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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• 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 (cont’d)
• 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 (cont’d)
• 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”)
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$100K $25K $50K $10K -$85K $15K -$ 6K $ 9K

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? (cont’d)
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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