COST CONCEPT, TERMS AND MEASUREMENT

INTRO
MANAGEMENT SERVICES Management Accounting Info -> Managers -> Decision Making • selling price
• process
Organizational Structure: • ⇓ cost
• product
Shareholders • branch

Client ⇓
BOD
⇓
CEO
⇓ ⇓ ⇓ ⇓
VP VP VP VP
(Marketing) (Finance) (Operations) (HR)
Managers ⇓
⇓
⇓ ⇓
Internal
Treasurer Controller
Audit

MANAGEMENT ACCOUNTING FINANCIAL ACCOUNTING

USERS
Standards?
Related to
Management (Internal Users)
Not bound by Accounting Standards
Future
VS. External
PFRS
Past Transactions

COST CONCEPT
TERMS 1. COST monetary amount of the resources given up
2. COST BEHAVIOR how cost behave/change as the amount of cost driver changes
3. COST POOL group of cost associated with activity. (Ex. OH Control account)
4. COST OBJECT intermediate and final disposition of cost pool. (Ex Product, Job,
Process)
5. COST DRIVER factor that causes the change
6. ACTIVITY any event, action, transaction that incurs cost

TYPES 1. PRODUCT COST • incurred to manufacture a product

• manufacturing cost/inventoriable cost

a. Direct materials
Directly related to Factory
b. Direct labor
c. Overhead Ex. Rent, Utilities, Taxes, Depreciation, etc.

2. PERIOD COST • non manufacturing cost

Ex. Operating expenses, Selling and Administrative Expense
(expensed as incurred- dederecho agad ng Income Statement unlike yung mga
product cost)

TRACEABILITY 1. DIRECT • Direct Material Prime Cost

• Direct Labor
2. INDIRECT • Overhead Conversion Cost

BEHAVIOR 1. VARIABLE • constant per unit, varies per total

2. FIXED COST constant per total, varies per unit Ex. Rent, Utilities, Taxes, Depreciation, etc.
3. MIXED contains both also known as semi variable cost

COST SEGREGATION TECHNIQUES Objective: To develop the cost functions/linear equation

y = a + bx
where: y total cost this is a dependent variable (because dependent based
sa activity driver)
a fixed cost
b variable cost per unit
x activity driver/level this is the independent variable
 Ex. Unit sold, DL hours, etc.

1. HIGH-LOW METHOD • basis: cost driver NOT cost

• we can use it for estimation purposes

2. SCATTERGRAPH METHOD vertical line Y axis and horizontal line X axis

3. LEAST SQUARES (REGRESSION

ANALYSIS) METHOD most accurate type of cost segregation

steps: a. Isulat mo muna ang cost function

i. y = a + bx
ii. Σ y = na + bΣx yung "n" is the number of observation.
ii. Σ xy = a Σx + bΣx² Ex. Jan to June = 6

b. Eliminate the a and substitute the x

CORRELATION ANALYSIS/
GOODNESS OF FIT accuracy or reliability of the cost function

1. COEEFICIENT OF CORRELATION (
r) measures the degree of relationship between 2 variables
if r is: a. -1.0 strong negative correlation pag tumaas yung isa, bababa yung isa
(inverse)
b. 0 no correlation
c. +1.0 strong positive correlation pag tumaas yung isang variable, tataas
din yung isa (direct)

2. COEFFICIENT OF
DETERMINATION ( r² ) • strength of the cost function
• kaya r² kasi imumultiply mo sa sarili nya
between: a. 0
The closer to -1 or +1 the better
b. 1
 CVP ANALYSIS
INTRO
CVP ANALYSIS useful for management decision making

CONTRIBUTION MARGIN INCOME

STATEMENT for internal use only. It cannot be used by external users since it is not compliant with PFRS

Sales xxx mfg. cost (DM, DL, VOH)

Less: Variable Cost xxx variable selling & admin
Contribution Margin xxx FOH
Less: Fixed Cost xxx fixed selling & admin
Profit xxx

CVP GRAPH

A Break-even point F Variable Cost

B Profit G Loss
C Fixed Cost H Total Cost
D Activity Base I Revenues
E Pesos

FORMULAS
BREAK EVEN POINT no income no loss
the ⇓ the better
Note: kung gusto mo syang bumaba dapat may mangyaring favorable ⇓ fixed cost
⇑ contribution margin

Fixed Cost
BEP Units =
Contribution Margin per Unit

BEP Peso Fixed Cost

=
Sales Contribution Margin Ratio

Note: If the company sells mulitiple product then we will consider the sales mix, composite breakeven
we will use the weighted average contribution margin

TARGET PROFIT the income objective set by the management

the ⇓ the better
 before tax

Required Fixed Cost + Target Profit

=
Sales in U Contribution Margin per Unit

before tax

Required Fixed Cost + Target Profit

=
Sales in P Contribution Margin Ratio

MARGIN OF SAFETY maximum amount by which sales could decline without incurring a loss
the ⇑ the better

Sales (units) xx Sales (Peso) xx Margin of Sarety

MOS % =
Less: BEP (xx) Less: BEP (xx) Sales
MOS XX MOS XX
other formula:

Profits
MOS % =
Contribution Margin

Note: the sales that we are talking about here can be actual or planned sales

DEGREE OF OPERATING LEVERAGE % change in sales kung ano yung effect nya sa profit
Example: your DOL is 5. Then your sales ⇑ by 10% then your profit will ⇑ by 50%

Contribution Margin
DOL =
Profit before tax

% ∆ Profit before tax

DOL =
% ∆ Sales

SENSITIVITY ANALYSIS this is the "what if" technique sasabihin ng problem kung anong gusto nyang mangyari

% ∆ Output
Sensitivity =
% ∆ Input

MAJOR ASSUMPTION UNDERLYING CVP ANALYSIS

1. All cost incurred by a firm can be separated into their fixed and variable components
2. The product selling price per unit is constant at all volume levels
3. Operating efficiency and employee productivity are constant at all volume levels
4. Units produced is equal to units sold
 ABSORPTION AND VARIABLE COSTING
INTRO
ABSORPTION COSTING
VARIABLE COSTING
(aka Full Costing and Conventional INCOME STATEMENT
(aka Direct Costing)
Costing)
DM Sales DM
DL (COGS) DL
OH (both V and F) GP OH (variable only)
(OpEx)
S&A (both V and F) Profit S&A (both V and F)
FOH

Absorption Costing Product Cost Inventory COGS

FIXED OVERHEAD (B/S) (I/S)

Variable Costing Period Cost OpEx

(I/S)
NOTE: their main difference is the treatment for Fixed Overhead

SUMMARY

NET INCOME
P=S AC = VC BE = BB
P>S AC > VC BE > BB
P<S AC < VC BE < BB

RECONCILIATION

VC NI xx
Add only if the ∆ is ⇑, deduct if ⇓ Add: ∆ in Inventory x FOH/unit xx
AC NI xx

Alternative formula:

AC NI xx
Add: FFOH Beg. Invty xx
Total xx
Less: FFOH End. Invty xx
VC NI xx

OTHER POINTS TO REMEMBER

DECISION-MAKING CONCERNS Companies must report financial information using GAAP, which requires the Absorption Costing to be used for
costing of inventory

Variable Costing is prefered for Internal Reporting Purposes

POTENTIAL ADVANTAGE OF
VARIABLE COSTING 1. Net Income is unaffected by changes of production levels
2. Consistent with CVP Analysis
3. Net Income tied to changes in sales and provides a realistic assessment of the company's success or failure
4. Presentation of Fixed and Variable makes it easier to identify and their effect on the company's result
 STANDARD COSTING AND VARIANCE ANALYSIS
STANDARD COSTING
STANDARD  ideal, benchmark, measure of performance

TYPES OF STANDARDS 1. Ideal Standards perfect performance; no allowance

(aka Theoretical or Maximum-Efficiency Standards)

2. Practical Standards tight but attainable standards; it allow allowances

(aka Currently Attainable Standards)

STANDARD COSTING  should be cost, best estimate of the management

1. Evaluate performance
USES:
2. Simplify costing

VARIANCE ANALYSIS
VARIANCES ARE USED FOR 1. Management by exception only those variances that are material or significant in amount,
whether Favorable or Unfavorable, should be investigated
2. Tool management for performance evaluation. It is intended to measure effectiveness and efficiency
3. Feedback attained by variance analysis will be used for planning and control

DIRECT MATERIAL VARIANCE

based on actual production

(Actual Prod x SQ/Unit)

ACTUAL FLEXIBLE STANDARD

AQ x AP AQ x SP SQ x SP

Material Price Variance Material Usage Variance

Point of Purchase Point of Production ALWAYS point of production

 if silent If point of purchase and point of
production are not equal, when
computing to the MUV, the AQ in flexible
is the material used

1. Material Price Variance Purchasing Agent

Who is Accountable?
2. Material Usage Variance Production Manager

DIRECT LABOR VARIANCE

based on actual production

(Actual Prod x SH/Unit)

ACTUAL FLEXIBLE STANDARD

AH x AR AH x SR SH x SR

Labor Rate Variance Labor Efficiency Variance

1. Labor Rate Variance Production Manager

Who is Accountable?
2. Labor Efficienct Variance Production Manager
FACTORY OVERHEAD VARIANCE

FOUR WAY ANALYSIS VARIABLE FIXED

Variable ACTUAL Actual Var. Rate x Actual Hrs + Actual Fixed Rate x Actual Hours
Spending
Fixed BAAH Std. Var. Rate x Actual Hour + Budgeted Fixed Cost
Efficiency
BASH St. Var. Rate x Std. Hour + Budgeted Fixed Cost
Volume
STANDARD Std. Var. Rate x Std. Hrs + Std. Fixed Rate x Std. Hours

THREE WAY ANALYSIS VARIABLE FIXED

ACTUAL Actual Var. Rate x Actual Hrs + Actual Fixed Rate x Actual Hours
Spending
BAAH Std. Var. Rate x Actual Hour + Budgeted Fixed Cost
Efficiency
BASH St. Var. Rate x Std. Hour + Budgeted Fixed Cost
Volume
STANDARD Std. Var. Rate x Std. Hrs + Std. Fixed Rate x Std. Hours

TWO WAY ANALYSIS VARIABLE FIXED

ACTUAL Actual Var. Rate x Actual Hrs + Actual Fixed Rate x Actual Hours
Actual vs BASH
Controllable Variance BAAH Std. Var. Rate x Actual Hour + Budgeted Fixed Cost

BASH St. Var. Rate x Std. Hour + Budgeted Fixed Cost

BASH vs Standard
Uncontrollable Variance STANDARD Std. Var. Rate x Std. Hrs + Std. Fixed Rate x Std. Hours

ONE WAY ANALYSIS VARIABLE FIXED

ACTUAL Actual Var. Rate x Actual Hrs + Actual Fixed Rate x Actual Hours

BAAH Std. Var. Rate x Actual Hour + Budgeted Fixed Cost

Actual vs Standard
Total Overhead Variance Analysis BASH St. Var. Rate x Std. Hour + Budgeted Fixed Cost

STANDARD Std. Var. Rate x Std. Hrs + Std. Fixed Rate x Std. Hours

NOTE: Budget is different from Standard.

Internal External
BUDGET STANDARD
Express in TOTAL Express in UNIT

MIX AND YIELD VARIANCE i-alay huhu

 BUDGETING
INTRO
DEFINITION
 formal written statement of management's plans for specified time period, expressed in financial terms
to set goals
Headed by Budget
 it is planning tool to set targets In order to achieve Committee
organiztion's objectives
to use as performance (who has overall responsibility
review for budget preparation)

Composed of:
President , Treasurer , Controller , and Managers from different organizations
Headed by:
Budget Director . (sya yung bahalang makipag communicate sa mga managers)

Short Term (1 year) 

TYPES
Long Term (> 1 year) to be discussed in Capital Budgeting

in Short Term Budgeting , the main output/end goal here is the Master Budget

Sales (first prepared and most critical)

Operating Budget DM Output:
(Productions and Sales) DL Budgeted Income Statement
MASTER BUDGET OH
COGS
Selling & Adm

Financial Budget Cash Flow

(3C and B) Capital Expenditure
Balance Sheet Budgeted
Cash Budget Financial
Beg. Balance xx Statements
Add: Receipts xx
Less: Disbursements (xx) Output:
Less: Min. Cash Balance (if any) (xx) Budgeted
xx/(xx) SCF, BS

Excess Financing
Ending Balance xx

Bank Loan
can be:
Issuance of Shares

1. T-accounts
Technique:
2. Follows instructions ng problems

COMPUTATIONAL FORMATS
BUDGETED PRODUCTION BUDGETED MATERIAL PURCHASES
Budgeted Sales xx Budgeted Production xx
Add: Desired End. Finished Invty. xx x Qty. of Mats required/unit of production xx
Total xx Total Materials to be used xx
Less: Expected Beg. Finished Invty. (xx) Add: Desired End. Materials Invty. xx
Budgeted Production xx Total xx
Less: Expected Beg. Materials Invty. (xx)
Budgeted Materials Purchases xx
BUDGETED MERCHANDISE PURCHASES
Budgeted Sales xx
Add: Desired End. Merchandise Invty. xx
Total xx
Less: Expected Beg. Merchandise Invty. (xx)
Budgeted Merchandise Purchases xx

TYPES OF BUDGET
1. MASTER BUDGET
2. CONTINOUS (ROLLING) BUDGET revised on a regular (continous) basis
3. FIXED BUDGET based on only one level of activity (sales or production volume)
4. FLEXIBLE BUDGET series of budget prepared for many series of activity
5. INCREMENTAL BUDGETING wherein current budget is simply adjusted to changes planned
6. ZERO-BASED BUDGETING prepared every period from a base of zero
7. LIFE-CYCLE BUDGET product's revenues and expenses are estimated over its entire life cycle
8. ACTIVITY-BASED BUDGET unlike in traditional costing
9. KAIZEN BUDGET means continous improvement
10. GOVERNMENTAL BUDGET not only a financial plan and basis for performance evaluation but also an expression of public policy and a
form of control having the force of law
 RELEVANT COSTING
INTRO
DEFINITION choosing the best option among alternatives

Future General Rule:

RELEVANT COSTS Variable Costs (DM, DL, VOH. Var. Selling & Admin
Incremental/Differential Fixed Costs (Avoidable Only)
(differ among alternatives)
Example: RENT (Tatanggalin si Product C then lilipat ng mas
maliit na space
A B C A B


P100,000.00 P70,000.00

P30,000.00
(Avoidable - RELEVANT)

DEFINITION OF TERMS
1. RELEVANT COSTS future cost that is expected to be different

2. DIFFERENTIAL COSTS ⇵ in total costs that result from selecting one alternative instead of another

3 AVOIDABLE COSTS cost that will be saved/not incurred

4. OPPORTUNITY COSTS benefit lost by taking one action as opposed to another

5. SUNK COSTS non-recoverable cost. (totally irrelevant)

6. JOINT COSTS cost incurred simultaneously for multiple products

7. FURTHER PROCESSING COSTS cost incurred beyond split off point

8. SPLIT OFF POINT earliest stage in production that you can already sell your product

9. SHUTDOWN COSTS usual cost that the company will continue regardless they continue or shutdown the operation

TYPES
1. MAKE OR BUY choose option that has a lower cost. Unavoidable fixed costs are irrelevant. Consider opportunity cost if any
(also known as outsourcing)

With Exccess Capacity Currently- 8,000, then

2. ACCEPT OR REJECT (Apply General Rule) Excess capacity is 2,000
Example: Your normal capaicty is
100,000 units
Without Excess Capacity Currently- 10,000, then NO
(Apply General Rule + Excess capacity
Opportunity Cost)
Contribution Margin
Example: may magpapaspecial order ng 1,000. pero since full capacity ka na, maapektuhan yung current
market mo kaya hindi mo sya matatanggap. Kapag di mo inaccept, then tinatawag itong loss/forgone
opportunity
 Effect on variable cost
3. RETAIN OR REPLACE EQUIPMENT To be considered:
Cost of the new equipment
Disposal value of existing asset must also be considered
Book value of old asset is irrelevant since this is already a sunk cost

4. CONTINUE OR SHUTDOWN
BUSINESS SEGMENT Sales xx
Less: Variable Cost (xx) + Retain
Less: Fixed Cost (avoidable) (xx)
Segment Margin xx
(-) Eliminate

5. SELL IMMIDIATELY OR PROCESS

FURTHER

Split off point Yung SP mo from SOP, pag pinrocess

(Here: meron ka ng SP) further mo before ibenta, your SP will ⇑

Joint Cost (DM, DL, OH) will incur Further Processing Costs
( common cost to all products. This is
IRRELEVANT because sunk cost na ito)

General Rule:

Scenario 1: IF: Incremental Revenue

(Increase in SP) > Incremental Cost
(Increase in Cost)
Then Process Further!!!

Scenario 2: IF: Incremental Revenue

(Increase in SP) < Incremental Cost
(Increase in Cost)
Ibenta mo na, sa split off
point palang!!!

6. WHICH PRODUCT TO PRODUCE

GIVEN SCARCE RESOURCES Irarank natin. Ang pinakabasis natin is ang Contribution Margin per scarce resource

Limited lang yung resources mo Example: A B C

SP/Unit 192.00 542.66 222.84
VC/Unit 158.72 420.54 167.76
CM 33.28 122.12 55.08
Constraint 3.20 8.60 3.60
10.40 14.20 15.30
Ranking 3 2 1

Explanation: maximum na ibabayad natin is 10.40 (least priority) para kikita pa din tayo. Kasi if
mas mataas dyan ang binayad natin, lugi tayo for product A
 RESPONSIBILITY ACCOUNTING
INTRO
DEFINITION accumulating cost and revenues on the basis of the manager who has the authority to make day to day
decisions about the items

MAIN CONCEPT 1. Management by Objectives managers participate in the goal setting activities of the company
they will strive to achieve

2. Goal Congruence different managers aligned their personal goals with overll objectives
of the company

3. Autonomous acting independently or having a freedom to do so

4. Motivation reasoning behind a focus effort

divisions Headed by:

OBJECTIVE proper evaluation of responsibily centers departments Managers
branches (concept of Controllability)
segment

meaning, we evaluate managers based only on the factors that they control

ORGANIZATIONAL STRUCTURE
DEFINITION company's framework and guidelines
task allocation, coordination, and supervision
will determine the modes in which how the organization will operate and perform

TYPES OF ORGANIZATIONAL
STRUCTURE 1. Centralized only one person makes decision for the whole entity

Advantage: Disadvantage:
 reduced cost  delay in work
 uniformity in action  remote control
 personal leadership  no loyalty
 flexibility  no secrecy
 improved quality work  no special attention
 better co-ordination

2. Decentralized decision making authority is spread throughout the organization to the lowest
level possible

Advantage: Disadvantage:

 enables mgrs to concentrate on other  lower level makes decision without

things fully understanding the big picture
 acknowledgs lower-level  lower level managers that differ from
 provides lower level experience they entire organization
will need when promoted  difficult to spread in a strongly
 increase motivation decentralized organization

TYPES OF RESPONSIBILITY CENTERS

MANAGEMENT RESPONSIBILITY
COST REVENUE INVESTMENT

1. COST CENTER 

Examples: Maintenance Dept, IT, HR, Payroll, Production

Good way of Evaluating Cost: Varaince Analysis (actual vs standard)
(since cost lang ang may control sila, i-eevaluate lang sila based on cost)
2. REVENUE CENTER 

Examples: Sales Department, Marketing Department

Good way of Evaluating Cost: Varaince Analysis (actual revenues vs target revenues)
(since revenues lang ang may control sila, i-eevaluate lang sila based on revenues)

3. PROFIT CENTER  

Examples: SM Dept. Store, Supermarket, Cinema

(both revenues and costs ay may control sila since nagbebenta sila and at the same time ay nag iincure din sila
ng expenses like salaries to workers, so ineevaluate natin sila based on controllable profit margin )

Sales xx
Less: Variable Cost (xx)
Less: Fixed Cost (controllable) (xx)
Profit Margin xx

same concept sa relevant costing

4. INVESTMENT CENTER   
(broadest power)

Examples: Head Office ng SM

(mag papa-lease sila sa tenants so mag gegenerate sila ng income and at the same time mag iincur ng costs)

THREE PERFORMANCE MEASURES

1. RETURN ON INVESTMENT (ROI)  is used to evaluate the efficiency of an investment or to compare the efficiencies of several different
investments.
 the ratio of net profit over the total cost of the investment
 the ⇑ the ratio, the better
OBJECTIVE: to express income as a proportion of the invested capital

WHY? Because, yung mga managers natin

wala naman silang control sa interest
and taxes

Before deducting Interest and Taxes

Operating Income
Average Operating Assets

(Beginning + Ending) / 2
These are the invested assets or capital (@ Book Value)

OR
DuPont Technique:

Return on Assets = Return on Sales x Asset Turnover

Net Income
Assets = Net Income
Sales x Sales
Assets

INCREASING ROI: ⇑ Sales ⇓ Expenses ⇓ Assets

2. RESIDUAL INCOME (RI)  is the difference between operating income and the minimum perso return required on a company's
operating assets
 the ⇑ the residual income, the better
OBJECTIVE: amount that reamins after deducting the required rate of return

Before deducting Interest and Taxes

Operating Income - ( Average Operating Assets x Min. Rate of Return)

These are the invested assets or capital

(@ Book Value)
This is the required/acceptable return for the company

INCREASING RESIDUAL INCOME: ⇑ Profit ⇓ Capital Investment ⇓ Imputed Interest (Less

Risk)

3. ECONOMIC VALUE ADDED (EVA)  more specific version of residual income that measures the investment center's real economic gains
 the ⇑ the EVA, the better
OBJECTIVE: indicates how much shareholder wealth is being created

Before deducting Interest BUT after Taxes

Operating Income - ( Average Operating Assets x WACC)

These are the invested assets or capital same as minimum rate of

(@ Market Value) return above
(Weighted Ave. Cost of Capital)

INCREASING EVA: ⇑ Profit ⇓ Financing ⇓ WACC

NOTE: sa EVA minsan hindi given ang Ave. Operating Asset so ang alternative computation dito ay TOTAL
ASSETS - CURRENT LIABILITIES

A = L + E

CL NCL
  
Long Term Capital

THREE ACCEPTABLE METHODS OF COST ALLOCATION (SERVICE ALLOCATION METHOD)

Office Factory

Payroll, HR, IT (Production Department)

(Service Departments)
Incurs costs

1. DIRECT METHOD  the overhead allocation method that allocates service department costs without consideration of services
rendered to other service departments

Service Dept Prod. Dept.

2. STEP METHOD  service department cost allocation method assigns indirect costs to cost objects after considering some of
the interrelationship of the objects

Service Dept ang first na i-aalocatan mo is the Service Department

with the highest cost
Service Dept
Prod. Dept.

3. RECIPROCAL/ALGEBRAIC
METHOD  most accurate method for allocating service department cost
 reciprocal services among the service providers

BALANCED SCORECARD
INTRO
DEFINITION in evaluating the managers, we consider both financial and nonfinancial aspects (more holistic)
Advantage: 1. allows view of all functions that affects business p[erformance
2. imrovement can be tracked overtime
3. not just a measurement tool but also a communication tool
Disadvantage: 1. not a tool that can be developed overnight

AREAS/PERSPECTIVES
1. FINANCIAL MEASURES how is success measured by SH?
4 Examples: ROI, RI, EVA

2. CUSTOMER SATISFACTION how do we create value for our customers?

3 Examples: Market Share (# of new customers, # of complaits, customer satisfaction levels)

3. INTERNAL OPERATIONS at which process must we excel to meet our customer and SH expectations?
2 Examples: Speed/Velocity (# of defect produced, # of vendor used, bottlenecks, delays, breakdown, etc.)

4. LEARNING AND GROWTH development of the employees

1 Examples: Trainings and Seminars
 TRANSFER PRICING
INTRO
DEFINITION this is the price charged by one division to another division

OBJECTIVE set transfer price to achieve goal congruence (Net Income of the whole company)
facilitate optimal decision making
provide basis in measuring divisional performance
motivate different department heads

BASIS OF TRANSFER PRICE

1. COST-BASED PRICE based on the costs incurred by the division in producing the product

2. MARKET-BASED PRICE based on the existing market prices of the competing product
often considered the best approach

3. NEGOTIATED PRICE selling division establishes minimum TP, while buying division establisher maximum TP

4. COST-PLUS PRICE also known as Absorption Cost Approach

Example: cost + 20%

5. VARIABLE COST PRICE DM, DL, VOH, Variable Selling & Admin
more useful in making short-run decisions because it considers VC and FC behavior patterns separately
more consistent with CVP analysis

6. FULL PRODUCTION COST PRICE DM, DL, OH

RULES

MAXIMUM TRANSFER Market Price

PRICE (cost by buying from outside supplier)

RULES with excess capacity Variable Cost

MINIMUM TRANSFER
PRICE without excess capacity VC + CM (opportunity cost)
(operating at full capacity)
 CAPITAL BUDGETING
INTRO
DEFINITION Long Term investment decisions (process of making capital expenditure decisions)
Because this is long term, Top Management and BOD are involved

Payback Period

NON DISCOUNTING
residual definition Accounting Rate of Return

TECHNIQUES

Net Present Value (NPV)

DISCOUNTING Profitability Index (PI)

considers Time Value of
Money Internal Rate of Return (IRR)

NON DISCOUNTING
1. PAYBACK PERIOD time it takes to recover the initial investment
the shorter the period, the better
Advantage: easy to compute and understand
Time Value of Money
Disadvantage: ignores Performace of project beyond the payback period

Formula:

Initial Investment
Annual Cash Flow

NOTE: minsan ang given ay Net Income instead of Cash Flows, para i-convert ang Net Income into Cash Flow ,
the formula is:

Net Income xx
Add: Dep'n Expense xx
Cash Flow xx

y0 y1 y2 y3 y4

EVEN (10M) 2M 2M 2M 2M

10,000,000 meaning, the payback period is 5 years

= 5 years
it can be: 2,000,000

UNEVEN (10M) 2M 3M 5M 4M

5M

10M
meaning, the payback period is 3 years
 Other Scenario:
Uneven pero may butal

2. ACCOUNTING RATE OF RETURN based directly on accounting data rather than the cash flows
measures the profitability
same as ROI
acceptable if RoR > management's required RoR
the ⇑ the more attractive the investment
Disadvantage: ignores Time Value of Money
based on income

Formula:

Average Annual Income

Investment

if silent, check first if: matic use:

a. With Salvage Value Average Investment
(mas priority and mas okay) (Initial Investment + Salvage Value / 2)

b. Without Salvage Value Initial Investment only

(aka simple acctg rate of return)

DISCOUNTING
meaning, nagdidiscount tayo ng Cash Flow (gumagamit tayo ng present values)

1. NET PRESENT VALUE acceptable if positive

the ⇑ the more attractive the investment

Formula:

Present Value of Cash Inflows xx

Less: Present Value of Cash Outflows (xx)
Net Present Value xx

(+) ACCEPT
basically, your initial investment (-) REJECT

y0 y1 y2 y3 y4 y5

(1M) 300K 300K 300K 300K 300K

i-pepresent value mo sila using the discount rate (aka cost of capital)

NOTE: if NPV is +, it is always true that the IRR > Cost of Capital (aka Discount Rate)
 Example: 1. ORDINARY ANNUITY

Example: 2. ANNUITY DUE

2. PROFITABILITY INDEX method that compares the relative merits of alternative capital investment projects
used in mutually exclusive projects
the ⇑ the more desirable the project
the project with > profitability index should be chosen

Formula:

PV of Cash Inflows
PV of Cash Outflows

basically, your initial investment

3. INTERNAL RATE OF RETURN this is the interest rate that makes the PVCI equals to PVCO (edi meaning, yung NPV natin is zero)
can be trial and error, other formula is using the annual CF, alamin mo yung rate na kapag pinresent value
mo ay mag eequal sa initial investment mo
Example: INTERPOLATION
IRR is compared to discounted rate (aka cost of capital)
if: IRR > CoC ACCEPT
IRR < CoC REJECT

KEYPOINTS TO REMEMBER
1. To convert Net Income into Cash Flow:

Net Income xx
Add: Dep'n Expense (100%) xx
Cash Flow xx

2. Tax Shield or savings: ⇑ Deductions, ⇓ Taxable Income, ⇓ Tax

Depreciation Expensin x tax rate = Tax Shield

Loss (example, binenta mo yung old equipment mo then nag loss ka, tax savings din yun)
Gain (example, binenta mo yung old equipment mo then nag gain ka, then kabaligtaran
naman)
 COST OF CAPITAL
INTRO
OTHER NAMES discount rate
required return
minimum rate of return
hurdle rate

Example: you borrowed funds para sa project na balak mo

capital 10% IRR (kita mo)

BDO ABC Co. Project
(apartment units)
8% interest

SOURCES
SOURCES COST FORMULA

1. CREDITORS interest interest rate x (1-tax rate)

(Long-term Debt) (cost of debt) fixed rate
Dividend y0
P/S Current Price y0
( net of floatation cost)
2. SHAREHOLDERS dividends
(Issue Shares) (cost of equity)

O/S RE
(kapag imbis na mag issue sila ng
shares, ginamit nalang yung pera
na nasa retained earnings,
remember part NET INCOME
dinedeclare as dividends, yung iba
naman napupunta sa RE)

1. Dividend discount model (DDM) Dividend y1 Dividend y1

+ growth + growth
(aka Gordon growth model) Current Price y0 Current Price y0
( net of floatation cost) ( gross of floatation cost)

Market Risk Premium Market Risk Premium

2. Capital asset pricing model (CAPM) RF + B(MR-RF) RF + B(MR-RF)

Legend:
RF = Risk Free Rate basically ito yung mga treasury bonds
B = Beta volativity or risk of the company with respect to the market
its value is between -1 to +1
+ nagrerespond directly kung anong nangyayari sa market
- bumaba yung demand
MR = Market Return ave return of PSE
Market Risk Premium MR-RF

3. WACC if combination of Creditors and SH

(i-coconsider natin dito yung capital structure ng isang company)

KEY POINTS TO REMEMBER

Ranking from Cheapest to Most Expensive: 1. Debt
2. Preference Shares
3. Retained Earnings
4. Ordinary Shares
 FINANCIAL STATEMENT ANALYSIS
INTRO
Example:

Users FS Decision Making

TOOLS: 1. Horizontal (Trend) Analysis

evaluation FS items over a period of time to determine the ⇵
base year is selected
∆'s are expressed in %
intracompany

2. Vertical (Common-Size) Analysis B/S items Total Assets

evaluation items within the FS as a % of base amount
used when comparing two or more companies I/S items Total Sales
intercompany

3. Ratio Analysis
evaluate relationships among FS items
Characteristics: a. Liquidity ability to pay short-term obligations (Suppliers)

b. Solvency ability to pay long-term obligations (Banks)

c. Profitability performance of the company

Pattern: 1. Return Net Income ( Nu merator)

2. Turnover Sales ( Nu merator) most of the time
3. Margin Sales ( De nominator)

RATIO ANALYSIS FORMULAS

LIQUIDITY
1. CURRENT RATIO
relates to current assets to the claims Current Assets
of short-term creditors Current Liabilities
the ⇑ the better

2. QUICK RATIO/ACID TEST RATIO

more conservative version of current
ratio
ability to pay short-term liabilities Cash + Marketable Securities + AR
using its most liquid assets Current Liabilities
Inventory is not considered (why?
Kasi matagal ito iconvert into cash)
the ⇑ the better

3. ACCOUNTS RECEIVABLE
TURNOVER gaano kabilis natin nacocollect yung Total Credit Sales
AR Average Accounts Receivable
the ⇑ the better

4. DAYS SALES OUTSTANDING/

AVE. COLLECTION PERIOD/ DAYS expressed as # of days 360 or 365 days
IN RECEIVABLE the ⇓ the better AR Turnover
5. INVENTORY TURNOVER
gaano kabilis natin nabebenta yung Total Cost of Sales
inventory Average Inventory
the ⇑ the better NOTE: If walang COS sa given, doon ka lang gagamit ng sales

6. DAYS IN INVENTORY/ AVERAGE

HOLDING PERIOD expressed as # of days 360 or 365 days
the ⇓ the better Inventory Turnover

7. PAYABLE TURNOVER
speed with which a company pay its Total Purchases
suppliers Average Accounts Payable

8. DAYS IN ACCOUNTS PAYABLE/

AVERAGE AGE length of time which payables remain 360 or 365 days
unpaid Payable Turnover

9. NORMAL OPERATING CYCLE

length of time it takes to convert an
investment of cash in inventory back into Days in Receivable + Days in Inventory

10. CASH CONVERSION CYCLE

length of time it takes to convert an
investment of cash in inventory back into
cash recognizing that some purchases are Days in Receivable + Days in Inventory - Days in Payable
made on credit

PROFITABILITY
1. RETURN ON SALES
portion of sales that went to the Net Income
company's earnings Net Sales

2. RETURN ON ASSETS
how much yung nagegenerate ng Net Income
assets natin (buong company) Average Total Assets
the ⇑ the better

3. RETURN ON EQUITY
measures the return that is received
from the business on the equity in the Net Income
business Average Total Equity
the ⇑ the better

4. EARNINGS PER SHARE

amount of net income earned by each Net Income - Preferred Dividends (if any)
common share Weighted Ave. # of Common Shares

5. OPERATING PROFIT MARGIN

amount of profit generated after Operating Profit
consideration of operating costs Net Sales
the ⇑ the better

6. CASH FLOW MARGIN

ability of the firm to translate sales Operating Cash Flow
into cash Net Sales

7. PRICE-EARNINGS RATIO
ano yung effect ng income natin sa
stock price
number of pesos required to buy P1 Market Value of Each Share
of earnings EPS
the ⇑ the better
8. DIVIDEND YIELD
rate of return in the investor's Dividend per Share
common stock investment Market Value of Each Share

9. DIVIDEND PAY-OUT RATIO

proportion of earnings distributed as Dividend per Share
dividends EPS

SOLVENCY RATIO
1. TIMES INTEREST EARNED
measures the company's capability to EBIT
pay interest Interest Expense
the ⇑ the better

2. DEBT TO EQUITY RATIO

proportion of assets provided by Total Liabilities
creditors compared to that provided by Total Equities
owners

3. DEBT RATIO
total assets that are financed by Total Liabilities
creditors Total Assets

4. EQUITY RATIO
total assets that are financed by
shareholders Total Equity 1 - Debt
or
Total Assets Ratio

OTHERS
1. DIVIDEND PER SHARE
how much yung binabayad or
dinedeclare na dividends on a per share
basis Dividend
usually SH lang ang tumitingin # of shares outstanding
the ⇑ the better

2. BOOK VALUE PER SHARE

sa mga common SH lang available Common Stock Equity
pag naliquidate/bankcrupt ang # of shares outstanding
company, ito yung marerecieve nila per

2. CASH FLOW PER SHARE

how much yung binabayad or
dinedeclare na dividends on a per share Net Income + Depreciation Expense
basis # of shares outstanding
SH and Creditors ang tumitingin
the ⇑ the better

NOTE: kapag ang Numerator mo ay IS item at and Denaminator mo ay BS item, dapat i- average mo yung BS item
madaming year ang given