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costs that are applicable to a particular decision cost that are avoidable cost differ between alternative

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relevant costs

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all cost incurred in the past that can not be changed by any decision made now or in the future. Should not be considered in decisions

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Sunk Costs

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Example: You bought an automobile that cost $10,000 two years ago. The cost is ___ no mater if you drive it, park it, or trade/sell it. You can not change the price

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Sunk Cost

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future payments of cash that is associated with a particular decision

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Out-of-pocket

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Example: Go on Vacation vs Stay Home. If you go on vacation you will spend money in the future.

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Out-of-pocket

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the potential benefit that is given up when one alternative is selected over another

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opportunity costs

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Example: If you were NOT attending college you could earn $20,000per year. Your _________ cost for attending college for one year $20,000 per year.

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opportunity costs

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****

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the decision to accept additional business should be based on incremental costs and incremental revenue.

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those that occur if the company decides to accept the new business

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incremental amounts

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In additional business

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Even if the selling price is less $8.50 and the normal price is $10.00 you should accept the new business if the NET INCOME increases by $20,000.

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Scrap or Rework defect you must include:

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you must include the opportunity cost or the NET return will be favorable.

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SELL or PROCESS

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Business are often faced with decision to sell partially completed products or to process them to completion As a general rule we process further only if incremental revenues exceed incremental costs.

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Sales Mix Selection

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When a company sells a variety of products some are likely to be more profitable than others. Management must consider: Contribution margin of each product facilities required to produce each product and the constraint on buildings/facilities the demand for each products

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Segment Elimination

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To consider eliminating a treadmill division because total expenses of $48,300 are greater than its sales of $47,800.

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Segment Elimination

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is an item that elimination if its revenue are less than avoidable expenses. Sales $47,800 Avoidable expenses $41,800 ___________________________ Decrease income $6,000

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Selling Product Prices

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Relevant Costs are useful to management to assist in determining prices for special short term decision.

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Long run pricing

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should include both variable and fixed costs.

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The Cost Plus Method

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where management adds a mark-up costs to reach a target price

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1. Determine the total costs of production and non-production 2. Determine the total costs per unit 3. determine the markup per unit 4. Determine the selling price per unit

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Four Steps to Total Cost Method

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Identify relevant costs and apply them to managerial decisions

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Historical costs are generally not relevant to decisions. Instead the relevant costs are additional costs called incremental costs. They can be called differential costs.

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capital budgeting

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outcome is uncertain large amounts of money are usually involved analyzing alternative longterm investments and deciding which assets to acquire or sell decision may be difficult or impossible to reverse investment investment involves a long-term commitment

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payback period

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the payback period of an investment is the time expected to recover the initial investment amount payback period = cost of investment ------------------ annual net cash flow

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using the payback period

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unacceptable for projects with long lives where time value of money effects major ignores the time value of money ignores cash flows after payback period

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rate of return

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focuses on annual income instead of cash flows accounting rate of return = annual after-tax net income ------------------------ annual average investment annual (beginning book value + ending book value /2)

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discount the future net cash flows from the investment at the required rate of return subtract the initial amount invested from sum of the discounted cash flows

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net present value

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using the net present value

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if its positive = acceptable since it promises a return greater than the required rate of return if its zero = acceptable since it promises a return equal to the required rate of return not acceptable = promises a return less than the required rate of return

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Internal rate of return (IRR)

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1. Present value of cash inflows=Present value of cash outflows 2. The net present value equal zero

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Using internal rate of return

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compare the internal rate of return on a project to a predetermined hurdle rate (cost of capital) To be acceptable a projects rate of return cannot be less than the cost of capital

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Comparing methods

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basis of measurement payback(cash flows) # of years accounting rate of return ( annual income) precent net present value ( cash flows) dollar amount internal rate of return( cash flows) percent

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Building Blocks of Analysis

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Liquidity and efficiency = meet short term obligations and generate revenue Solvency = ability to generate future revenue and long-term obligations Profitability = ability to provide financial rewards and financing Market Prospects= ability generate positive market expectations

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horizontal analysis*

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tools of analysis comparing a company financial condition and performance across time.

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vertical analysis*

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tools of analysis comparing a companys financial condition and performance to a base amount

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ratio analysis

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measurement of key relations between financial statement items

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Trend Analysis

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is a used to reveal patterns in the date covering successive periods trend percent = analysis period amount/base period amount x 100

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Common size statements

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common-size = analysis amount/base amount x 100

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Working capital

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working capital represents current assets financed from long term capital sources that do not require near-term repayment

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current ratio *

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short-term debt-paying ability of the company current ratio = current assets/current liabilities

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inventory turnover

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ratio measures the number of times merchandise is sold and replaced during the year inventory turnover = cost of goods sold/average inventory

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acid-test ratio

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the ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash acid-test ratio = quick assets/current liabilities

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are cash, short-term investments and current receivables

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quick assets

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accounts receivable turnover

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ratio measures how many times a company coverts its receivable into cash each year accounts receivable turnover = net sales / average accounts receivable/net

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days sales in inventory

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measures the liquidity of inventory days sales in inventory = ending inventory /cost of goods sold x 365

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days sales uncollected *

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ratio measures the liquidity of receivables days sales uncollected = a/r,net/ net sales x 365

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total asset turnover

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total asset turnover = net sales/average total assets ratio measures the efficiency of assets in producing sales

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debt ratio

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debit ratio = total liabilities / total assets ratio measures what portion of a company's assets are contributed by creditors

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equity ratio

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ratio measures what portion of a company assets are contributed by owners equity rate = total equity/assets

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debt-to-equity ratio

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debit-to-equity ratio = total liabilities / total equity ratio measures the solvency of companies

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times interest earned

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times interest earned = income before interest expenses and income taxes/interest expenses The most common measure of ability of a firms operations to provide protection to the long-term creditor

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profit margin

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ratio describes a company ability to earn a net income from sales

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profitability

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profit margin gross margin return on total assets basic earning per share book value per common share return on common stockholders

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gross margin

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gross margin = net sales - cost of sales /net sales ratio measures the amount remaining from $1.00 in sales that is left to cover operating expenses and a profit after considering cost of sales

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return of total assets *

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ratio is generally considered the best overall measure of company's profitability return on total assets = net income / average total assets

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is the potential benefit that is lost by taking a specific action when two or more alternative choices are available.

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opportunity cost

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requires a current/future outlay of cash

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out of pocket

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refers to the combination of product sold by a company

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sales mix

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incremental cost

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additional cost incurred only if a particular action is taken

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cost requires a current or future overlay of cash and is usually an incremental cost

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out of pocket

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Alpha Co. can produce a unit of Beta for the following costs: An outside supplier offers to provide Alpha with all the Beta units it needs at $60 per unit. If Alpha buys from the supplier, Alpha will still incur 40% of its overhead. Alpha should:

answer

Make Beta since the relevant cost to make it is $56. Relevant costs: Direct material $ 8 Direct labor 24 Overhead 24 (40 x .6) $ 56

question

Patrick Corporation inadvertently produced 10,000 defective personal radios. The radios cost $8 each to produce. A salvage company will purchase the defective units as they are for $3 each. Patrick's production manager reports that the defects can be corrected for $5 per unit, enabling them to be sold at their regular market price of $12.50. Patrick should:

answer

Rework and sell: 10,000 units x $12.50 = $125,000 Less cost of rework 10,000 units x $5 = $ (50,000) Less opportunity cost of not making new 10,000 units x ($12.50 - $8) = $(45,000) Incremental net income $30,00

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is the process of analyzing alternative long-term investments and deciding which assets to acquire or sell.

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capital budgeting

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time value of money concept

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a dollar today is worth more than a dollar tomorrow

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if the IRR of an investment is below the hurdle rate the project should

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not be accepted

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payback period nor accounting rate of return methods

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no not evaluating time of money

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long-term investments only

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capital budgeting

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earn a satisfactory return on investment

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capital budgeting

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purpose of restating future cash flows in terms of present values

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discounting

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business decision-making managers typically examine the two fundamental factors

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risk and rate of return

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payback period and accounting rate of return

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ignores the time value of money

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is the application of analytical tools to general-purpose financial statement and making business decisions

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financial statement analysis

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liquidity

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refers to short-term cash requirments

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three common financial analysis tools

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horizontal analysis, vertical analysis, ratio analysis

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the ability to generate positive market expectation

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market prospects

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horizontal analysis

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method used to evaluate changes in financial data across time

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current assets divided by current liabilities equal

answer

current ratio

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