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 (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) $100K
Expenses
Fixed Costs $25K
COGS (Variable) $50K
Depreciation $10K
Total Expenses -$85K
Gross Profit (Income - Expenses) $15K
State & Federal Taxes (~40%) -$ 6K
Net Profit (“Bottom Line”) $ 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? (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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