Accounting 200 Notes PDF

9/4 Lecture Costs What are Costs? -​ Cost is a resource consumed to operate a business. -​ We spend money on resources. These resources have costs. -​ Cost is a component of profit. Behavior of Cost -​ In order to make decisions, we need to classify costs based on “cost behavior”:...

9/4 Lecture Costs What are Costs? -​ Cost is a resource consumed to operate a business. -​ We spend money on resources. These resources have costs. -​ Cost is a component of profit. Behavior of Cost -​ In order to make decisions, we need to classify costs based on “cost behavior”: -​ Fixed Costs vs. Variable Costs -​ If the volume/level of activity increases, do the costs increase? -​ No -> Fixed Costs (doesn’t change relative to activity) -​ Yes -> Variable Costs (changes relative to activity) -​ How do costs vary with activity levels? -​ In the simplest cases, they do not. This is a fixed cost (FC). -​ Ex. McDonalds makes a burger; rent of the facility stays the same. -​ The cost of the rent is the same no matter how many burgers there are. -​ Some costs vary linearly. This is a variable cost (VC). -​ Activity levels change, and cost changes proportionally -​ The “activity” that causes a cost is commonly called a cost driver. -​ VC(q) = cost per unit (c) * quantity (q) -​ Ex. McDonalds makes another burger and consumes one additional patty. (cost driver: making burgers) -​ Total Cost (TC) is just fixed costs plus variable costs. -​ Total Profit is total revenue minus total costs. Mixed Costs -​ Costs are mostly not just variable or fixed.  -​ Mixed cost has both fixed and variable components. -​ Example: Amount paid to a salesperson who earns a base salary plus a sales-based commission. -​ On a graph, the fixed component is the y-intercept (zero q) and the variable component is the slope. More about Fixed Costs -​ Relevant Range -​ Relevant range of a fixed cost is related to its capacity—the amount of work a resource is capable of supporting before it must be replenished. -​ Ex. Teaching a class in a building. Rent is a fixed cost, but the room can only fit so many people, so you may need to rent another class. More about Variable Costs -​ Variable costs aren’t always linear. Variable costs can decrease or increase as quantity increases. These are called imperfect variable costs. -​ Diminishing costs over time -> this can be due to increased efficiency as more product is produced -​ Increasing costs over time -> this can be due to inefficiencies or higher shipping/storage costs as more product is produced -​ Relevant range -​ Normal operations within a range can seem linear, though when moving out of the range, it will turn out to be diminishing or increasing over time. Estimating Cost Structure -​ Most organizations use historical data to estimate their cost structure (proportion of fixed and variable cost). -​ High-low method of cost estimation -​ “Quick and dirty method;” useful as a first pass  -​ Uses two data points: the highest point and the lowest ACTIVITY point (not COST!) -​ Then, a line is fit through them. -​ Equation is linear: y=mx+b -​ m is the estimated variable costs -​ x is the level of activity -​ b is the estimated fixed cost -​ Pros: -​ Requires very little data -​ Gives a rough estimate of cost structure -​ Useful as a starting point for analysis -​ Cons: -​ Assumes activity measure you choose is a good one -​ Influence of outliers -​ Regression Method of cost estimation -​ Same basic purpose as high-low analysis, but uses all data points. -​ Simple vs. multiple regressions (one variable vs. many variables; we use simple in this class) -​ Fit a line through your data (line of best fit) -​ The line should minimize the total distance between the line and the data -​ Great for estimating relation in your data -​ Pros: -​ Uses the information in each observation -​ Cons: -​ Assumes a linear relationship Running a Regression -​ Check the canvas. Also, download excel on the computer! -​ What’s important: -​ Intercept Coefficient is the fixed cost -​ Units Sold coefficient is the variable cost -​ R Square is a percentage of how much the variable cost affects the total cost. 9/9 Lecture Figuring Out Total Costs Average Cost -​ Take total cost and divide it by quantity/activity level. -​ Wrong. The Behavior of Different Kinds of Costs -​ Variable Costs -​ Total Variable costs increase and decrease on activities increasing or decreasing -​ Slope is greater than zero -​ Y intercept = b = 0 (no fixed costs in the mix) -​ Variable cost per unit is constant on all activity levels. -​ Fixed Costs -​ Total Fixed costs stay constant on all activity levels. -​ Slope is zero -​ Y-intercept = b = fixed cost -​ Fixed cost per unit decreases as activity goes up (gets “split” between activity). -​ Mixed Costs  -​ Total Mixed costs increase and decrease on activities increasing or decreasing -​ Slope is greater than zero -​ Y intercept = b = fixed cost -​ Mixed cost per unit goes down as activity changes. Pure Variable vs. Mixed -​ Use y=mx+b format in order to figure out if a cost is purely variable or mixed. -​ Plug in the reported cost into y, variable cost per unit into m, and the activity level to x, then solve for b. -​ If b is zero, it is purely variable. If it is nonzero, it is a mixed cost. P-Value -​ The lower it is, the better the representation the model generated is of the actual data. What Relevant Range Means -​ In terms of fixed costs—fixed costs are not going to be fixed at all ranges. For example, renting a room has a max capacity so you may have to rent another room. -​ In terms of variable costs—the variable cost per unit could change depending on the scope of the activity! For example, storage costs could increase if you have @#%)(&@#)($& 9/11 Lecture Profits “Breaking Even” -​ When profit equals zero, or -​ When revenues match the fixed cost The Nuts and Bolts -​ Profit = Revenue – Costs -​ Revenue = Price * # of units sold -​ Costs = VC per unit * # of units sold + FC -​ Profit = Price * # of units sold – VC per unit * # of units sold – FC CVP Model (Cost-Volume-Profit) Contribution Margin -​ How much of the profit is contributing to meeting the Fixed Cost -​ Contribution Margin = Total Revenue - VC -​ Contribution Margin per Unit = Price – VC per unit -​ The slope in the CVP formula -​ Profit Before Taxes = Contribution Margin per unit * Sales Volume in units – Fixed Costs The Notation -​ Π = Total Profit -​ v = Variable cost per unit -​ VC = Total variable cost -​ cm = contribution margin per unit (𝑝 − 𝑣) -​ CM = total contribution margin (𝑐𝑚 × 𝑞) Break Even Analysis -​ Will we make money? -​ Break Even point (q*) is the quantity of units that need to be sold in order to avoid loss (zero profit). 𝐹𝐶 𝐹𝐶 𝐹𝐶 -​ 𝑞* = 𝐶𝑀 = 𝑞(𝑐𝑚) = 𝑞(𝑝−𝑉𝐶) -​ Set profits to zero for the equation! -​ Π = CM – FC (Remember! CM is the total contribution margin!) -​ Π = 𝑐𝑚 × 𝑞 − 𝐹𝐶  -​ 0 = 𝑐𝑚 × 𝑞 − 𝐹𝐶 -​ 𝐹𝐶 = 𝑐𝑚 × 𝑞 Target Profit Analysis -​ Very simple! If you’re trying to hit a certain profit point, just move the guidelines from the break even point to where you want to be! 𝑇𝑎𝑟𝑔𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 -​ 𝑞* = 𝐹𝐶 + 𝐶𝑀 What if I Don’t Have Unit Cost Info? -​ The question changes from: -​ How many units must I sell to break even? To… -​ How much revenue must I generate to break even? -​ Π = 𝐶𝑀 − 𝐹𝐶 = 0 -​ 𝐶𝑀 = 𝐶𝑀 𝑅𝑎𝑡𝑖𝑜 × 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐶𝑀 -​ 𝐶𝑀 𝑅𝑎𝑡𝑖𝑜 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑝−𝑣 -​ Or 𝐶𝑀 𝑅𝑎𝑡𝑖𝑜 = 𝑝 (if you have per unit info) -​ So… 𝐹𝐶 -​ 𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 = 𝐶𝑀 𝑅𝑎𝑡𝑖𝑜 × 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 Multiple Products in the CVP Model -​ How can you compute break even when having multiple different products? -​ Compute break even for each then take a weighted average. 9/16 Lecture Finding a Weighted Average -​ The first step to performing multiple product breakeven analysis is to compute the weighted average contribution margin (𝑤𝑎𝑐𝑚) per unit. -​ The weighted average contribution margin is determined by: 𝑆𝑎𝑙𝑒𝑠 𝑉𝑜𝑙𝑢𝑚𝑒 𝑜𝑓 𝑃𝑎𝑟𝑡 -​ First taking the percentage of sales mix: ( 𝑆𝑎𝑙𝑒𝑠 𝑉𝑜𝑙𝑢𝑚𝑒 𝑜𝑓 𝑊ℎ𝑜𝑙𝑒 )  -​ Then, multiply the contribution margin by the weighted average contribution margin, then add all the contribution margins together! -​ 𝑤𝑎𝑐𝑚 = 𝑠𝑎𝑙𝑒𝑠 𝑚𝑖𝑥 %1 × 𝑐𝑚1 + 𝑠𝑎𝑙𝑒𝑠 𝑚𝑖𝑥 %2 × 𝑐𝑚2 +... -​ You can get individual breakeven units by multiplying the breakeven number with the sales mix % of an individual product. The Limitations to the CVP Model -​ Any decision tool is only as good as its underlying assumptions. -​ There are many assumptions the CVP model makes. -​ Selling price per unit is constant -​ Unit Variable Cost is constant (linear assumption)—no economies of scale; we are staying within relevant range -​ Fixed costs are fixed—we are staying within relevant range -​ Selling prices, unit variable costs and fixed costs are known with certainty—impossible to perfectly predict -​ Assumes amount of production is equal to amount of sales -​ Multi product analysis assumes that products are sold in a fixed ratio—a constant sales mix -​ Make your analyses more robust by considering changes in any of these assumptions to see how it affects your results Operating Leverage and Risk Operating Leverage -​ The higher the proportion of fixed costs in the cost structure, the higher the 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 operating leverage: 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡𝑠 -​ Operating Leverage creates risk. If you cannot sell enough to cover your fixed costs, you will make a loss! -​ The more operating leverage you have, the more the profit swings with changes in volume. 9/18 Lecture Decision Making Relevant Costs -​ Optimal decision-making involves choosing among alternative courses of actions. Key to making good decisions is to focus attention only on those costs and benefits relevant to the comparison of alternatives. -​ The question is always, “What difference will an action make?” -​ Our different options will be the difference in costs and revenue. Example: Reorganization -​ Revenues/costs are only relevant if they have a change through a course of a decision. Sunk Costs -​ Costs that have already occurred and cannot be changed are classified as sunk costs. -​ Sunk costs are not considered relevant since making decisions will not change them. Vernacular -​ Another way to describe relevant costs and benefits is differential revenue and avoidable cost. Types of Decisions -​ One-time-only special orders -​ Special (wholesale) orders that are sales of large quantities for a discount at a single instance.. Depends on how much it costs to sell the large quanitity normally. -​ Insourcing vs. outsourcing -​ Segment elimination -​ Eliminating a line of product/department to cut costs Opportunity Cost -​ Cost: a sacrifice of resources -​ Using a resource for one purpose prevents its use elsewhere. -​ The benefit forgone as a result of choosing one course of action rather than another is the opportunity cost. Outsourcing -​ Companies can sometimes purchase products needed for less than it would cost to make them. -​ Buying goods and services from other companies rather than producing them internally is commonly called outsourcing. Some Other Concerns… -​ Outsourcing and segment elimination affects the numbers, but they have a bunch of other factors to consider: -​ Employee lives will be disrupted. -​ The sale of different product lines are frequently interdependent (the loss of one line could be by design; Costco hot dogs are cheap to bring people to the store and buy things that actually generate revenue!). -​ What will happen to the space freed by the eliminated segment? -​ Volume changes can affect elimination decisions. 9/23 Lecture Margin of Safety Formula 𝑅𝑒𝑣𝑒𝑛𝑢𝑒−𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 -​ 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 × 100 Notes -​ The higher the margin of safety, the lower the fixed costs. -​ Is the percentage between how far your current revenue is to breaking even. 10/2 Lecture The Balance Sheet The Critical Equation -​ Assets = Liabilities + Owners’ Equity -​ Assets = Current assets + noncurrent assets -​ Liabilities = Current liabilities + noncurrent liabilities -​ Owner’s equity = Assets What are Assets? -​ It is acquired in a past transaction or exchange -> firm has right to future benefits -​ Future benefits can be measured with a reasonable degree of precision -​ Internally developed intangibles (Intellectual Property) will generally not appear on a balance sheet. -​ Elsa isn’t worth anything! -​ Purchased intangibles do not appear on the balance sheet. -​ Even if they have an expense attached to it. -​ Measuring Assets -​ They are worth what they have been paid for Current Assets -​ Cash -​ Short-term investments -​ Readily marketable securities -​ Accounts Receivable -​ Inventory -​ Prepaid expense -​ Expenses paid before the service is used Noncurrent Assets -​ Long-term investments -​ Long term notes receivable—loans with maturity > 1 year -​ Property, Plant and Equipment -​ Intangible Assets -​ Trademark, patent, copyrights Liabilities What are Liabilities? -​ A claim on assets by “creditors” (non-owners) that represents an obligation of future payment of cash, goods, or services -​ The obligation is based on benefits or services received currently or in the past. -​ The amount and timing of settlement (e.g. cash payment) is reasonably certain. Current Liabilities -​ Accounts payable -​ Money spent on suppliers from credit but not paid yet -​ Wages payable -​ Wages owed but not paid yet -​ Interest payable -​ Interest owed but not paid yet -​ Current maturities of long-term debt -​ The current component of long-term debt -​ Deferred revenues -​ Money collected but service not yet provided—customer paid in advance Noncurrent Liabilities -​ Notes payable -​ Generally long-term; a promise of paying money back in the long-term -​ Bonds payable Stockholders’ Equity Contributed Capital -​ Common stock, invested by stockholders in exchange of partial ownership Earned Capital -​ Retained earnings [ 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 + 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠] -​ Cumulative earnings of a company that are not distributed to the owners and are reinvested in the business -​ Dividends (distributions to stockholders) reduce retained earnings -​ Other comprehensive income -​ Results from certain items that, by the rules, do not appear on the income statement and are not reflected in retained earnings – an advanced topic Working Capital -​ The comparison of assets to liabilities -​ Working Capital = Current Assets – Current Liabilities -​ If it is negative, you need to put in capital in order for the business to work day-to-day -​ If it is positive, you have more money coming in compared to more money coming out during the time period -​ Does NOT mean profit! Common Size -​ Presenting each item of a balance sheet as a percentage of assets (size) -​ The income statement would measure size as a percentage of revenue -​ Assets = total value of what the company has = total value of company’s funding 10/9 Lecture Revenue Recognition Cash -​ When cash is received on the date the revenue is earned, the following financial statement accounts are affected: -​ Cash -​ Revenue -​ When cash is received after the company delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded. -​ Accounts Receivable -​ Revenue -​ Then, Cash and lose Accounts Receivable -​ If cash is received before the company delivers goods or services, a liability account UNEARNED REVENUE is recorded. -​ Cash -​ Unearned Revenue (liability) -​ Then, Revenue and lose unearned revenue Matching Principle -​ Provides the fundamental basis for recording expenses -​ Costs incurred to generate revenues should be reported as expenses in income in the same period that those revenues are recognized in income -​ If a cost relates to current period revenue, then that cost becomes an expense in the current period Expense Recognition Matching Principle -​ When cash is paid on the date the expense is incurred  -​ Expense incurred goes up, retained earnings (stockholder’s equity) goes down -​ Cash goes down -​ When cash is paid after the expense is incurred -​ Expense goes up, retained earnings (stockholder’s equity) goes down -​ A liability PAYABLE is recorded -​ Then, the payable goes down and the cash goes down. -​ If cash is paid before the expense is incurred -​ Prepaid expense (asset) goes up -​ Cash goes down -​ Then, expense incurred goes up, retained earnings (stockholder’s equity) goes down -​ Prepaid expense goes down The Building Blocks of a Financial Statements Transactions -​ Any event that has a financial impact on the firm and can be reliably recorded Double-Entry Accounting -​ Every transaction has two sides: -​ The firm gives up something -​ The firm receives something -​ The two sides of the transaction must balance so that the basic accounting equation remains in balance -​ Assets = Liabilities + Owners’ Equity -​ Accounts are a basic summary device used to track activity (transactions) on the financial statements The Accounting Cycle -​ Start of new period  -​ During the period -​ Analyze transactions -​ Record journal entries in the general journal -​ Post amounts to the general ledger -​ At the end of the period -​ Prepare a trial balance to determine if debits equal credits -​ Are the two sides matching? -​ Adjust revenues and expenses and related balance sheet accounts -​ Prepare a complete set of financial statements and disseminate to years -​ Something something send it out 10/23 Lecture Each Step to the Accounting Cycle Analyzing Transactions -​ IMPORTANTO: Make sure it’s a transaction in the first place! 1.​ Identify the accounts affected (must be at least TWO accounts) and classify each account as an asset (A), liability (L), or stockholder’s equity (SE), revenue (R), or expense (E). 2.​ Make sure the equation is balanced Recording Transactions in Accounts -​ Journal Entries are used to formally record business transactions using a debit/credit format.​ Dr. Account Name $Amount​ Cr. Account Name $Amount -​ Each individual account can be represented by a T-account. T-accounts summarize all transactions for that account so we can determine the balance -​ Debit is the name of the left side of the account, credit is the name of the right side.  -​ -​ In each transaction, and in aggregate, DEBITS = CREDITS.. ALWAYS! -​ Example here! (BB means beginning balance; EB means ending balance) Preparing Financial Statements -​ The trial balance is a list of all the accounts with their balances​ Ordered in this way: Assets, then liabilities and stockholder’s equity -​ Shows whether total debits = total credits -​ May be done at any time, but usually done at the end of fiscal year Making Accounting Adjustments Why Do We Need Them? -​ For example, employees might have earned wages during an accounting period but will not be paid until the next period -​ Failure to recognize the wages owed would understate liabilities and would overstate net income for the period  -​ Therefore, both the balance sheet and the income statement would be inaccurate -​ SO, the company makes an accounting adjustment The Four Types of Accounting Adjustments -​ Prepaid (deferred) expenses -​ Cash is paid after revenues are recognized -​ Unearned (deferred) revenues -​ Cash is received before revenues are recognized -​ Accrued expenses -​ Accrued revenue Unearned Revenue -​ A liability -​ The adjustment:​ Unearned revenue (-L) [debit]​ Revenue (+R, +SE) [credit]​ COGS (+E, -SE) [debit]​ Inventory (-A) [credit] -​ Quick thing about COGS: -​ All direct costs are COGS, all indirect costs are just expenses. Prepaid Expense -​ An asset -​ Property, Plant, and Equipment (which depreciates) falls into this category, although such assets aren’t called “prepaid expenses” (next heading!) -​ The adjustment:​ Expense (+E, -SE) [debit]​  Prepaid Expense (-A) [credit] (goes down by only the amount that you use this period) Depreciation (a Prepaid Expense) -​ Applies to long-term PP&E (other than land) due to decrease in usefulness over time -​ This decrease in usefulness is recorded as an expense; appears on the income statement -​ The adjustment:​ Depreciation Expense (+E, -SE) [debit]​ Accumulated Depreciation (+XA) [credit] -​ Accumulated depreciation account (a contra-asset account [next heading!]) is set up to track the aggregated depreciation on each PP&E asset -​ Shown on the balance sheet -​ Preserves original cost of the asset in total Note on “Contra-Accounts” -​ To preserve the record of PP&E’s historical cost, the amount that has been used (i.e., depreciation) is not subtracted directly from the asset account. Instead, it is accumulated in a new kind of account called a contra account. -​ In general, contra-accounts are accounts that are directly linked to another account Accrued Revenue -​ Revenue earned but not collected -​ The adjustment:​ Cash (+A) [debit]​ Accounts receivable (-A) [credit] Accrued Expense -​ Expense incurred but not paid -​ Can be wages, notes, etc. -​ The adjustment:​ Accrued Expense Payable (-L) [debit]​ Cash (-A) [credit] Adjusting Entries -​ Journal entries made at the end of an accounting period to match revenues and expenses in the appropriate period 10/28 Lecture Allocating Costs to Products and Services Manufacturing Firms -​ Direct Materials -​ Material costs that can be easily and directly traced to products -​ Often called raw materials -​ Direct Labor -​ Factory wages that can be easily traced to products -​ Manufacturing Overhead -​ Other factory costs such as indirect materials and labor, utilities, rent, maintenance, PP&E depreciation Product Cost Flows 1.​ Raw Materials Account a.​ Purchase of raw materials debited into raw materials b.​ All materials used is credited out 2.​ Work in Process Account a.​ Materials used, direct labor and overhead are debited in b.​ Finished goods are credited out  3.​ Finished Goods Account a.​ Finished goods are debited in b.​ Goods sold are credited out 4.​ Cost of Goods Sold Account Product Costs vs. Period Costs -​ Product costs (a part of COGS) are first put into the balance sheet and then put in the income statement when they are sold as COGS, not as an expense -​ Period costs (selling, administrative costs, etc.) are put straight into the income statement Depreciation on Manufacturing Equipment vs. Non-manufacturing Equipment -​ Depreciation on manufacturing equipment is first put into the balance sheet as a liability then put into the income statement as cost of goods sold (a part of COGS!), not as an expense -​ Depreciation on equipment not related to manufacturing is just put straight into the income statement (as it isn’t a part of COGS!) Indirect Costs -​ Depreciation of Manufacturing Assets -​ Manufacturing Supervisor’s Salary -​ Factory Utilities Cost Allocation -​ A procedure that distributes a common cost to the various activities or objects that benefit from it -​ Cost pool—total amount of indirect manufacturing costs to be allocated -​ Cost driver—a measurable attribute that (hopefully) has a causal relationship with the costs incurred -​ For example, in a firm that produces tables and chairs, allocate utilities cost by splitting them by how long it takes to make each chair vs each table 10/30 Lecture Managing Working Capital What is Working Capital? -​ Working Capital = Current Assets – Current Liabilities -​ Helps us understand if a company has the right kind of assets to pay off debts as they become due -​ Companies have to spend cash before they receive cash -​ Therefore, if working capital is negative, owners often have to invest first in order to get returns The Cash Conversion Cycle (CCC) -​ The time to receive cash, time to pay cash, and net time cash deficient -​ Time to receive cash -​ Time to collect money -​ Time to pay cash -​ When do you pay your vendors -​ Net time cash deficient -​ How long it takes to get cash and pay vendors Measuring CCC 𝐶𝑂𝐺𝑆 -​ Inventory turnover = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦+𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 -​ (average inventory is 2 ) -​ How many times all a company’s inventory is sold during the year -​ The more the better (obviously!) 365 -​ Average Days to Sell = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 -​ The number of days, on average, it takes to produce and sell inventory -​ The fewer days it takes, the better (means you’re selling more faster)  -​ Key is to optimize inventory investment—too much inventory is expensive, too little causes stock-outs and lost sales 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑜𝑟 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 -​ Accounts Receivable Turnover = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑅 + 𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝐴𝑅 -​ (average AR is 2 ) -​ How many times, on average, accounts receivable are collected during a period -​ Helps to understand how liquid the accounts receivable are, how quickly they convert to cash 365 -​ Days Sales Outstanding/Average Collection Period = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 -​ Number of days on average it takes for a company to collect an account receivable -​ Average collection period should not exceed the credit period given -​ I.e. if customer is required to pay within 30 days, the average days to collect shouldn’t exceed 30 days 𝐶𝑂𝐺𝑆 -​ Accounts Payable Turnover = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑃 + 𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝐴𝑃 -​ (average AP is 2 ) -​ How many times, on average, a company pays of its purchases from suppliers during the year 365 -​ Days Payable Outstanding = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 -​ Number of days, on average, it takes to pay back suppliers -​ Suppliers are a source of trade credit—delaying payment to them allows company to in Finally… -​ CCC = Days Inventory Outstanding + Days Receivables outstanding – Days Payables Outstanding Statements of Cash Flows -​ Just saying what your net income is is not enough! -​ You need to include where the cash is going as well. 11/4 Lecture The Statements of Cash Flows -​ Answers the questions, “Is the firm generating sufficient cash flows from its customers to finance operations and to acquire buildings and equipment? Must it seek new funds from lenders or owners?” -​ Like the Income Statement, measured over a period of time. (Between two Balance Sheet dates) -​ Has three components: -​ Operating Activities -​ Investing Activities -​ Financing Activities Operating Activities -​ The usual focus of a firm’s operating activities is on selling goods or rendering services, but the activities are defined broadly enough to include any cash receipts or payments that are not classified as investing or financing activities. Cash Inflows -​ Receipts from customers for sales made or services rendered -​ Receipts of interest and dividends -​ Other receipts that are related to investing or financing activities, such as lawsuit settlements, and refunds from suppliers Cash Outflows -​ Payments to employers and suppliers -​ Payments to purchase inventories -​ Payments of interest to creditors  -​ Payments of taxes to government -​ Other payments that are not related to investing or financing activities, such as contribution to charity Investing Activities Cash Inflows Cash Outflows Financing Activities Cash Inflows Cash Outflows Basic Cash Flow Equation (Indirect Method) 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑎𝑠ℎ = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠’ 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑜𝑛𝑐 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑎𝑠ℎ = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑 𝐶𝑎𝑝𝑡𝑖𝑎𝑙 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 What’s Really Important? -​ Make sure you put things in the right category: Operating, Investing, Financing Two Formats to Report Cash Flow from OPERATING ACTIVITIES The Indirect Method -​ Starts with net income and applies a series of adjustments to net income to convert it to a cash-basis income number -​ Does not report any detail concerning individual operating cash inflows and outflows -​ Uses the Equation shown above The Direct Method -​ Shows individual amounts of cash inflows and cash outflows for the major operating activities  -​ The net difference between these inflows and outflows is the net cash flow from operating activities. Things To Know -​ Both methods should report the same amount of net cash flow from operating activities. -​ Net cash flows from investing and financing activities are prepared in the same manner under both the indirect and direct methods; only the format for cash flows from operating activities differ. Constructing Cash Provided By Operations Indirect Method 1.​ Start the operating section with Net Income 2.​ Adjust for non-cash and non-operating transactions that are included in net income (change net income to adjust for all of these numbers!) a.​ All revenue and expense items that do not involve cash i.​ Depreciation and amortization expense ii.​ Stock-based compensation expense b.​ Gains and losses that affect net income, but which are not classified as operating activities from the cash flow perspective (those that belong in investing/financing activities) c.​ Changes in all operating assets (other than cash) and operating liabilities (typically are current assets and liabilities) Constructing Cash Provided By Investing and Financing -​ Just use a “direct-like” approach; just list the sources and uses of cash 11/6 Lecture Current Ratio 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 11/18 Lecture Analyzing Performance Based on Financial Statements How Should We Measure The Success of a Business? -​ General outline for running a business: -​ Financing – raising money by issuing debt or selling ownership in the form of equity -​ Investing – use that money to buy productive assets -​ Operating – use the productive assets to run the business and earn a return -​ Measuring success -​ Do the assets generate a healthy return? -​ Did we invest well? = Am I buying productive assets? -​ Are we operating well? = Is the materials we are selling generating a healthy return (productivity, inventory turnover, are costs low and revenues high)? -​ Financing choices come later Return on Assets -​ How do we measure success? = Do the productive assets generate a healthy return? -​ Return: income -​ Also known as ROI (Return on Investment) 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 -​ 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐵𝑎𝑙𝑎𝑛𝑐𝑒+𝐸𝑛𝑑𝑖𝑛𝑔 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 -​ Remember: Average Total anything is 2 ! -​ You want this number to be Higher!!! -​ Measures the profit earned for each dollar invested in the company’s assets Understanding ROI/ROA -​ Turnover: sales/revenue 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 -​ 𝑅𝑂𝐴 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 × 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 -​ 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 is the Profit Margin -​ How efficiently do we earn money? -​ Increase by cutting costs (which increases Net Income without changing Revenue) 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 -​ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 is the Asset Turnover -​ How effectively do our assets generate revenue? -​ Increase by getting rid of unproductive assets or using existing assets more effectively Understanding ROE (Return on Equity) -​ Measures the income for each dollar of equity invested in the company 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 -​ 𝑅𝑂𝐸 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠' 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 × 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠' 𝐸𝑞𝑢𝑖𝑡𝑦 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 -​ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 is ROA (Profit margin and Asset Turnover) 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 -​ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠' 𝐸𝑞𝑢𝑖𝑡𝑦 is Financial Leverage -​ How many dollars worth of assets do we get to manage for every $1 we invested? Operating Leverage 𝐶𝑀 𝑆𝑎𝑙𝑒𝑠−𝑉𝐶 -​ Remember: 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑃𝑟𝑜𝑓𝑖𝑡 -​ %𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 × 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = %𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 -​ When operating leverage is high, a small change in revenue can lead to a large change in net income -​ Higher reward, but higher risk! Financial Leverage -​ How much of the assets are being financed by debt VS. equity -​ Think of utilizing debt as fixed costs, and equity as variable costs. Using debt is riskier, but gives a chance for higher returns. -​ 𝑅𝑂𝐴 × 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑅𝑂𝐸 -​ When financial leverage is high, a small change in overall profitability can lead to a large change in profitability to the company’s owners -​ Higher reward, but higher risk! -​ If debt financed assets bring in a higher return than the interest rate on the debt that financed the assets, the extra return accrues to shareholders! -​ A more levered company will have a higher ROE Full Breakdown of ROE 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 -​ 𝑅𝑂𝐸 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 × 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 × 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠' 𝐸𝑞𝑢𝑖𝑡𝑦 -​ AKA: 𝑅𝑂𝐸 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 (𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦) × 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 (𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒𝑛𝑒𝑠𝑠) × 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒 (𝑅𝑖𝑠𝑘𝑖𝑛𝑒𝑠𝑠) -​ Financial Leverage: Are you starting off financed by the owners or financed through debt? -​ Asset Turnover: Are your assets being used effectively? -​ Profit Margin: Are you selling at low costs with high yield? The Pieces of a Common-Sized Income Statement 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 𝑁𝑜𝑛 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 -​ 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 -​ Gross Profit Margin ( 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 ) -​ The Market Power – The uniqueness of my product -​ A decrease over time suggests my technology is stale; there is a new competitor  -​ How to increase the gross profit margin: -​ Charge a higher price (have a more unique product) -​ Reduce production costs without losing customers -​ Remove excess capacity, increase efficiency -​ (Cut off assets that aren’t generating returns efficiently) 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 -​ Operating Expense Margin ( 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 ) -​ Decrease can be good: -​ Getting rid of unnecessarily layers of management -​ Decrease can be bad: -​ Lower pay can mean lower quality employees -​ Cutting research & development or advertising can hurt long term growth 𝑁𝑜𝑛 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 -​ ( 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 ) -​ Consistently small, should have a negligible portion -​ If large, should be a one time transaction -​ Analyze large one time transactions individually -​ This is probably not important 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 -​ ( 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 ) -​ Income taxes are complicated. We probably won’t be going over this Analyzing Profitability Comparing the Same Firm Over Time -​ Compare Profit Margin; Asset Turnover; Financial Leverage, and ultimately ROE across years of operation Comparing the Firm to Other, Similar Firms -​ Compare the same things, but across other firms 11/20 Lecture Valuing a Company Intrinsic Value -​ The price that a rational investor is willing to Discounted Cash Flows Models -​ Discounted dividends -​ Discounted “free cash flows” Multiples -​ “Market-based” model -​ P/E, P/B, P/whatever Valuation Model Using Market Principles The Formula -​ 𝐼𝑉𝑖 = 𝑋𝑖 × (𝑃/𝑋)𝑐' -​ 𝐼𝑉𝑖 - Intrinsic Value of company i -​ 𝑋𝑖 - Company i’s summary performance measure (e.g., earnings, book value of equity -​ (𝑃/𝑋)𝑐' - the mean, median, weighted average, or other summary statistics of the ratio of equity value to performance measure X for companies in a “comparable set”, i.e., companies similar to company i Common Ratios/Market Multiples to Value Equity 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘 -​ 𝑃𝑟𝑖𝑐𝑒 𝑡𝑜 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 -​ 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘 -​ 𝑃𝑟𝑖𝑐𝑒 𝑡𝑜 𝐵𝑜𝑜𝑘 = 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠' 𝐸𝑞𝑢𝑖𝑡𝑦 -​ 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 -​ Price-to-earnings (P/E) ratio:  -​ 𝐼𝑉𝐸𝑞𝑢𝑖𝑡𝑦 *= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 × 𝑃/𝐸 𝑟𝑎𝑡𝑖𝑜 𝑜𝑓 𝑐𝑜𝑚𝑝𝑎𝑟𝑎𝑏𝑙𝑒 𝑐𝑜𝑚𝑝𝑎𝑛𝑖𝑒𝑠 (𝑃/𝐸)𝑐 -​ Price-to-book (P/B) ratio: -​ 𝐼𝑉𝐸𝑞𝑢𝑖𝑡𝑦 *= 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 × 𝑃/𝐵 𝑟𝑎𝑡𝑖𝑜 𝑜𝑓 𝑐𝑜𝑚𝑝𝑎𝑟𝑎𝑏𝑙𝑒 𝑐𝑜𝑚𝑝𝑎𝑛𝑖𝑒𝑠 (𝑃/𝐵)𝑐 Identifying “Comparable” Companies -​ Key to success is to find the right peer firms. -​ Equity value is a function of risk, growth, and profitability (and DuPont decomposition on effectiveness, efficiency, and leverage). -​ Comparable companies show similar levels of risk, growth, profitability, etc. Combining -​ Rather than attempting to weigh the merits of different estimates (earnings VS. book value), some investors prefer to combine them in the hope that the estimation error for a specific multiple is mitigated by other multiples -​ (Take the average of them; add them then divide by two) Variance Analysis -​ A tool for comparing actual performance with budgeted estimates -​ By comparing the actual outcomes with standards or budgets, managers can identify areas of excellence and those needing improvement, fostering a culture of continuous development. What is a Variance? -​ Difference between the actual outcome and the budgeted for a given period -​ Favorable: -​ Earned more than expected -​ Higher revenue or lower costs -​ Unfavorable variance: -​ Earned less than expected -​ Lower revenue or higher costs Total Profit Variance -​ 𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 − 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 (𝑜𝑟 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑) 𝑃𝑟𝑜𝑓𝑖𝑡 -​ What we really want is the story behind the variance -​ Why is the variance the way that it is? What is the Root Cause of a Profit Variance? -​ Comes from an incorrect estimate from the CVP model! -​ 𝑃𝑟𝑜𝑓𝑖𝑡 = (𝑃𝑟𝑖𝑐𝑒 − 𝑉𝐶 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡) × 𝑈𝑛𝑖𝑡𝑠 𝑆𝑜𝑙𝑑 − 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 -​ Incorrect estimates of demand (units sold) -​ Volume Variance -​ Incorrect estimates of price -​ Sales Price Variance -​ Incorrect estimates of costs -​ Fixed Cost Variance -​ Variable Cost Variances Volume Variance -​ Caused by an incorrect estimate of demand; changes revenues and VC -​ To find: -​ Create a Flexible Budget -​ Use the budgeted CVP formula to re-estimate what your budgeted profit would have been with the actual sales volume -​ Use the original inputs from the master budget, only update sales volume -​ Sales quality not only affects revenue but also all variable costs that vary with sales volume -​ The volume variances use the actual sales volume but holds everything else (VC per unit, price per unit, fixed costs) constant -​ 𝑆𝑎𝑙𝑒𝑠 𝑉𝑜𝑙𝑢𝑚𝑒 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝐹𝑙𝑒𝑥𝑖𝑏𝑙𝑒 𝐵𝑢𝑑𝑔𝑒𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑀𝑎𝑠𝑡𝑒𝑟 𝐵𝑢𝑑𝑔𝑒𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒  -​ OR = (𝐴𝑐𝑡𝑢𝑎𝑙 𝑉𝑜𝑙𝑢𝑚𝑒 − 𝐵𝑢𝑑𝑔𝑒𝑑 𝑉𝑜𝑙𝑢𝑚𝑒) × 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑃𝑟𝑖𝑐𝑒 -​ 𝑉𝐶 𝑉𝑜𝑙𝑢𝑚𝑒 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝐴𝑐𝑡𝑢𝑎𝑙 𝑉𝑜𝑙𝑢𝑚𝑒 − 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑉𝑜𝑙𝑢𝑚𝑒) × 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑉𝐶 -​ (𝑆𝑎𝑙𝑒𝑠 𝑎𝑛𝑑 𝑉𝐶 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒) = (𝐴𝑐𝑡𝑢𝑎𝑙 𝑉𝑜𝑙𝑢𝑚𝑒 − 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑉𝑜𝑙𝑢𝑚𝑒) × (𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐶𝑀) Breaking Down the Flexible Budget Variance Analyzing Variances -​ Take the time and look through and think about any large variances -​ Since small variances may just be caused by randomness -​ Is the variance caused by a bad estimate? Issue with the budgeting process Could be purposeful if managers underestimated sales or overestimated costs to create an easy target -​ Is the variance caused by production problems? Inefficiencies we need to fix -​ Any large favorable differences we can learn from? Are there things we are doing well? -​ DON’T GET TOO CAUGHT IN THE WEEDS THAT YOU FORGET THE BIG PICTURE! 12/2 Lecture - not doing Decentralization From a Level 1 Crook… -​ When you run your own business, you get to make all of the decisions -​ As your business grows, you need to hire managers to help run the growing business -​ As a result, you delegate authority to them (i.e. decentralization). Benefits -​ Timely decision making -​ Allow specialized people to make specialized decisions -​ Empower employees (satisfaction) -​ Training future executives Costs -​ These managers will have their own priorities and ambitions -​ They may make decisions to optimize their own satisfaction at the expense of the company. How to Minimize the Costs -​ Constant Monitoring -​ Not really feasible -​ Also not good for morale -​ Performance pay -​ Ties a raise/bonus to an underlying measure of the employee’s performance -​ Designed to incentivize employees to work hard and make good decisions Performance Evaluation Cost Centers -​ Minimize costs and maximize efficiency -​ Through a cost center – a department in control of costs -​ Procurement departments, legal department, accounting department -​ How to evaluate: -​ Budget variances -​ Encourage improvement -​ Compare to last period Profit Centers -​ Maximize revenues and minimize costs -> Measure Division Profit -​ Through a department that is in control of both revenues and costs -​ Encourage growth through comparing to last period -​ Encourage a long-term focus 12/9 Lecture