ENGM 661
Engineering Economics for
Managers
Financial Statements
Cost Concepts
 Life Cycle Costs
the sum of all expenditures
associated with an item during its
entire service life
 first cost
machine cost, training, installation, tooling,
supporting equipment
 operating
and maintenance costs
 disposal cost
Sunk Costs
Opportunity Costs
Direct vs Indirect Costs
Direct Material
Direct Labor
Conversion
cost
Selling
Price
Indirect
Material/Labor
Prime
costs
Cost
of goods
manufactured
Factory
Overhead
Fixed
General/Admin
Selling
Profit
Cost
of goods
sold
Fixed vs Variable
 Fixed - do not vary with production
general admin., taxes, rent, depreciation
 Variable - costs vary in proportion to the
quantity of output
material, direct labor, material handling
Fixed vs Variable
 Fixed - do not vary with production
general admin., taxes, rent, depreciation
 Variable - costs vary in proportion to the
quantity of output
material, direct labor, material handling
TC(x) = FC + VC(x)
Fixed vs Variable
TC
VC
FC
TC(x) = FC + VC(x)
Break Even
R
TC
FC
Profit = R(x) - FC - VC(x)
Break Even
R
TC
FC
Profit = R(x) - FC - VC(x)
Break-Even Analysis
Site
Fixed Cost/Yr
A=Austin
$20,000
S= Sioux Falls 60,000
D=Denver
80,000
TC = FC + VC * X
Variable Cost
$50
40
30
Break-Even (cont)
Break-Even Analysis
250,000
200,000
Austin
Total Cost
150,000
S. Falls
Denver
100,000
50,000
0
0
500
1,000
1,500
2,000
Volume
2,500
3,000
3,500
4,000
Example
 Company produces crude oil from a field
where the basis of decision is the number of
barrels produced. Two methods for
production are:
 automated
tank battery
 manually operated tank battery
Example
 Automated tank battery
 annual depreciation = $3,200
 annual maintenance = $5,200
 Other fixed & variable costs
Automated Tank Battery
Automatic Tank Battery Operations
Fixed Cost / day
Control panel power
Circulating pump
Maintenance
Meter calibration
Chemical pump power
Total
2.69/day or $982/yr
Variable Cost / day
Pipeline pump (5 hsp @ 50% util)
Chemical additives (7.5 qts/day)
Inhibitor (2 qts/day)
Gas (10.8 MCF/day x 0.0275/MCF)
Total
5.68/day / 500 barrels
= $0.01136 / barrel
$0.15
0.82
1.00
0.40
0.32
$2.69
$0.63
3.75
1.00
0.30
$5.68
TC(x) = (982 + 3,200 + 5,200) + 0.01136 X
Example
 Manual Tank Battery
 annual depreciation = $2,000
 annual maintenance = $7,500
 other costs
Manual Tank Battery
Automatic Tank Battery Operations
Fixed Cost / day
Chemical pump power
Circulating pump
Total
0.98/day or $358/yr
Variable Cost / day
Chemical additives (7.5 qts/day)
Gas (10.8 MCF/day x 0.0275/MCF)
Total
4.05/day / 500 barrels
= $0.00810 / barrel
$0.16
0.82
$0.98
3.75
0.30
$4.05
TC(x) = (2,000 + 7,500 + 358) + 0.00810 X
BreakEven
TCA(x) = TCM(x)
BreakEven
TCA(x) = TCM(x)
9,382 + 0.01136 x = 9,858 + 0.0081 x
BreakEven
TCA(x) = TCM(x)
9,382 + 0.01136 x = 9,858 + 0.0081 x
0.0033 x = 476
BreakEven
TCA(x) = TCM(x)
9,382 + 0.01136 x = 9,858 + 0.0081 x
0.0033 x = 476
x* = 145,000
Example
Cost of Production
Automatic vs Manual
12,000
11,000
Automatic
10,000
Manual
9,000
8,000
-
50,000
100,000 150,000 200,000
Barrels per Year
Average vs Marginal Cost
TC ( x )
AC ( x ) =
x
MC ( x ) =
TC ( x )
x
Example
 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
Example
TC ( x) 950
=
+ 0.20
AC ( x) =
x
x
TC ( x)  (950 + 0.20 x)
=
= 0.20
MC ( x) =
x
x
Example
Average vs Marginal Cost
(Automobile)
cost
1.5
1.0
Average
Marginal
0.5
0.0
0
10,000
20,000
Miles per year
30,000
Marginal Returns
Example
 Small firm sells garden chemicals.
x = number of tons sold per year
SP(x) = selling price per ton (to sell x tons)
= $(800 - 0.8x)
TR(x) = total revenue at x tons
= $(800 - 0.8x) x
TC(x) = total production cost for x tons
= $(8,000 + 400x)
Example
TP(x) = total profit at x tons
= TR(x) - TX(x)
= (800x - 0.8x2) - (8,000 + 400x)
= -0.8x2 + 400x - 8,000
Compute
a. x at which revenue is maximized
b. marginal revenue at max revenue
c. x at which profit is maximized
d. average profit at max profit
Example
TR(x) = -0.8x2 + 800x
a. max R
TR( x)
(-0.8 x 2 + 800 x)
=0=
x
x
= - 1.6 x + 800
x = 500 tons
Example
TR(x) = -0.8x2 + 800x
b. Marginal Revenue
MR(500) = -1.6(500) + 800
= $0
Example
TP(x) = -0.8x2 + 400x - 8,000
c. max profit
TP( x)
(-.8 x 2 + 400 x + 8,000)
=0=
x
x
= - 1.6 x + 400
x = 250
Example
TP(x) = -0.8x2 + 400x - 8,000
c. average profit
AP ( x ) =
- 0.8 x 2 + 400 x - 8,000
x
= - 0.8 x + 400 - 8,000 / x
AP ( 250) = $168 / ton
Terms
 Bookkeeping
accumulate the results of an entities financial
activities
 Financial Accounting
external evaluation of financial statements of an
entity
 Managerial Accounting
use of economic & financial information to plan and
control activities of an entity
 Cost Accounting
determines product, process, or service costs; a
subset of managerial accounting
Terms
 Tax Accounting
the preperation of income tax returns as a
specialized field within accounting - tax
planning
 Auditing
external review and evaluation of an entitys’s
financial records and health
internal audits
government audits
IRS audits
Functions of Accounting
 Internal Control
all measures used by an organization to guard
against errors, waste and fraud
 Audits of Financial Statements
investigation of a company’s financial statements
to determine the fairness of these statements
 Annual Reports
comparative financial statements enable user’s to
identify trends in the company’s performance and
financial position
Principles of Accounting
 Principles of accounting dictate that financial
statements must show
 financial position at end of accounting
period
 earnings for the accounting period
 cash flows during that period
 investments by & distribution to owners
Transactions Approach
 In recording economic activities, accountants
focus on completed transactions - those that
cause an immediate change in the financial
resources or obligations of a company
 purchasing raw materials
 sales of finished goods
 Strength - the reliability of the information that
is recorded, based on past events, objectivity
Financial Statements
 Balance Sheet
financial position of a company indicating resources it
owns, debts, and the amount of owner’s equity
 Income Statement
profitability of the business over the preceeding
accounting period
 Statement of Owner’s Equity
explains changes in the amount of owner’s equity in the
business
 Statement of Cash Flows
summarizes cash receipts and cash payments of business
over the preceeding accounting period
Balance Sheet
 Statement of financial position
 does not show the current market value of an entity’s
assests
 Assets
economic resources owned by a business and are expected
to benefit future operations
 cost principle
 going concern
 objectivity principle
 stable dollar assumption
Current Assets - convertible to cash within 1 yr.
Balance Sheet
 Liabilities
probable future sacrifices of economic
benefits as result of current obligations
Current Liabilities - must be paid within
1 yr.
 Owner Equity
ownership right of proprietors or stockholders
Changes in OE by


investment by owner
earnings from profitable operation of
Accounting Equation
Owner Equity = Assets Liabilities
K-Corp Consolidated Balance
Current Assets
Cash
Accounts Receivable
Inventories
Total Current Assets
Other Assets
Land
Building
Equipment
Total Assets
Current Liabilities
Accounts Payable
Notes
Total Current Liabilities
Mortgage
Total Liabilities
Owner's Equity
Paid In Capital
Retained Earnings
Total Liabilities &
Owner Equity
1997
1996
$22,300
46,800
54,200
$123,300
$16,800
38,600
48,200
$103,600
100,000
85,400
78,400
$387,100
100,000
94,600
85,600
$383,800
$62,400
5,000
$67,400
125,800
$193,200
$55,600
20,000
$75,600
132,300
$207,900
100,000
93,900
100,000
75,900
$387,100
$383,800
Income Statement
 Projects profit/loss of an entity over a period of
time
Net
Sales - gross sales less returns,
defects, etc.
Cost-of-Goods
sold - cost of raw material
& direct labor
Selling,
Gen, Admin - operating expenses
of an entity which do not directly contribute to
product (sales people, managers, ...)
Interest
Expense - interest paid on
long/short term debt.
K-Corp Income Statement
Net Sales
Cost of Goods Sold
Gross Margin
Operating Expenses
Sales Expenses
Depreciation Equip
Depreciation Bldg
Administrative
Utilities
Total Operating
Income from Operations
Taxes
Net Income
$574,800
428,300
146,500
87,400
7,200
9,200
14,500
4,600
$122,900
23,600
5,600
$18,000
Changes to Owner Equity
 Begin Balance - last year’s ending balance
 Paid-in Capital - sold 10,000 shares at $19 /share
stock par value of $10 / share.
common stock = 10,000 x $10
= $100,000
addition paid in =10,000 x ($19-$10) = $ 90,000
 Retained Earnings - cumulative net income which
has been retained for business
 Dividends - distribution of earnings to stockholders
Changes to Owner Equity
Balance Sheet
Sheet
8/31/96
A =L +OE
Income Statement
Revenues
- Expenses
Net Income
Statement of OE
Begin Balance
Paid in capital changes
Retained earnings
+ Net Income
- Dividends
Ending Balances
Balance
8/31/97
A = L + OE
K-Corp Income Statement
Net Sales
Cost of Goods Sold
Gross Margin
Operating Expenses
Sales Expenses
Depreciation Equip
Depreciation Bldg
Administrative
Utilities
Total Operating
Income from Operations
Taxes
Net Income
$574,800
428,300
146,500
87,400
7,200
9,200
14,500
4,600
$122,900
23,600
5,600
$18,000
Retained (97) = Retained (96) + $18,000 = $93,900
K-Corp Consolidated Balance
Current Assets
Cash
Accounts Receivable
Inventories
Total Current Assets
Other Assets
Land
Building
Equipment
Total Assets
Current Liabilities
Accounts Payable
Notes
Total Current Liabilities
Mortgage
Total Liabilities
Owner's Equity
Paid In Capital
Retained Earnings
Total Liabilities &
Owner Equity
1997
1996
$22,300
46,800
54,200
$123,300
$16,800
38,600
48,200
$103,600
100,000
85,400
78,400
$387,100
100,000
94,600
85,600
$383,800
$62,400
5,000
$67,400
125,800
$193,200
$55,600
20,000
$75,600
132,300
$207,900
100,000
93,900
100,000
75,900
$387,100
$383,800
Statement of Cash Flows
 Identify the sources and use of cash during
year
 Operating Activities
 net income $18,000 from income
statement
 depreciation expense $16,400 from
balance sheet added back in because it is
not an actual cash outlay
K-Corp Cash Flows
Net Income
Add (deduct) items
Depreciation Exp
Increase in Accts Rec.
Increase in Invent.
Increase in Accts. Pay
Increase in Notes Pay
Net Cash from Operations
Cash from Investing
Cash from Financing
Retire long term dept
Issue of long term dept
Sale of common stock
Payment of Dividends
Net Increase in Cash
$18,000
16,400
-8,200
-6,000
6,800
-15,000
$12,000
0
-6,500
0
0
0
$5,500
K-Corp Cash Flows
Net Income
Add (deduct) items
Depreciation Exp
Increase in Accts Rec.
Increase in Invent.
Increase in Accts. Pay
Increase in Notes Pay
Net Cash from Operations
Cash from Investing
Cash from Financing
Retire long term dept
Issue of long term dept
Sale of common stock
Payment of Dividends
Net Increase in Cash
$18,000
16,400
-8,200
-6,000
6,800
-15,000
$12,000
0
-6,500
0
0
0
$5,500
K-Corp Consolidated Balance
Current Assets
Cash
Accounts Receivable
Inventories
Total Current Assets
Other Assets
Land
Building
Equipment
Total Assets
Current Liabilities
Accounts Payable
Notes
Total Current Liabilities
Mortgage
Total Liabilities
Owner's Equity
Paid In Capital
Retained Earnings
Total Liabilities &
Owner Equity
1997
1996
$22,300
46,800
54,200
$123,300
$16,800
38,600
48,200
$103,600
100,000
85,400
78,400
$387,100
100,000
94,600
85,600
$383,800
$62,400
5,000
$67,400
125,800
$193,200
$55,600
20,000
$75,600
132,300
$207,900
100,000
93,900
100,000
75,900
$387,100
$383,800
You Can Go Broke Making Money!
K-Corp Pro-Forma Cash Flows
Cash Flows from Ops.
Net Income
Depreciation
Increase in Receivables
Increase in Inventory
Increase in Current Liab
Net Increase/Decrease
Beginning Cash
Ending Cash
Feb
$250
50
0
(10)
50
$340
Mar
$500
50
(250)
(100)
75
$275
Apr
$600
50
(475)
(300)
100
($25)
May
$750
50
(600)
(500)
150
($150)
Jun
$900
50
(900)
(900)
180
($670)
250
590
865
840
690
$590
$865
$840
$690
$20
Financial Statement
Analysis
 Liquidity Measures
 current
ratio
 quick ratio
 working capital
 Long Term Credit Risk
 debt
to assets ratio
 debt to equity
Financial Statement
Analysis
 Profitability Measures
 return
on assets
 return on equity
 net profit margin
 earnings per share
 Activity Ratios
 accounts
receivable turnover
 inventory turnover
Liquidity
 Working Capital
WC = Current Assets - Current Liabilitie s
= 123,300 - 67,400
= 55,900
Liquidity
 Working Capital
WC = Current Assets - Current Liabilitie s
= 123,300 - 67,400
= 55,900
Q: Is $55,900 sufficient working capital to
cover
2-3 months of expenses?
Liquidity
 Current Ratio (Industry > 2.0)
Current Assets
CR =
Current Liabilitie s
123,300
=
67,400
= 1.83
Liquidity
 Quick Ratio
(Industry > 1.0)
Current Assets - Inventory
QR =
Current Liabilities
123,300 - 54,200
=
67,400
=1.03
Long Term Credit Risk
 Debt to Assets (Industry < 33%)
Total Liabilities
DA =
Total Assets
193,200
=
387,100
= 0.50
Long Term Credit Risk
 Debt to Assets (Industry < 33%)
Total Liabilities
DA =
Total Assets
193,200
=
387,100
= 0.50
1996
0.54
Long Term Credit Risk
 Debt to Equity Ratio
(Industry 33-50%)
Total Liabilities
DE =
Owner ' s Equity
193,200
=
193,900
= 0.996
Long Term Credit Risk
 Debt to Equity Ratio
(Industry 33-50%)
Total Liabilities
DE =
Owner ' s Equity
193,200
=
193,900
= 0.996
1996
1.182
Profitability Measures
 Return on Assets
ROA =
(Industry 8-10%)
Net Income
Total Average Assets
18,000
=
387,100 + 383,800
2
= 0.047
Profitability Measures
 Debt to Equity
(Industry 12-15%)
Net Income
ROE =
Average Owner Equity
18,000
=
(193,900 + 175,900) / 2
= 0.097
Profitability Measures
 Net Profit Margin
(Industry 4-6%)
(Industry Specific)
Net Income
NPM =
Net Sales
18,000
=
574,800
= 0.031
Profitability Measures
 Earnings per Share
(Industry Specific)
Net Income
EPS =
Common Shares Outs tan ding
18,000
=
1,000
= 18
Activity Ratios
 Accounts Receivable Turnover (Industry Specific)
Net Sales
ART =
Avg Accounts Re ceivable
574,800
=
(46,800 + 38,600) / 2
= 13.46
Activity Ratios
 Inventory Turnover
Cost of Goods Sold
IT =
Average Inventory
428,300
=
(54,200 + 48,200) / 2
= 8.365
(Industry > 10)
Financial Leverage
Firm with No Leverage
Balance Sheet
Assets
Liabilities
Owner Equity
Total Liability &
Owner Equity
Income from Operations
Interest Expense
Net Income
$100,000
$0
100,000
$100,000
$18,000
0
$18,000
Financial Leverage
Firm with No Leverage
Balance Sheet
Assets
Liabilities
Owner Equity
Total Liability &
Owner Equity
Income from Operations
Interest Expense
Net Income
$100,000
$0
100,000
ROA =
$100,000
18,000
= 0.18
ROE =
100,000
$18,000
0
$18,000
18,000
= 0.18
100,000
Financial Leverage
Firm with Leverage
Balance Sheet
Assets
Liabilities
Owner Equity
Total Liability &
Owner Equity
Income from Operations
Interest Expense
Net Income
$100,000
$50,000
50,000
$100,000
$18,000
4,000
$14,000
Financial Leverage
Firm with Leverage
Balance Sheet
Assets
Liabilities
Owner Equity
Total Liability &
Owner Equity
Income from Operations
Interest Expense
Net Income
$100,000
$50,000
50,000
$100,000
$18,000
4,000
$14,000
ROA =
14,000
= 0.14
100,000
14,000
= 0.28
ROE =
50,000
Financial Leverage
Firm with Leverage
Balance Sheet
Assets
Liabilities
Owner Equity
Total Liability &
Owner Equity
Income from Operations
Interest Expense
Net Income
$100,000
$50,000
50,000
$100,000
$18,000
4,000
$14,000
Note: ROI = 18,000/100,000
ROA =
14,000
= 0.14
100,000
14,000
= 0.28
ROE =
50,000