MANAGEMENT ACCOUNTING VS.

FINANCIAL ACCOUNTING COST-VOLUME-PROFIT ANALYSIS

MANAGEMENT ACCOUNTING FINANCIAL ACCOUNTING PROFORMA

Internal Users External Users QTY TOTAL % RATIO
Internal and External Data Internal Data DIRECT SALES XX XX 100% BASE
Management’s Decision- Making Financial in nature RELATIONSHIP VC (XX) (XX) (XX%) VC RATIO
Financial and Non-Financial Historical WITH QTY CM XX XX XX% CM RATIO
Future-oriented Reliability, Precision & Verifiability FC (XX) (XX%)
Relevance, Timeliness & Materiality Aggregated and Simplified Blue fonts OP XX XX% ROS BEFORE TAX
Business Segments: Net Income is Business as a Whole: Net Income is → Constants TAX % XX%
BEFORE Tax (NIBT) AFTER Tax (NIAT) NI XX
*Cost Accounting – subset of both.
= FC ÷ (CMR – PM before Tax)
PESO
MANAGEMENT Use of accounting information by the company managers to SALES = MOS + BEP
ACCOUNTING make rational economic decisions. RATIO = MOSr + BEPr
FINANCIAL Primary goal is to maximize shareholders’ wealth i.e., = SALES – VC
MANAGEMENT wealth creation = FC + PROFIT
PESO
= UNITS SOLD X (SP - VCU)
Deciding on company’s goals and = SALES X CMR
PLANNING = SPu – VCU
objectives.
MANAGEMENT Deciding on how to use company’s = CM ÷ UNITS SOLD
ORGANIZING UNITS
FUNCTIONS resources. = SPu X CMR
CONTRIBUTION MARGIN
Deciding on what corrective actions to = ∆ CM ÷ ∆ UNITS
CONTROLLING = CM ÷ SALES
do.
*Decision-making is inherent function of management. = ∆ CM ÷ ∆ SALES
= CMU ÷ SPu
RATIO
= 100% - VCR
Authority to give orders (downward authority) e.g., VP-Ops over
= PM ÷ MOSR
OM.
LINE FUNTION = ∆ PROFIT ÷ ∆ SALES
Line Managers are directly involved in achieving the company’s PESO = FC ÷ CMR
objectives. UNITS = FC ÷ CMU
Authority to advise but not to command (laterally or upward BREAK-EVEN = BEPs ÷ SALES
authority). RATIO = BEPu ÷ SOLD UNITS
STAFF FUNCTION
Staff Managers provide support via assistance or advice to = 100% - MOSR
other managers. PESO = (FC + PBT) ÷ CMR PBT = PAT ÷ (1-
WITH TARGET PROFIT
UNITS = (FC + PBT) ÷ CMU TAX RATE)
Primarily staff function, but has line authority within the = SALES – BEPS
PESO
accounting department (recording function). = PROFIT ÷ CMR
CONTROLLER UNITS = SPu – BEPu
e.g., Financial Reporting, Tax Administration, Government
Reporting, Protection of Assets MARGIN OF SAFETY = MOS ÷ SALES
Custody function. = PROFIT RATIO ÷ CMR
TREASURER RATIO
e.g., Investor Relations, Investments, Insurance = 100% - BEPs RATIO
Responsible for making significant corporate investment = 1 ÷ DOL
and financing decisions. = CM ÷ PBT
FINANCIAL MANAGER DEGREE OF OPERATING = % ∆PBT ÷ % ∆SALES
e.g., Financial Analysis and Planning, Investment
Decisions LEVERAGE (DOL) = 1 ÷ MOSR
= (FC ÷ PBT) + 1
COST BEHAVIOR WITH REGRESSION ANALYSIS % ↑ IN PROFIT = %↑SALES X DOL
= CM – FC
= MOS PESO X CMR
COST FUNCTION: Y = a + bX
PROFIT = SALES X PROFIT RATIO
Y → TOTAL COST (DV) X → Activity or Cost driver (IV)
a → TFC (Y- axis intercept) B → VCU (Slope) PROFIT
bX → TVC PROFIT RATIO: OR CMR X MOSR
SALES
*DOL → direct relationship with sales; inverse relationship with MOS.
COST ESTIMATION: SEGREGATING VARIABLE AND MIXED COST → measures how sensitive the PBT is to sales volume increases or decreases.
*BEP → ↓FAVORABLE ↑UNFAVORABLE
1. HIGH-LOW METHOD - uses two extreme data points to determine the slope (VCU) and the
intercept (TFC). DESIRED SALES
 TO COMPUTE VCU: PBT AS % OF PESO = FC ÷ (CMR – PRBT)
HIGHEST COST (HC) – LOWEST COST (LC) SALES UNITS = FC ÷ (CMU – PMu)
VCU =
HIGHEST ACTIVITY (HA) – LOWEST ACTIVITY (LA) PAT AS % OF
PESO = FC ÷ (CMR – [PRAT ÷ (1 – TAX RATE])
SALES
 TO COMPUTE FC: AS ROS OR PM
PESO = FC ÷ (CMR – PMR)
HC – (HA x VCU) or LC – (LA x VCU) RATIO
PBT AS % OF
PESO = FC ÷ (CMR – [1 – PRBT])
 TO COMPUTE TOTAL COST: CMR
Y = FC + (VCU x COST DRIVER) PAT AS % OF
PESO = FC ÷ (CM – [1 – [PRAT ÷ (1 – TAX RATE])
→ Ignore OUTLIERS (too high/ too low). CMR
PBT AS PER
2. GRAPHIC METHOD (SCATTER DIAGRAM METHOD) UNITS = FC ÷ (CMU – PMU)
UNIT
- Visual representation of the relationship between total cost (y) and activity level (x).
PAT AS PER
3. LEAST-SQUARE METHOD UNITS = FC ÷ CMU – (PMU ÷ 1 – TAX RATE)
UNIT
- “LINE OF BEST FIT”
- Most accurate.
SALES MIX
TYPES:
SIMPLE – 1 Dependent Variable; 1 Independent
UNITS
MULTIPLE – 1 Dependent Variable; 2 or more IV
A B
SALES/ units XX XX
 TO COMPUTE VCU:
VCU (XX) (XX)
∑Y = na + b∑x → “ey na beks”
CMU XX XX
→ Divide ‘n’ by ‘∑x.’
X PRODUCT MIX XX% XX%
→ Multiply the factor to the formula. UNITS OF EACH PRODUUCT
( )
→ Deduct the values to the 2nd formula to compute for “b (VCU)”. TOTAL UNITS
 TO COMPUTE FC: WACMU XX + XX = XX
∑XY = ∑xa + b∑x2 → “eksi eksa beks 2” FC
=
→ Substitute “b” to compute “a (FC)”. WACMU
 TO COMPUTE TOTAL COST:
Y = a + bX → “ya bix” PESO
→ Substitute “a” and “b”. A B
→ Multiply “b” to the cost driver. CMU / CM XX XX
÷ SPU/ SALES (XX) (XX)
CORRELATION ANALYSIS CMR XX% XX%
- Does not establish cause-&-effect pattern, it merely indicates a linear relationship. X PESO MIX XX% XX%
SALES OF EACH PRODUUCT
( )
TOTAL SALES
 COEFFICIENT OF CORRELATION (r) WACMR XX + XX = XX
- Value ranges from -1.0 + 1.0 FC
=
WACMR
SCATTER DIAGRAM/ GRAPHICAL
“r” LINEAR RELATIONSHIP
REPRESENTATION *WACMU/ WACMR – used as a denominator to compute for the overall BEP (units/ peso)
+1.0 DIRECT/ POSITIVE UPWARD SLOPING LINE TO THE RIGHT *SALES MIX (based on unit sales) – used to compute for the respective units/ share of each
0 NONE NO APPARENT PATTERN/ RANDOM POINTS product to break-even.
-1.0 INVERSE/ NEGATIVE DOWNWARD SLOPING LINE TO THE RIGHT
INDIFFERENCE POINT – level of volume at which total costs or profits are the same between two
 COEFFICIENT OF DETERMINATION (r2) alternatives.
- Measures “GOODNESS OF FIT”. ALTERNATIVE A ALTERNATIVE B
- Value ranges from 0 to +1.0 COST-BASED FC + (VCU X Q) = FC + (VCU X Q)
- The closer r2 is to +1.0 the better i.e., more confidence the independent variable PROFIT-BASED (VCU X Q) – FC = (CMU X Q) - FC
predicts the behaviour of the dependent variable. *Q – based on the number of units

RAHYNE, CPA [@rrhdamcpa]

 ABSORPTION AND VARIABLE COSTING WITH PRICING DECISIONS For Variable Costing

PROFORMA To get the Variable Costs:

ABSORPTION VARIABLE Cost per unit
SALES XX @ SP SALES XX @ SP
DIRECT MATERIALS (DM) P7.50
VFOH @ SOLD UNITS VFOH @ SOLD UNITS
COGS (XX) VC XX DIRECT LABOR (DL) 2.50
FFOH ÷ PROD. X SOLD VSAE @ SOLD UNITS VARIABLE MANUFACTURING OVERHEAD (VMOH) 6.00
GP XX CM XX VARIABLE MANUFACTURING COST PER UNIT (VMOH/unit) P16
FSAE FFOH
OPEX (XX) FC (XX) VARIABLE SELLING AND ADMINISTRATIVE EXPENSES (VSAE) 0.50
VSAE @ SOLD UNITS FSAE
NI XX NI XX TOTAL VARIABLE COST PER UNIT 16.50

RELATIONSHIP BETWEEN PRODUCTION AND SALES YEAR 1 YEAR 2 YEAR 3

UNITS INCOME SALES (IN UNITS) 80K 60K 90K
P=S AC = VC VC PER UNIT P16.50 P16.50 P16.50
P>S AC > VC TOTAL VC 1.320M 990K 1.485M
P<S AC < VC *To get the variable cost per year, we just simply multiply the variable cost per unit by the number of
*Production moves with AC; Sales moves with VC. units sold.

∆ PROFIT = ∆ INVENTORY X FFOHunit FIXED MANUFACTURING OVERHEAD 400,000

Where: FIXED SELLING AND ADMINISTRATIVE EXPENSES 37,500
 ∆ PROFIT = AC PROFIT – VC PROFIT TOTAL FIXED COSTS 437,500
 ∆ INVENTORY = END. INVENTORY – BEG. INVENTORY or *Fixed costs would be obtained by just getting the sum of fixed manufacturing overhead and fixed
PRODUCTION – SALES selling and administrative expense.
 UNIT FFOH = TOTAL FFOH ÷ PRODUCTION IN UNITS
To summarize:
Computation of income if the entity operates for more than a year: YEAR 1 YEAR 2 YEAR 3
1. Compute the Sales revenue each year (SALES/UNITS X SP). SALES REVENUE 2M 1.5M 2.250M
2. Get the cost per unit. Note that under AC, FFOH (COGS) should be divided by production VARIABLE COSTS 1.320M 990K 1.485M
(FFOH ÷ PRODUCTION). CONTRIBUTION MARGIN 680K 510K 765K
3. Compute the total COGS under AC (SALES/UNITS X COST/UNIT); and the OPEX (FSAE FIXED COSTS 437.5K 437.5K 437.5K
& VSAE) per year. OPERATING INCOME 242.5K 72.5K 327.5K
4. Prepare the income statement to compute OI under AC.
5. For VC, get the cost per unit (VFOH + VSAE). Note that there are differences in amount of income under both costing methods:
6. Compute the total VC by multiplying the cost per unit with sales/units (SP/units X VCU); YEAR 1 YEAR 2 YEAR 3
and the TFC (FFOH + FSAE) each year. AC, INCOME 242.5K 172.5K 277.5K
7. Prepare the income statement to compute OI under VC. VC, INCOME 242.5K 72.5K 327.5K
DIFFERENCE IN INCOME 0 100K (50K)
SHORTCUT: *There is a difference because of the treatment of fixed manufacturing overhead under the two
YEAR 1 YEAR 2 YEAR 3 costing methods.
Beg. Inventory XX XX XX
Add: Production XX XX XX To see the difference, let us analyse how fixed manufacturing overhead is treated under both
Less: Sales (XX) (XX) (XX) methods:
End. Inventory XX XX XX YEAR 1 YEAR 2 YEAR 3
Beg. Inventory (XX) (XX) (XX) FOH EXPENSED UNDER ABSORPTION COSTING 80K 60K 90K
∆ Inventory XX XX XX FOH EXPENSED UNDER VARIABLE COSTING P16.50 P16.50 P16.50
DIFFERENCE IN EXPENSES 1.320M 990K 1.485M
Apply the formula:
YEAR 1 YEAR 2 YEAR 3 TECHNIQUE (using the equation for reconciling the income under both methods)
∆ Inventory XX XX XX YEAR 1 YEAR 2 YEAR 3
X FOH/unit XX XX XX BEGINNING INVENTORY 0 0 20K
Difference in Income XX(XX) XX(XX) XX(XX) ADD: PRODUCTION 80K 80K 80K
LESS: SALES (80K) (60K) (90K)
To compute the Ending Inventory: ENDING INVENTORY 0 20K 10K
 VC, EI = VCU X (Production – Sales) BEGINNING INVENTORY 0 0 20K
 AC, EI = FFOH ÷ Production + VCU X (Production – Sales) ∆ IN INVENTORY 0 20K (10K)

ILLUSTRATION Applying the formula:

ABC Company manufactures metal cans used in the food processing industry. A case of cans sells YEAR 1 YEAR 2 YEAR 3
for P25. The variable costs of production for one case of cans are as follows: ∆ INVENTORY 0 20K (10K)
FIXED OH RATE P5 P5 P5
Direct Material P7.50 DIFFERENCE IN INCOME 0 100K (50K)
Direct Labor 2.50
Variable Manufacturing Overhead 6.00 RELEVANT COSTING WITH LINEAR PROGRAMMING
Total Variable Manufacturing Cost per case P16.00
 For cost to be relevant, it has to be future (avoidable) and different.
Variable selling and administrative cost amount to P0.50 per case. Budgeted fixed manufacturing GR: FCs are irrelevant because they are unavoidable.
overhead is 400K per year, and fixed selling and administrative cost is 37.5K per year. The following XPN: If FCs are avoidable.
data pertain to the company’s first three years of operation. (A unit refers to one case of cans)
APPROACHES
YEAR 1 YEAR 2 YEAR 3 Total revenues and costs are determined for each
TOTAL
Planned production (in units) 80K 80K 80K alternative, and the results are compared.
Finished goods inventory (in units), Jan. 1 0 ??? ??? PROFORMA
Actual production (in units) 80K 80K 80K SALES XX PROFIT (NEW/ CURRENT) XX
Sales (in units) 80K 60K 90K VC (XX) PROFIT (NOW/ PREVIOUS) (XX)
Finished goods inventory (in units), Dec. 31 ??? ??? ??? CM XX INCREASE/DECREASE XX(XX)
Actual costs were the same as budgeted costs. FC (XX)
NI XX
Required: Prepare operating income statements for ABC Co. for the first 3 years of operation using Only the differences or changes in costs and
DIFFERENTIAL
a) Absorption Costing revenues are considered.
b) Variable Costing CM XX (↑) (↓)
FC (XX) (↑) (↓)
YEAR 1 YEAR 2 YEAR 3 PROFIT XX (↑) (↓)
SALES (IN UNITS) 80K 60K 90K
SELLING PRICE P25 P25 P25 MAKE OR BUY (outsourcing decision)
SALES REVENUE 2M 1.5M 2.250M
*Sales are the same whether you use AC or VC. COST TO MAKE COST TO BUY
AVOIDABLE VCs PURCHASE PRICE
Cost per unit DM MATERIALS HANDLING
MATERIALS HANDLING
ABSORPTION VARIABLE
DL
COSTING COSTING
VMOH
DIRECT MATERIAL P7.50 P7.50
AVOIDABLE FCs
DIRECT LABOR 2.50 2.50
OPPORTUNITY COST
VARIABLE MANUFACTURING OVERHEAD 6.00 6.00
FIXED MANUFACTURING OVERHEAD (400K ÷ 800K) 5.00 -
ACCEPT OR REJECT
COST PER UNIT P21 P16
*As for the COGS, note that the cost per unit will be different for each costing method.
TO GET THE PROFITunit: TO GET THE ACTUAL PROFIT:
SPECIAL ORDER SP XX PROFITunit XX
YEAR 1 YEAR 2 YEAR 3
RELEVANT COSTSunit X SPECIAL ORDER/unit XX
SALES (IN UNITS) 80K 60K 90K
(+Distribution costs/ shipping (XX) ACTUAL PROFIT XX
COST PER UNIT P21 P21 P21
costs, if any)
COGS 1.680M 1.260M 1.890M
*To get the COGS per year under absorption costing, just multiply the cost per unit by the number of PROFIT/unit XX
units sold. *Add VSAE, Opportunity Cost, Avoidable FC to RC

Operating expenses would be the same: SPECIAL ORDER PRICING (MINIMUM SELLING PRICE)
YEAR 1 YEAR 2 YEAR 3
SALES (IN UNITS) 80K 60K 90K ∟FULL CAPACITY: Regular SP = Add all the costs including FCs or divide the units at full
VSAE P0.50 P0.50 P0.50 capacity to the total costs at full capacity
TOTAL VSAE 40K 30K 45K ∟EXCESS CAPACITY: VCs + Distribution/ Shipping Costs
FSAE 37.5K 37.5K 37.5K
TOTAL OPEX 77.5K 67.5K 82.5K

RAHYNE, CPA [@rrhdamcpa]

 SPECIAL ORDER PRICE < REGULAR SP PRODUCTION AND INVENTORY BUDGET
ACCEPT AT EXCESS CAPACITY
REJECT AT FULL CAPACITY

CONTINUE (RETAIN) OR SHUTDOWN (DROP) A BUSINESS EGMENT

PROFORMA *Sales – starting point of budgeting.

SALES XX *Reverse the procedure.
LESS: VARIABLE EXPENSES (XX)
CONTRIBUTION MARGIN XX ILLUSTRATION:
LESS: TRACEABLE FIXED COST (Direct/ Avoidable)) (XX) X Co. has budgeted sales at 100K and expects a profit of 10% of sales. Expenses are estimated as
SEGMENT MARGIN XX follows: Selling = 16% of sales; Administrative = 4% of sales. Labor expected to be 40% of the total
LESS: COMMON FIXED COST (Indirect/ Unavoidable) (XX) manufacturing costs. Factory overhead is to be applied at 75% of direct labor costs. Inventories are
PROFIT (LOSS) XX projected as follows:
*Common FC (dropped segment) – allocated in other segments.
January 1 December 31
TO COMPUTE NEW PROFIT/ LOSS: ALTERNATIVELY: Materials 1.5K 4K
SEGMENT MARGIN (remaining PROFIT, NOW (total profits of all Work-In-Process 5K 15K
XX XX
segment) segments) Finished Goods 8K 3K
COMMON FC (after allocation) (XX) SEGMENT MARGIN (dropped segment) (XX)
NEW PROFIT/ LOSS XX NEW PROFIT/ LOSS XX REQUIRED: Determine the budgeted amount for:
TO DETERMINE THE DECREASE/ INCREASE A. COGS; B. TMC; C. Factory Overhead; D. Materials Purchases
IN PROFIT:
PROFIT, NOW (Before Shutdown) XX 1.5K (DM, beg) 22.5K (DM, usage) 5K (WIP, beg) 8K (FG, beg) 100K (SALES)
PROFIT, NEW (After Shutdown) (XX) 25K (DM, purchases) 30K (DL) 75K (TMC) 65K (CGM) (70K) (CGS)
INCREASE/ DECREASE IN PROFIT (4K) (DM, end) 22.5K (FOH) (15K) (WIP, end) (3K) (FG, end) 30K (GP)
XX
22.5K (DM, usage) 75K (TMC) 65K (CGM) 70K ((CGS) (20K) (EXP)
10K (PROFIT)
PRODUCT ELIMINATION POINT (SHUTDOWN POINT) SALES 100%
CGS (70%)
GP 30%
FC - SDC EXP (20%) → 16% + 4%
SDP =
UCM PROFIT 10%
*Shutdown cost – an unavoidable cost. Thus, deduct it against FC to get the relevant
avoidable portion e.g., Plant Maintenance & RPT SALES AND ACCOUNTS RECEIVABLE BUDGET

BEP > SDP PROFIT EXPECTED SALES > SDP CONTINUE → Collection pattern is still in reverse.
BEP < SDP LOSS EXPECTED SALES < SDP SHUTDOWN → AR balance as of a given date represents sales from previous months that have not
EXPECTED SALES = SDP INDIFFRENCE been collected.
Expected Sales using BEP. → If % of cash sales & AR sales are given, and the question is cash receipts (collection),
include the cash sales (month of sale); and, (Sales X % AR sales) X % Collection in the
SELL OR PORCESS FURTHER following months.
→ Q: AR bal: Multiply the % of receivable against sales, not the % of collection.
SELL PROCESS → Q: Cash payments: Deduct the discount first, then, multiply to the % of payment.
A XX XX FINAL SALES VALUE – ADDT’L PROCESSING COST → IMPORTANT MONTHS TO REMEMBER:
B XX XX FINAL SALES VALUE – ADDT’L PROCESSING COST a) Month’s sale
C XX XX FINAL SALES VALUE – ADDT’L PROCESSING COST b) Month following the sale
XX XX
c) Second month following the sale
*Joint costs – irrelevant (past cost).
*Sell = Sales Value at Split-off point
ILLUSTRATION:
Past collections experienced by X Co. indicate that 60% of the sales billed in a month are collected
SELL > PROCESS SELL
during the month of sales, 30% are collected in the following month, and 10% are collected in the
SELL < PROCESS PROCESS FURTHER
second following month. The following are the projected sales for next year:
SCRAP OR REWORK
January 480K
February 420K
→ SCRAP – Sell at a bargain price.
March 500K
→ REWORK = SP – (MATS + LABOR + OH)
April 550K
*Inventory cost is sunk cost. Thus, irrelevant.
May 600K
BEST PRODUCT COMBINATION
REQUIRED:
a. March Collections; b. May Collections; c. AR balance as of April 1; d. AR balance as of June 1
Compute the CM/hr/meter/kg (constraint)
PRODUCT A PRODUCT B PRODUCT C COLLECTION PATTERN: 60 – 30 – 10
UNIT CM XX XX XX
÷ HOURS/unit XX XX XX A. March Collections
CM/hr/meter/kg XX XX XX Mar: 500K x 60%
Rank from highest to lowest. Feb: 420K x 30% 474K
Determine the best product combination. Jan: 480K x 10%
XX → Limitation (e.g., hours) B. May Collections
(XX) → 1ST in ranking (units)** X Machine per hr May: 600K x 60%
XX April: 550K x 30% 575K
(XX) → 2nd in ranking (units)** X Machine per hr March: 500K x 10%
XX Remaining Limitation ÷ Machine per hr C. AR, April 1/ March 31
(XX) → 3RD in ranking (units)** X Machine per hr March: 500K x 40%
0 Feb: 420K x 10% 242K
Jan: 480K x 0%
Compute the highest possible profit.
D. AR, June 1/ May 31
A – XX units** X UCM = XX
May: 600K x 40%
B – XX units** X UCM = XX April: 550K x 10% 295K
C – XX units** X UCM = XX March: 500K x 0%
TOTAL CM XX
LESS: FC XX ILLUSTRATION
PROFIT XX Canada Inc. has projected sales to be 80K in April, 100K in May and 120K in June. Canada collects
 LINEAR PROGRAMMING 40% of a month’s sale in the month of sale, 40% in the month following the sale, and 20% in the
→ It can handle many constraints. second month following the sale. What is the AR balance on June 30?
→ Maximization of company’s CM to the objective function.
AR, June 30 (40 – 40 – 20)
 OBJECTIVE FUNCTION: Maximize Z = bA + bB June: 120K x 60% = 72K
*”b” – UCM May: 100K x 20% = 20K
 NON-NEGATIVITY CONSTRAINT: A,B ≥ 0 April: 80K x 0% = 0
*Note that if the question is AR balance, do not use the % of collection but the % of receivable.
BUDGETING WITH PROBABILITY ANALYSIS *In June, 40% has been collected. Thus, 60% is still unpaid. In May, 40% has been collected out of
the 60% receivable. Thus, 20% still remains unpaid. In April, 20% has been collected. Thus, 0% still
OPERATING BUDGET remains unpaid.
I. Sales Forecast [starting point]
II. Sales Budget [most difficult] ILLUSTRATION
III. Production Budget Indonesia Inc. has projected sales: February, 10K; March, 9K; April, 8K; May 10K; and June, 11K.
IV. Inventory Budget Indonesia has 30% cash sales and 70% sales on account. Accounts are collected 40% in the month
a) Raw Materials following the sale and 55% collected the second month. What would be the total cash receipts in
b) Direct Labor May?
c) Overhead 30%: Cash
V. Cost of Sales Sales 70%: Credit (0 – 40 – 55)
VI. Marketing and Admin Expense May, Cash Receipts
FINANCIAL BUDGET May: 10K x 30% = 3K
VII. Cash Budget April: (8K x 70%) x 40% = 2,240
VIII. Working Capital Budget March: (9K X 70%) x 55% = 3,465
IX. Projected (Pro-forma) FS *Cash receipts mean cash collections.
a) Income Statement *30% was collected immediately in the month of sale. 70% credit sales was collected 40% in the
b) Financial Position month following the sale; and 55% in the second month following the sale.
c) Cash Flow [last prepared]

RAHYNE, CPA [@rrhdamcpa]

ILLUSTRATION Receipts from PPE.
Venezuela Co. expects purchases for June to be 130K and its purchases for July to be 124K. Receipts from sale of investment in debt
INFLOWS
Venezuela pays 60% of its purchases in the month of purchase and receives 2% discount. Venezuela INVESTING securities.
pays for the remaining 40% in the next month without discount. For purchases only, what are the ACTIVITIES Receipts from notes receivable.
expected cash payments in July? (Non-Current Payment to acquire PPE.
Assets) Payment to acquire debt or equity securities.
OUTFLOWS
July Payments: 60 (98%) – 40 Payments to make loans to other generally in
the form of notes receivable.
July: 124K x 60% x 98% = 72,912
Debt securities – Bonds, unsecured debt instruments, short-term/long-term promissory notes,
June: 130K x 40% = 52K
certificate of deposit, commercial paper, mortgage-backed securities, and T-bills.
*60% of purchases are paid in the same month (with a 2% discount); 40% of purchases are paid in
FINANCING Receipts from investments by owners.
the following month (without a discount). INFLOWS
ACTIVITIES Receipts from issuance of notes payable.
(Non-Current Payment to owners in the form of dividends.
MERCHANDISE PURCHASE BUDGET Liabilities & OUTFLOWS Payment to settle notes payable.
Equity)
MONTH 1 MONTH 2 Equity securities – Common stock, preferred stock, stock warrants and convertible preferred
Inventory, beg. XX XX shares.
+ Purchases XX XX
- Inventory, end (XX) (XX) EXPECTED VALUE
COGS XX XX  Uses probabilities as weights to compute the arithmetic mean or average of possible
*Inventory should be valued at cost. outcomes.
*Inventory end of the previous month is the beg of the current month. Example:
*Start first at COGS then work back: SALES PROBABILITY PROFIT
SALES 100% VOLUME (LOSS)
- COGS % XX XX X XX% X XX XX
GP % *If there is mark-up, divide to sales. XX XX X XX% X XX XX
XX/units XX
ILLUSTRATION Budgeted Sales = XX/units X SP
Nigeria Merchandising has budgeted the following sales for the 4th quarter of 2025: EV of Monthly Profit = Total P/L
October P 123,500
November 156,000 ILLUSTRATION
December 208,000 France Company prepared the following probability distribution describing the relative likelihood of
monthly sales volume levels and related profit (loss) for its lone product that sells for P 50 per unit:
Other budgeted estimates are:
- All merchandises are to sell at its invoice cost plus 30% mark-up. SALES PROBABILITY PROFIT
- Beginning inventories are budgeted at 40% of the same month's projected cost of goods sold. VOLUME (LOSS)
600 6,000 X 10% X (P 70,000) (7K)
- 80% of merchandise purchases are paid in the purchase month, while balance is paid the next 3.6K 12,000 X 30% X 10,000 3K
month. 3.6K 18,000 X 20% X 60,000 12K
7.2K 24,000 X 30% X 100,000 30K
REQUIRED: Determine the projected amount for: 2.5K 25,000 X 10% X 140,000 14K
17.5K units 52K
A) Merchandise purchases in October
B) Merchandise purchases in November
REQUIRED: Using the expected value approach,
C) Total payment in November for merchandise purchases
A) How much is the budgeted sales for the month? 17.5K units X 50 = 875K
B) What is the expected value of the monthly profit? 52K
OCT. NOV.
Inventory, beg. 38K ← 40% (95K) 48K ← 40% (120K)
INDIFFERENCE POINT
+ Purchases 105K 136K Inventory, Dec. 1
- Inventory, end (48K) (64K) ← 40% (208K ÷ 1.3)
Cost of Goods Sold 95K ← 123,500 ÷ 1.3 120K 156K ÷ 1.3 ILLUSTRATION
Peru Company plans to introduce a new product that requires an initial cash investment of P 44 M.
November Payments: 80 – 20 If the product becomes successful, the net cash inflow is forecasted at P 80 M. However, if the
CGS x 1.3 = Sales Nov: 136K (80%) product becomes a failure, net cash inflow is estimated at P 20 M.
129.8K A) If the success rate is 70%, what is the value of act "to invest?"
CGS = Sales ÷ 1.3 Oct: 105K (20%)
B) What probability-percentages should be assigned to the events 'success' and 'failure' to be
ASSUME indifferent between the two actions "to invest" and "not to invest?"
INCREASE IN INVENTORY BEG -0-
DECREASE IN INVENTORY END -0- ‘x’ –probability of SUCCESS
‘1-x’ – probability of FAILURE
ILLUSTRATION
Brazil Co. is preparing its cash budget for the next month based on the following projections: NCF PROBABILITY B. INDIFFERENCE POINT
Sales 400K A) SUCCESS: 80M X 70% CASH INFLOW = CASH OUTFLOW
Gross Profit Rate 25% 62M
FAILURE: 20M X 30% 80 (x) + 20 (1 –x) = 44
Increase in Inventories 30K (44M) 80x + 20 - 20 = 44
Decrease in Accounts Payable for Inventories 12K 18M 60x = 24
What will be the estimated cash disbursements for inventories?
x = 40% (success)
Inventory, beg. 0 1 – x = 60% (failure)
+ Purchases 330K + 12K = cash disbursement *NCF – Net Cash Flow; Expected Value – WA based on probabilities
- Inventory, end (30K)
Cost of Goods Sold 300K ← 75% (400K) JOINT PROBABILITY

DM FG ILLUSTRATION
DM, BEG. XX FG, BEG. XX Colombia Company has three sales departments, each contributing the following percentages of
+ PURCHASES XX + PRODUCTION XX total sales: Alcohol, 30%; Beverages, 50%; and Cigars, 20%. Each department has had the following
- DM, END. (XX) FG, END (XX) average annual damaged goods rates: Alcohol, 10%; Beverages, 12%; and Cigars, 5%. A random
DM USAGE XX SALES XX corporate audit has found a weekly damaged goods rate of sufficient magnitude to alarm Colombia's
management.
ILLUSTRATION
Vietnam Co. manufactures a single product. The company keeps inventory of raw materials at 50% REQUIRED:
of the coming month’s budgeted production. Each unit of product requires 3 pounds of materials. The Determine the probability in percentage that the damage occurred in the:
production budget is (in units): May, 1K; June, 1.2K; July, 1.3K; Aug., 1.6K. Determine the raw A) Alcohol department → 3/10 = 30%
materials purchases in July. B) Beverages department → 6/10 = 60%
C) Cigars department → 1/10 = 10%
JULY DM, June 30/ July 1
DM, beg. 1,950 ← 50% (1.3K x 3 pounds) ALCOHOL BEVERAGE COGAS
+ DM purchases 4,350 SALES MIX 30% 50% 20%
- DM, end (2.4K) ← 50% (1.6K x 3 pounds) DAMAGE RATE 10% 12% 5%
DM, usage 3.9K ← 1.3K units x 3 pounds 3% + 6% + 1% = 10%

ILLUSTRATION DECISION TREE

India Co. has budgeted sales of 24K finished units for the forthcoming 6-month period. It takes 4 lbs.
of direct materials to make one finished unit. Given the following: ILLUSTRATION
Finished Units Direct Materials (pounds) A wine maker must decide whether to harvest grapes now or in four weeks. Harvesting now will yield
Beg. Inventory 14,000 44,000 100,000 bottles of wine, netting P 2 per bottle. If the wine maker waits for four weeks and weather
Target Ending Inventory 12,000 48,000 turns cold (probability: 20%), the yield will be cut in half but net P 3 per bottle. If the weather does
How many pounds of direct materials should be budgeted for purchase during the 6-month period? not turn cold, the yield depends on rain. With rain (probability: 50%), a full yield netting P 4 per
bottle will result. Without rain, there will still be a full 100,000-bottle yield, but the net amount will
DM (pounds) FGI (units) be P 3 per bottle only.
Beg. 44K Beg. 14K
+ Purchases 92K + Production 22K REQUIRED:
- Ending (48K) - Ending (12K) Determine the optimal expected value. 310K
Usage 88K Sales 24K
NOW 100K (2): P200K
PROFORMA CASH FLOW STATEMENT

Receipts from sale of goods & performance

of services. D
INFLOWS
OPERATING Receipts from royalties, fees, commissions COLD (20%) 50K (3): P150K
ACTIVITIES and other revenues. LATER
(Current Asset & Payment to suppliers. RAIN (50%) 100K (4): P400K
Current Payment to employees. (4 WEEKS)
Liabilities) OUTFLOWS Payment for taxes. NOT COLD (80%)
Payment for interest expenses. 310K 350K
Payment for other operating expense. NO RAIN (50%) 100K (3): P300K

RAHYNE, CPA [@rrhdamcpa]

 STANDARD COSTING WITH GP VARIANCE ANALYSIS C) Materials quantity variance (MQV)
To compute: MQV: (AQ – SQ) X SP
 STANDARD COST SYSTEM – product costing system that determines product cost by using = (4K – 3.6K) x 5 = 2K UF (over usage of materials)
standards or norms; it allows actual costs to be compared against norms for control purposes.
D) Materials price variance (MPV)
BUDGETS STANDARDS To compute: AQ X (AP – SP)
PURPOSE Expected costs What costs should be. = 4K X (6 – 5) = 4K UF (overspending)
Cost levels that should not Levels to which the costs should be
EMPHASIS
be exceeded reduced. Alternatively,
ANALYSIS Measure of performance. Imposes responsibility. AC AQ X AP 4K (6) : 24K MPV: 4K UF
MPV
AQ X SP 4K (5) : 20K
FORMULAS SC SQ X SP MQV 3.6K (5) : 18K MQV: 2K UF
BUDGETED QUANTITY x STANDARD PRICE DM VARIANCE 6K UF
BUDGETED COST = (Budgeted Qty = Planned Production @ Normal Capacity x
Quantity Standard) 5. In the following year, B purchased 5,000 bars [AQpurchased] at a total cost of P 20,000, and 4,000
STANDARD QUANTITY x STANDARD PRICE bars [AQused] of these were used; the standard quantity allowed for the actual production was 3,800
STANDARD COST =
(Standard Qty = Actual Production x Quantity Standard) bars.
ACTUAL COST = ACTUAL QUANTITY x ACTUAL PRICE
“Should have” – standard Determine:
A) Total materials cost variance
DM VARIANCE B) Materials quantity variance
MATERIALS BUDGET VARIANCE = Actual – Budget (std) C) Materials price usage variance
MATERIALS QTY VARIANCE D) Materials purchase price variance
Also Materials Usage Variance & Materials Efficiency = (AQ – SQ) SP E) If Jelly B has a favorable MPV and an unfavorable MQV, then this most likely results from:
Variance a. Machine efficiency problems
MATERIALS PRICE VARIANCE b. Product mix production changes
= AQ (AP – SP)
Also Materials Spending Variance c. Purchase and use of lower-than-standard quality materials
MATERIALS PRICE USAGE VARIANCE = AQused(AP – SP) d. Purchase and use of higher-than-standard quality materials
MATERIALS PURCHASED PRICE VARIANCE = AQpurchased(AP – SP)
Qty → x SP; Price → x AQ ACTUAL STANDARD
AQused = 4K bars SQ = 3.8K bars
Alternatively, AP = P4/ bar (P20K/ 5K bars) SP = P5/ bar
AC AQ X AP MPV
AQ X SP DM VARIANCE TIP: Pag material variance, hanapin na agad yung dalawang actual (AQ/AP) & standard (SQ/SP).
SC SQ X SP MQV Then, substitute nalang sa formula.

*SQ → Based on ACTUAL PRODUCTION: ACTUAL PRODUCTION X QTY. STANDARD DM Variance: AC – SC = 4K (4) – 3.8K (5) = 16K – 19K = (3K) F
*ACTUAL PRICE = DIRECT MATERIALS COST ÷ TOTAL MATERIALS (PURCHASED/USED) MQV: (AQ – SQ) X SP = (4K – 3.8K) 5 = 1K U
MPUV: AQused X (AP-SP) = 4K (4-5) = (4K) F
DL VARIANCE MPPV: AQpurchased X (AP-SP) = 5K (4-5) = (5K) F
DL VARIANCE = Actual – Budget (std)
LABOR EFFICIENCY VARIANCE (LEV) LABOR VARIANCE
= (AH – SH) SR 6. During the year, B paid a total payroll of P 22,000 to laborers, who rendered 2,000 labor hours
Also Labor Usage/Quantity Variance
LABOR RATE VARIANCE (LRV) to produce the 1,200 units of Tripod. Determine the following:
= AH (AR – SR)
Also Materials Spending Variance
Efficiency → x SR; Rate → x AH A) TOTAL LABOR COST VARIANCE
DL Variance = Actual cost – Standard cost
Alternatively, = 2K (11) – 2.4K (10) = 2K F
REMINDER: FOR LABOR:
AC AH X AR DL VARIANCE MQV = ∆Q x SP Efficiency – gaano
LRV B) LABOR EFFICIENCY VARIANCE (LEV)
AH X SR MPV = AQ x ∆P kabilis ang trabaho
SC SH X SR LEV To compute: LEV: (AH – SH) X SR Rate – Workers’ salary
LEV = ∆H x SR
= (2K – 2.4K) X 10 = 4K F
LRV = AH x ∆R
*SH → Based on ACTUAL PRODUCTION: ACTUAL PRODUCTION X STD. HOURS
*ACTUAL RATE = TOTAL DIRECT LABOR COST ÷ DIRECT LABOR HOURS USED C) LABOR RATE VARIANCE (LRV)
*LEV excludes idle time spent in the production (regarded as unfavourable) To compute: AH X (AR – SR)
IDLE TIME VARIANCE = IDLE TIME X STANDARD LABOR RATE = 2K X (11 - 10) = 2K U

ILLUSTRATION D) What is a possible reason B would experience an unfavorable LRV and favorable LEV?
MATERIALS AND LABOR VARIANCE ANALYSIS a. Labor employed was heavily weighted towards higher-paid experienced workers.
b. Workers assigned for the job were replaced by workers from other departments.
B Company has established the standard for a single unit of its product, Mini Tripod: c. Defective materials extended the labor hours required to produce a single unit.
d. Labor employed was heavily weighted towards low-paid unskilled workers.
INPUTS STANDARDS
Direct Materials 3 metallic bars at P5 per bar MATERIALS MIX AND YIELD VARIANCES
Direct Labor 2 labor hours at P10 per hour DM VARIANCE = Actual – Budget (std)
MATERIALS PRICE VARIANCE (MPV) = AQ (AP – SP)
 At the start of the year, the budget includes a planned production of 1K units of tripod based MATERIALS MIX VARIANCE (MMV) = (AQ x SP) – TAQASP
on normal capacity. MATERIALS YIELD VARIANCE (MYV) = TAQASP – STD COSTS
 At the year-end, actual production was 1.2K units of tripod, which resulted to using 4K bars, *TAQASP – Total Actual Quantity at Average Standard Price
purchased at a cost of P6 per bar. *Budget (Standard Cost) = Actual Production X Standard Cost
*MPV – itemize
OUTPUT INPUT (DM) *Average Standard Price is based on Standard Mix(%) x Standard Quantity
BP: 1K units BQ: 3K bars (1K units X 3/ metallic bar) X P5 → BC: 15K → Planning
SQ: 3.6K bars (1.2K units X 3/metallic bar) X P5 → SC: P18K → Controlling AQ X AP:
AP: 1.2K units MPV
AQ: 4K bars X P6 → AC: 24K → Organizing AQ X SP: DM VARIANCE
MMV
TAQASP:
*Normal capacity is the budgeted production. MYV MQV
SQ X SP:
*Standard cost is based on the actual production.
*Analysis: The company plans to incur 15K, but it actually incurred 24K, when the standard says it
ILLUSTRATION
should incur 18K only. MATERIALS PRICE, MIX AND YIELD VARIANCES
REQUIRED:
Mc Inasal produces the popular “APT” Colonge that has gone viral in social media. The merger has
1. Based on the BUDGETED production of 1,000 units: established the following standards for one kilo of “APT” Cologne:
A) How many bars must the company plan to use? (Budgeted quantity) Ingredients Standard Qty Standard Unit Cost Standard Cost
1K units X 3 bars/ unit = 3K bars Asin 500 grams (50%) P2.00 1,500
B) How much materials cost is included in the budget? (Budgeted materials cost) Patis 400 grams (40%) P4.00 1,600
3K bars X P5/bar = 15K Tawas 100 grams (10%) P5.00 500
TOTAL 1,000 grams (100%) 3,600
2. Determine the actual cost of materials used.
4K bars X P6/ bar = 24K The company reported the following production and cost data for the January 2025 operations:

3. Based on the ACTUAL production of 1,200 units: Ingredients Actual Qty Actual Unit Price Actual Cost
Asin 60,000 P2.00 120,000
A) How many bars should have been used? (Standard quantity) Patis 30,000 P5.00 150,000
1.2K units X 3 bars/unit = 3.6K Tawas 10,000 P4.00 40,000
B) How much materials cost should have been incurred? (Standard materials cost) TOTAL 100,000 310,000
3.6K bars X P5/ bar = 18K
C) How many labor hours should have been spent? (Standard hours) Mc Inasal produced 90 kilos of “APT” cologne in January 2025.
1.2K units X 2 hrs/ unit = 2.4K hrs
D) How much labor cost should have been incurred? (Standard labor cost) REQUIRED:
1) Total Materials Cost Variance 3) Materials Mix Variance
2.4K hrs X P10/hr = 24K
2) Materials Price Variance 4) Materials Yield Variance
WHERE:
4. Determine the following: AC > SC: UNFAVORABLE (credit balance)
1) DM VARIANCE = = ACTUAL COST – STANDARD COST
A) Materials budget variance: AC < SC = FAVORABLE (debit balance)
= 310K – (90 (3.6K))  SC is based on the actual production.
 Budget Variance = Actual – Budget = 14K F
 Budget Variance = AC of Materials – BC of Materials 2) MPV = AQ (AP – SP)  Asin 60K (2 – 3) = 60K F
= 24K – 15K = 9K UF (overspending/budget deficit/ deduction to profit)  Patis 30K (5 – 4) = 30K U 40K F
 Tawas 10K (4 – 5) = 10K F
B) Materials standard cost variance.
 DM Variance = Actual cost – Standard cost
= 24K – 18K = 6K UF

RAHYNE, CPA [@rrhdamcpa]

 3) MMV = (AQ x SP) – TOTAL ACTUAL QUANTITY AT AVERAGE 1. FOH Variance: AFOH – SHSR
STANDARD PRICE (TAQASP) = 85K – 10K (8) = 5K U
AQ x SP Should be weighted average
 Asin = 60K (3) using standard mix (like in sales AFOH: 85K
 Patis = 30K (4) mix). CON: 2) 7K F
350K BASH: 92K
 Tawas = 10K (5) 10K F Standard Mix: 50%-40%-10% SHSR: 80K VOL: 3) 12K UF
TAQ x ASP = 100k (3.6) 360K ASP: 3 (.5) + 4 (.4) + 5 (.1) = 3.6
*Start with the budget computation because all OH Variance has FOH budget.
4) MYV = TAQASP – STANDARD COST
= 360K – 324K *Unfavorable means additional costs, thus decreasing the profit.
= 36K U
2-way: CON.VOL 3-way: SE.VOL 4-way: S.S.E.VOL
AFOH AFOH Spending Spending (Variable)
ALTERNATIVE SOLUTION BASH
CONtrollable
BAAH Efficiency Spending (Fixed)
3) MMV = (AQ – SQ) x SP 4) MYV = (AQ – SQ) x SP VOLume
SHSR BASH VOLume Efficiency
 Asin (60K – 50K) x 3 = 30K U = (100K – 90K) x 3.6 = 36K U SHSR VOLume
 Patis (30K – 40K) x 4 = 40K F *AP x SQ
 Tawas (10K – 10K) x 5 = -0- *90kg x 1K = 90K *Since BAAH and BASH are budgeted, they come from the flexible budget formula. Ilalagay lang sa
100K 100K 10K F X, either actual or standard hours para maging BAAH or BASH.
 The basis of standard quantity is standard mix, thus, distribute 100K
using the standard mix of each ingredient. ILLUSTRATION
2-WAY, 3-WAY AND 4-WAY FACTORY OVERHEAD VARIANCE ANALYSIS
RECOMMENDED SOLUTION
AC  AQ x SP
MPV X Co. provides the following production data:
AQ x SP DM
TAQ x ASP MMV VARIANCE Standard factory overhead cost per unit of product: 4 hours at P3.00 per hour.
MQV
SC  SQ x SP MYV
Budgeted Fixed Factory Overhead 20K
AQ x SP 310K Normal Capacity 2.5K units
MPV: 40K F Actual Production 2K units
AQ x SP 350K DM
TAQ x ASP 360K VARIANCE 14K Actual Hours 7.5K hours
MMV: 10K F
MQV: 26K U Actual Factory Overhead Incurred (75% fixed) 25K
SQ x SP 324K MYV: 36K F
REQUIRED: Determine the following:
1. Budgeted Factory Overhead
FACTORY OVERHEAD
2. Standard Factory Overhead
3. Budgeted FOH based on actual hours
Flexible Budget Formula: FOH = a + bX → like the cost function
4. Budgeted FOH based on standard hours
5. Controllable variance
Only three (3) can be substituted to X:
6. Volume variance
a) BUDGETED HOURS Based on planned production
7. Spending variance
b) ACTUAL HOURS
Based on actual production 8. Efficiency variance
c) STANDARD HOURS
9. Variable spending variance
10. Fixed spending variance
Where:
 a = Budgeted Fixed Cost
FOH Budget
 b = Variable Cost Rate
FOH = 20K + 1x
 bX = Total Variable Cost
 Standard: 1 unit: 4 hours
 Normal Capacity: 2.5K units
FACTORY OVERHEAD BUDGET
 BH: 10K hours (2.5K x 4)
FFOH 20K FR 2
ILLUSTRATION
VFOH 10K VR 1
X Co. shows the following data regarding its factory overhead: BFOH 30K SR 3
Flexible Budget Formula: FOH = 20K + 1x where: X – number of labor hours *Always start with the FOH budget formula.
 Standard: 1 unit of product requires 4 labor hours (Usually given)
 Normal capacity: 2.5K units (Budgeted Production) Standard: 1 unit: 4 hours
 Budgeted hours: A) 10K hours (Denominator Activity) BP: 2.5K units: 10K (BH)
└First to be substituted to X; based on normal capacity; 2.5K x 4 AP: 2K units: 8K (SH)
*Use the ratio technique to compute for BH and SH, if not given.
FFOH B) 20K (given) Fx OH Rate (FR) E) 2 (20K ÷ 10K)
VFOH C) 10K (squeeze) Var. OH Rate (VR) F) 1 (given) 1. BFOH: 20K + 1 (10K) = 30K
TOTAL BUGETED OH D) 30K (20K + 1 (10K)) Std. OH Rate (SR) G) 3 (30K ÷ 10K)
(BFOH) 2. SFOH: SH x SR = 8K (3) = 24K
3. BAAH: 20K + 1 (7.5K) = 27.5K
REQUIRED: 4. BASH: 20K + 1 (8K) = 28K
1. Compute for the missing amounts.
2. What is the budgeted FOH if adjusted based on 7.5K actual hours (BAAH)? FOH = 20K + 1 AFOH: 26K Controllable: 5) 2K F
(7.5K) = 27.5K (BAAH) BASH: 28K
SHSR: 24K Volume: 6) 4K U
3. What is the budgeted FOH if adjusted based on 8K standard hours (BASH)? FOH = 20K + 1(8K)
= 28K (BASH)
AFOH: 26K
Spending: 7) 1.5K F
BAAH: 27.5K
*BUDGETED HOURS = BUDGETED PRODUCTION x LABOR HOURS Efficiency: 8) 500 F
BASH: 28K
*Fixed Overhead (FFOH) – given in the flexible budget formula Volume: 6) 4K U
SHSR: 24K
*Variable Overhead (VFOH) – work back
*FIXED OVERHEAD RATE = FFOH ÷ BUDGETED HOURS TOTAL = FIXED + VARIABLE
*VARIABLE OVERHEAD RATE = VARIABLE OVERHEAD ÷ BUDGETED HOURS, if not given AFOH: 26K = 19.5K + 6.5K
*STANDARD OVERHEAD RATE = TOTAL BUDGETED OVERHEAD ÷ BUDGETED HOURS BAAH: 27.5K = 20K + 7.5K
BASH: 28K = 20K + 8K
FACTORY OVERHEAD VARIANCE ANALYSIS SHSR: 24K = 16K + 8K

 Also known as Applied Factory OH AFOH: 26K (given)

FOH VARIANCE = AC – SC = AFOH – SFOH  also Budget Variance AFOH (Fixed): 26K x 75%
(1 – way) = AFOH – (SH x SR) AFOH (Variable): 26K x 25%

2 – way: “CON.VOL” AFOH > SFOH  FOH is UNDERAPPLIED (UF) FOH = 20K + 1x
AC → AFOH CONtrollable AFOH < SFOH  FOH is OVERAPPLIED (F) BAAH (Fixed): 20K
BASH Variance BAAH (Variable): 1 (7.5K)
From the flexible budget formula
SC → SHSR VOLume Variance BASH (Fixed): 20K
 Can also be computed: BASH (Variable): 1 (8K)
(Budgeted Hrs. – Std. Hrs) x FFOH rate
 Also known as Capacity Variance. SHSR: 8K (3) Standard Rate (SR) is capable of being segregated.
 Always fixed. SH x FR: 8K (2): 16K Since it can be based on Fixed Rate or Variable Rate
*AFOH is normally given. SH x VR: 8K (1): 8K
*SFOH is also SHSR.
*BASH (BUDGETED ADJUSTED STANDARD HOURS) = BUDGETED FFOH + (SH x Var. FOHr) 9) AFOH (V) 6.5K
- BAAH (V) 7.5K
ILLUSTRATION Variable “S” 1K F
2-WAY FACTORY OVERHEAD VARIANCE ANALYSIS
10) AFOH (F) 19.5K
- BAAH (F) 20K
The normal capacity of Bon-Chan Company is 12K labor hours per month. At normal capacity, the
Fixed “S” 500 F
standard factory overhead rate is P8 per labor hour based on 72K of budgeted fixed cost per month
and a variable cost rate of P2 per labor hour. During January, Bon-Chan operated at 12.5K labor
ILLUSTRATION
hours, which actual factory overhead cost of P85K. The number of standard labor hours allowed for
FACTORY OVERHEAD VARIANCE ANALYSIS – BUDGET, VARIABLE & FIXED VARIANCES
the production attained is 10K labor hours.
Summary:
REQUIRED: Assume the same data in the previous item:
1. Overall FOH Variance 2. FOH Controllable Variance 3. FOH Volume Variance ONE-WAY TWO-WAY THREE-WAY FOUR-WAY
AFOH: 26K CON = (5)2KF S (7)1.5K F S (V) (9)1K F
FOH Budget SFOH: 24K VOL = (6)4KU E (8)500 F S (F) (10)500 F
FOH Var: 2K U 2K U VOL (6)4K U E (V) (8)500 F
FOH = 72K + 2x
2K U VOL (F) (6)4K F
 BH: 12K hours 2K U
FFOH 72K FR P6 1. BFOH: 30K
VFOH 24K VR 2 2. SFOHH: 24K
BFOH 96K SR 8 3. BAAH: 27.5K
 SH: 10K hours 4. BASH: 28K
BASH: 72K + 2 (10K) = 92K

RAHYNE, CPA [@rrhdamcpa]

 ADDITIONAL REQUIREMENTS: (continued from previous item) SEGMENTED INCOME STATEMENT

a) Budget (Flexible) Variance (2-way)  Detailed version of the contribution format of income statement.
b) Budget (Flexible) Variance (3-way) Budget Variance is always AC – SC  Highlights controllability of costs by behavioural classification.
c) Variable Controllable Variance
d) Fixed Volume Variance SALES XX
e) Variable FOH Variance LESS: VARIABLE MANUFACTURING COSTS (XX)
f) Fixed FOH Variance MANUFACTURING CONTRIBUTION MARGIN XX
LESSS: VARIABLE NON-MANUFACTURING COSTS (XX)
TOTAL = FIXED + VARIABLE CONTRIBUTION MARGIN XX
AFOH: 26K = 19.5K + 6.5K LESS: CONTROLLABLE DIRECT FIXED COSTS (XX)
BAAH: 27.5K = 20K + 7.5K CONTROLLABLE OR PERFORMANCE MARGIN XX
BASH: 28K = 20K + 8K LESS: NON-CONTROLLABLE DIRECT FIXED COSTS (XX)
SHSR: 24K = 16K + 8K SEGMENT MARGIN XX
LESS: ALLOCATED COMMON COSTS (XX)
BUDGET Variance: Actual – Budget PROFIT XX
a) 2-way
AC: AFOH *All controllable costs are direct costs but not all direct costs are controllable.
CON: 2K F
BC: BASH *Indirect costs are always non-controllable.
b) 3-way *Non-controllable costs are costs that have been allocated; share in the total costs of the company.
AC: AFOH SPENDING: 1.5K F
BC: BAAH ILLUSTRATION
c) AFOH (V) 6.5K The manager of X branch recently reported annual sales of 1.2M and presented the following cost
- BASH (V) (8K) information to its head office:
Var. “CON” 1.5K F
d) BASH (F) 20K Variable Manufacturing Costs 450K
- SHSR () (16K) Allocated Corporate Overhead Costs 120K
Fx. “VOL” 4K U Variable Selling and Administrative Expenses 230K
e) AFOH (V) 6.5K Controllable Fixed Cots Traceable to X Branch 320K
- SHSR (V) (8K) S (V) + E (V) Uncontrollable Fixed Costs Traceable to X Branch 280K
VFOH Var 1.5K F = 1K F + 500 F
f) AFOH (F) 19.5K REQUIRED:
- SHSR (F) (16K) S (F) + VOL (F) 1. Determine the following:
FFOH Var: 3.5K U = 500 F + 4K U a.) Manufacturing CM b.) Controllable or performance margin c.) Segment Margin
2. Identify the appropriate margin that shall be used to evaluate the performance of:
*Volume Variance = Fixed Volume Variance a.) Manager b.) Business unit (X branch)
*Efficiency Variance = Variable Efficiency Variance
Sales 1.2M
LABOR VARIANCE Less: variable manufacturing costs (450K)
ACTUAL  AHAR Manufacturing Contribution Margin (1) 750K
SPENDING Less: Variable Non-Manufacturing Costs (230K)
BUDGETED  AHSR
STANDARD  SHSR EFFICIENCY Contribution Margin 520K
Less: Controllable Direct Fixed Costs (320K)
GROSS PROFIT VARIANCE ANALYSIS Controllable or Performance Margin (2) 200K
Less: Non-Controllable Direct Fixed Costs (280K)
 Gross profit variance analysis is a useful tool in evaluating operational performance as Segment Margin (3) (80K)
gross profit must be adequate enough to cover operating and other expenses and generate Less: Allocated Common Costs (120K)
a desired amount of profit. Profit (loss) (200K)

SALES = UNIT SALES X UNIT SELLING PRICE 2A) Manager: Performance Margin: 200K
- COGS = UNIT SALES X UNIT COST 2B) X branch: Segment Margin: (80K)
GP = UNIT SALES X (UNIT SELLING PRICE – UNIT COST)
RETURN ON INVESTMENT (ROI)
GROSS PROFIT (GP) VARIANCE = GP (ACTUAL/ CURRENT – GP (BUDGET/ PREVIOUS)
ROI = MARGIN X TURNOVER
ANALYSIS: ↓ ↓ ↓
PRICE FACTOR = SAES PRICE VARIANCE = AQ x ∆SP = AQ (ACTUAL SP – BUDGETED SP) OPERATING INCOME OPERATING INCOME SALES
= =
COST FACTOR = COST PRICE VARIANCE = AQ x ∆CP = AQ (ACTUAL CP – BUDGETED CP) OPERATING ASSETS SALES OPERATING ASSETS
VOLUME FACTOR = ∆Q x BUDGETED UNIT GP = (AQ – BQ) x BUDGETED UNIT GP (ROA) (ROS) (ATO)
SALES VOLUME VARIANCE = ∆Q x BUDGETED SP
COST VOLUME VARIANCE = ∆Q x BUDGETED CP Du Pont Technique
ROS x ATO = ROA
Sales Variance SALES PRICE VARIANCE = Actual Sales – AQ @ Budgeted SP
SALES VOLUME VARIANCE = AQ @ Budgeted SP – Budgeted Sales MARGIN TURNOVER
COST PRICE VARIANCE = Actual CGS – AQ @ Budgeted CP CASE 1 HIGH LOW REALISTIC
Cost Variance
COST VOLUME VARIANCE = AQ @ Budgeted CP – Budgeted CGS CASE 2 LOW HIGH REALISTIC
CASE 3 HIGH HIGH MONOPOLISTIC
RESPONSIBILITY ACCOUNTING, TRANSFER PRICING AND BALANCED SCORECARD CASE 4 LOW LOW PROBLEMATIC

RESPONSIBILITY ACCOUNTING *ROI is also known as Return on Assets (ROA)

*Margin – net profit margin, return on sales (Price)
 Performance management tool where managers are held responsible for their performance, *Turnover – assets turnover, investment turnover, capital turnover (Sales)
subordinates as well as activities within the managers’ area of authority and control. *Operating Income is based on Earnings Before Interests & Taxes (EBIT)
 This is consistent with MANAGEMENT BY OBJECTIVES (MBO) – Managers and *Operating Assets – based on the average balance for the reporting period and composed of
subordinates agree on goals as well as the methods to achieve them and subordinates productive assets used to earn the operating income (i.e., idle assets are excluded)
are subsequently evaluated with reference to the agreed plan.
 This system functions best under a decentralized form of organization. RESIDUAL INCOME (RI)
 DECENTRALIZATION – separation of an entity into manageable units.
 Decentralized organizations must avoid SUB-OPTIMIZATION, which happens when RESIDUAL INCOME = OPERATING INCOME - REQUIRED INCOME
managers decide in favor of their own decentralized unit even at the expense of the entire Where: Required Income = Operating Assets x Minimum ROI
organization.
 Most decentralized organizations are divided into responsibility centers (also called *MINIMUM ROI may also be known as DESIRED RATE OF RETURN or MINIMUM REQUIRED
Strategic Business Units). RATE OF RETURN.
 RESPONSIBILITY CENTER – component of an entity whose manager has authority *MINIMUM ROI under RI is usually based on the imputed interest rate, which is imposed and set
over, and is responsible and accountable for, a particular set of activities. by a higher authority like a head office (for branches) or a holding company (for subsidiaries)

FOUR COMMON TYPES OF RESPONSIBILITY CENTERS ROI-RI CONNECTION

a) COST CENTER – managers are mainly responsible for the costs incurred by
the unit e.g., HR & Accounting Department RI = (ROI – Minimum ROI) x Assets
b) REVENUE CENTER – managers are responsible mainly for the revenues Case 1: Target Performance
generated by the unit i.e., Sales targets e.g., Ticket outlets, convenience store ROI > Minimum ROI, RI = (+)
c) PROFIT CENTER – managers are responsible for both revenues and cost of Case 2: Break-Even Performance
the unit e.g., College of Accountancy ROI = Minimum ROI, RI = 0
d) INVESTMENT CENTER – managers are responsible for revenues, costs and Case 3: Poor Performance
investment of capital e.g., Magnolia product division, Sampaloc branch of ROI < Minimum ROI, RI = (-)
KFC
– Has autonomy to make its own decisions. ILLUSTRATION
RETURN ON INVESTMENT, RESIDUAL INCOME & ROI PRICING
 PERFORMANCE REPORT – end-product of the responsibility accounting, shows
and compares actual results with the intended (budgets or standards) results of a For each of the following independent cases, the minimum Desired Return on Investment (ROI) is
responsibility center. 20%.

RESPONSIBILITY CENTER KEY PERFORMANCE MEASURES Division Z2 Division Z8 Division Z2

COST CENTER Variance Analysis: Actual Costs vs. Budgeted/ Standard Costs Sales P400K 700K  Unit Selling Price: P20
REVENUE CENTER Variance Analysis: Actual Sales vs. Budgeted/ Target Sales Operating Income (1)_______ 42K  Total Fixed Costs: 100K
Variance Analysis: Actual Profit vs. Budgeted/ Target Profit Operating Assets (2) _______ (5) _______
PROFIT CENTER
Segmented Income Statement Margin 15% (6) _______ Division Z8
Variance Analysis: Actual Profit vs. Budgeted/ Target Profit Turnover (3) _______ (7) _______  Unit Selling Price: P700
INVESTMENT CENTER
Segmented Income Statement/ ROI, Residual Income, EVA Return on Investments 30% (8) _______  Total Fixed Costs: 258K
Residual Income (4) _______ 22K

RAHYNE, CPA [@rrhdamcpa]

 REQUIRED:
1. Compute for each division’s missing items (1 to 8). LIMITATIONS OF TRANSFER PRICE (TP)
2. How many more units shall be sold by Division Z2 to achieve a 40% ROI?  UPPER LIMIT (Buyer’s MAXIMUM TP)
3. How much increase in selling price will allow Z8 to reach 50% ROI from its current unit sales?  Purchase price from outside supplier
 LOWER LIMIT (Seller’s MINIMUM TP)
Division Z2 Division Z2 Division Z2  FULL CAPACITY
(1) Margin = Income ÷ Sales (3) Turnover = Sales ÷ (4) RI = Income – Required
 Regular Selling Price
15% = Income ÷ 400K Assets Income
Income = 60K Turnover = 400K ÷ 200K RI = 60K – 20% (200K)  EXCESS CAPACITY
Turnover = 2x RI = 20K  Unit Variable Cost
(2) ROI = Income ÷ Assets (3) ROI = Margin x Turnover (4) RI = (ROI – Min. ROI) Assets
30% = 60K ÷ Assets 30% = 15% x Turnover RI = (30% - 20%) 200K MINIMUM TP = UNIT VARIABLE COST + LOST UNIT CM
Assets = 200K Turnover = 2x RI = 20K  EXCESS Capacity: Minimum TP = Unit VC + 0 = Unit Variable Cost
 FULL Capacity: Minimum TP = Unit VC + (SP – Unit VC) Regular SP
Division Z8 Division Z8 Division Z8 *Unit Variable Cost – Outlay cost; Lost Unit CM – Opportunity cost
(5) RI = Income – Required Income (6) Margin = Income ÷ Sales (8) ROI = Income ÷ Assets
22K = 42K – Required Income Margin = 42K ÷ 700K ROI = 42K ÷ 100K *Excess capacity – unsold units; can be produced without ready buyer yet
Required Income: 20K Margin = 6% ROI = 42% *Full capacity – sold out
20K = 20% x Assets
Assets = 20K ÷ 20% = 100K (7)Turnover = Sales ÷ Assets (8) ROI Margin x Turnover  SUB-OPTIMIZATION – when managers of both selling and buying divisions act in their own
Turnover = 700K ÷ 100K ROI = 6% x 7
Turnover = 7x ROI = 42% individual interests.
 GOAL CONGRUENCE – occurs when division managers make decisions that are
2) Division Z2 3) Division Z8 consistent with the goals and objectives of the entire organization.
Target Profit: 40% x 200K = 80K* Target profit: 50% x 100K = 50K*  OUTLAY COST - includes selling division’s variable production costs plus any additions
Unit Sales** = 400K ÷ 20 = 20K** Unit Sales: 700K ÷ 700 = 1K units** costs incurred.
Unit CM: (60K + 100K) ÷ 20K** = 8  OPPORTUNITY COST – margin or profit sacrificed by transferring units internally rather
Since current unit sales will be held than selling them to external customers.
↑CM = ↑FC + ↑P constant (same):  DUAL PRICING – an attempt to eliminate the internal conflicts associated with transfer
8x = 0 + (80K* - 60K) ↑SP = ↑P ÷ Unit Sales
prices by giving both the buying and selling divisions the price that works best for them.
X = 20K ÷ 8 = 2.5K units ↑ SP = (50K* - 42K) ÷ 1K units**
Increase in selling price: P8
ILLUSTRATION
TRANSFER PRICING
ECONOMIC-VALUE ADDED (EVA)

 Measures a segment’s economic profit based on residual wealth after accounting for the cost of X Company’s Division ‘S’ (selling division) produces a small tool used by other companies as a key
capital. part in their products. Cost and sales data related to the small tool are given below:
 Used for incentive compensation and investor relations.
Selling price per unit 50
Variable costs per unit 30
EVA = OPERATING INCOME AFTER TAX - REQUIRED INCOME
Fixed costs per unit* 12
Where: Required Income = (Total Assets – Current Liabilities) x WACC
*based on capacity of 40K tools per year.
*WACC is also called hurdle rate, cutoff rate, target rate, standard rate or minimum acceptable The company’s Division ‘B’ (buying division) is introducing a new product that will use the same tool
rate of return. being produced by Division S. An outside supplier has quoted the Division B a price of 48 per tool.
*WACC is based on the long-term sources of financing – debt and equity – hence, the computation: Division B would like to purchase the tools from Division S, only if an acceptable transfer price can
(TOTAL ASSETS – CURRENT LIABILITIES) being equal to (LONG-TERM LIABILITIES AND be worked out.
EQUITY)
*Operating Income After Tax is based on the formula: EBIT = (100% - TAX RATE) REQUIRED: Consider the following independent cases:
1. Division S has ample idle capacity to handle all the Division B’s needs:
ILLUSTRATION a.) What is the maximum transfer price for Division S?
X Co. presents the following year-end data: b.) What is the maximum transfer price for Division B?
Book Value Fair Value
2. Division S is presently selling at all the tools it can produce to outside customers:
Current Assets 800K
a.) What is the minimum transfer price?
Non-Current Assets 3.2M
Current Liabilities 400K b.) Shall the Division B purchase the tools from Division or from the outside supplier? Why?
Non-Current Liabilities (10% interest rate) 1M 1M 3. Division S is presently selling 36K tools per year to outside customers while Division B requires
Stockholder’s Equity 2.6M 3M 10K tools per year:
a. What is the minimum transfer price for Division S?
Additional data: b. Shall the company make-and-transfer 10K tools or buy the tools from outside supplier? Why?
 Income before interests and taxes: 520K
 Income tax rate: 20% 1) EXCESS CAPACITY 2) FULL CAPACITY
 Cost of equity capital: 12% A) Minimum TP (Division S): UVC = P30 A) Minimum TP: SP = P50
B) Maximum TP (Division B): PP = P48 B)  Division S: TP = 50 Supplier:
 Supplier: PP = 48 Savings = P2
REQUIRED:
RI vs. EVA
1. Weighted Average Costs of Capital (WACC)
RI = EBIT – REQUIRED INCOME  Division S’s Excess Capacity: 40K – 36K = 4K units
2. Economic Value-Added (EVA) EVA = INCOME AFTER TAX – REQUIRED INCOME
 Division B’s Demand: 10K units
Source Weight (FV) Cost WACC
DEBT 25% (1M) 10% (1 – 0.2) = 8% 2% A) Minimum Transfer Price
EQUITY 75% (3M) 12% 9% EXCESS: 4K u x 30 = 120K
4M 11% FULL: 6K u x 50 = 300K
*25% x 8% = 2%; 75% x 12% = 9% 420K ÷ 10K = P42
Or,
*Weight is based on the FV: 1M/4M & 3M/4M
A) Minimum TP = UVC + Lost UCM A) Minimum TP = 30 (4/10) + 50 (6/10) = P42
*Cost of Interest should exclude tax savings, thus it should be net of tax. Kasi yung Interest is Tax
= 30 + (120K* ÷ 10K) = P42
Deductible Expense, pero yung Dividend hindi sina-subject sa kahit anong tax since hindi siya *Lost CM: 6K u (50 – 30) = 120K
pwedeng i-claim as tax deductible expense.
*Tax Deductible Expense yung Interest since pinababa niya yung cost of tax na babayaran. B) Supplier: PP = 48 vs. Division S: TP = 42
Make & Transfer:
EVA: 416K* - 396K** Savings = P6 x 10K units = 60K
2) EVA = 20K
*520K (100K% - 20%) TRANSFER PRICE COMPUTATION
**11% (4M – 400K) or 11% (1M + 2.6M)
 Assets – CL  LTL + Equity Disney Co. is operating with two divisions. Division S is producing a product line that is required as
a component part of the product being manufactured by Division B.
TRANSFER PRICING
For Division S, the costs of producing the component part per unit are:
 When one division of a manufacturing company supplies components or materials to Direct Materials P10
another division. Direct Labor P8
25 (A)
Variable Factory Overhead P5
 TRANSFER PRICE – the price charged by the selling (producing) division to the buying Fixed Factory Overhead P2
division. The product of Division S is being sold in a highly competitive market for P 30 per unit. (D)

METHODS Division B is currently buying 80% of the production output of Division S at a negotiated price of P28
 COST-BASED PRICE (C) per unit. It is expected that 25K units of product will be produced by Division S.
 Inefficiencies of the selling division may be passed on to the buying
division. With emphasis on divisional welfare rather than the company’s welfare, a new transfer price must be
 Based on division’s variable cost, full (absorption) cost or cost-plus. developed. It is suggested that (B) 40% mark-up on cost will be added when transferring the product
→ Variable cost [lowest cost]; Full costs [+Mark-up] from Division S to Division B.
→ The downside of this is that the manager gets to dictate the price.
 MARKET PRICE The unit selling price of the product of Division B is P45 while the additional unit processing cost is
 Ideal transfer price that maximizes the over-all company profit. P8.
→ The price dictated by market forces of supply and demand. But the
downside of this is it fluctuates a lot. REQUIRED:
 NEGOTIATED PRICE Determine Division B’s gross profit per unit under each of the following independent assumptions:
 Most widely used transfer price when market prices are subject to a) Transfer price is full-cost based.
rapid fluctuation or when there is no intermediate market price that b) Transfer price is cost-based plus mark-up.
exists. c) Transfer price is based on negotiated price.
 In negotiating a transfer price, the usual range shall be based on the d) Transfer price is market-based.
following:
 MAXIMUM PRICE (BUYING DIVISION): Market Price a) 45 – 8 – 25 = P12
b) 45 – 8 – 25 (1.4) = P2
 MINIMUM PRICE (SELLING DIVISION): Outlay cost +
c) 45 – 8 – 28 = P9
Opportunity Cost
d) 45 – 8 – 30 = P7
 ARBITRATRY PRICE
 Imposed by the corporate headquarters to promote over-all
company goals.
RAHYNE, CPA [@rrhdamcpa]
 BALANCED SCORECARD FACTORS AFFECTING
EFFECT ON DEMAND EXAMPLE
DEMAND
 BALANCED SCORECARD – an approach to performance measurement that combines PRICE OF SUBSTITUTE If the price of pork increases, the
DIRECT
traditional financial measures with non-financial performance measures. GOODS demand for beef may increase.
o Created by David Norton and Robert Kaplan PRICE OF COMPLEMENTARY If the price of gasoline increases, the
INVERSE
 VALUE-BASED MANAGEMENT – performance evaluation technique which focuses on GOODS demand for cars tends to decrease.
traditional financial measures. If the price of the good is expected to
EXPECTED FUTURE PRICES DIRECT increase in the future, there will be an
 BSC translates an organization’s STRATEGY into a comprehensive set of financial increase in demand.
(lagging indicators) and non-financial (leading indicators) performance metrics As consumer income goes up, the
DIRECT FOR
CONSUMER WEALTH/ INCOME demand for many products (normal
classified into four (4) perspectives: NORMAL GOODS
goods) increases.
1. FINANCIAL PERSPECTIVE (“How do we look to shareholders?”)
Demand for inferior goods (e.g.,
2. CUSTOMER PERSPECTIVE (“How do customers see us?”) instant noodle, sardines) increases as
3. INTERNAL BUSINESS PROCESSES PERSPECTIVE (“What must we excel INVERSE FOR
CONSUMER WEALTH/ INCOME consumer income decreases since
at?”) INFERIOR GOODS
consumers buy more inferior goods
4. LEARNING AND GROWTH PERSPECTIVE (“Can we continue to improve and when they are short of money.
create value?”) An increase in population increases
POPULATION GROWTH DIRECT
number of potential buyers.
 STRATEGY MAPPING – links the four BSC perspectives with company strategies based on As market size expands, demand for
SIZE OF MARKET DIRECT
cause-and-effect pattern. the product also increases.
The effect depends on whether the
 A typical BSC report contains: CONSUMER TASTES/ shift in taste or preference is favorable
INDETERMINATE
a) OBJECTIVES – statements of what the strategy must be achieved. PREFERENCE or unfavorable to the demand for the
b) PERFORMANCE MEASURES – described how success in achieving the product.
strategy will be measured. *Substitute goods – goods that can be used in place of another.
c) BASELINE PERFORMANCE – the current level of performance. *Complementary goods – one usually cannot function without the other.
d) TARGETS – the level of performance needed in the performance
measure. ELASTICITY OF DEMAND (ED)
e) INITIATIVES – key action programs required to achieve strategic
objectives.  Measures the sensitivity of quantity demanded to any change in price.
 Objectives focus on what is to be achieved. Performance measures,
baseline performance and targets relate to how it will be measured. Initiative ED = ∆% IN QUANTITY DEMANDED ÷ ∆% IN PRICE
focus on how it will be achieved.
Where,
THE FOUR PERSPECTIVES IN MORE DETAIL ∆% IN QUANTITY DEMANDED = ∆ IN QUANTITY DEMANDED ÷ AVERAGE QUANTITY
PERSPECTIVE FOCUS EXAMPLE KPIs ∆% IN PRICE = ∆ IN PRICE ÷ AVERAGE PRICE
Financial Financial Performance ROI; Operating Margin
Customer Customer Satisfaction Level of Returns; Service Rating ILLUSTRATION:
Internal Processes Business Efficiency New product lead time; Unit Costs DAY 1 – unit price was set at P1.00 each, the sales reached 100 units.
Organizational Capacity Knowledge and Innovation Employee retention; Flow of NPD ideas DAY 2 – unit price was increased to P1.50 each, the sales decreased to 60 units.

Which among the four BSC perspectives is/are: Average Quantity = (100 + 60) ÷ 2 = 80*
 The 2 Controllable factors? Average Price = (1 + 1.5) ÷ 2 = 1.25**
 Internal processes, Learning & Growth
 The 2 Non-Controllable factors? ED = [(100 – 60)/80*) ÷ [1.5 – 1) ÷ 1.25**
 Customer, Financial ED = 0.50 ÷ 0.40
 The Leading Indicators/ Lead Measures? ED = 1.25
 Learning & Growth, Customer Internal Processes
 The Lagging Indicator/ Lag Measure? ED ELASTICITY QUANTITY DEMANDED (degree of reaction)
>1 ELASTIC Reacts MORE proportionately to changes in price
 Financial
=1 UNITARY Reacts proportionately to changes in price
 Also called “Organization Capacity” Perspective?
<1 INELASTIC Reacts LESS proportionately to changes in price
 Learning & Growth
=0 PERFECTLY INELASTIC Does not react to changes in price
*The demand for Luxury goods tends to be more elastic than the demand for BASIC or STAPLE
ECONOMICS
goods.
*The demand for badly needed goods like ‘maintenance’ medicine tends to be perfectly inelastic.
 ECONOMICS – study of the allocation of scarce resources.
 From a business perspective, economics is concerned with studying the production,
 UTILITY – satisfaction derived from the acquisition or consumption of a particular good.
distribution and consumption of goods and services to maximize desired outcomes.
 LAW OF DIMINISHING MARGINAL UTILITY – the marginal (additional) utility from
consuming each additional unit usually decreases.
DIVISION DEFINITION MAJOR AREAS
 DISPOSABLE INCOME – amount of income consumers have after paying taxes. When
Study of choices that Demand and supply,
personal disposable income goes up, consumers buy more.
MICROECONOMICS individuals, households and prices and outputs,
 MARGINAL PROPENSITY TO CONSUME (MPC) (or Marginal Propensity TO SPEND)
business firms make. market structures
National income, describes how much of each additional peso in personal disposable income that the
Study of the effects on the aggregate supply and consumer will spend.
national economy and the aggregate demand,  MARGINAL PROPENSITY TO SAVE (MPS) – percentage of additional income that is
MACROECONOMICS saved.
global economy of these employment and
choices. inflation, governmental → Since consumers can either spend or save money: MPC + MPS = 100%
policies and regulation
Balance of payments, Where:
INTERNATIONAL Study of economic activities
currency exchange MPC = ∆ IN CONSUMPTION ÷ ∆ IN DISPOSABLE INCOME
ECONOMICS that occur between nations.
rates, globalization MPS = ∆ IN SAVINGS ÷ ∆ IN DISPOSABLE INCOME

CAPITALISM: FREE-MARKET ECONOMY SUPPLY

 POV: Producer/ Manufacturer/ Seller
 CAPITALISM – “free market” economic system where individuals & business firms
determine production, distribution and consumption.  SUPPLY – relationship between the price of a good and the quantity supplied.
 Resources are privately-owned.  QUANTITY SUPPLIED – amount of a good that producers plan to sell at a particular.
 Economic decisions are made primarily by individuals and business firms.  LAW OF SUPPLY – the higher the price of a good, the greater is the quantity supplied.
 The price is based on supply and demand in the general market.  SUPPLY CURVE – shows the positive relationship between the quantity supplied and
price. Supply curves are positively sloped.
 FACTORS OF PRODUCTION are the scarce economic resources needed to produce
goods and services. WHAT HAPPENS? OTHER NAMES
CHANGE IN MOVEMENT ALONG THE CHANGE IN QUANTITY
FOUR MOST COMMON FACTORS OF PRODUCTION PRICE SUPPLY CURVE SUPPLIED
1. LAND – Natural resources e.g., Land, water, mineral, timber ↑ IN SUPPLY DRIVES THE
SHIFT IN THE
2. LABOR – Human resources e.g., Human works, human skills, human efforts SUPPLY CURVE TO SHIFT CHANGE IN SUPPLY
SUPPLY CURVE
3. CAPITAL – Financial resources e.g., Savings and Man-made resources e.g., RIGHTWARDS
Equipment
4. ENTREPRENEURSHIP – Human resource that organizes land, labor and FACTORS AFFECTING SUPPLY EFFECT ON SUPPLY EXAMPLE
capital. As production costs go up, fewer
products will be supplied at a given
PRODUCTION COSTS INVERSE
DEMAND price. If costs go down, more
 POV: Consumer products will be produced.
An increase in the number of
 DEMAND – The relationship between the price of a good and the quantity demanded. It producers will cause an increase in
NUMBER OF PRODUCERS DIRECT
the amount of goods supplied at a
is also defined as the schedule of quantities of a good that people are willing to buy at
certain level of price.
different prices.
If other products can be produced with
 QUANTITY DEMANDED – amount that consumers plan to buy at a particular price.
PRICE OF SUBSITUTE GOODS INVERSE greater returns, producers will
 LAW OF DEMAND – the higher the price of a good, the smaller the quantity demanded. produce those goods.
 DEMAND CURVE – shows the inverse relationship between the quantity demanded and A rise in the price of a complement in
price. Demand curves are negatively sloped. PRICE OF COMPLEMENTARY
DIRECT production increases supply and
GOODS
shifts the supply curve rightward.
WHAT HAPPENS? OTHER NAMES If it is expected that prices will be
CHANGE IN MOVEMENT ALONG THE CHANGE IN QUANTITY EXPECTED FUTURE PRICES DIRECT higher for the good in the future,
PRICE DEMAND CURVE DEMANDED production of the good will increase.
↑ IN DEMAND DRIVES THE Technological advancement
SHIFT IN THE
DEMAND CURVE TO SHIFT CHANGE IN DEMAND TECHNOLOGY DIRECT increases supply and thus shifts the
DEMAND CURVE
RIGHTWARDS supply curve rightward.
Subsidies reduce the production
GOVERNMENT SUBSIDIES DIRECT
cost of goods and, therefore,

RAHYNE, CPA [@rrhdamcpa]

 increase the goods supplied at a  INETERMEDIATE GOOD – produced by one firm; component of the final good.
given price.
Increase in taxes would raise TWO PRINCIPAL METHODS OF CALCULATING GDP
GOVERNMENT TAX AND
INVERSE production costs, thereby EXPENDITURE (EXPENSE) APPROACH INCOME APPROACH
TARIFFS
decreasing supply. GDP = C + I + G + (X – M)
Government Unexpected storms may destroy
restrictions, weather farms, decreasing the supply of Where: GDP = WAGES + SELF-EMPLOYMENT
conditions, and certain crops. C  HOUSEHOLD CONSUMPTION INCOME + RENT + INTEREST + PROFITS
SPECIAL INFLUENCES
innovations or new I  BUSINESS INVESTMENT + INDIRECT BUSINESS TAXES (e.g., VAT)
method may affect G  GOVERNMENT SPENDING + DEPRECIATION & AMORTIZATION +
supply of goods. X  EXPORTS INCOME OF FOREIGNERS
M  IMPORTS
EQUILIBRIUM (X – M)  “NET EXPORTS”
*GDP is measured either in current prices (nominal GDP) or in prices of a given year (real GDP)
 EQUILIBRIUM – state wherein the demand and supply are in balance.
 EQUILIBRIUM PRICE – price at which the quantity demanded equal quantity supplied.  ECONOMIC GROWTH – happens when there is an increase in real GDP in an economy.
Also known as MARKET-CLEARING PRICE.  RECESSION – happens when there is a decline in real GDP growth (i.e., negative GDP
 EQUILIBRIUM QUANTITY – is the quantity bought and sold at the equilibrium price. growth)
 GROSS NATIONAL PRODUCT (GNP) – market value of all the final goods and services
 Equilibrium is a MARKET-CLEARING situation where no surplus or shortage exists. produced by citizens of a country.
WHERE THEREFORE CAUSE
PRICE CEILING BUSINESS CYCLES
- Maximum price
that a seller may  BUSINESS CYCLES – refer to cumulative fluctuations in real GDP over a period of time.
MARKET
ACTUAL PRICE < EQUILIBRIUM PRICE QD > QS charge for a good
SHORTAGE
and is normally STAGES IN ONE COMPLETE BUSINESS CYCLE
set below the I. Peak
equilibrium price.
II. Recession → aka CONTRACTION
PRICE FLOOR
III. Trough
- Minimum price
IV. Expansion → aka BOOM or RECOVERY
that a seller may
MARKET V. Peak
ACTUAL PRICE > EQUILIBRIUM PRICE QD < QS charge for a good
SURPLUS
and is normally
set above the  DEPRESSION – prolonged form of recession; major downsizing in the economy.
equilibrium price.
 Economists use ECONOMIC INDICATORS to forecast turns in the business cycle.
 GOVERNMENT INFLUENCES may change market equilibrium through various means:  LEADING INDICATORS – building permits, new orders for consumer
goods, stock prices
EQUILIBRIUM PRICE  COINCIDENT INDICATORS – level of retail sales, current unemployment
IF THEREFORE rate, level of industrial production
WILL
TAXES HIGHER ↑ PRODUCT INPUT COSTS HIGHER  LAGGING INDICATORS – duration of unemployment, loans outstanding,
SUBSIDIES - ↓ PRODUCTION COSTS LOWER ratio of inventories to sales
RATIONING - CURB [control] DEMAND LOWER
Government can affect price of commodity through price fiat by INFLATION AND UNEMPLOYMENT
REGULATION
establishing an artificial price ceiling or price floor.
*Externalities – Another factor that causes inefficiencies in the pricing of goods, which is the damage  INFLATION – sustained increase in an economy’s average price level.
to environment caused by production.
PRIMARY CAUSES
COSTS OF PRODUCTION  DEMAND-PULL INFLATION – happens when too much demand are not met by a
corresponding increase in the supply.
The analysis of PRODUCTION COSTS distinguishes analysis in the short run vs. analysis in the long  COST-PUSH INFLATION – happens when there is an increase in production costs
run: or higher cost of raw materials and other inputs (supply-shock theory)
 In the short run, at least one input of production is fixed (e.g., plant depreciation).
 In the long run, no inputs are fixed -- all inputs are variable (e.g., additional plant can be built). MOST COMMON INDICES TO MEASURE INFLATION
1. CONSUMER PRICE INDEX (CPI) – measures price changes for goods and services
 While business firm can vary all inputs in the long run, they must nevertheless operate in the short purchased by consumers.
run. Hence, analysis of production costs tends to focus on the SHORT RUN where total production
costs are separated into fixed costs and variable costs: (CPI this year) - (CPI last year)
INFLATION RATE = X 100
CPI last year
COST FORMULA LEGEND
1 TC FC + VC (= ATC x Q) TC = Total Cost ATC = Average TC 2. WHOLESALE PRICE INDEX (WPI) – measures the price changes at the wholesale
2 VC TC – FC (= AVC x Q) FC = Fixed Cost AVC = Average VC level, specifically finished goods, intermediate goods and crude materials.
3 FC TC – VC (= AFC x Q) VC = Variable Cost AFC = Average FC 3. GDP DEFLATOR – measures the changes in price for goods and services included
4 MC ∆TC ÷ ∆Q (=∆TVC ÷ ∆Q) MC = Marginal Cost Q = Quantity in GDP.
5 ATC TC ÷ Q (= AFC + AVC) ∆TC = Change in total Cost Nominal GDP
6 AVC VC ÷ Q (= ATC – AFC) ∆Q = Change in Quantity GDP DEFLATOR = X 100
Real GDP
7 AFC FC ÷ Q (= ATC – AVC) ∆ATC = Change in Total Variable Cost
 DEFLATION – decrease in the average price level.
 LAW OF DIMINISHING RETURNS – cause of inefficiencies; an economic theory that  DISINFLATION – decline in inflation rate.
predicts that after some optimal level of capacity is reached, adding additional factor of  DEFLATIONARY SPIRAL – when prices are falling, consumers delay purchase and
production will actually result in small increases in output. businesses delay investments, both in anticipation of lower future prices.
 HYPERINFLATION – very high rate of inflation.
 LONG-RUN production costs are all variable costs.  STAGFLATION – occurs when an economy’s output (real GDP) decreases and its price
 ECONOMIES OF SCALE (a decline in ATC) [Advantage] level rises – production stagnates while prices go up.
Example: ↑ Labor hours by 10%, ↑Output by 50%. Hence, ATC decreases.
 DISECONOMIES OF SCALE (an increase in ATC) [Disadvantage]  There is an inverse relationship between inflation and unemployment rate.
Example: ↑ Input by 60%, ↑Output by 3%. Hence, ATC increases.
 CONSTANT RETURNS TO SCALE (long-run ATC does not change) NUMBER OF PEOPLE UNEMPLOYED
Example: Doubling production by doubling production facility. UNEMPLOYMENT RATE = X 100
LABOR FORCE

 LABOR FORCE = EMPLOYED + UNEMPLOYED

PROFIT AND MARKET STRUCTURES
ILLUSTRATION
 TWO CONCEPTS OF PROFIT Europa has a total population of 20M, and of these, 420K are currently out of work and another
To an accountant: ACCOUNTING PROFIT = TOTAL REVENUE – EXPLICIT 400K are actively searching for new employment. A further 1M are retires, 1.2M are students
COSTS and 1.2M choose to not work. What is Europa’s current unemployment rate?
To an economist: ECONOMIC PROFIT = TOTAL REVENUE – EXPLICIT COSTS –
IMPLICIT COSTS LABOR FORCE = 20M – 1M – 1.2M – 1.2M = 16.6M
UNEMPLOYMENT RATE = 820K ÷ 16.6M = 4.94%
 EXPLICIT COSTS – expenses incurred or to be paid.
 IMPLICIT COSTS – opportunity costs and do not involve actual payments. THREE (3) TYPES OF UNEMPLOYMENT RATE
1. CYCLICAL – ↑ Recession, ↓ Expansion
FOUR BASIC MARKET STRUCTURES 2. FRICTIONAL – new college graduates or newly resigned employees (temporary)
3. STRUCTURAL – mismatch between the kind (location) of jobs available and the skills
PRICE EASE OF COMMON (location) of those who are unemployed.
MARKET # OF FIRMS PRODUCTS
CONTROL ENTRY EXAMPLES
PURE Identical or Very Easy Agricultural
COMPETITION
VERY MANY
Homogenous
None
(No Barrier) Products FISCAL POLICY vis-à-vis MONETARY POLICY
MONOPOLISTIC Similar but Fairly Easy Fast Food,
MANY Limited
COMPETITION Differentiated (Low Barrier) Cosmetics  FISCAL POLICY – refers to government actions to achieve economic goals.
Standardized  FISCAL EXPANSION – an increase in deficit.
Limited or Appliances, Oil
OLIGOPOLY FEW with Hard
Differentiation
Wide Cars, Computers  FISCAL CONTRACTION – increase in taxes to reduce a deficit.
Government  MONETARY POLICY – changing interest rates and the money supply in the economy.
PURE MONOPOLY ONE Unique Wide Blocked Franchise, Utility
Companies ECONOMIC THEORIES

 MONOPSONY – market where only one buyer exists for all sellers.  CLASSICAL ECONOMIC THEORY – market equilibrium will eventually result in full
 BLACK MARKET – illegal market. employment over the long-run without government intervention.
 KEYNESIAN THEORY – economy does not necessarily move towards full employment on
GROSS DOMESTIC PRODUCT its own.
 MONETARIST THEORY – focuses on the use of monetary policy to control economic
 GROSS DOMESTIC PRODUCT – market value of all the final goods and services produced growth.
by a country.
 FINAL GOOD – an item that is bought by its final user.
RAHYNE, CPA [@rrhdamcpa]
 SUPPLY-SIDE THEORY – bolstering [strengthening] an economy’s ability to supply more CASH AND MARKETABLE SECURITIES
goods is the most effective way to stimulate growth.
 NEO KEYNESIAN THEORY – focuses on using a combination of fiscal and monetary  Managing cash and its temporary investment efficiently.
policy.
FOUR (4) REASONS FOR HOLDING CASH
INTERNATIONAL TRADE AND FOREIGN CURRENCY 1. TRANSACTION MOTIVE (LIQUIDITY MOTIVE) – to facilitate normal transactions of the
business.
COMMON REASONS FOR INTERNATIONAL TRADES 2. PRECAUTIONARY MOTIVE (CONTINGENT MOTIVE) – to provide for buffer [protection]
 EXPANSION – to develop new markets. against contingencies.
 OUTSOURCING – to obtain commodities. 3. SPECULATIVE – to avail of profit-making opportunities e.g., sudden price drop
 COST-CUTTING – to obtain goods and services at lower costs. 4. CONTRACTUAL MOTIVE – required by contracts or covenants e.g., compensating
balance
 COMPARATIVE ADVANTAGE – one country has the ability to produce a good or service
at a lower opportunity cost.  OPTIMAL CASH BALANCE (OCB) aka ECONOMIC CASH QUANTITY (ECQ) or
 OPPORTUNITY COST – money value benefits lost. ECONOMIC CONVERSION SIZE (ECS)
 BALANCE OF TRADE = EXPORTS – IMPORTS  based on the following formula under the BAUMOL model (named after the American
 TRADE SURPLUS – Exports > Imports economist William Baumol)
 TRADE DEFICIT – Imports > Exports
 TARIFF – tax on an imported product. OPTIMAL CASH BALANCE (OCB)
 QUOTA – a restriction on the amount of a good that may be imported during a period. WHERE:
 FOREIGN EXHANGE MARKET – currency of one country is exchanged for the currency of 2DT D → Annual Demand for Cash
OCB = √ T → Costs per Transaction
another. O
 EXCHANGE RATE – price of one currency unit expressed in units. O → Opportunity Cost of Holding Cash
 DIRECT – domestic price of one unit of foreign currency. WHERE:
OPPORTUNITY COSTS = (OCB ÷ 2) x O
 INDIRECT – foreign price of one unit of domestic currency. (OCB ÷ 2) → AVERAGE CASH BALANCE
 SPOT – for immediate delivery. WHERE:
TRANSACTION COSTS = (D ÷ OCB) x T
(D ÷ OCB) → NUMBER OF TRANSACTIONS PER YR
 FORWARD – for future exchange or delivery.
*OCB – optimal amount of cash to be raised by selling marketable securities
*D – total amount of new cash needed
EFFECTS OF CURRENCY APPRECIATION EFFECTS OF CURRENCY DEPRECIATION
*T – fixed costs of trading securities
Cheaper foreign goods Cheaper domestic goods
*O – rate of return forgone on marketable securities
More domestic employments due to higher
Downward pressure of inflation
exports
Competition problems for domestic Higher cost of imported materials and other  BAUMOL MODEL – assumes the demand for cash is spread evenly throughout the year.
producers inputs  CASH BREAK-EVEN POINT (BEP) – sales level at which total cash inflows equal to total
cash outflows.
WORKING CAPITAL MANAGEMENT
FORMULA:
 WORKING CAPITAL MANAGEMENT (WCM) – managing the firm’s current assets and CASH BEP IN UNIT SALES = FIXED PAYMENTS ÷ UNIT CONTRIBUTION MARGIN
current liabilities to achieve a balance between risks (i.e., liquidity risks) and returns (i.e., CASH BEP IN PESO SALES = FIXED PAYMENTS ÷ CONTRIBUTION MARGIN RATIO
profitability)
 Liquidity risks – risks of not meeting short-term financial obligations due to insufficient ILLUSTRATION
cash. OPTIMAL CASH BALANCE – BAUMOL MODEL
 WORKING CAPITAL FINANCING – optimal level, mix and use of current assets and current
liabilities. Korea Co. is expecting to have total payments of P1.8M for one year, cost per transaction amounted
 PERMANENT (FIXED) – minimum working capital requirement regardless of the seasonal to P25 and the interest rate of marketable securities is 10%.
variations.
 SEASONAL (VARIABLE OR INCREMENTAL) – additional working capital is needed during A) What is the company’s optimal initial cash balance that minimizes total costs?
the more active business season. B) What is the total number of transactions or cash conversions that will be required per year?
C) How frequent in days shall Korea do the transaction or cash conversion within the year?
POLICY OTHER NAMES MEANING D) What will be the average cash balances for the period?
 Maintains high level of working capital. E) How much is the total cost of maintaining cash balances?
 Reduces liquidity risks but is
CONSERVATIVE RELAXED POLICY considered less profitable due to more A) OCB (“EOQ”): √2 (1.8M)25 ÷ 0.10 = 30K
reliance on long-term financing, which B) Number of transactions (“orders”): 1.8M ÷ 30K = 60 transactions
incurs relatively higher financing costs. C) Frequency (in days): 360 days ÷ 60 = every 6 days
 Minimum amount of working capital. D) Average cash balance: 30K ÷ 60 = 15K
 Enhances profitability by relying more E) Transaction (“Ordering”) cost: 60 (25) = 1.5K
on short-term debts rather than long-
AGGRESSIVE RESTRICTED POLICY Opportunity (“Carrying”) cost: 15K (10%) = 1.5K
term debts but is considered risky due to
Total Costs: 1.5K + 1.5K = 3K (lowest possible cost)
higher chances of short-term
insolvency.
BALANCED OR SEMI- Working Capital is not too high  CASH CONVERSION CYCLE (CCC) aka CASH FLOW CYCLE – the average time from the
AGGRESSIVE OR SEMI- (conservative) nor too low (aggressive). point cash is paid for raw materials or merchandise inventories until cash is collected on
MODERATE the accounts receivable.
CONSERVATIVE
POLICY
Matching the maturity of financing source  NORMAL OPERATING CYCLE (NOC) – length of time within which the firm purchases or
SELF-LIQUIDATING OR with an asset’s useful life e.g., short-term produces then sells inventory, and receives cash.
MATCHING
HEDGING POLICY assets are financed with short-term
liabilities. NORMAL OPERATING CYCLE & CASH CONVERSION CYCLE

ILLUSTRATION NOC = AVE. AGE OF INVENTORY + AVE. AGE OF RECEIVABLE

WORKING CAPITAL POLICY: CONSERVATIVE VS. AGGRESSIVE CCC = AVE. AGE OF INVENTORY + AVE. AGE OF RECEIVABLE – AVE. AGE OF PAYABLE

Australia Company has P1M in current assets, 40% of which are considered permanent current Alternatively, CCC = NOC – AVE. AGE OF PAYABLE
assets. In addition, the firm has P500K invested in fixed assets. In the current year, the company WHERE FORMULA OTHER NAME/S
reported earnings of P200K before considering the following interests and tax charges: AVE. AGE OF INVENTORY INV. ÷ CGS PER DAY INVTY CONVERSION PERIOD
AVE. AGE OF RECEIVABLE REC. ÷ SALES PER DAY REC. COLLECTION PERIOD
Short-term financing 5% AVE. AGE OF PAYABLE PAY. ÷ PURCH PER DAY PAYABLE DEFERRAL PERIOD
Long-term financing 10%
Tax rate 20% CASH MANAGEMENT STRATEGIES
 Help to shorten the CCC.
Plan A – Australia finances all fixed assets and half of its permanent current assets with long-term
financing. Requires customers to mail payments
Plan B – Australia finances all fixed assets and permanent assets plus half of its temporary current to a post office box, a local bank then
LOCKBOX
assets with long-term financing. Accelerating collections collects the checks from the box and
SYSTEM
deposit them promptly in the client’s
REQUIRED: account.
A.) How much is the difference in earnings after tax between Plan A and Plan B? Reducing precautionary
LINE OF CREDIT Predetermined borrowing limit.
idle cash
B.) Which working capital policy between Plan A and Plan B is considered conservative? Aggressive?
Requires checks to be written from
special disbursement accounts
TOTAL ASSETS: 1.5M PLAN A ZERO-BALANCE
Slowing disbursements having zero-peso balance with no
 FIXED ASSETS: 500K  10% (500K + 200K) ACCOUNT (ZBA)
minimum maintaining balance
 CURRENT ASSETS: 1M  5% (200K + 600K)
required.
PERMANENT (40%): 400K TOTAL INTEREST CHARGES: 110K
TEMPORARY (60%): 600K
 FLOAT – difference between cash balance per bank and cash balance per book
PLAN B
 POSITIVE/ DISBURSEMENT FLOAT: bank balance > book balance
 10% (500K + 400K + 300K)
 5% (300K) Possible cause: Outstanding checks issued by the firm that have not cleared yet.
TOTAL INTEREST CHARGES: 135K  NEGATIVE or COLLECTION FLOAT: book balance > bank balance
1. MAIL FLOAT – mailed by customers but not yet received by the seller.
PLAN A PLAN B 2. PROCESSING FLOAT – received by the seller but not yet deposited.
EBIT 200K EBIT 200K 3. CLEARING FLOAT – deposited but have not cleared yet.
INTERESTS (110K) INTERESTS (135K)
EBT 90K EBT 65K  MARKETABLE SECURITIES – short-term money market instruments that can easily be
TAX (20%) (18K) TAX (20%) (13K) converted to cash.
NET INCOME 72K NET INCOME 52K
COMMON EXAMPLES
A) 72K – 52K = 20K  CERTIFICATES OF DEPOSITS (CD) – saving deposits at financial institutions (e.g.,
Time Deposit)
B)  MONEY MARKET FUNDS – commercial paper, and other large-denomination, high-
 CONSERVATIVE: PLAN B (LOW RISKS, LOW RETURNS) yield securities.
 AGGRESSIVE: PLAN A (HIGH RISKS, HIGH RETURNS)  GOVERNMENT SECURITIES
 Mas maraming chinarge sa short-term financing.

RAHYNE, CPA [@rrhdamcpa]

 TREASURY BILLS – debt instruments representing obligations of the (EOQ ÷ 2) → AVERAGE INVTY IN UNITS
National Government and usually sold at a discount through competitive WHERE:
ORDERING COSTS = (D ÷ EOQ) x O
bidding. (D ÷ EOQ) → NUMBER OF ORDERS PER YR
CB BILLS OR CERTIFICATES OF INDEBTEDNESS (CBCIs) – If Safety Stock is maintained, AVERAGE INTY = (EOQ ÷ 2) + SAFETY STOCK
indebtedness by the Central Bank.
 COMMERCIAL PAPERS – short-term, unsecured, material promissory notes issued ILLUSTRATION
by private corporations. ECONOMIC ORDER QUANTITY, CARRYING COSTS AND ORDERING COSTS
 REPURCHASE AGREEMENTS – Commitment to resell the security at the original
contract price plus an agreed interest income. Squid Game Co. requires 40K units for its signature product “4-5-6”. The units will be used evenly
 BANKERS’ ACCEPTANCES – a draft drawn which is accepted by the bank becomes throughout the year. The cost to place one order is P250 while the cost to carry the inventory for one
a negotiable instrument and is available for investments. year is P5 per unit.

RECEIVABLE MANAGEMENT REQUIRED:

A) Determine the optimal order quantity (EOQ).
 Refers to set of policies, procedures and practices with respect to managing collectibles. B) How many and how often orders should be placed within a year?
C) Determine the average inventory in units.
 CREDIT STANDARD: consider the “5 C’s” in determining which customer shall be granted D) Determine the annual inventory carrying costs.
credit and how much will the credit limit be. E) Determine the annual inventory ordering costs.
 Character – willingness to pay
 Capacity – ability to generate cash flows A) EQ = √2 DO ÷ C = √2 (40K) 250 ÷ 5 = √4M = 2K units
 Capital – financial sources (i.e., net worth) B) Number of orders: 40K units ÷ 2K units = 20 orders = D ÷ EOQ
 Conditions – economic or business conditions. Frequency: 360 ÷ 20 orders = every 18 days = 360 ÷ No. of orders
 Collateral – pledges to secure debt. C) Average inventory: EOQ ÷ 2 = 2K units ÷ 2 = 1K units (Simple Average)
D) Carrying Costs: (EOQ ÷ 2) C = 1K (5) = 5K
 CREDIT TERM – (1)credit period and (2)cash discount offered. E) Ordering Costs: (D ÷ EOQ) O = 20 (250) = 5K
TOTAL COST 10K
ILLUSTRATION
AVERAGE INVESTMENT IN ACCOUNTS RECEIVABLE  REORDER POINT – refers to the number of units at which goods should be re-ordered to
minimize the sum of carrying costs and stock-out costs.
SG Co. sells on terms of 2/10, n/30. 75% of customers normally avail of the discounts. Annual sales o STOCK-OUT COSTS – opportunity costs and other costs incurred when inventory
are 9M, 80% of which is made on credit. Cost is approximately 80% of sales. units run out-of-stock e.g., lost contribution margin on sales.

REQUIRED: REORDER POINT

A) Average balance of AR. B) Average investment in AR.
REORDER POINT = DELIVERY TIME STOCK + SAFETY STOCK
 Credit Sales: 9M (80%) = 7.2M
 Average Daily Credit Sales: 7.2M ÷ 360 days = 20K Alternatively: REORDER POINT = MAX LEAD TIME x AVE. USAGE PER UNIT OF TIME
 Average Collection Period: 75% (10 days) + 25% (30 days) = 15 days WHERE:
 Average AR balance: 20K x 15 days = A) 300K DELIVERY TIME STOCK = NORMAL LEAD TIME x AVE. USAGE PER UNIT OF TIME
AR BALANCE = DAILY CREDIT SALES x COLLECTION PERIOD SAFETY STOCK = (MAX. LEAD TIME – NORMAL LEAD TIME) AVE. USAGE PER UNIT OF TIME
Alternatively, DEMAND-BASED = (MAX. USAGE – NORMAL USAGE) X NORMAL LEAD TIME
 Average Investment in AR: 300K x 80% = B) 240K
 LEAD TIME – period from the time an order is placed until such time the same order is
ILLUSTRATION
received.
COLLECTION POLICY – CASH DISCOUNT
 NORMAL/ AVERAGE LEAD TIME – refers to the usual delay.
 MAXIMUM LEAD TIME – add to normal lead time.
Taiwan Co. presents the following information:
 Annual credit sales: P36M AR BALANCE = DAILY CREDIT SALES x COLLECTION PERIOD
 SAFETY STOCK (aka BUFFER STOCK) – extra number of units maintained to protect
 Collection period: 2 months against stock-out costs.
 Rate of return: 14%  Alternatively, safety stock may be computed using the demand-based formula:
Taiwan considers changing its credit term from n/30 to 2/10, n/30 with the following expected results: (MAX. USAGE – NORMAL USAGE) x NORMAL LEAD TIME
(1) 50% of its customers will take advantage of the discount while sales remain constant.
(2) Collection period is expected to decrease from two months to one month.
 Applications of EOQ:
 When used for production, EOQ becomes the ECONOMIC LOT SIZE (ELS):
REQUIRED:
What is the net advantage (disadvantage) of implementing the proposed discount?
ILLUSTRATION
REORDER POINT AND SAFETY STOCK
 Average Daily Credit Sales: 36M ÷ 360 days = 100K
 AR Balance (Now): 100K x 60 days = 6M Gong Yoo purchases 7.2K units of its product every year. Gong Yoo works 360 days per year. The
 AR Balance (New): 100K x 30 days = 3M normal purchase lead time is 10 working days while maximum lead time is 15 working days.
 Annual Return: 14% (6M – 3M) = 420K
 Discount To Be Taken: 50% (36M) x 2% = 360K REQUIRED:
 Net Advantage: 420K – 360K = 60K A) Safety (Buffer) stock B) Reorder point

ILLUSTRATION Average Inventory Average Daily Demand

CREDIT POLICY – RELAXATION OF CREDIT STANDARDS & EXTENSION OF CREDIT (EOQ ÷ 2) + Safety Stock 7.2K units ÷ 360 days = 20 units
PERIOD
A) Safety (Buffer) Stock
UK Co. reports the following information: (15 days – 10 days) 20 = 100 units*
Selling price per unit P 10 VCR: 80%*
Variable cost per unit P8 CMR: 20%** B) Reorder Point
Total Fixed Costs P 120K (15 days) 20 = 300 units
Annual credit sales 240K units AR BALANCE = DAILY CREDIT SALES x COLLECTION PERIOD
Collection period 3 months Alternative solution:
Rate of return 25% (10 days) 20 + 100* = 300 units
UK considers relaxing its credit standards and extending its credit period. The following results are
expected: (1) sales will increase by 25%; (2) collection costs will increase by P40K; (3) bad debt ILLUSTRATION
losses are expected to be 5% on the incremental sales; and (4) collection period will increase to 4 SAFETY STOCK & STOCK-OUT COSTS
months.
REQUIRED: Each stock-out of a product sold by X Co. costs P2K per occurrence. The carrying cost per unit of
What is the net advantage (disadvantage) of implementing the relaxation of credit standards and inventory is P5 per year and the company orders 18 times a year at a cost of P200 per order.
extension of credit period? Unit of Safety Stock Probability of a Stock-Out
0 50%
 Increase in Sales: 25% (240K units x P10) = 600K 200 40%
400 30%
 Annual Benefit (Increase in CM): 600K x 20%** = (1) 120K
600 20%
 Increase in Collection Costs: (2) 40K
800 10%
 Incremental Bad Debt Losses: 5% (600K) = (3) 30K
What is the optimal level of safety stock?
 AR Balance (Now): (2.4M ÷ 360 days) x 90 days = 600K
 AR Balance (New): (3M ÷ 360 days) x 120 days = 1M Safety Stock Carrying Cost + Stock-out Costs = Total Costs
 Opportunity Costs: (1M – 600K) x 80% x 25% = (4) 80K 0 0 36K (50%) 18K
 Net Disadvantage: 120K – (40K + 30K + 80K) = 30K 200 200 (5) 36K (40%) 15.4K
400 400 (5) 36K (30%) 12.8K
INVENTORY MANAGEMENT 600 600 (5) 36K (20%) 10.2K
800 800 (5) 36K (10%) 7.6K (lowest)
ECONOMIC ORDER QUANTITY (EOQ)
 Unit Carrying Costs: P5 (given)
 EOQ – refers to the order size (number of units) that minimizes the sum of ordering costs  Maximum stock-out cost: P36K  2K x 18 orders
and carrying costs.
 CARRYING COSTS - ↑Order Size, ↑Total Carrying Costs ECONOMIC LOT SLOT (ELS) WHERE:
Examples: Storage, insurance, spoilage, obsolescence, security, record-keeping, P → ANNUAL PRODUCTION IN UNITS
interest foregone 2PS S → SETUP COSTS PER BATCH OF
 ORDERING COSTS - ↑Order Size, ↓Total Ordering Costs ELS = √ PRODUCTION
C
Examples: Delivery, inspection, handling, purchasing, processing, receiving, quantity C → COST OF CARRYING ONE UNIT FOR
discount lost ONE YEAR

ECONOMIC ORDER QUANTITY (EOQ)  OCB  When used for cash management, EOQ becomes OPTIMAL CASH
WHERE: BALANCE (OCB).
2DO D → Annual Demand or Usage in Units
EOQ = √ O → Costs of placing one Order
C
C → Cost of Carrying one unit for one year
CARRYING COSTS = (EOQ ÷ 2) x C WHERE:

RAHYNE, CPA [@rrhdamcpa]

ILLUSTRATION ILLUSTRATION
ECONOMIC LOT SIZE SHORT-TERM CREDIT FINANCING – RECEIVABLE FACTORING

X Bookstore publishes a book about RFBT. X Co. prints 20K copies of the book evenly throughout Panglao Co. has 200K in receivable that carries 30-day credit term, 2% factor’s fee, 6% holdback
the year. The set-up cost is P600 while the optimal production run (economic lot size) is 2K. reserve and an interest of 12% per annum on advances.

REQUIRED: REQUIRED:
How much is the unit carrying cost of the book per year? A) How much is the cash proceeds from factoring the receivable?
B) What is effective annual rate of financing thru factoring the receivable?
ELS = √2PS ÷ C
A) 200K 1,840+4K 360
2K = √2 (20K) 600 ÷ C
(4K)  Fee (2%) B) X
182,160 30
(2K)2 = (√2 (20K)600 ÷ C)2 (12K)  Holdback (6%) = 3.205…% (12)
184K = 38.47%
4M = 24M ÷ C (1,849)  Interest: 184K x 12% x (30/360)
C = P6.00 182,160

SHORT-TERM CREDIT FINANCING COST OF CAPITAL, LEVERAGE & CAPITAL STRUCTURE

FACTORS COSIDERED IN SELECTING  COST OF CAPITAL – rate of return necessary to maintain market value or stock price of a
SOURCES OF SHORT-TERM FUNDS
SOURCES OF SHORT-TERM FUNDS firm.
UNSECURED CREDITS COST  Computed as a weighted average of the various long-term capital sources such
 e.g., accruals, trade credit and commercial  Effective costs of various credit sources. as: Long-Term Debt, Preferred Stock, Common Stock and Retained Earnings
papers. AVAILABILITY  OTHER NAMES: Minimum Acceptable Rate of Return, Required Rate of
SECURED LOANS  Readiness of credit as to when needed and Return, Hurdle Rate, Desired Rate, Standard Rate, Cut-Off Rate
 e.g., receivable financing – pledging and how much is needed.
factoring; inventory financing – blanket lien, INFLUENCE
SOURCE OF CAPITAL COST OF CAPITAL
trust receipts, warehouse receipts  Influence of use of one credit source and
Long-Term Debt Yield Rate (100% - Tax Rate)
BANKING CREDITS availability of other sources of financing.
Preferred Stock Yield Rate
 e.g., term loan, line of credit, revolving REQUIREMENT
Common Stock Yield Rate + Growth Rate
credit agreement  Additional covenants e.g., loans.
Retained Earnings Yield Rate + Growth Rate
COST OF SHORT-TERM FUNDS (Assume a 360-day year)
ILLUSTRATION
WEIGHTED AVERAGE COST OF CAPITAL
COST OF TRADE CREDIT WITH SUPPLIER

DISCOUNT RATE 360 DAYS Suyou co. wants to determine the weighted average cost of capital that it can use to evaluate capital
COST= X investment proposals. The company’s capital structure with corresponding market values follows:
100%-DISCOUNT RATE CREDIT PERIOD-DISCOUNT PERIOD

COST OF BANK LOANS (EFFECTIVE ANNUAL RATE) 8% Term Bonds 600K (30%)
10% Preferred stock (P100 par) 200K (10%)
INTEREST 360 DAYS Common stock (no par, 10K shares outstanding) 400K (20%)
COST = X Retained Earnings 800K (40%)
NET PROCEEDS LOAN TERM
TOTAL 2M (100%)
 If loan does not require a compensating balance:
 Non-discounted: Net Proceeds = Face Value Additional data:
 Discounted: Net Proceeds = Face Value Less Interest 1) Current market price per share: 2) Expected common dividend: P2 per share
 If loan requires a compensating balance:  Preferred stock: P100 3) Dividend growth rate: 4%
 Non-discounted: Net Proceeds = Face Value Less Compensating Balance  Common Stock: P40 4) Income tax rate: 30%
 Discounted: Net Proceeds = Face Value Less Interest Less Compensating Balance
REQUIIRED:
COST OF COMMERCIAL PAPERS A) Cost of bonds
B) Cost of preferred stock
INTEREST + ISSUE COSTS 360 DAYS C) Cost of common stock and retained earnings
COST = X
FACE VALUE - INTEREST - ISSUE COST PAPER TERM D) Weighted average cost of capital

COST OF FACTORING RECEIVABLES Additional Question:

What is the EPS if EBIT is P500K?
INTEREST + FACTOR' SFEE 360 DAYS Net Income - Preferred Dividends
COST = X
FACE VALUE - INTEREST - FACTOR' S FEE - FACTOR' SHOLDBACK REMAINING MATURITY PERIOD EPS =
Weighted Average CS Outstanding (WACSO)

EBIT or Operating Income P500K

ILLUSTRATION - Interests (8%) (48K)
SOURCE OF CAPITAL COST OF CAPITAL
SHORT-TERM CREDIT FINANCING – TRADE CREDIT Profit before tax 452K
Long-Term Debt Yield Rate (100% - Tax Rate)
- Taxes (30%) (135.6K) Preferred Stock Yield Rate
El Nido Trading purchases merchandise for P200K, 2/10, n/30 Profit after tax 316.4K Common Stock Yield Rate + Growth Rate
- Preferred dividends (10%) (20K) Retained Earnings Yield Rate + Growth Rate

Income available to common shares 296.4K Follow this formula to compute for the costs.
REQUIRED:
A) The annual cost of trade credit; B) The annual cost of trade credit if term is changed to 1/15, n/20.
296,400
EPS = = P29.64
4K 360 A) (2 ÷ 98) x [360 ÷ (30 – 10)]= 36.73% 10,000
X B) (1 ÷ 99) x [360 ÷ (20 – 15)] = 72.73%
196K* 20 days
Cost of Debt: Interest – Tax Savings = 48K – (150K – 135K) = 33.6K
= 2.04…% (18 times) = 36.73%
*Payment within Discount Period (98%)
SOURCES WEIGHT COSTS
ILLUSTRATION Bonds 30% 8% (1 – 0.3) = A) 5.6% 1.68%
Preferred Stock 10% 10% (100) ÷ 100 = B) 10% 1%
SHORT-TERM CREDIT FINANCING – BANK LOANS
Common Stock & RE 60% (2 ÷ 40) + 4% = C) 9% 5.4%
WEIGHTED AVERAGE COST OF CAPITAL (WACC) D) 8.08%
Bora Trading was granted a one-year P200K bank loan with 12% stated interest.
*600K x 5.6% = 33.6K  should be the final cost of debt
REQUIRED: The effective annual rate, under the following cases:
DIVIDEND PER SHARE
A) Bora receives the entire amount of P200K. DIVIDEND YIELD (%) =
B) Bora granted a discounted loan. MARKET PRICE PER SHARE
C) Bora is required to maintain a compensating balance P10K.
COST OF LONG-TERM DEBT  KD
D) Bora is required to maintain a compensating balance of 10% under a discounted loan.
 YIELD RATE – based on a debt instrument’s EFFECTIVE interest rate.
Interest: P x R x T A) 24K ÷ 200K = 12%
200K x 12% x (360/360) = 24K B) 24K ÷ (200K – 24K) = 13.64%
C) 24K ÷ 190K = 12.63% To approximate the YIELD-TO-MATURITY (YTM) rate on debt instrument:
D) 24K ÷ (180K – 24K) = 15.38%
INTEREST ± DISCOUNT (PREMIUM) AMORTIZATION
YTM =
Alternative Solutions (NET PROCEEDS + FACE VALUE) ÷ 2
B) 12% ÷ (100% - 12%) = 13.64%
D) 12% ÷ (100% - 12% - 10%) = 15.38% Alternatively,
Express the denominator as a weighted average based on “60-40”:
ILLUSTRATION DENOMINATOR = (NET PROCEDS x 60%) + (FACE VALUE x 40%)
SHORT-TERM CREDIT FINANCING – COMMERCIAL PAPER
CURRENT YIELD RATE
Elyu Co. plans to sell a 180-day commercial paper amounting to 100M, which it expects to pay a ANNUAL INTEREST
CY =
discounted interest of 12% per annum. Elyu expects to incur 100K in dealer placement fees and CURRENT MARKET PRICE
paper issue costs.
*Cost of long-term debt is expressed as after-tax since interest charges are tax deductible
REQUIRED: expenses.
Determine the effective cost of Elyu’s credit.
ILLUSTRATION
Interest: P x R x T COST OF DEBT: CURRENT YIELD vs. APPROXIMATE YIELD-TO-MATURITY
100M x 12% x (180/360) = 6M
6M+100K 360 Cici Co. has an outstanding P1K par value bond with 20 years to maturity. The bond carries an
EAR = X annual interest payment of P110 and is currently selling for P1,080.
100M-6M-100K 180

6.1M REQUIRED: Determine the following:

EAR = X 2=12.99% A) Current Yield
93.9M
B) Approximate Yield-to-Maturity (using simple average).
C) Approximate Yield-to-Maturity (using weighted average).

RAHYNE, CPA [@rrhdamcpa]

  A rise in price will reduce
Interest – Premium Amortization: A) 110 ÷ 1,080 = 10.19% the quantity of goods that can
110 – (80 ÷ 20) = 106* B) 106* ÷ 1,040 = 10.19% be purchased.
C) 106* ÷ 1,048 = 10.11%
Simple Average:  Using the CAPM approach in computing cost of common equity and retained earnings,
(1,080 + 1K) ÷ 2 = 1,040 the formula is:
KE = KRF + β (KM – KRF)
Weighted Average: WHERE,
1,080 (60%) + 1K (40%) = 1,048
KE → EXPECTED/ REQUIRED RATE OF RETURN
 Used as cost of equity capital.
COST OF PREFERRED STOCK (PS)  KP
KRF → RISK-FREE RATE
 Based on Treasury Bill (T-Bill) rate.
 The yield rate that must be used for preferred shares is the DIVIDEND YIELD.
β→ BETA COEFFICIENT
 Measure the volatility (sensitivity) or systematic risk of a security compared to the stock market.
DIVIDEND RATE DIVIDEND PER SHARE

DIVIDEND PER SHARE PRF. DIV. RATE X PAR VALUE PER SHARE β>1 Stock price is more volatile than the stock market.
DIVIDEND RATE = β=1 Stock price is as volatile as stock market.
MARKET PRICE PER SHARE
β<1 Stock price is less volatile than stock market.
*Market price per share – should be net of any flotation or issue costs. *A negative value for β signifies that stock price moves in opposite direction with the stock market.
* KM – MARKET RETURN; (KM – KRF) – MARKET RISK PREMIUM; β (KM – KRF) – RISK PREMIUM
 FLOTATION COST – cost of issuing or floating securities in the market.
LEVERAGE
ILLUSTRATION:
COST OF PREFERRED STOCK  LEVERAGE – In business, it refers to the usage of fixed costs, representing risks to the
firm.
Aamon Co. pays an annual dividend of P10 per share for its preferred stock with a P100 par value.  OPERATING LEVERAGE – represents risk of being unable to cover fixed operating costs.
Aamon can sell each share of preferred stock for a price of P125.
CM ∆ % IN EBIT
DEGREE OF OPERATING LEVERAGE (DOL)= OR
REQUIRED: Determine the following: EBIT ∆ % IN SALES
A) Cost of preferred stock (assuming a tax rate of 25%). WHERE,
B) Cost of preferred stock (assuming a flotation cost of P25 per share). CM (CONTRIBUTION MARGIN) = SALES – VARIABLE COSTS
EBIT (EARNINGS BEFORE INTEREST AND TAXES) = CM – FIXED OPERATING COSTS
A) 10 ÷ 125 = 8%
B) 10 ÷ (125 – 25)  FINANCIAL LEVERAGE – represents risk of being unable to cover fixed financial
obligations.
COST OF COMMON STOCK (CS) & RETAINED EARNINGS (RE)  KE
EBIT ∆ % IN EPS
DEGREE OF FINANCIAL LEVERAGE (DFL)= OR
 Yield rate is the Dividend Yield. EBIT - FFC ∆ % IN EBIT
 Dividend per share must be based on the next dividend to be paid i.e., expected dividend. WHERE,
EXPECTED DIVIDEND PER SHARE = PAST/PRESENT DIVIDEND PER SHARE X (100% + FFC (FIXED FINANCING CHARGES) = INTEREST CHARGES + PRE-TAX PREF. DIVIDENDS
GROWTH RATE
 In computing cost of CS & PS, market price per share should be net of any flotation or  TOTAL LEVERAGE – measure of total risk, determines how EPS is affected by a change
issue costs. in sales.
CM ∆ % IN EPS
 In computing cost of RE, flotation cost should be ignored as RE is neither sold nor issued. DEGREE OF TOTAL LEVERAGE (DTL) = OR
EBIT - FFC ∆ % IN SALES
ILLUSTRATION
Alternatively, DTL = DOL x DFL
COST OF COMMON EQUITY: GORDON GROWTH MODEL (GGM)

ILLUSTRATION
Joy Co.’s common stock is selling for P50 per share with 20% flotation cost and a dividend per share
LEVERAGE: DOL, DFL & DTL
of P2. Both earnings and dividends are expected to grow by 5%. Tax rate is 30%.

REQUIRED: Determine the following. Novaria Co. sells 50K units of a product at P10 each. The unit variable cost is P8 while the fixed
operating costs amounted to P50K. The co. has current interest charges of P6K and preferred
A) Cost of common stock (assuming the P2 dividend is yet to be paid).
B) Cost of common stock (assuming the P2 dividend was just paid recently). dividends of P2.4K. The corporate tax rate is 40%.
Fixed Financing Charges*
C) Cost of retained earnings (assuming the P2 dividend is yet to be paid).  Interest: 6K
D) Cost of retained earnings (assuming the P2 dividend was just paid recently). REQUIRED: Determine the following: Fixed Costs (given)  P. Div.: 4K
A) Degree of operating leverage (DOL)  50K 10K*
*Expected Dividend: 2 (1.05) = 2.1 A) (2 ÷ 40**) + 5% = 10% B) Degree of financial leverage (DFL)
*Price (net of FC): 50 (80%) B) (2.1* ÷ 40**) + 5% = 10.25% C) Degree of total leverage (DTL)
C) (2 ÷ 50) + 5% = 9% D) What happens to DOL, DFL and DTL if sales increase by 50%? 2.4K ÷ (100% - 40%)
D) (2.1* ÷ 50) + 5% = 9.2%
50K units CM 100K
EBIT
ILLUSTRATION CM 100K FC (50K) 2x (DOL) 2.5x (DTL) - INTEREST
COST OF COMMON EQUITY: CAPITAL ASSETS PRICING MODEL (CAPM) - FC (50K) EBIT 50K 1.25x (DFL) EBT
EBIT 50K *FFC(10K) - TAX
Use the Security Market Line equation for CAPM in each of the following independent cases. 40K NET INCOME
75K units CM 150K 1.5x (DOL) - PS DIVIDENDS
CM 150K FC (50K) 1.67x (DTL) NET INCOME FOR CS
REQUIRED: - FC (50K) EBIT 100K 1.11x (DFL)
A) Determine the required rate of return for an asset with a beta 0.75 when the risk-free rate and EBIT 100K *FFC (10K)
market return are 8% and 12%, respectively. 90K
B) Determine the beta for an asset with a required rate of return of 15% when the risk-free rate and
market return are 10% and 12.5%, respectively. CAPITAL STRUCTURE
C) Determine the market return for an asset with a required rate of return of 16% and a beta of 1.20
when the risk-free rate is 10%.  CAPITAL STRUCTURE – refers to the mix of the long-term financing that comprises a
D) Determine the risk-free rate for a firm with required rate of return of 15% and a beta of 1.25 when firm’s sources of funds that mature beyond one year.
the market return is 14%. CAPITAL STRUCTURE = FINANCIAL STRUCTURE – CURRENT LIABILITIES
A) Ke = 8% + 0.75 (0.12 – 0.08) β = 2.0  OPTIMAL CAPITAL STRUCTURE (TARGET CAPITAL STRUCTURE) – mix of debt and
Ke = 11% C) 16% = 10% + 1.2 (Km – 10%) equity financing that maximizes a firm’s market value while minimizing its overall cost of
B) 15% = 10% + β (12.55 – 10%) Km = 15% capital.
β = 2.0 D) 15% = KRF + 1.25 (14% - KRF)  MARGINAL COST OF CAPITAL (MCC) – cost to the firm of the next peso of new capital
KRF = 10%
raised after exhausting internal source of financing (e.g., retained earnings).
 DEBT FINANCING – offers the lowest cost of capital due to its tax deductibility.
CAPITAL ASSET PRICING MODEL (CAPM): A RISK-BASED APPROACH
 TRADITIONAL THEORY OF CAPITAL STRUCTURE – when WACC is minimized and the
market value of assets is maximized, an optimal capital structure exists.
 A security risk consists of two components: (1) Diversifiable risks and (2) Non-
diversifiable risks.
VALUE OF THE FIRM = MARKET VALUE OF DEBT + MARKET VALUE OF COMMON EQUITY
OR, EBIT ÷ WACC
TYPE MEANING CATEGORIES
BUSINESS RISK
WHERE,
 Caused by fluctuations of
MARKET VALUE OF DEBT = INTEREST ÷ COST OF DEBT
earnings before interest and
taxes [EBIT]. MARKET VALUE OF COMMON EQUITY = (EBIT – INTEREST) ÷ COST OF COMMON EQUITY
DIVERSIFIABLE RISK LIQUIDITY RISKS
Portion of a security’s risk CAPITAL BUDGETING WITH INVESTMENT RISKS AND RETURNS
(Controllable or  Possibility that an asset may
that can be controlled
Unsystematic Risk or not be sold on short notice.
through diversification.
Company-Specific Risk)  CAPITAL INVESTMENT – long-term commitment of significant funds to meet certain
DEFAULT RISK objectives such as acquiring additional plant assets for business expansion.
 Risk that a borrower will be  INDEPENDENT CAPITAL INVESTMENT (for SCREENING DECISIONS) – projects that are
unable to make timely interest evaluated individually against predetermined corporate standard of acceptability.
and principal payments.  MUTUALLY EXCLUSIVE CAPITAL INVESTMENT (for PREFERENCE DECISIONS) –
MARKET RISK projects require choosing from among alternatives.
 Stock’s price will change  CAPITAL BUDGETING – process of measuring, evaluating, and selecting capital
due to changes in stock
investments.
NON-DIVERSIFIABLE market.
RISK
Results from forces SIX (6) FORMAL STAGES OF CAPITAL BUDGETING
(Non-controllable risk or INTEREST RATE RISK
outside the firm’s control. I. Identification and definition stage
Systematic Risk or  Resulting from fluctuations
Market-related risk) in the value of an asset as II. Search stage
interest rates change. III. Information-acquisition stage – both qualitative and quantitative information is
considered.
PURCHASING POWER RISK IV. Selection stage – choosing projects after cost-benefit evaluation
V. Financing stage
VI. Implementation and control stage – conduct of post-audit
RAHYNE, CPA [@rrhdamcpa]
 CAPITAL INVESTMENT FACTORS  BAILOUT PAYBACK PERIOD – is a payback method wherein cash recoveries include not
only the annual net cash inflows but also the estimated salvage value realizable at the
 NET INVESTMENTS end of each year of the project life.
 Primarily computed for investment decision-making purposes.
 Refer to COST (cash outflows) LESS SAVINGS (cash inflows) incidental to the ILLUSTRATION
acquisition of the capital investment projects. BAIL-OUT PAYBACK PERIOD
COSTS (Cash Outflows) SAVINGS (Cash Inflows)
A project costing P180K will produce the following annual cash flows and year-end salvage values:
 Purchase price of the asset, net of cash  Proceeds from sale of an old asset, net
discount. of related tax. Year 1 Cash Flows Salvage Value
 Freight, insurance, handling,  Trade-in value of the old asset (in case of 1 P50K P60K
installation, test runs. replacement) 2 P50K P55K
 Market value of existing idle assets.  Avoidable cost of immediate repairs on 3 P40K P50K
 Training cost, net of related tax. the old asset replaced, net of related tax. 4 P40K P45K

ILLUSTRATION: REQUIRED: Bail-out payback period.

NET INVESTMENT FOR DECISION-MAKING Y1 Y2 Y3
Investment 180K 180K 180K
Whitney Company, wanting increase production capacity, plans to replace an old machine with a Cash Flows (50K)  (50K)  (50K) Y1 (1)
new one: Salvage Value (60K) (50K)  (50K) Y2 (1)
I) The old machine was acquired three years ago. Its carrying value now is P 60,000, but it can be 70K (55K) (30K) Y3 (0.75) = 30K ÷ 40K
sold for P 70,000. Tax rate is 25%. 25K (50K) SV 2.75 years
II) The new machine can be acquired at a list price of P 500,000. A 10% cash discount is available if 0
paid for within 30 days from acquisition date. Excluded from the list price are following: shipping
charges of P 25,000, installation charges of P 18,000 and testing charges of P 15,000.  ACCOUNTING RATE OF RETURN – measures the capital project’s profitability from
III) Other assets with a book value of P 12,000 that are to be retired because of the acquisition of the accounting standpoint by relating the required investment to the annual net income.
new machine can be salvaged and sold for P 10,000.  NON-DISCOUNTED TECHNIQUE
IV) Additional working capital of P 20,000 will be needed to support operations planned with the new OTHER NAMES: Book Rate of Return, Simple Rate of Return, Unadjusted Rate of Return,
equipment. Financial Statement Rate of Return, Return on Capital Employed (ROCE)
V) The annual cash flow from the use of the new machine is P 50,000. At the end of its useful life of
5 years, the new machine must be disposed of with a zero-book value but with an expected salvage AVERAGE ANNUAL NET INCOME
ACCOUNTING RATE OF RETURN (ARR) =
value of P 4,000. ORIGINAL OR AVERAGE INVESTMENT

REQUIRED: ILLUSTRATION
A) What is the initial cost of net investments for decision-making purposes? PAYBACK PERIOD & ARR (EVEN CASH FLOWS)
B) What is the terminal cash flow expected at the end of life of the project?
Lady G Company plans to replace its old equipment. The cost of the new equipment is P 90,000,
COSTS (Cash Outflows) SAVINGS (Cash Inflows) with a useful life estimate of 8 years and a salvage value of P 10,000. The annual pre-tax cash
(II) *450K (I) 70K Tax on Gain on Sale savings from the use of the new equipment is P 40,000. The old equipment has zero market value
(II) 58K (2.5K)  10K x 25% and is fully depreciated. The company uses a cost of capital of 25%.
(IV) 20K (III) 10K Tax Savings/ Shield
528K 500  2K x 25% REQUIRED: Assuming that the income tax rate is 40%, determine: DECISION RULES (ACCEPTABLE)
78K A) Payback period  PB period ≤ Life ÷ 2
B) Accounting rate of return on original investment  ARR ≥ Costs of Capital
*Net Method: Net Investments: Costs – Savings C) Accounting rate of return on average investment
500K (90%) = 528K – 78K = A) P450K
NET INVESTMENTS 90K-0
Timing of Cash Flows Terminal Cash Flow A) PAYBACK PERIOD = = = A) 3.21 years
NET CASH INFLOWS 28K*
 Net Investment  Present (Year 0) (V) 4K Tax on Gain NET INCOME 18K***
 Net Returns  Future (Years 1 to 5) 1K  4K x 25%
B) ARR = = = B) 20%
NET INVESTMENT (Original) 90K
(IV) 20K NET INCOME 18K***
B) P23K C) ARR = = = C) 36%
NET INVESTMENT (Average) 50K**
*Terminal – will be received at the end of the life of an asset e.g., Salvage Value; One-time only
Simple Average = (Beg. Balance + End. Balance) ÷ 2
 NET RETURNS = (Cost + Salvage Value) ÷ 2 = (90K + 10K) ÷ 2 = 50K**
 Refer to either net income (under accrual basis) or net cash flows (under cash basis),
the latter may be computed under direct or indirect method: Net Cash IN before tax 40K
 DIRECT METHOD: NET CASH INFLOWS = CASH INFLOWS – CASH OUTFLOWS Less: Depreciation (10K)
 INDIRECT METHOD: NET CASH INFLOWS = NET INCOME + NON-CASH EXPENSES Profit before tax 30K
e.g., depreciation Less: Tax (40%) (12K)
Net Income 18K***
Add: Depreciation 10K
ILLUSTRATION
Net Cash IN after tax 28K*
NET RETURNS – INCREASE IN REVENUES
ILLUSTRATION
Mariah Cinema plans to install coffee vending machines costing P 200,000. Annual sales of coffee
PAYBACK PERIOD & ARR (UNEVEN CASH FLOWS)
are estimated to be 10,000 cups to be sold for P 15 per cup. Variable costs are estimated at P 6 per
cup, while incremental fixed cash costs, excluding depreciation, at P 20,000 per year. The machines
Katy P Co. has an investment opportunity costing P90K that is expected to yield the following cash
are expected to have a service life of 5 years, with no salvage value. Depreciation will be computed
flows over the next five years:
on a straight-line basis. The company’s income tax rate is 30%.
Year 1 Amount DECISION RULES (Acceptable)
1 40K  PB period ≤ Life ÷ 2
REQUIRED: Determine the following: 2 35K  ARR ≥ Costs of Capital
A) The increase in annual net income. 3 30K
B) The annual net cash inflows that will be generated by the project. 4 20K
5 10K
Sales 150K CASH INFLOWS 150K P135K
- VC (60K) - CASH OUTFLOWS (60K)
CM 90K (20K) REQUIRED: Assuming the hurdle rate of 30%, determine:
- FC (cash) (20K) (9K) A) Payback period in months
- FC (depreciation) (40K) B) NET CASH INFLOWS B) 61K (Direct Method) B) Book rate of return
Profit before tax 30K
- Tax (30%) (9K) A) Payback Period BB) ARR (Average)
Net Income A) P21K + 40K = B) P61K (Indirect Method) 90K  Year 1 (1 year)
ILLUSTRATION (40K) 90K*
50K = B) 20%
NET RETURNS – COST SAVINGS (90K+0) ÷ 2
(35K)  Year 2 (1 year)
Celine Company is planning to buy a high-tech machine that can reduce cash expenses by an 15K Net Income 9K*
average of P80,000 per year. The new machine will cost P 100,000 and will be depreciated for 5 (15K)  Year 3 (0.5 year) + Depreciation 18K  90K ÷ 5
years on a straight-line basis. No salvage value is expected at the end of the machine’s life. Income 0 A) 2.5 years Net Cash IN 27K  135K ÷ 5
= 30 months
tax rate is 25%.

REQUIRED:
 PAYBACK RECIPROCAL – provides a reasonable estimate of the internal rate of return
Determine the net cash inflows that will be generated by the project.
(IRR) provided that the following conditions are met:
Net cash IN before tax 80K  Alternative Solution
NET CASH INFLOWS 1
- Depreciation (20K) 80K (75%): 60K PAYBACK RECIPROCAL = =
Profit before tax 60K 20k (25%): 5K NET INVESTMENT PAYBACK PERIOD
- Tax (25%) (15K)  P65K
Profit after tax 45K *Payback reciprocal is a non-discounted technique used to estimate a discounted technique
+ Depreciation 20K (IRR).
Net Cash IN after tax 65K 
ILLUSTRATION
 COST OF CAPITAL – used as a discount rate in discounted capital budgeting techniques
like NPV and IRR. X Co. is planning to buy an equipment costing P640K with an estimate life of 30 years and is expected
to produce after-tax net cash inflows of P128K per year.
 PAYBACK PERIOD – measures the length of time required to recover the full amount of
initial investment. REQUIRED: Without using present value factors, what is the best estimate of the IRR?
 NON-DISCOUNTED TECHNIQUE
Payback period: 640K ÷ 128K = 5 years Payback reciprocal is a reasonable estimate of the
NET INVESTMENT Payback reciprocal: 1 ÷ 5 years = 20% internal rate of return (IRR) provided that the
PAYBACK PERIOD = following conditions are met:
NET CASH INFLOWS
 Payback period is at most half of the economic
life of the project [i.e., 5 years ≤ (30 ÷ 2)]

RAHYNE, CPA [@rrhdamcpa]

  Net cash inflows are uniform throughout the life REQUIRED: Assuming a cost of capital of 10% (round-off factors to four decimal places): Based on
of the project. the equivalent annual annuity, which project is more attractive?
Test of Reasonableness:
 PV Factor (20%, 30 years): 4.979 (rounded) Project Cash IN PV Factor PV, Cash In Cost NPV EAA
 PV, Cash In: 128K (4.979) = 637,312 MILEY 9,000 6.1446 55,301 50,000 5,301 862.77
 NPV: 637,312 – 640,000 = (P2,688)
SELENA 7,500 7.6061 57,046 50,000 7,046 926.33
2,688
= 0.42%
640,000 EAA = NPV ÷ PV Factor
Miley: EAA = 5,301 ÷ 6.1446
 NET PRESENT VALUE – measures the difference between the present value of cash
Selena: EAA = 7,046 ÷ 7.6061
inflows generated by the project and the amount of initial investment.
 CAPITAL RATIONING – is, given a constraint on capital budgets, the selection of
NPV = PRESENT VALUE OF CASH INFLOWS – PRESENT VALUE OF CASH OUTFLOWS
investment proposals that would maximize the over-all NPV of the firm.
 CASH INFLOWS – include annual net cash inflows and any cash realizable at the end of
ILLUSTRATION
the project life e.g., salvage value, return of working capital requirements
J-Lo Co. is considering five investment opportunities. The cost of capital is 12%.
 CASH OUTFLOWS – based on the net investment cost required at the inception of the
project.
Project Investment PV – Cash Flow NPV IRR (%) P.INDEX
1 P35K 39,325 P4,325 16 1.12
 PROFITABILITY INDEX
2 20K 22,930 2,930 15 1.15
 Expresses the present value of the cash benefits as to an amount per peso of investment
3 25K 27,453 2,543 14 1.10
in a capital project.
4 10K 10,854 854 18 1.09
 Used as a measure of ranking projects in descending order of desirability.
5 9K 8,749 (251) 11 0.97
PRESENT VALUE OF CASH INFLOWS
PROFITABILITY INDEX = REQUIRED:
PRESENT VALUE OF CASH OUTFLOWS A) Rank the projects in descending order of preference according to NPV, IRR and profitability index.
*A project is acceptable if its profitability index is more than 1.0.
B) If only a budget of P55K is available, which projects should be chosen?
 INTERNAL RATE OF RETURN (IRR)
Project NPV IRR PI B) Limited Budget: P55K
 Equates the present value of cash inflows to present value of cash outflows.
1 1st 2nd 2nd  1ST Combo: Projects 1 & 2
 IRR is the discount rate at which the NPV is zero.
2 2nd 3rd 1st  2ND Combo: Projects 2, 3 & 4
 IRR must be distinguished from CROSSOVER RATE (NPV Point of Indifference, Fisher  3RD Combo: Projects 1 & 4 
3 3rd 4th 3rd
Rate), which is the discount rate at which NPV of two capital investment projects are equal. Basis for selecting Projects 1 & 2
4 4th 1st 4th
OTHER NAMES: Time-Adjusted Rate of Return, Discounted Cash Flow Rate of Return, Profitability Index!
5 5th 5th 5th
Sophisticated Rate of Return, Break-Even Cash Flow Rate or Return.

ILLUSTRATION
 REAL OPTIONS – alternative actions that become available over the life of a capital
CROSSOVER RATE – NPV POINT OF INDIFFERENCE
investment.
Olivia Co. has a weighted average cost of capital of 12% and is evaluating two mutually exclusive
COMMON EXAMPLES
projects (Newton and Rodrigo), which have the following projections:
1. Option to delay
2. Option to expand
Project Newton Project Rodrigo
3. Option to abandon
Investment P1,000 P800
After-tax cash inflow P400 P400 4. Option to scale back
Asset life 4 years 3 years 5. Option to vary inputs/ output
6. Option to enter new market
The crossover rate for the two projects is closest to: 7. New product option

PV Factors 20% 19% 18% NPV Profile 20% 19% 18%  RISK ANALYSIS – in capital budgeting attempts to measure the likelihood of the variability
4 years 2.589 2.639 2.690 NEWTON P35.6 P55.6 P76 of future returns from the proposed investment.
3 years 2.107 2.140 2.174 RODRIGO P42.8 P56 P69.6
APPROACHES IN ASSESSING RISK IN CAPITAL INVESTMENTS
ILLUSTRATION Technique that adjusts the discount rate upward as
NPV, PROFITABILITY INDEX & IRR (EVEN & UNEVEN CASH FLOWS) RISK-ADJUSTED DISCOUNT RATE
investment becomes riskier.
Assumes a higher discount rate in later years of a
TIME-ADJUSTED DISCOUNT RATE
Madonna Co. gathered the ff. data on two capital investment opportunities: project’s life to uncertainties (e.g., inflation)
Project 1 Project 2 Considers multiple possible outcomes to determine
Cost of Investment P195,200 P150,000 SCENARIO ANALYSIS the overall expected outcome based on weighted
Cost of Capital 10% 10% average of all possible outcomes.
Expected useful life 3 years 3 years Uses forecasts of may NPVs under various “what-if”
Net cash inflows 100,000 100,000* SENSITIVITY ANALYSIS assumptions to see how sensitive NPV is to
*This amount is to decline by P20K annually thereafter. changing conditions.
Computer-based analysis that considers
REQUIRED: Round-off present value factors to three decimal places. uncertainties and probability distributions for
MONTE CARLO SIMULATION
inputs and uses random number of inputs to map
NPV = PV, CASH IN – PV, CASH OUT DECISION RULE (acceptable)
range of possible outcomes.
PI = PV, CASH IN ÷ PV, CASH OUT PI ≥ 1
Probability-based technique used when
IRR: PV, CASH IN = PV, CASH OUT IRR ≥ COST OF CAPITAL
management needs to decide through a series of “if-
DECISION TREE
then” scenarios that describe how the firm might react
A) Project 1’s NPV C) Project 1’s PI: based on future events.
PV, Cash IN 248,700  100K (2.487) 248,700
= 1.27x INVESTMENT RISKS AND RETURNS
PV, Cash Out (195,200) 195,200
P53,500
 INVESTMENT RISK - possibility that actual investment returns will differ from expected
D) Project 2’s PI:
202,040 return, which could result to either gain or loss.
B) Project 2’s NPV
= 1.27x OTHER NAMES: Security Risk & Speculative Risk
Y1: 100K (0.909): 90,900 150,000
Y2: 80K (0.826): 66,080 E) Project 1’s IRR:
COMPONENTS OTHER NAMES MEANING
Y3: 60K (0.751) 45,060 PV, Cash In = PV, Cash Out
 Unique to a given security.
PV, Cash In 202,040 100K (PV Factor) = 195.2K UNSYSTEMATIC/
DIVERSIFIABLE RISK  Default risk, business risk, liquidity
PV, Cash Out (150,000) CONTROLLED RISK
fall under this category.
P52,040 Target PV Factor  1.952
Life: 3 years, Discount Rate: 25% (IRR)  Not unique to a given security.
SYSTEMATIC/ NON-  Market risk, political risk,
NON-DIVERSIFIABLE
TRIAL & ERROR METHOD CONTROLLABLE purchasing power risk, foreign
RISK
Life: 3 years Target PV Factor RISK exchange risk normally would fall
A) 23%  2.011  1.952 under this category.
B) 27%  1.896
F) Project 2’s IRR:  STANDARD DEVIATION (SD)
 Measure of dispersion of potential returns from average returns.
PV, Cash In = PV, Cash Out  Commonly used to quantify risk of investment.
??????? = 150,000  The higher the SD, the higher the risk of an investment.

Choice A: 30% Choice B: 31%  STANDRAD ERROR OF THE MEAN

Year 1: 100K (0.769) Year 1: 100K (0.763)  Always smaller than SD.
Year 2: 80K (0.592) Year 2: 80K (0.583)  Measures how far a sample mean (e.g., expected return) deviates from the actual mean
Year 3: 60K (0.455) Year 3: 60K (0.445) of a population.
151,560 149,640  closer to P150K
 When comparing investments that have different expected returns, the more appropriate
Target: 150K
measure of investment’s relative risk is the COEFFICIENT OF VARIATION, a measure of risk
 DISCOUNTED PAYBACK – length of time required to equalize the discounted cash flows per unit of return.
(using the cost of capital as a discount rate) and initial investment of a capital project.
STANDRAD DEVIATION (σ)
OTHER NAME: Break-Even Time COEFFICIENT OF VARIATION =
EXPECTED RETURN (μ)
 EQUIVALENT ANNUAL ANNUITY (EAA) – an NPV-based technique used to compare
capital investment projects with unequal lives. *The higher the coefficient of variation is, the riskier the investment is relative to its expected
OTHER NAME: Annualized NPV return.

ILLUSTRATION ILLUSTRATION
Project Cost Life Annual Cash Inflow CAPITAL BUDGETING UNDER RISK: COEFFICIENT OF VARIATION
Miley P50,000 10 years P9,000
Selena P50,000 15 years P7,500 Rihanna Co. considers to invest in one of two mutually exclusive projects: Project Chris vs. Project
Brown. Depending on the state of the economy, the projects would provide the following cash inflows
in each of the next 5 years. Consider the following probability distribution:

RAHYNE, CPA [@rrhdamcpa]

 TIME INTREST EARNED EBIT
State of Economy Probability Project Chris Project Brown (INTEREST COVERAGE RATIO) INTEREST PAYMENTS
Recession 30% P1K P500 *Equity multiplier aka equity ratio reciprocal may be computed based on formula: ASSETS ÷ EQUITY
Normal 40% P2K P2K
Prosperity 30% P3K P5K  EFFICIENCY RATIOS (UTILIZATION RATIOS/ ACTIVITY RATIOS)
 Measure an entity’s ability to use its assets and manage its liabilities effectively
REQUIRED: Determine the following: in the currently period.
 How quickly various accounts are converted into sales or cash.
Project Chris Project Brown
Expected Return A 2K D 2,450 RATIO FORMULA
Standard Deviation (rounded, whole amount) B 775 E 1,781 INVENTORY TURNOVER COST OF GOODS SOLD
Coefficient of Variation C 0.39 F 0.73 (FOR MERCHANDISERS) AVERAGE INVENTORY
NET CREDIT SALES
Assuming Rihanna is a conservative, risk-averse type of investor, which project is likely to be RECEIVABLE TURNOVER
AVERAGE RECEIVABLES
chosen? NET CREDIT PURCHASES
PAYABLE TURNOVER
AVERAGE PAYABLES
Project (1) (2) (3) = (1) x (2) (4) = (2) – (A) (5) = (4)2 x (1) FINISHED GOODS TURNOVER COST OF GOODS SOLD
Chris Probability Cash Flows Expected Return Cash Flows – ER Variance (FOR MANUFACTURERS) AVERAGE FG INVENTORY
Recession 30% 1,000 300 - 1,000 300,000 WORK-IN-PROCESS TURNOVER COST OF GOODS MANUFACTURED
Normal 40% 2,000 800 0 0 (FOR MANUFACTURERS) AVERAGE WIP INVENTORY
Prosperity 30% 3,000 900 1,000 300,000 RAW MATERIALS TURNOVER COST OF MATERIALS USED
(A) ER = P2,000 600,000 (FOR MANUFACTURERS) AVERAGE RM INVENTORY
INVENTORY TURNOVER FG TURNOVER + WIP TURNOVER + RM
B) SD = Square root of variance C) Coefficient of Variation (FOR MANUFACTURERS) TURNOVER
= SD ÷ ER AGE OF INVENTORY 360 days
SD = √600,000
= 775 ÷ 2K (INVENTORY CONVERSION PERIOD) INVENTORY TURNOVER
SD = P775 (rounded)
= 0.39 (rounded) AGE OF RECEIVABLE 360 days
(RECEIVABLE COLLECTION RECEIVABLES TURNOVER
Project (1) (2) (3) = (1) x (2) (4) = (2) – (A) (5) = (4)2 x (1) PERIOD)
Brown Probability Cash Flows Expected Return Cash Flows – ER Variance AGE OF PAYABLE 360 days
Recession 30% 500 150 - 1,950 1,140,750 (PAYABLE DEFERRAL PERIOD) PAYABLES TURNOVER
SALES
Normal 40% 2,000 800 - 450 81,000 ASSET TURNOVER
Prosperity 30% 5,000 1,500 2,550 1,950,750 AVERAGE TOTAL ASSETS
SALES
(D) ER = P2,450 3,172,500 FIXED ASSET TURNOVER
AVERAGE FIXED ASSETS
NORMAL OPERATING CYCLE AGE OF INVENTORY + AGE OF RECEIVABLES
E) SD = Square root of variance F) Coefficient of Variation G) Project Chris
= SD ÷ ER (LOWER Coefficient Of NORMAL OPERATING CYCLE – AGE OF
SD = √3,172,500 CASH CONVERSION CYCLE
= 1,781 ÷ 2,450 Variation) PAYABLES
SD = P1,781 (rounded) *Age of Receivable – also known as Receivable Collection Period, Days Sales Outstanding (DSO),
= 0.73 (rounded)
Number of Days Sales in Receivable, or Days Receivable
CAPITAL BUDGETING TECHNIQUES
DECISION RULE  PROFITABILITY RATIOS (PERFORMANCE RATIOS) – used to determine how well
TECHNIQUE FORMULA an entity can generate profits from its operations.
( ACCEPTABLE)

NET INVESTMENTS RATIO FORMULA

PAYBACK PERIOD GROSS PROFIT
NET CASH FLOWS PB PERIOD ≤ LIFE ÷ 2
GROSS PROFIT MARGIN
SALES
EBIT
OPERATING PROFIT MARGIN
ACCOUNTING RATE OF NET INCOME SALES
RETURN (ARR) NET INVESTMENTS ARR ≥ COST OF CAPITAL NET PROFIT
NET PROFIT MARGIN
SALES
NPV PV, CASH IN – PV, CASH OUT NPV ≥ 0 INCOME*
RETURN ON SALES
SALES
PV, CASH IN INCOME*
PI RETURN ON ASSETS
PV, CASH OUT PI ≥ 1 AVERAGE ASSETS
INCOME*
RETURN ON EQUITY
IRR PV, CASH ON = PV, CASH OUT IRR ≥ COST OF CAPITAL AVERAGE EQUITY

FINANCIAL STATEMENT ANALYSIS *WHY INCOME FIGURE TO USE?

 If the intention is to measure operational performance, income is expressed as before interest
 FINANCIAL STATEMENT ANALYSIS – involves evaluation of an entity’s past performance, and tax. Alternatively, income before ‘after-tax’ interest may be used to exclude the effect of
present condition, and business potentials. capital structure.
 HORIZONTAL ANALYSIS  If the intention is to evaluate total managerial effort, income is expressed after interest and
 Shows changes of corresponding FS items over a period. tax.
 Changes in the value of a particular FS item can be analysed in terms of amount or in  Expressing income after interest but before tax is now rarely applied in business practice.
percentage.  Income should include dividends and interest earned if the said investments are included in
 The percentage change is calculated using: asset base.
 If used in the context of “Du Pont” technique, income must be expressed after interests, taxes
MOST RECENT VALUE - BASE PERIOD VALUE and preferred stock dividends. The Du Pont technique is based on the following formula:
PERCENTAGE CHANGE (∆%) =
BASE PERIOD VALUE
RETURN ON EQUITY = RETURN ON SALES x ASSETS TURNOVER x EQUITY MULTIPLIER
 VERTICAL ANALYSIS – process of comparing figures in the FS within a single period.
 CASH FLOW ANALYSIS – detailed study in the net change in cash and cash equivalents  MARKET VALUE RATIOS (MARKET PROSPECT RATIOS) – used to help potential
because of operating, investing and financing activities during the period. investors make equity investment decisions using trends in earnings, dividends and
 stock prices.
ACTIVITIES MEANING RELATED TO  Market value ratios are anchored on Earnings per Share (EPS), which is
Principal revenue-producing Changes in current assets and current considered profitability ratio:
OPERATING
activities. liabilities.
Acquisition and disposal of NET INCOME - PREFERRED DIVIDENDS
INVESTING long-term assets and Changes in non-current assets. EPS =
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING
investments.
Result in changes in the size  EPS must be distinguished from common shareholder’s Book Value per Share
and composition of the Changes in long-term liabilities and (BVPS), which is based on:
FINANCING
contributed equity and equity accounts.
borrowings. COMMON SHAREHOLDERS' EQUITY
BVPS =
NUMBER OF COMMON SHARES OUTSTANDING
 FINANCIAL RATIOS – relationships among the accounts found in the FS. ILLUSTRATION:
EPS, DIVIDEND & IPO SHARES
 LIQUIDITY RATIOS – measure an entity’s ability to meet short-term obligation and
provide insights on present cash solvency. Hulk Co. decided to go public when its net income available to common shareholders amounted to
P300K while the number of common shares issued and outstanding is 125K.
RATIO FORMULA
NET WORKING CAPITAL CURRENT ASSETS – CURRENT LIABILITIES REQUIRED:
CURRENT RATIO CURRENT ASSETS
1. Assume that pay-out ratio is 80%, how much of the total dividends shall a shareholder owning 5K
(WORKING CAPITAL RATIO) CURRENT LIABILITIES common shares receive?
QUICK RATIO QUICK ASSETS
2 Assume that the pay-out ratio is 80% and the price per share is P12, what is the dividend yield?
(ACID TEST RATIO) CURRENT LIABILITIES 3. Assume that the price-earnings ratio will be set 15 times and 25K new shares will be issued:
*Quick assets are cash items and other current assets than can be quickly converted into cash i.e.,
A) How much is the initial public offering (IPO) per share of the share of the 25K new shares?
cash, receivables, marketable securities.
B) How much is the net proceeds from issuance if flotation cost is 4%?
 SOLVENCY RATIOS (LEVERAGE RATIOS) – measure an entity’s long-term
EPS = 300K ÷125K = 2.40* 2) Dividend Yield = Dividends Per Share ÷
financial viability.
Market Price Per Share
1) Payout Ratio = Dividends per share ÷ EPS Dividend Yield = 1.92** ÷ 12 = 16%
RATIO FORMULA 80% = Dividends Per Share ÷ 2.40*
TOTAL LIABILITIES Dividends Per Share: 80% (2.40) = 1.92** 3) New EPS: 300K ÷ (125K + 25K) = 2.00***
DEBT RATIO
TOTAL ASSETS 5K shares x 1.92** per share = P9.6K PE Ratio = Price Per Share ÷ EPS
TOTAL EQUITY 15 times = Price Per Share ÷ 2.00***
EQUITY RATIO
TOTAL ASSETS 3A) Price Per Share: 2 (15) = P30
TOTAL LIABILITIES 3B) Net Proceeds: (25K shares x 30) x 96% =
DEBT-EQUITY RATIO
TOTAL EQUITY P720K
1
EQUITY MULTIPLIER
EQUITY RATIO
RAHYNE, CPA [@rrhdamcpa]
 RATIO FORMULA Variable OH* 4K
MARKET PRICE PER SHARE Fixed OH** 1.4K
PRICE-EARNINGS RATIO TOTAL 15.4K
EPS
DIVIDEND PER SHARE *Applied on the basis of direct labor hours.
DIVIDENDS YIELD **Applied at the rate of 10% of variable cost.
MARKET PRICE PER SHARE
DIVIDEND PER SHARE
DIVIDEND PAYOUT
EPS The company has been requested to prepare a bid for 350 units of the same product. If an 80%
RETENTION RATIO learning curve is applied, what is the total cost on the bid-order for 350 units?
100% - DIVIDEND PAYOUT
(PLOWBACK RATIO)
TOTAL (DL
50 units 350 units UNIT(S) AVERAGE
 OTHER FINANCIAL RATIOS & VFOH)
DM P1.5K P10.5K 50 250 12,500
RATIO FORMULA DL 8.5K 100 200 20,000
*38.7K 350 38,700*
CASH + MARKETABLE SECURITIES VFOH *4K 200 160 32,000
CASH RATIO
CURRENT LIABILITIES TOTAL VC P14K P49.2K 400 128 51,200
QUICK ASSETS (10%) FFOH **1.4K 4,920
DEFENSIVE INTERVAL
AVERAGE CAPITAL EXPENDITURES TOTAL
P15.4K P54,120
OPERATING CASH FLOW (CF) COSTS
CASH FLOW MARGIN
NET SALES
TIMES PREFERRED DIVIDENDS NET INCOME AFTER TAX  FINANCIAL MARKET – marketplace (physical or cyberspace) where trading of securities
EARNED PREFERRED DIVIDENDS occurs.
TOTAL ASSETS
CAPITAL INTENSITY RATIO
NET ASSETS Financial markets may be broadly classified into MONEY MARKETS and CAPITAL
OPERATING CF + AFTER-TAX INTEREST – MARKETS:
FREE CASH FLOW
CAPITAL EXPENDITURES
TYPES MEANING EXAMPLES
 ADDITIONAL FUNDS NEEDED (AFN) BSP Treasury Bills
FS Analysis helps in making financial forecasts, particularly the required ADDITIONAL Commercial Papers
FUNDS NEEDED (AFN), determined based on entity’s capital requirements and from a Certificate of
variety of financial ratios. Where short-term debt Deposits
MONEY MARKETS
instruments are traded. Banker’s Acceptance
Required increase in assets  ∆ in Sales x (Assets ÷ Sales) Repurchase
- Spontaneous increase in liabilities  ∆ in Sales x (Liabilities ÷ Sales) Agreements
- Increase in retained earnings*  Earnings after tax – Dividend payment Mutual Funds
ADDITIONAL FUNDS NEEDED from external sources (e.g., creditors, investors) PRIMARY MARKET
 Trade of new securities
AFN, aka External Funds Needed (EFN), may alternatively be computed using the following by mostly large investors.
formulas: Long-term debt or equity
CAPITAL MARKETS
 AFN = Total Changes in Equity – Internal Financing securities are traded. SECONDARY MARKET
 AFN = (Assets – Liabilities) (% ∆ Sales) – (Projected Sales x Profit Margin x Plowback  Trade of existing
securities by mostly small
Ratio)
investors.
Sales: P1M (∆ = 20% increase) Alternative Solutions
 BOND VALUATION – process of determining the fair price or market value of bonds based
Assets: (3M/5M) x 1M = P600K  3M x 20%
Liabilities: (500K/5M) x 1M = (100K)  500K x 20% on the present value of the regular interest payments and the face value at the maturity date.
Retained Earnings: (6M x 10%) x 25% = (150K)
AFN: 350K ILLUSTRATION
NI: 600K A firm has given the following information for each of its outstanding bonds:
 Capital Intensity Ratio: 60% = Assets ÷ Sales
 After-Tax Profit Margin: 10% = Net Income ÷ Sales Face Value Annual Coupon Interest Years to Maturity Required Return
 Dividend Payout: 75% = Dividend Per Share ÷ EPS P1,000 9% 5 6%
 Retention/ Plowback Ratio: 100% - Payout = 25%
What is the current value of each bond?
VARIOUS TOPICS IN MANAGEMENT SERVICES Current Value of Each Bond (discounted @6%)
 Principal (Year 5): 1,000 (0.747)
 LEARNING CURVE P1,126
 Interests (5 years): 90** (4.212)
 Assumes that labor time decreases in a definite pattern as labor operations are
repeated. **Annual Interest: 9% (1,000) = 90
 Describes the inefficiencies arising from experience – with experience comes increased
productivity.
 This is based on statistical findings that as the cumulative output doubles, the  STOCK VALUATION – process of determining the theoretical value of companies and their
cumulative average labor input time required per unit will be reduced by some stocks based on different methods such as the Gordon Dividend Growth Model.
percentage.
 The learning curve is usually designated by the complement of the rate of reduction ILLUSTRATION
e.g., if the rate of reduction 20%, then there is 80% learning curve. A firm has issue of preferred stock outstanding that has a stated annual dividend of P4. The required
return on the preferred stock has been estimated to be 16%. The value of the preferred stock is:
ILLUSTRATION
Orange Company expects 90% learning curve. The first batch of new product required 100 hours. Current Value of Preferred Stock
The second batch should take: Dividend Yield: Dividend ÷ Price
Batch(es) AVERAGE TOTAL 16% = 4 ÷ Price
1 100 100 Price = 4 ÷ 0.16
90% 80
2 90 180 Price = P25 per share

ILLUSTRATION ILLUSTRATION
The average labor cost per unit for the first batch produced by a new process is P120. The cumulative A firm has experienced a constant annual rate of dividend growth of 9% on its common stock and
average labor cost after the second batch is P72 per product. Using a batch size of 100 and assuming expects the dividend per share in the coming year to be P2.70. The firm can earn 12% on similar risk
the learning curve continues, what is the total labor cost of four batches? investments. The value of the firm’s common stock is:

Batch(es) AVERAGE TOTAL Current Value of Common Stock

1 120 120 Cost of CS: Yield % + Growth %
60%
2 72 144 12% = (2.7 ÷ Price) + 9%
4 43.2 172.8 x 100 = P17,280 Price = 2.7 ÷ (12% - 9%)
Price = P90 per share

ILLUSTRATION
A common stock currently has a beta of 1.7, the risk-free rate is 7% annually, and the market return
is 12% annually. The stock is expected to generate a constant dividend of P6.70 per share. A pending
lawsuit has just been dismissed and the beta of the stock drops to 1.4. The new equilibrium price of
ILLUSTRATION the stock shall be:
Banana Inc. finds that production is affected by an 80% learning effect. The company has just
produced 50 units of output at 100 hours per unit. Costs were as follows: Capital Asset Pricing Model
Cost of Equity: Risk Free % + Risk Premium %
First 50u Next 50u Cost of Equity: 7% + 1.4 (12% - 7%) = 14%*
Materials @ P20 P1,000 P1,000
Labor and labor-related costs: Gordon Growth Model
Direct Labor (100 hours at P8) 800 Cost of Equity: Yield % + Growth %
Variable OH (100 hrs at P2) 600*
200 14%* = (6.7 ÷ Price) + 0%
Total P2,000 P1,600 x 1.50 = 2.4K Price = 6.7 ÷ 14% = P47.86

The company has just received a contract calling for another 50 units of production. It wants to add - END -
a 50% mark-up to the cost of materials and labor and labor-related costs. Determine the contract
price. - REMINDER -
“During these moments, it's important to take a step back and remember why we started in the
Direct Labor and VFOH first place. Think about the effort that you have put in so far. All the late nights, early mornings,
UNITS AVERAGE TOTAL and sacrifices you've made. Consider the progress you've made towards your goal, no matter
1 20 1K how small it may seem.”
50 units 80% 600*
2 16 1.6K
“For I consider that the sufferings of this present time are not worth comparing with the glory that is
ILLUSTRATION going to be revealed to us.” – Romans 8:18
Fruit Manufacturing recently completed and sold an order of 50 units that had the following costs:

Direct Materials P1.5K

Direct Labor 8.5K
RAHYNE, CPA [@rrhdamcpa]