of Return
or = or = IncomeIncome
Return on Investment Investment Return on Investment Investment
= Higher than interest rate = Higher than interest rate
Payback PeriodPayback Period
Payback Period = Payback Period = Total Project CostTotal Project Cost
Net IncomeNet Income
= shall not exceed term of loan= shall not exceed term of loan
Chapter VII – Management Chapter VII – Management AuditAudit
Definition Definition
Management Audit – systematic and Management Audit – systematic and dispassionate examination, analysis and dispassionate examination, analysis and appraisal of management overall performance.appraisal of management overall performance.
Signifies critical assessment of management of Signifies critical assessment of management of the enterprise from the broadest possible point the enterprise from the broadest possible point of viewof view
Thrust of this audit is on evaluation with Thrust of this audit is on evaluation with appropriate analysis for improvement on appropriate analysis for improvement on contribution towards industrial development.contribution towards industrial development.
ReferencesReferences
Manual on Project Evaluation, Seminar Manual on Project Evaluation, Seminar Workshop of Field Personnel on Workshop of Field Personnel on Credit Credit Evaluation, Loan Documentation and Evaluation, Loan Documentation and Collection, 2003.Collection, 2003.
Matz, Adolph, Milton, Usry F., Macuja, Estela Matz, Adolph, Milton, Usry F., Macuja, Estela F., F., Cost Accounting, Planning and ControlCost Accounting, Planning and Control, , 1984 1984
Mejorada, Nenita D., Mejorada, Nenita D., Management Management ServicesServices Part IIPart II, 1985, 1985
Reddy, Jayaprakash R., Reddy, Jayaprakash R., Management Management AccountingAccounting, 2004., 2004.
Happy Schooling!Happy Schooling!
