Overview of Accounting Part 1

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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

Industrial & Manufacturing Engineering Department Cal Poly Pomona

EGR 403 - The Big Picture

Framework: Accounting & Breakeven Analysis Time-value of money concepts - Ch. 3, 4 Analysis methods
Ch. 5 - Present Worth Ch. 6 - Annual Worth Ch. 7, 8 - Rate of Return (incremental analysis) Ch. 9 - Benefit Cost Ratio & other techniques

Refining the analysis

Ch. 10, 11 - Depreciation & Taxes Ch. 12 - Replacement Analysis
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Introduction
Engineers need to understand accounting to fully understand the language of middle and upper management Performance evaluations of engineers often based on accounting data (e.g., budgeting) It is difficult to interpret information and find accounting mistakes without some accounting background
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Introduction (contd)
Accounting courses for engineers: IME 239 or take courses in an MBA program Engineering projects are undertaken based largely on their ability to generate Profit. Profit is an accounting term. Profit = Revenue - Expenses
Revenue (money in) is a.k.a. income or sales Expenses (money out) are a.k.a. costs
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Introduction (contd)
Manufacturing is cost driven
Products/processes designed to use least $$ Manufacturing costs need to be controlled Continuous Improvement programs reduce cost

Intangible considerations are also important

Resources & Capabilities Strategy

EGR 403 will concentrate on the financial aspects of economic decision making.
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Financial Statements
Balance Sheet (General Accounting)
Snap shot of what the company owns and how much they owe. Discloses information to investors.

Income Statement (Cost Accounting)

Shows profit for the period based on Generally Accepted Accounting Practices (GAAP)

Cash Flow Statement (Sources & Uses of Funds)

Shows the actual need for cash over time so that the company can manage their cash properly

The first two statements will be discussed

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Accounting Concepts
Cigar Box Accounting Method - Revenue goes into the cigar box. Expenses go out. What is left is your profit. Accrual Accounting - Expenses are matched with revenue so that profit reflects actual activity and expenses in the time period. The matching principle is necessary for taxation and reporting performance.
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Costs & Depreciation

Costs fall into two categories:
Expenses - useful life of less than one year
Fixed - do not vary (e.g., lease costs, rent, insurance) Variable - vary with volume of production (e.g., labor, materials, supplies, rent, etc.) Cost of Good Sold = COGS.

Capital Expenditures - $ spend on improvements or additions with useful life greater than one year (e.g., machinery, buildings, furniture, etc.).
Depreciation - allocation of the cost of capital expenditures so that revenue is matched with expenses for items that will last more than one year (Land is not depreciable).
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Depreciation Example
You purchase a $50,000 CNC machine. Useful life = 5 years. Salvage value = 0. If you deduct the entire $50K as an expense the first year, you are not matching the revenue since there are 4 years of life left. Straight line depreciation = $50,000/5 years = $10,000/year. Depreciation expense = $10,000/year for 5 years. This matches revenue with expenses.
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Profit & Loss Statement

(a.k.a. P & L, or Income Statement)
Income (total revenue) Expenses Fixed Costs COGS (Variable) Depreciation Total Expenses Gross Profit (Income - Expenses) State & Federal Taxes (~40%) Net Profit (Bottom Line)
EGR 403 - Cal Poly Pomona - SA1

$100K $25K $50K $10K -$85K $15K -$ 6K $ 9K

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What Happens to Net Profit?

Dividends are paid to owners (share holders) as part of their return for investing in the business. Their money is at risk. Example: $9K Net Profit
$3K to dividends (1/3 used here as example) $6K retained in the business

Dividends are considered personal income for shareholders and therefore taxed again (double taxation). So the majority of corporate profits go to taxes.
(note to those listening to narrative: go to slide 12 when retained earnings are mentioned)
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What Happens to Net Profit? (contd)

What can the company do with the remaining $6K? This is capital allocation
Retained Earnings - invest in facilities & equipment Retire debt (pay off loans, retire bonds) Profit sharing, bonuses, indirect benefits Research & development Permanent raises or other increased benefits Help the community (donations, scholarships, etc.) Buy back stock
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The Bottom Line

Profits were traditionally shown on the books using black ink. A company showing a profit is sometimes said to be in the black. Losses (negative profits) were traditionally shown on the books using red ink. A company showing a loss is sometimes said to be in the red.
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