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CPA Reviews: Part II - Business Enviro

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bullet Topic: CPA Reviews: Part II - Business Enviro
    Posted: 01/12/2007 at 07:34

Part II - Business Environment & Concepts

Non-Corporate Entities

Sole Proprietorships
Assigning a Partnership Interest
Limited Partnerships
Limited Liability Company (LLC)
Other Unincorporated Associations


Attributes of Corporations
Mergers and Consolidations
Stockholders Rights and Liabilities
Financing the Corporation
Directors and Officers
S Corporations


Microeconomics with Strategy Emphasis
Demand Elasticity
Supply and Demand Curve

Business Cycles

Business Cycles

Economic Measures

Economic Measures
Pricing Index
Aggregate Supply
Aggregate Demand
Fiscal Policies

Foreign Exchange

Foreign Exchange
Balance of Payments
Flexible Exchange Rates

Financial Modeling

Annual Effective Cost of Credit
Net Present Value
Internal Rate of Return

Strategies For Short and Long Term Financing Options

Strategies For Short and Long Term Financing Options
Cost of Cap l
Risk Terms

Liquid Asset Management

Cash Management
Inventory Management
Ratio Analysis

Information Technology

Role of Business Information Systems
Roles and Responsibilities Within the IT Function
IT Fundamentals
Disaster Recovery and Other Threats and Risk Management
Implications of Electronic Commerce

Cost Accounting: Actual Cost, Job Order and Process

Cost Accounting Basics
Job Order Cost
Process Cost

Cost Accounting: Joint Products and Standard Costs

Joint Products
Standard Costs
Cost and Managaerial Accounting Terms

Managerial Analysis and Control

Direct Costing
Cost Volume Profit Relationships
Incremental Analysis
Value of Perfect Information
Regression Analysis

Managerial Planning and Control

Compound Interest Computations
Present Value of a Single Sum
Compound Value of an Annuity (Future Value)
Present Value of an Annuity
Cap l Budgeting
Prof bility Index
Inventory Planning and Control

Aggregate Demand
Aggregate Demand
Aggregate demand (AD) is equal to the total (aggregate) real expenditures on 
final goods and services within an economy for a given time period. The 
aggregate demand curve is a curve that shows the demand relationship between 
Real GDP and the general price level. As the general price level decreases, 
Real GDP increases, and vice versa. The graph below illustrates the aggregate 
demand curve. Notice that it is downward sloping to the right. There are 
three reasons why the aggregate demand curve is downward sloping. Those 
reasons are as follows:
    a.  A change in price level, or the wealth effect - a change in the 
        price level changes the power of financial assets (money). So, if 
        the price level falls, consumers can buy more goods with the same 
        fixed quantity of money. Hence, real GDP increases.
    b.  An interest rate effect - If the price level falls, the lower price 
        level causes a reduction in the demand for money. That reduction in 
        the demand for money lowers the real interest rate and spurs 
        additional demand. That will cause GDP to increase.
    c.  An international trade effect - With everything else remaining 
        constant, a decrease in price level will make the goods that are 
        produced domestically cheaper. When domestic goods are cheaper than 
        foreign goods, net exports will increase, consumers will tend to 
        buy more domestic goods and fewer foreign goods, and real GDP will 
                AD       AD1
        |          \      \
   P1   |-----------\      \
        |           |\      \
 Price  |             \      \
 Level  |           |  \      \
        |               \      \
   P2   |----------------\      \
        |                |\      \
        |           |    
        |                |
                    Y1   Y2
                   Real GDP
A decline in the price level from P1 to P2 will result in the real GDP 
increasing from Y1 to Y2  given the aggregate demand curve AD.
Notice that the Aggregate Demand graph shows two parallel downward sloping 
aggregate demand curves. The one representing the current state of the 
aggregate demand curve is labeled AD and the aggregate demand curve 
representing the alternate state is labeled AD1. The AD1 curve has shifted 
outward and to the right indicating that at every price level GDP will be 
greater than with the original AD curve. The aggregate demand curve shifts 
from AD to AD1 for various reasons. 
The factors that cause a shift in the aggregate demand curve include the 
    1.  Change in consumer spending
    2.  Change in investment spending
    3.  Change in government spending
    4.  Change in net export spending
The outward shift to the right of the AD1 curve could have been caused by 
the following positive consumer spending factors:
    1.  Consumers having more wealth (e.g., increase in stock prices)
    2.  Consumers having higher expectations concerning the economy
    3.  Consumers having lower household debt. Thus, they have borrowing 
    4.  Consumers having lower taxes
The outward shift to the right of the AD1 curve could have been caused by 
the following positive investment spending factors:
    1.  Lower interest rates
    2.  Higher expected business profits
    3.  Lower business taxes

Aggregate Supply Aggregate Supply Now that we have examined the elements that are included in GDP and the items that are useful in predicting GDP, let's analyze GDP from an AGGREGATE SUPPLY and AGGREGATE DEMAND perspective. Aggregate supply is a curve that represents the Real GDP that all firms will produce at each price level. The graph below depicts the shape of the aggregate supply curve. Aggregate Supply | | | | | | Vertical Price | | Range Level | | | / | / Intermediate | / Range |-----------------/ |Horizontal Range | |_____________________________________________________ Real GDP The horizontal range of the aggregate supply curve represents the aggregate supply during the recession phase of the business cycle. In the horizontal range, firms can employ resources that have been idle without putting upward pressure on price levels. In the intermediate range of the aggregate supply curve, expansion of real output will be accompanied by an increasing price level. In the vertical range of the aggregate supply curve, the economy is operating at full capacity and increases in price level will not be accompanied by increases in production because of the lack of unused capacity. In the vertical range there is a strong tendency toward increases in the price level. The vertical range occurs during the latter stages of the expansion phase of the business cycle.

Annual Effective Cost of Credit Annual Effective Cost of Credit IMPORTANT NOTE: THE MOST EFFECTIVE AND EFFICIENT WAY TO PREPARE FOR THE CPA EXAM IS TO WORK THROUGH AS MANY MULTIPLE CHOICE QUESTIONS AS POSSIBLE. EACH QUESTION YOU GET WRONG IS AN OPPORTUNITY TO LEARN SOMETHING DIRECTLY RELATED TO EXAM MATERIAL. ALSO, A USEFUL WAY TO EXPLAIN TOPICS IS THROUGH MULTIPLE CHOICE QUESTIONS. THUS, MULTIPLE CHOICE QUESTIONS ARE USED THROUGHOUT THE FINANCE TEXT AND EXTRA QUESTIONS ARE PROVIDED AT THE END OF EACH SECTION. ANNUAL EFFECTIVE COST OF CREDIT: = ACTUAL INTEREST -------------------------------- BORROWED FUNDS AVAILABLE FOR USE COMPENSATING BALANCE - Required minimum balance for loans. A borrower must maintain a minimum balance in a checking or savings account to reduce the default risk for the lender. Compensating - balances reduce the amount of cash from borrowing that can be used. EXAMPLE: The bank offers you a loan at 8% on condition that you maintain a 20% compensating balance. What is the effective rate of interest? a. 6.4% b. 10.0% c. 18.0% d. 8.0% From Test Bank prepared by C. R. Krishnaswamy to accompany Principles of Corporate Finance by Brealey and Myers; Irwin, McGraw-Hill, 2000. Answer: (b) is correct. Assuming a $1000 loan, the formula is as follows: Actual Interest = $1000 x .08 = $80 = .10 = 10% ------------------------ --------------- ---- Available Borrowed Funds $1000-.20($1000) $800 EXAMPLE: Compensating balances: a. are used to finance inventories. b. earn high rates of interest for the firm. c. are ordered monthly (or quarterly) following forecasts d. increase the effective interest earned by banks on credit lines. e. Require a commitment fee. From Test Bank prepared by David A. Burnie to accompany Corporate Finance by Ross, Westerfield, and Jaffe, McGraw-Hill Irwin. Answer: (d) is correct. Because compensating balances reduce the amount of the borrowed funds that can actually be used the true, effective cost is increased. EFFECTIVE COST OF CREDIT EXAMPLES 1-3: The Frame Supply Company has just acquired a large account and needs to increase its working cap l by $100,000. The controller of the company has identified three alternative sources of funds which are given below. A. Borrow $110,000 from a bank at 12 percent interest. A 9 percent compensating balance would be required. B. Issue $110,000 of six-month commercial paper to net $100,000. (New paper would be issued every 6 months.) C. Borrow $125,000 from a bank on a discount basis at 20 percent. No compensating balance would be required. Assume a 360-day year in all of your calculations. 1. The cost of 2. The cost of 3. The cost of Alternative A. Alternative B. Alternative C. is is is a. 9.0 percent. a. 9.1 percent a. 10.0 percent b. 10.5 percent. b. 10.0 percent b. 20.0 percent c. 12.0 percent. c. 11.1 percent c. 25.0 percent d. 13.2 percent d. 18.2 percent d. 40.0 percent e. 21.0 percent e. 20.0 percent e. 50.0 percent Answers: For all three questions, we are looking for the annual percentage cost. 1. (d) is correct Actual Interest = $110,000 x .12 = $13,200 = .1318 = 13.2% --------------------- ---------------------- -------- Usable Borrowed Funds $110,000-(.09)$110,000 $100,100 2. (e) is correct Every six months it cost $10,000 to use $100,000. Actual Interest = $110,000-$100,000 = $10,000 = .10 = 10% per 6 mos -------------------- ----------------- ------- Usable Borrowed Funds $100,000 $100,000 If every 6 months the cost is 10%, then the annual cost would be 20% (10% x 2). 3. (c) is correct. Discounting a note at the bank means taking the interest out of the amount borrowed at the beginning of the loan period. Actual Interest = $125,000 x .20 = $25,000 = .25 = 25% --------------------- ------------------------ -------- Usable Borrowed Funds $125,000 - (.20)$125,000 $100,000

Assigning a Partnership Interest Assigning a Partnership Interest 1. Any general or limited partner may assign or sell their partnership interest. a. An assignment does not dissolve partnership. b. Thus, the assignor remains a partner and is still liable for partnership debts. c. The consent of other partners is not required, unless otherwise agreed. 2. The assignee does not become a partner without the consent of all other partners. a. The only right an assignee gets is the right to receive assignor's share of profits if any (e.g. assignee does not have a right to vote, manage or to inspect partnership books). b. The assignee is not liable for the assignor's share of losses. 3. A creditor of an individual partner may obtain from a court a charging order against an individual partnerís share of profits. This is the only right the creditor receives. a. The creditor cannot attach the partnerís interest in partnership property. b. A charging order does not cause a dissolution of the partnership. c. A charging order does not make the creditor a partner and does not allow the creditor to vote, participate in management or obtain partnership information. d. A charging order gives the creditor essentially the same rights as an assignee. e. Assignees are entitled to partnership profits, and are responsible for the income taxes thereon. Profits with no money being distributed are a deterrent to charging orders. Partner Dissociation Dissociation is the act of a partner leaving the partnership. Dissociation will lead to either a buyout of the partnerís interest, or dissolution and winding up of the partnership. A partner is dissociated from a partnership upon the occurrence of any of the following events: 1. The partnershipís having notice of the partnerís express will to withdraw as a partner or on a later date specified by the partner; 2. An event agreed to in the partnership agreement as causing the partnerís dissociation; 3. The partnerís expulsion pursuant to the partnership agreement; 4. The partnerís expulsion by the unanimous vote of the other partners if: a. it is unlawful to continue with that partner. b. there has been a transfer of the partnerís transferable interest or a court order charging the partnerís interest. c. Within 90 days after the partnership notifies a corporate partner that it will be expelled because of dissolution, revoked charter or its right to conduct business has been suspended. d. A partnership that is a partner has been dissolved and its business is being wound up. 5. On application by the partnership or another partner, the partnerís expulsion by judicial determination because: a. The partner engaged in wrongful conduct. b. The partner committed a material breach of the partnership agreement. c. Conduct by partner makes it not practical to continue with that partner. 6. The partner a. Becoming a debtor in bankruptcy b. Executing an assignment for creditors c. Potential or actual appointment of custodian of all or mostly all of partnerís property. Partner has 90 days to stay appointment of trustee, receiver or liquidator. 7. In the case of a partner who is an individual, a. Partnerís death. b. The appointment of a guardian for the partner; or c. Judicial determination that partner is not capable of carrying on duties under partnership agreement. 8. Transfer of the entire transferable interest in a trust or estate that is a partner. A partner has the power to dissociate at any time, rightfully or wrongfully. It is wrongful only if 1. It is a breach of the partnership agreement. 2. For a term partnership or partnership for a particular undertaking before completion of term or undertaking; e.g., partner who is chief engineer of a bridge project quits when bridge is 50% complete. a. The partner withdraws by express will, except if the partner dissociating follows within 90 days of another partnerís dissociation by death or otherwise it is not wrongful. b. A partner is expelled by judicial determination. c. The partner is a debtor in bankruptcy. A partner who wrongfully dissociates is liable to the partnership and to the other partners for damages caused by the dissociation Note above that item 2 is a default rule in RUPA applying only if the issue is not addressed in the partnership agreement. Effect of Partnerís Dissociation 1. The right to participate in management terminates. 2. The partnerís duty of loyalty terminates. 3. The partnerís duty of loyalty and care continue only with regard to matters arising and events occurring before dissociation. Purchase of Dissociated Partner's Interest If dissociation occurs without resulting in dissolution, the partnership has the right to continue the business and the dissociated partner has the right to be paid the value of his interest. In this case the buyout is mandatory. The buyout may be by the partnership, one or more remaining partners or a third party acceptable to the remaining partners. The buyout price is the amount, on the date of dissociation, as if the assets of the partnership were sold at a price equal to the greater of liquidation value or going concern value without the departing partner. The partnership must pay interest from the date of dissociation to the date of payment. This is a default rule. If the partnership agreement fixes the method of calculating payment, that will be used. The partnership may offset against the buyout price all amounts due from the dissociated partner including amounts due for wrongful dissociation. If the dissociated partner does not agree with the partnershipís stipulated buyout price and no agreement is reached after 120 days, the dissociated partner shall receive the partnershipís offer in cash as the undisputed minimum value and may thereafter bring suit to achieve a higher buyout price. DISSOCIATED PARTNERíS LIABILITY TO OTHER PERSONS A partner who dissociates without causing a dissolution is liable as a partner to the other party in a transaction entered into by the partnership before dissociation for a period of two years after dissociation. Further, for a period of two years a dissociating partner is liable to third parties if they act after dissociation believing that the departed partner is a member of the partnership. A statement of dissociation operates conclusively as constructive notice to third parties 90 days after filing. EVENTS CAUSING DISSOLUTION AND WINDING UP OF PARTNERSHIP BUSINESS A partnership is dissolved and its business must be wound up under any of the following: 1. Notice from a partner they wish to withdraw in a partnership at will and that partner has not dissociated prior to such notice. ďPartnership at willĒ means a partnership in which the partners have not agreed to remain partners until the expiration of a definite term or the completion of a particular undertaking. 2. For term partnerships: a. Within 90 days after a partnerís dissociation by death or otherwise, and at least half the remaining partners express their will to dissolve and wind up the business. b. The express will of all the partners to wind up the business. c. Expiration of the term or completion of the undertaking. 3. An event occurs agreed to in the partnership agreement resulting in the winding up of the business. 4. An event that makes it unlawful for all or substantially all of the business to continue. 5. On application by a partner, a judicial determination that continuation of the business is not practical. 6. On application by a transferee of a partnerís transferable interest, a judicial determination that it is equ ble to wind up the business. A partnership continues after dissolution only for the purpose of winding up its business. After winding up is complete, the partnership is terminated. At any time after dissolution of a partnership and before the winding up is completed, all the partners, including any dissociating partner other than a wrongfully dissociating partner, may waive the right to have the business wound up and the partnership terminated. In that event, the partnership resumes as if dissolution had not occurred. In this process, third parties are protected. A partnership is bound by a partnerís act after dissolution that is necessary for winding up partnership affairs, or would have bound the partnership before dissolution if the other party did not have notice of the dissolution. Note: Third parties are assumed to have notice 90 days after the filing of a Statement of Dissolution. DISTRIBUTION UPON DISSOLUTION Ė GENERAL PARTNERSHIPS Creditors have first claim on partnership assets. Partners who are creditors have equal claim with other creditors under RUPA; however, since partners are responsible for partnerships debts, creditors in reality are paid first. The second order of distribution is to settle partnerís accounts with credit balances (equity) with no distinction being made between cap l and/or profits. Finally, partners who have debit balances in their cap l account are required to contribute the balance. If a partner does not/or cannot (e.g. bankruptcy) contribute sufficient funds to erase a debit balance, the remaining partners are liable.

Balance of Payments Balance of Payments The BALANCE OF PAYMENTS is the sum of all the currency transactions that take place between a country and all foreign nations. The nation's balance of payments shows all of the payments a nation receives from foreign countries and all of the payments that it makes to the foreign countries. The U. S. balance of payments is an economic measure that shows the extent to which imports are balanced with exports. The structure of the balance of payments report for a year is shown below: The U. S. Balance of Payments Report Structure Current Account: U. S. goods or merchandise exports + XXX U. S. goods imports - XXX ---- Balance of Goods XXX U. S. exports of services + XXX U. S. imports of services - XXX ---- Balance of Services XXX --- Balance of Goods and Services XXX Net Investment Income - XX Net Transfers - XX ---- Balance on Current Account XXX Cap l Account: Foreign purchases of assets in the U. S. + XXX (cap l inflow to the U. S.) U. S. purchases of assets in foreign countries - XXX ---- Balance on Cap l Account XXX Official Reserves Account: Official Reserves X -- Total 0 In the Balance of Payments, the BALANCE OF GOODS AND SERVICES, within the CURRENT ACCOUNT, receives most of the attention. This is because of the impact of the "net" difference between exports and imports. If there is a negative balance, which means total exports less total imports is negative, then the U. S. would be operating at a TRADE.DEFICIT. When he balance of goods and services is positive it means that the U. S. had a favorable balance of trade and there was a TRADE SURPLUS. NET INVESTMENT INCOME in the Current Account refers to the net difference between interest and dividends paid to U. S. by foreigners and interest and dividends paid by the U. S. to foreigners. NET TRANSFERS in the Current Account refer to foreign aid and pensions to U. S. residents living abroad less remittances by immigrants to relatives living in foreign countries (cash sent by Mexican workers in the U. S. to relatives in Mexico, for example). The CAP L ACCOUNT includes the purchase and sale of real or financial assets and the extension and repayment of loans. Among the foreign purchases of assets in the U. S. might be a Japanese businesswoman who buys an apartment building in New York City or a French company that invests in U. S. Government bonds. The OFFICIAL RESERVES portion of the balance of payments report represents the amount that will permit the total of the pluses and minuses within the current and cap l accounts to equal zero. For example, if the balance of the current and cap l accounts are negative, the Federal Reserve will draw on its official reserves, in the foreign currency needed, to zero out the balance. Drawing on its Official Reserves means the country is considered to have a BALANCE OF PAYMENTS DEFICIT. Persistent balance of payment deficits over a period of years may force a country to adopt policies to deal with depleted Official Reserves. Such policies might include TRADE BARRIERS to discourage imports or DEVALUATION of their currency (currency depreciation) to make exports more attractive.

Budgeting Budgeting A budget may be defined as a plan for future operations expressed in dollars or units or both. Its purpose is to show the results of future operations given the goals, policies, forecasts and standards of operations. Budgeting may also be referred to as a managerial tool for profit planning and control, as actual results of operation may be compared with budgeted results of operations to identify problem areas. The budgeting process is of the utmost importance in the successful management of complex business enterprises and necessarily embodies the consensus of top management concerning the future direction of the enterprise. The budgeting process requires decisions which result in commitments critical to the financial success of the enterprise such as: 1. Expected sales levels (short and long run) 2. Individual product sales 3. Inventory levels by product 4. Production schedules to meet inventory levels 5. Purchasing of materials and supplies 6. Personnel to carry out planned activity level 7. Cap l expenditures required to meet production 8. Cash balances required to carry out planned activities Sales Budget The first step in the budgeting process (given the goals and policies of operation) is to forecast the level of sales for the budget period. Consideration must be given to general economic conditions, the company's pricing policy, expected sales effort, past sales levels, the company's relative market position, the trend of acceptance for the company's products, etc. The sales budget should be broken down by geographic locations, product lines and sales entities to facil te the control function of budgeting. Inventory Budget After the sales budget has been prepared, the inventory levels needed to meet sales and conform to company policy may be determined. This budget would be broken down by storage areas and product lines to facil te control. Example: Assume sales levels by month as follows: January $ 900,000 February 1,200,000 March 1,000,000 April 1,500,000 Company policy is to maintain inventory levels at 30% of the cost of goods sold of the following month. All products are sold at a mark-up of 25% of cost. Compute the inventory levels at the end of January, February and March Solution: Step 1. Compute the cost of goods sold for February, March and April. Cost 100% Mark-up 25% Selling price 125% Cost as a percent of selling price = 100 / 125 = 80% Cost of goods sold for: February $1,200,000 x 80% = $ 960,000 March $1,000,000 x 80% = $ 800,000 April $1,500,000 x 80% = $1,200,000 Step 2. Compute the ending inventory for January, February and March. January $ 960,000 x 30% = $288,000 February 800,000 x 30% = $240,000 March 1,200,000 x 30% = $360,000 Production Budget After the required inventory levels have been determined, the production necessary to meet required inventory levels and forecast sales may be scheduled. This budget would be broken down by production facilities and product line for control purposes. Example: Referring to the previous example, prepare a production budget for February and March, assuming that each unit costs $10 to produce. Solution: Computation of February production Cost Units Beginning inventory $288,000 28,800 Production ? ? Goods available for sale $ ? ? Less: ending inventory 240,000 24,000 Cost of goods sold $960,000 96,000 ======== ====== It is evident that we can back into the production required of $912,000 or 91,200 units as follows: 96,000 + 24,000 = 120,000 - 28,800 = 91,200 Production budget for February and March: February Cost Units Production required to meet sales budget $ 960,000 96,000 Add: desired ending inventory 240,000 24,000 Total production required $1,200,000 120,000 Less: estimated beginning inventory 288,000 28,800 Budgeted production $ 912,000 91,200 ========== ====== March Cost Units Production required to meet sales budget $ 800,000 80,000 Add: desired ending inventory 360,000 36,000 Total production required $1,160,000 116,000 Less: estimated beginning inventory 240,000 24,000 Budgeted production $ 920,000 92,000 ========== ====== Raw Materials Budget After the production budget has been prepared, the inventory levels and purchase requirements for raw materials may be determined. This budget indicates the cost (usually standard) and quantities of raw materials needed to meet production requirements and conform with company policies. Example: Referring to the previous example, assume that each unit produced requires 2 pounds of material X and 1 yard of material Y. Management desires that these raw materials be on hand in sufficient quantities to insure uninterrupted production. Planned inventory levels of material X, which can be obtained on short notice, are 10% of the next month's production. Material Y, however, must be ordered with considerable lead time and deliveries are erratic. Therefore, it has been decided that the inventory level of material Y be maintained at 40% of the next month's production. Compute the inventory levels of raw materials X and Y at the end of January and February. Solution: February production = 91,200 units March production = 92,000 units January 31 inventory requirements: Material X 91,200 x 2 = 182,400 x 10% = 18,240 pounds Material Y 91,200 x 1 = 91,200 x 40% = 36,480 yards February 28 inventory requirements: Material X 92,000 x 2 = 184,000 x 10% = 18,400 pounds Material Y 92,000 x 1 = 92,000 x 40% = 36,800 yards Cash Budget After all other budgets have been prepared (covering all aspects of the enterprise's operation), their effects on cash flows are summarized in the cash budget. The cash budget is usually broken down into monthly periods (or shorter for the very near future) showing the itemized cash receipts and disbursements during the budget period, including the financing activities and the beginning and ending cash balances. The cash budget is usually set up as follows: January February March Beginning cash balance $15,000 $ 30,000 $ 25,000 Add: cash receipts(1) 60,000 75,000 100,000 $75,000 $105,000 $125,000 Less: cash disbursements(1) 45,000 80,000 105,000 Ending cash balance $30,000 $ 25,000 $ 20,000 ======= ========= ========= (1) These amounts would be itemized as to source or use) The cash budget is a useful tool in the planning process for it provides management with information concerning the: 1. expected sources and uses of funds 2. availability of funds for investment purposes 3. need for external financing 4. availability of funds for the repayment of debt 5. availability of funds for distribution to owners Pro-Forma Financial Statements Once the budgeting process is completed through the cash budget, financial statements may be drawn up on a pro-forma basis. These statements will show the results of operation if the plans, as set forth in the budgets, are achieved. These statements will be analyzed by top management to determine if the results of planned future operations are consistent with the enterprise's objectives and goals. When conflicts are identified, the planning process begins anew.

Business Cycles BUSINESS CYCLES AND REASONS FOR BUSINESS FLUCTUATIONS The BUSINESS CYCLE refers to the continual ebb and flow of economic activity. No two cycles are exactly the same. The business cycle is characterized by changes in real Gross Domestic Product (GDP) and other measures such as the rate of unemployment and the rate of inflation. There are four phases of the business cycle. The intensity and duration of these phases will vary from one business cycle to the next. The four phases are 1. PEAK, 2. RECESSION (CONTRACTION), 3. TROUGH, and 4. EXPANSION (RECOVERY) as shown in the graph below: R Peak Peak E @ @ @ A @ @ @ . @ L @ @ . . . @ G . @ D . . P @ @ Recession Expansion (Recovery) (Contraction) @ @ @ @ Trough ____________________________________________________________ TIME (In Years) The LENGTH OF THE BUSINESS CYCLE is measured by the time elapsed between the peaks. The RECESSION PHASE is characterized by increasing unused productive capacity associated with increasing unemployment. The increasing unemployment causes reduced spending and the reduced spending in conjunction with higher levels of unused capacity usually results in a decline in output (GDP). A decline in GDP for two or more quarters constitutes a recession. However, because many prices are inflexible in terms of price reduction, the price level is likely to decline only if the recession is intense and of long duration. Recessions of high intensity and long duration are called depressions. DEFLATION is the opposite of inflation in that during a period of deflation the price levels decline. If price levels are declining, consumers tend to postpone spending in the hopes of paying lower prices in the future. Therefore, governments go to great lengths to avoid deflation by means of monetary and fiscal policy. When the economy has realized its lowest level of production (GDP) in the business cycle, a TROUGH has been reached. The trough phase in the business cycle is never recognized until the expansion phase is well under way. Thus, the trough phase can only be recognized in retrospect. What appears to be a trough phase may only be a slight pause in a continuing recession phase. The trough phase may last only a short time or it could persist for a long period. The EXPANSION, OR RECOVERY, PHASE is characterized by decreasing unemployment, greater utilization of productive capacity and an increase in real GDP. As the expansion phase progresses, the shrinking unused capacity and declining number of unemployed make it more likely that there will be inflationary pressures. As the expansion phase progresses, spending occasioned by the higher level of employment will increase. That increased spending, when considered against a backdrop of actual production creeping closer to productive capacity may lead to more aggressive pricing by producers. The higher levels of income increase demand for products but the diminishing unused productive capacity limits the supply. The result is increased inflationary pressure. It is during the expansion, or recovery, phase that businesses are likely to make cap l expenditures to increase their productive capacity. However, these cap l expenditure decisions are not likely to be made until the expansion, or recovery, phase is well under way. The PEAK PHASE is the period during which the economy has reached its highest level of production (GDP) in the business cycle. At the peak, there is often full employment and the level of real output is near the productive capacity. It is at this point that there are likely to be significant upward pressure on price levels as demand increases and supply is restricted by diminished available capacity. The economy of the United States of America has experienced several recessions in the past fifty years. The duration of those recessions varied from approximately one-half year to two years. The trend however, when measured by Gross Domestic Product, has been consistently upward. That upward growth is suggested by the trend line in the graph shown above. Although we have explained the phases of business cycles in terms of the level of unused productive capacity and the level of unemployment, the more basic cause of business cycles is TOTAL SPENDING as measured by GDP. If total spending declines, production is curtailed to avoid building inventory in the face of declining demand for the products. The result is that unemployment increases and income falls. When the total spending increases, higher levels of production become possible, employees are hired, and incomes rise . However, as the economy nears full employment and the factories approach full productive capacity, further increases in production output become more difficult to achieve. At this point, further increases in total spending will put pressure on prices as consumers earning higher incomes bid for the limited quantity of goods available. Business cycles affect all sectors of the economy. However, all sectors are not affected to the same extent. Companies producing cap l goods and consumer durable goods are greatly affected by business cycles. These companies produce high priced items that require considerable thought and analysis prior to purchase. In the case of CAP L GOODS (buildings, trucks, machinery and technology), considerable analysis precedes the decision to purchase. That analysis includes a projection of future cash flows and the calculation of the internal rate of return. If the internal rate of return is not sufficiently high, the purchase of the cap l asset will be postponed. In the case of CONSUMER DURABLE GOODS (automobiles, appliances, furniture and houses), the consumer gives considerable thought to an acquisition. The consumer is unlikely to make the purchase unless the consumer has a genuine need and has the income necessary to support the purchase. On the other hand, SERVICE GOODS (haircuts, doctor visits and entertainment) provided by service industries and NON-DURABLE CONSUMER GOODS (toiletries, food, and fuel) are purchased without much analysis. These purchases are not likely to be postponed until the expansion, or recovery, phase of the business cycle. It is true that the quantity and quality of services and non-durable consumer goods demanded will decline during a recession phase; however, the decline will not be nearly as severe as for cap l goods and consumer durable goods. In considering all aspects of the business cycle, it is necessary to discuss the various measures of unemployment. The NATURAL RATE OF UNEMPLOYMENT is the long-run rate of unemployment that would exist even if there were no CYCLICAL UNEMPLOYMJENT. It is important to consider that the unemployment rate cannot reach zero. People are always switching jobs, getting fired, or quitting. As a result, when the real unemployment rate is equal to the natural rate of unemployment, the economy is deemed to be at FULL EMPLOYMENT. Therefore, when the economy is at full employment there are still unemployed people. The FRICTIONALLY UNEMPLOYED are capable workers who are "between jobs" and have not been matched-up with their next job yet. The frictionally unemployed also include those young people who are looking for their first job. Frictional unemployment is caused by limited information, unfortunate timing, and geographical separation between potential employer and potential employee. The STRUCTURALLY UNEMPLOYED include workers who have skills that do not match up to the skills necessary for a particular job. Structural unemployment typically results from technological changes in the workplace. Another type of unemployment is CYCLICAL.UNEMPLOYMENT. Cyclical unemployment is caused by fluctuations in the business cycle. Cyclical unemployment usually occurs when the GDP begins to decline and the economy begins to go into the a recession. The graph below shows the relationship that exists among these various types of unemployment: | Structural Unemployment Natural |__________________________________________ Unemployment | | Frictional Unemployment | Total |__________________________________________ Unemploy- | ment | | | | Cyclical Unemployment | | | ______________________________________________

Cap l Budgeting Cap l Budgeting Cap l budgeting is the process of planning cap l expenditures-expenditures the benefits of which will be realized over a period longer than a year rather than in the current year (revenue expenditures). Cap l budgeting involves the: 1. generation of investment proposals 2. determination of investment benefits (profits and cash flow) 3. evaluation of investment benefits 4. ranking of investment proposals for decision purposes, based on their evaluation The technique employed in the evaluation is of primary importance because the different techniques do not always result in the same ranking of investment alternatives. The ranking of investment proposals is necessary because firms usually have more potential cap l expenditure proposals than they are capable of or willing to finance. Cap l Budgeting Techniques 1. Payback Method 2. Unadjusted Rate of Return Method (Accounting Method) 3. Discounted Cash Flow Methods a. Internal Rate of Return b. Net Present Value Payback Method Investments are ranked according to the length of time required to generate cash flows equal to their cost. The payback period is computed as: Cost of Investment Payback Period = ------------------------ Annual Cash Flows The payback method is frequently used in practice because: * it is easy to understand and apply. * when estimates of prof bility are not crucial because of a weak cash or credit position, the enterprise must look to a rapid return of its funds. The payback method is theoretically unacceptable because: * it ignores the time value of money * it ignores prof bility of the project * it ignores cash flows beyond the payback period * it is a measurement of liquidity, not prof bility. Example: Compute the payback period for an investment of $100,000 which generates an annual cash flow of $25,000. Solution: Investment cost $100,000 Payback period = ---------------- = -------- = 4 years Annual cash flow 25,000 Unadjusted Rate of Return Method Investments are ranked according to the ratio of the expected average net income to either the original investment or the average investment of the project. The unadjusted rate of return is computed as: Average Annual Net Income Unadjusted Rate of Return = ------------------------------ Investment or Average Investment The attributes of this method are: * it is easy to apply * it is easily understood by persons familiar with ratio analysis * it considers the prof bility of the project over its entire life. This method is theoretically unacceptable because it ignores the time value of money. Example: Compute the accounting rate of return for an investment of $70,000 which generates gross annual cash flows of $22,000, and is expected to have a useful life of 10 years. The tax rate is 40%. Solution: (a) Determination of annual net income from project Annual cash flow $22,000 Less depreciation 7,000 Annual income before taxes $15,000 Taxes (40%) 6,000 Annual net income $ 9,000 Average Annual Net Income (b) Accounting Rate of Return =----------------------- = Investment $9,000 = --------- = 12.9% $70,000 Note: If average cost of the project were used, the computation would be $9,000 $35,000 ($70,000 1/2) or 25.8%. If all projects are computed in the same manner, i.e., either using the original investment or average investment, their relative ranking will be the same. Discounted Cash Flow Methods The discounted cash flow methods of cap l budgeting are the theoretically correct methods of cap l budgeting as they explicitly consider the time value of money. In the determination of time value of money and the application of these methods, there are two important elements. First is the cash flow to be paid or received in a given period of time. For cap l expenditure proposals, there are two distinct cash flows: the investment and the investment's benefits. Discounted cash flow methods of cap l budgeting require reliable estimates of the investment's cash flows, for the results of these methods can be no more reliable than the data upon which they are based. The emphasis is upon cash flow rather than profit because money is the resource which is invested and reinvested to yield return to the enterprise. Second is the cost of cap l for the enterprise. The cost of cap l is the minimum rate of return which the firm must earn in order to fulfill the expectations of those who provide the firm's cap l (creditors and owners) and maintain its present valuation. The cost of cap l used in the discounted cash flow techniques is the marginal cost of cap l (a weighted average cost of the last dollar of cap l raised). Internal Rate of Return Method Investments are ranked according to their projected rate of return. Projects with an internal rate of return less than the desired rate of return (usually the cost of cap l) should normally be rejected. The internal rate of return of an investment is that discount rate which equates the present value of the benefits to be received (cash flows) from the investment with the cost of the investment (initial cash outlay). The internal rate of return is found by trial and error or interpolation. Example: Compute the internal rate of return for an investment of $100,000 which generates net annual cash flows of $20,000 and is expected to have a useful life of 10 years. Solution: P.V. Investment = P.V. Benefits $100,000 = $20,000 (IF) $100,000 = IF -------- 20,000 5 = IF Referring to the Present Value of an Annuity of $ 1 Table, reading the values of the n = 10 row we find: P.V. of $1 for ten periods at 15% = 5.0188 P.V. of $1 for ten periods at 16% = 4.8332 Therefore, the internal rate of return is approximately 15%. Net Present Value Investments are ranked according to their net present value which is defined as the present value of the cash flows of an investment, discounted at the cost of cap l, less the cost of the investment (initial cash outlay). Investments with a net present value equal to or greater than zero should be accepted because they are earning a rate of return equal to (NPV = 0) or greater than (NPV > 0) the minimum required rate of return (the cost of cap l). Example: Compute the net present value of the investment in the previous example assuming the cost of cap l is 10%. Solution: Present value of benefits = A (IF) = $20,000 6.1446 = $122,892 Less: Present value of investment 100,000 Net Present Value $ 22,892

Cash Management Cash Management Cash Management: * Cash is held for three reasons * Medium of exchange to conduct business * For emergencies. * In deflationary periods, cash goes up in value. * Recognize the importance of synchronizing cash inflows and outflows. Greater synchronizing means less idle cash. Growing business is good but puts strain on cash due to need to spend more before cash comes in from revenues. Long-term assets generate greater return so the less a company has tied up in working cap l the better. * Use zero balance account -- checking account where bank will automatically transfer into the account the amount of charges for each day on the same day. * Discounts for receivables and payables--Always pay within discount period and seek favorable credit terms for purchases. * Payments should be made at the end of the discount periods if the return is more than the firm's cost of cap l. The return on taking the discount is calculated using the following formula: (MEMORIZE) 360 / total pay period - discount period X discount / (1- discount) The return on taking the discount is also the cost of not taking the discount. Credit terms of 2/10 n/30 means the purchaser gets a 2% discount if paid within 10 days. If not paid by the 10th day, the full amount must be paid on or before the 30th day. Therefore, it costs 2% to use the seller's money for 20 days. (30-10) Example: The high cost of short term financing has recently caused Loy Ltd. to re-evaluate the terms of credit it extends to its customers. The current policy is 1/10, net 30. If Loy's customers can borrow at the prime rate, at what prime rate must Loy change its terms of credit to avoid an undesirable extension in its collection of receivables? a. 12.5% b. 16.0% c. 14.5% d. 10.0% e. 19.0% Answer: (e) is correct. First, we must calculate the cost of not taking the discount. Using the formula to calculate the cost of not taking a discount we have the following: 360 / (30-10) X 1 / 100 - 1 18 X .010101 = .1818 = 18.18% Thus, the prime rate where Loy must change its terms to avoid having customers not pay within the discount period would have to be greater than 18.18%. Thus, 19% is the only correct answer. In other words, what interest rate must Loy's customers be charged by banks to borrow money would Loy's customers prefer to just borrow from Loy by not paying within the discount period. If Loy charges less than bank's, then Loy's customers will not pay within the discount period. Lockbox Accounts Lockbox accounts are frequently used by large, multilocation companies to make collections in cities within areas of heaviest customer billing. The company rents a local post office box and authorizes a local bank to pick up the remittances mailed to that box number. The bank empties the box at least once a day and immediately credits the company's account for collections. The greatest advantage of a lockbox is that it accelerates the availability of collected cash. Generally, in a lockbox arrangement the bank microfilms the checks for record purposes and provides the company with a deposit slip, a list of collections, and any customer correspondence. If the control over cash is improved and if the income generated from accelerating the receipt of funds exceeds the cost of the lockbox system, then it is considered a worthwhile undertaking. (Intermediate Accounting, Keiso & Weygandt, Ninth Edition, Wiley.) Wire transfers are the fastest and most expensive way to transfer funds from lockboxes to a firm's main bank. A slower, but less expensive way, is to use a depository transfer check (official bank check). This is a bank check drawn on the local bank and payable to the concentration bank.

Compound Interest Computations Compound Interest Computations Computations involving compound interest may be necessary in any problem in which money is to be paid or received in different periods of time, such as with leases, bonds, pensions, investments, notes receivable and payable, contracts, and cap l budgeting, to name only a few examples. For this reason, the candidate must have a thorough understanding of the concepts and the time value of money. Compound Value of a Single Sum (Future Value) If $1.00 is invested today in a savings account that pays five percent interest compounded annually, what amount will be on deposit at the end of two years if all monies are left on deposit? Compound interest is interest for the period computed on the original principal plus the interest accumulated to the beginning of the interest period. The amount on deposit at the end of two years can be determined as follows: Beginning Period Principal + Interest = Ending Balance 1 $1.00 + ($1.00 x .05) = $1.05 2 1.05 + ($1.05 x .05) = 1.1025 To develop a general formula for the compound value of a single sum, the following terms will be used: P = Principal I = Interest i = Interest rate n = Number of periods FV = Future value Using these terms, the solution to the above problem may be illustrated as follows: Today End Period No.1 End Period No.2 | | | | Interest Period | Interest Period | |------------------ |---------------------------| $1.00 $1.05 $1.1025 Po----------------> Po + I Po + Po i Po (1 + i) P1---------------> P1 + I i P1 + P1 P1 (1 + i) P2 Note that the P2 is determined as follows: 2 P2 = P1 (1 + i) = Po (1 + i)(1 + i) = Po(1 + i) Using the information from the original problem, the compound value at the end of the second year is calculated as follows: 2 2 P2 = P0 (1 + i) = $1 (1 + .05) = $1(1.1025) = $1.1025 If the amount on deposit at the end of the second year were left on deposit for one more year, what would be the value on deposit at the end of the third year? Another year's interest would be earned. Therefore, the value at the end of the third year (P3) would be (1 + i) times the value at the end of the second year (P2). P3 = P2 (1 + i) = P1 (1 + i)(1 + i) = P0 (1 + i)(1 + i) 3 (1 + i) = P0 (1 + i) For the original problem, the value at the end of the third year is determined as follows: 3 3 P3 = P0 (1 + i) = $1 (1 + .05) = $1 (1.1576) = $1.1576 It should now be evident that the formula for the future value (compound value) of a single sum for n interest periods is: n FVn =Po(1 +I) This is the fundamental formula of compound interest, upon which the other formulae in this section will be based. Therefore, it is important that you understand its derivation. To assist in the application of this formula, tables of the compound value interest factor (1 + i)n have been constructed for various values of i and n. Using these factors, it is only necessary to multiply the principal (Po) by the appropriate interest factor for the given i and n values, to determine the future value. The fundamental formula may now be written as: FV = Po (IF) Example: If $1,000 is invested for 5 years at 6% interest compounded annually, what will its value be at the end of 5 years? To determine the appropriate interest factor from the Compound Value of $1 Table first locate the 6% column, then read down the values of the column to the n=5 row. This factor is 1.338. The future value is then determined as follows: FV = P(IF) = $1,000(1.338) = $1,338

Compound Value of an Annuity (Future Value) Compound Value of an Annuity (Future Value) An annuity is a series of equal payments for a specified number of periods. There are two types of annuities: * Ordinary Annuity-payments are made at the end of the period. Also called deferred annuity or annuity in arrears. * Annuity Due-payments are made at the beginning of the period. The concepts and techniques of compound interest and future value at the same for an annuity as for a single sum. Refer to compound value of a single sum for their review. Ordinary Annuity: If $1 is invested at the end of each year for three years in a savings account that pays 5% compounded annually, what amount will be on deposit at the end of the three years? The amount on deposit at the end of the third year is equal to the sum of the future values of the three ordinary annuity payments. The answer is illustrated graphically as follows: End of Period 0 1 2 3 |-------|--------|--------| Annuity $1 $1 $1 = $1.000 | | | |--------- = $1.050 | |------------------ = $1.102 $3.152 Future Value Computation of future value: Interest n Payment Amount Periods FV = P(1+i) 2 1. $1.00 2 $1(1.05) = $1(1.102) = $1.102 1 2. 1.00 1 1(1.05) = 1(1.050) = 1.050 0 3. 1.00 0 1(1.05) = 1(1.000) = 1.000 $1(3.152) = $3.152 Note: 0 * For the third payment, (1+i) = 1. n * The total of the interest factors (1+i) times the annuity equals the future value ($1 x 3.152 = $3.152). It is not necessary to compute each future value and sum them up. Rather, the total of the factors may be used to compute the future value of the annuity. Expressed algebraically, the formula for the future value of an ordinary annuity is: n __ n-m FV = A .\ (1+i) /__ m=1 (R, read sigma, means summation) n __ \ /__ n-m In the expression m=1 (1+1) , m (a counter) begins at 1 because the first annuity payment earns interest for one less period than there are periods (n), and goes to n (shown above __ ) because the last payment earns no \ /__ interest (n-m = 0). To assist in the application of this formula, tables of the n __ \ /__ n compound value interest factor m=1 (1+i) have been constructed for various values of i and n (refer to Compound Value of an Annuity of $1 Table). Using these factors, it is only necessary to multiply the Annuity (A) by the appropriate interest factor for the given i and n values to determine the future value of an ordinary annuity. The future value of an ordinary annuity formula may now be written as: FV = A(IF) Example: What is the future value of an ordinary annuity of $1,000 per year for 6 years at 7% compounded annually? To determine the appropriate interest factor from the Compound Value of an Annuity of $1 Table, first locate the 7% column, then read down the column of values to the n=6 row. This factor is 7.153. The future value of the ordinary annuity is determined as follows: FV = A(IF) = $1,000(7.153) = $7,153 Annuity Due: If $1 is invested at the beginning of each year for 3 years in a savings account that pays 5% compounded annually, what amount will be on deposit at the end of the third year? The amount on deposit at the end of the third year is equal to the sum of the future value of the three annuity due payments. The answer is illustrated graphically as follows: End of Period 0 1 2 3 |-------|--------|--------| Annuity $1 $1 $1 | | | | | |--------- = $1.050 | | | |------------------ = $1.102 | |-------------------------- = $1.158 $3.310 Future Value Computation of future value: Interest n Payment Amount Periods FV = P(1+i) 3 1. $1.00 3 $1(1.05) = $1(1.158) = $1.158 2 2. 1.00 2 1(1.05) = 1(1.102) = 1.102 1 3. 1.00 1 1(1.05) = 1(1.050) = 1.050 $1(3.310) = $3.310 n Note that the total of the interest factors (1+i) times the annuity equals the future value ($1 3.310 = $3.31). As with the ordinary annuity it is not necessary to compute each future value and sum them up. The total of the factors may be used to compute the future value of the annuity. Expressed algebraically, the formula for the future value of an ordinary annuity is: n-1 FV = A __ n-m \ (1+I) /__ m = 0 Here m begins at 0 because the first payment earns interest for each of the periods (n) and goes to n-1 because there is no payment at the end of the nth period. Tables of the compound value interest factor for an annuity n-m due (1 + i) are usually not available; however, the tables of the compound interest factor for an ordinary annuity can be adapted to show the interest factors of an annuity due. This is accomplished by taking the factor for the period one greater than the actual period of the annuity (n+1) and subtracting 1 from this interest factor. The reasons for this are: * Each annuity due payment earns interest for one more period than an ordinary annuity payment, and * There is no annuity due payment at the end of the last period such as there is in an ordinary annuity - (1 + i)0 = 1 Example: What is the future value of an annuity due of $1,000 for 4 years at 7% compounded annually? To determine the appropriate interest factor from the Compound Value of an Annuity of $1 Table, first locate the 7% column, then read down the column of figures to the n=5 row (4 years + 1). The factor is 5.751. The future value of the annuity due is determined as follows: FV = A (IF) = $1,000 (5.751 - 1) = $1,000 (4.751) = $4,751 To determine if an annuity table of compound value interest factors is for an ordinary annuity or an annuity due, you must analyze the factor for the first period. An annuity for one period is the same as a single sum. If the factor is 1.000 it shows that no interest has been earned at the end of the period; therefore, the amount must have been paid at the end of the period and is an ordinary annuity. If the factor is greater than 1.000, it shows that interest has been earned by the end of the period; therefore, the amount must have been paid at the beginning of the period and the annuity is an annuity due.

Cost Accounting Basics Cost Accounting Basics For financial accounting, the purpose of cost accounting is to determine the cost of a product or service. There are two basic cost accounting systems: 1. Job Order-Costs are accumulated by specific job or lot 2. Process-Costs are accumulated by department or productive process and allocated to the units processed based upon a cost flow assumption (generally weighted average or FIFO). (Standard cost can be applied to either system.) The cost system used by an enterprise will be determined by the type of operations performed. A job order costing system is appropriate when custom made or unique goods or services are produced, such that direct costs can be identified with the specific units of production. Job order costing is often used in industries such as printing, construction, auto repair, furniture and machinery manufacture, and professional services. A process costing system is appropriate when the operation continuously mass produces like units, one unit being indistinguishable from another. Process costing is often used in industries such as chemicals, food processing, petroleum, mining, and in the manufacturing of other standard products. Basic cost elements of production: Direct (raw) materials: Cost of materials that become part of the finished product and are directly traceable to the finished product. Examples: the cost of paper used in printing books and wood used in making desks. Direct labor: Cost of labor which works directly on the product, converting raw materials to a finished product, and is directly traceable to the finished product. Examples: wages of a printing press operator, or worker who assembles desks. Overhead: All other manufacturing costs. These costs are indirectly related to production of the finished product. Other terms that are synonymous with overhead include: manufacturing or factory overhead, burden, indirect costs, and applied manufacturing expense. Examples include indirect materials (oil for machines), indirect labor (supervisor's wages), utilities and property taxes on the manufacturing facility. Cost Classifications: Prime cost: Direct material cost plus direct labor cost. Conversion cost: Direct labor cost plus overhead cost. Product cost: The sum of direct material, direct labor and overhead costs which comprise the inventoriable costs. Period cost: Non-inventoriable cost which is expensed in the current period as incurred. Variable cost: Costs which vary in total directly with changes in the level of activity. The cost per unit is constant at different levels of activity. Fixed costs: Costs which remain constant in total, regardless of changes in the level of activity. Therefore, the per unit cost changes with changes in the level of operations. Relevant range: The limits within which the level of activity may vary and the above variable and fixed cost-volume relationships will remain valid. Basic cost accounting cost expiration computations: Cost of Materials Used: Beginning Inventory Material $ 12,000 Purchases 280,000 Total $292,000 Less: Ending Inventory Material 15,000 Cost of Materials Used $277,000 Cost of Goods Manufactured: Beginning Work-in-Process Inventory $ 16,000 Direct Material 277,000 Direct Labor 204,000 Overhead 306,000 Total $803,000 Less: Ending Work-in-Process Inventory 23,000 Cost of Goods Manufactured $780,000 Cost of Goods Sold: Beginning Finished Goods Inventory $ 81,000 Cost of Goods Manufactured 780,000 Goods Available for Sale $861,000 Less: Ending Finished Goods Inventory 96,000 Cost of Goods Sold $765,000

Cost and Managaerial Accounting Terms Cost and Managaerial Accounting Terms ABNORMAL SPOILAGE: Spoilage that does not normally occur in a particular production process. ABSORPTION COSTING: Both fixed and variable costs are assigned to product. Opposed to direct costing in which only variable costs are assigned to product and fixed costs are period costs. ACCOUNTING METHOD: A Cap l Budgeting term. Another name for the unadjusted rate of return method. Also called Book Value Method. The increase in future average annual net income from a project divided by the investment. BUDGET: A financial plan for future activity. BUDGET VARIANCE: The difference between actual and budgeted costs. As to overhead, comparison is made at actual production level. BY-PRODUCTS: One or more products of relatively small value which are obtained during production of the main product. CAP L BUDGETING: Financial evaluation procedure for proposed or planned cap l outlays. CASH BUDGET: A budget on a cash basis to determine projected cash position. CASH FLOW: The excess of cash received over cash disbursed (or vice versa) over a period. CONTRIBUTION MARGIN: Selling price less variable costs. CONTROLLABLE COST: A cost which can be controlled at some level of management. CONVERSION COST: Direct labor plus factory overhead. COST CENTER: A unit of production or service activity for which costs are accumulated. DIFFERENTIAL COST: Also called incremental or relevant cost. Two or more alternatives are compared by determining the change in costs under each alternative. DIRECT COSTING: Fixed overhead becomes a period cost and is excluded as a cost element of inventory. See Absorption Costing. EFFICIENCY VARIANCE: A variance applied to both direct labor and overhead. As to labor, the variance measures the difference between actual and standard labor hours times the standard overhead rate. As to overhead, the variance measures the difference between the actual usage of the activity base (e.g., labor hours or machine hours) and the standard usage times the variable overhead rate. EQUIVALENT FINISHED UNITS: The number of units complete in terms of whole units. For example, 1500 units 2/3 complete are 1000 units in equivalents. EXPECTED ANNUAL ACTIVITY: The activity which management anticipates for the year. Expected activity may not always be used to determine the overhead rate. See Normal Activity. EXPECTED VALUE: In probability, the value of a particular act times its probability. EXPIRED COST: A cost that becomes an expense of the current period because of the lack of future utility. FACTORY OVERHEAD: Factory costs other than Direct Material and Direct Labor. Also called manufacturing expense, indirect expense, or burden. FIXED COST: A cost which remains constant over a given period of activity. See Relevant Range. FLEXIBLE BUDGET: A budget prepared for more than one level of production. IDEAL CAPACITY: Absolute maximum production with no allowances for work stoppages. Also called Theoretical Capacity. IMPUTED COST: Costs not computed under conventional accounting methods and are not expenditures, but involve a foregone opportunity. Similar to Opportunity Cost. INCREMENTAL COST: Two or more alternatives are evaluated by considering only the change in cost factors. Same as Differential Costs. INDIRECT LABOR: Labor costs not traceable to specific units of output. INVENTORIABLE COST: Costs assigned to units for inventory purposes. JOB ORDER COSTING: Cost system in which costs of production are assigned to specific jobs or lots. JOINT COST: A cost applicable to more than one cost center or activity. JOINT PRODUCT COSTS: Costs applicable to two or more products produced by a single process. Up to the point of split-off costs must be assigned on an estimated basis. See Relative Sales Value Method. MANAGEMENT BY EXCEPTION: Concentrates on deviations from expected results. MARGINAL COSTING: See Direct Costing. MARGINAL INCOME: See Contribution Margin. MIXED COST: A cost which contains both fixed and variable elements. NET PRESENT VALUE METHOD: In Cap l Budgeting, a project is evaluated by computing the net present value of expected cash flows based on a predetermined rate of return. If the result exceeds the investment, the project meets the basic investment criteria. An index can be constructed: Net Present Value / Investment NORMAL ACTIVITY: Production expected in a given year based on an average over a period of years which includes seasonal, cyclical and trend factors. An overhead rate based on normal activity may result in sizeable under- and overapplications of overhead over a period of years. Budgeted Overhead = Overhead Rate based Average production for on normal activity the past 5 years. Budgeted Overhead = Overhead rate based Management's estimate on expected activity of production for the year Also see Practical Capacity. NORMAL SPOILAGE: Anticipated spoilage under efficient operations. OPERATIONS RESEARCH: Various mathematical and statistical models used in decision making. OPPORTUNITY COST: Income that could have been derived from a resource had it been applied to an alternate use. For example, warehouse space used to store inventory has an opportunity cost equal to the rental value. OUT-OF-POCKET COSTS: Current costs or outlays related to a particular activity. OVERAPPLIED OVERHEAD: The excess of overhead cost applied to product over costs actually incurred. Can be broken down to a Budget and Capacity Variance in Job Order Cost. PAYBACK: Period in which cash flow equals the investment in a project. Does not measure prof bility. PAYBACK RECIPROCAL: Method of approximating the true rate of return. Can be used only when the life of the project is twice the payback period and inflows are uniform. Investment $100,000 Payback 30,000 per year for 10 years Payback $300,000 / 100,000 = 3/1 Reciprocal 1/3 or 33 1/3% approximate true rate of return. PAYOFF TABLE: Used to evaluate various alternatives under different probabilities of occurrence to determine the alternative which maximizes profits. PERFORMANCE REPORT: Comparison of actual with budget. PERIOD COST: A cost associated with a particular period which cannot be carried forward to the succeeding period as an asset. See Expired Cost. PERT: A formal diagram of the timing relationships of a complex series of planned activities. PRACTICAL CAPACITY: Maximum level of production that a plant or department can operate efficiently. Ideal capacity less allowance for unavoidable stoppages. PRICE VARIANCE: A Direct Material Variance. The difference between the units acquired at actual and at standard. The price variance can also be computed based on the difference between the units used in production at actual and standard. PRIME COST: Direct Material and Direct Labor. PROCESS COSTING: A costing system in which unit costs are computed within a time frame, usually a month, by dividing the units produced into the costs during the period. Used with FIFO or Average. Used in production of similar type product over extended periods. PRO-FORMA STATEMENTS: Forecasted statements or statements prepared to show what would result "as if" certain events had taken place. QUANTITY VARIANCE: The difference between the actual quantity used and the standard allowed multiplied by the standard price. Also called the Usage Variance. RATE VARIANCE: A Direct Labor Variance, similar to the Price Variance for Direct Material. The difference between the actual and standard wage rate multiplied by actual amount of Direct Labor used. REALLOCATION: Allocation of service department costs to the various producing departments based on some criteria of allocation related to benefits derived. RELATIVE SALES VALUE METHOD: Assignment of joint product costs based on the relative sales value of each joint product. Results in the same gross profit percentage for all joint products. RELEVANT RANGE: A range of activity within which cost data is valid, particularly fixed costs. Takes recognition of the fact that if production increases or decreases enough, fixed costs will change. SALES MIX: The combination of quantities of products that make up total sales. Also, combination of items and various gross profit percentages that make up total contribution. SERVICE DEPARTMENTS: Departments that render specialized assistance to the producing departments. Costs must be ultimately borne by the producing departments. SPENDING VARIANCE: An overhead price variance comparing actual variable overhead with budgeted variable overhead. SPLIT-OFF POINT: Separation point for joint products. STANDARD COST: Predetermined cost that should be attained. STANDARD HOURS ALLOWED: Units produced times standard hours. STEP VARIABLE COSTS: Describe the effect of variable costs which change abruptly, thereby appearing on a graph as steps. SUNK COST: A cost which has been incurred and has no effect on contemplated action. TIME ADJUSTED RATE OF RETURN: A cap l budgeting term. The rate of interest at which the present value of future cash flows from a project is equal to the present value of the investment. TRANSFER PRICE: Exchange price by segments of the same organization when goods or resources are transferred. Example, manufactured goods shipped to retail outlets of the same company. UNADJUSTED RATE OF RETURN: The ratio of the future average annual net income to the initial investment. Also called the accounting method and the book value method. UNDERAPPLIED OVERHEAD: Excess of overhead cost incurred over the amount of overhead cost applied. UNEXPIRED COST: A cost which may be properly carried forward to future periods as an asset. USAGE VARIANCE: See Quantity Variance. VARIABLE COST: A cost which is constant per unit, but changes in total in proportion to changes in production activity. VARIANCE: Difference between actual from expected or budgeted results. WORK-IN-PROCESS INVENTORY: Cost of incomplete goods still in production stage.

Cost of Cap l COST OF CAP L * The cost of debt = Interest rate x (1 - tax rate). * The cost of stock = Annual Dividend ------------------------------- NET proceeds of stock issuance Same formula for both Preferred and Common Stock * The cost of retained earnings - The rate required by investors which is equal to the rate they could obtain elsewhere, assuming the same risk. = Annual Dividend -------------------------------- Gross proceeds of stock issuance Notice that the only difference between the calculation of the Cost of Common Stock and the Cost of Retained Earnings are the floatation costs. The cost of new external equity (cost of stock) is higher than the cost of retained earnings due to stock flotation costs (costs incurred to sell the stock). * Theoretically, there is an optimal cap l structure which minimizes the weighted average cost of cap l. EXAMPLES: Williams Inc. is interested in measuring its overall cost of cap l and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments. A. Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay flotation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent. B. Williams can sell 8 percent preferred stock, $100 par value, for $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. C. Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share. D. Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. E. Williams' preferred cap l structure is: Long-term debt 30% Preferred stock 20 Common stock 50 Question 1: The cost of funds from common stock for Williams Inc. is: a. 7.0 percent. b. 7.6 percent. c. 7.4 percent. d. 8.1 percent. e. 7.8 percent. 1. Answer: (b) is correct Using the information from section C above we can complete the formula for the cost of issuing common stock: Annual Dividend = $7 = $7 = .076 = 7.6% --------------------- ------------- ---- NET Proceeds from $100 - $3 - $5 $92 Issue of Common Stock Williams Inc. is interested in measuring its overall cost of cap l and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments. A. Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay flotation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent. B. Williams can sell 8 percent preferred stock, $100 par value, for $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. C. Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share. D. Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. E. Williams' preferred cap l structure is: Long-term debt 30% Preferred stock 20 Common stock 50 Question 2: The cost of funds from retained earnings for Williams Inc. is: a. 7.0 percent. b. 7.6 percent. c. 7.4 percent. d. 8.1 percent. e. 7.8 percent. 2. Answer: (a) is correct. Using the same information from Section C above, we complete the formula for the cost of retained earnings: Annual Dividend = $7 = .07 = 7% -------------------- ---- GROSS Proceeds from $100 Issuing Common Stock Williams Inc. is interested in measuring its overall cost of cap l and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments. A. Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay flotation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent. B. Williams can sell 8 percent preferred stock, $100 par value, for $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. C. Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share. D. Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. E. Williams' preferred cap l structure is: i. Long-term debt 30% ii. Preferred stock 20 iii. Common stock 50 Question 3. If Williams Inc. needs a total of $200,000, the firm's weighted average cost a. 19.8 percent. b. 4.8 percent. c. 6.5 percent. d. 6.8 percent. e. 7.3 percent. Answer: (c) is correct. Williams preferred cap l structure is shown in section E. So if Williams needs $200,000 they will get $100,000 (50%) from Common Stock, $40,000 (20%) from Preferred Stock and $60,000 (30%) from Long-Term debt. So the weighted average cost of cap l formula would be as follows: 50% (COST OF COMMON STOCK FINANCING) + 20% (COST OF PREFERRED STOCK FINANCING) + 30% (COST OF LONG-TERM DEBT FINANCING) Remember, INTERNALLY GENERATED FUNDS FROM RETAINED EARNINGS ARE CONSIDERED PART OF COMMON STOCK. Therefore, the $100,000 from Common Stock financing comes from Retained Earnings because in Section D the problem tells us Williams expects $100,000 from new retained earnings this coming year. So the formula is now: 50% (7 %) + 20% (COST OF PREFERRED STOCK FINANCING) + 30% (COST OF LONG-TERM DEBT FINANCING) Next, the cost of Preferred Stock Financing must be calculated using the same formula as Cost of Common Stock Financing. Obtaining information from Section B we have the following: Cost of Preferred Stock = Annual Dividend = $8($100) = $8 =.08 = 8% ----------------- -------- ---- Net Proceeds of $100-$5 $100 Issuing Preferred Stock Now that we have the cost of preferred stock, the formula is: 50%(7%) + 20% (8%) + 30% (COST OF LONG-TERM DEBT FINANCING) The final step is to determine the cost of long-term debt. The last sentence in Section A explicitly gives us the after-tax cost of Long-Term Debt of 4.8 percent. Thus, the final calculations are as follows: 50% (7%) + 20% (8%) + 30% (4.8%) 3.5% + 1.6% + 1.4% = 6.5%

Cost Volume Profit Relationships Break-even Analysis Frequently referred to as break-even analysis. CVP analysis stresses the relationships between the factors which affect profit, and serves as a basis for profit planning by management. * Fixed Costs-Costs which remain constant in total regardless of changes in the level of activity. Therefore, the per unit cost changes with changes in the level of operations. * Variable Costs-Costs which vary in total directly with changes in the level of activity. The cost per unit is constant at different levels of activity. * Relevant Range-The limits within which the level of activity may vary and the above cost-volume relationships will remain valid. * Contribution Margin-Selling price less variable cost. * Break-even Point-The level of operations at which there is no profit and no loss. Determined as follows: Fixed Cost (a) B.E.P. (units) = --------------- Contribution Margin Fixed Cost Fixed Cost Fixed cost (b) B.E. P ($) --------- OR ---------- divided by 1 - VC/SP CM/SP the contribution margin ratio. * Margin of Safety-The excess of actual or budgeted sales over sales at the break-even point. It reveals the amount by which sales could decrease before losses occur. Examples of Break-even Computations-Assume the following: Selling price per unit $2.00 Variable cost per unit $1.40 Fixed Costs per year $12,000 Tax rate 40% FC $12,000 $12,000 ē B.E.P. (units) -- = -------- = ----- = CM $2 - $1,40 $.60 = 20,000 units FC $12,000 12,000 ē B.E.P. ($) -- = ------ = ------ CM% .60 .30 ---- 2.00 = 40,000 sales Or 20,000 units x $2.00 = $40,000 Break-even analysis may be extended to determine the number of units or dollar sales required to earn or maintain certain profit before or after tax. Continuing the above example: * Volume required to produce a net income of $9,000 before income taxes. FC + NIBT $12,000 + 9,000 units = -------- = ---------------- = 35,000 units CM .60 FC + NIBT $12,000 + 9,000 $ sales = --------- = --------------- = 70,000 CM% .30 Margin of safety $70,000 - $40,000 = $30,000 * Volume required to produce a net income of $9,000 after taxes. FC + NIAT $12,000 + $9,000 ---- = ----- = 1-TR 1-.4 ----------- --------------- CM $.60 $12,000 + $15,000 ----------------- = $5,000 units .60 Margin of safety ($2 45,000) - $40,000 = $50,000 Assume labor negotiations are underway that will increase variable costs by 20%. How many units will the company have to sell to maintain a net income of $9,000 before taxes? Selling Price $2.00 Variable cost ($1.40 x 1.20) 1.68 Contribution margin $ .32 FC + NIBT $12,000 + $9,000 units = --------- = ---------------- = 65,625 units CM $ .32 Calculate the margin of safety. (Answer: $56,250)

Demand Elasticity Demand Elasticity It is important to remember that the equation for calculating the coefficient of the price elasticity of demand has the Quantity on the top and the Price on the bottom. To help you remember, think of a man that has his tie tied too tightly. It is so tight that his tongue is hanging out as in Q for quantity. The P (price) represents the tie around his neck. Inelastic demand is represented by a coefficient of price elasticity of demand that is less than 1. In such a situation the demand curve would tend to be more vertical than the one shown in graph A. The demand curve for coffee would likely be more vertical than the demand curve for milk given that there is more of a tendency for the caffeine in coffee to be slightly addictive. The inelastic demand curve suggests that a large percentage change in price will result in a relatively small percentage change in quantity demanded. The difference between elastic and inelastic demand may also be examined in terms of the total revenue before and after a price change. In the example in which the price changed from $3.50 to $3.00 the quantity changed from 8 gallons to 10 gallons. The revenue associated with the $3.50 price was $28 ($3.50 X 8 gallons) and the revenue associated with the $3.00 price was $30 ($3.00 X 10 gallons). Thus, for this relatively elastic demand curve (in the interval of $3.50 to $3.00 per gallon) illustrated in graph A, the decline in price resulted in an increase in revenue by $2. ($30 - $28). This focus on revenues permits us to draw the following conclusions concerning the relationship between revenue and price elasticity of demand: If the demand curve... and... then... ------------------- --- ---- Is elastic Price falls Revenue increases Is elastic Price rises Revenue decreases Is inelastic Price falls Revenue decreases Is inelastic Price rises Revenue increases Demand is more elastic for goods that have multiple substitutes and less elastic for goods with relatively few substitutes. A strategy used by many companies is one that attempts to convince potential customers that the company's product is sufficiently differentiated from other products that there is no su ble substitute product. The company is attempting to create a relatively inelastic demand curve for the product. An inelastic demand curve would permit the company to increase price and thus increase revenues. In contrast, an elastic demand curve would result in a decrease in revenues if price were increased. Demand also tends to be more inelastic in the short run because it takes time to identify su ble substitutes. Thus, the demand for a product tends to be more elastic in the long run than it is in the short run. Thus, a strategy of raising prices to take advantage of a relatively inelastic demand curve in the short run could be counterproductive. The higher prices could attract competitors and the competitors would offer su ble substitute products. In the long run, the demand curve could become elastic because of the increased substitutes. Thus, the explo tion of an inelastic demand curve may only be prof ble in the long term if the company can sustain a competitive advantage. High value products are more likely to have elastic demand curves than are low value products. For high value products, such as automobiles, the consumer is more likely to shop around for substitute products because the potential savings associated with "shopping around" are likely to be great. On the other hand, the potential savings from shopping around for low value products, such as candy bars, is not nearly as great.

Direct Costing Direct Costing Defined Direct Costing, also called marginal and variable costing, is an accounting concept in which only variable manufacturing costs are assigned to the products manufactured. All fixed costs are excluded from the cost of the product and expensed as period costs. The fixed costs are considered to be more closely related to the ability to produce than to the actual production of goods, and therefore are considered a cost of the period rather than the product. Comparison of Absorption Costing with Direct Costing Absorption Costing (conventional or full costing) requires that all manufacturing costs be assigned to the products manufactured either directly or indirectly by allocation; therefore, the inventories include the fixed portion of overhead costs which are excluded under direct costing. Compare the standard cost for a single product under absorption and direct costing. Absorption Direct Direct materials 2 yards @ $1 $ 2.00 $ 2.00 Direct labor 2 hours @ $4 8.00 8.00 Overhead variable .50 per labor hr. 1.00 1.00 fixed .75 per labor hr. 1.50 -0- Total Standard Cost Per Unit $12.50 $11.00 * Direct and absorption costing yield the same net profit when sales and production are the same. * Direct costing yields more net profit than absorption costing when sales exceed production. The beginning inventory used during the period includes fixed cost from the prior period under absorption accounting; therefore, the costs expensed during the period are greater under absorption costing. * Direct costing yields less net profit than absorption costing when production exceeds sales. The ending inventory includes fixed costs of the current period which are transferred to the next period under absorption costing, thereby reducing the expense of the current period. * Direct costing is not acceptable for financial reporting purposes because an element of inventory cost is excluded. This can easily be corrected by adjusting the inventories and cost of goods sold to include fixed costs. * Direct costing is not acceptable for tax purposes or S.E.C. reporting. Direct Costing Illustrative Problem Illustrative Problem: The following sales, cost and production data relate to the only product produced by Roy Manufacturing Company: Sales price per unit $ 15 Variable manufacturing costs per unit 2 Variable selling costs per unit 1 Fixed manufacturing cost 1,600,000 Fixed selling costs 400,000 Normal production capacity 200,000 units Actual units in year 1 2 3 Production 300,000 200,000 170,000 Sales 300,000 170,000 200,000 Required: a. Prepare income statement for Roy Manufacturing Co. for years 1 through 3 using the Absorption Costing method. b. Prepare income statements for Roy Manufacturing Co. for years 1 through 3 using the Direct Costing Method. Solution: a. Absorption Costing-(000 omitted) Year 1 Year 2 Year 3 Sales (300,000 x $15) $4,500 (170,000 x $15) $2,550 (200,000 x $15) $3,000 Cost of Goods Sold: Beginning Inventory -0- -0- (30,000 x $10) $ 300 Cost of goods manufactured (300,000 x $10) $3,000 (200,000 x $10) $2,000 (170,000 x $10) $1,700 Capacity variance -0- (100,000 x $8) (800) ( 30,000 x $8) _____ _____ 240 Cost of goods available for sale $2,200 $2,000 $2,240 Less: Ending inventory - 0- -0- (30,000 x $10) _____ $ 300 _____ Cost of goods sold $2,200 $1,700 $2,240 Gross Profit $2,300 $ 850 $ 760 Selling Expenses: Variable costs (300,000 x $1) 300 (170,000 x $1) 170 (200,000 x $1) 200 Fixed costs 400 400 400 Net Income before tax $1,600 $ 280 $ 160 b. Direct Costing Year 1 Year 2 Year 3 Sales (same as Absorption) $4,500 $2,550 $3,000 Cost of Goods Sold: Beginning inventory -0- -0- (30,000 x $2) $ 60 Cost of goods manufactured (300,000 x $2) $ 600 (200,000 x $2) $ 400 (170,000 x $2) _____ _____ $ 340 Cost of goods available for sale $ 600 $ 400 $ 400 Less: Ending inventory -0- -0- (30,000 x $2) _____ $ 60 _____ Cost of goods sold $ 600 $ 340 $ 400 Contribution margin-Mfg. $3,900 $2,210 $2,600 Variable selling expenses 300 170 200 Contribution margin-final $3,600 $2,040 2,400 Fixed Costs-manufacturing 1,600 1,600 1,600 selling 400 400 400 Net income before taxes $1,600 $ 40 $ 400 ===== ====== ====== Note the following: * When sales and production are equal (Year 1) the two methods provide the same net profit. * When sales are less than production (Year 2) Absorption Costing produces higher net income than Direct Costing. This is due to the transfer of fixed cost from the current year to the next under Absorption Costing. In Year ., $240,000 of fixed cost is transferred to Year . in the ending inventory. (30,000 units $8 FC per unit) * When sales are greater than production (Year 3) Direct Costing produces higher net income than Absorption Costing. Again, the difference is due to the transfer of fixed cost in Absorption Costing. $240,000 of fixed cost was transferred into Year . in the beginning inventory. * In Direct Costing, net income follows sales. Note the increase in profit from Year 2 to Year 3 as sales increase. * In Absorption Costing, net income may or may not follow sales. Note the decrease in net income from Year 2 to Year 3 as sales increase. This, again, is caused by the transfer of fixed costs. It may be analyzed as follows: Increase in revenue 30,000 units x $15 $450,000 Less: Increase in variable cost-mfg. 30,000 units x 2 60,000 Increase variable cost-selling 30,000 units x 1 30,000 Increased contribution in Year 3 $360,000 Difference in Fixed Cost from Year 2 to 3 Decrease in Year 2 FC 240,000 Increase in Year 3 FC 240,000 Total difference in FC $480,000 Change in net income ($120,000) Arguments for Using Direct Costing * Reports are easier for management to interpret because the statements emphasize contribution margin which is the excess of selling price over variable costs. * Direct costing emphasizes the cost-volume-profit relationships and facil tes its analysis. * Other things remaining constant, profits move in the same direction as sales when direct costing is used, as profit is not affected by changes in the absorption of fixed costs resulting from increases or decreases in inventory. Under absorption costing, an increase in sales may result in an increase or decrease in profit as fixed costs are transferred from period to period. A decrease in sales may also result in an increase or decrease in profit under absorption costing. * Permits a more uniform and direct evaluation of product lines, sales areas, classes of customers because of the absence of fixed cost allocation. * The effect of fixed costs on income is emphasized by the inclusion of all such costs on the income statement. * Because it is simpler, clerical costs are lower. Arguments Against Using Direct Costing * Exclusion of fixed costs from inventory might adversely affect management decisions about pricing by emphasizing the short term aspects of the problem-(capacity, variable costs and contribution to fixed cost recovery). * Direct costing is not acceptable for financial reporting, tax or S.E.C. purposes. * Separation of costs into fixed and variable categories may be very difficult.

Disaster Recovery and Other Threats and Risk Management Disaster Recovery With greater dependence on the Internet or other forms of e-commerce, businesses may run the risk of significant loss of revenue without proper plans for disaster recovery and business continuity. We need preventive, detective, and corrective controls. Preventive controls are designed to stop errors (or irregularities). Detective controls discover that errors have occurred (perhaps slipping through the preventive controls. And corrective controls help recover from errors (or other problems). SYSTEMS DEVELOPMENT AND MAINTENANCE CONTROLS All systems must be properly and formally authorized to ensure economic justification & feasibility. User specifications must be sought. Users should detail the logical needs that the system must satisfy. The activities of the systems development life cycle must be followed & documented, to operationalize the user specifications. The phases of the life cycle are: * Systems planning - aligning proposed projects with the company's strategy and resources * Systems analysis - surveying the current system and determining users' needs * Conceptual design - diagramming the proposed system's basic functions, inputs, outputs, and data sources and destinations * System selection - objectively evaluating feasibility, especially cost-benefit * Detailed design - modeling the processes, databases, and controls * System implementation - conversion to the new system * Maintenance - This is ongoing throughout the life of the system, and there should be modification controls to prevent a programmer (or anyone else) from making unauthorized changes to a program. All proposed changes should be approved, thoroughly tested and documented. Auditors should gain an understanding of the change process, and review a complete set of final documentation materials for recent program changes. The auditor should verify that program changes were identified, listed, approved, tested, and documented. The changes should be implemented by someone independent of the user and programming functions. The auditor can review all programs' access control tables/lists. The internal audit function should be involved to ensure adequate system controls. All systems must be completely documented. Documentation may be classified as: * Administrative - how to administer the IT department * Systems - includes flowcharts and program listings * Operating - how to input transactions and correct errors Thorough testing of the programs must occur before implementation. Actual test results are compared with predetermined expectations. User acceptance testing of the entire system must occur. In maintenance, all program revisions must have documented need, proper authorization, and thorough testing. Source program library management system * This system safeguards source programs, for access by development programmers and by maintenance programmers. * It enforces password control. * It has as an objective the separation of the source program test libraries from the application load module library. * It maintains sequential program version numbers * It automatically produces audit trails & management reports * It has specially controlled access to maintenance commands (e.g., over passwords or version numbers). HARDWARE CONTROLS * Restricted physical access (locked doors, guards, limited entry, magnetic cards, biometric ID [e.g., fingerprint, retina, iris], back-ups stored off-site) as well as logical access (passwords). Certainly, these physical access controls are general controls that benefit all applications, and they should not be overlooked. * Diagnostic routines, in which the computer checks its connections to peripheral devices and internal memory, perhaps, upon starting up. * Echo checks, in which receiving hardware sends the same message back for comparison * Tape file protection rings & write-protect tabs on disks, to physically prevent writing. * Parity checks (extra 9th bit - odd or even parity, added to a byte to make the total number of "on" bits odd or even, whichever is the standard in that installation, so that the 9th bit may be checked upon the next reading) * Preventive maintenance, to replace older components before they fail * Fault tolerance, such as ... * Redundant arrays of independent disks (RAID) among which data are stored and updated simultaneously on several disks * Uninterruptible power supplies providing back-up power in an emergency * Multiprocessing, so that a back-up processor is available in case of a failure PROTECTION OF PROGRAMS AND DATABASES * User views (subschema) to restrict users to a subset of the entire database * Database (or file, or device) authorization table (listing, for each file & each user, separate authority to - read, insert, modify, delete) * Data encrypted when stored * Software & hardware monitors to detect & report usage of data, programs, and devices (by whom, from where, when, how long, for what) * Back-ups performed regularly (grandparent-parent-child for sequential batch processing, under which three generations of master files are kept), with back-ups stored securely, off-site. This is helpful in case of disaster or error. Other forms of storage controls include the use of a data librarian. DISASTER RECOVERY PLAN Essentially, the plan is based on management's cost-benefit analysis of potential disasters. Its objectives are to minimize the extent of loss, quickly (if temporarily) establish means of processing information, and resume normal operations quickly. Business interruption insurance is necessary, but not sufficient. Steps in developing the plan include: * Identify "mission-critical" applications, establish the priority for business continuity * Ensure availability of data, programs, & documentation * Database and program copies stored off-site * Data recovery procedures, e.g., to bring the most recent database copy to current status by re-processing transactions that have occurred since the back-up * There should be specific assignments and access to phone numbers of team members, and the order in which they should be called. The major players will have specific responsibilities for arranging for new facilities, operating the computer, installing software, establishing communication capability, recovering v l records, and arranging for supplies. * Alternative processing: * Hot site (completely equipped) * Cold site (space available, but not fully equipped) * Manual operations if no power * Test the plan (as with a fire drill), and regularly assess the need for revision. All of these are basically general controls. In addition, application controls (sometimes also called transaction controls or accounting controls) must be incorporated into each application's input, processing, & output. Following are some examples of application controls. INPUT CONTROLS - Edit checks, or validation controls, intended to detect errors in transaction data before the data are processed. These might be designed to check at varying levels of detail. * Character - the most detailed, a single character * Field - such as a customer number. Examples of field checks are listed below. * Record - such as the customer record, containing all of the fields about the customer (e.g., customer number, name, address, etc.). The program might look for unusual interrelationships among the fields in the record. For example, in a relationship check, if an employee is not a salesperson (employee position field), there should be no sales bonus in the pay fields. * Array, or file - Is this the correct file? The program could look at the internal label (often the first record on the file) to confirm the file name, version, or date. Examples of field checks: * Validity - Is this a valid member of a set, such as a valid customer number? * Field type - Is this properly numeric, or alphabetic, or a proper date? * Limit - Is this less than the upper limit, or greater than the lower limit allowed? * Completeness or missing-data - Is this field incorrectly left blank? * Echo - When the user types in an account number, the system echoes back on the screen the corresponding account name so that the user can confirm. * Sequence - The program could look for records incorrectly out of sequence, or for missing numbers in a sequence. * Sign - A given field, for example, might get an error warning if it becomes negative. * Self-checking digit - Here an additional, redundant, digit is added to, for example a customer number. For example, a fifth digit might be a number that is computable from the previous four digits when the computer performs an internal algorithm (predefined calculation). Then, if the proper fifth digit is not in agreement with the calculation, the computer signals an error in the input of that field. * If using paper input documents, they should be prenumbered and well-designed. * Any errors found should be corrected before posting. * Batch control totals (record count, financial / amount totals, hash totals) should be verified. These can then be compared to control totals on output. Record count: The number of records (transactions) in a batch Financial / amount total: A meaningful total of a batch (total dollars, or total hours worked) Hash total: A meaningless total in itself (such as total of the social security numbers of employees in a batch). Still, like the other batch totals, it can be useful to detect transactions that were lost, or wrongly included, or incorrectly keyed. PROCESSING CONTROLS * Equality of debits & credits should be checked after posting (trial balances) * Posting references should be used to provide an audit trail * Standardized adjusting entries should be used. * Subsidiary ledgers should be reconciled to the general ledger. OUTPUT CONTROLS Reports should be reviewed by managers, accountants, and internal auditors. They should not be accessible by anyone not authorized to see them. And paper reports should be shredded before disposal.

Economic Measures ECONOMIC MEASURES ECONOMIC MEASURES AND REASONS FOR CHANGES IN THE ECONOMY, SUCH AS INFLATION,DEFLATION, AND INTEREST RATE CHANGES. National income accounting is an attempt to measure the economic performance and production of a nation. The accounting results in a hierarchy of measures that are related to each other. We start with GROSS DOMESTIC PRODUCT (GDP). GDP is the total market value of all final goods and services produced within a nation's borders during a specified year. GDP even includes the goods that are produced in local factories owned by foreign companies. The value of the good or service is determined by the price paid by the final consumer. By only counting the value paid by the "final consumer," it helps to avoid the multiple counting of the value of the good as it moves from one stage of production to another. There are some transactions that are excluded from GDP. GDP excludes all financial and monetary transactions because they are not related to the production of the final good or service. A second-hand sale is one such transaction (example, resale of home). Second-hand sales contribute nothing to the production of goods in the current year. Similarly, financial transactions is the other type of transaction that is excluded. Financial transactions such as veterans benefits, social security benefits, welfare benefits, gifts from one individual to another, and the buying and selling of stocks and bonds are not included in GDP. They are not included because they too are not associated with the payment for something that was produced in the current year. Even though GDP should include "all" goods and services within an economy, GDP fails to include some items of production that should be included. Homemakers who repair their own roof or who use their own labor to build a garage are producing something, but the value of their labor is not captured in GDP. Likewise, the production of the "underground economy" is not included in GDP. The underground economy, which produces goods like illegal drugs and illegal labor, along with unreported tips by waiters and waitresses, would actually add to the GDP of the economy but are omitted. Determining GDP There are two basic ways of determining GDP, the EXPENDITURES APPROACH and the INCOME APPROACH. The expenditures approach focuses on totaling the expenditures on goods and services produced while the income approach focuses on totaling all of the income generated by the production of final goods and services. Even though the two approaches yield the same GDP amount, their component parts are very different. The two approaches to calculating GDP are contrasted below: EXPENDITURES APPROACH INCOME APPROACH Personal Consumption Total Aggregate Income Expenditures ---------------------- + Wages and Salaries Gross Private Domestic Profits Investment + Interest Government Purchases + Rents Net Exports + Indirect Business Taxes + Depreciation + Net Foreign Factor Income (N.F.F.I.) Expenditures Approach For the EXPENDITURES APPROACH, the various elements are defined as follows: PERSONAL CONSUMPTION EXPENDITURES - the amount households spend on consumer goods and services during the year. GROSS PRIVATE DOMESTIC INVESTMENT - the amount businesses spend on adding and replacing fixed assets (cap l goods) and improvements plus additions to business inventories. Gross Private Domestic Investment does not include the sale of stocks, bonds, or the resale of business assets. GOVERNMENT PURCHASES - the amount that the government spends on goods (office supplies), services (law enforcement), and infrastructure (roads and schools). Government Purchases exclude transfer payments such as social security payments or welfare payments. NET EXPORTS - the amount equal to total exports minus total imports. Total exports are all the goods and services produced domestically, but sold abroad. Total imports are all goods and services produced abroad but sold domestically. Income Approach For the INCOME APPROACH, the various elements are defined as follows: WAGES AND SALARIES - compensation of employees including salaries, wages, and fringe benefits. PROFITS - net income of sole proprietors, partners, and other unincorporated businesses. Additionally, profits include the dividends, income taxes, and undistributed profits of corporations. INTEREST - earnings from bonds, savings deposits, certificates of deposit, and other debt instruments. RENTS - rent and lease payments less the year's depreciation on the asset being rented or leased. The sum of the four income elements listed above (Wages and Salaries, Rents, Interest, and Profits) constitute the NATIONAL INCOME (NI). NI is discussed more fully later. National Income INDIRECT BUSINESS TAXES- Taxes that include excise taxes, sales taxes, business property taxes, and license fees. These taxes are regarded as part of the cost of producing goods and services and are passed on (in whole or in part) to consumers through higher prices. DEPRECIATION - Depreciation is the cap l consumption allowance related to cap l goods. This includes the depreciation on business assets and public assets such as bridges and government buildings. NET FOREIGN FACTOR INCOME- The income earned by foreigners in the domestic economy for their contribution of labor and cap l in the production of goods and service minus the income earned by domestic nationals working , or employing their cap l , abroad. The Net Foreign Factor Income can be either + or -. NET DOMESTIC PRODUCT (NDP) is the market value of all final goods and services within an economy (GDP) less depreciation (consumption of fixed assets). NATIONAL INCOME (NI), which has already been discussed, may be determined in another way. NI can be calculated by starting with NDP and subtracting two elements of GDP. Those two elements are indirect business taxes and Net Foreign Factor Income (NFFI). The following illustrates that approach: Net Domestic Product (NDP) - GDP less Depreciation XXX,XXX Subtract Indirect Business Taxes XXX Subtract Net Foreign Factor Income XXX ----------------------------------------------------------------- National Income XXX,XXX Personal Income PERSONAL INCOME (PI) is the total income received by individuals or households. PI includes amounts that are currently received but not earned (transfer payments such as, social security benefits and pension benefits) and excludes amounts earned but not received (social security contributions, corporate income taxes, and undistributed corporate profits). PI is available for use in consuming goods and services, increasing savings, and paying personal taxes. Starting with NI, PI is calculated as follows: National Income (NI) XXX,XXX Subtract Social Security Contributions XXX Subtract Undistributed Corporate Profits XXX Subtract Corporate Income Taxes XXX Add transfer payments XXX ----------------------------------------------------------------- Personal Income (PI) XXX,XXX Disposable Income DISPOSABLE INCOME (DI) is PI minus personal taxes (income taxes, personal property taxes, and inher nce taxes). DI is the amount of income left after paying personal taxes. DI is available for use in consuming goods and services and increasing savings. Personal Income (PI) XXX,XXX Less Personal Taxes XXX ----------------------------------------------------------------- Disposable Income (DI) XXX,XXX The following summarizes the relationships among GDP, NDP, NI, PI, and DI: Billions of some currency ------------------------- GDP 10,000 Depreciation - 1,500 ------ NDP 8,500 Indirect Business Taxes - 500 Net Foreign Factor Income - 100 -------- NI 7,900 Social Security Contributions - 800 Corporate Income Taxes - 400 Undistributed Corporate Profits - 600 Transfer Payments + 1,800 -------- PI 7,900 Personal Taxes - 1,400 -------- DI 6,500

Fiscal Policies Fiscal Policy FISCAL POLICIES are actions that are implemented by government through spending and taxation. The impact that these actions have on the aggregate demand are illustrated below: 1. An increase government spending will cause the aggregate demand curve to shift outward and to the right. The curve will shift out and to the right because the government will increase the consumption of goods and services, which stimulates aggregate demand and increases GDP. On the other hand, a decrease in government spending will have the opposite effect. 2. A change in taxation legislation will also impact the aggregate demand curve. As noted above, a decrease in personal taxes and business taxes will cause the aggregate demand curve to shift outward and to the right. This is so because consumers will now have more disposable income to spend in purchasing goods and services. With greater income comes greater demand causing the aggregate demand curve to shift outward and to the right. On the contrary, an increase in taxes will have the opposite effect. Another reason the aggregate demand curve would shift outward and to the right is because of the impact of net exports. The impact that net exports have on the aggregate demand curve is illustrated below: 1. A higher level of exports causes an increase in production. Higher incomes abroad will cause increased exports. 2. Depreciation of the domestic currency in relation to other currencies causes domestic exports to be cheaper in the world market. The result is increased exports and higher aggregate demand. Money Supply Another economic measure is the size of the MONEY SUPPLY. The money supply is best considered in the context of the MARKET FOR MONEY (MONEY MARKET) where both the demand for money and the money supply are considered in terms of their combined impact on interest rates. Market for Money | D \ |S | \ | Real | \ |Supply of Money Interest | \| Rate |----------\ Market equilibrium | |\ determines interest | | \ rates | | \ | | Demand for money |______________________________________________ Amount of Money The interest rate is the price paid for money and just like any market for commodities, the price of money (the interest rate) is determined by the forces of money supply and money demand. The graph shown above illustrates the intersection of the supply and demand curves for money and how that intersection (the market equilibrium of supply and demand) determines the real interest rate. Money is needed (demanded) for two basic reasons - for transactions and for a store of value (an asset). Thus, the demand for money is the combination of these two sub-demands. The transactional demand for money varies directly with Nominal GDP. As Nominal GDP increases, the transactional demand for money increases because the higher level of economic activity increases the number of economic transactions and thus increases the need for money. The demand for money that originates from money as a store of value is a demand that is inversely related to the interest rate. When the interest rate is high, people are less likely to hold money as an asset because it is costly to hold money assets. When interest rates are low, the opportunity cost of holding money assets is low and thus people are more likely to want the security of liquid money assets. Transactional Demand Asset Demand D | | | | |@ D Interest | Interest | @ Rate % | Rate % | @ | | @ | | @ | | | | | | ______________________ |_________________________ Amount of Money Amount of Money Demanded Demanded The demand curve in the "Market for Money" graph is the combination of the two demand curves shown immediately above. Thus, the demand curve in the "Market for Money" graph is steeper than the demand curve for "Asset Demand" but not as steep as the demand curve for "Transactional Demand." Notice that the demand curve for Transactional Demand is inelastic (a straight vertical line) in relation to interest rates. That means the transactional demand is not influenced by interest rates. As stated earlier, transactional demand is influenced by Nominal GDP. On the other hand, the asset demand is influenced by the interest rate and thus it is shown with a gently slanting line indicating that it tends to be elastic demand. Elastic demand means that a small percentage change in the interest rate percentage will result in a greater percentage change in the amount of money demanded. Referring to the "Market for Money" graph, it should be clear that an increase in the Nominal GDP will shift the demand curve up and to the right. With no change in money supply, such a shift would cause interest rates to increase because the market equilibrium point will shift upwards. On the other hand, a decline in Nominal GDP will cause the demand curve to shift down and to the left. Such a shift, with no change in money supply, would cause the market equilibrium to shift downwards and interest rates will decline. Measures of Money Supply Now that we have examined the sources of change in the demand for money, let's discuss the measures of money supply. There are three components of the money supply, M1, M2, and M3. In general the M1 money supply contains the most liquid of the financial assets, then M2, and finally M3. The various components (M1, M2, and M3) of the money supply are described and related to each other below: M1 includes the following: Currency (counts and paper money Travelers checks Demand deposits and other checkable deposits M2 includes all that is included in M1 plus the following: Savings deposits and money market deposits Certificates of deposit of less than $100,000 Money Market mutual funds Small denomination time deposits M3 includes all that is included in M2 plus the following: Certificates of deposit and time deposits of $100,000 or more With regard to the money supply, economists typically focus on the M1 level. The other levels of money supply (M2 and M3) are measures used for other more specialized purposes. For example, M3 is used as a trend variable in the index of leading economic indicators. Federal Reserve System In the United States of America, the FEDERAL RESERVE SYSTEM (THE FED) and its member banks are the means by which the money supply is changed. In addition to being the central bank of the United States, the Fed issues currency, clears checks, supervises the banking system, and implements MONETARY POLICY. Monetary policy involves the use of OPEN MARKET OPERATIONS, the RESERVE RATIO, and the DISCOUNT RATE as a means of changing the reserves of the member banks.By changing the reserves of member banks of member banks, the member banks will have more or less money to lend to consumers and businesses. Open Market Operations OPEN MARKET OPERATIONS alter the reserves of member banks as a result of the Fed's net purchase or sale of government securities. If the Fed wants to expand the money supply, it merely seeks to become a net buyer of government securities from commercial banks or from the public. The buying of government securities puts money in the hands of the sellers, and that money moves to the commercial banks thus increasing the reserves of the commercial banks. The increase in reserves permits the banks to make more loans, thus increasing the money supply even more. The opposite is true when the Fed is a net seller of government securities in an attempt to reduce the money supply. The selling of securities takes money out of the hands of the buyers and thus, out of the commercial banks. The removal of the money form the commercial banks decreases the reserve. The reduced reserve will decrease the amount that the bank may loan. The Fed may also use the RESERVE RATIO to influence the money supply. If the Fed decreases the reserve ratio, it means that the member banks must keep less of their deposits in the form of reserves. Reserve funds can then be loaned to consumers or businesses, expanding the money supply. However, if the reserve ratio is increased, member banks are required to keep more money in their reserves and are not going to have as much money to loan out. A reduction in loans will reduce the money supply. Lastly, the member banks borrow from the Fed and the interest rate that the Fed charges the member banks is called the DISCOUNT RATE. By borrowing from the Fed, member banks can increase their reserves and thus increase their lending to consumers and to businesses. Thus, an increase in the discount rate will cause banks to cut back on their borrowing from the Fed, and a decrease in the discount rate will cause banks to increase their borrowing from the Fed. A lower discount rate will cause the money supply to increase and a higher discount rate will cause the money supply to decline. Of the three tools the Fed uses to influence the money supply, by far the most important is the open market operations tool (buying and selling of government securities). The Fed uses the reserve ratio tool only occasionally and it uses the discount rate tool only as an afterthought to announce to the public that it is seeking to increase the money supply or decrease the money supply. Now that we have examined the supply of and the demand for money, as well as their impact on interest rates, let's examine the implications of changes in the elements that make up the market for money. If the problem with the national economy is that there is high unemployment and the tendency is toward a recession, the chain of events might be as follows: The Fed Buys Government Securities --> Money Supply Increases --> Interest Rate Declines --> Spending Increases --> Aggregate Demand Increases --> Real GDP Increases --> Employment Increases --> Recession Averted On the other hand, if the concern is that the national economy is experiencing inflationary pressures, the chain of events might be as follows; The Fed Sells Government Securities --> Money Supply Declines --> Interest Rate Increases --> Spending Declines --> Aggregate Demand Declines --> Inflation Pressures Diminish

Flexible Exchange Rates Flexible Exchange Rates FLEXIBLE EXCHANGE RATES are exchange rates that are determined by the forces of supply and demand without government intervention. In such a world, changes in exchange rates would be determined by changes in tastes, relative income changes, relative price-level changes, relative interest rates, and the actions of currency speculators. In such a perfect world without government intervention, there would be no need for the use of the Official Reserves to bring a zero balance to the balance of payments. This would be the case because the exchange rates would perfectly reflect the demand-supply situation as it relates to goods and services. Government intervention in the foreign exchange market distorts the demand-supply situation. Although flexible exchange rates would eliminate the concern about the adequacy of the Official Reserves at the Federal Reserve, there are some negatives associated with flexible exchange rates. The uncertainty and variability of exchange rates might discourage trade between countries and such variability in trade would cause domestic industries to experience business fluctuations that could be disruptive to the country's economy. For example, if the U. S. economy is experiencing nearly full employment and the U. S. dollar depreciates, the demand for U. S. exports will increase and it could cause demand-pull inflationary pressures on the economy. On the other hand, an appreciation of the U. S. dollar could cause a decrease in U. S. exports and an increase in imports with the consequence being a decline in U. S. employment as a result of less demand for U. S. goods and services. In order to avoid the adverse effects of flexible exchange rates, some countries have fixed their exchange rates. Such "fixing" of the exchange rate does not stop the forces of supply and demand from operating as usual. Therefore, the country with FIXED EXCHANGE RATES must adopt policies to effectively stabilize the exchange rate for the country's currency. One such policy is the use of the country's Official Reserves of foreign currency to INTERVENE in the currency market by buying and selling the country's currency. Such CURRENCY INTERVENTIONS require that the county have sufficient Official Reserves to buy and sell as needed. That may not be possible if the country's Official Reserves have been depleted by persistent balance of payment deficits over many years. If there are not sufficient Official Reserves to pursue a currency intervention policy to stabilize exchange rates, the country may attempt to stabilize the exchange rate through TRADE POLICIES, EXCHANGE CONTROLS, and CONTACTIONARY POLICIES. These three less than desirable actions to stabilize exchange rates are commented on below: Trade policies - Imports could be discouraged by new tariffs and by import quotas. Exchange controls - The government is the sole buyer and seller of foreign currency. This, of course, encourages a "black market" for currency. Contractionary policies - policies to restrict imports by impacting demand. This can be accomplished through increased taxes, reductions in government spending, or an increase in interest rates. MANAGED FLOATING EXCHANGE RATES, which are currently used in the U. S., are nearly flexible exchange rates. Managed floating exchange rates are rates that are free to fluctuate depending on the supply and demand forces in the marketplace. However, currency intervention is sometimes used to influence supply and demand forces and thus impact the exchange rate during periods of threatened extreme exchange rate fluctuations. SPOT RATES are the current exchange rates at a point in time. A company engaging in international trade may protect itself from adverse fluctuations in the exchange rate by HEDGING their transactions. The act of hedging involves the use of FUTURES CONTRACTS or FORWARD CONTRACTS to provide some insurance that the sales price associated with an international transaction will not be eroded by an adverse change in the spot rate. Such contacts involve FORWARD EXCHANGE RATES. Forward exchange rates are the rates at which currencies can, by contract, be exchanged at some future date for the agreed upon amount. The future date is usually 30, 60, 90 or 180 days from the date of the contract. Example: XYZ Company sold transportation equipment to a German Company for 10,000,000 deutschmarks (DM) with credit terms of "net 180". The payment will be made in DM, and XYZ will then convert them to dollars. The following information is available concerning DM in terms of U. S. dollars: Spot rate .59 180 day forward rate .60 The spot rate indicates that one DM is worth $.59, and thus, $1.00 will buy 1.69 DM ($1.00 / .59). The DM is selling at a forward premium because its forward rate is greater than the spot rate. If XYZ wishes to avoid any exchange-rate risk by hedging the transaction, it should sell 10,000,000 DM forward 180 days. When XYZ receives the 10,000,000 DM it will be able to convert them to U. S. dollars at the contracted forward rate of .6000. Thus, XYZ can exchange the DM for $6,000,000. If the spot rate is .6100 on the day that XYZ obtains the 10,000,000 DM, XYZ would have incurred an opportunity cost. However, XYZ has effectively protected itself against a decline in the spot rate. By entering into the futures contract, XYZ was able to predict with certainty the U. S. dollars that would be received. The amount of the discount or premium on forward exchange rates will vary based the volatility of the currency. The greater the volatility, the greater the premium or discount. Comparative Advantage The concept of "COMPARATIVE ADVANTAGE" permits us to place international trade in the proper perspective. Consider the production possibility curves for Germany and Ireland in terms of the potential production of steel and wool. The two curves below show that Germany has a greater possibility associated with the production of steel than does Ireland. The curves also show that Ireland has a greater possibility associated with the production of wool that does Germany. 100 | Germany |\ Tons | \ of | \ Steel | \ |(1) \ (1) Production Possibilities | \ | \ |_______\_______ 50 Tons of Wool 100 | | | 50 |* Tons | * of | * Steel | (1) * (1) Production | * Possibilities |________________________* 100 Tons of Wool Cost ratio for the two products for each country is as follows: Germany's Cost Ratio: One ton of steel equals 1/2 ton of wool or one ton of wool equals 2 tons of steel. Ireland's Cost Ratio: One ton of steel equals two tons of wool or one ton of wool equals 1/2 ton of steel. Suppose that the world-wide exchange ratio for steel and wool is one ton of steel is equal to 2 tons of wool. Then Germany should produce steel and exchange some of the steel for wool and Ireland should produce wool and exchange some of it for steel. Comparative Advantage The principle of comparative advantage states that if each nation in a two-nation world specializes in the production of a good in which it has a comparative advantage, trade will be prof ble to both nations. Based on the idea of comparative advantage, FREE TRADE is more likely to bring about a more efficient allocation of resources and a higher level of consumer satisfaction. In spite of the benefits associated with the comparative advantage theory, there are BARRIERS TO FREE TRADE. Listed below are some of the barriers to free trade. 1) Protective tariff-protects domestic producers from foreign competition. 2) Import quota-Limits the quantity of an item that may be imported. 3) Non-tariff barrier-Unreasonable standards concerning product safety and or quality. 4) Voluntary export restrictions-Foreign firms voluntary limit the amount of their exports to a particular country with the expectation that their action will avoid more stringent barriers to trade. 5) Anti-dumping-In an attempt to prevent some foreign companies from selling their product at a price which is below the cost of making the product, some countries establish "anti-dumping" duties on the specific product. The following organizations are involved in international trade 1) International Monetary Fund (IMF)-An international organization that holds currency reserves from over 180 member countries and makes currency loans to national central banks. The IMF also makes loans to countries about to default on government and non-government loans. 2) General Agreement on Tariffs and Trade (GATT)-Agreement among a large number of nations to eliminate import quotas and reduce tariffs. GATT was designed to set international trade rules and to reduce trade barriers among member nations. The rules work to eliminate import quotas and reduce tariffs. 3) World Trade Organization (WTO)-Replaced GATT to resolve any disputes arising from the agreements under GATT. Transfer Pricing TRANSFER PRICING refers to the pricing situation that often arises in a decentralized company. One division of the company may produce an intermediate product (transmission assembly) that will be purchased by another division of the same company for use in the final product (auto). The issue is the appropriate selling price of the intermediate product. The choice of the transfer price for the intermediate product has important implications as the company seeks to maximize its profits. The division that sells the final product will maximize profit by producing and selling a quantity that is determined by the intersection of the marginal revenue curve and the marginal cost curve. The transfer price is an important element in the determination of the marginal cost of the producer of the final product. If there is no external market for the intermediate product (a transmission assembly that is uniquely suited to one particular brand of auto), then all transmission production will be purchased by the auto maker and the auto maker will not be able to purchase the transmission from any other producer. In such a situation, the transfer price should equal the intermediate product manufacturer's marginal cost of production at the level of production demanded by the producer of the final product. When there is a perfectly competitive external market for the intermediate product, the transfer price determination is much more simple. In this situation, the intermediate product manufacturer could sell any excess production to customers outside the firm. Likewise, if the buying division needs a larger quantity of the intermediate product than the quantity manufactured by the sister division, the needed quantity could be purchased externally. In such a situation, the transfer price should equal the market price for the intermediate product. BIBLIOGRAPHY: Boyes, William and Melvin, Michael. Macroeconomics, second edition. Houghton Mifflin Co.: Boston. 1994. Gwartney, James D., Sobel, Russell S., and Stroup, Richard L. Macroeconomics: Private and Public Choice, 9th edition. Dryden Press: Philadelphia. 2000. Gwartney, James D. and Stroup, Richard L. Macroeconomics: Private and Public Choice, 8th edition. Dryden Press: Philadelphia, 1997. Madura, Jeff. International Financial Management, 6th edition. South-Western College Publishing: Cincinnati. 2000. McConnell, Campbell R. and Brue, Stanley L. Economics: Principles, Problems, and Policies, 15th edition. McGraw-Hill Irwin: Boston. 2002. McGuigan, James R., Moyer, R. Charles, and Harris, Frederick H. deB. Managerial Economics: Applications, Strategy, and Tactics, 9th edition. South-Western College Publishing: Cincinnati. 2002. Ulbrich, Holley H. and Warner, Mellie L. Managerial Economics. Barron's Business Library. Barron's Educational Series: New York. 1990.

Foreign Exchange Foreign Exchange Market IMPLICATION TO BUSINESS OF DEALINGS IN FOREIGN CURRENCIES, HEDGING, AND EXCHANGE RATE FLUCTUATIONS The market for FOREIGN EXCHANGE may be viewed as any other global market for a commodity (an undifferentiated product). The foreign exchange market is a market where currencies of different nations are traded. Each currency can be related to another and this relationship is called the EXCHANGE RATE. The exchange rate is the domestic price of one nation's currency for one unit of another nation's currency. For example, when the exchange rate between a U. S. dollar and a Canadian dollar is $.76 U. S. per Canadian dollar, it means that it takes $.76 U. S. to buy $1.00 Canadian. Or, from the Canadian perspective, it takes $1.3158 Canadian to buy $1.00 U. S. (1/.76 =1.3158). Therefore, if a hotel room in Canada costs 180 Canadian dollars per night and the U. S. Dollar to Canadian Dollar exchange rate is $.76, then the cost of one night in the Canadian hotel in U. S. dollars is $136.80 (180 Canadian dollars times .76). If that exchange rate were to increase to .80, the cost of the Canadian hotel room would increase to $144.00 U. S. Dollars. Such an increase would have a negative impact on the number of U. S. tourists visiting Canada. The market for Canadian dollars may be viewed as follows: Demand Supply | \ \ / | \ \ / .80 |------------\------\/ | \ /\ | \ / \ | \ / \ .76 |----------------/ \ | |\ \ US $ | | \ D1 1 Can $| | \ |_____________________________ Q Quantity of Canadian Dollars Suppose there is an increase U. S. imports from Canada. This will create an increase in demand for Canadian dollars. The increased demand will shift the demand curve upward and to the right. If there is no commensurate increase in the supply of Canadian dollars (a shift out and to the right in the supply curve) the result will be an increase in the exchange rate as displayed above. Assuming no change in the supply of Canadian dollars for foreign exchange, the revised demand curve (D1) would result in an exchange rate of .80. Any action that will increase the demand for Canadian goods and services will increase the demand for Canadian dollars. When the U. S. dollar price for one Canadian dollar increases as it did from .76 to .80, we say that the U. S. dollar has DEPRECIATED in relation to the Canadian dollar. A depreciated U. S. dollar buys fewer Canadian dollars and thus fewer Canadian goods and services. Hence, the purchasing power of the U. S. dollar has decreased (or declined in comparison to the Canadian dollar. It now takes more U. S. dollars to buy the same Canadian dollar. Therefore the U. S. consumer will decrease the number of Canadian goods and services purchased and switch to purchasing the relatively less expensive U. S. goods and services. On the other hand, if the U. S. dollar price for one Canadian dollar decreases, we would say that the U. S. dollar has appreciated relative to the Canadian dollar. This means that the U. S. dollar can now buy more Canadian dollars and the purchasing power of the U. S. dollar has increased. When the U. S. dollar depreciates, foreign goods become more expensive in terms of U. S. dollars and the IMPORTS of foreign goods will decline as consumers and businesses are more inclined to buy domestic products. The other effect of a depreciating U. S. dollar is that U. S. goods become cheaper to consumers and businesses in foreign countries. Thus, a depreciating dollar tends to increase EXPORTS from the U. S. Of course, the opposite is also true. An appreciating U. S. dollar will cause imports to increase and exports to decline. Therefore, the exchange rate for a domestic currency vis-ŗ-vis the other countries of the world has a tremendous impact on the domestic country's balance of payments.

Implications of Electronic Commerce ELECTRONIC COMMERCE E-commerce includes many activities, such as creating a Web site to support investor relations, to advertise products/services, to track orders, to speed delivery along the supply chain. It thus involves all aspects of a company's interactions with its stakeholders. To be successful, e-commerce implementations must support the business's overall strategy, and produce transactions with validity, integrity, and privacy. EDI (Electronic Data Interchange) * Between 2 entities (bank, supplier for JIT) * No paper required * Compresses the processing (business, cash) cycle * Controls are essential * Need common standards ("protocols") among the parties, and data dictionaries defining the fields EDI may be implemented via dedicated point-to-point private networks, or .... Value Added Network or Third Party Network (in which a third party supplies a higher quality connection providing users with a mailbox, facil ting batch processing, once or several times per day) Major risks associated with the implementation of an EDI system are ... * Choosing an inappropriate technology (one which will not interface most effectively with their trading partners) * Unauthorized system access into the system * Tapping into data as it is transmitted * Loss of data integrity through human or system error * Incomplete transactions received * System failures EFT (Electronic Funds Transfer) EFT allows daily review of collection results and the making of overnight investments but requires special controls, such as: * Segregation of duties, where only certain people can perform certain functions * Feedback of receipt to sender * Reports to reconcile with bank * Reports which flag large/multiple/unscheduled EFTs * Audit trails and logs * Reasonableness checks/edits in programs EDI has been popular in business, for B2B (business-to-business) commerce well before the widespread use of the Internet. EDI involves two businesses using a private communication link (or a VAN). Other forms of electronic commerce Direct consumer marketing (electronic marketplaces) Online delivery of dig l products (e.g., software updates, music) Direct market links throughout the supply chain Point-of-sale systems usually automate source data collection, where the cashier keys in the item purchased, or the item is scanned for a UPC (bar code) or optical character recognition of actual characters/numbers on a tag. This reduces clerical errors and speeds customer check-out. Not only is cash controlled, but inventory is reduced for each sale in real time. Suppliers may be permitted access to inventory data for replenishment, although this increases inherent risk. In this case, procedures are required for: * Authentication - user IDs and passwords should be confirmed * Authorization - an access control list, stored internally in the operating system, would show which users had what kind of authority over which items of data * Accountability - all changes would be recorded in a log * Data transmission - controls (e.g., encryption) would maintain confidentiality and integrity of data transmitted Protocols are rules and standards for the design of hardware & software. They facil te physical connections, synchronize the transfer of data, and provide a basis for error checking. Open systems promote compatibility, allowing hardware & software of different manufacturers to interface seamlessly. JPEG and GIF are open system standards for images. Moreover, they are scalable (efficiently compatible with small and large systems), portable, and interoperable among systems. EFT requires common protocols so that the buyer's originating bank may remove funds from the buyer's account and transmit them electronically to the automatic clearing house (ACH) bank, and the funds may then go to the seller's account in the receiving bank. The ACH is a central bank that carries accounts for its member banks. Because ACHs are required only to accept and process EFT formats limited to 94 characters of data, value-added banks (VABs) have arisen to accept disbursement & remittance advices in longer and more varied formats. THE INTERNET The Internet is an international network of independently owned smaller networks and computers that operate as a giant, linked, seamless computing network. Users can communicate inexpensively and transmit data globally. Data are not centrally stored but rather are on geographically dispersed servers. The Internet "backbone" is the part of the network that acts as the primary path for traffic that is most often sourced from, and destined for, other networks. Companies such as IBM and Sprint maintain backbones. Microsoft's Internet Explorer is a popular browser, although there are others, such as Netscape Navigator. A browser is software that converts text (written in Hypertext Markup Language - HTML) into Web pages, based on tags (such as "bold" or "table") embedded into the text. Extensions of HTML, that can do more than just format Web pages, are XML (extensible markup language) and XBRL (extensible business reporting language). An intranet is an internal network used within a company that looks like the Internet as it is accessed with browsers. It is inaccessible by the general public. Groupware (such as Lotus Notes) is software designed to support the work of teams, possibly using a company intranet, to share information, maintain calendars for meetings, maintain company bulletin boards and personnel policies, and allow brainstorming on projects and reports. An extranet is the linked intranets of two or more companies. SPECIAL INTERNET ISSUES Dependence on the Internet for e-commerce requires that the system be up & running continuously. Besides equipment failure, human error and fraud, there are malicious threats: * Viruses and worms * Logic bombs (triggered by a predetermined event) * Back doors (to enter a system, avoiding normal log-on) * Trojan horses (masquerading as log-on program to capture ID's) * Denial-of-service attacks (clogging ports to prevent legitimate users' access to a site) * Unlike on secure or private lines, data may be captured or altered en route. And anyone in the world could potentially access your system. FIREWALLS should be used to enforce access controls * Network-level firewalls - low cost, low security - a screening router (hardware and/or software) to examine source & destination addresses * Application-level firewalls - expensive, customizable - "proxy" applications can permit routine e-mail but log in, authenticate, & restrict access by particular user & task ENCRYPTION Private-key encryption (e.g., DES) - same key shared by sender & receiver, to encrypt & decrypt Public-key encryption (e.g., RSA) - many senders may have public key to encrypt, but only the receiver has private key to decrypt Dig l signature - sender uses his private key to encrypt a "digest" of his message, and receiver's public key to encrypt the package of the digest & the message; receiver decrypts & compares Dig l certificate - a trusted third party (certification authority) encrypts sender's message, certifying sender's authenticity OTHER TECHNIQUES FOR INTERNET SECURITY * Message sequence numbering (to detect missing messages) * Message transaction log (to recover lost messages) * Request-response at periodic intervals to confirm other party's connection * Call-back devices (hanging up, and calling back at authorized number/address) * Protect against line errors with echo checks & parity checks

Incremental Analysis Incremental Analysis (Relevant Costing) The concepts of C.V.P. Analysis (particularly contribution margin) may also be used to evaluate the effects of proposed changes or alternatives on prof bility and the level of operations. In the application of C.V.P. concepts the candidate must be able to identify for analysis the relevant quant tive information, which varies depending on the nature of the problem. Historic amounts or amounts which do not change are irrelevant in decision making. The relevant amounts are the future, differential amounts (incremental analysis), the amounts which are different or change in the future depending on which alternative is selected. Incremental Analysis Illustrative Problem 1. Able Company operates at 90% of plant capacity, producing 90,000 units of product. The total cost of manufacturing 90,000 units is $76,500 (VC = $49,500, FC = $27,000), resulting in a cost per unit of $.85. Recently, a large customer, who purchases 15,000 units per year, canceled his orders for the following year. Rather than operate at 75% of capacity, the company is seeking new customers. A potential customer, Buy-More Co. has offered to purchase 20,000 units at $.65 per unit. Should Abel Co. accept this special order? Solution: Selling Price $.65 Variable Cost .55 ($49,500 / 90,000) C.M. $.10 Yes. It makes a contribution to the recovery of F.C. and profit. 2. Referring to problem 1, if a second customer, Could-Be Co. is willing to buy 12,000 units at $.75 per unit, which order should be accepted? Answer: "Could-Be" resulting in $400 additional contribution. (12,000 @ $.20 CM vs. 20,000 @ $.10 CM) 3. Zelta Co. manufactures a single product which it sells to other manufacturers for further processing and sale to ultimate consumers. The unit selling price and unit cost data for present production of 100,000 units per year are as follows: Selling Price $7.00 Direct Materials $1.15 Direct Labor 1.80 Variable OH 1.15 Fixed OH .80 Variable selling expense .85 Fixed selling expense .35 6.10 Profit per unit B.T. $ .90 Zelta Co. is considering performing the required further processing itself and selling the product to the ultimate consumer. Additional processing requires no special facilities. The unit selling price and cost data of the further processing are estimated to be: Selling price per unit $8.50 Direct labor per unit .70 Variable overhead per unit .20 Variable selling expense per unit .10 Fixed overhead per year 15,000 Fixed selling expense per year 10,000 Should Zelta perform the further processing? Answer: Yes, $50,000 added profit. The fixed overhead and selling expenses are not incremental costs but rather reallocations of existing costs. Note that no additional facilities were required for the additional processing. Incremental revenue is $1.50 ($8.50 - $7.00) and incremental costs are $1.00 ($.70 + $.20 + $.10). The incremental contribution margin is $.50 per unit or $50,000 total. Assumptions Which Underlie C.V.P. Analysis 1. Costs which can be classified as either fixed or variable. 2. Variable costs change at a linear rate. 3. Fixed costs remain unchanged over the relevant range. 4. Selling price does not change as the physical sales volume changes. 5. There is only a single product, or the sales mix remains constant. 6. Productive efficiency does not change. 7. Inventories are either kept constant or are zero. 8. Volume is the only relevant factor affecting cost. 9. There is a relevant range of validity for all of the underlying assumptions and concepts.

Internal Rate of Return INTERNAL RATE OF RETURN (IRR) As discussed earlier, the NPV is calculated using the cost of cap l percentage based on prevailing interest rates. A positive NPV means to go forward with the project. Instead, we can calculate the Internal Rate of Return, which is the interest rate that results in a NPV of zero. Thus, the IRR (internal rate of return) does not depend on the prevailing market rate of interest (cost of cap l). After calculating the IRR the company would decide if the IRR is high enough to go forward with the project. EXAMPLE: Using the same data described in the NPV example determine the IRR. Answer: The IRR is a little higher than 15%. NPV = -$1000 + ($300) X (PV i = ?) n = 5 0 = $1000 = $300 x (PV i = ?) n = 5 $1000 = (PV i = ?) ----- n = 5 $ 300 3.3334 = (PV i = ?) ( n = 5) Now, looking at the "Present Value of an Ordinary Annuity of 1 "table (see below) we find that for n = 5 the factor 3.3334 reveals an interest rate (IRR) of a little greater than 15% because the factor for i = 15% is 3.35216. Recall that in the NPV example the factor for n = 5 and i = 8% was 3.99271. The higher the interest rate the lower the factor. Present Value of An Ordinary Annuity of 1 (Partial Table) (n) Periods 10% 12% 15% ---------------------------------------------- 5 3.79079 3.60478 3.35216 EXAMPLE: The internal rate of return for a project can be determined a. if the internal rate of return is greater than the firm's cost of cap l. b. only if the project cash flows are constant. c. by finding the discount rate that yields a new present value of zero for the project. d. by subtracting the firm's cost of cap l from the project's prof bility index. e. only if the project's prof bility index is greater than one. Answer: (c) is correct. The internal rate of return (IRR) for a project is indeed that discount rate which yields a net present value of zero. Choice (a) is wrong because the IRR can be determined regardless of its relation to the cost of cap l. In fact, a major reason for determining the IRR is to see whether it is more or less than the cost of cap l. Choice (b) is wrong because cash flows do not need to be constant to determine the IRR, although constant flows would facil te the manual computation. Choice (d) is wrong because it has nothing to do with the computation, and choice (e) is wrong because IRR can be determined regardless of whether the prof bility index is greater or less than one. PAYBACK PERIOD - The number of years to recoup the investment. This method is not valid for virtually all situations, except investing in a volatile country. EXAMPLE: An investment requires an initial investment of $10,000 and will generate cash flows of - 2,000 + 3,000 + 4,000 + 4,000 + 4,000 + 4,000 over years 1 through 6 respectively. What is the payback period? Answer: In approximately 4 1/4 years the company will recoup its investment of $10,000. (-2000 + 3000 + 4000 + 4000 + 4000 (1/4) = $13,000) EXAMPLE: The payback period for an investment project is defined as a. the number of years required for cumulative project profits to equal the initial investment. b. the number of years required for cumulative project cash flows to equal the average investment. c. the number of years required for cumulative project cash flows to equal the initial investment. d. a period of time sufficient to earn a return equal to the cost of cap l. e. the number of years required for the discounted project cash flows to equal the initial investment. Answer: (c) is correct. The payback period, which divides the initial net investment by the annual net cash inflow, does indeed derive the number of years for cumulative project cash flows to equal the initial investment. It deals with cash flows, not profits (choice a), and it divides into the initial investment, not the average investment (choice b). It absolutely does not consider the cost of cap l (choice d) or the discounted cash flows (choice e). DISCOUNTED PAYBACK PERIOD - STEPS: 1. First, discount all cash flows, then determine the payback period. 2. This method is not worth the trouble. 3. We should just do the NPV. ECONOMIC VALUE ADDED (EVA) Economic Value Added (EVA) focuses on managerial effectiveness in a given year. EVA is an estimate of a business's true economic profit for the year, thus it is different from accounting profit. EVA represents the residual income that remains after the cost of all cap l, including equity cap l, has been deducted, whereas accounting profit is determined without deducting the cost of cap l. The basic formula for EVA is as follows: EVA = Net operating profit after taxes, but before interest. - After-tax dollar cost of cap l used to generate the profit. OR EVA = EBIT (1 - Corporate tax rate) - (Operating cap l)(After-tax percentage cost of cap l). Operating cap l is the sum of the interest-bearing debt, preferred stock, and common equity.

Inventory Management Inventory Management How much to order, and when The objective is to minimize three costs: * Ordering costs Varies with number of purchases Includes receiving costs * Carrying (holding) costs Storage (opportunity cost - lost space rental) Interest on money tied up (opportunity cost - of cap l) Spoilage, damage Obsolescence Property taxes Insurance * Stockout costs Lost contribution margins Customer bad will Factory shutdowns Economic Order Quantity (EOQ) EOQ Model Assumptions * Constant, known demand * Same order size each time * No quantity discounts * Entire order received at one time * No limit on order size EOQ Computations (how much to order): /------ \/2aD / K Where a = cost per purchase D = Annual demand K = Fixed cost of purchasing Example: Moss Converters Inc. uses 100,000 pounds of raw material annually in its production process. Material cost is $12 per pound. The cost to process a purchase order is $45, which includes variable costs of $35 and allocated fixed costs of $10. Out-of-pocket handling and storage costs amount to 20 percent of the per pound cost. The company's cost of cap l is 15 percent. The formula to determine the economic order quantity is EOQ = SQRT (2 AD/K) A = the annual unit demand. D = the cost per order. K = the cost of carrying one unit per year. Moss' economic order quantity is a. 1,291 units. b. 1,464 units. c. 1,708 units. d. 1,936 units. e. 1,972 units. Answer: (a) is correct. The annual demand is given as 100,000 pounds. The cost per order is given as $35. (Only the variable cost should be considered for this, not any allocated fixed cost which will not change in total if we process more or fewer purchase orders.) Carrying costs must be computed as the handling and storage costs plus the cost of cap l, or 20% + 15%, multiplied by $12 (the cost per pound). Thus K= 35% times $12, or $4.20. Consequently, EOQ equals the square root of 2 * 100,000 * $35 / $4.20, or the square root of 1,666,667, or 1,291. Example: Companies that adopt just-in-time purchasing systems often experience a. an increase in carrying costs. b. a reduction in the number of suppliers. c. fewer deliveries from suppliers. d. a greater need for inspection of goods as the goods arrive. e. less need for linkage with a vendor's computerized order entry system. ANSWER: (b) is correct. JIT purchasing often involves a reduction in the number of suppliers, as the company uses only the most dependable suppliers, and works closely with them to teach them exactly what specifications are required, including prompt deliveries and near-zero defects. An increase in carrying costs (choice a) would not result, since the goal is to reduce the amount of inventory carried. Fewer deliveries (choice c) would not result, since JIT often increases the number of deliveries, with each one containing a smaller number of units than previously. A greater need for inspection (choice d) would not result since JIT includes teaching the suppliers exactly what specifications are required, including near-zero defects. Less need for linkage with the vendor (choice e) would not result, since JIT involves greater linkage so that orders may be placed and received as quickly as possible. Just-In-Time (JIT) seeks to minimize inventories with frequent, smaller purchases. * Long-term relationships with fewer suppliers * Suppliers are selected for quality and reliability * Demand-pull - order inventory when needed

Inventory Planning and Control Reasons for Inventory Control The management of inventories to achieve the needs of the business at the lowest possible cost is of the utmost importance. Inventories are generally a relatively large balance sheet item and mismanagement of inventories, ranging from raw materials to finished goods, can cause a variety of serious problems. Among these are: disruptions of production, loss of customer goodwill, loss of contribution margin or lost sales. However, businesses that "never run out of anything" may be incurring needless high costs of carrying inventory that may prevent the realization of adequate profits. We can show the pros and cons of this in balanced form as follows: Costs that may be incurred Costs that may be in carrying inventory incurred by not carrying enough inventory 1. Management costs 1. Discounts not realized 2. Insurance 2. Disruptions of production 3. State and local taxes 3. Additional purchasing cost 4. Interest 4. Additional transportation cost 5. Space 5. Customer relations 6. Obsolescence 6. Additional high cost of rush orders and/or production 7. Handling 7. Lost profit on sales not made Costs Relevant to Inventory Control It is apparent that many of these factors are not in the accounting records and must be determined by analysis. In some cases the cost may be insignificant or zero depending on the circumstances. Care must be used in determining whether a particular cost is relevant. For example, if the space is available (whether or not owned) and cannot be used for other prof ble purposes, the cost of space is not relevant. However, if additional space must be obtained or inventory storage prevents the use of the space for other prof ble activities, the cost is relevant. Interest cost of carrying inventory should be considered regardless of whether or not funds were borrowed to purchase inventory, since funds not used for such purpose could be prof bly put to an alternate use. The rate of interest depends on the facts in each case, such as: the cost of borrowing, the average cost of cap l (including debt and equity cap l) or the rate that could be earned by an alternate use of the cap l. Economic Order Quantity (Standard Order) The economic order quantity is the amount of inventory that should be purchased at any one time in order to minimize to total costs associated with inventory (carrying costs and ordering costs). The economic order quantity may be computed by trial and error or by formula as follows: Symbols Q = Economic order quantity S = Total units sold during the period O = Ordering cost per order C = Carrying cost per unit Formula /-------- Q = / 2SO / ----- \/ C Example: A manufacturer purchases bicycle frames at a cost of $5 per unit. The total annual needs are 50,000 units at an average rate of 200 frames per workday. Maximum daily usage is 250 frames. Delivery of an order normally takes 4 days. Other information: Cost of borrowing (or return that could be earned by alternate use of funds) 8% x $5.00 $ .40 Rent per unit per year .18 Taxes per unit per year .06 Insurance .06 Total carrying cost per year $ .70 Cost per purchase order $14.00 Solution: (a) Formula: /-------- Q = / 2SO / ----- \/ C /-------------------- Q = / 2(50,000)($14) / -------------- \/ .70 /------------- Q = \/ 2,000,000 Q = 1,415 ===== (b) Trial and Error: Order size (Q) 1,000 1,500 2,000 Average Inventory (Q/2) 500 750 1,000 No. of orders (S/Q) 50 33 1/3 25 Annual storage cost (C Q/2) $ 350 $525 $ 700 Purchase order cost (O S/Q) $ 700 $467 $ 350 $1,050 $992 $1,050 ====== ==== ====== We can see that 1,500 units per order results in the lowest cost. If we try 1,400 or 1,600 we would know in which direction the cost trend is moving as follows: Order size 1,400 1,600 1,415 Average inventory 700 800 708 No. of orders 35 5/7 62 1/2 35 1/3 Annual storage cost $490 $560.00 $496.00 Purchase order cost $500 $437.50 $493.50 $990 $997.50 $989.50 ==== ======= ======= Lead Time and Safety Stock When we have determined the economic order quantity of the size of an order that minimizes annual cost, we must determine when to order. To do this we must know: 1. Lead time-interval between the placing of an order and delivery, in this case 4 days. 2. Economic order quantity-in this example, 1415. 3. Demand during Lead Time-4 x 200 = 800. The order point is determined as the safety stock plus average usage during lead time. The safety stock must be sufficient to provide for maximum usage of stock during lead time. For example: Maximum daily usage 250 Average daily usage 200 Excess 50 Lead time x 4 Safety Stock 200 Average usage during lead time 800 Order Point 1,000 units ===== Or we could simplify this by saying that the order point should be: Maximum usage x lead time or 250 x 4 = 1,000 units Note: If inventory level was zero, caused by maximum usage during lead time, the inventory level would go to only 1,415 when the order was received. JUST-IN-TIME INVENTORY PHILOSOPHY: Under JIT inventory methods raw materials are obtained "just-in-time" for use in production, finished goods are produced "just-in-time" for delivery, and other inventory items are provided just when needed. A JIT system minimizes or potentially eliminates inventory and its related carrying costs. Implementation of a JIT system requires a backlog of orders and reliable suppliers so that the production process is not interrupted. The benefits of JIT would be lost if a company had to shut down its operation for long periods while waiting for new orders or materials/supplies. Advantages of a JIT system include: * Release of funds invested in inventory. * Frees space. * Reduces production time (throughput time). * Reduces/eliminates nonvalue-add activities such as movement of inventory, storage, setup time. * Improves quality as defective inventory must be corrected immediately; there are no inventory pools to hold defective units. * As goods are produced to order not for inventory, better control is required over lost or spoiled goods. * Simplifies accounting by charging costs directly to cost of goods sold (no inventory). If inventory exists, the inventory is "backed out" of the cost of goods sold account. Backing inventory amounts out of cost of goods sold is referred to as backflush accounting.

IT Fundamentals Hardware, Software, and Data Organization OPERATING SYSTEMS Most people are familiar with a version of Microsoft's Windows as their operating system. There are others also, such as Unix, Linux, OS/2, and Apple's Macintosh. Among the responsibilities of the operating system is the allocation of computer resources (processors, main memory, printers, etc.) to applications, as well as the scheduling of the applications. Thus, it is critical that the operating system (OS) protect itself and its users. For security, the OS should have a log-on procedure, requiring a user ID and password. Sometimes, there is then created an access token containing key information about the user and his privileges. The OS might include as well an access control list defining access privileges for each valid user for all system resources. System audit trails record activity at the system level. They may include keystroke monitoring, recording every key pressed by every user. Or they may involve simply event monitoring, listing activities executed, the user ID, and the starting/stopping times. PROGRAMMING LANGUAGES Software is written in a programming language. When computers were first invented, all programs were written in first-generation language, or machine language, instructing the computer precisely what to do, such as what piece of data (the precise numerical location in internal memory and the number of bytes/bits) to be moved to what other location, or to be moved to which internal register to be subtracted from other data that had already been moved to that register. And all of this was written in binary code. Eventually, language translators (assemblers, compilers, and interpreters) were invented to translate from the more natural language (the "source program") into machine language for execution (the "object program" or "load module"). Second-generation language - This was an assembler language, which was essentially a one-for-one mapping into machine language instructions from a form that allowed the programmer to use mnemonic abbreviations representing binary-coded instructions. Third-generation languages - These were actual rudimentary sentences, that could be compiled or interpreted into machine language procedures. They were thus also called procedure-oriented languages, and included FORTRAN, COBOL, BASIC, C, AND PL1. Fourth-generation languages - These are even more powerful, such as SQL (Structured Query Language) for querying a database. Event-driven languages - Here we have moved beyond procedural languages, since the program is not executed every time in the programmer's specified sequence. Instead, the user may alter the flow according to events that he might initiate, by clicking an icon. Languages that allow humans to interface with the computer through screen icons allow GUI (graphical user interfaces). Object-oriented languages - Here, languages like Java manipulate objects, which are software packets containing both data and instructions. FILES, AND DATABASE MANAGEMENT SYSTEMS (DBMSs) Until recently (and even now, to a large extent), all companies organized their data into files, such as the customer master file. That file would be composed of - * Records (e.g., one record for each customer), which would be composed of * Fields (e.g., the customer name field, or the customer zip code field) which would be composed of * Bytes, or characters/digits, which would be composed of * Bits, the binary ones and zeroes a computer uses to represent data. Files may be organized in the following ways: * Sequential, in which all records are in sequence, according to their primary keys (e.g., by customer number for a customer file). Sequentially organized files are efficient for updating or processing an entire master file with a batch of current transactions. * Indexed, in which records may be retrieved by the operating system's searching through a file's index for the primary key, and the index will provide the disk address, just as an index in the back of a book refers you from a key word to a page number. * Randomized, in which a "hashing scheme" or algorithm performed on the primary key provides the disk address. For example, the operating system will divide the key into a number, and the remainder that results from that division will be the disk address of the record with that key. Randomized files provide very fast access for querying particular records. Files are stored on secondary storage devices, such as - * Tape, if sequential access only is needed * Magnetic disk, or CD, DVD, if direct or random access is needed Primary storage consists chiefly of RAM (random access memory) where data and programs are temporarily stored during processing, but it also contains ROM (read-only memory) and cache (very fast-access temporary memory for frequently used items). Now, database management systems - DBMSs - (software enabling users to create, modify, and utilize an organization's information, previously stored on multiple separate files) are quite popular, providing: * Data independence (data exist independent of any particular application, and can be used by any application that is authorized. Thus, for example, "quantity-on-hand" for an inventory item may be used by both the purchasing and the inventory control applications, but is stored and maintained only once.) * Reduced data redundancy (each data item is stored only once, regardless of how many applications use it) * Accessibility of data by many users, flexibility in designing new forms of output that may draw on different data * Organizational cooperation, since one user must be careful not to erroneously change data used by others * Vulnerability. This is a disadvantage, as the reduced redundancy and the accessibility by many users do require special precautions, such as passwords, frequent back-ups of the database, and transaction logs (files) of each change made to an item of data. DBMSs include data description language and data manipulation language to facil te the design, querying, input, and reporting of data. Structured query language (SQL) is a standard, text-based, programming language using keywords "select," "from," and "where," to retrieve data. The database administrator designs and controls the data dictionary (where each data item in the database is defined and explained), the overall schema (blueprint or layout), and each user's individual view (subschema). DIFFERENT DATABASE SCHEMA DESIGNS CHAIN (LINKED LIST) Invoice 1 data|Pointer - - - -> Invoice 2 data|Pointer - - - - >Invoice 3 data|* In this example, each record contains data about the invoice, and a "pointer." By "pointer," we mean that the physical disk address (or some number from which the disk address may be easily derived) of another record is stored within the first record. So here, the first record contains necessary data fields about Invoice 1 (e.g., invoice number, date, amount) and also contains a field which points to the next invoice in the chain of invoices outstanding for that customer. The asterisk (*) at the end indicates nothing further to which to point. The Chain schema is more like a flat-file than a database, as it is a one-to-one configuration, or "cardinality." The cardinality is the nature and extent of the relationships among the records of the database. TREE (HIERARACHY) (ONE-TO-MANY "CARDINALITY") Customer Master Record | Invoice 1 data| Invoice 2 data| Line 1 Line 2 Line 3 Line 4 Line 5 Here, one "parent" record may have many pointers - "children" - and each child may have its own children records. So the customer record points to (contains the disk addresses of) the invoices outstanding for that customer. In turn, each invoice record points to the inventory line items billed on that invoice. NETWORK (MANY-TO-MANY "CARDINALITIES") Hamburger | | Cheeseburger Beef Bun Beef Bun Cheese Here, one "parent" record (finished good record) may point to many "children" records (raw material records). Moreover, a given child may have many (more than one) parents. And redundancy is reduced, because a given raw material record need exist in only one place, while being pointed to by many finished goods records. Records may be physically dispersed, but logically connected. The three previous schema designs are "navigational" models, where the user must navigate pre-defined "structured" paths, with embedded pointers. The user must know the structure, and the database may be accessed only along the pre-defined (and thus inflexible) path. This is different from the - RELATIONAL MODEL PARTS PARTNO PARTNAME P1032 WHATZIT P1048 FRAMMIS P1079 GIZMO P1083 WHACHACALLIT SUPPLIERS SUPPNO SUPPNAME SUPPADDRESS S129 Joe's Junk 23 Main St. Mytown, State S234 Sam's Stuff 1 Chestnut Yourtown, State S386 Gary's Garage 3 Broadway Histown, State PRICES - PARTS BY SUPPLIER PARTNO SUPPNO PRICE P1032 S234 2.39 P1032 S386 2.45 P1048 S129 4.95 P1079 S129 1.67 P1079 S234 1.89 P1079 S386 1.95 P1083 S129 3.12 P1083 S386 3.08 The relational model keeps its data in multiple separate tables (rows & columns) using no explicit pointers. Instead, relationships may be formed on an ad hoc basis as needed. A supplier's address need be stored and maintained in only one place, even though that supplier may provide many parts. Similarly a given part may be supplied by many different suppliers, so many-to-many cardinalities are supported, but may require a linking table (parts-by-supplier in this case). The linking table has a composite primary key, partno-suppno in this case. A different linking table may relate parts to finished goods, or to customers who buy them. So there is great flexibility in the relational schema, where many different paths may co-exist. In the relational model, tables are normalized, resulting in more tables but fewer columns in each one, as each individual table refers to only a single concept. This will reduce redundancy and possible anomalies. Anomalies are types of inconsistencies which would exist if you had everything stored in one large table, for example, with one row per part and all the information about that part on that row. Then, if an inventory part were deleted, you would also delete all the information about the supplier (the delete anomaly) if you purchase only that one part from that supplier. Or, you may have the supplier's address listed next to each part that supplier supplies, requiring many updates, one or more of which might be neglected (the update anomaly), if the supplier moves. Or, you may not be able to insert a new supplier until you purchase something from him (the insert anomaly). So, if you imagine that everything is initially stored in one large table, normalization involves systematically decomposing it into a set of tables eventually in "third normal form (3NF)." In third normal form, the database is free of anomalies. The database designer systematically eliminates repetitions and unnecessary dependencies, reducing the number of columns (fields, attributes) in the table and instead spinning off additional tables, moving through 1NF, 2NF, and finally to 3NF. The relational DBMS can enforce referential integrity. The reference to supplier S234 in the parts-by-supplier table has integrity, because there is such a supplier in the suppliers table. Systems Operations and Processing Modes Many transaction processing systems use batch processing, in which transactions are accumulated into groups or batches for processing at some regular interval (e.g., daily, weekly, monthly). These batches of transaction records are usually sorted into the same sequence as the master file records before processing against the master file. Hence, 3 physical files are involved: the transaction file, the old (or current) master file, and the new (or updated) master file. Batch processing is appropriate for applications with high activity ratio - that is, a high percentage of records in the master file are affected by each update run. Payroll is a good example. The other chief mode is on-line processing, in which individual transactions are processed as they are received, usually at their point of origin. On-line real-time processing processes transactions immediately as they happen (or are captured), providing updated information to users on a timely basis. On-line real-time processing is appropriate for applications with high volatility - that is, there are many changes to the file per hour. Let's consider the phases involved in the batch processing of a payroll application, as an example. First there would be data capture, in which data from time cards may be keyed in. In more modern systems, data may be captured electronically, when employees swipe their plastic ID cards through a reader. Then, there would be an edit phase, where errors in the input transactions (e.g., missing employee numbers) may be detected. Then, if this is batch processing, the time data transactions would likely need to be sorted by employee number preceding the master file maintenance phase, in which the employee master file is updated with the current period's transactions. In the course of, or following, the maintenance, the reporting phase produces internal reports (such as pay by cost center and payroll register for accounting purposes, labor variances for control, and position control report for management) and external reports (such as taxes withheld). If there is on-line access, authorized personnel can produce queries, such as lists of employees with certain skills, or ad hoc reports designed by users and produced as needed for a particular purpose. An audit trail should exist in the payroll (or any other) application, by which transactions may be traced from the original time record to the payroll register, and backwards through the phases. A telecommunication information system - uses communication technology to move data from distant points. Distributed data processing (DDP) distributes the processing of the data to users, so that each user can process his own transactions. It may use a centralized database, in which remote users request data and then transmit it back to the central location. Or, it may distribute the database to the users. With distributed data, the system may use a partitioned database, in which each user gets at his local workstation the segment of the database for which he is the primary user. Or, the distributed data may be replicated, where each user gets a complete copy of the database. The replicated database implementation is primarily justifiable simply to support read-only queries, with a high degree of data sharing. With DDP, we want data concurrency, where each user has access to accurate and up-to-date records. Thus lockout procedures may be necessary, in which software prevents simultaneous accesses to the same data item, where two users may be attempting to change the same record at the same time. A local area network (LAN) is a linked federation of computers in close proximity (same floor or same building). Each workstation needs a network interface card fitted into one of the PC's expansion slots. Generally, there is (at least) one server to store common software and data. A wide area network (WAN) is a network more geographically dispersed. It uses bridges to connect same-type LANs, and gateways to connect different types of LANs, or LANs to WANs, or PCs to mainframes. The topology (physical arrangement) may be a star (one server computer in the middle, with an individual link from it to each workstation), a hierarchy (connected like an organization chart), a ring (a circle of equal workstations, also called peer-to-peer), or a bus (a single cable, like a bus going down the street, picking up workstation messages and dropping them off) Instead of purchasing and maintaining its own transmission media for, say, electronic data interchange with a trading partner, a company may use a VAN (value-added network). This is a public network that adds value to the data communications process by handling the interfacing with multiple types of hardware and software used by different companies, each with its own "mailbox" on the VAN. Many CPA firms use VPNs (virtual private networks) to allow its associates to use the Internet in a secure, encrypted manner to communicate while working outside the office. The remote worker uses the LAN as if he is in the same office (except for slower response time). A client-server system distributes processing between a server (a central file storage site which may search for and distribute an individual record requested by a user) and the clients (workstations which may read or update the record). It can work with different topologies. The server stores shared databases and system software, while individual applications (e.g., spreadsheets) and data may reside on the client workstation. Client-server systems are replacing mainframe systems, because they use cheaper hardware & software, and they are flexible & expandable. Instead of centralizing all data, applications, and expertise, client-server systems distribute them. Empowering users, they also require more skill from users in technology, output design, & controls. CASE (Computer-aided software engineering) tools are now widely employed to use computer software to build computer software, increasing the productivity of systems professionals. For example, they can take a data flow diagram and lead the developer to create a system based on it.

Job Order Cost Accumulation of Costs a. Costs for each job or lot are accumulated on Job Cost sheets. Job cost sheets show cost of material and labor charged to the job based on actual cost. Overhead, however, cannot be charged to the job at actual--- a predetermined rate must be used. A job cost sheet might appear as follows: Job 525 Direct Material-18 lbs. @ $4.50 $ 81.00 Direct Labor-24 hrs. @ $4.25 102.00 Mfg. Overhead-$3 per labor hour 72.00 Cost of job charged to work-in-process $255.00 b. An upward accumulation of job and departmental costs is maintained in plant or factory ledgers. c. Control accounts are maintained in the General Ledger. Activity Base Computation-Predetermined Rates While actual direct material and direct labor costs can be readily obtained, the books must be closed to assign actual overhead costs to specific jobs. Jobs must be continually costed for billing and control purposes and such procedures could not be delayed until actual overhead is determined. Therefore, the predetermined overhead rate is used. The overhead rate chosen will vary with the type of manufacturing operation, but generally will be computed as follows: Budget Estimated Manufacturing Expense -------------------------------------- Budget Estimated Activity Base The Activity Base ideally should be an activity or quantity that is closely related to changes in overhead cost. In this way an increase in the activity base will measure the resulting increase in overhead. Activity bases frequently used are: 1. Units 4. Prime Cost (D.M. + D.L.) 2. Material Cost 5. Machine Hours 3. Labor Cost 6. Labor Hours Illustrative Problem-Computation of Predetermined Rate The Jigsaw Company has three departments --- Molding, Fabrication and Finishing. Budgeted costs and production data for the three departments are as follows: BUDGETED Material Labor Labor Manufacturing Department Cost Cost Hours Expense Molding $12,000 $6,000 1,200 $18,000 Fabrication 6,000 4,000 800 8,000 Finishing 3,000 4,500 900 9,000 Compute overhead rates for each of the departments assuming management has selected overhead activity bases as follows: (1) Molding---Material Cost (2) Fabrication---Labor Cost (3) Finishing---Labor Hours (1) $18,000 / = 150% 12,000 (2) $8,000 / = 200% 4,000 (3) $9,000 / = $10 900 Assume that Job x accumulated costs and labor hour data as follows: Material Labor Molding $80 7 hrs. @ $5 Fabrication $30 3 hrs. @ $6 Finishing $25 2 hrs. @ $5.50 Determine the cost of Job x which is to be charged to Work in Process. Molding Fabrication Finishing Total Material$ 80 $30 $25 $135 Labor 35 18 11 64 Overhead(1) 120 (2) 36 (3) 20 176 Total $235 $84 $56 $375 (1) 150% x $80 (2) 200% x $18 (3) 2 x $10 In Job No. 120 we notice that work-in-process is charged with a total of $375 and upon completion finished goods will be charged likewise. Allocation of Service Department Costs While Direct Material and Labor are at actual, the use of a predetermined rate for overhead will necess te comparison with actual and, if done properly, can furnish management with some useful information, which we will consider later. Actual overhead costs are accumulated in the Manufacturing Expense Control Account to be compared with the overhead applied (predetermined rate) to the product. The accumulation of actual overhead costs is a relatively simple accounting matter in total; however, since these costs are indirect, they must be allocated to departments on some basis. Overhead costs that are directly attributable to a department or activity are, of course, assigned to that department or activity which is called a "cost center." Costs that are accumulated in service departments must ultimately be reallocated to the producing departments. The producing departments must ultimately bear all costs. Problem: (Allocation of Service Department Costs) The Edelweiss Co. has three producing departments, D, E and F. Costs are also accumulated in the Building Service, Power Plant, Maintenance and Personnel Departments. At the end of the period, overhead costs have been accumulated in these departments as follows: Costs Department D $ 22,420 Department E 28,760 Department F 39,880 Building Service 13,000 Power Plant 16,000 Maintenance 19,000 Personnel 4,000 Total Costs $143,060 Other data is also given concerning these departments: Departments D E F B/S No.of employees 16 22 32 4 Floor space 1,200 1,800 3,000 - Power used-Kilowatt Hours 12,000 16,000 18,000 - Machine Hours 3,600 2,400 4,000 - P/P M P Total No. of employees 12 18 6 110 Floor Space 1,600 1,400 1,000 10,000 Power used-Kilowatt Hours - 4,000 - 50,000 Machine Hours 3,600 2,400 4,000 10,000 If we use the step method, we can close out the departments one by one. There are no rules except common sense in determining the basis of allocation. The above shows an obvious relationship. In some situations considerable judgment may be required and the allocation basis can be quite complex. When a service department's costs are allocated, no reallocation of costs is made to that department. Solution: 1. Allocate building service costs to all departments. (Floor Space) 2. Allocate personnel costs to all other departments. (Number of Employees) 3. Allocate power plant costs to the producing departments and maintenance. (Power Used) 4. Allocate maintenance costs to the producing departments. (Machine Hours) Allocation of Costs Producing Departments D E F B/S $22,420 $28,760 $39,880 $13,000 1,560 2,340 3,900 ($13,000) ======== 848 1,166 1,696 4,490 5,990 6,736 8,378 5,586 9,310 $37,696 $43,842 $61,522 ====== ====== ====== P/P M P Total $16,000 $19,000 $4,000 $143,600 2,080 1,820 1,300 5,300 636 954 ($5,300) 18,716 ($18,716) 1,500 ======= 23,274 ($23,274) $143,060 ======== ======== Note: This is not the only possible solution to the problem. As no basis of allocation was specified, any systematic and rational allocation can be used. There are other methods of allocating departmental overhead costs such as the direct method, where costs of non-producing departments are allocated directly to producing departments. Another more complicated method can be used where service departments perform services for each other such as the above problem in that the Personnel and Building Service Departments perform services for each other. Solving this type of problem, giving recognition to this fact requires the use of simultaneous equations. While more accurate than the step method, it is not widely used in practice, because the difference in results is usually not significant. Application of Overhead to the Product Overhead Over and Under Applied. We have seen that Direct Costs, Material and Labor are applied to the product based on actual costs, but because costs must be assigned to the product before actual overhead can be determined and allocated, a predetermined rate is used for overhead. Later, when actual overhead is determined, the difference between actual and estimated results in an over or under application of overhead to the product, such as: a. If actual overhead exceeds the overhead applied by means of a rate, this results in overhead being underapplied. b. If actual overhead is less than the overhead applied to the product, this results in overhead being overapplied. The over- or under-applied overhead, if material, should be allocated to work-in-process, finished goods, and cost of goods sold to adjust these balances to full cost in accordance with GAAP. If immaterial, the over- or under- applied overhead is usually treated as an adjustment to the cost of goods sold. Actual overhead costs are accumulated in the Manufacturing Expense Control Account. Journal entries typically leading up to this situation are as follows: (1) Stores Material is purchased for plant use. Accounts Payable (2) W in P-Direct Material Materials are requisitioned for use in the plant, some as direct Mfg. Exp. Control material. Material overhead costs Stores are charged to Mfg. Exp. Control. (3) Payroll Wages are paid. Cash Sundry payroll tax credits (4) W in P-Direct Labor Wages are assigned to the product Mfg. Exp. Control (direct) or charged to actual Payroll overhead (indirect). (5) Mfg. Exp. Control Overhead costs are charged to Mfg. Exp. Sundry Credits Control such as rent, insurance, Allowance for taxes and depreciation. Depreciation (6) W in P Overhead Dept. 1 Overhead charged to product based on the predetermined rate is W in P Overhead Dept. 2 recorded. An alternate method would be to credit "Mfg. Exp." W in P Overhead Dept. 3 directly. If this is done entry 8 would be unnecessary. Mfg. Overhead Applied Dept. 1 Mfg. Overhead Applied Dept. 2 Mfg. Overhead Applied Dept. 3 (7) Mfg. Exp. Dept. 1 Mfg. Exp. Control is closed out to Mfg. Exp. Dept. 2 the departments based on the Mfg. Exp. Dept. 3 company's method of allocating actual costs to the producing Mfg. Exp. Control departments. (8) Mfg. Overhead Applied Dept. 1 Mfg. Overhead applied is closed out to Mfg. Overhead Applied Dept. 2 Mfg. Expense. Mfg. Overhead Applied Dept. 3 Differences result in Mfg. Exp. Dept. 1 Mfg. Exp. Over/Under Mfg. Exp. Dept. 2 Applied. Mfg. Exp. Dept. 3 (9) Mfg. Exp. Dept. 1 Difference between actual Mfg. Exp. Dept. 2 and applied overhead as Mfg. Exp. Dept. 3 indicated by the results of entry . Mfg. Exp. Over/Under Applied Flexible Budgets and Overhead Analysis Flexible budgeting is a reporting system wherein the planned level of activity is adjusted to the actual level of activity before the budget to actual comparison report is prepared. It may appropriately be employed for any item which is affected by the level of activity. Assume that F Co. has a flexible budget as follows: Percent of Normal 80% 90% 100% 110% Fixed Cost $10,000 $10,000 $10,000 $10,000 Variable 12,000 13,500 15,000 16,500 $25,000 Direct labor hours 16,000 18,000 20,000 22,000 Predetermined Rate-$1.25 per labor hour @ 100% ($.50 FC + $.75 VC) or ($25,000 ( 20,000 D.L. hrs.) During the period the plant operated at 92% of normal and incurred overhead costs of $23,960. For management information purposes the manufacturing expense over/under applied account can be analyzed and broken up into two variances-a budget variance and a volume or capacity variance. Overhead Analysis (Unfavorable) (Favorable) DR CR Actual Overhead $23,960 Budget Variance Budget at actual direct labor hours 92% ( 20,000 hrs. = 18,400 hrs. FC (20,000 x .50) 10,000 VC (18,400 x .75) 13,800 23,800 $160 Volume or Capacity Variance Mfg. Overhead Applied FC 18,400 x .50 9,200 VC 18,400 x .75 13,800 23,000 *800 Total Variance $ 960 $960 * Caused by volume falling short of normal by 1,600 hours at .50 per hour (FC rate).

Joint Products Joint Products Joint products are two or more products of more than nominal value produced simultaneously in the same processing operation. Because the joint products are produced from the same operation, the cost of production must be allocated to the products on an estimated basis. The acceptable methods of allocation are: 1. The relative sales value method Hilow and Hilee are produced simultaneously at a cost of $54,000 in the extracting operation. 15,000 gallons of Hilow and 22,500 gallons of Hilee sell for 1.50 and 2.00 per gallon, respectively. Allocate the cost of production. Sales value Hilow 15,000 x $1.50 = $22,500 Sales value Hilee 22,500 x $2.00 = 45,000 Total Sales Value $67,500 ======= Cost of producing Hilow $22,500 x $54,000 = $18,000 ------- $67,500 Cost of producing Hilee $45,000 x $54,000 = $36,000 ------- $67,500 Use of this method produces the same percentage of gross profit. 2. Unit of measurement Joint costs are allocated based on units, pounds, tons or gallons, etc. Applying unit of measurement to Hilow and Hilee would result in the following cost allocation: Hilow-15,000 gallons Hilee-22,500 gallons Total 37,500 Hilow 15,000 /37,500 x $54,000 = $21,600 Hilee 22,500 /37,500 x $54,000 = $32,400 3. Assignment of weights This method is quite arbitrary whereby consideration is given to such factors as volume, selling price, technical engineering and marketing processes. 4. Profit contribution method Costs are allocated based on the profit margin or contribution remaining after deduction of all direct costs and expenses from the selling price. Joint Costs--Processing After Split-Off Frequently, joint products must pass through one or more processes after split-off with other joint products. The relative sales value may be unknown at point of split-off or because of the extensive additional processing required to make the product salable, may be difficult to determine. It is recommended that costs incurred after joint processing be applied as reductions in revenue on a dollar-for-dollar basis and the remaining revenue used as a basis for assignment of cost. Case example: Products X and Y are produced in Department 1. Product X is further processed in Department 2 and Y is further processed in Department 3. Cost data for the three departments are: Product Department X Y Total Cost 1 Joint Joint $36,000 2 $ 8,000 8,000 3 $19,000 19,000 ====== $63,000 Sales Value $36,000 $54,000 Solution: Adjustment of Sales Value X Y Sales Value $36,000 $54,000 Less: Incremental Cost 8,000 19,000 Adjusted Relative Sales Value $28,000 $35,000 $28,000 28 Assigned to X ------------- -- = 4/9 $28,000 + $35,000 63 Assigned to Y 35 = 5/9 -- 63 Joint Dept. 1 costs assigned X - 4/9 x $36,000 = $16,000 Y - 5/9 x $36,000 = 20,000 Total joint costs $36,000 ======= By-Products A by-product is an item of relatively small value produced incidental to the production or manufacture of one or more main products. The recovery value of by-products may be treated as 1. Other income 2. Reduction of total production cost of the main product(s). 3. Replacement cost method-only applicable to those situations where the by-product is used within the plant eliminating the need to purchase materials from suppliers. Production costs of the main product are reduced accordingly. Bilow, a by-product, is produced by the Extracting Department along with Hilow and Hilee. In March $370 was received from Bilow sales. Journal Entries: Method 1 Cash $370 Other income $370 Method 2 Cash $370 Work in Process, Extracting $370 Method 3, except that Bilow is used to replace material in the Foundry. WIP, Foundry $370 WIP, Extracting $370

Limited Liability Company (LLC) Limited Liability Company 1. A Limited Liability Company (LLC) is a cross between a partnership and a corporation and has been recognized in virtually every state in the U.S. a. Most states require at least 2 members to form an LLC. b. A few states permit a one person LLC. 2. A Limited Liability Company differs from other business forms in three key areas: a. LIABILITY ADVANTAGE: Unlike partners, LLC owners (called members) have no personal liability beyond the amount of their investment in most cases (their limited liability is similar to a limited partner or corporate stockholder). b. PARTICIPATE IN MANAGEMENT: An LLC owner may fully participate in management like partners (unlike limited partners or corporate stockholders who have limited management rights). c. FEDERAL TAX ADVANTAGE: An LLC can have the same federal tax advantage of a partnership or S corporation (i.e. not subject to taxation on both the entity and profits distributed to members, like a corporation) 3. An LLC must file its articles of organization with the state: a. Its name must clearly indicate the limited liability of its owners (e.g. use L.L.C., L.C., "limited company" or "limited liability company" after its name) b. The agreement between LLC members governing the operation of the LLC is called an operating agreement (like a partnership agreement) and is not filed with the state. 4. There are two main methods of managing an LLC; a. An LLC may be member managed. 1. Unless otherwise agreed, each member has an equal right to manage. 2. Each member has both actual and apparent authority to bind the LLC. b. An LLC may be managed by managers elected by the members. 1. The managers do not need to be members. 2. Members have no actual or apparent authority to bind the LLC unless the member is also a manager. 3. LLC managers have the same limited liability as LLC members. 5. LLC members have the following rights: a. The right to profits, losses and other distributions: 1. Operating agreement determines how profits, losses and distributions are made. 2. If nothing is said profits, losses and distributions are typically made on the basis of contributions made by members (not equally as in a partnership). b. Unless otherwise agreed, a member has the right to assign her interest in the LLC; 1. The assignment doesnít dissolve the LLC. 2. The assignee doesnít become a member of the LLC. 3. The assignee only receives the right to receive assignorís share of distributions. 6. Dissolution of an LLC: a. An LLC is dissolved in much the same manner as a partnership. b. e.g. An LLC is automatically dissolved when a member ceases to be associated with the company (referred to as dissociation) by withdrawal, death, bankruptcy, etc. c. In most states remaining members may continue the business by unanimous consent.

Limited Partnerships Limited Partnerships 1. A limited partnership is a partnership of two or more parties formed in compliance with a state statute with the express purpose of permitting limited partners to share in partnership profits without the risk of personal liability. a. There must be one or more general partners and one or more limited partners: 1. A general partner in a limited partnership has the same rights and duties that a general partner in a general partnership has. 2. A limited partner has few duties and limited liability. b. But, a general partner may also be a limited partner in the same partnership. c. A certificate of limited partnership must be filed with the state and must contain: 1. the name and address of the limited partnership, which must include the words "limited partnership" 2. the names, addresses and signatures of all general partners 3. the latest date the limited partnership will dissolve 4. the name and address of its registered agent d. The certificate of limited partnership must be amended if a new general partner is admitted or withdraws or if any information in the certificate becomes untrue. 2. Liability in a limited partnership: a. General partners have unlimited personal liability. b. Limited partners have no liability beyond their cap l contribution: 1. A limited partnerís promise to contribute cap l must be in writing. 2. Limited partners are liable for any cap l contribution not made. c. Limited partners have no right to take part in the control or day-to-day management of the partnership: 1. If they do participate in daily management, they are personally liable to any party reasonably believing they were a general partner. 2. rationale: If you give the appearance to others that you are a general partner, then you are liable like a general partner (apparent authority). 3. If the partnership name includes a limited partner's name, the limited partner is also liable to any creditor who didn't know they were a limited partner. d. Limited partners may vote on the following without incurring liability: 1. dissolution of the limited partnership 2. fundamental changes in the limited partnership (e.g. sale of substantially all assets of the limited partnership or a major change in the nature of the business) 3. admission or removal of a general or limited partner 4. amending the certificate of limited partnership 3. Unless otherwise agreed, admitting new general or limited partners requires the unanimous written consent of all limited and general partners. 4. Limited and general partners may be secured or unsecured creditors of the partnership. 5. Limited partners have the right to inspect and copy partnership books and records to specifically include the right to receive copies of any partnership tax returns. 2001 LIMITED PARTNERSHIP ACT * A limited partner is one who is designated as a limited partner in the partnership agreement. * A general partner is one who is designated as a general partner in the partnership agreement. LIMITED PARTNERSHIP * Commonly referred to a ďdomesticĒ limited partnership. The act encompasses all prior limited partnerships which were designated as such under prior acts. * It is of the essence of a limited partnership to have two classes of partners. Accordingly, there must be at least one limited and one general partner. The act provides that a limited partnership dissolves if its sole general partner or sole limited partner dissociates and the limited partnership fails to admit a replacement within 90 days. Two partners are required under the Act. * Limited partnership means an entity having one or more general partners and one or more limited partners which is formed under the Act by two or more persons. * Partnership agreement means the partnership agreement whether oral or implied, in a record or in any combination, concerning the limited partnership. * Person means an individual, corporation, business trust, estate, trust, partnership, limited liability company, association, joint venture, government, government subdivision, agency, or instrumentality, public corporation, or any other legal or commercial entity. * Person dissociated as a general partner means a person dissociated as a general partner of a limited partnership. Likewise with respect to limited partners.

Markets Perfectly Competitive Market Now that we have dealt with both demand and supply curve, we can discuss the markets in terms of demand, supply, and the interaction of demand and supply in a PERFECTLY COMPETITIVE MARKET. So far we have spoken of the price elasticity of demand as being relatively elastic or relatively inelastic. It is common for a firm's demand curve for a particular good to be perfectly elastic even though the demand curve for the entire market for the good to be relatively inelastic. This is particularly the case when there is no opportunity for product differentiation and there are many sellers and many buyers. The graphs D and E, below, will illustrate that situation: Market Demand Firm Demand Graph D Graph E Price Price s d s s d s $3.50 s $3.50 d d d d d d s s d s s s s_________________________ ________________________ 50,000,000 gallons/month 500,000 gallons/month From the perspective of the firm (Graph E), the demand curve is the same as the marginal revenue curve because the milk producer can sell all that he or she can produce at the $3.50 per gallon price. The information presented immediately below provides evidence that the demand curve faced by the firm in a perfectly competitive market is horizontal at the unit price point ($3.50 per unit) and that the horizontal demand curve also is same as the marginal revenue curve. Selling Price Total Average Marginal Units Sold Per Unit Revenue Revenue Revenue ---------- -------- ---------- ------- ------- 500,000 $3.50 $1,750,000.00 $3.50 500,001 $3.50 $1,750,003.50 $3.50 $3.50 500,002 $3.50 $1,750,007.00 $3.50 $3.50 500,003 $3.50 $1,750,010.50 $3.50 $3.50 The average revenue is the total revenue divided by the number of units sold. The marginal revenue is the change in the total revenue as the number of units sold changes. Graph D represents the aggregate market for milk in the New York City region for one month. It represents the sum of the demand for all persons in the New York City region (the earlier Graph A represented the demand curve for only one family to keep it simple). In graph D, the supply curve also shows the aggregate marginal cost curve for all producers of milk in the New York City region. Graph E illustrates the demand curve faced by a single producer that sells milk in the New York City region. Notice that the demand curve for that firm is a HORIZONTAL DEMAND CURVE. The horizontal demand curve implies a perfectly elastic demand curve. If the producer increases the price from $3.50 per gallon to $3.60 per gallon, he or she will not be able to sell any milk at all. The purchasers of milk will merely purchase their milk from a competitor who continues to sell it at $3.50 per gallon. If the producer reduces the price from $3.50 per gallon to $3.40 per gallon, the quantity supplied, as reflected on the firm's supply curve, would fall to some quantity less than the 500,000 gallons associated with the $3.50 per gallon price. Thus, a reduction in price would reduce quantity sold and reduce revenues. That implies lower profits. No producer faced with a perfectly elastic demand curve would dare to attempt to sell at a price lower than the market's equilibrium price. That is so because the producer can sell all that he or she can produce at the market price. In such a situation, the producer can improve profits only by lowering the marginal cost of production and shifting the supply curve to the right. In such a situation the producer would be selling a larger quantity at the same $3.50 per gallon price and the marginal cost of the last unit produced of the larger quantity would still be no more than $3.50 per gallon. Profits would increase! The MARKET STRUCTURE just described for a commodity type Product (such as milk) is regarded as "PERFECT COMPETITION." Monopolistic Competition Market Structure There are other situations (MONOPOLISTIC COMPETITION MARKET STRUCTURE) in which there are many buyers and a relatively few sellers. The fast food industry is an example of an industry with a market structure that could be described as monopolistic competition. In monopolistic competition the demand curve and the marginal revenue curve are not identical. This is so because selling a larger quantity of the product can only be accomplished if the price of the product is reduced (unlike a commodity product in a perfectly competitive market). This divergence of the demand and marginal revenue curves is illustrated in Graph F, below: Demand (D) and Marginal Revenue (MR) Monopolistic Competition Graph F d d m d Price m d m d m D m MR ____________________________________________________________ Quantity Demanded Notice that the marginal revenue (MR) curve is beneath the demand (D) curve, suggesting that increasing quantities will be demanded only at a lower price. That was not the case with perfect competition. In perfect competition, the firm could sell all that it could produce at the same price. Thus, in perfect competition, the demand curve and the marginal revenue curve were identical. Firms in an industry characterized by monopolistic competition rely on differentiation among products or among suppliers of the products in order to earn more profits. In monopolistic competition, there are fewer suppliers with each supplier possessing a modest amount of market power as a result of reduced competition. Many retail businesses, personal service businesses, and manufacturing businesses seek to differentiate their product by creating customer loyalty through special services, quality, and location. Customer loyalty will cause customers to patronize the company without seeking substitutes for the product. In retailing, location is a powerful form of differentiation. The retailer with the better location is likely to have a steeper slope to the demand curve than a retailer who has a less desirable location. The less than perfect competition is also caused by barriers to entry into the industry and by the fact that some companies in the industry may have something unique to offer in terms of product, service, or location. Barriers to entry such as patents, licenses, franchising, proprietary information, and size of investment, will often limit the number of competitors in the industry. Another barrier to entry and source of product differentiation is advertising. Advertising and product branding are used by businesses to create and maintain product differentiation and create a subtle barrier to entry. Successful product differentiation and the creation of barriers to entry give the business more monopoly power than other competitors. That monopoly power will manifest itself in terms of a relatively more vertical demand curve (less price elasticity of demand). Supply Chain Management System A Supply chain management system is a means by which firms have been successful in lowering their logistics, materials management, and distribution costs. SUPPLY CHAIN MANAGEMENT systems refer to improvement of a company's processes for production and delivery services, purchasing, invoicing, inventory management, and distribution. The advent of e-commerce has created opportunities for the linking of the various companies in a supply chain from the production of raw materials to the delivery of the finished product to the consumer. A properly designed supply chain system creates opportunities for reduction of inventory management costs (possibly less spoiled product), reduced clerical costs (computer matching of invoice with receiving report), improved scheduling of timely delivery of the product to avoid out-of-stock situations (improved logistics) at all levels (producer, processor, wholesaler, and retailer), and improved customer service as a result of the producer being more responsive to the consumer's product demands. The lower cost occasioned by the successful implementation of supply chain management will lower the marginal cost of the products produced. The lower marginal cost will shift the firm's supply curve to the right and encourage the business to produce more of the product or service at the same price. Thus, the successful implementation of the supply chain management system has the promise of increasing profits to the firm until such time as all in the industry implement supply chain management systems. Of course, as more and more firms in the industry successfully implement supply chain management systems, the market's aggregate marginal cost will decline and the market's supply curve will shift to the right. With no change in the demand curve, the result will be lower prices and a larger quantities produced as the market arrives at a new equilibrium price for the product. The ultimate result will be a reduction in the price to the consumer as a result of competition among producers.

Microeconomics with Strategy Emphasis Market Influences MARKET INFLUENCES ON BUSINESS STRATEGIES, INCLUDING SELLING, SUPPLY CHAIN, AND CUSTOMER MANAGEMENT STRATEGIES An understanding of micro-economics (the economics of the firm) starts with an understanding of the demand and supply curves and their intersection to determine the equilibrium price. Let us review by examining a family's demand curve for a commodity product such as milk in a regional marketing area such as New York City. The graph below illustrates the demand curve. Demand Curve for Milk in New York City Price Graph A $6.00 $5.50 $5.00 . $4.50 . $4.00 . $3.50 . $3.00 . $2.00 . $1.50 D 2 4 6 8 10 12 14 16 Gallons per Month The demand curve in graph A, above is illustrated by the line that is Downward sloping to the right (D). The demand curve is downward sloping because of the law of diminishing marginal utility. The law of diminishing marginal utility recognizes that the total satisfaction derived from the consumption of milk (or any good) will initially increase as more of the good is consumed and then total satisfaction will start to diminish. The diminishing total satisfaction is reflected in the demand curve in that as the quantity per month increases, the consumer will be willing to pay less for the next additional unit of the good. The consumer might be willing to pay $3.50 per gallon for 8 gallons of milk per month, but would only be willing to purchase the ninth gallon of milk per month at some price less than $3.50 per gallon. Shift Demand Curve to the Right From a strategic viewpoint, businesses seek to shift the demand curve to the right in order to sell a larger quantity at the same price or the same quantity at a higher price. The various ways that a demand curve might shift to the right are the following: 1. Increase the number of consumers 2. A change in tastes in favor of the good 3. Increase in the price of substitutes 4. An increase in the income of consumers A shift in the demand curve should be contrasted with a change in quantity demanded on the same demand curve. A SHIFT IN THE DEMAND CURVE to the right signals that at each price point the consumer is willing to buy a larger quantity of the good. On the other hand, a CHANGE IN QUANTITY DEMANDED refers to a change in demand on a particular demand curve. A change in quantity demanded may be illustrated by reference to graph A. Given the demand curve in graph A, a change in price from $3.50 per gallon to $3.00 per gallon will result in an increase in quantity demanded from 8 gallons per month to 10 gallons per month. Thus, the term "change in quantity demanded" does not refer to a situation in which the demand curve has shifted. Graph B below illustrates the shift in the demand curve from D to D1. Demand Curve for Milk in New York City Price Graph B $6.00 @ @ $5.50 * $5.00 @ * $4.50 @ $4.00 * @ * $3.50 * @ @ $3.00 * @ $2.00 * D1 D $1.50 2 4 6 8 10 12 14 16 Gallons per Month When you contrast demand curve D with demand curve D1 it is clear that for all price points the quantity demanded is greater for demand curve D1 than it is for demand curve D. That demand curve shift to the right could have been caused by any of the four causes mentioned earlier. The slope of the demand curve is of particular importance from a strategic perspective. Demand curves tend to be either elastic or inelastic. An elastic demand curve suggests that a small percentage change in price will result in a larger percentage change in quantity demanded. Using the demand curve in graph A, we can calculate the PRICE ELASTICITY OF DEMAND for the situation in which the price declines from $3.50 per unit to $3.00 per unit. Graph A shows that the quantity of 8 gallons is associated with the $3.50 per gallon price and the quantity of 10 gallons is associated with the $3.00 price. The coefficient of the price elasticity of demand for that portion of the demand curve is calculated using the following equation: Percentage change in quantity / Percentage change in price The decline in price from $3.50 to $3.00 results in a $.50 change in price. That represents the following percentage change in price: $.50 / Average of $3.50 and $3.00 = $.50 / $3.25 = 15.38% The increase in quantity from 8 gallons (associated with the $3.50 price) to 10 gallons (associated with the $3.00 price) represents the following percentage change in quantity demanded: 2 gallon change / Average of 8 gallons and 10 gallons = 2 gallons / 9 gallons = 22.22% Therefore the price elasticity of demand is 22.2% change in quantity / 15.38% change in price = 1.44 Therefore the coefficient of the price elasticity of demand for that price change is 1.44. A coefficient greater than one suggests an elastic demand curve and a coefficient less than one suggests an inelastic demand curve.

Net Present Value NET PRESENT VALUE (NPV) Steps: 1. Determine all cash inflows and outflows for a project. 2. Calculate the present value of all cash flows using the cost of cap l percentage. (A positive NPV means to go forward with the project). EXAMPLE: A project requiring a current investment of $1000 will generate $300 for each of the next 5 years (assumed to be received at the end of each year). Should this opportunity be undertaken if the company's cost of cap l is 8% and the "present value of an ordinary annuity factor, i = 8, n = 5 equals 3.99271. ANSWER: TIME -----> -$1000 + $300 + $300 + $300 + $300 + $300 LINE | | | | | | Now Year 1 Year 2 Year 3 Year 4 Year 5 NPV = $1000 + ($300 x PV i = 8%) n = 5 NPV = -$1000 + ($300 x 3.99271) NPV = -$1000 + ($1197) = $197 Because the NPV is positive we go forward with project. EXAMPLE: A project should be accepted if the present value of cash flows from the project is a. Equal to the initial investment. b. Less than the initial investment c. Greater than the initial investment. d. Equal to zero. Answer: (c) is correct. The NPV is positive when the cash flows from the project exceed the initial cost.

Other Unincorporated Associations Other Unincorporated Associations 1. A joint venture is a business association of two or more owners acting together for profit for a limited purpose and for limited duration a. joint ventures are usually for a single project whereas a partnership involves an ongoing business b. joint ventures are treated as a partnership in most cases by the law 2. A Limited Liability Partnership (LLP) is a cross between a general partnership and a limited partnership and has been adopted in over 36 states a. an LLP is treated by the law as a general partnership for almost all purposes (e.g. partners in an LLP are general partners, partners are jointly liable for partnership contract debts and an LLP is taxed as a partnership) b. in an LLP partners have limited liability like a limited partner in one case only, for the negligence, wrongful acts or misconduct of other partners 1. some states extend this limited liability to include acts of employees or agents 2. two states (New York and Minnesota) limit a partner's liability to all obligations of the LLP c. exceptions: in most states a partner is still liable for his/her own misconduct and the misconduct of those acting under the partner's direct management or control d. as with a limited partnership, an LLP must file with the state and its name must clearly indicate it is a limited liability partnership (i.e. use LLP or Limited Liability Partnership after its name) 3. A Business Trust or Massachusetts Trust is a trust that has been established to operate a business for profit. It has three essential characteristics: a. the trust estate is for the purpose of operating a business for profit. b. each trust beneficiary receives a certificate evidencing ownership in the trust which is freely transferable. c. trustees have the right to manage the business free from the beneficiaries' control 1. as long as the beneficiaries have no control over management of the business, they are not personally liable. 2. if the trustees are elected or can be removed by the beneficiaries, the trust is treated as a partnership and the beneficiaries are personally liable. 4. An unincorporated, nonprofit association is an association of two or more parties for social or char ble purposes. a. It is not a partnership because it is not done for profit. b. Members are not personally liable for an undertaking unless they authorized or assented to it.

Partnerships Partnerships Summary of Significant Changes in the Revised Uniform Partnership Act (RUPA) Which Simplify Partnership Law Prior law generally viewed partnerships as a collection of the partners and perhaps a legal entity. RUPA states that a general partnership is a legal entity that can own and convey property, and sue and be sued in its own name. Under RUPA, a partnership is an entity distinct from its partners resulting in greater partnership stability. No partner has an interest in specific partnership property. Partnerships do not have perpetual existence like corporations, but nearly so since the partnership continues in existence when one or more partners leave. Formerly, the partnership was dissolved by the exit, for whatever reason, of any partner. RUPA is a default act, meaning that it generally applies in situations not covered in the partnership agreement. The partnership agreement, however, may not override the default rule to eliminate a partnerís duty of loyalty or obligation of good faith and fair dealing, or unreasonably reduce a partnerís duty of care. In most states, requirements are specified for filing, amending and canceling partnership agreements. However, there are no required filings under RUPA. Generally, filing may be made for: 1. a statement of partnership authority 2. a statement of denial of partnership authority 3. a statement of dissociation 4. a statement of dissolution 5. a statement of merger Partners are jointly and severably liable for all partnership obligations. Property taken by a partner improperly from a third party is the responsibility of the partnership even if the partnership never received the property. A partnership agreement may be in writing oral or implied. The partnership has no duty to have books and records; however, if the partnership does have books and records, they must be maintained at the partnershipís principal office. Partners have the right to partnership information, including inspection of books and records, if any, under reasonable circumstances. Creditors of a partner may attach the interest of a partner, but may not attach specific partnership property. Creditors may be assigned rights to a partnerís interest, but have no rights to partnership property only earnings and/or distributions made to the debtor partner. Creditors assigned rights to a partnerís profits are responsible for the income taxes thereon, whether cash is distributed or not. GENERAL PARTNERSHIPS 1. A partnership is an association of two or more co-owners of a business for profit. a. Must have two or more persons (can be a person, corporation, partnership, estate, trust, joint venture, or government agency). Person includes any commercial entity that is legal. b. Must have co-ownership of a business: 1. Two key factors are sharing of profits and sharing of management. 2. The parties must be co-owners of a business, not co-owners of property. c. Must be a business operated for profit (e.g. social clubs, religious organizations or associations are not partnerships). 2. A partnership is formed by an agreement of all partners to conduct the business. a. The partnership agreement may be oral, implied or in writing: 1. Partnerships impossible to perform in one year require a writing (e.g., A, B and C form ABC partnership and agree that it will not terminate for 5 years.) 2. Limited partnerships and limited liability companies require a writing. 3. A written partnership agreement (sometimes called the articles of partnership) can only be amended by unanimous consent of all partners. b. If a partner breaches the partnership agreement, (s)he is liable. 3. A partnership may also be created from the conduct of the parties (e.g., if two or more parties are co-owners of a business and share profits, they may be a partnership even though they did not consider themselves to be a partnership) 4. Under RUPA, a partnership is considered to be a separate entity. a. It is subject to Worker's Compensation, FICA, FUTA, etc. b. It is a separate entity for ownership of property (e.g. ABC partnership may own real estate in the name of the partnership). c. Assets of the firm are considered separate and distinct from the assets of individual partners. d. Partnerships do not pay income tax. They file an information return on Form 1065 reporting sales, expenses, and partnership income. All items of partnership income or loss flow through to the individual returns of the partners. e. Unlike a corporation, a partnership does not have perpetual existence and the departure of a partner does not ordinarily dissolve the partnership. (see section on dissolution and dissociation) GENERAL PARTNERSí RESPONSIBILITIES 1. Partners in a general partnership have unlimited personal liability a. General partners are jointly liable for all partnership debts and contract obligations (joint liability means all partners must be sued as a group). b. They are jointly and severally liable for all partnership torts (joint and several liability means all partners may be sued as a group or sued individually). 2. General partners are agents of the partnership and agents of each other. a. Partners owe the same duties that all agents do. 1. Owe a duty of Obedience to partnership agreements. 2. Owe a duty of Due care to fellow partners and the partnership. 3. Owe a duty to Inform their fellow partners of relevant facts. 4. Owe a duty to Account for all money and property received or expended. 5. Owe a fiduciary duty of Loyalty to the partnership and each other (e.g., cannot compete with the partnership or make a profit at the expense of the partnership). b. When acting with real or apparent authority, each partner can impose contract liability on the partnership and on their fellow partners. c. Any partner committing a tort while acting on partnership business imposes tort liability on himself, the partnership and fellow partners (respondeat superior). d. Each must give actual notice to old customers and published notice to new customers upon their termination from the partnership. PARTNERíS RIGHTS 1. Each partner has an equal right to participate in the management of the business, unless the partners specifically agree otherwise. a. Most decisions require only a majority vote b. Unless otherwise agreed, the following require unanimous consent of all partners: 1. admit new general partners or new limited partners 2. transfer partnership property to others 3. change a written partnership agreement 4. change the cap l of the firm 5. admit liability in a law suit (confess a judgment) or submit a claim to arbitration 6. make a fundamental change in partnership business to specifically include selling the partnership's goodwill 2. Each partner has an equal right to share in distributions, unless otherwise agreed. a. Unless otherwise agreed, profits and losses are split equally: 1. The partners may specify an unequal division of profits and losses (e.g. A, B and C agree profits and losses will be split 60% for A, 30% for B and 10% for C). 2. If a division of profits is specified but not losses, losses will follow profits. b. Unless otherwise agreed, a partner is not entitled to compensation 3. Each partner has the right to be reimbursed for loans and advances made to the partnership and for payments made on behalf of the partnership plus interest. a. Partners also have the right to be indemnified for liability incurred while properly acting on behalf of the partnership. b. A partner entitled to repayment is only paid after all other creditors are paid. 4. All partners and limited partners have the right to full information about the partnership. a. They have the right to inspect and copy books and records at reasonable times. b. A partner has the right to demand a formal account (a complete review of all financial transactions of the partnership, including financial statements). 1. An accounting is granted when circumstances make it just and reasonable. 2. e.g. breach of fiduciary duties or wrongful exclusion from the partnership. 5. Each partner is a co-owner of partnership property. a. Each has an equal right to use partnership property for partnership purposes, but has no right to use it for any other purpose without the consent of other partners. b. A partner cannot transfer or assign his/her individual interest in partnership property to others. No partner has an individual interest in partnership property. c. Partnership property may not be attached by an individual partner's creditors. d. If a partner dies, partnership property remains as partnership property (entity concept), not the heirs. A deceased partnerís interest is part of his/her estate. A partnerís estate has no continuing interest in the business. 6. Power of dissociation A partner has the right to dissociate him/herself from the partnership. Dissociated partner must serve notice to the remaining partners of dissociation and is responsible for all partnership acts and debts up until dissociation. Third parties must be made aware of dissociation. If not, the dissociated partner is liable for third parties damaged on the assumption of partnerís continuance in the partnership. 7. The ďIn KindĒ Rule Partners have the right to receive cash distributions (profits or liquidation payments) and may not be paid ďin kindĒ unless otherwise agreed. Partners similarly have no right to demand payment in kind. Creditors may be paid ďin kindĒ if agreed.

Present Value of a Single Sum Present Value of a Single Sum Money has a time value. A dollar received today has a greater value than a dollar to be received one year from today because of the interest which it can earn. The value today of a dollar to be received one year from today can be no greater than the amount which invested at an appropriate interest rate will have a future value equal to a dollar. Therefore, given an interest rate greater than zero, the value today of a dollar received in the future must be less than a dollar. Under present value concepts a dollar to be received at some future date is made comparable to a dollar today by discounting. Discounting is the reverse of compounding-the inherent interest in a future value is removed to determine the original principal. The present value (discounting) formula is developed from the fundamental compound value formula. n FV = Po (1+i) n Po = FV / (1+i) n Po = FV x 1 / (1+i) The present value may be identified as PV or Po as the subscript zero in the term Po indicates the present. Example: Previously we determined that the future value of $1 at 5% compounded annually for two years was $1.1025. Conversely, we can state that the present value of $1.1025 at 5% compounded annually for two years is $1. This is computed as follows: n PV = FV x 1 / (1 + i) 2 PV = $1.1025 x 1 / (1.05) PV = $1.1025 x 1 / 1.1025 PV = $1.00 To assist in the application of the present value formula, tables of the present value interest factor 1/(1 + i)n have been constructed for various values of i and n (refer to Present Value of $1 Table). Using these factors, it is only necessary to multiply the future value by the appropriate interest factor for the given i and n values, to determine the present value. The present value formula may now be written as: PV = FV (IF) Example: What is the present value of $1,216 to be received four years from today at 5% compounded annually? To determine the appropriate interest factor from the Present Value of $1 Table first locate the 5% column, then read down the values of the column to the n=4 row. This factor is .82270. The present value is now determined as follows: PV = FV (IF) PV = $1,216 (.8227) PV = $1,000.40 Proof: FV = Po (IF) (FV interest factor) FV = $1,000.40 (1.216) FV = $1,216.48 (The difference is due to rounding in the construction of the tables.)

Present Value of an Annuity Present Value of an Annuity The concepts and techniques of discounting are the same for an annuity as for a single sum. Refer to present value of a single sum for their review. Ordinary Annuity: What is the present value of a three year ordinary annuity of $1 per year discounted at 5% compounded annually? The present value is equal to the sum of the present values of the individual annuity payments. The answer is illustrated graphically below: End of Period 0 1 2 3 |-------|--------|--------| $1 $1 $1 Annuity $.95238 = | | | | | | .90703 = ---------| | | .86384 = ------------------| $2.72325 Present Value ======== Computations of present value: Discount n Payment Amount Periods PV = FV x (1/(1 + i) ) --------- ------------------- 1. $1 1 $1 x 1 /(1.05) = $1( .95238) = .95238 2. $1 2 $1 x 1 / = 1( .90703) = .90703 2 (1.05) 3. $1 3 $1 x 1 /= 1( .86384)/ = .86384/ 3 (1.05) 1(2.72325) = 2.72325 Note that the total of the interest factors 1 (1+i)n times the annuity equals the present value of the annuity ($1 2.72325 = $2.72325). As with the compound value of an annuity, it is not necessary to compute the value of each annuity payment and sum them up. The total of the interest factors may be used to compute the present value. The formula for the present value of an ordinary annuity is: __ n-1 PV = A x \ 1 /__ --------- m=0 (1 + i)n-m This formula is basically the reciprocal of the compound value of an annuity formula. However, m begins at 0 because the last payment is discounted for n periods and goes through n-1 because there is no payment at the beginning of the first period (n-m = 0). To assist in the application of this formula, tables of the present value interest factor for an ordinary annuity have been constructed for various values of i and n (refer to Present Value of an Annuity of $1 Table ). Using these factors, it is only necessary to multiply the annuity (A) by the appropriate interest factor for the given i and n values to determine the present value of ordinary annuity. The present value formula of an ordinary annuity now becomes: PV = A(IF) Example: What is the present value of an ordinary annuity of $1,000 per year for 6 years at 7% compounded annually? To determine the appropriate interest factor from the Present Value of an Annuity of . Table, first locate the 7% column; then read down the values of the column to the n = 6 row. The factor is 4.7665. The present value is now determined as follows: PV = A(IF) = $1,000(4.7665) = $4,766.50 Annuity Due: What is the present value of a three year annuity due of $1 discounted at 5% compounded annually? The present value is equal to the sum of the present values of the individual payments. The answer is illustrated graphically below. End of Period 0 1 2 3 |-------|--------|--------| $1 $1 $1 0 Annuity $1.00 = | | | | | .95283 = ---------| | | .90703 = -----------------| $2.85986 Present Value ======== Computations of present value: Discount 1 Payment Amount Periods PV = FV (1 + i)n 1. $ 1 0 $1 x 1 / = $1 x = 1.000 = $1.00 (1.05)0 2. $1 1 $1 x 1 / = $1 x .95283 = .95283 (1.05)1 3. $1 1 $1 x 1 / = $1 x .90703 = .90703 (1.05)2 $1 x 2.85986 = $2.85986 ============ ======== Note that the total of the interest factors times the annuity equals the future value ($1 2.85986 = $2.85986). As with the ordinary annuity it is not necessary to compute the present value of each annuity payment and sum them up. The total of the interest factors may be used to compute the present value. The formula for the present value of an annuity due is: __ n n-m PV = A x \ 1/(1+i) /__ m=1 Here m begins at 1 because the last payment is discounted for n-1 periods and goes through n because the first payment is at the beginning of the first period (n-m = o). Tables of the present value interest factor for an annuity due are usually not available; however, the tables of the present value factors for an ordinary annuity can be adapted to show the interest factors of an annuity due. This is accomplished by taking the factor for the period one less than the actual period of the annuity (n-1) and adding 1 to this interest factor. The reasons for this are: * Each annuity due payment is discounted for one less period than an ordinary annuity payment and * There is an annuity due payment at the beginning of the 0 first period [1 (1 + i) = 1] which does not exist in an ordinary annuity. Example: What is the present value of an annuity due of $1,000 per year for 4 years at 7% compounded annually? To determine the appropriate interest factor from table 4, first locate the 7% column; then read down the column values to the n = 3 row (4 years-1). The factor is 2.6243. The present value is now determined as follows: PV = A (IF) = $1,000 (2.6243 + 1) = $1,000 (3.6243) = $3,624.30 To determine if an annuity table of present value interest factors is for an ordinary annuity or an annuity due, you must analyze the first period factor. If the factor is smaller than 1.000, it shows that interest has been removed; therefore, the amount must have been paid at the end of the period and it is an ordinary annuity. If the factor is 1.000, it shows that no interest was removed; therefore, the amount must have been paid at the beginning of the first period and it is an annuity due.

Pricing Index Nominal GDP The general level of product prices tends to change from year to year because of inflation or deflation. GDP that has not been adjusted for price level changes is called the "NOMINAL GDP." Nominal GDP is based on the "current" price for each final good or service. A GDP amount that has been adjusted for inflation or deflation is called "REAL GDP." Real GDP is the sum of final goods and services measured in constant prices (eliminating the influence of price level changes from year to year). Real GDP is the proper measure of actual production changes from year to year because the impact of price level changes has been removed. In adjusting Nominal GDP to Real GDP, one must divide each year's Nominal GDP by that year's price index. Real GDP amounts are comparable from one year to another because they are based on an index that reflects a stable currency from year-to-year. In the United States of America, the price index used to convert Nominal GDP to Real GDP is the GDP DEFLATOR, a specialized index designed for use with GDP amounts. This specialized GDP index is a very broad index that measures not only consumer goods but also cap l goods, goods and services purchased by the government, and goods and services in world trade. Consumer Price Index Another pricing index that is used to measure the change in price levels is the CONSUMER PRICE INDEX (CPI). The CPI index is different from the index used with GDP amounts because the GDP index is based upon the actual goods and services produced each year. The CPI index is based on the prices of 364 consumer goods and services (often called a "basket of goods"). The CPI is a weighted price index such that the proportion of the various goods and services in the basket does not change from year-to-year. Therefore, if 20% of the basket of goods were food items during the period 1993-1995, then food items are considered to make up 20% of the basket of goods in all other years. For example, the CPI was 166.6 in the year 1999 and increased to 172.2 in the year 2000. This means that there was an increase in the cost of the basket of goods from 1999 to 2000, hence inflation. The inflation rate between 1999 and 2000 was 3.4% ((172.2 - 166.6) / 166.6). The CPI index is used in the United States of America as a basis for adjusting social security benefits, federal income tax brackets, and selected other contractual payments. Inflation Price indices are used to measure price level changes within an economy. INFLATION is the increase in the general level of prices in an economy. There are two basic types of inflation - COST-PUSH INFLATION and DEMAND-PULL INFLATION. COST-PUSH INFLATION is an increase in the price level caused by an increase in the cost of the resources used in production. As a result of the increasing cost of resources, the firm has to charge higher prices to offer the same quantity supplied and cover the increased production costs. Thus, resulting in price level increases. DEMAND-PULL INFLATION is an increase in the price level caused by an increase in demand during a period when supply is limited by capacity. In general, this means that consumers are demanding more goods than the suppliers are supplying. Or in other words, there are "too many dollars chasing too few goods." This results in the consumer's bidding higher prices for the limited supply of goods. The end result is that consumers "pull" the price levels up. Index of Leading Ecomonic Indicators The INDEX OF LEADING ECONOMIC INDICATORS is used to foresee changes in GDP. This index includes ten economic variables that, together, provide clues about the future direction of the economy. Because it takes time for economic policies to work, the index provides insight to policy makers about the future direction of the economy. This allows policy makers the opportunity to act before it is too late. The ten economic variables are commented on below: 1. Initial weekly claims for unemployment insurance - an increase in the claims for unemployment insurance suggests that firms are letting people go. An increase signals that there is diminishing demand for labor because production, as measured by GDP, is declining. 2. New orders for consumer goods - new orders with manufacturers usually result in increased production and an additional boos to an economy's production (GDP). However, if there is a decrease in the number of new orders, it usually means the economy is slowing. 3. Average workweek - a lengthening workweek suggests more production and higher GDP. However, a shortening of the average workweek suggests production is slowing and that GDP is likely to decline. 4. New orders for cap l goods - an increase in new orders for cap l goods suggests firms are expanding, which could result in increased production. A decline in new orders for cap l goods means that firms do not have a need to increase their production capacities by acquiring land, buildings, and equipment. 5. Vendor on-time delivery - Slower on-time deliveries suggest increased demand for good as a result of firms' inability to keep up with the increased demand. On the other hand, more on-time deliveries suggest that there is not an increasing demand for goods or services because firms are able to keep up with orders. 6. Building permits for houses - An increase in permits means more production and greater output for the economy. 7. Stock prices - Increasing stock prices reflect expected increases in corporate profits based on higher production and thus greater productive output. A decrease in the stock prices means investors are skeptical about productive output and profits. Thus, the investors withhold their investments as production slows. 8. Money Supply - Increases in the money supply cause lower interest rates, higher aggregate demand, and higher GDP. 9. Long-term vs. short-term interest rate differential - A small difference between long-term and short-term interest rates suggests that the Fed is causing higher short-term rates (the rates that the Fed has the most control over) to slow the economy. Higher short-term interest rates are associated with lower GDP. 10. Consumer expectations - Such expectations measured by the index of consumer expectations are subtle reflections of future consumption by consumers. A decline in the index may predict a future decline in aggregate demand and lower GDP.

Probability Probability Probability is the mathematical representation of the likelihood that a particular event will occur. It may be expressed in the form of a percentage, a fraction or a decimal. For example, the probability that heads will result on the flip of a fair coin is 50% (1/2 or .5). The probabilities of the various possible occurrences are collectively called the probability distribution, which totals 100% or 1.0. Probability distributions may be either objective or subjective. Objective probability distributions are established by the application of statistical procedures to empirical evidence. Examples would include the probability distributions associated with the flip of a fair coin or the rolling of fair dice. Subjective probability distributions are those which cannot be established by the application of statistical procedures but rather are the result of subjective estimation by knowledgeable persons; for example, the probability distribution associated with the likelihood of Congress passing a specific bill. It is important that a candidate be familiar with the terminology and basic application of probability theory. Specifically, the candidate should have a working knowledge of the following: * Probability distribution * Payoff tables * Expected profit * Value of perfect information * Regret tables * Expected loss These points may best be explained and illustrated by use of an example. Assume that a specialty food store stocks a perishable item which costs $3 per case and sells for $7 per case. If the item is not sold during the first day it is offered for sale, it must be destroyed. Analysis of the sales records for the past 80 days shows that there has been no trend in the sales for this item. Sales of the item during this period were as follows: Cases sold per day Number of days 5 8 6 16 7 32 8 24 Probability Distribution The probability that a particular event will occur may be determined as the ratio of the number of times the event occurs in observations to the total observations. The probability distribution (objective) for the example is shown below. Sales Observations Probability 5 8 8/80 = 10% = .1 6 16 16/80 = 20% = .2 7 32 32/80 = 40% = .4 8 24 24/80 = 30% = .3 80 80/80 = 100% = 1.0 Payoff Table (Conditional Profits Table) The payoff table shows the profit from any possible combination of available alternative actions and potential event occurrences. Each value in the table is conditional on an action being taken and a particular event occurring. The payoff table for the example is as follows: Payoff Table Alternative Inventory Actions Possible Demand 5 cases 6 cases 7 cases 8 cases 5 cases $20a $17b $14 $11 6 cases 20 24 21 18 7 cases 20 24 28 25 8 cases 20 24 28 32 (a) profit per case = $7 selling price - $3 cost = $4 profit for sales of 5 cases = 5 $4 = $20 (b) loss per case unsold = $3 cost, profit from sale of 5 cases less loss for 1 case = $20 - 3 = $17 Expected Profit The expected profit for an alternative action is obtained by weighting the conditional profit of each possible outcome of the alternative by the probability of its occurrence and totaling the results. The expected daily profit resulting from stocking 8 cases in the example would be determined as follows: Expected Profit from Stocking 8 Cases Conditional x Probability of = Expected Demand Profit Demand Profit 5 $11 .10 $ 1.10 6 18 .20 3.60 7 25 .40 10.00 8 32 .30 9.60 1.00 $24.30 The expected daily profits for the alternative stock action of the example are: Cases Stocked Expected Profits 5 $20.00 6 23.30 7 25.20 8 24.30 The optimum inventory action would be for the store to stock 7 cases as this alternative yields the greatest expected profit.

Process Cost Process Cost Basics In process cost a continuous flow of product is assumed and under ordinary conditions the cost per unit would not change significantly from period to period. Cost computations, admittedly oversimplified, can be expressed as follows: 4/1 4/30 PERIOD COSTS M, L & OH / = UNIT COST UNITS PRODUCED Things get complicated, however, because of beginning and ending inventories of work-in-process and the assumptions under which costs are assigned. In process cost, we may compute costs using FIFO or weighted average. Where there is no beginning inventory, there is no difference in the two inventory methods. The basic steps in working process cost problems for both the FIFO and weighted average methods is shown in five steps. Note that step four is called a "cost of production report" which simply stated is the computation of inventory costs for finished product and the ending inventory of work-in-process. Step 5 is not usually a required step, but a check to determine if prior computations are correct. Treatment for spoiled units is covered after Process Cost Procedure. Process Cost Procedure 1. Account for all units (do not use equivalents) Beginning Inventory If one item is missing, for example, lost units, the number + units started lost will be the number used - transferred out to equal zero. - lost - ending inventory = zero 2. Compute equivalent finished units (EFU) FIFO Average Finished Units Beginning Inventory (3) Finished +End Inventory(1) +Units started & finished(4) +End Inv.(1) +Abnormal Spoilage(1) OR + Abnormal Spoilage1 +Abnormal Spoilage(1) -Beginning Inventory(2) +Ending Inventory(1) (1) Units x % complete (2) Units x % complete at beginning of period (3) Units x % completed during the current period (100% - the % complete at beginning of inventory (4) Finished units - beginning inventory units (not equivalents) Separate EFU's may have to be computed for material, labor, overhead and prior department costs. 3. Compute unit costs. Set up a schedule as follows: FIFO Period Cost / EFU = Unit Cost Material xxxx xxx xx Labor xxxx xxx xx Overhead xxxx xxx xx Departmental unit cost xx Prior dept. cost (if applicable) xxxx xxxx xx Total unit cost xx AVERAGE COST Beg. Inv. + Period = Total / EFU = Unit Cost Material xxxx xxxx xxxx xxx xx Labor xxxx xxxx xxxx xxx xx Overhead xxxx xxxx xxxx xxx xx Departmental Unit Cost xx Prior Dept. Cost xxxx xxxx xxxx xxxx xx Total Unit Cost xx 4. Cost of Production Report-FIFO. In FIFO, the cost flow assumption is that the beginning inventory cost flows through first. Therefore, the first step is to complete the beginning inventory. Cost of units finished and transferred out Beginning inventory costs xxx (1) + Cost to complete (units ( % completed this period x unit cost) xxx (2) Total cost of beginning inventory units xxx + Cost of units started and finished (finished - beginning inventory) x total unit cost xxx Cost of units finished and transferred out xxx Cost of ending work-in-process inventory Units x % complete x unit cost xxx (3) Cost of abnormal spoilage (loss) Units x % complete x unit cost xxx (3) Total manufacturing costs accounted for xxx === (1) Includes material, labor, overhead and, if applicable, prior department costs. (2) Separate computations may be required for material, labor, and overhead costs. NOTE: Prior department costs would not be applied as they are already included in the beginning inventory if applicable. (3) Separate computations may be required for material, labor, overhead and prior department costs. Cost of Production Report-Average. In average, costs and units are not isolated for the period, but instead, beginning inventory costs and units are merged as can be seen in the unit cost computation in Step 3. Cost of units finished and transferred out Units x total unit cost xxx Cost of ending work-in-process inventory Units x % complete x unit cost xxx (1) Cost of abnormal spoilage (loss) Units x % complete x unit cost xxx (1) Total manufacturing costs accounted for xxx === (1) Separate computations may be required for material, labor, overhead and prior department costs. 5. Costs to be accounted for: Dr. Beginning inventory Cr. Finished transferred Period costs (M, L and OH) Finished remaining Prior dept. costs Ending inventory Lost units (if computed separately) Treatment of Spoiled Units (Lost, Defective, Spoiled, etc.) 1. Abnormal spoilage should be computed as a separate cost and written off as a period loss. 2. Normal spoilage is included in production costs for the period as follows: a. Units lost during production are simply ignored in the computation of the EFU and their period costs will be absorbed by the units produced including both finished good units and ending inventory of work-in-process. Note: If the problem is silent as to when units are lost, assume loss at beginning of process. b. When units are transferred in from another department, it will be necessary to compute a new unit cost, such as: 18,000 units transferred from B to C at a cost of $36,000; 2,000 units were lost at the beginning of the process. The new unit cost becomes $36,000 / 16,000, or $2.25. At times problems may ask for a lost unit adjustment computation. In the foregoing situation this would be computed as follows: Transferred-in Unit Cost $2.00 Lost unit adjustment 18,000 - 16,000 = 2,000 lost 2,000 x $2.00 = $4,000 / 16,000 = .25 New unit cost $2.25 ===== Note to Students: Cost accounting textbooks vary in their treatment of units normally lost in production. Some advocate computing a cost on the lost units and adding such cost to the good units. Others recommend ignoring the lost units, thus having the effect of spreading the cost over both the finished and ending inventory work in process. If you are instructed in a problem to compute a cost on lost units, you must include the lost units in the EFU to the extent such lost units were completed. Exercises 1. 20,000 units were started in the department, 8,000 were in process one-half complete at the end of the month, 27,000 were completed and 4,000 were found defective. How many units were in process at the beginning of the month? ____________ 2. 26,000 units were transferred into the department. Units in process at the beginning of the month, one-third complete, 18,000. At the end of the month 12,000 units were in process, three-fourths complete. 1,000 units were lost and 31,000 were finished and transferred. Compute the EFU for FIFO assuming that: a. Material is added as work in process ____________ b. Material is added at the beginning of processing ____________ c. Material is added at the end of the process ____________ Compute the EFU for average costing purposes assuming that d. Material is added when the process is one-half complete _____________ e. Material is added at the beginning of processing ____________ 3. 15,000 units were transferred in from the mixing department to cooking at a cost of $28,000. Beginning units totaled 6,000 at a cost of $13,000. One-thousand units were lost. Compute the transferred-in costs per unit for FIFO costing purposes. ___________ Make the same computation for average costing purposes. ____________ Solutions to Exercises 1. 19,000; 2. (a) 34,000, (b) 25,000, (c) 31,000, (d) 43,000, (e) 43,000; 3. $2.00, $2.05. Process Cost Illustrative Problem The Joy Manufacturing Co. manufactures a single product that passes through two departments: extruding and finishing-packing. The product is shipped at the end of the day that it is packed in the finishing-packing department. The production in the extruding and finishing-packing departments does not increase the number of units started. The cost and production data for the finishing-packing department for the month of January are as follows: Finishing- Cost Data Packing Dept. Work in process, January 1: Cost from preceding department $34,500 Material $14,750 Labor 15,800 Overhead 6,230 Costs added during January: Cost from preceding department 93,500 Material 41,250 Labor 48,800 Overhead 23,370 Percentage of completion of work in process January 1: Material 100% Labor 60% Overhead 50% January 31: Material 100% Labor 80% Overhead 70% January Production Statistics Units in process, January 1 5,000 Units in process, January 31 4,000 Units received from prior department 13,000 Units completed and transferred or shipped 12,000 Required: Compute each of the following assuming the company uses A) FIFO and B) Weighted Average Process Cost: 1. Account for all units. 2. Compute the equivalent finished units for material, labor, overhead, and prior department costs. 3. Compute the unit cost. 4. Prepare a cost of production summary. 5. Show all the debits to the Work-in-Process account, all credits and reconcile the balance to the ending inventory of work-in-process computed in (4) above. Solution: A) FIFO Step . Finishing-Packing In Process 1/1 5,000 Started 13,000 Total units to account for 18,000 ====== Completed 12,000 In Process 1/31 4,000 Lost in Production 2,000 Total units accounted for 18,000 ====== Step .-EFU (FIFO) Finishing-Packing Material Labor Overhead Prior Dept. Finished 12,000 12,000 12,000 12,000 + Ending Inv. 4000 x 100% 4,000 4000 x 80% 3,200 4000 x 70% 2,800 4000 x 100% 4,000 16,000 15,200 14,800 16,000 - Beginning Inv. 5000 x 100% (5,000) 5000 x 60% (3,000) 5000 x 50% (2,500) 5000 x 100% (5,000) EFU - FIFO 11,000 12,200 12,300 11,000 Step .-Unit Cost Period Cost EFU Unit Cost M $41,250 11,000 $ 3.75 L 48,800 12,200 4.00 OH 23,370 12,300 1.90 $ 9.65 Transferred in costs $93,500 11,000 8.50 $18.15 ====== Step .-Cost of Production Report Cost of Finished Units Opening WIP Costs 1/1 (34,500 + 14,750 + 15,800 + 6,230) $71,280 Cost to Complete Material 5,000 x 0% x $3.75 - Labor 5,000 x 40% x $4.00 8,000 Overhead 5,000 x 50% x $1.90 4,750 Prior Dept. 5,000 x 0% x 8.50 - Cost of 5,000 complete units $ 84,030 Add: Cost of units started and finished during January 7,000 x $18.15 127,050 Cost of 12,000 finished units $211,080 Cost of WIP 1/31 Material 4,000 x 100% x $3.75 $ 15,000 Labor 4,000 x 80% x $4.00 12,800 Overhead 4,000 x 70% x $1.90 5,320 Transferred in Costs 4,000 x 100% x $8.50 $ 34,000 67,120 Total manufacturing cost accounted for $278,200 ======= Step .-Costs To Be Accounted For Costs Finishing-Packing Beginning Inventory $ 71,280 Period Costs 206,920 $278,200 ======== Transfers from WIP $211,080 Ending Inventory WIP 67,120 $278,200 ======== Solution: B) Weighted Average Step . Finishing-Packing Department Units in process, January 1 5,000 Units received from preceding department 13,000 Total units to be accounted for 18,000 ====== Units completed and transferred or shipped 12,000 Units in process, January 31 4,000 Units lost during January 2,000 Total units accounted for 18,000 ====== Step .-EFU (Weighted Average) Finishing-Packing Material Labor Overhead Prior Dept. Finished 12,000 12,000 12,000 12,000 +Ending Inventory 4000 x 100% 4,000 4000 x 80% 3,200 4000 x 70% 2,800 4000 x 100% 4,000 EFU Weighted Average 16,000 15,200 14,800 16,000 ====== ====== ====== ====== Step .-Unit Cost Costs Finishing-Packing Dept. Beg. Inv. Period Total EFU Unit Cost M $ 14,750 $41,250 $56,000 16,000 $3.50 L 15,800 48,800 64,600 15,200 4.25 OH 6,230 23,370 29,600 14,800 2.00 Preceding Dept. Costs $34,500 $93,500 128,000 16,000 8.00 Total manufacturing costs $278,200 $17.75 ======== ====== Step .-Cost of Production Report Cost of Finished Units 12,000 units x $17.75 $213,000 Cost of WIP 1/31 Material 4000 x 100% x $3.50 $14,000 Labor 4000 x 80% x $4.25 13,600 Overhead 4000 x 70% x $2.00 5,600 Prior Dept. 4000 x 100% x $8.00 32,000 65,200 Total manufacturing costs accounted for $278,200 ======== ACTIVITY BASED COSTING Activity Based Costing is a method of assigning costs to goods and services that assumes all costs are caused by the activities (cost drivers) used to produce those goods and services. ABC first relates costs to the activities that cause the costs (cost drivers), then assigns costs to products/services based upon their use of those activities (cost driver) in production. ABC results in the use of multiple predetermined rates for overhead costs as companies engage in many different activities that cause overhead cost (multiple cause/effect relationships exist within a company for overhead costs). As a result, ABC provides more detailed measures of cost than departmental or plantwide allocation methods. Advantages of ABC include: * Provide more insight into the causes of cost. Managers must know: 1) the activities that go into making the good/service and 2) the cost of those activities to employ ABC. * Stresses cost control results from control of activities. ABC is based on the concept that the production of goods and services consumes activities, and activities consume economic resources (costs). * Promotes improved quality/continuous improvement. Nonvalue-added activities (cost drivers), such as movement, storage, set up, inspection, defective rework are minimized or eliminated.

Prof bility Index Prof bility Index Investments are ranked according to the ratio of the present value of the benefits (discounted at the cost of cap l) to the investment. Investments with a prof bility index equal to or greater than 1 should normally be accepted as they are earning a rate of return equal to (PI = 1) or greater than (PI > 1) the cost of cap l. Example: Compute the prof bility index for the previous example. Solution: Present Value of Benefits Prof bility index = ------------------------- Investment = $122,892 -------- 100,000 = 1.23 ==== Illustrative Problem Investalot Corporation is considering the purchase of a new machine which will cost $106,111. Freight charges and installation costs are anticipated to be $5,000. Management estimates that variable costs will be reduced by $16,000 per year and that additional revenues of $14,000 per year will be generated if this machine is purchased. The machine has an estimated useful life of 10 years and will have a $15,000 salvage value. Investalot Corporation computes depreciation on the straight line basis, has an effective tax rate of 40% and a 15% cost of cap l. If Investalot Corporation purchases this new machine it will trade in an old, idle machine, receiving a trade-in allowance equal to its book and fair value of $11,111. Should the company buy this machine? Solution: Investment-initial cash outlay Purchase price $106,111 Add: Freight and installation 5,000 Depreciable cost $111,111 Less trade-in allowance - 11,111 Initial cash outlay $100,000 Benefits-Annual Cash Flows a. For years 1 through 10 Additional revenues $14,000 Reduction in variable costs 16,000 $30,000 Less depreciation ($111,111 - 15,000 = 96,111 10%) 9,611 Increase in net income before taxes $20,389 Less: Taxes @ 40% 8,156 Increase in net income after taxes $12,233 Add: depreciation 9,611 Additional annual cash flows $21,844 ======= b. For the 10th year In addition to the annual cash flows Investalot will receive the salvage value $15,000 ======= Assuming use of the Net Present Value Method Present value of annuity- 10 years @ 15% $21,844 5.0188 = $109,631 Present value of a single sum- 10th year @ 15% $15,000 x .2472 = 3,708 Present value of benefits $113,339 Less: Present value of investment 100,000 Net present value $ 13,339 ========= Investalot Corporation should purchase the new machine as the net present value is equal to or greater than zero. Assuming use of the Internal Rate of Return Method To use interpolation the present value is needed at two rates such that one is above and the other below the present value of the investment. The present value at 20% is computed as follows: Present value of annuity $21,844 x 4.1925 = $91,581 Present value of single sum $15,000 x .1615 = 2,423 Present value of benefits @ 20% $94,004 ======= Discount Rate Present Value 15% = $113,339 IRR = 100,000 (Investment Cost) 20% = 94,004 Interpolation may now be used to determine the internal rate of return. A 5 percent change in the discount rate (15% to 20%) resulted in a change of $19,335 in the present value ($113,339 to $94,004). What is needed is some percentage change from 15 percent such that the change in present value will be $13,339 ($113,339 - $100,000). This percentage change is computed as follows: .05 / $19,335 = X / $13,339 (5% is to $19,335 as X is to $13,339) $19,335 X = $666.95 X = 666.95 / $19,335 X = .034 The internal rate of return is approximately 18.4% (15% + 3.4%).

Ratio Analysis RATIO ANALYSIS Ratios are used to examine trends for a given company, for projecting into the future, and for comparing against other companies or industry averages. Liquidity is a measure of the nearness to cash. Solvency is the long-term ability to pay liabilities when they mature. Financial flexibility is the ability to react and adjust to problems and opportunities. Working Cap l Components Working Cap l: Current Assets - Current Liabilities Acid-Test Ratio: (Cash + Temporary Investments + Net Receivables) / Current Liabilities Measures The Firm's Ability To Pay Off Its Short-Term Debt From Its Most Liquid Assets. Current Ratio Current Ratio: Current Assets / Current Liabilities The Most Commonly Used Measure Of Near-Term Solvency. Example: Assuming a current ratio of 3:1, paying off $1 of accounts payable has what effect on: * Current Ratio? * Working Cap l? Answers: --Current Ratio - Make up any numbers that give you a current ratio of 3 to 1. Let's use current assets = $6 and current liabilities = $2 giving us a current ratio as follows: Current Assets / Current Liabilities X $6 / $2 = 3 If we take $1 of current assets to payoff $1 of current liabilities the ratio becomes: $6-$1/$2-1 = 5 / 1 = 5 Thus the current ratio goes up. Working Cap l Using the same numbers the working cap l is currently: Current Assets - Current Liabilities = $6 - $2 = $4 If we take $1 of current assets to pay off $1 of current liabilities then the working cap l becomes: $5 - $1 = $4 Thus working cap l stays the same. Asset Management Ratios (Activity ratios) - How well is the firm using its assets to generate revenue and income. When balance sheet amounts are compared with income statement amounts, the balance sheet amounts should be converted to an average for the year. Inventory Turnover Ratio Inventory turnover ratio - (Cost of sales) / (Average inventory) Number of days of inventory or days' sales in average inventory or inventory turnover in days - (Selling days in year [365, 360, or 300]) / (Inventory turnover ratio) or (Average inventory) / (Average cost of sales per day) Receivables turnover ratio (Net credit sales) / (Average gross accounts receivable) Average Collection Period (Number of days of receivables or days' sales in average receivables) shows the average number of days required to collect: (Selling days in year [365, 360, or 300]) / (Receivables turnover ratio) or (Average gross accounts receivable) / (Average daily sales) (Average daily sales = net credit sales / number of selling days in the period.) Return on total assets (Net income after interest and taxes) / (Average total assets) Debt ratio or debt to total assets - the percentage of funds provided by creditors: (Total liabilities) / (Total assets) Debt-equity ratio compares resources provided by creditors with those provided by shareholders: (Total liabilities) / (Shareholders' equity) Gross Profit Margin Gross Profit Margin = Gross Profit / Sales Gross Profit is affected by 1. inventory costing method - FIFO, LIFO 2. revenue recognition method - installment sales method, cost recovery method, percentage of completion versus completed contract methods, and other variations. Opportunity Cost - the lost benefit of the next best use of cap l.

Regression Analysis Regression Analysis Regression analysis is a mathematical technique used to predict the value of one variable and its changes (the dependent variable) based upon the value of some other variable (the independent variable). When the independent variable is a function of time such as months, quarters, or years, then the term "time regression", "time trend", or "time series" analysis is sometimes used. Simple regression analysis involves the use of only one independent (explanatory) variable, while multiple regression analysis allows for more than one independent variable. Regression analysis may be used to predict future sales, revenues, profits, demands, costs, etc. or to separate a semi-variable item into its fixed and variable components. Methods of Measuring Relationships Between Variables 1. High-Low Method: Only two observations of the variables are used to measure the relationship between them. The values of the variables are measured at a high and low level of the independent variable, and the change in the dependent variable is divided by the change in the independent variable to determine its relationship to the independent variable. The fixed portion or minimum level of the dependent variable can be determined by deducting from its total value (at the high or low observation) its value determined in relation to the independent variable (at that same observation). The observations should be within the relevant range for the variables, and be representative of normal results at these levels. The High-Low Method has the advantage of being easy and inexpensive to use; however, it has the disadvantage of being the least accurate of the methods as it uses only two observations and these may not be representative of the relationship between the variables. Example: Direct Labor Cost of Observations Hours Utilities High 2800 $1334 Low 1300 884 Change 1500 $ 450 Relationship $450 / 1500 = $0.30 per direct labor hour Determination of fixed portion: High Low Total Utilities Cost $1334 $884 Cost based on direct labor hours ($.30 per) 840 390 Fixed portion $ 494 $494 Predicted Utilities Cost at 2000 direct labor hours: $494 + ($.30 x 2000) = $494 + $600 = $1094 2. Scattergraph Method: Multiple observations of the two variables are plotted on a graph in order to visually determine their relationship. The values of the dependent variable are plotted on the Y axis (vertical axis) and those of the independent variable on the X axis (horizontal axis). Each point on the graph represents an observation of the variables (X and Y). A straight line (Trend Line) is then drawn through the plotted points so that there is an equal distance between the Trend Line and the plotted points above and below the line. The Trend Line is then used to describe the relationship between the variables and to predict the value of the dependent variable for given values of the independent variable. The point at which the trend line intersects the Y axis indicates the fixed portion or minimum value of the dependent variable. If the plotted points on the scattergraph follow a generally straight line, a linear relationship is assumed to exist, and the variables are said to be correlated with each other. The Scattergraph Method has the advantage of being relatively simple to apply and understand; however, it is not objective as personal bias may distort the fitting of the trend line. Example: Y | | Trend Line 2000| @ | @ 1500| . @ | . @ . 1000| . @ . | @ . 500 |@ . | |--------|-----------------------X 1000 2000 3000 Fixed portion is $500 (intercept of the Y axis) The variable relationship is indicated by the slope of the trend line. 3. Regression (Least Squares) Analysis: A Regression Line is a mathematically fitted line to the observations of the variables which were plotted in the scattergraph. The least squares method fits the line to the observations so that the sum of the squared variances of the observations above and below the line are minimized. The regression line is to the scattergraph as an average is to a list of values; it indicates the average value of the dependent variable (y) associated with a particular value of the independent variable (x). The method assumes a linear relationship and is based upon the formula for a straight line, Y = a + bx, where Y = the independent variable; a = the fixed portion or minimum value of the independent variable; b = the slope of the line or the rate of variability in the dependent variable for changes in the independent variable; and x = the value of the independent variable. The method has the advantage of being more objective and accurate; however, it is time-consuming if done manually. Multiple regression analysis is a further expansion of the least squares method, allowing for the consideration of more than one independent variable. The formula could appear as Y = a + bx + cz, where c is the rate of variability for z, an additional independent variable. Correlation: The statistical measure of the relationship of dependent and independent variables is the Coefficient of Correlation (r). If perfect correlation exists all points (observations) lie on the regression line, and the coefficient of correlation would be +1 or -1, depending upon whether they are directly (positively) or inversely (negatively) related. If no correlation exists the coefficient would be 0, indicating that there is no statistical relationship between the variables. The Coefficient of Determination (r2) is the statistical measure of the fit of the regression line to the observations of the variables, and is found by squaring the coefficient of correlation. A coefficient of determination of .94 would mean that 94% of the change in the dependent variable (x) is related to the change in the independent variable (y).

Risk Terms Risk Terms * MARKET RISK - risk that an individual stock will go up or down if the stock market as a whole goes up or down. * LIQUIDITY RISK - the possibility that an asset may be sold for less than its market value if sold upon liquidation. * DEFAULT RISK - the risk that a borrower will default on interest or principle repayments. * INTEREST RATE RISK - fluctuations in the value of an asset as interest rates change. So investing in long-term bonds is more risky than short-term maturities. If interest rates go up bond prices go down. If interest rates go down bond prices go up. An asset with more risk should have a higher expected (actual) return to compensate for the additional risk. PORTFOLIO THEORY - spreads risk to reduce risk. Risk-return analysis should consider the benefits of diversification. All asset gains and losses do not go in the same direction. In other words, don't put all of your eggs in one basket. DERIVATIVES An agreement involving risks related to uncertainty in the future (potential gain or loss). Examples include futures and forward contracts, forward rate agreements, and interest rate swaps. For instance, a futures contract regarding Japan's stock index allows one to place a large bet that Japan's stock market will go up or down. The cost of doing this is very small-broker's commission. However, the potential gain or loss on such a contract is very large. Thus, the futures contract is a derivative because it involves risks related to uncertainty in the future.

Role of Business Information Systems Role of Business Info Systems Reports produced by a business information system should be timely, accurate, useful, understandable, concise, and economical to prepare. They should be relevant to the user, which often means that those higher in the organization need summarized information, while those in lower positions need more detailed information. The timing of reports may be periodic (i.e., every week, month, etc.), on demand (only when requested), or event-triggered (caused to be produced when something happens). They could be detailed (showing everything), summarized (showing only subtotals and grand totals), or exception-oriented (showing, for example, only the customers who are past due in their AR balances). And, in format, they could be tabular (rows and columns), graphic, or narrative. Another choice is to make them in hard copy (paper) or "soft copy" (on the monitor). The accounting information system (AIS) is a subsystem of the management information system (MIS). MISs include production, finance, marketing, distribution, and personnel functions. MISs provide information and support the daily decision-making needs of management. Traditionally, AISs include the transaction processing systems, or transaction cycles. These include budgeting and responsibility reporting systems. The main transaction processing systems are: * Revenue - Taking the customer's order, shipping the goods or providing the services, billing, and collecting the cash * Expenditure - Requesting goods/services, purchasing, receiving, and paying * Conversion - Converting resources purchased into goods/services available for sale, usually including assessing requirements, scheduling and initiating production, issuing materials, and then producing * General ledger - Receiving transactions produced by the above three transaction cycles, recording necessary adjustments, and producing financial and managerial reports Each of these systems is subject to risks. There are, for example ... * Strategic risks - doing the wrong things * Operating risks - doing the right things, but the wrong way * Financial risks - having financial resources lost, wasted, or stolen, or incurring unnecessary liabilities, through such as lack of physical control over assets, extension of credit to a customer who has no ability to pay, and payment by unauthorized employees to unapproved vendors * Information risks - receiving or producing incomplete or inaccurate information, unreliable hardware or software, and unauthorized access By way of definition, hardware is the physical equipment used in the computer system. Software, however, is the computer program that gives instructions to the central processing unit (CPU). Often, software is broadly used to include programming languages and system documentation. Popular forms of documentation which depict graphical representations of systems include: * Data flow diagram - showing the sources and destinations of data and the flow of that data into and out of processes performed on the data, as well as data stores (files). Unlike flowcharts, which depict how the data physically flow and the types of media used, data flow diagrams depict merely what data are flowing logically. * Document flowchart - showing the flow of documents and information between departments or participants in the system. There is usually a column for each participant. * System flowchart - showing the relationship among inputs, processing, and outputs in a system. * Program flowchart - showing the sequence of operations that a computer performs in executing a program. In designing systems, there are several principles: The compatibility principle - systems must be compatible with their environments, through the interface / boundary with other systems, receiving inputs and producing outputs for other systems. The flexibility principle - systems must be able to adapt to changes and new demands. The control principle - systems must have sufficient controls (see next session on controls). They must have a "requisite variety" of controls to protect against the variety of problems that could lead to entropy (disorder). Accountants are involved with systems as designers, as auditors, and/or as users. Accountants should be involved in the coding of data such as the chart of accounts, or inventory ID's. Codes may be: * Sequential (to highlight missing items, e.g., for coding check numbers or invoice numbers) * Block (reserving blocks of numbers, e.g., reserving the 100 to 199 block of numbers for coding current assets, 200 to 299 for fixed assets, etc.) * Group (dividing the entire code in to subsections, or subgroups; thus, for inventory, the first 2 digits of the inventory code might indicate the vendor, the next 3 might indicate the color, the next 2 might reveal the location in the warehouse, etc.) * Mnemonic (a memory-jogger, usually an abbreviation, such as, for states, NY for New York, CA for California, etc.) In selecting a coding scheme, you must consider the organization's information requirements, the organization's complexity, and you must allow space in the code for organizational growth. While the Financial Reporting System communicates information primarily with external parties, the Management Reporting System provides internal information to management. Management must deal immediately with business problems, as well as plan and control operations. So management would need budgets, variance reports, cost-volume-profit analyses, and non-GAAP formats. Directing management's attention to problems on a timely basis is important to internal control, for monitoring purposes. DECISION SUPPORT SYSTEMS (DSSs) DSSs assist management in unstructured or semi-structured decisions, as opposed to structured (repetitive, routine, perhaps programmable) ones. They may suggest choices for long-range, strategic planning decisions, but active managerial insights and judgments are required. They enable the end user to initiate and operate the system for ad hoc, quick responses. DSSs contain - * Relevant, specialized databases (e.g., historical data about the company) * Model bases (e.g., regression analysis, net present value) for analysis, with high-level ("natural") languages (e.g., English) * Supportive, interactive user interfaces (e.g., GUI - graphical user interface) * Variety of outputs (e.g., reports, graphs) ARTIFICIAL INTELLIGENCE SYSTEMS Expert systems are the most widely used form of artificial intelligence (AI). They can suggest expert decision choices to the inexperienced, containing a knowledge base, a database,and an inference engine for if-then conditions. Generalized shells are available, into which the company must input its particular knowledge and data. Expert systems are software programs that use facts, knowledge, and reasoning techniques to solve complex problems. They assure consistency with the decisions of the company authorities and are available 24 hours per day, 7 days per week. CPA firms have developed expert systems to help their employees properly value a loan portfolio, for example, or to do tax planning, or to guide audit decision-making. Less widely-used forms of AI include - * Fuzzy logic (e.g., search engines, that that look for words that are spelled similarly to, but not exactly like, other words) * Neural networks (finding patterns among attributes, such as weather patterns that result in severe storms) ENTERPRISE RESOURCE PLANNING SYSTEMS (ERPs) ERP systems run a company's applications. By way of definition, stand-alone application software would be a program that performs the data processing tasks the company requires, such as purchasing, payroll, or accounts receivable. ERP is integrated application software, combining many of these subsystems. ERPs are ultra-high end, expensive accounting software systems, intended to integrate all aspects of an organization's activities into one system. They are multi-module systems designed to create a seamless flow of information throughout the organization. SAP, Oracle, and PeopleSoft sell popular ERP systems. OLTP - Online Transaction Processing applications - support the daily processing of mission-critical transactions in a company's ERP. Its shared, enterprise-wide operations database is volatile, with a large number of relatively simple transactions per day in finance, sales, distribution, expenditure, production planning, and logistics. OLAP - Online Analytical Processing applications - include decision support tools for management. Its database is the data warehouse, drawn regularly from the OLTP database, and designed for complex, read-only queries and data mining - drill-down, roll-up (consolidate), and slicing & dicing data to view it in various dimensions (e.g., sales by day, by week, by product, by customer). Because ERPs may not contain every application a given company needs, the company may still need its old legacy systems, or bolt-on industry-specific applications from other vendors.

Roles and Responsibilities Within the IT Function Roles and Responsibilities In traditional manual systems, we sought to separate the functions of authorization of a transaction, recording of the transaction, and custody of the assets associated with the transaction. That way, no single employee could both perpetrate and conceal fraud or intentional errors. However, since functions previously separated are usually combined in integrated computerized information systems, it is now critical to prevent any person from having unrestricted access to the computer, its programs, and live data. To prevent an individual from both perpetrating and concealing a fraud, authority and responsibility should be clearly divided among the following functions: * Systems administration - ensuring that the different parts of an information system operate smoothly and efficiently * Network management - taking responsibility for the operation and reliability of the company's internal and external networks, assuring that all devices are appropriately linked and remain up and running, that messages are received as sent, and that response times are minimized. * Security management - ensuring that all aspects of the system are secure and protected from internal and external threats. * Change management - ensuring smooth and efficient changes in the system, preventing errors and fraud. * Users - recording transactions, authorizing data to be processed, and using system output. * Systems analysis - helping users determine their information needs and then designing (perhaps with specialized "systems designers") an information system to meet those needs. * Application programming - writing and/or maintaining application programs, such as payroll, accounts receivable, purchasing, and other company applications, based on the design of the systems analysts. * Systems programming - writing and/or maintaining system programs, such as the operating systems for the workstations and the network operating systems. * Computer operations - operating the machines, running the software, processing transactions and responding to system messages. Operators ensure that data are properly input to the computer, processed correctly, and that needed output is produced. It is v l that operators not also be programmers, as that would be most incompatible. * Information systems library - maintaining custody of the data, the source programs (in the language written by the programmers), and the object programs (in their executable, machine-language form). They may control physical media (tapes, disks, etc.), and/or they may control access to the programs and data as stored using password protection. * Data control - this group ensures that source data have been properly approved, and then monitors the processing, reconciling input and output. It also monitors input errors to ensure their correction and resubmission, and it distributes output. * Database Administration - The DBA is responsible for the maintenance, protection, control, and integrity of the database. The DBA creates the overall schema (layout) of the database, defines each user's subschema (personal view or authorized access domain), assigning degrees of access to individual records, monitoring usage, and planning for future expansion. * Web Administration - The Web administrator maintains the company's virtual public face on the computer screen, so that customers, potential customers, and any other stakeholders will have a positive experience interacting with the Web site. The Web site must remain up and running, protected, with minimal response delays.

Sole Proprietorships Sole Proprietorships This is the simplest form of business organization and the easiest to begin and to terminate. The proprietor furnishes all the cap l, receives all the profits and owns all the property of the proprietorship. Proprietors can sue and be sued. Their personal assets are at risk. The proprietor is taxed as an individual and reports sales and expenses on Schedule C of Form 1040 for Federal tax purposes. Proprietorships do not necessarily do business in their ownerís name. If not, they may be required under state law to file a d/b/a ďdoing business asĒ disclosure. A proprietorship endures at the will of the owner, but is automatically terminated upon the proprietorís death. Advantage: Simplicity, ability to do business across state or national boundaries. Disadvantage: Lack of cap l and management skills and depth.

Standard Costs Variance Analysis Standard cost systems are used because it is relatively easy to assign uniform costs to the product and the use of standards gives management a yardstick by which performance can be evaluated. In most standard systems all charges to Work-in-Process are at standard. A typical cost card for one unit of product may be as follows: Cost Card-Standard One Unit of Product G Material 4 lbs. @ $1.50 $ 6.00 Labor 2 hrs. @ $4.00 8.00 Overhead $2 per labor hour 4.00 Total $18.00 Other Information: Actual Units Produced 9,000 Actual Materials Used 38,000 lbs. Actual Material Cost $55,100 Actual Labor Used 18,500 hrs. @ $4.10 per hr. Actual Overhead $38,600 From this information we can compute material and labor variances. Material Variances Units Price Debit Credit Actual x Actual 38,000 x $1.45 = $55,100 Price Variance (38,000 x .05) Actual x Standard 38,000 x $1.50 = $57,000 $1,900 Quantity/Usage Variance (2,000 x 1.50) Standard x Standard (9,000 x 4) 36,000 x $1.50 = $54,000 $3,000 --------------------- Net Variance $1,100 Labor Hours Rate Actual x Actual 18,500 x $4.10 = $75,850 Rate/Wage Variance (18,500 x .10) Actual x Standard 18,500 x $4.00 = $74,000 $1,850 Efficiency Variance (500 x $4) Standard x Standard 18,000 x $4.oo = $72,000 $2,000 --------------------- Net Variance $3,850 Flexible Budgets For analysis and control purposes, the Company set up a flexible budget for overhead (manufacturing expenses). This budget is used to determine the overhead rate ($2 per labor hour) which is based on normal or expected capacity. Manufacturing Expenses 90% 95% 100% 105% Fixed $20,000 $20,000 $20,000 $20,000 Variable 18,000 19,000 20,000 21,000 38,000 39,000 40,000 41,000 Labor Hours 18,000 19,000 20,000 21,000 Overhead Rate $2 This means that management has selected an activity level of 20,000 labor hours on which to base the standard overhead rate. If the company based the rate on normal capacity, a moving average of production for several years is probably being used. If the rate is based on expected capacity, the rate is based on the amount which the company expects to produce during the period, taking into consideration inventory levels at the beginning of the year, sales estimates, and planned inventory levels at year end. Mixed Costs-Use of the High-Low Method It may be necessary to determine whether a cost or group of costs contain both fixed and variable elements and if so, to what extent. There are many statistical methods used for this purpose such as the scattergraph method, least squares, but the simplest is the high and low points method. This technique requires the use of two levels of cost and related activity. It is assumed that the change in cost from a lower level of activity to a higher level is variable. The variable cost change is translated into variable costs per unit of activity which can be used to compute the total variable cost at any level of activity and consequently the fixed cost. For example: Machining costs for various parts show costs as follows: Activity Level Costs 3,000 Machine Hours $10,500 5,000 Machine Hours 13,500 Change in Activity 2,000 Change in Costs $3,000 $3,000 Cost Per Machine Hour ------ = 2,000 1.50 Variable Cost Per Machine Hour Fixed cost computation 3,000 level of activity = $10,500 - (3,000 x 1.50) = $6,000 5,000 level of activity = $13,500 - (5,000 x 1.50) = $6,000 Once the computation is made as above for the 3,000 machine hour level, it is not necessary to make the computation for the 5,000 hour or any other level because the result should be the same. The level used need not necessarily be the high and low points, but when using this method keep the following points in mind. 1. The costs used at the levels selected should represent normal conditions. 2. The levels selected should be within the "relevant range" of activity, i.e., the range of activity within which fixed costs are valid. 3. The computation assumes that variable costs are linear, i.e., changes in activity result in uniform changes in cost and graphically would represent a straight line. Manufacturing Overhead Variances Total Variance-Basic Computation Actual Expenses $38,600 Standard 9,000 x 2 x 2 36,000 Total Variance $ 2,600 UNF Regardless of what analysis of overhead is made, the resulting variances must equal the total variance of $2,600. Two-Variance Method-Controllable and Volume Variance These overhead variances have been the most frequently required in recent CPA examination problems. All variances are simply the difference between actual and standard cost, which is called the net variance, divided into two or more variances to furnish management information. In the two-variance method, the controllable variance is a measure of the control of spending and efficient use of resources in that actual costs are compared with the budget at standard hours instead of actual hours. Hence, the term controllable refers to the fact that the two items measured by this variance, efficiency and spending, are controllable within the plant. The volume variance, which is caused by producing more or less than the level at which the overhead rate was computed (normal or expected capacity) is normally beyond the control of the plant and is sometimes referred to as the noncontrollable variance. DR CR Actual $38,600 $600 Controllable UNF Budget at Standard Hours 38,000 ($20,000 + 18,000 x $1) *2,000 Volume UNF Standard 9,000 x 2 x $2 36,000 * May also be referred to as capacity or non-controllable variance. Three-Variance Method---Budget, Efficiency and Capacity Variance The budget variance is computed at actual activity and for that reason is considered a measure of control of spending. To measure the spending effectiveness of fixed and variable elements individually, a breakdown of actual fixed and variable costs is needed, and converts the three variances into four variances. (See the four-variance method which follows.) Note also that a budget variance computed by using actual activity is a better measure of spending effectiveness since the activity base selected (labor hours, machine hours, etc.) is intended to be an indicator of changes in variable costs. The efficiency variance is a function of either more or less than standard usage of the activity base. The capacity variance is attributable to the over- or under-application of fixed costs. For example: An analysis of the capacity variance may be more clear by breaking down the overhead rate into the fixed and variable components. Labor Cost Hours Rate Fixed $20,000 20,000 $1.00 Variable 20,000 20,000 1.00 $2.00 Then compare the manufacturing overhead budget at standard with standard. Hours Standard Budget at Variance Costs Standard Fixed 18,000 x $1 = $18,000 $20,000 $2,000 Variable 18,000 x $1 = 18,000 18,000 -0- Variance $2,000 We can see that the Fixed Costs cause the variance in that the failure to produce at or above the level on which the overhead rate is fixed will produce an unfavorable capacity variance. DR CR Actual $38,600 $100 Budget UNF Budget based on actual hrs. $20,000 + 18,500 x $1 38,500 $500 Efficiency UNF Budget based on standard hrs. $20,000 + 18,000 x $1 38,000 $2,000 Capacity UNF Standard 9,000 x 2 x $2 36,000 Journal entries for the three variance method are as follows: (1)Manufacturing expense control (actual) $38,600 Indirect costs (material, labor, depreciation) $38,600 (2)Work-in-process (standard) $36,000 Overhead applied (an accumulation account) $36,000 WIP is charged at standard at the end of the period. (3)Overhead applied $36,000 Manufacturing expense control $36,000 To close out overhead applied to manufacturing expense control. (4)Manufacturing expense control is closed to variance accounts. This entry shows unfavorable variances. Budget Variance $ 100 Efficiency Variance 500 Capacity Variance 2,000 Manufacturing Expense Control $2,600 (5)Inventories and cost of goods sold, cost of goods sold only or income summary $2,600 Budget Variance $ 100 Efficiency Variance 500 Capacity Variance 2,000 If the variances are allocated to the inventories and cost of goods sold, these accounts are converted to actual. If the variances are closed to cost of goods sold only, the inventory accounts are not converted to actual and the current period bears all the effects of such variances. If the variances are charged to expense (income summary), the current period likewise bears the effects of the variances, but with no effect on gross profit. If the variances are material, they should be allocated to all inventories and cost of goods sold. Four-Variance Method for Overhead The four-variance method appeared in the CPA exam for the first time in November 1977. Even the three-variance method has appeared infrequently in the examination in recent years; therefore, it is unknown as to the extent the four-variance method will be tested in the future. Assume the same facts used to compute the variances by the three-variance method and, in addition, the actual overhead of $38,600 consists of $20,500 of fixed costs and $18,100 of variable costs. Fixed Spending, Fixed Volume, Variable Spending and a Variable Efficiency Variance Fixed Cost Variances: PASTE IN LINES Actual $20,500 500 UNF Spending Var. Budget 20,000 2,000 UNF Volume Var. Factory Overhead at Standard 18,000 x $1 18,000 Variable Cost Variances: Actual $18,100 400 FAV Spending Var. Budget Actual Hours 18,500 x $1 18,500 500 UNF Efficiency Var. Factory Overhead at Standard 18,000 x $1 18,000 The computation of these variances compares to the three-variance method as follows: Three-Variance Four-Variance Fixed 500 UNF Budget (Spending) 100 UNF Variable 400 FAV Efficiency 500 UNF Same Volume or Capacity 2,000 UNF Same The volume variance is the same in the two, three and four-variance methods. In the four-variance method the Budget Variance is divided into its fixed and variable elements, thus creating two spending variances, whereas the efficiency and volume variances are the same. Favorable or Unfavorable Variances In job order cost overhead was applied to product cost by means of a pre-determined rate. In standard cost systems all the elements of production cost are assigned to product based on a standard established before production begins. Even the most carefully established standards will differ from reality, and after all, the actual cost of the product must be controlling. Since work-in-process, finished goods and cost of goods sold are assigned standard costs (and even raw materials in some cases) we might say that such accounts are on an estimated or tentative basis. When actual costs are determined, they are compared with standard. These comparisons result in variances. If we have applied to product costs an amount that is less than the actual cost, we must say that the particular cost element, material, labor or overhead is understated. Since these tentative costs flow through work-in-process to finished goods to cost of goods sold, an understatement of these accounts results in an additional debit or charge. We call this additional charge unfavorable since it results in an additional cost added to the product. For example: Cost of Material - Actual $75,000 Standard Material Cost 74,000 Unfavorable Variance $ 1,000 Conversely, when costs at standard exceed actual, then product costs have been overstated and the resulting adjustment to actual is a credit and since costs are reduced by a credit, it is favorable. For example: Cost of Labor Ė Actual $102,000 Standard Labor Cost 105,000 Favorable Variance $ 3,000 Disposition of Variances Variances enter into the determination of periodic net income by: a. closing the variances to the income summary; in effect, the variances are treated as income or expense items. b. close the variance to cost of goods sold c. allocate the variances to the inventory accounts and cost of goods sold. Inventories cannot properly be carried at standard unless such standard cost approximates actual costs. Therefore, where the variances are material only, (c) above is a viable option. Another Method of Computing Material Price Variance Because purchasing is a separate and distinct function from manufacturing, some companies compute the price variance on material at the time of purchase. This results in the Stores or Materials account being carried at standard cost and requires an additional computation to compute the usage variance. Illustration: Pertinent data for Product R Purchased-16,000 ft. of plastic @ $1.20 Requisitioned from stock--12,500 ft. Standard price--$1.25 per foot Standard usage--5 ft. per unit Units produced--2,000--100% complete 500-- 80% complete Compute variances for material. Solution: Variance Actual Cost 16,000 x $1.20 $19,200 Price Variance (16,000 x $.05) 16,000 x $1.25 20,000 800 FAV Actual Usage at Standard Cost 12,500 x $1.25 15,625 Usage Variance (2,400 x 5) (500 x $1.25) 12,000 x $1.25 15,000 625 UNF Journal entries: Material (Stores) $20,000 Price Variance $800 Accounts Payable 19,200 Work-in-Process $15,000 Usage Variance 625 Material $15,625 Example: Convert the Materials and Work-in-Process Account to actual cost based on the above. Allocation of Variances Quantity Balances: Material 3,500 x .05 = $175 Work-in-Process 12,500 x .05 = 625 Total Purchased 16,000 $800 FAV Material at Standard Price 3,500 x $1.25 $4,375 Less: Price Variance Adjustment 175 Actual Cost $4,200 Proof: 3,500 units at $1.20 $4,200 Work-in-Process at Standard 12,000 x $1.25 $15,000 Less: Price Variance Adjustment (625) Add: Usage Variance Adjustment 625 Actual Cost $15,000 Proof: 12,500 units at $1.20 $15,000

Strategies For Short and Long Term Financing Options Financing Basics Different types of short-term credit: Accrued expenses - Wages Trade credit - Accounts Payable Short-term bank loans Commercial paper - short term notes issued by corporations with good credit ratings. Lines of credit - ability to automatically borrow up to a certain maximum. SIMPLE VERSUS COMPOUND INTEREST Simple interest does not involve compounding. Borrowing $1000 for 3 years at 8% results in $240 simple interest. (.08 x $1000 x 3 years) Compound interest results in more interest because interest is calculated on principle and interest after each compounding period of time. Borrowing $1000 for 3 years at 8% compounded annually results in approximately $259 interest ($1000 x .08) + ($1,080 x. 08) + ($1,166 x. 08). LONG-TERM FINANCING The financing of a company is reflected on the right side of the accounting equation-liabilities and stockholders equity. A company issues stock and borrows money through bank loans and bonds. For borrowing, the stated rate and the effective rate are always expressed as the ANNUAL rate, even if the loan period is less than 1 year. The effect of each type of financing on Net Income and Earnings Per Share (EPS) is presented in the table below. Remember, the formula for basic EPS is as follows: Net Income - Preferred Stock Dividends ---------------------------------------------- Weighted Average Number of Common Stock Shares _________________________________________________________ | NET INCOME | EPS | EPS | | | NUMERATOR | NUMERATOR | |____________________|____________________|_______________| ______________| | | | | | | | /\ | | ISSUE COMMON | | | || | | STOCK | NO EFFECT | NO EFFECT | || | |______________|____________________|____________________|_______||______| | | | | | | ISSUE | | || | | | PREFERRED | NO EFFECT | || | NO EFFECT | | STOCK | | || | | |______________|____________________|_________\/_________|_______________| | | | | | | ISSUE BONDS | || | || | NO EFFECT | | (BORROW) | || | || | | | | || | || | | |______________|________\/__________|_________\/_________|_______________| A major objective is to issue bonds when interest rates are low and issue stock when the stock price is high. LEASING AS A FORM OF FINANCING: Leasing instead of purchasing allows the lessee to use the property for a portion of the life of the property. If the lease qualifies as an operating lease the lessee would not record the leased property as an asset and would not have to record a liability for the future payments to be made under the lease agreement. Thus an operating lease is a form of off balance sheet financing. If the lease meets certain criteria it is considered a cap l lease. A cap l lease is treated as if the lessee purchased the property from the lessor. Therefore, the lessee would record the property as an asset and record a liability for the present value of the lease payments. Leases can be structured to qualify as an operating lease. Operating leases allow the lessee to not record the property as an asset, allowing for higher prof bility and operating ratios. The related liability is also left off which improves the debt ratios.

Supply and Demand Curve Supply and Demand Curve Now that we have dealt with the demand curve, it is time to turn to the supply curve. The supply curve slopes upward and to the right as shown in graph C. The intersection of the demand and supply curves is at a price of $3.50 and a quantity of 8 gallons per month. The intersection of the demand and supply curves is called the "price equilibrium point" and it determines the price at which the good will be sold and the quantity which will be sold. Demand and Supply Curves for Milk in New York City Price Graph C $6.00 $5.50 d $5.00 s $4.50 d $4.00 s $3.50 sd $3.00 s d $2.00 s $1.50 d 2 4 6 8 10 12 14 16 Gallons per Month The supply curve slopes upward as a result of the tendency for marginal costs to increase as the quantity produced increases. The law of diminishing returns is the basis on which marginal costs increase. Given a fixed amount of production resources (equipment and buildings), the addition of increments of labor will produce diminishing returns. Those diminishing returns translate into higher marginal costs as the quantity increases. Thus, with increasingly higher marginal cost, a producer would only be induced to produce a larger quantity if the price of the product were sufficiently high. The price has to exceed the marginal cost of the next unit of product produced in order to induce the producer to supply a larger quantity. Just like demand curves, supply curves may shift to the right or to the left. A shift to the right implies that a larger quantity will be supplied for every price point on the supply curve. A shift to the left implies that a smaller quantity will be supplied for every price point on the supply curve. Listed below are the various causes of a supply curve shift: Price of input resources - if the price of input resources declines, the marginal cost declines and the supply curve will shift to the right. A larger quantity will be offered at each price point. Number of suppliers - if the number of suppliers increases, the supply curve will shift to the right. In this case, the marginal cost has not changed but more is supplied because of a greater number of suppliers. Improved technology - if the technology is improved, the productivity of the supplier is likely to improved. This improved technology will reduce the marginal cost and result in the producer supplying a larger quantity for each price point. Prices of other goods - If the company is capable of producing product A and product B and the price of product B decreases, the company may curtail the production of product B and shift production to product A. In such a situation, the supply curve for product A will shift to the right as the company seeks to utilize the unused capacity occasioned by curtailing the production of product B. Changes in taxes - A decrease in excise taxes on a product, such as tobacco products, is the same as a reduction in the marginal cost of the product. The result is that a reduction in taxes will cause the supply curve to shift to the right. An increase in excise taxes will cause the supply curve to shift to the left to represent a reduction in the quantity supplied for each price point.

Value of Perfect Information Value of Perfect Information To determine the value of perfect information it is first necessary to compute the expected profit with perfect information. Obviously, if the outcome of an event were known prior to its occurrence, the alternative action which provided the greatest profit for that outcome would be selected as the course of action. The expected profit with perfect information for the example is computed below. Expected Profit with Perfect Information Cases Conditional Probability Expected Demand Stocked Profit x of Demand = Profit 5 5 $20 .1 $ 2.00 6 6 24 .2 4.80 7 7 28 .4 11.20 8 8 32 .3 9.60 1.00 $27.60 The value of perfect information may now be determined as the difference between the expected profit with perfect information and the expected profit of the optimum action without perfect information. For the example, this would be $2.40 ($27.60 - $25.20). To pay more than this amount, the store would be losing the advantage to be gained with the perfect information. Regret Table (Conditional Loss Table) The regret table shows the losses from any possible combination of available alternative actions and potential event occurrences. There are two types of losses which may occur: (a) Opportunity losses which are the losses of profit from inability to meet demand, and (b) obsolescence losses which are the losses from declining values of excess stock. Each value in the table is conditional on an action being taken and a particular event occurring. The regret table for the example appears below. Regret Table Alternative Inventory Actions Demand 5 Cases 6 Cases 7 Cases 8 Cases 5 $0 $3b $6 $9 6 4a 0 3 6 7 8 4 0 3 8 12 8 4 0 (a) if 5 cases are stocked and demand is 6 cases, the profit on sales of 1 case or $4 has been lost (opportunity loss) (b) If 6 cases are stocked and demand is 5 cases, the cost of 1 case or $3 will be lost as spoilage (obsolescence loss) Expected Loss The expected loss for an alternative action is determined in the same manner as the expected profit. For the example, the expected daily loss from stocking 8 cases is computed below. Expected Loss from Stocking 8 Cases Conditional x Probability = Expected Demand Loss of Demand Loss 5 $9 .1 $ .90 6 6 .2 1.20 7 3 .4 1.20 8 0 .3 0.00 1.00 $3.30 The expected daily loss for the alternative stock actions are: Cases Stocked Expected Loss 5 $7.60 6 4.30 7 2.40 8 3.30 The optimum inventory action is the one which minimizes the expected loss and is the same as when expected profits were used for the selection of the optimum inventory action. Note that the expected loss plus the expected profit computed earlier is equal to the expected profit with perfect information, and that the expected loss of the optimum solution is equal to the value of the perfect information. Expedted Loss Illustrative Problem Commercial Products Corp., an audit client, requests your assistance in determining the potential loss on a binding purchase contract which will be in effect at the end of the corporation's fiscal year. The corporation produces a chemical compound which deteriorates and must be discarded if it is not sold by the end of the month during which it is produced. The total variable cost of the manufactured compound is $25 per unit and it is sold for $40 per unit. The compound can be purchased from a vertically integrated competitor at $40 per unit plus $5 freight per unit. It is estimated that failure to fill orders would result in the complete loss of 8 out of 10 customers placing orders for the compound. The corporation has sold the compound for the past 30 months. Demand has been irregular and there is no sales trend. During this period, sales per month have been: Units Sold per Month Number of Months* 4,000 6 5,000 15 *Occurred in random 6,000 9 sequence Required: For each of the following, prepare a schedule (with supporting computations in good form) of the 1. Probability of sales of 4,000, 5,000 or 6,000 units in any month. 2. Marginal income if sales of 4,000, 5,000 or 6,000 units are made in one month and 4,000, 5,000 or 6,000 units are manufactured for sale in the same month. Assume all sales orders are filled. (Such a schedule is sometimes called a "payoff table".) 3. Average monthly marginal income the corporation should expect over the long run if 5,000 units are manufactured every month and all sales orders are filled. Solution: 1. Commercial Products Corp. Schedule Computing Computing the Probability of Unit Sales per Month Unit Sales per Month No. of Months Probability 4,000 6 6/30 = .2 5,000 15 15/30 = .5 6,000 9 9/30 = .3 30 1.0 2. Schedule of Marginal Income For Various Combinations of Unit Sales and Units Manufactured Units Manufactured (and Purchased) Unit Sales 4,000 5,000 6,000 4,000 $60,000 (1) $35,000 (2) $10,000 (2) 5,000 55,000 (3) 75,000 (1) 50,000 (2) 6,000 50,000 (3) 70,000 (3) 90,000 (1) Notes: Computation of Marginal Income (1) When all units manufactured are sold: 4,000 x ($40 - 25) = $60,000 5,000 x ($40 - 25) = 75,000 6,000 x ($40 - 25) = 90,000 (2) Reduction per 1,000 units when more units are manufactured than are sold: 1,000 x $25 = $25,000 (3) Reduction per 1,000 units when units must be purchased to fill sales orders: 1,000 x ($40 - [$40 + $5]) = $5,000 3. Schedule Computing Expected Marginal Income if 5,000 Units are Manufactured and All Sales Orders are Filled Unit Probability Marginal Expected Sales Income Value 4,000 .2 $35,000 $ 7,000 5,000 .5 75,000 37,500 6,000 .3 70,000 21,000 Expected average monthly MI $65,500

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