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## Engineering Management Accounting – Lecture 4

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**ELE 2EMT**Engineering ManagementAccounting – Lecture 4 George Alexander G.Alexander@latrobe.edu.au http://www.latrobe.edu.au/eemanage/ 17 August, 2007**Last week**• A closer look at why we classify certain expenditure as capital expenditure - assets • The importance of accurately valuing assets • The role of depreciation and how it works • Types of Depreciation • Depreciation Terminology • Straight Line Depreciation • Declining Balance Depreciation**This week**• Need for Business Analysis • The Profit & Loss Statement • Performance Ratios • Return on Investment • Break-Even Calculations • Price Elasticity • Economic Order Quantity**Need for Business Analysis**• Stakeholders and potential stakeholders need to know how to evaluate an organisation’s financial success. • The evaluation process requires a good understanding of financial statements and performance ratios.**Balance SheetStatement of Financial Position**• Every company publishes a balance sheet at the end of each fiscal year (FY) • Assets - a summary of all resources owned by or owed to the company • Liability - a summary of all financial obligations of the company • Net Worth - a summary of the financial value of ownership**Balance Sheet Relationship**Assets = Liabilities + Net Worth Net Worth = Assets - Liabilities Net Worth also called: Owner’s Equity or Proprietorship A = L + P P = A - L**Profit & Loss StatementStatement of Financial Performance**• The basic equation for profit is: Profit = Sales - Costs • P & L Statement shows an organisation’s sales revenues and costs over a given period, typically a year, quarter or month.**A well-written statement can help in identifying the areas**of the business associated with profit or loss. • Assessment can be based on a division, department, business unit, product line, etc.**Example Profit & Loss Statement**Net Sales $ 707,500 Less cost of goods sold $ 340,000 Gross Margin (gross profit) $ 367,500 Less operating expenses $ 325,500 Net Profit $ 42,000 Note: Tax is calculated on the Net Profit**Performance Ratios**• The gross margin percentage • The net profit percentage • The operating expenses ratio • Market ratios • Other financial ratios • Employee ratios • The stock turnover ratio**The Gross Margin Percentage**Gross Margin Percentage is the percentage of revenue available to cover expenses and provide profit after the cost of goods sold has been paid. Gross Margin Gross Margin Percentage = Net Sales $367,500 = = 0.52 or 52% $707,500**The Net Profit Percentage**The Net Profit Percentage (Net Income ratio) identifies the percentage of profit from each sales dollar. Net Profit Net Profit Percentage = Net Sales $42,000 = = 0.06 or 6% $707,500**The Operating Expenses Ratio**The Operating Expenses Percentage is the percentage of operating expenses needed from each sales dollar. Total Operating Expenses Operating Expenses Ratio = Net Sales $325,500 = = 0.46 $707,500 or in percentage 46%**Company financial reports**All publicly listed companies provide access to their financial reports on their web sites – http://www.telstra.com.au/abouttelstra/investor/index.cfm http://www.qantas.com.au/info/about/investors/index http://www.wesfarmers.com.au/default.aspx?MenuID=33 and so on.**Improving Net Profit**• Increasing prices • Pricing objectives • Supply v demand, etc. • Price Elasticity (refer later slides) • Reducing cost of goods sold • Alternative sources • Make or buy, etc. • Reducing operating expenses • Efficient use of resources • Management policies, etc.**Financial Ratio Analysis**• Financial ratios are somewhat limited in meaning when viewed in isolation. • They are more useful when used to compare similar companies (benchmarking), or when examining trends. • Some ratios are available on financial websites such as Commsec and InvestorWeb. • More detailed data is available on individual company websites.**Return on Assets**• Defined as the ratio of net profit to assets of an organisational segment (company, division, business unit, or the like), product line or brand. • It is a measure of financial efficiency that is often used to set marketing objectives. • The information required for calculating return on assets is obtained from the organisation’s balance sheet and profit and loss statement.**Example ROA Calculation**ROA = Net Profit / Total Assets Suppose that the total assets for the organisation is $425,000 and the net profit is $42,000. ROA = 42,000 / 425,000 = 0.0988 or 9.88 %**ROI Return on investment**ROI = Net Profit / Net Worth This shows the profitability of shareholders’ equity. Suppose that the total assets for the organisation is $425,000, the net profit is $42,000 and the total liabilities are $200,000. ROI = 42,000 /( 425,000 – 200,000) = 0.187 or 18.7%**Market ratios**• Dividend Yield % = Annual dividend Share price • Price/Earnings P/E = Share price Earnings per share • Dividend payout = Dividend per share Earnings per share**Other financial ratios**• Debt/Equity measures proportions of financing by creditors and owners. • Sales/Total assets measures how well the total assets are being used to generate sales. similarly for • Sales/Fixed assets**Employee ratios**• Sales per employee • Earnings per employee These need to be viewed cautiously as they are sensitive to initiatives such as outsourcing, and can vary greatly with the nature of the business – e.g.capital vs labour intensive.**The Stock Turnover Ratio**The Stock (Inventory) Turnover Ratio indicates the number of times stock turns over (sold) during the period specified in the profit and loss statement. The calculation is done in two steps as follows: Beginning Stock + Ending Stock Average Stock = 2 $100,000 + 160,000 = = $130,000 2**The Stock Turnover Ratio - Cont.**Net Sales Stock Turnover Ratio (Retail) = Average Stock $707,500 = = 5.44 times per period $130,000 Cost of Goods Sold Stock Turnover Ratio (Cost) = Average Stock $340,000 = = 2.62 times per period $130,000**Fixed Costs**Break-Even Point = Selling Price - Variable Costs Break-Even Calculations • The Break-Even Point is defined as the point at which costs and revenues meet (costs = revenue). • The concept is best described graphically, mathematically it is written as:**$ 50,000**Break-Even Point = = 10,000 units $ 10 - $ 5 Example Break-Even Calculation Suppose the following: Selling price $ 10 Variable cost $ 5 Fixed cost $ 50,000**(Q1 - Q2) / Q1**E = (P1 - P2) / P1 Price Elasticity • Defined as the effect of a change in price on the quantity of product demanded. • It involves calculating the ratio of the percentage change in quantity to the percentage change in price. E = Elasticity Q1 = Initial quantity demanded Q2 = New quantity demanded P1 = Initial price P2 = new price**(100 - 90) / 100**0.1 E = = = - 0.5 (5 - 6) / 5 - 0.2 Example Price Elasticity Calculation Suppose that the initial price was $5 and the initial quantity demanded was 100 units. If the price was raised to $6 and the quantity demanded declined to 90 units, then the Price Elasticity would be: Normally stated as 0.5**Economic order Quantity**• There are several factors to consider when deciding on the order size at which total costs can be minimised. • The main factors include: • Annual demand in units, • unit cost of placing an order, and • Annual holding costs as a percentage of the cost of one unit.**2 x (Annual demand in units x Unit cost of placing an order)**EOQ = Annual holding costs as a percentage of cost of one unit x Cost of one unit in dollars Example Annual demand 5,000 units Unit cost of the merchandise $ 1.50 Per-unit holding costs $ 0.30 (20% of unit cost) (warehousing, insurance, etc.) Cost of placing an order $ 5.00**$50,000**2 x ( 5000 x $5 ) EOQ = = = 408.25 units per order 0.2 x $1.50 $0.30 Cont.**Stock Cycle**stock level initial stock trigger level time order order order order order**Regulatory Authorities**• ASIC –Australian Investment & Securities Commission “enforces company and financial services laws to protect consumers, investors and creditors” http://www.asic.gov.au/asic/asic.nsf • ACCC – Australian Competition and Consumer Commission – national competition policy http://www.accc.gov.au/content/index.phtml/itemId/142 • ACA – Australian Telecommunications Authority http://www.aca.gov.au/