BASIC CONSIDERATION IN MANAGEMENT ADVISORY SERVICES

MANAGEMENT ADVISORY SERVICES - area of accounting work concerned with PROVIDING

ADVICE and TECHNICAL ASSISTANCE to help clients improve the use of resources to achieve
their goals.
MANAGEMENT CONSULTANT - person who is qualified by EDUCATION, EXPERIENCE,
TECHNICAL ABILITY and TEMPERAMENT to advise or assist businessmen on a professional basis
in identifying, defining, and solving specific management problems involving the organization,
planning, direction, control and operation of the firm.
Emergence of Growth of MS Consultancy:
1. growth in size and complexity of business firms
2. complexities in managing and conducting business
3. lack of competent staff
4. trend towards industrialization
5. need for adequate and timely information in management decision making
6. development of techniques for solution of management problems and businessmen’s
awareness of their usefulness
Reasons for Hiring Management Consultants:
1. help define specific problems and develop solutions
2. provide specific skills and experience
3. provide confidential service
4. train client personnel
5. improve intra-company communications
6. render independent opinion
7. help get results

MAS by CPAs - considered in the practice of professional accounting and are bound by the
Code of Ethics for Professional Accountants.
Advantages of CPAs over other professionals in MAS practice:
- familiar with the client and his business, and enjoy the client’s confidence
- members of a profession with recognized standing and equipped with technical know-
how in accounting and taxation.

Characteristics of MAS:
 services are rendered for management
 involves problem solving
 relates to future
 broad in scope
 involves varied assignments
 engagements are usually non-recurring
 engagements require highly qualified staff
 human relations play a vital role in each engagement

Scope of MAS:
Is usually related to services rendered by CPA’s in areas of auditing, tax and accounting,
and may involve activities such as:
 counseling management in its analysis, planning, organizing, operating and controlling
functions;
 reviewing and suggesting improvement of policies, procedures, systems, methods,
organizational relationships;
 introducing new ideas, concepts, and methods to management; and
 conducting special studies, proposing plans and programs, and providing guidance and
technical assistance in their implementation.
Broad Areas of MAS:
A. Normally Related to Accounting and Finance Functions:
1. Financial Accounting Systems Design and Development
2. Management Accounting Systems Design and Development
3. Development and Establishment of Budgeting Controls:
a. Cost Accounting
- development of Standard Cost System
- Cost Analysis and Control
- Variance Analysis
b. Financial Management
- establishment of Capital Budgeting procedures
- study of Cost of Capital and Cost of Debt
- Financial Analysis for project studies
- establishment of Operating and Cash Budgets
- Valuation of common stocks for purposes of mergers and sale
B. Not Normally Related to Accounting and Finance Functions:
1. General Management Consultation
a. Management/Operations Audit
b. Measurement of Operating Performance
c. Merger and Acquisition studies
d. Development of Compensation Programs
e. Pension Plan Review
f. Special Studies on industry potential
g. Long-Range Planning
2. Project Feasibility Studies - involves financial, technical, and marketing evaluation of
proposed projects.
3. Organization and Personnel
a. Review of existing organization structure
b. Organization and Administrative Manual Preparation
c. Job Evaluation and Salary Administration
d. Development of Personnel Ratings Programs
e. Retirement Plan Studies
f. Studies of Office Cost Reduction Systems
g. Determining Cost of Alternatives in CBAs
4. Industrial Engineering
a. Production, planning, scheduling and control
b. Plant Layout Studies
c. Inventory Management Studies
d. Materials Control System Design and Development
e. Development of Work Standards
f. Purchasing Management, including Value Analysis
5. Marketing
a. Product Profitability Analysis
b. Pricing Policy Determination
c. Market Forecasting
d. Distribution Cost Analysis
e. Salesmen’s Incentive Compensation Evaluation
6. Operations Research - involves use of mathematical techniques, such as linear
programming, PERT/CPM, Queuing Theory, Simulation, etc. to solve operational
problems.
* The List is not necessarily exhaustive or complete. Practitioner may offer other services.
MAS Classifications based on Required Expertise:
1. USUAL Services
 evaluation of form of business organization
 analysis of financial and operating statements
 design and installation of accounting systems
 design and filing systems for storing accounting records
 suggestions for improvements in internal control
 establishment of control to assist management and expedite the audit process
 preparation of insurance claims in case of business interruption
 research and evaluation of alternative methods of handling a transaction for its effect
on finance and tax consequences
 assistance in preparation of forecasts and budgets
 presentation and explanation of statements
 assisting clients in purchase or sale of business
 testifying in client’s behalf
 determination of the effect of various employee compensation plans on net income
 aid in labor union negotiations
2. Somewhat SPECIALIZED Services
 assisting in the installation of mechanized accounting system
 making control analysis of operations
 finding sources of capital and figuring the approximate cost of small business loans,
bonds issue, and stock issuance
 giving advice on dividend policy and plans for expansion
 calculations on government contracts and allocating costs in compliance with reporting
requirements
 advising on accounting and tax matters relative to state planning
 surveying credit losses
 assisting in bankruptcy and receivership proceedings
 recruiting accounting and bookkeeping personnel for the client
 preparing an analysis of paper flow
 presenting and analyzing the pros and cons of various retirement and profit-sharing
plans
 advising on various wage incentive plans
3. HIGHLY SPECIALIZED Services
 reviewing the organization structure
 auditing management policies
 conducting motion studies
 surveying an industry of trade for current trends
 evaluating the desirability of a particular area of pant location
 preparing market analysis
 reviewing an insurance program
 advising on data processing allocation
 ANALYTICAL APPROACH AND PROCESS (3 Broad Stages):

I. ANALYSIS Stage
1. Ascertaining the pertinent facts and circumstances
2. Seeking and identifying objectives
3. Defining the problem or opportunity for improvement

II. DESIGN Stage

4. Evaluating and determining possible solutions
5. Presenting findings and recommendations
In case the client request the consultant to proceed

III. IMPLEMENTATION Stage

6. Planning and Scheduling actions
7. Advising and providing technical assistance in implementation.

MAS PRACTICE STANDARDS

GENERAL Standards:
1. Professional Competence - undertake only engagements which one can reasonably
complete.
2. Due Professional Care - when performing an engagement
3. Planning and Supervision - work is conducted in accordance with the understanding with
the client and with professional standards and rules of conduct
4. Sufficient Relevant Data - provide reasonable basis for making conclusions and formulating
recommendations
5. Forecasts - not permit his name to be used in connection with any forecast

TECHNICAL Standards:
1. Role of MAS Practitioner - should maintain his independence to enable him to render
professional judgment and opinion objectively
2. Understanding with the Client - concerning the nature, scope, and limitations of the
enggment to be performed
3. Client Benefit -obtain an understanding of possible benefits the client wishes to achieve
4. Communication of Results -communicate to the client principal findings, conclusions,
recommendations, or other results of the engagement including the major facts and
assumptions used, limitations, reservations, or other qualifications.

ROLE of Consultants and Clients in MAS Engagements:

* FULL SCOPE Engagements - covers the 7 phases of the Analytical Process
Consultant: Limited to that of an advisor; in Implementation Stage, his role is merely to provide
technical assistance.
* SPECIAL STUDY Engagements - involves only the first 5 stages of the analytical process;
client seeks only an impartial and objective study of a case and resulting recommendations.
Consultant: proceed thru first 5 stages, apply objective judgment to the facts, and present
finding and recommendations to client for decision and further action.
Client: supply pertinent information and make decision on the case. Action beyond the point of
decision is solely the responsibility of the client.
*INFORMAL ADVICE - informal and no presumption that an extensive study has been
performed.
Consultant: respond as practicable and express the basis for the response.
STAGES in MAS ENGAGEMENTS:
1. Negotiating the Engagement
2. Preparing for and stating the engagement
3. Conducting the engagement
4. Preparing and presenting the reports and recommendations
5. Implementing the recommendations
6. Evaluating the engagement
7. Post engagement follow-up

MAS ENGAGEMENT CYCLE:

A) Pre-Engagement considerations
B) Engagement Planning
C) Engagement Management and Execution
D) Engagement Conclusion
 MANAGERIAL ACCOUNTING: Basic Frameworks and Contemporary Developments

Managerial Accounting/ Management Accounting/Internal Accounting- field of accounting that

provides economic and financial information for internal users particularly the managers or
decision-makers in an organization.

Management Functions and the Need for Managerial Accounting Information: (All involves
decision-making)
a. PLANNING, involves:
-
Setting of immediate, as well as long range goals
-
Predicting future conditions
-
Considering different means or strategies by which goals may be achieved
-
Deciding which strategies should be used
b. DIRECTING and MOTIVATING, involves overseeing the day to day activities
c. CONTROLLING, involves checking the performance of activities against the plans or
standards set and deciding what corrective actions

ACTIVITIES involved in Managerial Accounting:

1. Determining, accumulating, and explaining costs
2. Computing product cost/service cost
3. Determining cost behavior
4. Providing assistance to management in profit planning/budgeting
5. Accumulating and presenting data
6. Providing bases for cost control
7. Assisting managers in developing the company’s prices

APPLICATION of Managerial Accounting:

-
BUSINESSES – provides economic information needed by managers so that they can attain
their profit or other economic goals.
-
NON-PROFIT ORGANIZATIONS – provided by management accountants in attaining their
organization’s objectives.

Principles Governing the Design of Management Accounting Systems:

-
The System should help establish the decision-making authority over the
organization’s assets.
-
The Information generated should support planning and decision-making.
-
The Reports should provide a means for performance monitoring and evaluation.

MANAGEMENT FINANCIAL ACCOUNTING

ACCOUNTING
 USERS Internal External
 PURPOSE Used in planning, Provide information about
controlling, decision- financial position and
making and performance results of operation
evaluation.
 REPORTS Different types depending Financial Statements
on the needs primarily
 STANDARDS Company can set its own GAAP
rules
 REPORTING ENTITY Report is within the Relate to business as a
company’s value chain whole
 PERIOD Cover any time Usually cover a year,
quarter, or month
STANDARDS OF ETHICAL CONDUCT FOR MANAGEMENT ACCOUNTANTS (AIMA):
Obligation to organization they serve, their profession, the public, and themselves to maintain
the highest standards of ethical conduct. Adherence to the standards integral to achieving the
OBJECTIVES OF MANAGEMENT ACCOUNTING.
 COMPETENCE
-
Maintain an appropriate level of competence
-
Perform professional duties in accordance with relevant laws, regulations and technical
standards
-
Prepare complete and clear reports and recommendations after appropriate analyses
 CONFIDENTIALITY
-
Refrain from disclosing confidential information
-
Inform subordinates regarding the confidentiality of information acquired
-
Refrain from using or appearing to use confidential information acquired
 INTEGRITY
-
Avoid actual or apparent conflicts of interest
-
Refrain from engaging in any activity that would prejudice their ability to carry out their
duties ethically
-
Refuse any gift, favor, or hospitality that would influence or would appear to influence their
actions
-
Recognize and communicate professional limitations
-
Communicate unfavorable, as well as favorable, information and professional judgments or
opinions
-
Refrain from engaging or supporting any activity that would discredit the profession
 OBJECTIVITY
-
Disclose information fairly and objectively
-
Disclose fully all relevant information

RESOLUTION OF ETHICAL CONFLICT:

When faced with significant ethical issues,
-
Discuss with the immediate supervisor, except when it appears latter is involved, the
problem should be presented to the nest higher managerial level. If immediate
supervisor is the CEO or its equivalent, the acceptable reviewing committee id the
audit committee, executive Committee, BOD,BOT or the owners.
-
Clarify relevant concepts by confidential discussion with an objective advisor.
-
After exhausting all levels of internal review, resign from the organization and
submit an appropriate report/memo to an appropriate representative of the
organization
EXCEPT where legally prescribed, communication of such problems to authorities or individuals
not employed or engaged by the organization is considered inappropriate.

ACCOUNTING SYSTEMS MANUAL

-
A collection of instructions set forth the basic systems and accounting policies and
procedures which must be followed within the business organization.
Contains:
1. Organization of Accounting, Auditing, and Systems Departments;
2. Basic policies on systems and accounting;
3. Chart of Accounts and Codes;
4. Books of Accounts, including contents and sources of entries;
5. Statements and Reports;
6. Flowcharts; and
7. Sample or Specimen Forms
More Comprehensive Comparison of the Two Accounting Areas

Bases Financial Accounting Management Accounting

 Guiding Principle GAAP Needs of Management
 Accounting Equation Accounting Equation No single unifying concept
 Relevant Data Past/Historical Past, Present and Future
 Type of Utilized Data Financial Both Financial and Non-
Financial
 Reportorial Requirement Mandatory Optional
 Beneficiaries Various, with focus on Internal Users
External Users
 Output Financial Statements Financial Reports
 Frequency Annually or Quarterly Depending on Necessity
 Emphasis on Segments On entity as a whole Much emphasis on segment
reporting
 Values Precision or accuracy Timeliness
 Sources of Data Internal External and Internal
 Related Fields Accounting Accounting, Economics,
statistics, management,
marketing, etc.
CERTIFICATION AVAILABLE FOR MANAGEMENT ACCOUNTANTS

The Institute of Management Accountants

IMA is the world’s leading organization dedicated to empowering management accounting and
finance professionals to drive business performance. With a network of nearly 65,000
professionals, IMA provides a dynamic forum for management accounting and financial
professionals to develop and advance their careers thru its Certified Management Accountant
(CMA) and Certified Financial Manager (CFA) programs, cutting-edge professional research and
practice development education, networking, and the advocacy of the highest ethical and
professional practices.
IMA members are today’s leaders, managers, and decision makers in management accounting
and finance. They are dedicated to continued professional development, achieving the highest
levels of professional certification, and supporting each other in their commitment to
professional excellence.
CMA or CFA Certification is not required for IMA membership, but you must be a member of
IMA in order to pursue these globally recognized credentials.

The CMA/CFM Certification

To participate in the certification program, you must be a member of the Institute of
Management Accountants (IMA).

The Certified Management Accountant (CMA)

The CMA designation is an advanced, globally recognized credential that supports management
accounting and finance professionals who drive business performance from inside
organizations. It is designed to foster the professional development of those who hold it,
preparing them to anticipate the needs of their organizations and play an integral role in the
strategic decision-making process, while also upholding the highest level of professional and
ethical standards. IMA’s CMA program embodies an extensive and advanced-level curriculum
requiring candidates to demonstrate thorough knowledge of accounting, finance and important
related fields, as well as the ability to integrate accounting and financial information into the
business decision process. CMA exam topics include economics, business finance, situational
analysis, and decision making, with a strong emphasis on ethics. Combined with relevant rule-
based subject matter, the four-tiered CMA exam is designed to develop and measure critical
thinking and decision-making skills.

The Certified Financial Manager (CFM)

The CFM credential provides professionals who are involved with corporate cash management,
financing and investment decisions, and risk management with a means for further
demonstrating an expanded skill set. The CFM exam provides an in-depth measure of
competence in areas such as financial statement analysis, working capital policy, capital
structure, valuation issues, and risk management

Certification Requirements for CMA/CFM

Education Qualification
To be certified as a CMA or CFM, candidates must fulfill both an education requirement and an
experience requirement. Verification of one of the following must be presented to complete
the education requirement:
1. Bachelors Degree, in any area, from an accredited college or university.
a. View a partial listing of international accredited institutions accepted without an
evaluation. Degrees not from accredited foreign institutions must be evaluated by an
independent agency approved by the ICMA.
b. All transcripts must be admitted in English and show the official seal of the college or
university.
2. Score in the 50th percentile or higher on either the Graduate Management Admission Test
(GMAT) or the Graduate Record Examination (GRE)
3. Professional qualification comparable to the CPA, CMA, CFM, etc. Included in the global
listing of professional credentials that qualify is being a CPA member of PICPA. The
professional credentials qualify as an entrance credential for the CMA/CFM programs.
Applicants must arrange to have confirmation of professional credentials sent directly to
the ICMA from the certifying organization.

Experience Qualification
The CMA and CFM programs are designed to distinguish professionals engaged in management
accounting and financial management. Candidates for certification must complete two
continuous years of professional experience in management accounting or financial
management. This may be completed prior to application or within seven years of passing
examination.
Qualifying experience consists of positions requiring judgments regularly made employing the
principles of management accounting and financial management. Such employment includes
financial analysis, budget preparation, management information system analysis, financial
management, management accounting, and auditing in government, finance or industry,
management consulting, auditing in public accounting, research, teaching or consulting related
to management accounting or financial management.
Employment requiring the occasional application of management accounting principles
(computer operations, sales and marketing, manufacturing, engineering, personnel, and
general management) will not satisfy this requirement. Similarly, internships, and trainee,
clerical, or non-technical positions do not provide appropriate experience to fulfill this
requirement.

Waiver or Exemption for Part 1 Business Analysis

Recognizing that successful completion of the requirements for other rigorous professional
accounting and financial certification programs demonstrates a candidate’s competence in
business analysis, a waiver of Part 1, Business Analysis, will be granted to those who have
earned selected certifications. To qualify for the waiver, direct verification of the certification
must be received from the issuing organization. The appropriate fee must also be paid.
CONTROLLER - The Chief Management Accountant

-Mainly responsible for the accounting aspect of management planning and control.
Functions:
1. Planning for Control
2. Reporting and Interpreting
3. Evaluating and Consulting
4. Tax Administration
5. Government Reporting
6. Protection of Assets
7. Economic Appraisal

CONTROLLERSHIP TREASURERSHIP
Planning and Control Provision for Capital
Reporting and Interpreting Investor Relation
Evaluating and Consulting Short-term Financing
Tax Administration Banking and Custody
Government Reporting Credit and collection
Protection of Assets Investments
Economic Appraisal Insurance

CONTEMPORARY DEVELOPMENTS
Factors that contributed to CHANGES:
1. COMPETITION
2. TECHNOLOGICAL ADVANCEMENTS

Objectives of New Management Practices:

1. Enhance quality of products and services
2. Reduce costs
3. Increase output
4. Prompt delivery of goods and services
5. Increase Profit

NEW MANAGEMENT PRACTICES

1. JIT
2. TQM
3. BPR
4. TOC
The OLD and NEW ways of Managing

Point of Reference OLD Management NEW Management

Business Relationship Independent companies Interdependent companies
Suppliers evaluated sad to
reliability and credibility
Employee Isolation Integration
Creative, innovative
Takes responsibility, with
initiative
Endeavors self-education and
improvement
Empowered, multi-skilled and
participatory
Demands for ownership
Labor cost become fixed and
has diminished in total
Labor cost is now part of
factory overhead/conversion
cost
Emphasis Input-output based Process based
Product-oriented Process oriented
Methods Inspection is made at end of the Inspection is made at the
process beginning of the process
Organizational structure is Lean and mean organizational
hierarchical and functional system, system-based
Production is labor-intensive Production id technologically
oriented
Use of mechanical equipment and Use of electronic and
machineries mechanical equipment and
machineries
Emphasis on company-customer Emphasis on suppliers-
relations (forward approach) company-customer relations
(integrated approach)
Less investment in capital Heavy investments in capital
expenditures expenditures
Generally, lesser cost of production Generally, lower cost of doing
in the short-run business in the long run
Managerial Terms Line and staff Process re-engineering
Job description Process value analysis
Standards Benchmarking
Lead time Just-in-time
Job order costing, process costing Back flush costing
Convenience-based management Life-cycle costing
Convenience-based costing Activity-based costing and
activity-based management
Financial measures Non-financial and non-
quantitative measures
Balanced scorecard approach
Theory of constraints
JUST IN TIME – what you need becomes available just in time you will use it.

JIT Purchasing - where RM are received JIT to go into production.

JIT Manufacturing – manufactured parts are completed JIT to be assembled into company’s
product; and products are manufactured JIT to be delivered to customers.

Advantages:
1. Inventory Cost Savings - saves cost of maintaining and carrying inventories.
2. Release of Facilities – investment property
3. Prompt delivery of goods and services; and quick response to customer needs
4. Reduction of defective output resulting into minimization of wastage and losses; and
greater satisfaction of customers

TOTAL QUALITY MANAGEMENT

-
An approach to continuous improvement that focuses on servicing customers and uses the
front-line workers to identify and solve problems systematically.

Quality Costs – costs incurred on quality related processes; costs incurred to prevent defects, or
incurred as a result of defects occurring.

a. Conformance Costs – incurred to prevent key defective units from falling into the hands
of customers
1. Prevention – relate to activity that reduces number of defects
2. Appraisal – relate to inspection

b. Non-conformance Costs – incurred because defects are produced despite efforts to

prevent them
1. Internal Failure – result from identification/discovery of defects during
appraisal/inspection process
2. External Failure – results when defective product id delivered to a customer

CONFORMANCE COST NON-CONFORMANCE COST

Prevention Cost Appraisal Cost Internal Failure Cost External Failure Cost
Quality training Inspection/testing of Cost of scrap/spoilage Returned products
incoming materials,
supplies, and in-
process goods
Quality engineering Maintenance of test Rework costs Repair cost in the field
equipment
Systems development Process control Downtime costs by Product liability
monitoring quality problems lawsuits
Statistical process Product quality Disposal of defective Warranty claims
control activities standards products
Technical support Service calls
Lost sales

BUSINESS PROCESS RE-ENGINEERING – redesigning/elimination of inefficient business

processes.

Business Process –any series that are followed to carry-out some tasks or activities in a business
organization
PR Procedures – business process is diagrammed in detail, analyzed, and then completely
redesigned.
OBJECTIVES: - simplification of business process
-
Elimination of non-value added activities
-
Reduction of opportunities for errors
-
Cost reduction

THEORY OF CONSTRAINTS – the key to success is the effective management of constraints.

Constraint – anything that prevents an individual/business organization from getting more of

what the individual/organization wants
-
Prevents the individual/organization from achieving higher performance relative
to its goal

Basic Feature: a process of CONTINUOUS PROCESS

Basic Steps:
1. Identify the constraint (internal/external)
2. Study the constraint and decide how to overcome or exploit such limitation
3. Prioritize effective management of existing constraint
4. Introduce improvement to break the constraint
5. If the constraint is identified in Step 1 is broken, repeat Step 1. Find another weak point
or constraint

 Principles of QUALITY BASED MANAGEMENT:

1. Quality, Technology and Change
2. Serve the Customer-the KING
3. 5 S’- Sorting out, Systematic Arrangement, Spic and Span, Standardizing, and Self
Discipline
4. Search of Excellence

 QUALITY-BASED Processes:
1. Process mapping and process value analysis
Process mapping (input/output) lines up activities from the start to the end of the
process cycle to show the connections of different activities in completing a particular
cycle (production, specific department/unit cycle)
Process value analysis shows the relevance of the interrelationships and
interdependence of activities in a given process to determine their usefulness,
identifying possible areas where improvements could be done, and creating options on
how to make the process more relevant and feasible
Throughput time/ manufacturing time is the sum of all activities from input to output
which includes the process time, wait/queue time, move time and inspection time
2. Process re-engineering – is a macro-approach to process improvement; creates new
standards, beliefs, goals, practices, procedures, and system of doing things
3. Kaizen – a Japanese term which refers to the process of continuously improving
systems, relationships, processes, set-ups, policies, and other details of activities
4. PDCA (Plan-Do-Check-Act) Cycle/Deming Wheel is “management by fact” or a scientific
approach to continuous improvement model based on a process-centered approach.
Careful planning precedes doing in a small-scale manner, checking the outcome of the
experiment and adopting the model in larger-scale if found successful.
5. Benchmarking identifies the best practices in the organization and make the benchmark
could either financial or non-financial in nature, Internal or external in source.
Benchmark – is the best in- the-class or the best performance in a given environment.

6. Product-Life Cycle Costing - estimates and determines the total cost of a product over its
life cycle.
-
gets the average unit cost over the entire life span of the
product
Stages:
Infancy/Start-up stage
Growth stage
Expansion Stage
Maturity/decline stage
 THE MAJOR INFORMATION SYSTEMS
INFORMATION SYSTEM is the network of all methods used in communicating information
within the organization. It is a collection of procedures, programs, equipment, and methods
that process data and make it available to management for decision making.

Information is needed in all levels of management, whether in:

 STRATEGIC Level - composed of the Vice-Presidents and the CEO responsible for strategic
planning using unstructured decisions.
 TACTICAL Level - composed of the middle managers such as directors in each specific task
or field responsible for tactical planning using semi-structured decisions.
 OPERATIONAL Level - composed of the lower management such as managers
of departments responsible for operational planning using structure decisions.

THE MAJOR INFORMATION SYSTEMS:

 FINANCIAL INFORMATION SYSTEM is used in showing and communicating the flow of
monetary information.
 PERSONNEL INFORMATION SYSTEM shows the flow of information about the personnel
working in an organization.
 LOGISTICS INFORMATION SYSTEM shows information about the physical flow of goods
within an organization.
 MANAGEMENT INFORMATION SYSTEM is a set of data gathering, analyzing and reporting
functions designed to provide management with the information it needs to carry out its
functions.
 ACCOUNTING INFORMATION SYSTEM is an orderly arrangement of procedures, personnel,
written records, equipment and devices used for the systematic/organized collection,
processing and reporting of financial and other information essential to the official and
effective conduct and evaluation of activities/transactions.

OBJECTIVES:
a. Provide means by which interested parties may be given information on the financial
position and results of operations of an organization.
b. Facilitate management planning, control, ands decision making.
c. Comply with various laws and government requirements.
d. Protect the organization and safeguard its assets.

BASIC ELEMENTS:
a. Set of interrelated activities.
b. Written records and reports.
c. Equipment and devices used.
d. Personnel directly involved.

ESSENTIAL COMPONENTS:
 Business Papers and Forms
 Business Machines
 Journals and Ledgers
 Chart of Accounts
 Flowchart
 Organizational Charts
 Financial Reports
 Internal Control
FLOWCHART is a pictorial presentation of flow of work and/or documents through a
department or an entire organization.

a. SYSTEMS Flowchart shows a logical diagram of the flow of data through all parts of the data
processing system; identifies which functions are manual, mechanical, and computerized.
b. DOCUMENT Flowchart traces the flow of documents and reports for a particular function or
activity through the system from origin to destination.
c. PROGRAM Flowchart shows the different operation and decisions required in a specific
program.

ORGANIZATIONAL CHARTS shows the lines of authority, responsibility, control, and functions in
a business organization.

TYPES of Management Information System (MIS):

 TRANSACTION PROCESSING System (TPS) - for lower managers
- Follows the input-output system. The inputs are transaction data such as bills,
paychecks, inventory analysis, and so on.
- Normally for lower manager’s use.
- Produces detailed reports.
- There is one (1) TPS for each department.
- Also a basis for MIS and DSS.

 MANAGEMENT INFORMATION System (MIS) - for middle managers

- Input and output system.
- Normally used by middle managers.
- Draws input from all departments.
- Produces several kinds of reports - summary reports, exception reports, periodic
reports, on-demand reports.

 DECISION SUPPORT System (DSS) - for top management

- Input and output system.
- Mainly for top managers. Produces analytic models – the key attribute of a DSS is that it
uses models. A model is a mathematical representation of a real system. The models use
a DSS database, which draws on the TPS and MIS filed, as well as external data such as
stock reports, government reports, national and international news. This model allows a
manager to do a simulation-play a “what if” game- to reach discussions

COMPONENTS of a DSS:
→ Hardware
→ Software
→Data resources
→model resources
→people resources

EXAMPLES of DSS Applications:

Airline DSS
Real Estate DSS
Geographic DSS

 EXECUTIVE INFORMATION System/EXECUTIVE SUPPORT System - for top management

- Is an easy-to-use DSS made especially for top managers. It specifically supports strategic
decision making.
- Draws from data not only from systems internal to the organization but also from those
outside.
 - An EIS might allow senior executives to call up predefines reports from their PCs,
whether desktops or laptops. They might, for instance, call up sales figures in many
forms-by region, by week, by fiscal year, by projected increases.
- EIS includes capabilities for analyzing data and doing “what if” scenarios.
- EISs also have the capability to browse through information on all aspects of the
organization and then zero-in on areas the manger believes would require attention.

 EXPERT/KNOWLEDGE Systems - for all levels, including non management

- Is a set of interactive computer programs that helps users solve problems that would
otherwise require the assistance of a human expert.
- Simulated the reasoning process of experts in certain well-defined areas. That is,
professionals, called knowledge engineers, interview the experts and determine the
rules and knowledge that must go into the systems.
- Programs incorporate not only surface knowledge (textbook knowledge) but also deep
knowledge (tricks of the trade)

EXAMPLES of Expert Systems:

MYCIN - helps diagnose infectious diseases
PROSPECTOR - assess geological data to locate mineral deposits
DENDRAL - identifies chemical compounds
REBES - helps investigates crime scenes
CARES - helps social workers assess families for risk of child abuse
CLUES - evaluates home-mortgage-loan applications
MUCKRAKER - assists journalists with investigative reporting
CRUSH - takes a body of expert advice and combines it with worksheets
reflecting a user’s business situation to come up with a customized strategy to beat out
competitors.

 OFFICE AUTOMATION Systems - for all levels, including non management

- Are those that combine various technologies to reduce the manual labor required in
operating an efficient office environment.
- These technologies include voice mail, e-mail, scheduling software, desktop publishing,
word processing, fax and so on.
- OAS are used throughout all levels of an organization.
- The backbone of an OAS is a network-perhaps, a LAN, an internet over a LAN, or an
extranet.
 COSTS IN MANAGERIAL ACCOUNTING

COST – monetary measure of amount of resources given up or used for some purpose.
-
monetary value of goods and services expended to obtain current or future benefits.

COST TERMS:
Cost Object - anything for which cost is computed. Ex. product, product line, segment
Cost Driver - any variable (level of activity/volume) that usually affects cost over a period of
time. Ex. production, sales, number of hours
Cost Pool - grouping of individual cost items; an account in which a variety of similar costs
are accumulated. Ex. WIP, Factory Overhead Control
Activity - an event, action, transaction, task, or unit of work with a specified purpose.
Ex. Value-Adding Activities - activities are necessary to produce the product.
(assembling)
Non Value-Adding Activities -do not make product/service more valuable to the
customer. (moving materials or equipment)

CLASSIFICATION OF COSTS:
 As to TYPE
1. PRODUCT Cost-incurred to manufacture the product.
* Product Cost of units sold during the period are recognized as expense (COGS/COS) in the
Income Statement.
* Product Cost of unsold units become costs of inventory and treated as an asset in the
Balance Sheet.
2. PERIOD Cost-nonmanufacturing costs that include selling, administrative, and Research
and Development cost. These are expensed in the period of incurrence and do not become
part of inventory.
 As to FUNCTION
1. MANUFACTURING Cost-all costs incurred in the factory to convert raw materials into
finished goods.
* Direct Manufacturing Costs – Materials and Labor
* Indirect Manufacturing Costs - Manufacturing OH or Factory OH Costs
2. NON-MANUFACTURING Cost- all costs which are not incurred in transforming materials
to finished goods.
* R & D – incurred in designing and bringing new products to the market
* Marketing Cost – advertising and promotion
* Distribution Cost – costs incurred in delivering products to customers
* Selling Cost – sales staff salaries and commissions and other selling expenses
* After-Sales Cost – incurred in dealing with customers after sales, such as warranty, repair
costs, costs incurred in receiving, entertaining and acting on customer complaints
* General and Administrative Costs – all non-manufacturing costs not falling under any
other category
 As to TRACEABILITY/ASSIGNMENT to Cost Object
1. DIRECT Cost – related to particular cost object and be effectively traced to cost object.
2. INDIRECT Cost – related to a cost object, but cannot practically economically, and be
effectively traced to such object. Cost assignment is done by allocating indirect cost to be
related cost object.
 For DECISION MAKING
1. RELEVANT Cost – future costs that will differ under alternative courses of action.
2. DIFFERENTIAL Cost – difference in costs between any two alternative courses of action.
* INCREMENTAL Cost – increase in cost from one alternative to another
* DECREMENTAL Cost – decrease in cost
3. OPPORTUNITY Cost – income or benefit given up when one alternative is selected over
another.
4. SUNK, PAST, or HISTORICAL Cost – already incurred and cannot be charged by any
decision.
 As to BEHAVIOR (Reaction to Changes in Cost Driver)
1. VARIABLE Cost – within relevant range and time period under consideration, the total
amount varies directly to change in activity level/cost driver, and the per unit amount is
constant.
2. FIXED Cost – within relevant range and the period under consideration, total amount
remains unchanged, and per unit amount varies inversely/indirectly with change in cost
driver.
* Committed FC – long-term is nature and cannot be eliminated even for a short period of
time without affecting profitability or long-term goals. Ex. Depreciation
* Discretionary/Managed FC – arise from periodic decision of management to spend certain
fixed costs. Maybe changed by management from period to period, if circumstances
demand. Ex. Research, Advertising, maintenance contracts
3. MIXED Cost – cost has both variable and fixed components.
4. STEP Cost – when activity changes, step cost shifts upward or downward by certain
interval/step.
* Step Variable Cost – have small steps
* Step Fixed Cost – have huge steps

RELEVANT RANGE - range of activity that reflects the company’s normal operating range.

TOTAL AMOUNT PER COST DRIVER

VARIABLE COST Varies directly with Cost Constant
Driver
FIXED COST Constant Varies inversely with Cost
Driver

Analysis of Mixed Costs:

Mixed/Total Cost - have variable and fixed components.

Y = a + bx
Y = Total Cost b = Variable Cost per driver
a = Total Fixed Cost x = activity level/cost driver

LINEARITY ASSUMPTION - within the relevant range, there is strict linear relationship
between the cost and cost driver. Costs may therefore be shown graphically as lines.

Separation of Fixed and Variable Components:

1. HIGH-LOW Method - cost components from two data points. The data points, taken
from historical data, represent the highest and lowest activity levels during the period
under consideration.
* do not select data points distorted by abnormal conditions
* activity level is the cost driver
a) Graphical approach b) Mathematical approach

2. SCATTERGRAPH Method
Comments:
- is a more accurate way of separating variable and fixed cost components.
- Abnormally high and low points can easily be seen.
 However, method is subjective. Results of analysis may differ. No two analyses are likely
to draw the same regression line.

3. LEAST SQUARES Method - uses mathematical formulas to fit the regression line, unlike
scattergraph where the line is fitted by visual inspection. The procedure involves a
computation of regression line that minimizes the sum of squared errors/deviations.
 Objective:
 come up with the cost function Y = a + bx
 values of a and b may be computed solving the ff:
∑y = na + b∑x
∑xy = a∑x + b∑x2

Compute ∑y, ∑x, ∑xy, ∑x2

X = units produced
Y = cost
N = number of observations/data

4. MULTIPLE REGRESSION Analysis – used when dependent variable (cost) is caused by more
than one factor. In other words, the dependent variable (cost) is related to more than one
independent variable (units, machine hours, etc.)

5. CORRELATION Analysis - a measure of co-variations between dependent and independent

variables.
* If all plotted points fall on the regression line, there is perfect correlation.
* If correlation between cost and cost driver is high, and the past relationship between such
variables will continue in the future, then the cost driver chosen will be useful for predicting
future levels of cost being analyzed.

COEFFICIENT OF CORRELATION (denoted by r) – measure of extent of linear relationship

between two variables.

Range of Values of r; from -1 to 1

r = -1≤ 0 ≤ 1

when r = 0, there is no correlation

when r = ±1, there is perfect correlation

when r is POSITIVE, there is positive or direct relationship between the dependent (y) and
independent (x) variables. That is, the value of y increases when the value of x increases.
The regression line slopes upward to the right.

when r is NEGATIVE, there is negative or inverse or indirect relationship between the

variables. The value of y decreases as the value of x increases. The regression line slopes
downward to the right.

COEFFICIENT OF DETERMINATION (denoted by r2) computed by squaring the value of r.

Represents the percentage of total variation in the dependent variable y that is explained or
accounted for by regression equation.

STANDARD ERROR OF ESTIMATE - standard deviation about the regression line

- estimated values computed using the regression equation may differ from actual costs.
- Prediction Errors/Errors of Estimate
 If r2 = 1, the standard error = 0
 A small value of standard error indicates a good fit.
 COST VOLUME PROFIT ANALYSIS

- a systematic examination of the relationships among costs, cost driver or activity

level/volume, and profit.
- Management’s study of the relationships among costs, volume, and profit. This study is
used in planning, controlling and evaluating the objectives of the enterprise.
Purposes
Elements of CVP Analysis:
1. Sales
a. Selling Price
b. Units/Volume
2. Total Fixed Cost
3. Variable Cost per Unit
4. Sales Mix

Applications of CVP Analysis:

PLANNING and DECISION-MAKING, may involve choosing:
a. TYPE OF PRODUCT to produce or sell;
b. PRICING POLICY to follow;
c. MARKETING STRATEGY to use; and
d. Type of PRODUCTIVE FACILITIES to acquire.

CONTRIBUTION MARGIN INCOME STATEMENT (for Management’s Use)

Sales (Units * SP) PXXX

Less: Variable Cost XXX
Contribution Margin XXX
Less: Fixed Cost XXX
Income before Tax XXX

Inherent Assumptions of CVP Analysis:

1. Costs are classifiable either Variable or Fixed Cost.
2. Cost and Revenue relationships are predictable and linear over a relevant range of
activity/time.
3. Total VC change directly with cost driver, but VC per unit is constant over the relevant
range.
4. Total FC is constant over the relevant range, but per unit FC vary inversely with the cost
driver/volume.
5. SP per unit and market conditions remain unchanged.
6. Production equals Sales, i.e., there is no change in inventory.
7. If company dells multiple products, Sales Mix is constant.
8. Technology/productive efficiency, is constant.
9. Time value of money is ignored.
 BREAK-EVEN ANALYSIS

Break-Even Point – Sales Volume level (Pesos/Units) where total revenues equal total costs.

Methods:

a) Graphical Method

Break-Even Chart Profit-Volume Graph

FC P Sales

Units Sales Units

0

b) Formula Approach

1. BEP = FC
CM%
2. BES= FC
CMu
Other Formulas:
CM = S – VC VC% = VC/S VC% = 1 – CM%
CMu = SP – VCu 1 = CM% + VC%
CM% = CM/S CM% = 1 – VC%

c) Multiple Product

1. BEP = FC
WaCM%
2. BES= FC
WaCMu

MARGIN OF SAFETY – amount of Peso Sales or number of units by which actual/budgeted sales
may be decreased without resulting into a loss.

MSP = SP - BEP MS% = MSP/SP or MSU/SU

MSU = SU – BEU or MSP/SP
OPERATING LEVERAGE
Operating Leverage Factor (OLF) or Degree of Operating Leverage (DOL) – used to measure the
extent of the change in profit before tax resulting from change in sales.

DOL/OLF = Total CM or % Change in Profit before Tax

Profit before Tax % of Change in Sales

% Change in Profit = % Sales * DOL

Change in Profit Factors may cause profit to change:
 Selling Price
 VC per Unit
 Volume (number of units)
 Total FC
 Sales Mix

RSu = Required Sales in Units P% = Profit Ratio

RSP = Required Sales in Pesos Pu = Profit per unit
DP = Profit before Tax TxR = Tax Rate
NP = Profit after Tax

A. SINGLE Product
RSu RSP
a. To earn desired amount of RSu = FC + DP RSP = FC + DP
profit before tax CMU CM%
b. To earn desired amount of RSu = FC + NP RSP = FC + NP
profit after tax 1 + TxR 1 + TxR
CMU CM%

c. To earn desired profit RSu = _____FC_______ RSP= _____FC_______

ratio CMU - Pu CM% - P%
Pu = SP * P%

B. MULTIPLE Product
a. To earn desired amount of RSu = FC + DP RSP = FC + DP
profit before tax WaCMU WaCM%
b. To earn desired amount of RSu = FC + NP RSP = FC + NP
profit after tax 1 + TxR 1 + TxR
WaCMU WaCM%
 COST ACCOUNTING SYSTEMS

COST ACCOUNTING - part of accounting system that measures costs for decision-making and
financial reporting purposes.

Cost Accounting PROCESSES:

1) COST ACCUMULATION – involves collecting costs by natural classification, such as materials
and labor.
2) COST ALLOCATION/COST ASSIGNMENT – involves tracing and assigning costs to cost
objects, such as departments or products.

Cost Accounting SYSTEMS:

* JOB-ORDER Costing - used by firms that provide limited quantities of products or
services unique to a customer’s needs or specifications. Costs are assigned or traced to
individual products.
Ex. Automobile repair shops, tailoring/dressmaking

* PROCESS Costing - used by firms that produce many units of a single product (or
nearly identical products) for long periods of time.
In this system, costs are accumulated in a particular operation or department for an
entire period. Total Cost incurred in each operation or department is then divided by total
number of units produced to determine the average cost per unit of product.
Ex. Softdrinks company, toy manufacturers

* STANDARD Costing - used with other cost accounting systems, such as JOB ORDER
Costing and PROCESS Costing.
This method uses predetermined factors (quantity and price) to compute the standard
cost of materials, labor and factory overhead, so that such costs may be assigned to various
inventory accounts and COGS/COS.

* BACKFLUSH Costing - streamlined cost accounting method that simplifies, speeds up, and
reduces accounting effort/procedures in accumulating product costs.
Eliminates the detailed tracking of cost of work in process.

* ACTIVITY-BASED Costing - uses multiple drivers to predict and allocate costs to products
and services.
In ABC System, the various activities performed in a business segment or in an entire
organization are identified, costs are collected on the basis of the underlying nature and extent
of such activities, and costs are assigned to the products or services based on consumption of
such activities by products or services.
 STANDARD COST VARIANCE ANALYSIS

Standard – measure of acceptable performance established by management as guide in making

economic decisions.
-
Benchmark/Norm for measuring performance.

Quantity Standards –indicate the quantity of Raw Materials/Labor Time required producing a
unit.

Cost Standards – indicate cost of quality standards should be.

Variance – Difference between Actual and Standard Cost

USERS of Standard Costs: Manufacturing, Service, Non-profit Organizations

-
May also be used in Job Order and Process Costing Systems.

Standard Costing Control Loop:

1. Establish Standards
2. Measure actual performance
3. Compare actual performance with the standard
4. Analyze the variances
5. Investigate the variances
6. Take corrective action when needed

MANAGEMENT BY EXCEPTION
-
Only variances that are material or significant in amount, whether favorable/unfavorable,
should be investigated.

SETTING STANDARD COSTS:

Types of Standards
 IDEAL – attainable under the best circumstance; also called Theoretical/Maximum
Efficiency Standards
 PRACTICAL – Currently Attainable Standards; tight but attainable standards; attainable
under normal though highly efficient operating conditions
-
Normally used for product costing and cash budgeting purposes

MATERIAL Standards:
 Standard Price/unit x Standard Quantity/hour = Standard Cost of Materials

DIRECT LABOR Standards:

 Standard Time/unit x Standard Rate/hour = Standard Cost of Labor

FACTORY OVERHEAD Standards:

 Variable FOH= Hours x Variable OH Rate/hour
 Fixed FOH = expressed in Total Figures using Practical (Normal) Capacity

STANDARDS and BUDGETS are predetermined amounts. However, Standard is a unit amount,
whereas Budget is total amount.

TOTAL BUDGETED COST = Budgeted Production x Standard Cost per Unit

TOTAL STANDARD COST = Actual Production x Standard Cost per Unit

BUDGET VARIANCE = Actual Cost – Budgeted Cost

STANDARD COST VARIANCE = Actual Cost – Standard Cost

VARIANCE ANALYSIS
Direct Materials
Actual Qty. @ Actual Price
Spending/Price Variance
Actual Qty. @ Std. Price Materials Price Variance
Efficiency/ Quantity Variance
Std. Qty. @ Std. Price

Direct Labor
Actual Time @ Actual Rate
Spending/Price Variance
Actual Time @ Std. Rate Labor Cost Variance
Efficiency/ Quantity Variance
Std. Time @ Std. Rate

Factory Overhead
FIXED VARIABLE
Actual Actual
Spending/Price Variance
Budgeted Std. Rate x Actual Hrs. Controllable
Variance
Efficiency/ Qty. Variance
Budgeted Std. Rate x Std. Hrs.
Volume Variance
Standard Standard

RESPONSIBILITY FOR VARIANCES

VARIANCES POSSIBLE CAUSES RESPONSIBLE PERSONS
Materials Price/Spending Quality of Materials Purchasing Manager
Quantity Purchased
Delivery time (rush orders)
Materials Efficiency/ Quantity Quality of Materials Production Manager
Defective Machines
Unskilled Workers
Poor Supervisor
Labor Spending/Rate Workers’ Skill Supervisors responsible
Overtime Premiums For Labor Rates
Labor Efficiency/Time Workers’ Skill Production Managers
Workers’ Efficiency
Imposition of Control
Measures

Disposition of Variances:
1. Insignificant – closed to COGS/COS
2. Significant/Material – Pro-rata adjustment to COGS/COS

Advantages of Using Standard Costs:

1. Serve as Key Element in application of Management by Exception, Management by
Objectives, and Responsibility Accounting.
2. Promote Economy and Efficiency among employees
3. Simplifies Bookkeeping and Costing Procedures.

Relationship between Delivery Cycle Time and Throughput Time:

Receipt of Order Start of Production Delivery to Customer

Process Time, Inspection Time, Move Time, Queue Time

Wait Time
THROUGHPUT TIME

DELIVERY CYCLE TIME

In Delivery Cycle Time, only the process time is value-added time, the rest are non-value added
time.

MATERIALS PRICE, MIX AND YIELD VARIANCE ANALYSIS

When production process, involves combining/mixing several materials in varying

proportions, 3-way analysis is used.

Formulas:

Actual Material Cost - total actual cost of materials used

Less: Std. Material Cost - Actual Production x Average Std. Output Cost
Materials Cost Variance

Price Variance = Difference in Price x Actual Qty.

Mix Variance = Total Actual Qty. @ Std. Price

Less: Total Actual Input at Average Std. Input Cost*

Yield Variance = Total Actual Input at Average Std. Input Cost

Less: Std. Cost**
**Actual Output x Ave. Std. Output Cost***

*ASIC = Total Std. Input Cost

Total Std. Input Quantity

***ASOC = Total Std. Input Cost

Total Std. Output Qty.

Yield %= Std. Output Qty.

Std. Input Quantity

Total Factor Productivity = Units of Output

Cost of all inputs
INNOVATIONS – Other Performance Measures

1. DELIVERY CYCLE TIME – the length of TIME between RECEIVING an order from customer to
the TIME when Completed Order is DELIVERED to such customer.
-only process time is value added time, the rest are non-value added.

2. THROUGHPUT/MANUFACTURING CYCLE TIME – TIME REQUIRED to CONVERT RAW

MATERIALS into FINISHED PRODUCTS.

Composed of:
 Process Time – time work is actually done on the product
 Inspection Time – time spent to check if product is defective
 Move Time – time required to move materials and WIP from one workstation to another
 Queue Time – amount of time product spends waiting to be processed, moved,
inspected, and shipped.

3. MANUFACTURING CYCLE EFFICIENCY – the objective is to REDUCE/ELIMINATE NON-VALUE

ADDED TIME in the delivery cycle time.

MCE = Value-Added Time or Process Time

Throughput/Manufacturing Cycle Time

Evaluation: if MCE<1, Non-Value Added time is present in the production process

 ABSORPTION and VARIABLE COSTING

Absorption (Full) Costing is a product costing method that includes ALL manufacturing costs in
the cost of a unit product. It is the traditional method of product costing in which direct
materials, direct labor, and both variable and fixed manufacturing overhead are treated as
product costs and are charged to inventories.

Variable (Direct/Marginal) Costing/Contribution Margin Reporting includes only the VARIABLE

Manufacturing Costs in the cost of a unit product. It is a costing method whereby direct
materials, direct labor and variable manufacturing overhead are treated as product cost, while
fixed manufacturing overhead is treated as period costs (cost expensed currently in the income
statement).

Applications of Variable Costing:

Variable costing is used for internal purposes only. It uses include:
1. Inventory valuation
2. Income measurement
3. Relevant cost analysis
4. CVP analysis and other short-run decision making situations

Effect on Net Income:

1. If production is equal to sales; absorption profit is equal to variable costing profit.
2. If production is greater than sales; absorption profit is higher than variable costing
profit.
3. If production is lesser than sales; absorption profit is lower than variable costing profit.
4. Under Variable Costing, income tends to move with sales, whereas under Absorption
Costing, income tends to move with production. Thus, net income can be influenced by
inventory changes under absorption costing, but not under direct costing.

Net Income Reconciliation:

Fixed Manufacturing Cost attached in Beg. Invty. XXX
Less: Fixed Manufacturing Cost attached in End. Invty. XXX
Difference in Net Income XXX

Note: Fixed Manufacturing Costs are only attached to beginning and ending inventories under
absorption costing.

Extremes:
Throughput (Supervariable) Costing treats direct materials as the only variable costs.
Features:
 Only material costs are inventoriable; WIP or FG inventories are not recorded.
 Direct labor and FOH are treated as period costs
 COGS id the cost of materials put in process
 Sales less COGS(purely materials) = Throughput
 Results in lower income than Variable Costing when production exceeds sales.
 Penalize High Production and rewards low production. Hence, in tune with JIT and other
philosophies that seeks lower inventories.

Superabsorption Costing treat costs from all links in the value chain as inventoriable cost.
 VARIABLE COSTING
Advantages Disadvantages
Total FC is reported in the income statement Variable Costing is not acceptable for external
when incurred. This highlights the effect of FC and income tax reporting.
on net income.
FC is not accounted for as inventoriable cost. Costs are required to be separated into fixed
This simplifies the record keeping and and variable. This can be very difficult and
provides a better basis for accounting and often subject to individual judgment.
control of the total FC incurred.
Net income is not influenced by production Costs are not properly matched with revenues
and inventory changes. Net income varies with in accordance with GAAP.
sales.
The income statement-reporting format is Too much attention may be given to VC at the
extremely useful for management purposes expense of disregarding FC.
like determining cost-volume relationships
and contribution margin data.

Product Components:
ABSORPTION VARIABLE
Direct Materials Direct Materials
Direct Labor Direct Labor
Variable FOH FOH
Fixed FOH

Distinction between Period Cost and Product Cost:

PERIOD COST PRODUCT COST
 Apportioned between sold and
 Charged against current revenue
unsold units
 Not part of the inventory  Inventoriable Cost
 Reduces income for current period  Reduces current income by portion
by its full amount allocated to sold units

Principal Differences between Absorption and Variable Costing:

ABSORPTION VARIABLE
 Cost segregation Seldom segregates Segregates cost into variable
and fixed
 Cost of Inventory All manufacturing cost Only variable manufacturing
cost
 Fixed FOH Product Cost Period Cost
 Income Statement Distinguishes production and Distinguishes Variable and
other costs. Fixed Cost

Difference in Net Income: Timing difference on Fixed Cost.

 Production = Sales; AC Income = VC Income
 Production < Sales; AC Income < VC Income
 Production > Sales; AC Income > VC Income
ARGUMENTS involving Variable Costing:
USE AGAINST
 Reports are simpler and more  Segregation of mixed costs might be
understandable difficult
 Data needed for BE and CVP Analysis  Matching principle is violated
are readily available
 Problems in allocating Fixed Cost is  Inventory cost and other related
eliminated accounts, such as working capital,
current ratio and acid test ratio are
understated
 More compatible with standard cost
accounting system
 Provide useful info for pricing decisions
and other decision making problems

INCOME STATEMENTS:
ABSORPTION VARIABLE
Sales XX Sales XX
Less: COGS XX Less: Variable Cost XX
Gross Profit XX Contribution Margin XX
Operating Expense XX Less: Fixed Cost XX
Net Income XX Net Income XX

Reconciliation of Income Figures:

Absorption Costing Income XX
Add: FOH, Beg. Inventory XX
Total XX
Less: FOH, End. Inventory XX
Variable Costing Income XX

Accounting for Difference in Net Income:

Change in Inventory (Production less Sales) XX
Multiply by FOH per Unit X
Difference in Income XX
 ACTIVITY BASED MANAGEMENT AND COSTING

ACTIVITY-BASED MANAGEMENT – is using information about activities to manage many aspects

of an organization, and focuses on processes and on tasks and activities within processes,
rather than simply managing costs.

Differences between Traditional and ABC Costing:

Traditional ABC
a. Cost Pools One or a limited number Many, reflect different
activities
b. Applied Rate Volume-based, financial Activity based, non-financial
c. Suited for Labor-intensive, low overhead Capital intensive, product-
companies diverse high overhead
companies
d. Benefits Simple, inexpensive Accurate product costing,
eliminate non-value added
activities.

ACTIVITY-BASED COSTING – is a method of assigning indirect costs, including non-

manufacturing OH, to products and services. It first assigns costs to activities, then to the
products based on each product’s use of activities. It is a premise that products consume
activities and activities consume resources.

 Benefits of ABC:
a. Improved product or service cost data.
b. Improved decisions about pricing, service mixes and product strategies based on more
accurate cost information.
c. Cost reduction by eliminating non-value added activities.
d. Greater control of costs because of its focus on the behavior of costs at their origination,
both short term and long-term.
e. More accurate evaluation of performance by programs and responsibility center.

ACTIVITY CENTER – Unit of the organization that performs a set of tasks.

 Major Categories of Activities in ABC System:

a. Unit-level Activities - are those performed each time a unit is produced or sold. The
costs these activities are the typical variable costs.
Examples: Materials, energy to run machines
b. Batch-level Activities - are those that a company performs when it makes a group of
units, regardless of how many units in a batch.
Examples: Machine set-ups, Quality inspections
c. Product (Customer) Sustaining Activities – arise because a company does particular
types of business, or maintains a particular product of service.
Examples: Customer records and files, Product specifications, Customer service
d. Facility-level Activities- relate to an entire plant, office, or company as a whole.
Examples: Plant management, Building depreciation and rent, Heating and lighting

COST POOL – Means indirect cost pool. Refer to groupings or aggregations of costs, usually for
subsequent analysis.
 Cost Pools Group Costs into either:
a. Plants, which are entire factories, b. Department within plants
stores, banks, and so forth c. Activity centers.
PLANTWIDE ALLOCATION – Uses the entire plant as a cost pool. Then, allocate all costs from the
pool to product using a single overhead allocation rate, or one set or rates, to all of the
products of the plant, independent of the number of departments in the plant.
DEPARTMENTAL ALLOCATION – Each department is a separate cost pool, which accumulates
costs. Then using separate rates, for each department, allocate from each cost pool to products
produced in that department.

COST DRIVER – a factor that causes or drives an activity’s cost.

 Criteria used for selecting cost drivers:

a. Causal relation – choose a cost driver that causes the cost. Although, this is ideal
but is not always possible because indirect costs are generally not casually linked to cost
objects.
b. Benefits received – choose a cost driver so costs are assigned in proportion to
benefits received.
c. Reasonableness - costs are assigned based on fairness or reasonableness if costs
cannot be linked based on causality or benefits received.

 Examples of Cost Drivers:

Manufacturing:
Labors Hours/Cost No. of Customers
Machine Hours Items produced/sold
Machine Set-ups Flight hrs.
Kls. Of Materials handled No. of operations
Purchase Orders Scrap/Rework Orders
Quality Inspections Computer time
Number of parts in a product Hrs. of testing time
Square footage No. of billing hrs.
Design time No. of vendors
Asset value
Non-manufacturing:
No. of hospital beds occupied
No. of take-offs and landing for an airline
No. of rooms occupied in a hotel
No. of trips for a bus company
No. of kilometers driven

 Steps in ABC:
a. Identify the activities that consume resources, and assign costs to those activities.
b. Identify the cost driver/s associated with each activity.
c. Compute a cost rte per cost driver unit.
d. Assign costs to products by multiplying the cost driver rate times the volume of cost
drivers consumed by the product.

FORMULA:

Predetermined Indirect Cost Rate = Estimated Indirect Cost

Estimated Volume of the Allocation Base
 ACCOUNTING INFORMATION and SHORT-TERM DECISION-MAKING

Decision Making is the function of selecting courses of action for the future.

Decision Model is a forward method used by managers for making a choice, which involves
both quantitative and qualitative analyses.

Basic Steps:

a. IDENTIFY THE PROBLEM

May involve questions on:
 Whether to accept/reject a special order/business proposal;
 Whether to make/buy a part, sub-assemble, or provide a line (insourcing/outsourcing);
 Whether to sell or process a product further;
 Whether to continue operating or close a business segment;
 Which best product mix considering capacity constraints;
 How profit factors should be charged to achieve a profit goal
 How much price should be charged for the company’s product or service (Pricing
Decisions)

b. OBTAIN INFORMATION AND MAKE PREDICTIONS

 Qualitative and Quantitative Info:
Qualitative factors - outcome that cannot be easily and accurately be measured in
numerical terms.
Quantitative factors - can be expressed in numbers.
 Relevant Info – to be gathered should be relevant and related to the decision-making
case.
Relevant Cost and Revenues - differ among alternative courses of action; Avoidable
Cost; Differential Cost.
i. Differential Cost are present in one alternative but are absent in whole or in part
in another alternative.
ii. Avoidable Cost can be eliminated, in whole or in part, when one alternative is
chosen over the other.
iii. Opportunity Cost refers to contribution to income that is forgone when one
action is taken over the next best alternative course of action.
Irrelevant
i. Sunk (Past) Cost has already been incurred and therefore cannot be avoided
regardless of any alternative taken; are always irrelevant in decision-making, but
they may serve as basis for making predictions.
ii. Future Cost do not differ between or among alternatives under consideration.

c. IDENTIFY AND EVALUATE THE ALTERNATIVE COURSES OF ACTION THEN CHOOSE THE BEST
ALTERNATIVE
 Only relevant factors should be considered
 The best alternative will give the highest income or the lowest loss

d. IMPLEMENT THE DECISION

e. EVALUATE THE PERFORMANCE OF THE DECISION IMPLEMENTED TO PROVIDE FEEDBACK

 Feedbacks may help decision makers to make better decisions in the future.
 PRICING DECISIONS

Objectives:
-
To maximize profit/target margin
-
To meet desires dales returns/market share
-
To maintain stable relationship between the company and industry leader’s prices
-
To enhance the image that the company wants to project

Factors that influence product pricing:

1. Internal Factors
-
All relevant costs
-
Company’s marketing objectives, as well as, its marketing mix strategy
-
Company’s capacity

Peak Load Pricing – prices may vary inversely with capacity usage. Company’s
products would be sold at higher prices if it does not operate at full capacity.

2. External Factors
-
Type of market where the products/services are sold
i. Perfect competition – a firm can sell as much of a product it can produce, all
at a single market price.
ii. Imperfect competition – a firm’s price will influence the quantity it sells.
iii. Monopolistic market – a monopolist is usually able to change to a higher
price because it has no competitors
-
Supply and demand
-
Customer’s perception of value and price
-
Price elasticity of demand - effect of price changes on sales volume
i. High elastic demand – small price increases cause large volume declines.
ii. High inelastic demand – prices have little or no effect on volume
-
Legal requirements –both local and international

 Some Illegal pricing schemes:

1. Predatory Pricing – is establishing prices so low to drive out competition from the
market.
2. Discriminatory Pricing – is charging different prices to different customers for the
same product or services
3. Collusion Pricing (Cartel) – is where companies conspire to restrict output and set
artificially high prices.
-
Competitors’ action
Pricing Methods:

1. Cost-Based Pricing –starts with the determination of cost, then a price is set so that such
price will recover all costs in the value chain and provide a desired return on investment.
 Cost-Plus Price = Cost + Markup
 Prices may be based on:
i. Total Cost: Price = Total Cost + (Total Cost*MU %)
ii. Absorption Product Cost: Price = APC + (APC*MU %)
iii. Variable Manufacturing Cost: Price = VMC + (VMC*MU %)
iv. Total Variable Cost: Price = TVC + (TVC*MU %)

2. Market-Based Pricing (Buyer-Based Pricing) – are based on product’s perceived value and
competitor’s actions
 Target Price – is the expected market price for a product/service, considering the
consumer’s perceptions of the value and competitor’s reactions
 Target Price Less Target Profit = Target Cost
i. Target Costing – first determines the Target/Market Price at which it can sell its
product /service, and then design the product/ service that can be produced at
the target cost to provide the target profit.
ii. Value Engineering involves a systematic assessment of all aspects of the value
chain costs of a product/service from R&D, Design, Process Design, Production,
Marketing, Distribution, and Customer Service. The object is to minimize cost
without sacrificing customer satisfaction.
iii. Life-Cycle Costing involves determination of a product’s estimated revenue and
expense over its expected life cycle.
-
R & D Stage
-
Introduction Stage
-
Growth Stage
-
Mature Stage
-
Harvest/Decline Stage
iv. Whole-Life Cost are composed of:
-
Life Cycle; and
-
After purchase costs incurred by customers.
Reduction of Whole-Life Cost provides benefits, both to buyer and the seller.
Customers may pay a premium to a product with a low after-purchase cost.

3. Competition-Based Pricing is based on competitor’s prices

4. New Product Pricing (Introductory Price Setting)

 Price Skimming – the introductory price is set at a very high level. The objective is to sell
to customers who are not concerned about the price, so that the firm may recover R&D
costs.
 Penetration Pricing – is where the introductory price is set at very low level. The
objective is to gain deep market penetration quickly.
 RESPONSIBILITY ACCOUNTING

RESPONSIBILITY ACCOUNTING is an accounting system and managerial control device that

involves:
1. IDENTIFYING RESPONSIBILITY CENTERS with corresponding objectives
2. DEVELOPING MEASURES of achievement of such objectives
3. PREPARING/ANALYZING REPORTS of such measures

RESPOSIBILITY CENTER is a sub unit of an organization, such as department, division, plant,

business process, or any segment whose manager ahs authority over, and is responsible and
accountable for a specific or defined group of activities.
a. COST Center has control over the incurrence of costs but not over revenues or investments.
Ex. Maintenance Dept.
b. Revenue Center has control over Revenues. Ex. Sales Dept.
c. Profit Center has control over both cost and revenues. Ex. Branch
d. Investment Center has control over both Cost and Revenue, as well as over investment in
PPE, receivable, Inventory and Other Assets.
e. Service Center operated as Cost Center; exists primarily and solely to provide specialized
support to other segments or sub units of the organization.

ORGANIZATIONAL STRUCTURES:
 CENTRALIZED Organization – top management makes most decisions and controls most
activities of the organizational segments.
 DECENTRALIZED Organization – there is employee empowerment; top management
grants subordinates managers a significant degree of autonomy and independence.

 A Responsibility Accounting System works best in a decentralized organization.

BENEFITS of Decentralization:
1. Greater awareness of needs of people involved in sub unit.
2. More timely decisions.
3. Faster management development.
4. Greater initiative.
5. Improvement of employee’s morale.
6. Sharper management focus.

GOAL CONGRUENCE and MANAGERIAL EFFORT:

GOAL CONGRUENCE – one purpose of responsibility accounting system; a condition where
employee working on their own personal interests or the interest of their responsibility center,
make decisions that help meet overall goals of the firm.
MANAGERIAL EFFORT – the exertion of decision makers to reach a common goal or objectives;
includes all conscious actions such as planning and supervising.

 To achieve GOAL CONGRUENCE and MANAGERIAL EFFORT, employees must be properly

motivated.

SUB-OPTIMIZATION – occurs when one segment takes action in its best interest but detrimental
to the organization as a whole.

Other KEY CONCEPTS:

AUTHORITY – is the power to direct and exact performance from others.
RESPONSIBILITY – refers to obligation to perform.
ACCOUNTABILITY – duty report performance to one’s superior and the physical means to
substantiate performance.
CONTROLLABILITY – extent which a manger can influence activities, cost, revenues, or capital.

MANAGEMENT-BY-OBJECTIVES (MBO) – a behavioral, communication-oriented, responsibility

approach where a manager and his/her subordinates agree upon objectives and the means on
how such objective can be attained.

 PERFORMANCE EVALUATION
Managerial Performance should be evaluated on the basis of those factors controllable
by the manager being evaluated. To achieve this, it is best to use the CONTRIBUTION
APPROACH to performance measurement.

FINANCIAL PERFORMANCE MEASURES

Pro forma Statement

A B Total
Sales
Less: Variable Mftg. Cost
1 Mftg. Contribution Margin
Less: Variable Non-Mftg. Cost
2 Contribution Margin
Less: Controllable Fixed Cost
3 Short-run Performance Margin
Less: Direct Non-Controllable FC
4 Segment Margin
Less: Common Cost Allocated to Segment
5 Operating Income

6. Return on Investment (ROI) = *Income

** Investment
 Income may be: Operating Income; EBIT; Net Income; Net Income adjusted to Price
Level Change; or Cash Flow
** Investment Base may be: Total Assets; Total Assets used/employed (excluding idle asset);
Working Capital plus Other Assets; or Stockholders Equity

7. Residual Income is the excess of income earned by an investment center over the desired
income or return in invested capital.

Income earned by, or expected income xx

Less: Desired Income (Investment x Desired Rate of Return*) xx
Residual Income xx

DRR* is usually Cost of Capital

 Imputed Interest is the Target ROI

8. Economic Value Added (EVA) is a more specific version of Residual Income. It represents the
segment’s true economic profit because it measures the benefit obtained by using
resources in a particular way.

After-Tax Operating Income (EBIT x [1 – Tax Rate]) xx

Less: Desired Income (After-tax WACC x [TA-CL]) xx
Economic Value Added xx
-
Equity Spread (ES) – calculates equity value creation of shareholder value

Equity Spread (ES) = Equity Capital, Beg. X (Return on Equity – Percentage Cost of Equity)
-
Total Shareholder Return (TSR) = Change in Stock Price + Dividend per Share
Initial Stock Price
-
Market Value Added (MVA):
Market Value of Equity (Outstanding Shares x Market Price) xx
Less: Equity Supplied by Shareholders xx
Market Value Added (MVA) xx

 NON-FINANCIAL and other performance measures:

1. Frequency of REWORK 5. Customer’s Comments/COMPLAINTS
2. RETURNED merchandise 6. COMPETITIVE RANK
3. QUALITY LEVEL of Output 7. On-time DELIVERY
4. Total SET-UP TIME 8. PRODUCT DEVELOPMENT time

BREAK-EVEN TIME is the time when the cumulative Present Value of Cash Inflows is equal to
the cumulative Present value of Cash Outflows.

CUSTOMER RESPONSE TIME (DELIVERY CYCLE TIME) is the time period from the placement of
the order to the delivery of goods/services composed of:
 Order Receipt Time – period of time between placement of an order to its readiness for
set-up.
 Manufacturing Cycle Time /Manufacturing Lead Time/Throughput Time – period of time
from the moment the order is ready for setup to its completion.
 Order Delivery Time

9. MANUFACTURING CYCLE EFFICIENCY = Value-Added Production Time

Manufacturing Cycle Time

BALANCED SCORECARD Approach – a goal congruence tool or a performance measurement

system that strikes the balance between financial and operating measures, links performance
to rewards, and gives explicit recognition to the diversity of interest of stakeholders.

A typical scorecard includes measures of performance in terms of:

 PROFITABILITY
 CUSTOMER SATISFACTION
 INNOVATION
 EFFICIENCY, QUALITY and TIME
 TRANSFER PRICING

Transfer Price – is the amount charged by one segment for goods/services

transferred/provided to another segment.

Factors considered in selecting a Transfer Pricing Policy:

a. Goal Congruence – a transfer price should permit a segment to operate as an independent
entity and achieve its goals while functioning in the best interest of the organization.
b. Segmental Performance – the selling segment should not lose income by selling within the
company.
c. Negotiation – the buying segment should not incur greater costs by buying within the
company.
d. Capacity – if selling segment has:
 Excess Capacity, it should be used to produce goods for transfer within the company.
 No excess capacity, the selling segment should not incur a loss by selling to another
segment.
e. Cost Structure – the transfer price should be analyzed and broken down into variable and
fixed components.
f. Taxes

Transfer Price may be the:

 Market Price, if a market for goods/services exists.
-
A transfer price equal to prevailing market price encourages both the selling and the
buying segment to sell/buy internally.
 Incremental Cost plus Opportunity Cost to the seller.
-
The opportunity cost is usually the contribution margin lost from outside customers. The
transfer price is the minimum amount the selling segment would be willing to transfer
goods/services to another segment.
 Full Absorption Cost
-
Transfer price includes labor, materials and allocated FOH
 Cost plus Markup
-
Markup may be P or %; or
-
The cost may be the actual/standard cost
 Negotiated Transfer Price
-
Is appropriate when market price are subject to rapid fluctuation
Minimum Price –Seller’s Incremental VC plus Opportunity Cost
Maximum Price – the prevailing market price
 Dual Transfer Price
Seller segment records the transfer price at market price
Buyer segment records the purchased cost at cost (Variable Production Cost)
 OPERATING AND FINANCIAL BUDGETING

Budget – is a realistic plan, expressed in quantitative terms, for a certain future period of time.

Advantages:
 Used by management to communicate their plans and goals.
 Force management to plan for the future.
 Resources are appropriately allocated.
 Potential bottlenecks are discovered before they occur.
 Promotes coordination of activities
 Goals and objectives identified in the budgeting process serve as benchmarks/standards
for evaluating performance.

Budget Committee is composed of key management who are responsible for overall policy
matters relating to the budget program and fro coordinating the preparation of the budget.

Master Budget encompasses organization’s operating and financial plans for a certain future
period of time (Budget Period). It is composed of operating and financial budget.

Budget Manual describes how a budget is to be prepared. It includes:

 Budget Planning Calendar is the schedule of activities for the development and
adoption of the budget.
 Distribution Instruction for all Budget schedules, so that segments involved in budget
preparation would know to whom/from whom a computed budget schedule is to be
given/acquired.

Budget Report shows a comparison of actual and budget performance.

Types of Budgets and other Budgeting Concepts:

1. Master Budget and its components.
2. Fixed Budget is based only on one level of activity.
3. Continuous/Rolling Budget is revised on a regular/continuous basis.
4. Flexible Budget is a series of budgets prepared for many levels of activity.
5. Incremental Budgeting is a process where current periods budget is simply adjusted to allow
changed planned for the coming period.
6. Zero-based Budgeting is prepared every period from the base of zero. All expenditures must
be justified.
7. Life-Cycle Budget is where a product’s revenues and expenses are estimated over its entire
life cycle (from R&D to withdrawal of customer support)
8. Activity Based Budgeting is where the activities are identified, a cost pool is established for
each activity, cost driver is identified for each pool, and the budgeted cost for each pool is
determined by multiplying the budgeted demand for activity by estimated cost per unit.
9. Kaizen Budgeting assumes continuous improvement of products and processes, the effects
of improvement and the costs of their implementation are estimated.
10. Governmental Budgeting is not only a financial plan and basis for performance evaluation
but also an expression of public policy and form of control having the force of law.
 OVERVIEW OF MASTER BUDGET

SALES BUDGET

ENDING INVENTORY BUDGET

PRODUCTION BUDGET
(RM, WIP, FG)

MATERIAL COST BUDGET LABOR COST BUDGET FOH COST BUDGET

COGS/COS BUDGET R&D/DESIGN COST

BUDGET

MARKETING COST
BUDGETED INCOME BUDGET
STATEMENT
DISTRIBUTION COST
BUDGET

CUSTOMER SERVICE COST

BUDGET

ADMINISTRATIVE COST
BUDGET

FINANCIAL BUDGET:

CAPITAL EXPENDITURE BUDGETED BALANCE

BUDGET CASH BUDGET SHEET

BUDGETED STATEMENT OF
CASH FLOWS
 ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Financial Statement Analysis involves careful selection of data from financial statements in
order to assess and evaluate the firm’s past performance, its present condition, and business
potentials.

OBJECTIVES:
The primary purpose of FS Analysis is to evaluate and forecast the company’s financial
health. Interested parties can identify the company’s financial strengths and weaknesses and
know about:
 PROFITABILITY of the business
 Firm’s ability to MEET OBLIGATIONS
 SAFETY OF THE INVESTMENT in the business
 EFFECTIVENESS OF MANAGEMENT in running the firm

GENERAL APPROACH to FS Analysis:

 Evaluation of the ENVIRONMENT
 Analysis of SHORT TERM SOLVENCY
 Analysis of CAPITAL STRUCTURE and LONG-TERM SOLVENCY
 Evaluation of MANAGEMENT’S EFFICIENCY
 Analysis of PROFITABILITY

PROBLEMS/LIMITATIONS of FS Analysis:
1) COMPARISON OF FINANCIAL DATA
* Difference between companies
* Difference in accounting methods and estimates
* Valuation problem – Historical Cost do not reflect Current Market Value of Firm’s Assets.
The effects of price level changes must be considered.
* The timing of transactions and use of averages in applying various techniques
2) THE NEED TO LOOK BEYOND RATIOS
Ratios are not sufficient, thus, other factors must be considered, such as:
 Industry trends
 Changes in technology
 Changes in consumer tastes
 Change in the economy
 Changes within the company

STEPS in FS Analysis:
1. ESTABLISH THE OBJECTIVES of the Analysis
2. STUDY THE INDUSTRY where the firm belongs
3. STUDY THE FIRM’S BACKGROUND and quality of its management
4. EVALUATE THE FIRM’S FS using the evaluation techniques
5. SUMMARIZE THE RESULTS of the studies and evaluation
6. DEVELOP CONCLUSIONS relevant to established objectives
 TECHNIQUES IN FINANCIAL STATEMENT ANALYSIS

A. HORIZONTAL Analysis (Trend Ratios and Percentages)

Involves comparison of figures shown in the Financial Statements of two or more
consecutive periods.

Percentage Change = RECENT Value – BASE PERIOD Value

BASE PERIOD Value

B. VERTICAL Analysis (Common Size Statements) is the process of comparing figures in the
Financial Statements of a single period. This is accomplished by expressing all figures in the
statements as percentages of an important item such as Total Assets (BS) or Total/Net Sales
(IS). These converted statements are called common-size statements or percentage
composition statements.

C. RATIO Analysis provide users with relevant information about the firm’s Liquidity, use or
leverage, asset management, cost control, profitability, growth and valuation.

a. LIQUIDITY Ratios provide information about the firm’s ABILITY TO PAY its CURRENT
OBLIGATIONS and continue operation.

RATIO FORMULA SIGNIFICANCE

 Current Ratio/Working Current Assets
Test of Short-term debt
Capital Ratio/Banker’s Current Liabilities
paying ability
Ratio
Quick Assets
Current Liabilities
Measure firm’s ability to pay
 Acid Test/Quick Ratio short-term debt without
Quick Assets = Cash + Cash
relying on inventory
Equivalents + Net Receivables +
Marketable Securities
Cash + Cash Equivalents + More conservative acid-test
 Cash Ratio Marketable Securities ratio; no inventory and
Current Liabilities receivables
Cash + Cash Equivalents +
Measure liquidity of current
 Cash to Current Ratio Marketable Securities
assets
Current Assets
Operating Cash flow Show significance of cash flow
 Cash flow Ratio
Current Liabilities for settling obligations
Cash Equivalents + Net Receivables Reflects percentage of near
 Defensive Interval + Marketable Securities cash items to daily operating
Daily Operating Cash flow cash flow
Increase in Retained Earnings + Shows amount of current
Depreciation investment that was financed
 Investment Financing
Current Investment by Depreciation and Retained
Earnings
Weighted Non-Cash Current Assets
Current Assets Measure of liquidity of
current assets stated in days.
 Liquidity Index Non-Cash Current Assets are Shows period to period
weighted by multiplying their changes in an equity’s
balances by average days they are liquidity
removed from conversion to cash.
b. LEVERAGE Ratios measure the company’s USE OF DEBT to finance assets and operations.

FINANCING LEVERAGE (trading on equity) – the use of debt to finance assets and operations. It
is advisable to trade on equity when earnings from borrowed funds exceed the cost of
borrowing.
- as leverage increases, the risk borne by creditors, as well as the risk that the firm may not be
able to meet maturing obligations.
- since interest expense is tax deductible, leverage increases the company’s return when it is
profitable.

SOLVENCY is the firm’s ability to pay long-term obligations.

Key Ingredients:
1. Capital Structure – sources of financing.
a. Equity (Risk Capital) – ownership interest
b. Debt – interest of creditors
2. Earning Power – the capacity of the firm’s operations to produce cash inflows.

RATIO FORMULA SIGNIFICANCE

 Financial Leverage Ratio/ Amount of asset financed by
Ave. Total Assets
Equity Multiplier/ Leverage equity.
Ave. Common Equity
Factor ↑Ratio, ↑Leverage, ↑Risk
Return on Common Equity
 Financial Leverage Index Index > 1 = Favorable
Return on Assets
Measures the extent of capital
Interest Bearing Debt
 Interest-Bearing Debt Ratio is financed by interest-bearing
Equity + Interest Bearing Debt
debt.
Total Liabilities Measures the percentage of
 Total Debt Ratio
Total Assets funds provided by creditors.
Compares resources provided
Total Liabilities
 Debt to Equity ratio by creditors with resources
Equity
provided by shareholders.
 Debt to Tangible Networth Total Liabilities More conservative measure of
Ratio Equity – Intangible Assets long-term debt payment.
Indicators margin of safety for
 Times Interest Earned/ EBIT
payment of fixed interest
Interest Coverage Ratio Interest Expense
charges.
EBIT + Interest Portion of Indicates margin of safety for
 Fixed Charge Coverage
Operating Lease payment of all fixed charges.
Ratio/ Earnings to Fixed
Interest + Interest Portion of
Charges Ratio
Operating Lease
Operating Cash Flow Measures portion of total
 Operating Cash Flow to
Total Debt liabilities that can be paid out
Total Debt Ratio
of cash flows from operation.

c. COST MANAGEMENT Ratios measure how firm CONTROLS ITS COST.

RATIO FORMULA SIGNIFICANCE

Measure how much can be
 Gross Profit Net Sales – COS
spent for marketing, R&D and
Rate/Percentage Net Sales
Administrative Costs.
 Labor Cost Ratio Labor Cost Measures percentage of labor
Net Sales cost to sales.
 Employment Growth No. Workers, Present – Base Year Measure operational growth.
Rate No. Workers, Present
d. ASSET MANAGEMENT Ratios measure how a firm USES ITS ASSETS TO GENERATE REVENUE and
income.
RATIO FORMULA SIGNIFICANCE
 Finished Goods/ COS Indicates if a firm holds
Merchandise Inventory TO Ave. Inventory excessive inventory.
No. of Days in a Year
 Average Age of Inventory TO Measures average number of
Inventories/No. of Days Or days that inventory is held for
Invty. Ave. Inventory sale.
Ave. Daily COS
Net Credit Sales Measures average number of
 Receivable TO Ratio
Ave. Accts. Receivable days to collect receivable.
No. of Days in a Year
 Ave. Age of Receivables/ No. Receivable TO Ratio
Measures average number of
of Days of Receivable/Ave. Or
days to collect receivable.
Collection Period Ave. Accounts Receivable
Ave. Daily Sales
Measures average number of
 Operating Cycle or Ave. Age of Inventories + Ave.
days to convert inventories to
Conversion Period Age of Receivables
cash.
 Average Age of Accounts Ave. Accts. Payable Determines if a firm is paying
Payable Ave. Daily Purchase its invoices on a timely basis.
 Fixed Assets TO Ratio Net Sales Measure level of use of PPE
Ave. Net Fixed Assets
Measures level of capital
Net Sales
 Total Assets TO Ratio investment relative to sales
Ave. Total Assets
volume.
Net Sales Measures the level of total
Total Capital assets having explicit costs
relative to sales volume.
 Total Capital TO Ratio
Total Capital = Total Assets
having explicit costs (Equity +
Interest Bearing Debt)
 Investment rate Total Capital, Present– Base Measures percentage of
Year change in total capital.
Total Capital, Base Year
 Plowback Ratio Measures the percentage of
Amount Available for net income available for
Reinvestment investment.
Net Income  ↑Rate = ↓
External Financing

e. PROFITABILITY Ratios measure EARNINGS in relation to some base.

RATIO FORMULA SIGNIFICANCE
 Profit Margin on Sales/ Net Net Income Measures percentage of net
Profit Percentage Net Sales income to sales
 Net Operating Income to Measures percentage of
EBIT
Sales operating income to sales.
Net Sales
 Return on Investment/ Indicated whether
Net Income
Return on Total Assets/ management use funds.
Ave. Total Assets
Return on Invested Capital
 Net Operating Income to EBIT Variation of return or
Total Capital Equity + Interest-Bearing Debt investment.
Change in EBIT Variation of return or
 Marginal Profitability Rate
Change in Capital investment.
 NI – Preferred Dividends Measures the return on
 Return on Common Equity
Ave. Common Equity carrying amount of equity
 Marginal Return on Change in Net Income Variation of return on
Common Equity Change in Common Equity common equity.
NI – Dividends on
 Return on Total Equity Redeemable Preferred Stock
Ave. Total Equity
Net Operating Profit after Measure of shareholder value
Taxes – Capital Charge/Total creation.
 Economic Value Added Cost of Capital
(EVA)
Capital Charge = Total Capital
employed x WACC

f. GROWTH Ratios measure the CHANGES IN ECONOMIC STATUS of a firm over a period of time.
RATIO FORMULA SIGNIFICANCE
Income Available to Common Reflect the company’s earning
 Basic Earnings per Share
Shareholders power.
(BEPS)
Ave. Common Shares Outstanding
Earnings per Share Shows the relationship of
 Earnings Yield Market Price per Share earnings per share to market
price per share.
Cash provided by Operations less Indicator of short term
Preferred Dividends capacity to make capital
 Cash flow per Share
Common Shares Outstanding outlays and dividend
payments.
Cash Dividends per Common Shows whether firm pays out
 Dividend Payout Ratio Share most of its earning s in
Earnings per Share dividends or reinvests it.
Cash Dividend per Common Share Shows the relationship of
 Dividend Yield Market Price per Common Share common dividends per share
to market price per share.
Net Cash provided by Operations Measures the ability to pay
 Ratio of Operating Cash flow
Cash Dividend dividends from current
to Cash Dividend
operating sources.
Amount Retained Measures the percentage
 Internal Growth Rate Asset Base increase in assets kept in the
business.
Return on Common Equity * (1- Measures the relationship of
 Sustainable Equity Growth
Dividend Payout Ratio) earnings retained and the
rate
return thereon.

g. VALUATION Ratios measure of SHAREHOLDER VALUE as reflected in the price of firm’s stock
RATIO FORMULA SIGNIFICANCE
Measures amount of net
Equity
 Book Value per Share assets available to
Shares Outstanding
shareholders.
Measures how high is the
shares’ market price in
 Market to Book Ratio or Market Price per Share
relationship to Book Value.
Price to Book Ratio Book Value per Share
Well-managed firms should
sell at High multiples.
 Price Earnings Ratio Market Price Measure relationship
Earnings per Share between the shares’ market
price and earnings per share.
 Growth companies likely to
have high PE ratio.
Measures what shareholders
Dividend Yield + Capital Gains
 Return to Shareholders actually earn over a specified
Measurement Period
period.
Reflects the market valuation
of new investment.
Market Value of All Securities
 Q Ratio Q Ratio > 1 means the firm is
Replacement Cost of Assets
earning return greater than
the amount invested.
Dividends per Share + Market Calculation of return or the
 Return on Shareholder’s
Value of Reinvented Earnings price of common shares.
Investments (ROSI)
Price per Share

GP Variance for Two or more products:

* 4-Way Analysis, Plus:

SALES MIX Variance:
Actual Units X SP XX
Less: Actual Units X Cost XX XX
Less: Actual Units x (Budgeted/Std./Base) GP/Unit XX
SALES MIX VARIANCE XX

FINAL SALES VOLUME Variance:

Actual Units x (Budgeted/Std. Base) GP/Unit XX
Less: Budgeted/Std./Base GP XX
FINAL SALES VOLUME XX

D. Analysis of VARIATION IN GROSS PROFIT AND NET INCOME

-
The General Price Level is inversely related to the purchasing
-
power of money.

Effect of Changing Price Levels:

INFLATION – an INCREASE in general price level
DEFLATION - a DECREASE in general price level

Price Indices used in calculation of Price Level Changes:

 CONSUMER PRICE Index (CPI) measures price level by monthly pricing of specific set of
goods/services purchased by typical urban consumer.
 GROSS DOMESTIC PRODUCT PRICE Index (GDP Deflator) includes the prices of all goods
and services produced in the country.
 PRODUCER PRICE Index measures the prices of specified commodities at the time of
their first commercial sale.

IMPACT OF INFLATION:
* Higher rates of inflation lead to higher interest rates which discourage investments.
* Inflation increases prices of resources, increasing demand for capital.
* If tax structure is not indexed for inflation. Taxpayers may be pushed to higher tax brackets
ever though real income has not increased
* Inflation distorts profit
* Accuracy of business planning prediction is reduced
* Inflation hurts creditors, fixed income groups, and savers, but benefits debtors.

E. CASH FLOW Analysis is a detailed study of net change in cash as a result of operating,
investing, and financing activities during the period.
STATEMENT OF CASH FLOW is the basic FS prepared and used in analyzing cash flows.

CASH FLOWS include Cash and Cash Equivalents.

CASH EQUIVALENTS are short term, highly liquid investments that are:
-
readily convertible to known amounts of cash; and
-
so near their maturity date that their market value is relatively insensitive to
changes in interest rates.

CLASSIFICATION of Cash Flows:

 OPERATING Activities – cash effects of transactions that create revenue and expenses;
generally relate to current assets and current liabilities.

Cash Inflow Cash Outflow

- -
Sale of goods and services Payment to suppliers
- -
Interest income Salaries and wages
- -
Dividend income Taxes
-
Interest expense
-
Payment of other expenses

 INVESTING Activities – generally relate to changes in non-current assets.

Cash Inflow Cash Outflow

- -
Sale of PPE Purchase of PPE
- -
Sale of Debt and Equity Securities Purchase of Debt and Equity Securities
- -
Collection of principal on loans Lending money

 FINANCING Activities – relates to changes in long-term liabilities and stockholder’s equity.

Cash Inflow Cash Outflow
- -
Sale of company’s stock Payment of dividends
- -
Issuance of Bonds or Notes Redemption of long-term debt
-
Reacquisition of Capital stock

 SIGNIFICANT NON-CASH Activities:

These are not reported in the body of Statement of Cash Flows. These are reported in a
Separate Schedule or in a separate Note/Supplementary Schedule.
 GROSS PROFIT VARIANCE ANALYSIS

3-way Analysis:

VOLUME/QUANTITY Factor = Difference in Units x [Budget/Standard/Base]GP per unit

PRICE Factor = Difference in Selling Price x Actual Units
COST Factor = Difference in Cost x Actual Units

4-way Analysis:

 SALES Variance
PRICE Factor = Difference in Selling Price x Actual Units
VOLUME/QUANTITY Factor = Difference in Units x [Budget/Standard/Base]SPrice
 COST Variance
PRICE Factor = Difference in Cost x Actual Units
VOLUME/QUANTITY Factor = Difference in Units x [Budget/Standard/Base]Price

6-way Analysis:

 SALES Variance
PRICE Factor = Difference in Selling Price x [Budget/Standard/Base] Units
VOLUME/QUANTITY Factor = Difference in Units x [Budget/Standard/Base]Price
PRICE-VOLUME Factor = Difference in SP x Difference in Units
 COST Variance
PRICE Factor = Difference in Cost x [Budget/Standard/Base] Units
VOLUME/QUANTITY Factor = Difference in Units x [Budget/Standard/Base]Cost
PRICE-VOLUME Factor = Difference in SP x Difference in Units
 NONFINANCIAL PERFORMANCE MEASURES

Companies have traditionally relied heavily on financial performance measures to

evaluate employee performance. In recent years, more and more companies have begun using
nonfinancial measures, such as customer satisfaction and product quality, because nonfinancial
performance measures direct employees’ attention to what they can control.

This chapter discusses innovative ways to evaluate performance “beyond the numbers”.
Performance evaluation begins with an understanding of the organization’s goals.

VALUES OF THE ORGANIZATION

A mission statement describes the organization’s values, makes specific commitments to

those who have an interest in the organization (such as shareholders) and identifies the major
strategies the organization plans to use to achieve its goals. Identifies the major strategies the
organization plans to use to achieve its goals.
Mission statements should answer the following statements:
1. Who are the organization’s stakeholders? Who matters to the organization?
2. How will the organization add value to each stakeholder group? This identifies the critical
success factors which are those factors important for the organization’s success.

ETHICAL BEHAVIOR

The organization’s mission statement communicates its guiding principles, beliefs, and
values. It helps people in the organization identify priorities. This guides employees as they
make decisions that help the organization achieve its goals. Communicating what the
organization stands for and what it needs to do to be successful is the foundation of the
organizational performance.

BALANCED SCORECARD

The balanced scorecard is a management method that focuses attention on achieving

organizational objectives. It recognizes that organizations are responsible to different
stakeholder groups, such as employees, suppliers, customers, business partners, the
community, and shareholders. The balanced scorecard is a set of performance targets and
result that show an organization’s performance in meeting its objectives relating to its
stakeholders.

Sometimes different stakeholders have different wants. The organization must balance
those competing wants. Hence, the concept of a balanced scorecard is to measure how well the
organization is doing in view of competing stakeholder wants.

For many years, organizations focus only on financial results, which reflected mainly the
shareholders’ interests. In recent years, organizations have shifted attention to customer issues,
such as quality and service, to employees, and to the community.

The balanced scorecard has been developed and used in many companies. Mostly, it has
been used at the top management level where it supports the company’s strategic
management system.

The balanced scorecard concept has been helpful for top and middle management to
shape and clarify organizational goals and strategy. It has been useful at the worker level, when
the complex trade-offs implied by the balanced scorecard are translated into simple
performance measures.
BALANCED SCORECARD

“To succeed FINANCIAL

financially, Objectives Measures Targets Initiatives
how should we
appear to our
shareholder?”

“To achieve CUSTOMER

our mission, Objectives Measures Targets Initiatives
how should we
appear to our
customers?”

VISION
AND
STRATEGY

“To satisfy our INTERNAL BUSINESS PROCESS

shareholders, and Objectives Measures Targets Initiatives
customers, at
what business
processes must
we excel?”

“To achieve LEARNING AND GROWTH

our mission, Objectives Measures Targets Initiatives
how will we
sustain our
ability to
change and
improve?”
PERFORMANCE EVALUATION: THE PROCESS

CONTINUOUS IMPROVEMENT AND BENCHMARKING

Continuous improvement means continuously reevaluating and improving the efficiency of

activities. It is search to (1) improve the activities in which the organization engages through
documentation and understanding, (2) eliminate activities that do not add value, and (3)
improve the efficiency of activities that do not add value.

Competitive benchmarking involves the search for, and implementation of, the best way to do
something as practiced elsewhere in one’s own organization or in other organizations.
Benchmarking identifies an activity that needs to be improved, finds an organization that is the
most efficient at that activity, studies its process, and then utilizes that process. Companies also
use benchmarking to make dramatic one-time breakthroughs.

Following are some important benchmarking guidelines:

1. Don’t benchmark everything at the best-in-the-business level. No company can be the best at
everything.
2. Benchmark only best-in-class processes and activities that are the most important
strategically.
3. Look for internal, regional, or industry benchmarks for less important activities.

PERFORMANCE MEASUREMENT: THE MEASURES

VALUE CHAIN ANALYSIS

There is no single set of right performance measures that can be espoused in a textbook.
Performance measures must be based on the organization’s goals and strategy, which are likely
to be different for each organization.

The value chain provides a good place to begin identifying the most useful factors to measure.
Recall that the value chain is the linked set of activities that an organization undertakes to
produce a good or service. Use the value chain activities that, if measured, would give
managers and workers the best incentives to achieve the organization’s goals.

Suppliers Organization Strategy and Administration Customers

Research and Customer
Design Production Marketing Distribution
Development Service

CUSTOMER SATISFACTION PERFORMANCE MEASURES

Customer satisfaction reflects the performance of the organization on quality control and
delivery performance.
Quality Control The objective is to increase customer satisfaction with the product, reduce the
costs of dealing with customer complaints, and reduce the costs of repairing products or
providing a new service.
Delivery Performance The objective is to deliver goods and services when promised so
customers will continue to buy goods and services from you and provide word-of-mouth
advertising.

FUNCTIONAL PERFORMANCE MEASURES

An organization must do internal functional performance evaluation. Many activities are
performed throughout the product life cycle. The efficiency level of these activities affects the
overall performance of the organization in attaining its goals for other stakeholders, such as
stockholders and employees.

Functional Measures of Performance

Accounting Quality
Percent of Late Reports
Percent of Errors in Reports
Manager Satisfaction with Accounting Reports
Clerical Quality
Errors per type page
Number of times messages are not delivered
Forecasting Quality
Percent error in sales forecasts
Usefulness of forecasts to decision makers
Procurement/Purchasing Quality
Percent of supplies received on schedule
Average time to fill emergency orders
Production Control Quality
Time required to incorporate engineering changes
Time that line is sown due to shortage of materials

TIME MEASURES

The total time it takes to produce a good or service is called production cycle time. The cycle
time includes processing, moving, storing, and inspecting. It is commonly believed that a
product’s service, quality, and cost are all related to cycle time. A cycle time increases, so do
the costs of processing, inspection, moving, and storage, while service and quality decrease.

Organizations may also find value in knowing the amount of time it takes to complete a
sequence of activities. Many believe that by eliminating long cycle times, the costs of
nonproduction personnel, equipment, and supplies would be reduced. Also, customers value a
prompt response and a short processing time.

Production Cycle Efficiency measures the efficiency of the total production cycle. This formula
produces a percentage that represents the time that is actually spent processing the unit. The
higher the percentage, the less time-and costs-spent on nonvalue-added activities such a
moving and storage.

ENVIRONMENTAL PERFORMANCE

Many companies are concerned about environmental issues and attempt to measure their
performance and provide incentives for good performance.

Waste Ratio is a performance measure to track waste minimization:

Waste Ratio = Waste (Pounds)

Total Output (Pounds)

The waste minimization program is an attempt to add environmental performance to other

performance measures, such as efficiency variances and customer satisfaction. By measuring
environmental performance and rewarding good performance, companies hope to provide
incentives for their employees to create a clean environment. Good environmental
performance is also in a company’s best interest because it reduces governmental regulations,
fines, litigation costs and ill will from the community.

EMPLOYEE INVOLVEMENT

Many organizations involve workers in creating ideas for improving performance. In some
Japanese companies, every worker is expected to submit an idea for improvement at least once
a week. Competent managers know that workers have good ideas for improving the operations
of a company. After all, the workers are much closer than the managers to an organization’s
production and sales activities.

Worker involvement is important for three reasons:

1. Many managers believe that when workers take on real decision-making authority, their
commitment to the organization and its goal increases.
2. When decision-making responsibility lies with the workers closer to the customer, decision
making becomes more responsive and informed.
3. Giving decision-making responsibility to workers uses their skills and knowledge and
provides them with motivation to further develop their skills and knowledge in their effort
to improve the organization’s performance.

Effective worker involvement decentralizes decision-making authority and empowers workers.

Effective worker involvement presents three challenges for management.
1. Management must create a system that conveys the organization’s goals and critical
success factors to all members. Information, training sessions, and the performance
indicators themselves will determine the extent to which employees understand.
2. The measures the organization uses to judge individual performances will determine the
success of the system in promoting goal congruence. Management must analyze the
performance measures chosen by each organizational unit to make sure that they (a)
promote the desired behavior, (b) are comprehensive, (c) support the achievement of
the organizational goals, and (d) reflect the unit’s role in the organization.
3. Management must ensure that the performance measures are applied consistently and
accurately. The measures used to evaluate performance reflect each other’s unit’s
understanding of its contribution to the magazine.

Performance Measures of Worker Involvement and Commitment

1. Worker Development : Measured by percentage of workers in mentor programs
2. Worker Empowerment : Measured by percentage of workers authorized to issue credit
3. Worker Recognition : Measured by percentage of workers recognized by awards
4. Worker Recruitment : Measured by percentage of employment offers accepted
5. Worker Promotion : Measured by percentage of positions filled from within the
company
6. Worker Succession Planning: Measured by percentage of eligible positions filled through
succession planning
 QUANTITATIVE TECHNIQUES

Rationale: Management Accountants use QTs in developing necessary information needed by

the management in carrying out their functions that include planning, controlling, and decision
making.

Basic Reasons using QT in business:

→ Managers aim to influence the future. To do that, the future must be predicted. Second,
plans must be in place. Third, actions should be controlled to see to it that it conforms with the
plans.
→ QT in business, in accordance with the basic objective of managing the future, may be
classified as follows:
↔Predictive Techniques
 Probability deals with a chance that a future event may or may not occur.
 Statistics deals with measurement, normally based on samples. Samples may be chosen
based on unrestricted sampling or restricted sampling. It measures the central tendency
(i.e., average, middle point, or normal occurrence), variability (i.e., variance, standard
deviation, and coefficient of variation), and test of hypothesis (i.e., z-test, chi square,
etc.)
 Expected Value is the estimated value of a set of future events. May be simple average
expected value or a weighted average expected value. Though the latter is more
accurate to use and is the one determined if the problem is silent. The Decision Tree
Analysis also uses this technique.
 Forecasting
 Simulation and Sensitivity Analysis (Predictive Value Analysis) anticipates the future
event by anticipating the changes in the parameters and affecting their values thereof.
Examples are Continuous Probability Simulation, Monte Carlo Simulation and Value
Chain Analysis.
↔ Optimizing Techniques
 Linear programming is a technique applied to optimize the use of limited resources.
Limited Resources may include direct labor hours, machine hours, materials, money,
market, and other constraints in business organizations. Methods used may be the
equation method, graphical method, or tabular method. Transportation Table and
Simplex Table are special methods of linear programming.
 Waiting line Theory (Queuing Theory) deals with balancing the cost of providing a
service unit with the savings that could be derived from reducing the waiting line.
↔ Controlling Techniques
 Network Models relates to project management. A project consists of related and
interrelated activities. These activities must be organized and planned to endure a cost-
effective operations. Techniques used in project management are Gantt chart, Critical
Path Method (CPM), and Program Evaluation Review Technique (PERT).
 Quality Tools are also aimed to provide valuable monitoring information and standards
for higher productivity rate and minimization or elimination of waste and errors. Quality
tools include statistical graphs (such as histogram, bar graph, pie graph, X graph,
productivity graph, and regression line), Pareto’s law, fish-bone analysis, Taguchi quality
control technique, and mini-max analysis.
→ These QT in business are also used in budgeting process. They are used to develop and
organize the plans of the business.

Quantitative Models (Mathematical Models):

Real life decision situations are modeled mathematically under certain assumptions in
order to achieve a deterministic solution.
Simulation - a technique for experimenting with logical/mathematical models using a
computer.

Steps in Simulation:
a. Defining an Objective.
b. Formulating a Model – variables, their behavior, and their interrelationships are spelled
out in precise logical/mathematical terms.
c. Validating the Model – to ensure realistic results.
d. Designing the Experiment – involves sampling the operation of the system.
e. Conducting the Simulation and Evaluating the Results.

Commonly Used QUANTITATIVE MODELS:

 Probability Analysis
 Decision Tree
 Gantt Chart
 PERT (Program Evaluation and Review Technique)
 Linear Programming
 Learning Curves
 Sensitivity Analysis
 Regression Analysis
 Present Values
 Inventory Models

A. PROBABILITY ANALYSIS – is commonly used in Planning, as well as Decision-Making under

Certainty.
 Decision-making under Certainty – for each decision alternative, there is only one event,
and therefore only one outcome. (100% chance of occurrence)
 Decision-making under Conditions of Risk – the probability distribution of possible
future states of nature is known.
 Decision-making under Conditions of Uncertainty – each alternative has several
events/outcomes. The probability distribution of possible future states of nature is not
known and must be determined subjectively.

Probability – a mathematical expression of doubt or assurance about the occurrence of a

chance vent. Its value varies from 0 to 100.
 Probability of 0 – event cannot occur
 Probability between 0 and 1 - indicates likelihood of event’s occurrence
 Probability of 1 to 100 - event is certain to occur

Types of Probabilities:
1. Objective Probabilities - is calculated from either Logic or Actual Experience.
2. Subjective Probabilities – are based on Judgment and Past Experience.

Probability Distribution – specifies the values of variables and their respective probabilities.

Basic Terms Used in Probability Analysis:

Mutually Exclusive – two events cannot occur simultaneously.
Joint Probability – both events will occur.
Conditional Probability – one event will occur if the other event has already occurred.
Independent Events – occurrence of one event do not affect the other event.
Dependent Events – occurrence of one event has effect on the other event.
Payoff - the value assigned to different outcomes from a decision.

→ EXPECTED VALUE - is calculated by multiplying the probability of each outcome by its payoff
and summing the products.
 -
Represents the Long-term Average Payoff from repeated trials.
→ PAYOFF (DECISION) TABLE – presents the outcomes (payoffs) of specific decisions when
certain states of nature (non-controllable events) occur.
-
Is a helpful tool for identifying the best solution given several decision
alternatives and future conditions that involve risk.
→ EXPECTED VALUE OF PERFECT INFORMATION (EVPI) – is the difference between Expected
Value without Perfect Information and the result, if the Best Course of Action is taken.

Expected Value without Perfect Information xx

Less: Best Course of Action (xx)
EVPI xx

Perfect Information – the knowledge that a future state of nature (event) will occur with
certainty.
-
Assumed that no probability distribution is an accurate representation.
Cost of Perfect Information:
Management may have the opportunity to acquire additional information that may help
in choosing the best alternative. However, obtaining information requires incurrence of cost.

B. DECISION TREE – is a graphic representation of decision points, the alternative courses of

action available to the decision maker, and the possible outcome from each alternative, as
well as relative probabilities and the expected values of each event.

ADVANTAGES DISADVANTAGES
 Facilitate evaluation of alternatives by  May be difficult to determine all possible
giving a visual presentation of expected events, outcomes, and their probabilities
results of each alternative
 Useful when sequential people are  A case involving many events and
involved sequential decisions may result into a more
complex decision tree which may not be
easy to use

Nodes – intersections in a decision tree.

 - Decision Points/Nodes
-
The points at which the decision-maker must choose an action.
 - Chance Points (State of Nature/Probability Nodes
-
Points at which some event are related to the previous decision will occur
---- - Branches/connectors

Steps in Preparing:
1. Identify the decision points and chance points.
2. Determine events that may result from chance points
3. Estimate outcomes (payoffs) of each event, as well as their estimated probabilities.
4. Compute expected value of outcomes.
5. Evaluate the results and choose the best course of actions.

C. GANTT CHART (Bar Chart) – shows the different activities or tasks in a project, as well as
their estimated start and completion times.

ADVANTAGES DISADVANTAGES
 Simple to construct and use, can be used  does not show interrelationships among
on small type of projects. activities in a project
 Very useful control tool  Only simple relationships can be shown
 Can be used to monitor activities in a
project
D. LEARNING CURVES (Experience Curve) – a mathematical expression of phenomenon that
incremental unit cost to produce (or incremental unit time to produce) decrease as
managers and labor gain experience from practice.

-
The Learning Curve Model shows constant percentage reduction (from 20% to 40%) in
average direct labor input time required per unit as Cumulative Output Doubles.

E. SENSITIVITY ANALYSIS – study of how outcome of a decision process changes as one or

more of assumption changes.

F. QUEUING THEORY (Waiting Line Theory) – a study of random arrivals at a processing or

servicing facility of limited capacity it allows the decision maker to calculate the:
1. Length of future waiting lines;
2. Average time spent in line awaiting service/processing;
3. Additional facilities required; and
4. Service level/capacity that minimizes waiting and operating costs.

Examples: - Check Out Counters/Cashiers

-
Movie Ticket Booths
-
Expressway toll booths
-
School (Registrar’s) Office Windows
-
Bank Teller Windows

OBJECTIVE: To minimize total cost involved, both service and waiting cost.

Costs involved:
1. Faculty and Operating Costs – cost of providing service
2. Waiting Cost – cost of idle resources waiting on line, including income foregone
(opportunity cost) in case of waiting customers.

FORMULA:
N=average no. of work units waiting in line/serviced Nq=average no. in waiting line
B=average no. of work units arriving in one unit time W=average waiting time before
T=average no. of work units serviced in one unit time service

i. N= B ii. Nq = B2 iii. W = Nq
T-B T (T-B) B

G. LINEAR PROGRAMMING – a quantitative technique used to find optimal solution to short-

term resource allocation problems, such as:
1. Maximization of revenue, contribution margin, or profit function
2. Minimization of cost function, subject to constraints

Formulating a Linear Program:

i. Identify decision variables
ii. Express the objective and constraint functions in terms of decision variables
 Decision Variables-the unknown used to construct the objective and constraint
functions.
 Constraints-limit the values of variables.
 MELD-the feasible region, where all constraints are satisfied.

Methods for Solving Linear Programming Problems:

 Graphical Method – limited to problems with only two variables.
  Simplex Method – applicable even when there are more than two variables, based on a
matrix/linear algebra and provides a systematic way of algebraically evaluating each
corner point in a feasible area.

Other Business Applications:

 Determination of Best Product Mix
 Determination of Optimum Materials Mix
 Assignment of jobs to Manufacturing Equipment
 Workforce Scheduling
 Determination of Transportation Routes
H. PROGRAM EVALUATION AND REVIEW TECHNIQUES (PERT) – a networking technique used
for planning and controlling the activities in a project. It provides management pertinent
information about a project, such as:
→ Expected completion time.
→ When each activity is scheduled to start and finish
→ Which part of the project must be finished first to avoid making the whole project late.
→ How resources may be shifted from one part to another part.
→ The progress of each part as of a certain date.

PERT Diagram – an arrow diagram on a network showing interrelationships or

interdependencies of the various activities of the project. Although more complex than the
Gantt Chart, it has the advantage of incorporating probabilistic time estimates and identifying
the critical path.

-Node - can be called an event when all activities leading to a node are finished.
Event - represents a specific accomplishment at a particular instant in time; represents
the start or finish of an activity.
→-Branch – represents the activities in a project.
Activity – task to be accomplished; represents the time and resources necessary to move
from one node/event to another.
Types of Activity:
 Series – an activity cannot be performed unless its predecessor activity is finished.
 Parallel – activities can be performed simultaneously.

Formula:
to = optimistic time; tm = most likely time; tp = pessimistic time; te = expected time
te = to + 4tm + tp
6
CRITICAL PATH METHOD (CPM) – may be considered as a subset PERT. CPM is a network
technique that uses deterministic time and cost estimates. Aside from cost estimates, CPM
includes the concept of crash efforts and crash costs.

Critical Path – the longest path thru the network.

 A delay in the completion of activities in the critical path would cause a delay in the
completion of the entire project.
 Shortening the total completion time of the whole project can be accomplished only by
shortening the critical path.

Slack Time – the length of time by which a particular activity can Slip (be delayed) without
having any delaying effect on the end event.
 Activities along the critical path have a slack of 0.
 All non-critical activities have positive slack.

Crash Time – time required to complete an activity assuming that all available resources are
devoted to such activity.
Crashing the Network – determining the minimum cost for completing the project in minimum
time so that optimum trade-off between time and cost is achieved.

 Activity time and activity cost are estimated for both normal and crash efforts.

Accountant’s Role in PERT:

 Determination of cost estimates and actual cost of each activity.
 Preparation of activity/project cost reports and computation/analysis of cost variances.

BENEFITS LIMITATIONS
 Very useful technique in planning and  Reliable time and cost data may not be
controlling activities. readily available and obtaining them may be
difficult.
 In harmony with accountant’s budgetary  Persons involved may overstate budgeted
tasks and in application of responsibility costs and time estimates to avoid
accounting system. unfavorable variances and pressure from
superiors
 May be used to solve managerial problems
pertaining to project scheduling,
information systems designs, and
transportation system design.
 Keep the project on schedule and provide
feedback to management.

WORKING CAPITAL MANAGEMENT AND FINANCING DECISIONS

 Working Capital Management is the administration and control of the company’s
working capital. Its primary objective is to achieve a balance between return (profitability) and
risk.

Working Capital for the:

 Financial Analyst is only Current Assets.
 Accountants are Current Assets less Current Liabilities.

CURRENT ASSETS – are reasonably expected to be realized in cash/consumed/sold during the

normal operating cycle.
-
Temporary CA are current assets that fluctuate with the firms operational needs.
-
Permanent CA is the portion of company’s current assets required to maintain firm’s
daily operations; or the minimum level of current assets required if the firm is to
continue its operations.

CURRENT LIABILITIES – liquidation requires the use of current assets or incurrence of other
current liabilities.

Working Capital Financing Policies:

1. Conservative/Relaxed Policy –operations are conducted with too much working capital;
involves financing almost all asset investments with long-term capital.
ADVANTAGES DISADVANTAGES
 Reduces risk of illiquidity  Less profitable because of higher financing
cost
 Eliminates firm’s exposure to fluctuating
loan rates and potential unavailability of
short-term credit

2. Aggressive/Restricted Policy – operations are conducted on a minimum amount of working

capital; uses short-term liabilities to finance, not only temporary but also part or the entire
permanent current asset requirement.

3. Matching/Self-Liquidating/Hedging Policy – matching the maturity of a financing source

with specific needs.
 Short-term assets are financed with short-term liabilities.
 Long-term assets are funded by long-term financing sources

4. Balanced Policy – balanced the trade-off between risk and profitability in a manner
consistent with its attitude toward bearing risk.

DECIDING ON APPROPRIATE WORKING CAPITAL POLICY:

It depends on the amount of risk a company is willing to take. The primary consideration
therefore is the trade-off between returns (profitability) and risk (Risks of Illiquidity) associated
with:
 Asset Mix Decision – appropriate mix of current and non-current asset.
 Financing Mix Decision – appropriate mix of short-term and long-term liabilities to finance
current assets

RISK RETURN TRADE-OFF:

 Risk = Return
 Current Asset = Liquidity,Returns
 Fixed Assets earns greater returns
 Long-term Financing has less liquidity risk than short-term debt, but has higher explicit
rate, hence, lower return.
MANAGEMENT OF CURRENT ASSETS
Objectives: Determination of appropriate mix of current asset components, considering safety
and liquidity, as well as, profitability.

Cash Conversion Cycle (Operating Cash Conversion Cycle) – is the length of time it takes for the
initial cash outflows for goods and services to be realized as cash inflows from sales.

Cash Conversion Cycle = Inventory Conversion1 + Receivables Collection2 – Payable Period3

1. Invty. Conversion or Ave. Age of Invty. = 360/Invty. TO* or Ave. Invty./Ave. COGS per day
2. Rec. Collection Period or Ave. Age of Rec. = 360/AR TO ** or Ave. AR/Ave. Sales per day
3. Payable Def. Period or Ave. Age of Payables = 360/AP TO *** or Ave. AP/Ave. Purchases
per day
 Invty. TO = COGS/Ave. Inventory
 AR TO = Net Credit Sales/Ave. AR
 AP TO = Net Credit Purchases/Ave. AP
CASH MANAGEMENT involves maintenance of appropriate level of cash and investment in
marketable securities to meet the firm’s cash requirements and to maximize income on idle
funds.
Objectives: To invest excess cash for a return while returning sufficient liquidity to satisfy future
needs.

Reasons for Holding Cash:

 Transaction Purposes – to conduct ordinary business transactions.
-
to meet cash outflow requirements for operational or financial obligations.
 Compensating Balance Requirements – part of a loan agreement.
 Potential Investment Opportunities – excess cash reserve are allowed to build up in
anticipation for a future investment opportunity.
 Speculation – to take advantage of possible changes in prices, as well as changes in
FOREX Rates.

The Concept of Float:

Float = Bank Balance less Book Balance

Aspects of Float:
1. Time a company takes to process checks internally.
2. Time consumed clearing the check thru the banking system.

Types of Float:

1. Negative Float = Book Balance > Bank Balance, which means there is more cash tied up
in the collection cycle and it earns 0% rate of return.
 Mail Float – peso amount of customer’s payments have been mailed by a customer but
not yet received by the seller.
 Processing Float – peso amount of customer’s payment have been received by the
seller but not yet deposited.
 Clearing Float – peso amount of customer’s checks have been deposited but not yet
cleared.
 Good cash management dictates that above floats must be minimized, if not eliminated.

2. Positive Float (Disbursement Float) = Book Balance < Bank Balance

-
Management should increase this type of float.

Cash Management Strategies:

1. Accelerate Cash Collection – to reduce negative float.
 Bill customers promptly
 Offer Cash Discounts for prompt payments
  Use of lockbox system
 Establish local collection offices
 Request customers to pay at firm’s depositary bank
 Use of automatic/electronic fund transfer
2. Control (Slow down) Disbursements
 Stretch payables by paying as late as possible within the credit period
 Maintain Zero Balance Accounts
 Play the float-increase the positive float
 Less frequent payroll and schedule issuance of checks
3. Reduce the need for precautionary cash balance
 More accurate cash budgeting
 Have ready lines for credit
 Invest idle cash in highly liquid, short term investments or cash equivalents

CASH FLOW MANAGEMENT

Cash Flow can be managed by:
1. Preparing Cash Budgets
2. Preparing Cash Break-Even Chart
 Cash Break Even Chart
-
Shows the Cash BE Point – the amount of Sales in person or number of units to be
sold so that total cash inflows are equal to cash outflows.
-
Shows the amount of Cash Deficiency when sales is below the Cash BE Point.
3. Determining the Optimal Cash Balance using the Baumol Cash Management Model
 Baumol Cash Management Model - an EOQ type model which can be used to
determine the optimal cash balance where the costs of maintaining and obtaining cash
are at the minimum.

Such costs are the:

i. Cost of securities transactions or cost of obtaining a loan.
ii. Opportunity Cost of holding cash or cost of borrowing cash.

Optimal Cash Balance where:

OC = Optimal Cash Balance
T = Transaction Cost (Fixed) per transaction; includes the cost of securities transaction or cost of
obtaining a loan
i = interest rate on Marketable Securities or cost of borrowing
D = total demand for cash over a period of time

OC = 2TD
i

MANAGEMENT OF MARKETABLE SECURITIES

Marketable Securities – short-term money market instruments that can be converted into cash.
Ex. Government Securities – debt instruments representing obligations of the National
Government issued by the BSP
Commercial Papers – short-term unsecured promissory notes issued by corporations
with very high credit standing.
 Reasons for Holding Marketable Securities:
-
serve as substitute for cash
-
serve as temporary investment
-
to meet known financial obligations
Decision Criteria for Marketable Securities:
1. RISK
i. Default Risk – refers to the chances that issuer may not be able to pay the
interest/principal on time.
 ii. Interest Rate Risk – refers to fluctuations in securities price caused by changes in
market interest rates.
iii. Inflation Risk – risk that inflation will reduce the real value of the investment.
2. MARKETABILITY – refers to how quickly a security can be sold before maturity without
significant price concession
3. TERM TO MATURITY – maturity dates should coincide with date at which the firm needs
cash.

MANAGEMENT OF ACCOUNTS RECEIVABLES

AR Management is the formulation and administration of plans and policies related to
sales on account and ensuring the maintenance of receivables at a predetermined level and
collectability is planned.

Objective:
 to have both optimal amount of receivables outstanding and optimal amount of bad debts.
 this balance requires trade-off between:
a. benefit of more credit sales
b. cost of AR

Factors in determining AR Policy:

 Credit Standard – the criteria that determines which customers will granted credit and how
much.
 Credit Terms – define the credit period and any discount offered for early payment.

Factors to consider in establishing Credit Standards (4C’s):

 CHARACTER – customer’s willingness to pay
 CAPACITY – customer’s ability to generate cash flows
 CAPITAL – customer’s financial sources
 CONDITIONS – current economic and business conditions

Cost and Benefits of Credit Extension Policy:

 Cash Discounts
 Credit Collection Costs
 Bad Debt Losses
 Financing Costs

Ways of Accelerating Collection:

 Shorten Credit terms
 Offer special discounts
 Speed up mailing time
 Minimize float

Determinants of Size of Receivables:

 Terms of Sale
 Paying Practices of Customers
 Collection policies and practices
 Volume of Credit Sales
 Credit Extension Policies and Practices
 Cost of Capital

Aids in Analyzing Receivables:

 Ratio of Receivables to Net Credit Sales
 Receivable TO
 Ave. Collection Period
 Aging of Accounts

MANAGEMENT OF INVENTORIES
The formulation and administration of plans and policies; to efficiently and satisfactorily
meet production and merchandising requirements; and minimize costs relative to inventories.

Objective: to maintain inventory at a level that best balances the estimates of actual savings,
the cost of carrying additional inventory, and the efficiency of inventory control.

Inventory Management Techniques:

1. Inventory Planning – determination of quality; quantity; and location of inventory, as well
as time of ordering, in order to meet future business requirements.
 EOQ Model
 Reorder Point
 Just-in-time
2. Inventory Control – regulation of inventory within the predetermined level.
 Fixed Order Quantity System – an order for a fixed quantity is placed when inventory
level reaches the reorder point.
 Fixed Reorder Cycle System – orders are made after a review of inventory levels has
been done at regular intervals
 Optional Replacement System
 ABC Classification System – inventories are classified for selective controls.
a. A items – High Value items requiring highest possible control.
b. B items – Medium Cost items requiring normal control.
c. C items – Low Cost items requiring simplest possible control.
3. Modern Inventory Management – often applied in the context of automated
manufacturing.
 Materials Required Planning (MRP) – designed to plan and control raw materials used
in production.
 Manufacturing Resource Planning (MRP II) – a closed loop system that integrates all
facets of a business.
 Enterprise Resource Planning (ERP) – integrated information systems of the whole
enterprise.

INVENTORY MODELS
A basic inventory model exists to assist in two inventory questions:
1. How many units should be ordered?
2. When should the units be ordered?

ECONOMIC ORDER QUANTITY – the quantity to be ordered, which minimize the sum of
ordering and carrying costs. The total inventory cost function includes:

1. Carrying Costs (increase with order size)

-
Storage, Interest, Spoilage, Insurance Costs
2. Ordering Costs (decrease with order size)
-
Transportation/Delivery, Administrative Cost of purchasing, receiving and inspecting
goods.

ASSUMPTIONS:
 Demand occurs at constant rate
 Lead time on receipt of orders is constant
 Entire quantity ordered is received at one time
 Unit cost of items are constant
 No limitation on the size of the inventory

TRADING Concern MANUFACTURING Concern

EOQ = 2aD ELS = 2aD

K K

where: a = cost of placing an order (ordering where: a = set-up cost

cost) D = annual production required
D = annual demand in units k = annual cost of carrying one unit in
k = annual cost of carrying one unit in inventory for one year
inventory for one year

Average Inventory = EOQ

2
REORDER POINT: the objective is to order at a point in time so as not to run out of stock
before receiving the inventory ordered but not so early that excessive quantity of safety stock
is maintained. When order point is computed, there may be a Stock-Out Situation if:
1. Demand > Lead Time
2. Order Time > Lead Time

Lead Time – period between the order is placed and received.

Normal Lead Time Usage = Normal Lead Time x Average Usage

Safety Stock = (Maximum Lead Time – Normal Lead Time) x Average Usage

REORDER POINT, if there is Safety Stock Required: Normal Lead Time Usage + Safety Stock
or Maximum Lead Time x Average Usage

REORDER POINT, if there is No Safety Stock Required: Normal Lead Time Usage

FINANCING DECISIONS

 SHORT-TERM FINANCING – Short-term credit; debt scheduled to be paid within one (1)
year.
Factors considered in selecting the source of Short-term Financing:
1. Cost – less expensive
-
Rates are usually lower than long-term rates
-
So not usually involve flotation or placement costs
2. Availability when needed
3. Risk - short-term debts are riskier, due to fluctuation on interest rates and more
frequent debt servicing.
4. Flexibility – usually more flexible
5. Restrictions – certain lenders may impose restrictions.
6. Effect on Credit Policy – sources may negatively affect credit rating
7. Expected Money-market conditions
8. Inflation
9. The company’s profitability and liquidity position, as well as stability

Sources of Short-term Financing:

I. Spontaneous Sources
 a. Trade Credit/Accounts Payable – considered as spontaneous financing because it is
automatically obtained.
-
A continuous source of financing.
-
More readily available.
COST: Usually bears no interest, but cost is implicit (the discount policy and credit
period)
i. No Trade Discount - purchase on credit without trade discount are usually priced higher
than cash purchases.
ii. Trade Discount – implicit cost is incurred if discount is not availed.

Annual Rate = Interest Cost per Period x 360 or 365

Usable Loan Amount No. of days fund is used

Or

Discount x 360 or 365

100% - Discount Net Period* - Discount Period

Net Period* or No. of days account is outstanding

b. Accruals/Accrued Expenses – represent liabilities for services that have been already
provided to the company.
COST: None

c. Deferred Income – Customer’s Advance Payments.

COST: None

II. Negotiated Sources

 Unsecured Short-term Credit

a. Commercial Bank Loans – short-term business credit provided by commercial banks

i. Line of Credit – maximum amount of credit to a firm

→ Revolving Credit Agreement – bank makes a formal contractual commitment
ii. Transaction Loan (Single Payment Loan) – short-term credit for specific purpose

COST:
 Regular Interest Rate = Interest
Borrowed Amount
 Discounted Interest Rate = Interest
Borrowed Amount - Interest
 Effective Interest Rate = Interest
Usable Loan Amount*
Usable Loan Amount* =
Loan – Discount Interest – Compensating Balance

b. Commercial Paper – short-term, unsecured promissory notes (IOUs) issued by large

firms with great financial strength and high credit rating.
-
Entail lower cost than bank financing
-
Interest < Prime Rate*
Prime Rate*- rate charged by commercial banks to their best business clients.

COST:
Effective Annual Interest Rate = Interest Cost per Period
Usable Loan Amount
x
360 or 365 days
 No. of days funds are borrowed

 Secured Short-term Credit

a. Pledging Receivables – receivables is provided by borrowers as collateral for short-term
loan.

b. Pledging Inventories – part or all of borrower’s inventories are provided as collateral for
a short-term loan.
→ Classification of Inventory Claims:
i. Floating Lien – creditor has general claim on all the borrower’s inventory.
ii. Trust Receipt – lender holds title to specific units of inventory pledged.
iii. Warehouse Receipt – inventory pledged is placed under the lender’s physical and
legal possession.

c. Other Sources.
i. Factoring – a factor buys the Accounts Receivable and assumes the risk of collection.
ii. Banker’s Acceptance – a guarantee of payment at maturity.
-
Often used by importers and exporters.

 LONG-TERM FINANCING DECISIONS

Capital Structure – mix of long-term sources of funds.

Capital Structure = Financial Structure – Long-term Debt

→ Objective – maximize the market value of the firm thru an appropriate mix of long-
term sources of funds.
→ Composition – Long-term Debt, Preferred Stock, Common Stockholders’ Equity

Optimal Capital Structure – mix of long-term sources of funds that will minimize the firm’s
overall cost of capital.

Cost of Capital – cost of using funds; also called the Hurdle rate, Required Rate of Return, Cut-
Off Rate.
-
Weighted Average Rate of Return the company must pay to its long-term
creditors and shareholders for the use of their funds.

COMPUTATION:

Source Capital Cost of Capital

After-tax Rate of Interest = i (1-Tax Rate)

 Creditors Long-term Debt

Preferred Dividends per Share

 Preferred
Preferred Stock Current Market Price or Net Issuance Price
Stockholders
Earnings per Share
 Common
Common Stock Market Price per Share
Stockholders

Other Computations of Cost of Capital:

1. Capital Asset Pricing Model (CAPM)

R = RF + β (RM - RF)
 Where: R = Rate of Return RM = Market Return
Β = Beta Coefficient RF = Risk Free Rate

2. Dividend Growth Model

a. Cost of RE = D1 + G
P0
b. Cost of New CS = D1 +G
P0 (1 – Flotation Cost)

Where: P0 = Current Price

D1 = Next Dividend
G = Growth Rate in Dividends ( it is assumed that the Dividend Payout Ratio,
Retention Rate and EPS Rate is Constant.
Flotation Cost = cost of issuing new securities
Factors influencing Capital Structure Decisions:
1. Business Risk – uncertainty inherent in projections; ↑Business Risk, ↓Debt should be
included in the Capital Structure.
2. Tax Position - ↑Tax Rate, ↑ Debt should be included in the Capital Structure because
interest is tax deductible.
3. Financial Flexibility – the firm’s ability to raise capital on reasonable terms even under
adverse conditions.
4. Managerial Aggressiveness – refers to some financial managers’ inclination to use more
debt to boost profit.

LEVERAGE – refers to that portion of fixed costs which represents a risk to the firm.
a. Operating Leverage – measure of operating risk.
-
refers to fixed operating costs found in the firm’s Income
Statement.
 ↑Operating Leverage, ↑Business Risk, ↓Optimal Debt Ratio

Degree of Operating Leverage/DOL = CM

EBIT

b. Financial Leverage – measure of financial risk

-
refers to financing charged in hopes of increasing the return of
common stockholders.
 ↑Financial Leverage, ↑Financial Risk, ↑ Cost of Capital

Degree of Financial Leverage/DFL = EBIT

EBIT-Interest

c. Total Leverage – measure of total risk

 ↓Operating Leverage, ↑Optimal Amount of Financial Leverage
 ↓Operating Leverage, ↓Optimal Amount of Debt

Degree of Total Leverage/DTL = DOL x DFL

Sources of Long-term Financing:

 Principal Sources of Funds:

1. External Sources – Debt, Equity, and Hybrid Financing
2. Internal Sources – Operations

a. Debt Financing
Advantages Disadvantages
 Basic control is not shared with creditor  Risk of not meeting the obligation
 Cost is limited  Adds risk to a firm
 Reduces cost of capital  Has a maturity date
 Substantial flexibility  Affect risk profiles
 Clearly specified and fixed  Certain managerial prerogatives are given up
 Maybe paid in cheaper pesos  Clear cut limits to amount of debt

Basic Types of Bonds or Long-term Debt:

1. Debenture Bonds – unsecured loans; can be issued only by companies with high credit
ratings.
2. Mortgage Bonds – pledge of certain assets for a loan.
3. Income Bonds – only pay interest when issuing company has earnings, riskier than other
bonds
4. Serial Bonds – with staggered maturities.

b. Equity Financing – a major source is common stock and retained earnings

Common Stocks as source:

Advantages Disadvantages
 Does not require fixed dividend  Stockholders control and share in earnings
are diluted
 No fixed maturity  Requires higher underwriting cost
 More attractive to investors than debt  Cash dividends are not tax deductible
 Average cost of capital may increase
above optimal level when too much
equity is issued
 ↑Common Stock Value, Equity Financing > Debt Financing

Retained Earnings as source:

Earnings after deducting interest, taxes and preferred dividends may be retained
ands used to pay cash dividends or plowed back into the firm in the form of Stock
Dividend/APIC.
Advantages: - After-tax opportunity cost is lower.
-
Leaves present control structure intact

c. Hybrid Financing – sources of funds possess a combination of features; include preferred

stock, leasing, option securities, such as warrants and convertibles.

Preferred Stock – a hybrid security because some of its characteristics is similar to common
stock and bonds.

Features:
1. Priority to assets and earnings
2. Always have a par value
3. Most provide cumulative dividends
4. Some are convertible into common stocks

Advantages Disadvantages
 No default risk  Not tax deductible
 Dividend is limited to stated amount  Makes payment of dividends mandatory
(cumulative)
 No voting rights
 No call features and provision of sinking
 fund

Lease Financing

Lease – rental agreement that typically requires a series of fixed payments that extend over
several periods.

 Leasing vs. Borrowing – leasing represents an alternative to borrowing. The BASIC

DIFFERENCE of Leasing from debt: Ownership of the asset.

Benefits of Leasing:
1. Increased flexibility
2. Maintenance at known cost
3. Lower administrative cost
4. Tax shield

Types of Leases:
a. Operating Lease – usually short-term and cancelable.
-
Maintenance provided by lessor
-
Treated as expense
-
Obligation is not shown in the Balance Sheet
b. Financial/Capital Lease – non-cancelable, longer term lease that fully
amortizes lessor’s cost of asset.
-
Maintenance is usually provided by the lessee.
c. Sale-Leaseback Arrangement –assets owned by firm are purchased by lessor and leased
back to the firm.
d. Direct Leases – identical to Sale-Leaseback Arrangement, except that
lessee does not necessarily own the asset.
e. Leveraged Leases – special lease arrangement under which the lessor
borrows substantial portion of acquisition cost of leased asset.

Convertible Securities - are preferred stock or debt issue that can be exchanged for a specified
number of shares of common stock at the will of the owner.
Advantages Disadvantages
 Give investors opportunity to realize  May be thought of selling common stock
capital gains at higher than market price
 Provide a way of selling common stock at  If firm’s stock price rises sharply, it would
prices higher than currently prevailing have been better-off if it waited and sold
common shares at a higher price

Option – a contract that gives the holders the right to buy (sell) stocks at some
predetermined price within a specified period of time.

Warrant – an option granted by the corporation to purchase a specified number of shares

common stock at a stated price exercisable until sometime in the future called expiration
date.
-
A company issued call-option.

CAPITAL BUDGETING

PLANNING is done at the strategic, tactical, and operational levels. Strategic Planning
is the domain of top management, Tactical Planning of the middle management, and
Operational Planning of the lower management. One of the strategic management techniques
in the field of financial management is Capital Budgeting.
CAPITAL BUDGETING
-
The process of identifying, evaluating, planning and financing capital investment projects of
an organization.
-
Seals with analyzing the profitability and/or liquidity of a particular project proposal. It is
premised on the following assumptions:
a. Funds are available
b. Business opportunities abound waiting to be tapped
c. Business opportunities are subject to quantitative evaluation

FINANCING DECISIONS – judgment regarding the method of raising capital to fund an

investment.
INVESTMENT DECISIONS – judgment which assets to acquire to achieve company objectives.

Characteristics of Capital Investment Decisions:

1. Usually require large commitment of resources
2. Involve long-term commitments
3. More difficult to reverse than short-term decisions
4. Involve much risk and uncertainty

Stages:
a. Identification and definition
b. Search for potential investments
c. Information gathering - qualitative and quantitative
d. Selection - choosing investment projects
e. Financing
f. Implementation and monitoring

Projects that need capital budgeting analyses are:

1. Replacement
 Purchase or lease long-term assets
2. Improvement
 Retain the old technology or introduce a new/modern technique or technology
 Improve channel of distribution or not
3. Expansion
 Establish a branch or not
 Introduce a new product or not
 Develop a new channel of distribution or not
4. Others
 Research and development
 Exploration
 New projects
 Internally develop a major marketing program or outsource services from available
service contractors
 Exchanging (or trading) of major professional players in sports business
 Similar applications

Basic Variables in Capital Budgeting, the major concerns are:

→ Net cost of investment - How much money is needed?
→ Net returns - How much would the investments be returned?
→ Project Evaluation Techniques - Which investment proposal would give the best return on
investment, profitability-wise and/or liquidity-wise?
CAPITAL INVESTMENT FACTORS:
1. Net Investment 2. Cost of Capital 3. Net Returns
NET INVESTMENT = Cash Outflow less Cash Inflow
CASH OUTFLOW/COST CASH INFLOW/ SAVINGS
 Initial Cash Outlay  Trade-in Value of Old Asset
 Working Capital Requirement  Proceeds from sale of old asset (net of
tax)
 Market Value of Existing Idle Asset to be  Avoidable Cost (net of tax)
utilized
 Net Purchase Price of new asset (net of  Proceeds from sale or trade-in allowance
discount), whether taken or not from disposal of old asset
 Additional or incidental costs paid or  Tax savings from loss on sale of old asset
incurred
 Additional tax paid or incurred in case of  Savings from avoided repairs and
gain from sale or disposal of old asset maintenance, if the old asset is replaced
 Additional tax paid from savings on
avoided cost of repairs, if the old asset is
replaced
 Increase in working capital base

COST OF CAPITAL/Hurdle Rate/Required Rate of Return/ Cut-off Rate – the cost of using
funds; weighted average Rate of Return must pay to its long-term creditors and shareholders or
the use of their funds.

NET RETURNS:
1. Accounting Net Income
2. Net Cash Inflows

Economic Life – period of time asset can provide economic benefits.

Depreciable Life – period used for accounting/tax purposes over which the asset’s depreciable
cost is systematically and rationally allocated.

Terminal Value/End of Life Recovery Value – net cash proceeds expected to be realized at the
end of project’s life.

Rational Investors have two preferences as to Net Returns:

a. YIELD PREFERENCE THEORY - denotes to net income
b. LIQUIDITY PREFERENCE THEORY – refers to cash dividends

In business, many investors prefer liquidity than yield as a concept of net returns.
However, long-term and institutional investors prefer yield on investments while short-term
investors prefer liquidity on investments.

Methods of Evaluating Capital Investment Projects (PETs):

Project Investments are evaluated on their liquidity or profitability. Net cash inflow is
used to measure liquidity while net income is used to measure profitability. Generally, the more
liquid the proposed project, the better it is. The higher profitability, the better the investment
is.
Evaluating proposed investments mayor may not consider the time value of money,
hence, the classification of evaluation models as to traditional models and discounted models,
as follows:

TRADITIONAL MODELS (do not consider time value of money)

Model Concept of Net Focus of Basis of Decision
 Returns Measurement Recovery Criterion
The shorter the
Payback Period Net cash inflows liquidity Time
better
The higher the
Payback Reciprocal liquidity Rate of Return
Net cash inflows better
The shorter the
Payback Bailout Net cash inflows liquidity Time
better
Accounting Rate of The higher the
Net income profitability Rate of Return
Return better

DISCOUNTED MODELS (not consider time value of money)

Concept of Net Focus of Basis of Decision
Model
Returns Measurement Recovery Criterion
positive = accept
Net Present Value Net cash inflows liquidity Amount
negative = reject
Internal Rate of The higher the
Net cash inflows liquidity Rate of Return
Return better
↑1 = accept
Profitability Index Net cash inflows liquidity Rate of Return
↓1 = reject
positive = accept
NPV Index Net cash inflows liquidity Rate of Return
negative = reject
Discounted The shorter the
Net cash inflows liquidity Time
Payback Method better

 DO NOT CONSIDER TIME VALUE OF MONEY

1. PAYBACK Method
ADVANTAGES DISADVANTAGES
 Simple to compute and easy to understand  Do not consider time value for money
 Gives information about project’s liquidity  Emphasis on liquidity over profitability
 Good surrogate for risk  Do not consider salvage value
 Ignores cash flows after payback period
 QUICK PAYBACK PERIOD IS LESS RISKY.

Payback Period – otherwise known as Unadjusted Breakeven Time; refers to the length of time
before an investment is recovered. It is the time period where the cumulative cash inflows is
equal to the cost of investment.

Equation: Cash to date = Cost of Investment

Formula:
Payback Period = Net Cost of Initial Investment
Annual Net Cash Inflows

2. PAYBACK RECIPROCAL represents the percentage of cash returns provided by an investment

in a given period.

Formula: Payback Reciprocal = 1/payback Period

3. PAYBACK BAIL-OUT Period – cash recoveries include operating net cash inflows, salvage
value and proceeds from sale.
-
also determines the number of years to recoup the investment. Investment is recovered
when the total cash (cash to date plus salvage value) equals the cost of investment.
 Equation: Cash to date + Salvage Value = Cost of Investment

4. ACCOUNTING RATE OF RETURN/Book Value Rate of Return/Financial Accounting Rate of

Return/Average Return on Investments/Unadjusted Rate of Return – measures the
profitability of a proposed project. It is the only project evaluation technique that measures
the attractiveness of a proposed investment based on profitability.

ADVANTAGES DISADVANTAGES
 Closely parallels concepts of income  Do not consider time value for money
measurement and investment return
 Facilitates re-evaluation of project’s  Effect of inflation is ignored
 Considers income over life of the project
 Indicates project’s profitability

Formula:
a. Based on Original Investment:
ARR = Net Income/Original Investment

b. Based on Average Investment:

ARR = Net Income/Average Investment*

Average Investment* = Original Investment + Salvage Value

2
c. Based on Average Book Value in a given year:
ARR = Net Income/Average Book Value*

Average Book Value* = Book Value-beg. + Book Value-end.

2
 CONSIDER TIME VALUE OF MONEY

→ Present Value – value now of some future cash flow

→ Future Value – amount available at specified future time based on a single investment
→ Annuities – series of equal payments at equal intervals of time
 Ordinary Annuity/Annuity in Arrears – cash flow occur at the end of the period
 Annuity Due/ Annuity in Advance - cash flow occur at the beginning of the period

1. NET PRESENT VALUE

ADVANTAGES DISADVANTAGES
 Emphasizes cash flows  Requires predetermination of cost of
capital
 Recognizes time value of money  Net present value of different projects
may not be comparable
 Assumed discount rate as reinvestment
rate
 Easy to apply

Formula:
Present Value of Cash Inflows*
Less: PV of Cash Outflows; PV of COI; or COI
Net Present Value

Present Value of Cash Inflows* are computed as follows:

CASH INFLOWS UNEVEN EVEN
Present Value Table Single Payment Annuity
 Present Value of Cash Inflows ∑(ACI x PVF) (ACI x PVFA)

2. PROFITABILITY INDEX
ADVANTAGES DISADVANTAGES
 Emphasizes cash flows  Assumes IRR as re-investment rate of
return
 Recognizes time value of money  Includes negative earnings
 Computes true return of project

Formulas:

Profitability Index = Total PV of Cash Inflows or Total PV of Cash Inflows

Total PV of Cash Outflows Cost of Investment

Net Present Value Index = Net Present Value

Cost of Investment

The Profitability Index and the NPV Index are normally used to rank projects that are
acceptable (projects having positive NPVs). The ranking of acceptable projects is done when
there is a constraint on resources such as money, manpower, and materials. The process of
allocating available money to the most prioritized investment proposals is known as “Capital
Rationing”. In the ranking process, the project that has the highest index has the highest
priority.

INTERNAL RATE OF RETURN is interchangeably referred to as the Discounted Rate of

Return, Discounted Cash Flow Rate of Return, Time Adjusted Rate of Return, Hurdle rate, or the
Minimum Required Rate of Return. It is the rate of return, where:
a. PV of Cash Inflows = PV of Cash Outflows
b. NPV = 0
c. Profitability Index = 1

The higher the IRR, the better. If: IRR>ROI Acceptable

IRR>ROI Reject

3. PAYBACK RECIPROCAL – reasonable estimate of Internal Rate of Return, provided that the
following conditions are met:
a. Economic life of project is at least twice the payback period.
b. Net cash inflows are constant throughout the life of the project.

Formula:
Payback Reciprocal = Net Cash Inflows or 1
Investment Payback Period

4. DISCOUNTED PAYBACK or BREAKEVEN TIME – period required where:

Discounted Cumulative Cash Inflow = Discounted Cumulative Cash Outflow

or

Cumulative Present Value of Cash Inflows = Cost of Investment

The Discounted Payback Period also computes the number of years before an
investment is recouped. However, the time value of money is considered in the recomputation
where future cash streams are discounted to their present values.

Discount Rate is composed of the following:

Discount Rate = Risk-free Rate + Adjusted Risk-premium Rate
 Where:
Risk-free Rate is the prevailing Market Rate of ROI that is almost free of risk such a
treasury bills.
Adjusted Risk-premium Rate represents the equivalent ROI needed to compensate the
business risk in a given investment. It represents the market risks such as organizational risk,
industry risk, political industry, foreign exchange currency adjustments, and the like.

DISCOUNT RATE vs. INTERNAL RATE OF RETURN

IRR DISCOUNT RATE
Used in: Net PV Method, Profitability Index, NPV
-
Index, Discounted Payback Period
Profit/Loss: None Discounted

PETs SUMMARY:
Project Evaluation Technique Concept of Net Returns Basic Formula/Principles
Traditional Models
PP = COI/ACI; or where:
Payback Period Net Cash Inflows
Cash to Date = Cost of Investment
Salvage Value is added to cash
inflows in operations to get the total
Payback Bailout Period Net Cash Inflows
cash; or where:
Total Cash = Cost of Investment
Payback Reciprocal Net Cash Inflows PR = 1/PP
a. Based on Original Investment:
ARR = NI/OI
b. Based on Average Investment:
ARR = NI/AI*; where:
AI* = OI + SV
Accounting Rate of Return Net Income 2
c. Based on Average Book Value in
a given year:
ARR = NI/ABV*; where:
ABV* = BV-beg. + BV-end.
2
Discounted Models
PVCI
Net Present Value Net Cash Inflows Less: COI
NPV
Profitability Index Net Cash Inflows PI = PVCI/COI
NPV Index Net Cash Inflows NPV Index = NPV/COI
At IRR: PVCI = COI
Internal Rate of Return Net Cash Inflows NPV = 0
PI = 1
Where: Cumulative PVCI = COI
Discounted Payback Period Net Cash Inflows or
DCCI = DCCO