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
2. GRAPHIC METHOD (SCATTER DIAGRAM METHOD) PBT AS PER
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 ILLUSTRATION
SALES REVENUE 2M 1.5M 2.250M
*Sales are the same whether you use AC or VC. AJ Company currently sells 10K units of its lone product at a price of P50 per unit. The product costs
at this level of activity are given below:
Cost per unit
ABSORPTION VARIABLE Variable Costs: Fixed Costs:
COSTING COSTING Direct Materials P13 Fixed Overhead P100K
DIRECT MATERIAL P7.50 P7.50 Direct Labor 7 Fixed Selling Expense 20K
Variable Overhead 8
DIRECT LABOR 2.50 2.50
Variable Selling Expense 2
VARIABLE MANUFACTURING OVERHEAD 6.00 6.00
FIXED MANUFACTURING OVERHEAD (400K ÷ 800K) 5.00 -
REQUIRED:
COST PER UNIT P21 P16
a) What is the present profit?
*As for the COGS, note that the cost per unit will be different for each costing method.
b) The company could increase its sales by 30% if it spends P25K for advertisements. Determine
the effect on company profit using: 1) Total approach 2) Differential approach
YEAR 1 YEAR 2 YEAR 3
SALES (IN UNITS) 80K 60K 90K
10K units 13K units
COST PER UNIT P21 P21 P21 Sales 500K 650K
COGS 1.680M 1.260M 1.890M Less: VC (300K) (390K)
*To get the COGS per year under absorption costing, just multiply the cost per unit by the number of CM 200K 260K
units sold. Less: FC (120K) (145K)
Profit P80K (a) 115K
Operating expenses would be the same:
YEAR 1 YEAR 2 YEAR 3 B1) TOTAL APPROACH B2) DIFFERENTIAL APPROACH
SALES (IN UNITS) 80K 60K 90K Profit (new) 115K CM *60K 
VSAE P0.50 P0.50 P0.50 Less: Profit (now) (80K) Less: FC (25K )
TOTAL VSAE 40K 30K 45K 35K increase Profit 35K
FSAE 37.5K 37.5K 37.5K *3K units (50 – 30)
TOTAL OPEX 77.5K 67.5K 82.5K

RAHYNE, CPA [@rrhdamcpa]

 MAKE OR BUY (outsourcing decision) TO COMPUTE NEW PROFIT/ LOSS: ALTERNATIVELY:
SEGMENT MARGIN (remaining PROFIT, NOW (total profits of all
XX XX
COST TO MAKE COST TO BUY segment) segments)
AVOIDABLE VCs PURCHASE PRICE COMMON FC (after allocation) (XX) SEGMENT MARGIN (dropped segment) (XX)
DM MATERIALS HANDLING NEW PROFIT/ LOSS XX NEW PROFIT/ LOSS XX
MATERIALS HANDLING TO DETERMINE THE DECREASE/ INCREASE
DL IN PROFIT:
VMOH PROFIT, NOW (Before Shutdown) XX
AVOIDABLE FCs PROFIT, NEW (After Shutdown) (XX)
OPPORTUNITY COST INCREASE/ DECREASE IN PROFIT XX

ILLUSTRATION ILLUSTRATION

Ferrari must decide whether it must continue to produce an engine component or buy it from Sarao- The combined income statement of Chris Retails for East and West branches is given below:
Philippines for P25K each. The demand for the coming year is 20 units. The costs of producing a
single unit of the engine component are as follows: East Branch West Branch Total
Sales P1.2M P800K P2M
Direct Materials P12K Less: Variable Expenses (840K) (360K) (1.2M)
Direct Labor 8K Contribution Margin P360K P440K P800K
Factory Overhead (70% fixed) 10K Less: Traceable Fixed Expenses (210K) (180K) (390K)
P30K Segment Margin P150K P260K P410K
Less: Common Fixed Expenses (180K) (120K) (300K)
If Ferrari buys the components, the facility now used to make the components can be rented out to Profit (Loss) (P30K) P140K P110K
another firm for P90K.
If East Branch were eliminated, then its traceable fixed expenses could be avoided. The total
REQUIRED: common fixed expenses are merely allocated and would be unaffected.
a) Should Ferrari make or buy the components? a) What will be the new company profit (loss) if East Branch is eliminated?
b) How much is the maximum amount that Ferrari is willing to pay an outside supplier for the b) What will be the decrease in company profit if East Branch is closed and 20% of its traceable
engine component? fixed expenses would remain unchanged while West’s sales would decrease by 20%?

Make Buy SOLUTION #1: SOLUTION #2 a) WEST Branch Alternative Solution:

DM 12K --- Make Buy Make Buy Segment Margin 260K Profit (now) 110K
DL 8K --- 460K 500K 460K 500K Less: Common FC (300K) Less: SM, EAST (150K)
VFOH 3K --- (90K) 90K  Profit (40K) Profit (new) 40K
FFOH 7K 7K 410K 550K
PP ---- 25K  correct b) WEST Branch
23K 25K A) BUY, net advantage = P50K CM *353K
X 20 units X 20 units Less: TFC, West (180K)
460K 500K Less: TFC, East **(42K)
Less: Common Fixed Cost (300K)
ACCEPT OR REJECT Profit (new) (170K)
Less: Profit (now) 110K
TO GET THE PROFITunit: TO GET THE ACTUAL PROFIT: Decrease in Profit P280K
SPECIAL ORDER SP XX PROFITunit XX
RELEVANT COSTSunit X SPECIAL ORDER/unit XX *CM: 440K x 80%
(+Distribution costs/ shipping (XX) ACTUAL PROFIT XX **TFC, East: 210K x 20%
costs, if any)
PROFIT/unit XX PRODUCT ELIMINATION POINT (SHUTDOWN POINT)
*Add VSAE, Opportunity Cost, Avoidable FC to RC
FC - SDC
SDP =
ILLUSTRATION UCM
*Shutdown cost – an unavoidable cost. Thus, deduct it against FC to get the relevant
Eloy Company produces and sells toy cars. Each toy car sells for P50 and the company sells avoidable portion e.g., Plant Maintenance & RPT
approximately 500K toy cars each year. Unit cost data for 2024 are given below:
BEP > SDP PROFIT EXPECTED SALES > SDP CONTINUE
Fixed Variable Fixed Variable BEP < SDP LOSS EXPECTED SALES < SDP SHUTDOWN
Direct Mats - P16 Factory Overhead P8 P5 EXPECTED SALES = SDP INDIFFRENCE
Direct Labor - 12 Distribution Costs 2 3 Expected Sales using BEP.

Eloy has received an offer from a foreign customer to purchase 20K toy cars at P40. If the offer is ILLUSTRATION
accepted, the company has idle capacity to accommodate the order but the unit variable distribution
costs will increase by P2 for insurance and import duties. John Lloyd Company expects that sales will drop below the current level of 5K units per month. An
income statement prepared for the monthly sales of 5K units show the following:
REQUIRED:
a) What is the relevant unit cost of the special order? Sales (5K @ P3) P15K
b) Should Eloy accept or reject the special order? Less:
Variable Costs (5K @ P2) P10K
A) Relevant Costs (VC): 16 + 12 + 5 + (3 + 2) = P38 Fixed Costs 5K 15K
Profit -0-
B)
If plant operations are suspended, a shutdown cost (i.e., plant maintenance and real property taxes)
Special order price: P40
of P2K per month will remain as incurred. Since there is no immediate possibility of profit under
Profit per unit: 40 – 38* = 2
Accept, profit shall be: present conditions, the problem of the company is just how to minimize the loss.
2 x 20K units = P40K
REQUIRED:
a) Determine the shutdown point in units.
SPECIAL ORDER PRICING (MINIMUM SELLING PRICE)
b) Should the company continue or shut down operations if sales next month are expected to
be:
∟FULL CAPACITY: Regular SP = Add all the costs including FCs or divide the units at full
1) 4K units? 2) 2K units? 3) 3K units?
capacity to the total costs at full capacity
∟EXCESS CAPACITY: VCs + Distribution/ Shipping Costs
(SD Point)
Continue  4K units 2K units 3K units
SPECIAL ORDER PRICE < REGULAR SP Contribution margin 4K 2K 3K
ACCEPT AT EXCESS CAPACITY Less: Fixed Costs (5K) (5K) (5K)
REJECT AT FULL CAPACITY Profit (Loss) (1K) (3K) (2K)
vs. vs. vs.
ILLUSTRATION Shutdown  (2K) (2K) (2K)

K Company sells “Swiftie” at a unit price of P45,000, with the following unit production costs: BEP = FC ÷ UCM SDP = (FC – SD Costs) ÷ UCM
BEP = 5K ÷ (3 – 2) = 5K units A) SDP = (5K – 2K) ÷ (3 – 2) = 3K units
Direct Materials P14K B)
Direct Labor 12K 1) 4K units > SDP: CONTINUE
Variable overhead 9K 2) 2K units < SDP: SHUTDOWN
Fixed overhead 6K 3) 3K units = SDP: CONTINUE or
SHUTDOWN (Indifference Point)
A special order for 1K units was received from Manuel Company. Additional shipping costs for this
sale are P3K per unit. SELL OR PORCESS FURTHER

REQUIRED: SELL PROCESS

A XX XX FINAL SALES VALUE – ADDT’L PROCESSING COST
What is the minimum selling price per unit for the special order if:
B XX XX FINAL SALES VALUE – ADDT’L PROCESSING COST
a) K Company is operating at FULL capacity? 45K + 3K = 48K C XX XX FINAL SALES VALUE – ADDT’L PROCESSING COST
b) K Company has EXCESS capacity? 35K + 3K = 38K XX XX
*Joint costs – irrelevant (past cost).
CONTINUE (RETAIN) OR SHUTDOWN (DROP) A BUSINESS EGMENT *Sell = Sales Value at Split-off point

PROFORMA SELL > PROCESS SELL

SALES XX SELL < PROCESS PROCESS FURTHER
LESS: VARIABLE EXPENSES (XX)
CONTRIBUTION MARGIN XX
LESS: TRACEABLE FIXED COST (Direct/ Avoidable)) (XX)
SEGMENT MARGIN XX
LESS: COMMON FIXED COST (Indirect/ Unavoidable) (XX)
PROFIT (LOSS) XX
*Common FC (dropped segment) – allocated in other segments.
RAHYNE, CPA [@rrhdamcpa]
ILLUSTRATION a)
A - 50 units X 20 = 1,000
Nicos Company produces products G, I & N for a joint costs of P100K. Each product may be sold at B - 80 units X 18 = 1,440
its split-off point or processed further. Additional processing costs are entirely variable. Relevant data C - 150 units X 25 = 3,750
are given below: CM 6,190
- FC (4,000)
Product Sales Value at Split-Off Additional Processing Costs Final Sales Value Highest → Profit B) 2,190
G P100K P70K P250K
I 200K 40K 220K • LINEAR PROGRAMMING
N 60K 60K 100K ✓ It can handle many constraints.
P360K P170K P570K ✓ Para madetermine yung objective function, it involves maximization of the company’s
CM. e.g., Maximize Z (CM) = 3A + 4B: 3 & 4 – CMUs of each products
REQUIRED: ✓ Anong magpipigil na ma-reach ang objective? Constraints, kaya kapag walang
a) Which product (s) should the company sell at split-off point? constrainits, produce lang nang produce ng units.
b) If the company can only sell all the products at split-off point or process all the products further ✓ Non-negativity constraint function – Yung ilalagay na numbers na isa-substitute sa
beyond the split-off point, then which option is recommended? number of units, bawal negative kaya, A & B ≥ 0.
✓ Optimal Product Mix/ Best Product Combination – combination of products that will
Split-Off Point Further Processing Costs G give the company the highest profit.
✓ To compute for the optimal product mix: Consider the combinations between
I
Joint Cost: P100K products A & B.
N

SELL PROCESS
G: 100K 180K = 250K – 70K
I: 200K 180K = 220K – 40K
N: 60K 40K = 100K – 60K
360K 400K

A) SELL: Products I & N

B) PROCESS: All Products (P40K net advantage)

SCRAP OR REWORK

→ SCRAP – Sell at a bargain price.

→ REWORK = SP – (MATS + LABOR + OH)
*Inventory cost is sunk cost. Thus, irrelevant.
Credits to Sir Aljon’s discussion
Good Young Company has 5K obsolete truck parts that are carried in inventory at a cost of P50K.
The Company is faced with a decision whether to scrap the parts or modify them:
ANALYSIS:
➢ If the parts were junked, the company would realize only 10% of its cost.
 To compute for the OPTIMAL PRODUCT MIX/ BEST PRODUCT COMBINATION:
➢ Should the company modify the parts, it will spend P8K for materials, P2K for direct labor,
✓ Magco-consider ng combinations Product A & B. Titingnan kung anong value ng Z, remember
and overhead equal to 60% of prime costs. The new parts will sell for P24K in the market.
na ang Z function is 3A + 4B.
✓ Provide three columns for Product A, Product B, & Z (CM).
REQUIRED:
✓ Ang tanong na dapat sagutin dito, how would you come-up with more or less, maximize
Should the company modify or scrap the parts?
combination?
✓ Sa Material 1 cost function, nabago yung “≤” into “=”, ganon din sa Material 2. Kasi the target
SCRAP (Junk) → “Sell” REWORK (Modify) → “Process Further”
10% (50K) = P5K 24K – [8K + 2K + 60% (10K)] = P8K is to maximize profit, kung gusto ng malaking kita, dapat ma-maximize yung sales. Para ma-
maximize yung sales, maximize production; To maximize production, maximize the use
REWORK (Modify): net advantage = P3K of materials. Sa makatuwid, hindi lang gagamit ng ≤ 120, but we will exhaust this.
Inventory cost of P50K (sunk cost) is irrelevant → “Joint Cost” counterpart ✓ Ang assumption is this: Kapag walang prinoduce na A, lahat ilalaan sa Material 1, thus, 24
ang kayang maproduce ng B (120 ÷ 5), kasi 24 X 5, ubos na yung 120. What if naman lahat
BEST PRODUCT COMBINATION ng 120 pounds ng Material 1, ilalaan kay A, walang iproproduce na B. If B is 0, A is 60 (120
÷ 2).
Compute the CM/hr/meter/kg (constraint) ✓ A = 0, B = 24 (combo 1); A = 60, B = 0 (combo 2): Why should they be considered? Are they
PRODUCT A PRODUCT B PRODUCT C maximized? Inuubos ba nila lahat ng availabale resources? Yes, lahat ng 120 ubos. (Refer to
UNIT CM XX XX XX the illustration above)
÷ HOURS/unit XX XX XX ✓ Do the same sa Material 2. Ubusin din yung 80, same process lang.
CM/hr/meter/kg XX XX XX ✓ A = 0, B = 40 (combo 3); A = 20, B = 0 (combo 4).
Rank from highest to lowest. ✓ Saan malalaman yung huling combination? Sa parehong function. Pagsabayin or
Determine the best product combination. simultaneous solving sa least square: Either get rid of A to solve B or get rid of B to solve for
XX → Limitation (e.g., hours) A.
(XX) → 1ST in ranking (units)** X Machine per hr ✓ Anong mas madaling i-eliminate? A.
XX ✓ Parang sa least square lang na dinidivide muna yung parehong A para maging pareho sila at
(XX) → 2nd in ranking (units)** X Machine per hr macancel. Then, multiply yung factor sa M1, then, deduct the results/ equation to the values
XX Remaining Limitation ÷ Machine per hr
of M2.
(XX) → 3RD in ranking (units)** X Machine per hr ✓ To know the value of A, substitute lang sa M1 equation. Thus, the last combo is: A = 10, B =
0 20. (Refer to the illustration above)
Compute the highest possible profit. ✓ Since lahat ng ito maximize combinations, pag nilagay isa-isa sa function (Maximize Z = 3A
A – XX units** X UCM = XX + 4B), magkakaroon ng limang values ng Z.
B – XX units** X UCM = XX ✓ But first, test the constraints against each other: Yung kakayahan ba ni Material 1, kakayanin
C – XX units** X UCM = XX ni Material 2 and vice versa.
TOTAL CM XX ✓ Si Material 1, kaya niyang magproduce ng 24B, tingnan sa Material 2 kung kaya rin niya mag-
LESS: FC XX produce ng 24B; 24 X 2 (ito yung 2B ni M2) = 48 lang ang need, meyron 80 si M2, thus,
PROFIT XX feasible.
✓ Ang hindi feasible ito: Kung si M1 kaya niyang 60 units of A pero pag si M2, hindi na kaya,
BEST PRODUCT COMBINATION kailangan na ng 240 meters, kasi 60 X 4 (4A ni M2) = 240 na. Kaya ibig sabihin yung 60 units
Mr. Nacpae produces products A, B and C. One machine is used to produce the products. The sales of A, si M1 lang ang kaya, si M2, hindi kaya. Therefore, impossible to happen, wag na i-
demands, contribution margins and time on the machine (in hours) are as follows: consider. Not Feasible or NF, in other words, impossibleng mangyari kaya wag nang i-
substitute pa kay Z.
Market Limit Unit Contribution Margin Hours on Machine ✓ Another, si M2, kaya niyang gumawa ng 40 units of B, si M1, hindi niya kaya kasi 40 x 5 (5B
A 100 units P 20 10 per unit ni M1) = 200, kasi hanggang 120 ang kaya.
B 80 units P 18 5 per unit ✓ Another, kaya bang gumawa ni M1 ng 20 units of A? Kaya, why? 20 x 2 (2A ni M1) = 40 only
C 150 units P 25 10 per unit kasi meyrong 120 pounds.
✓ Lastly, A = 10, B = 20, substitute to M1, saktong 120 (2(10) + 5(20)); Sa M2, saktong 80 (4(10)
There are 2.4K hours available on the machine during the week. Total fixed cost is P4K. + 2(20)). Thus, feasible itong combo na ito.
✓ Sa combo 5, ito lang yung combi na, lahat ng available resources, ubos.
REQUIRED: ✓ Then, substitute lang yung mga feasible combinations sa objective function. Kaya ang
A. What is the best product combination that maximizes the weekly contribution? Optimal Product Mix: 10 of A, 20 of B. (ALGEBRAIC METHOD)
a) 90 units of A; 0 unit of B; 150 units of C
b) 50 units of A; 80 units of B; 150 units of C
c) 100 units of A; 80 units of B; 100 units of C
d) 100 units of A; 80 units of B; 150 units of C
B. How much is the profit associated with the best product combination?

Product A Product B Product C

Unit CM P 20 P 18 P 25
Hours per unit 10 hours 5 hours 10 hours
CM per hour 2 3.6 2.5
(3rd) (1st) (2nd)

2.4K hours (limited)

(400)  B: 80 units x 5 hours
2K
(1.5K)  C: 150 units x 10 hours
500
(500)  A: 50 units x 10 hours
0

RAHYNE, CPA [@rrhdamcpa]

 • GRAPHIC METHOD
✓ Yung pag plot sa graph is comparable to X & Y axis. ILLUSTRATION
✓ I-plot lang yung M1 & M2 combinations. Canada Inc. has projected sales to be 80K in April, 100K in May and 120K in June. Canada collects
✓ Para marepresent yung “=” sa graph, need i-shade yung graph. 40% of a month’s sale in the month of sale, 40% in the month following the sale, and 20% in the
✓ Kung saan nag-merge yung blue at yellow, ito yung feasible region, which means second month following the sale. What is the AR balance on June 30?
dito lang possibleng mangyari yung production.
✓ Kaya tinanggal yung 60,0 at 0,40 kasi malayo sa feasible region. AR, June 30 (40 – 40 – 20)
✓ Then, identify the corner points ng feasible region. June: 120K x 60% = 72K
✓ Yung algebra na simultaneous solving, ang counterpart sa graph ay the May: 100K x 20% = 20K
intersection. April: 80K x 0% = 0
✓ Sa BE, hindi graphic, pero in practice mas ginagamit ito. *Note that if the question is AR balance, do not use the % of collection but the % of receivable.
*In June, 40% has been collected. Thus, 60% is still unpaid. In May, 40% has been collected out of
BUDGETING WITH PROBABILITY ANALYSIS the 60% receivable. Thus, 20% still remains unpaid. In April, 20% has been collected. Thus, 0% still
remains unpaid.
OPERATING BUDGET
I. Sales Forecast [starting point] ILLUSTRATION
II. Sales Budget [most difficult] Indonesia Inc. has projected sales: February, 10K; March, 9K; April, 8K; May 10K; and June, 11K.
III. Production Budget Indonesia has 30% cash sales and 70% sales on account. Accounts are collected 40% in the month
IV. Inventory Budget following the sale and 55% collected the second month. What would be the total cash receipts in
a) Raw Materials May?
b) Direct Labor 30%: Cash
c) Overhead Sales 70%: Credit (0 – 40 – 55)
V. Cost of Sales May, Cash Receipts
VI. Marketing and Admin Expense May: 10K x 30% = 3K
FINANCIAL BUDGET April: (8K x 70%) x 40% = 2,240
VII. Cash Budget March: (9K X 70%) x 55% = 3,465
VIII. Working Capital Budget *Cash receipts mean cash collections.
IX. Projected (Pro-forma) FS *30% was collected immediately in the month of sale. 70% credit sales was collected 40% in the
a) Income Statement month following the sale; and 55% in the second month following the sale.
b) Financial Position
c) Cash Flow [last prepared] ILLUSTRATION
Venezuela Co. expects purchases for June to be 130K and its purchases for July to be 124K.
PRODUCTION AND INVENTORY BUDGET Venezuela pays 60% of its purchases in the month of purchase and receives 2% discount. Venezuela
pays for the remaining 40% in the next month without discount. For purchases only, what are the
expected cash payments in July?

July Payments: 60 (98%) – 40

July: 124K x 60% x 98% = 72,912
*Sales – starting point of budgeting. June: 130K x 40% = 52K
*Reverse the procedure. *60% of purchases are paid in the same month (with a 2% discount); 40% of purchases are paid in
the following month (without a discount).

ILLUSTRATION: MERCHANDISE PURCHASE BUDGET

X Co. has budgeted sales at 100K and expects a profit of 10% of sales. Expenses are estimated as
follows: Selling = 16% of sales; Administrative = 4% of sales. Labor expected to be 40% of the total MONTH 1 MONTH 2
manufacturing costs. Factory overhead is to be applied at 75% of direct labor costs. Inventories are Inventory, beg. XX XX
projected as follows: + Purchases XX XX
- Inventory, end (XX) (XX)
January 1 December 31 COGS XX XX
Materials 1.5K 4K *Inventory should be valued at cost.
Work-In-Process 5K 15K *Inventory end of the previous month is the beg of the current month.
Finished Goods 8K 3K *Start first at COGS then work back:
SALES 100%
REQUIRED: Determine the budgeted amount for: - COGS %
A. COGS; B. TMC; C. Factory Overhead; D. Materials Purchases GP % *If there is mark-up, divide to sales.

1.5K (DM, beg) 22.5K (DM, usage) 5K (WIP, beg) 8K (FG, beg) 100K (SALES) ILLUSTRATION
25K (DM, purchases) 30K (DL) 75K (TMC) 65K (CGM) (70K) (CGS) Nigeria Merchandising has budgeted the following sales for the 4th quarter of 2025:
(4K) (DM, end) 22.5K (FOH) (15K) (WIP, end) (3K) (FG, end) 30K (GP)
22.5K (DM, usage) 75K (TMC) 65K (CGM) 70K ((CGS) (20K) (EXP) October P 123,500
10K (PROFIT) November 156,000
SALES 100% December 208,000
CGS (70%)
GP 30%
EXP (20%) → 16% + 4% Other budgeted estimates are:
PROFIT 10% - All merchandises are to sell at its invoice cost plus 30% mark-up.
- Beginning inventories are budgeted at 40% of the same month's projected cost of goods sold.
SALES AND ACCOUNTS RECEIVABLE BUDGET - 80% of merchandise purchases are paid in the purchase month, while balance is paid the next
month.
→ Collection pattern is still in reverse.
→ AR balance as of a given date represents sales from previous months that have not REQUIRED: Determine the projected amount for:
been collected. A) Merchandise purchases in October
→ If % of cash sales & AR sales are given, and the question is cash receipts (collection), B) Merchandise purchases in November
include the cash sales (month of sale); and, (Sales X % AR sales) X % Collection in the C) Total payment in November for merchandise purchases
following months.
→ Q: AR bal: Multiply the % of receivable against sales, not the % of collection. OCT. NOV.
→ Q: Cash payments: Deduct the discount first, then, multiply to the % of payment. Inventory, beg. 38K ← 40% (95K) 48K ← 40% (120K)
→ IMPORTANT MONTHS TO REMEMBER: + Purchases 105K 136K Inventory, Dec. 1
a) Month’s sale - Inventory, end (48K) (64K) ← 40% (208K ÷ 1.3)
b) Month following the sale Cost of Goods Sold 95K ← 123,500 ÷ 1.3 120K 156K ÷ 1.3
c) Second month following the sale
November Payments: 80 – 20
CGS x 1.3 = Sales Nov: 136K (80%)
ILLUSTRATION: 129.8K
CGS = Sales ÷ 1.3 Oct: 105K (20%)
Past collections experienced by X Co. indicate that 60% of the sales billed in a month are collected
during the month of sales, 30% are collected in the following month, and 10% are collected in the
ASSUME
second following month. The following are the projected sales for next year:
INCREASE IN INVENTORY BEG -0-
DECREASE IN INVENTORY END -0-
January 480K
February 420K ILLUSTRATION
March 500K Brazil Co. is preparing its cash budget for the next month based on the following projections:
April 550K
Sales 400K
May 600K Gross Profit Rate 25%
Increase in Inventories 30K
REQUIRED: Decrease in Accounts Payable for Inventories 12K
a. March Collections; b. May Collections; c. AR balance as of April 1; d. AR balance as of June 1 What will be the estimated cash disbursements for inventories?

COLLECTION PATTERN: 60 – 30 – 10 Inventory, beg. 0

+ Purchases 330K + 12K = cash disbursement
A. March Collections - Inventory, end (30K)
Mar: 500K x 60% Cost of Goods Sold 300K ← 75% (400K)
Feb: 420K x 30% 474K
Jan: 480K x 10% DM FG
B. May Collections DM, BEG. XX FG, BEG. XX
May: 600K x 60% + PURCHASES XX + PRODUCTION XX
April: 550K x 30% 575K - DM, END. (XX) FG, END (XX)
March: 500K x 10% DM USAGE XX SALES XX
C. AR, April 1/ March 31
March: 500K x 40%
ILLUSTRATION
Feb: 420K x 10% 242K
Jan: 480K x 0% Vietnam Co. manufactures a single product. The company keeps inventory of raw materials at 50%
D. AR, June 1/ May 31 of the coming month’s budgeted production. Each unit of product requires 3 pounds of materials. The
May: 600K x 40% production budget is (in units): May, 1K; June, 1.2K; July, 1.3K; Aug., 1.6K. Determine the raw
April: 550K x 10% 295K materials purchases in July.
March: 500K x 0%
RAHYNE, CPA [@rrhdamcpa]
 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 COLD (20%) 50K (3): P150K
OPERATING Receipts from royalties, fees, commissions
ACTIVITIES and other revenues. LATER
(Current Asset & Payment to suppliers. RAIN (50%) 100K (4): P400K
(4 WEEKS)
Current Payment to employees.
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
Receipts from PPE.
Receipts from sale of investment in debt
INFLOWS
INVESTING securities. STANDARD COSTING WITH GP VARIANCE ANALYSIS
ACTIVITIES Receipts from notes receivable.
(Non-Current Payment to acquire PPE. ▪ STANDARD COST SYSTEM – product costing system that determines product cost by using
Assets) Payment to acquire debt or equity securities. standards or norms; it allows actual costs to be compared against norms for control purposes.
OUTFLOWS
Payments to make loans to other generally in
the form of notes receivable. BUDGETS STANDARDS
Debt securities – Bonds, unsecured debt instruments, short-term/long-term promissory notes, PURPOSE Expected costs What costs should be.
certificate of deposit, commercial paper, mortgage-backed securities, and T-bills. Cost levels that should not Levels to which the costs should be
FINANCING Receipts from investments by owners. EMPHASIS
INFLOWS be exceeded reduced.
ACTIVITIES Receipts from issuance of notes payable. ANALYSIS Measure of performance. Imposes responsibility.
(Non-Current Payment to owners in the form of dividends.
Liabilities & OUTFLOWS Payment to settle notes payable.
Equity) FORMULAS
Equity securities – Common stock, preferred stock, stock warrants and convertible preferred BUDGETED QUANTITY x STANDARD PRICE
shares. BUDGETED COST = (Budgeted Qty = Planned Production @ Normal Capacity x
Quantity Standard)
STANDARD QUANTITY x STANDARD PRICE
EXPECTED VALUE STANDARD COST =
(Standard Qty = Actual Production x Quantity Standard)
✓ Uses probabilities as weights to compute the arithmetic mean or average of possible
ACTUAL COST = ACTUAL QUANTITY x ACTUAL PRICE
outcomes.
“Should have” – standard
Example:
SALES PROBABILITY PROFIT
DM VARIANCE
VOLUME (LOSS)
MATERIALS BUDGET VARIANCE = Actual – Budget (std)
XX XX X XX% X XX XX
MATERIALS QTY VARIANCE
XX XX X XX% X XX XX
Also Materials Usage Variance & Materials Efficiency = (AQ – SQ) SP
XX/units XX Variance
Budgeted Sales = XX/units X SP MATERIALS PRICE VARIANCE
EV of Monthly Profit = Total P/L = AQ (AP – SP)
Also Materials Spending Variance
MATERIALS PRICE USAGE VARIANCE = AQused(AP – SP)
ILLUSTRATION MATERIALS PURCHASED PRICE VARIANCE = AQpurchased(AP – SP)
France Company prepared the following probability distribution describing the relative likelihood of Qty → x SP; Price → x AQ
monthly sales volume levels and related profit (loss) for its lone product that sells for P 50 per unit:
Alternatively,
SALES PROBABILITY PROFIT
AC AQ X AP MPV
VOLUME (LOSS)
600 6,000 X 10% X (P 70,000) (7K) AQ X SP DM VARIANCE
3.6K 12,000 X 30% X 10,000 3K SC SQ X SP MQV
3.6K 18,000 X 20% X 60,000 12K
7.2K 24,000 X 30% X 100,000 30K *SQ → Based on ACTUAL PRODUCTION: ACTUAL PRODUCTION X QTY. STANDARD
2.5K 25,000 X 10% X 140,000 14K
*ACTUAL PRICE = DIRECT MATERIALS COST ÷ TOTAL MATERIALS (PURCHASED/USED)
17.5K units 52K

REQUIRED: Using the expected value approach, DL VARIANCE

A) How much is the budgeted sales for the month? 17.5K units X 50 = 875K DL VARIANCE = Actual – Budget (std)
B) What is the expected value of the monthly profit? 52K LABOR EFFICIENCY VARIANCE (LEV)
= (AH – SH) SR
Also Labor Usage/Quantity Variance
INDIFFERENCE POINT LABOR RATE VARIANCE (LRV)
= AH (AR – SR)
Also Materials Spending Variance
Efficiency → x SR; Rate → x AH
ILLUSTRATION
Peru Company plans to introduce a new product that requires an initial cash investment of P 44 M.
Alternatively,
If the product becomes successful, the net cash inflow is forecasted at P 80 M. However, if the
AC AH X AR
product becomes a failure, net cash inflow is estimated at P 20 M. LRV DL VARIANCE
AH X SR
A) If the success rate is 70%, what is the value of act "to invest?"
SC SH X SR LEV
B) What probability-percentages should be assigned to the events 'success' and 'failure' to be
indifferent between the two actions "to invest" and "not to invest?" *SH → Based on ACTUAL PRODUCTION: ACTUAL PRODUCTION X STD. HOURS
*ACTUAL RATE = TOTAL DIRECT LABOR COST ÷ DIRECT LABOR HOURS USED
‘x’ –probability of SUCCESS *LEV excludes idle time spent in the production (regarded as unfavourable)
‘1-x’ – probability of FAILURE IDLE TIME VARIANCE = IDLE TIME X STANDARD LABOR RATE

NCF PROBABILITY B. INDIFFERENCE POINT

CASH INFLOW = CASH OUTFLOW
ILLUSTRATION
A) SUCCESS: 80M X 70% MATERIALS AND LABOR VARIANCE ANALYSIS
62M
FAILURE: 20M X 30% 80 (x) + 20 (1 –x) = 44
(44M) 80x + 20 - 20 = 44 B Company has established the standard for a single unit of its product, Mini Tripod:
18M 60x = 24

x = 40% (success) INPUTS STANDARDS

1 – x = 60% (failure) Direct Materials 3 metallic bars at P5 per bar
*NCF – Net Cash Flow; Expected Value – WA based on probabilities Direct Labor 2 labor hours at P10 per hour

JOINT PROBABILITY ▪ At the start of the year, the budget includes a planned production of 1K units of tripod based
on normal capacity.
ILLUSTRATION ▪ At the year-end, actual production was 1.2K units of tripod, which resulted to using 4K bars,
Colombia Company has three sales departments, each contributing the following percentages of purchased at a cost of P6 per bar.
total sales: Alcohol, 30%; Beverages, 50%; and Cigars, 20%. Each department has had the following
average annual damaged goods rates: Alcohol, 10%; Beverages, 12%; and Cigars, 5%. A random OUTPUT INPUT (DM)
corporate audit has found a weekly damaged goods rate of sufficient magnitude to alarm Colombia's BP: 1K units BQ: 3K bars (1K units X 3/ metallic bar) X P5 → BC: 15K → Planning
management. SQ: 3.6K bars (1.2K units X 3/metallic bar) X P5 → SC: P18K → Controlling
AP: 1.2K units
AQ: 4K bars X P6 → AC: 24K → Organizing
REQUIRED:
Determine the probability in percentage that the damage occurred in the: *Normal capacity is the budgeted production.
A) Alcohol department → 3/10 = 30% *Standard cost is based on the actual production.
B) Beverages department → 6/10 = 60% *Analysis: The company plans to incur 15K, but it actually incurred 24K, when the standard says it
C) Cigars department → 1/10 = 10% should incur 18K only.

RAHYNE, CPA [@rrhdamcpa]

 REQUIRED: ILLUSTRATION
1. Based on the BUDGETED production of 1,000 units: MATERIALS PRICE, MIX AND YIELD VARIANCES

A) How many bars must the company plan to use? (Budgeted quantity) Mc Inasal produces the popular “APT” Colonge that has gone viral in social media. The merger has
1K units X 3 bars/ unit = 3K bars established the following standards for one kilo of “APT” Cologne:
B) How much materials cost is included in the budget? (Budgeted materials cost)
3K bars X P5/bar = 15K Ingredients Standard Qty Standard Unit Cost Standard Cost
Asin 500 grams (50%) P2.00 1,500
2. Determine the actual cost of materials used. Patis 400 grams (40%) P4.00 1,600
4K bars X P6/ bar = 24K Tawas 100 grams (10%) P5.00 500
TOTAL 1,000 grams (100%) 3,600
3. Based on the ACTUAL production of 1,200 units:
The company reported the following production and cost data for the January 2025 operations:
A) How many bars should have been used? (Standard quantity)
1.2K units X 3 bars/unit = 3.6K Ingredients Actual Qty Actual Unit Price Actual Cost
Asin 60,000 P2.00 120,000
B) How much materials cost should have been incurred? (Standard materials cost)
Patis 30,000 P5.00 150,000
3.6K bars X P5/ bar = 18K
Tawas 10,000 P4.00 40,000
C) How many labor hours should have been spent? (Standard hours) TOTAL 100,000 310,000
1.2K units X 2 hrs/ unit = 2.4K hrs
D) How much labor cost should have been incurred? (Standard labor cost) Mc Inasal produced 90 kilos of “APT” cologne in January 2025.
2.4K hrs X P10/hr = 24K
WHERE: REQUIRED:
4. Determine the following: AC > SC: UNFAVORABLE (credit balance) 1) Total Materials Cost Variance 3) Materials Mix Variance
A) Materials budget variance: AC < SC = FAVORABLE (debit balance) 2) Materials Price Variance 4) Materials Yield Variance
▪ Budget Variance = Actual – Budget
▪ Budget Variance = AC of Materials – BC of Materials 1) DM VARIANCE = = ACTUAL COST – STANDARD COST
= 24K – 15K = 9K UF (overspending/budget deficit/ deduction to profit) = 310K – (90 (3.6K)) → SC is based on the actual production.
= 14K F
B) Materials standard cost variance. 2) MPV = AQ (AP – SP)  Asin 60K (2 – 3) = 60K F
▪ DM Variance = Actual cost – Standard cost  Patis 30K (5 – 4) = 30K U 40K F
= 24K – 18K = 6K UF  Tawas 10K (4 – 5) = 10K F

C) Materials quantity variance (MQV)

To compute: MQV: (AQ – SQ) X SP 3) MMV = (AQ x SP) – TOTAL ACTUAL QUANTITY AT AVERAGE
= (4K – 3.6K) x 5 = 2K UF (over usage of materials) STANDARD PRICE (TAQASP)
AQ x SP Should be weighted average
D) Materials price variance (MPV)  Asin = 60K (3) using standard mix (like in sales
To compute: AQ X (AP – SP)  Patis = 30K (4) 350K mix).
= 4K X (6 – 5) = 4K UF (overspending)  Tawas = 10K (5) 10K F Standard Mix: 50%-40%-10%
TAQ x ASP = 100k (3.6) 360K ASP: 3 (.5) + 4 (.4) + 5 (.1) = 3.6
Alternatively,
AC AQ X AP 4K (6) : 24K MPV: 4K UF 4) MYV = TAQASP – STANDARD COST
MPV
AQ X SP 4K (5) : 20K = 360K – 324K
SC SQ X SP MQV 3.6K (5) : 18K MQV: 2K UF = 36K U
DM VARIANCE 6K UF
ALTERNATIVE SOLUTION
5. In the following year, B purchased 5,000 bars [AQpurchased] at a total cost of P 20,000, and 4,000 3) MMV = (AQ – SQ) x SP 4) MYV = (AQ – SQ) x SP
bars [AQused] of these were used; the standard quantity allowed for the actual production was 3,800  Asin (60K – 50K) x 3 = 30K U = (100K – 90K) x 3.6 = 36K U
bars.  Patis (30K – 40K) x 4 = 40K F *AP x SQ
 Tawas (10K – 10K) x 5 = -0- *90kg x 1K = 90K
Determine: 100K 100K 10K F
A) Total materials cost variance  The basis of standard quantity is standard mix, thus, distribute 100K
B) Materials quantity variance using the standard mix of each ingredient.
C) Materials price usage variance
D) Materials purchase price variance RECOMMENDED SOLUTION
E) If Jelly B has a favorable MPV and an unfavorable MQV, then this most likely results from: AC → AQ x SP
MPV
AQ x SP DM
a. Machine efficiency problems
TAQ x ASP MMV VARIANCE
b. Product mix production changes MQV
SC → SQ x SP MYV
c. Purchase and use of lower-than-standard quality materials
d. Purchase and use of higher-than-standard quality materials
AQ x SP 310K
MPV: 40K F
AQ x SP 350K DM
ACTUAL STANDARD TAQ x ASP 360K MMV: 10K F VARIANCE 14K
AQused = 4K bars SQ = 3.8K bars MQV: 26K U
SQ x SP 324K MYV: 36K F
AP = P4/ bar (P20K/ 5K bars) SP = P5/ bar

TIP: Pag material variance, hanapin na agad yung dalawang actual (AQ/AP) & standard (SQ/SP).
Then, substitute nalang sa formula. FACTORY OVERHEAD

DM Variance: AC – SC = 4K (4) – 3.8K (5) = 16K – 19K = (3K) F Flexible Budget Formula: FOH = a + bX → like the cost function
MQV: (AQ – SQ) X SP = (4K – 3.8K) 5 = 1K U
MPUV: AQused X (AP-SP) = 4K (4-5) = (4K) F Only three (3) can be substituted to X:
MPPV: AQpurchased X (AP-SP) = 5K (4-5) = (5K) F a) BUDGETED HOURS Based on planned production
b) ACTUAL HOURS
Based on actual production
LABOR VARIANCE c) STANDARD HOURS
6. During the year, B paid a total payroll of P 22,000 to laborers, who rendered 2,000 labor hours
to produce the 1,200 units of Tripod. Determine the following: Where:
 a = Budgeted Fixed Cost
A) TOTAL LABOR COST VARIANCE  b = Variable Cost Rate
DL Variance = Actual cost – Standard cost  bX = Total Variable Cost
= 2K (11) – 2.4K (10) = 2K F
REMINDER: FOR LABOR:
MQV = ∆Q x SP Efficiency – gaano FACTORY OVERHEAD BUDGET
B) LABOR EFFICIENCY VARIANCE (LEV)
MPV = AQ x ∆P kabilis ang trabaho
To compute: LEV: (AH – SH) X SR ILLUSTRATION
LEV = ∆H x SR Rate – Workers’ salary
= (2K – 2.4K) X 10 = 4K F X Co. shows the following data regarding its factory overhead:
LRV = AH x ∆R
Flexible Budget Formula: FOH = 20K + 1x where: X – number of labor hours
C) LABOR RATE VARIANCE (LRV) • Standard: 1 unit of product requires 4 labor hours (Usually given)
To compute: AH X (AR – SR) • Normal capacity: 2.5K units (Budgeted Production)
= 2K X (11 - 10) = 2K U • Budgeted hours: A) 10K hours (Denominator Activity)
└First to be substituted to X; based on normal capacity; 2.5K x 4
D) What is a possible reason B would experience an unfavorable LRV and favorable LEV?
a. Labor employed was heavily weighted towards higher-paid experienced workers. FFOH B) 20K (given) Fx OH Rate (FR) E) 2 (20K ÷ 10K)
b. Workers assigned for the job were replaced by workers from other departments. VFOH C) 10K (squeeze) Var. OH Rate (VR) F) 1 (given)
c. Defective materials extended the labor hours required to produce a single unit. TOTAL BUGETED OH D) 30K (20K + 1 (10K)) Std. OH Rate (SR) G) 3 (30K ÷ 10K)
(BFOH)
d. Labor employed was heavily weighted towards low-paid unskilled workers.
REQUIRED:
MATERIALS MIX AND YIELD VARIANCES 1. Compute for the missing amounts.
DM VARIANCE = Actual – Budget (std) 2. What is the budgeted FOH if adjusted based on 7.5K actual hours (BAAH)? FOH = 20K + 1
MATERIALS PRICE VARIANCE (MPV) = AQ (AP – SP)
(7.5K) = 27.5K (BAAH)
MATERIALS MIX VARIANCE (MMV) = (AQ x SP) – TAQASP
3. What is the budgeted FOH if adjusted based on 8K standard hours (BASH)? FOH = 20K + 1(8K)
MATERIALS YIELD VARIANCE (MYV) = TAQASP – STD COSTS
= 28K (BASH)
*TAQASP – Total Actual Quantity at Average Standard Price
*Budget (Standard Cost) = Actual Production X Standard Cost
*BUDGETED HOURS = BUDGETED PRODUCTION x LABOR HOURS
*MPV – itemize
*Fixed Overhead (FFOH) – given in the flexible budget formula
*Average Standard Price is based on Standard Mix(%) x Standard Quantity
*Variable Overhead (VFOH) – work back
*FIXED OVERHEAD RATE = FFOH ÷ BUDGETED HOURS
AQ X AP: MPV *VARIABLE OVERHEAD RATE = VARIABLE OVERHEAD ÷ BUDGETED HOURS, if not given
AQ X SP: DM VARIANCE
MMV *STANDARD OVERHEAD RATE = TOTAL BUDGETED OVERHEAD ÷ BUDGETED HOURS
TAQASP:
MYV MQV
SQ X SP:

RAHYNE, CPA [@rrhdamcpa]

 FACTORY OVERHEAD VARIANCE ANALYSIS TOTAL = FIXED + VARIABLE
AFOH: 26K = 19.5K + 6.5K
 Also known as Applied Factory OH BAAH: 27.5K = 20K + 7.5K
FOH VARIANCE = AC – SC = AFOH – SFOH → also Budget Variance BASH: 28K = 20K + 8K
(1 – way) = AFOH – (SH x SR) SHSR: 24K = 16K + 8K

2 – way: “[Link]” AFOH > SFOH → FOH is UNDERAPPLIED (UF) AFOH: 26K (given)
AC → AFOH CONtrollable AFOH < SFOH → FOH is OVERAPPLIED (F) AFOH (Fixed): 26K x 75%
BASH Variance AFOH (Variable): 26K x 25%
SC → SHSR VOLume Variance
 Can also be computed: FOH = 20K + 1x
(Budgeted Hrs. – Std. Hrs) x FFOH rate BAAH (Fixed): 20K
 Also known as Capacity Variance. BAAH (Variable): 1 (7.5K) From the flexible budget formula
 Always fixed. BASH (Fixed): 20K
*AFOH is normally given. BASH (Variable): 1 (8K)
*SFOH is also SHSR.
*BASH (BUDGETED ADJUSTED STANDARD HOURS) = BUDGETED FFOH + (SH x Var. FOHr) SHSR: 8K (3) Standard Rate (SR) is capable of being segregated.
SH x FR: 8K (2): 16K Since it can be based on Fixed Rate or Variable Rate
ILLUSTRATION SH x VR: 8K (1): 8K
2-WAY FACTORY OVERHEAD VARIANCE ANALYSIS
9) AFOH (V) 6.5K
The normal capacity of Bon-Chan Company is 12K labor hours per month. At normal capacity, the - BAAH (V) 7.5K
standard factory overhead rate is P8 per labor hour based on 72K of budgeted fixed cost per month Variable “S” 1K F
and a variable cost rate of P2 per labor hour. During January, Bon-Chan operated at 12.5K labor
10) AFOH (F) 19.5K
hours, which actual factory overhead cost of P85K. The number of standard labor hours allowed for - BAAH (F) 20K
the production attained is 10K labor hours. Fixed “S” 500 F

REQUIRED: ILLUSTRATION
1. Overall FOH Variance 2. FOH Controllable Variance 3. FOH Volume Variance FACTORY OVERHEAD VARIANCE ANALYSIS – BUDGET, VARIABLE & FIXED VARIANCES

FOH Budget Summary:

FOH = 72K + 2x Assume the same data in the previous item:
▪ BH: 12K hours ONE-WAY TWO-WAY THREE-WAY FOUR-WAY
FFOH 72K FR P6 AFOH: 26K CON = (5)2KF S (7)1.5K F S (V) (9)1K F
VFOH 24K VR 2 SFOH: 24K VOL = (6)4KU E (8)500 F S (F) (10)500 F
BFOH 96K SR 8 FOH Var: 2K U 2K U VOL (6)4K U E (V) (8)500 F

2K U VOL (F) (6)4K F

▪ SH: 10K hours 2K U
BASH: 72K + 2 (10K) = 92K 1. BFOH: 30K
2. SFOHH: 24K
1. FOH Variance: AFOH – SHSR 3. BAAH: 27.5K
= 85K – 10K (8) = 5K U 4. BASH: 28K

AFOH: 85K CON: 2) 7K F ADDITIONAL REQUIREMENTS: (continued from previous item)

BASH: 92K
SHSR: 80K VOL: 3) 12K UF
a) Budget (Flexible) Variance (2-way)
b) Budget (Flexible) Variance (3-way) Budget Variance is always AC – SC
*Start with the budget computation because all OH Variance has FOH budget. c) Variable Controllable Variance
*Unfavorable means additional costs, thus decreasing the profit. d) Fixed Volume Variance
e) Variable FOH Variance
2-way: [Link] 3-way: [Link] 4-way: [Link] f) Fixed FOH Variance
AFOH AFOH Spending Spending (Variable)
CONtrollable
BASH BAAH Efficiency Spending (Fixed)
VOLume
SHSR BASH VOLume Efficiency TOTAL = FIXED + VARIABLE
SHSR VOLume AFOH: 26K = 19.5K + 6.5K
BAAH: 27.5K = 20K + 7.5K
*Since BAAH and BASH are budgeted, they come from the flexible budget formula. Ilalagay lang sa BASH: 28K = 20K + 8K
X, either actual or standard hours para maging BAAH or BASH. SHSR: 24K = 16K + 8K

ILLUSTRATION BUDGET Variance: Actual – Budget

2-WAY, 3-WAY AND 4-WAY FACTORY OVERHEAD VARIANCE ANALYSIS a) 2-way
AC: AFOH
BC: BASH CON: 2K F
X Co. provides the following production data:
Standard factory overhead cost per unit of product: 4 hours at P3.00 per hour. b) 3-way
AC: AFOH SPENDING: 1.5K F
Budgeted Fixed Factory Overhead 20K BC: BAAH
Normal Capacity 2.5K units c) AFOH (V) 6.5K
Actual Production 2K units - BASH (V) (8K)
Actual Hours 7.5K hours Var. “CON” 1.5K F
Actual Factory Overhead Incurred (75% fixed) 25K d) BASH (F) 20K
- SHSR () (16K)
REQUIRED: Determine the following: Fx. “VOL” 4K U
1. Budgeted Factory Overhead e) AFOH (V) 6.5K
2. Standard Factory Overhead - SHSR (V) (8K) S (V) + E (V)
3. Budgeted FOH based on actual hours VFOH Var 1.5K F = 1K F + 500 F
4. Budgeted FOH based on standard hours f) AFOH (F) 19.5K
5. Controllable variance - SHSR (F) (16K) S (F) + VOL (F)
6. Volume variance FFOH Var: 3.5K U = 500 F + 4K U
7. Spending variance
8. Efficiency variance *Volume Variance = Fixed Volume Variance
9. Variable spending variance *Efficiency Variance = Variable Efficiency Variance
10. Fixed spending variance
LABOR VARIANCE
FOH Budget ACTUAL → AHAR
FOH = 20K + 1x SPENDING
BUDGETED → AHSR
▪ Standard: 1 unit: 4 hours STANDARD → SHSR EFFICIENCY
▪ Normal Capacity: 2.5K units
▪ BH: 10K hours (2.5K x 4) GROSS PROFIT VARIANCE ANALYSIS
FFOH 20K FR 2
VFOH 10K VR 1 ✓ Gross profit variance analysis is a useful tool in evaluating operational performance as
BFOH 30K SR 3
gross profit must be adequate enough to cover operating and other expenses and generate
*Always start with the FOH budget formula.
a desired amount of profit.
Standard: 1 unit: 4 hours
SALES = UNIT SALES X UNIT SELLING PRICE
BP: 2.5K units: 10K (BH)
- COGS = UNIT SALES X UNIT COST
AP: 2K units: 8K (SH)
GP = UNIT SALES X (UNIT SELLING PRICE – UNIT COST)
*Use the ratio technique to compute for BH and SH, if not given.
GROSS PROFIT (GP) VARIANCE = GP (ACTUAL/ CURRENT – GP (BUDGET/ PREVIOUS)
1. BFOH: 20K + 1 (10K) = 30K
2. SFOH: SH x SR = 8K (3) = 24K
ANALYSIS:
3. BAAH: 20K + 1 (7.5K) = 27.5K
PRICE FACTOR = SAES PRICE VARIANCE = AQ x ∆SP = AQ (ACTUAL SP – BUDGETED SP)
4. BASH: 20K + 1 (8K) = 28K
COST FACTOR = COST PRICE VARIANCE = AQ x ∆CP = AQ (ACTUAL CP – BUDGETED CP)
VOLUME FACTOR = ∆Q x BUDGETED UNIT GP = (AQ – BQ) x BUDGETED UNIT GP
AFOH: 26K Controllable: 5) 2K F SALES VOLUME VARIANCE = ∆Q x BUDGETED SP
BASH: 28K COST VOLUME VARIANCE = ∆Q x BUDGETED CP
SHSR: 24K Volume: 6) 4K U

Sales Variance SALES PRICE VARIANCE = Actual Sales – AQ @ Budgeted SP

AFOH: 26K SALES VOLUME VARIANCE = AQ @ Budgeted SP – Budgeted Sales
Spending: 7) 1.5K F
BAAH: 27.5K COST PRICE VARIANCE = Actual CGS – AQ @ Budgeted CP
Efficiency: 8) 500 F Cost Variance
BASH: 28K COST VOLUME VARIANCE = AQ @ Budgeted CP – Budgeted CGS
Volume: 6) 4K U
SHSR: 24K

RAHYNE, CPA [@rrhdamcpa]

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

FOUR COMMON TYPES OF RESPONSIBILITY CENTERS RI = (ROI – Minimum ROI) x Assets

a) COST CENTER – managers are mainly responsible for the costs incurred by Case 1: Target Performance
the unit e.g., HR & Accounting Department ROI > Minimum ROI, RI = (+)
b) REVENUE CENTER – managers are responsible mainly for the revenues Case 2: Break-Even Performance
generated by the unit i.e., Sales targets e.g., Ticket outlets, convenience store ROI = Minimum ROI, RI = 0
c) PROFIT CENTER – managers are responsible for both revenues and cost of Case 3: Poor Performance
the unit e.g., College of Accountancy ROI < Minimum ROI, RI = (-)
d) INVESTMENT CENTER – managers are responsible for revenues, costs and
investment of capital e.g., Magnolia product division, Sampaloc branch of ILLUSTRATION
KFC RETURN ON INVESTMENT, RESIDUAL INCOME & ROI PRICING
– Has autonomy to make its own decisions.
For each of the following independent cases, the minimum Desired Return on Investment (ROI) is
▪ PERFORMANCE REPORT – end-product of the responsibility accounting, shows 20%.
and compares actual results with the intended (budgets or standards) results of a
responsibility center. Division Z2 Division Z8 Division Z2
Sales P400K 700K ▪ Unit Selling Price: P20
RESPONSIBILITY CENTER KEY PERFORMANCE MEASURES Operating Income (1)_______ 42K ▪ Total Fixed Costs: 100K
COST CENTER Variance Analysis: Actual Costs vs. Budgeted/ Standard Costs Operating Assets (2) _______ (5) _______
REVENUE CENTER Variance Analysis: Actual Sales vs. Budgeted/ Target Sales Margin 15% (6) _______ Division Z8
Variance Analysis: Actual Profit vs. Budgeted/ Target Profit Turnover (3) _______ (7) _______ ▪ Unit Selling Price: P700
PROFIT CENTER ▪ Total Fixed Costs: 258K
Segmented Income Statement Return on Investments 30% (8) _______
Variance Analysis: Actual Profit vs. Budgeted/ Target Profit Residual Income (4) _______ 22K
INVESTMENT CENTER
Segmented Income Statement/ ROI, Residual Income, EVA

SEGMENTED INCOME STATEMENT REQUIRED:

1. Compute for each division’s missing items (1 to 8).
✓ Detailed version of the contribution format of income statement. 2. How many more units shall be sold by Division Z2 to achieve a 40% ROI?
✓ Highlights controllability of costs by behavioural classification. 3. How much increase in selling price will allow Z8 to reach 50% ROI from its current unit sales?

SALES XX Division Z2 Division Z2 Division Z2

LESS: VARIABLE MANUFACTURING COSTS (XX) (1) Margin = Income ÷ Sales (3) Turnover = Sales ÷ (4) RI = Income – Required
15% = Income ÷ 400K Assets Income
MANUFACTURING CONTRIBUTION MARGIN XX Income = 60K Turnover = 400K ÷ 200K RI = 60K – 20% (200K)
LESSS: VARIABLE NON-MANUFACTURING COSTS (XX) Turnover = 2x RI = 20K
CONTRIBUTION MARGIN XX
LESS: CONTROLLABLE DIRECT FIXED COSTS (XX) (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
CONTROLLABLE OR PERFORMANCE MARGIN XX Assets = 200K Turnover = 2x RI = 20K
LESS: NON-CONTROLLABLE DIRECT FIXED COSTS (XX)
SEGMENT MARGIN XX Division Z8 Division Z8 Division Z8
LESS: ALLOCATED COMMON COSTS (XX) (5) RI = Income – Required Income (6) Margin = Income ÷ Sales (8) ROI = Income ÷ Assets
22K = 42K – Required Income Margin = 42K ÷ 700K ROI = 42K ÷ 100K
PROFIT XX Required Income: 20K Margin = 6% ROI = 42%
20K = 20% x Assets
*All controllable costs are direct costs but not all direct costs are controllable. Assets = 20K ÷ 20% = 100K (7)Turnover = Sales ÷ Assets (8) ROI Margin x Turnover
*Indirect costs are always non-controllable. Turnover = 700K ÷ 100K ROI = 6% x 7
Turnover = 7x ROI = 42%
*Non-controllable costs are costs that have been allocated; share in the total costs of the company.
2) Division Z2 3) Division Z8
ILLUSTRATION Target Profit: 40% x 200K = 80K* Target profit: 50% x 100K = 50K*
The manager of X branch recently reported annual sales of 1.2M and presented the following cost Unit Sales** = 400K ÷ 20 = 20K** Unit Sales: 700K ÷ 700 = 1K units**
information to its head office: Unit CM: (60K + 100K) ÷ 20K** = 8
Since current unit sales will be held
Variable Manufacturing Costs 450K ↑CM = ↑FC + ↑P constant (same):
Allocated Corporate Overhead Costs 120K 8x = 0 + (80K* - 60K) ↑SP = ↑P ÷ Unit Sales
Variable Selling and Administrative Expenses 230K X = 20K ÷ 8 = 2.5K units ↑ SP = (50K* - 42K) ÷ 1K units**
Controllable Fixed Cots Traceable to X Branch 320K Increase in selling price: P8
Uncontrollable Fixed Costs Traceable to X Branch 280K
ECONOMIC-VALUE ADDED (EVA)
REQUIRED:
1. Determine the following:  Measures a segment’s economic profit based on residual wealth after accounting for the cost of
a.) Manufacturing CM b.) Controllable or performance margin c.) Segment Margin capital.
2. Identify the appropriate margin that shall be used to evaluate the performance of:  Used for incentive compensation and investor relations.
a.) Manager b.) Business unit (X branch)
EVA = OPERATING INCOME AFTER TAX - REQUIRED INCOME
Sales 1.2M Where: Required Income = (Total Assets – Current Liabilities) x WACC
Less: variable manufacturing costs (450K)
Manufacturing Contribution Margin (1) 750K *WACC is also called hurdle rate, cutoff rate, target rate, standard rate or minimum acceptable
Less: Variable Non-Manufacturing Costs (230K) rate of return.
Contribution Margin 520K *WACC is based on the long-term sources of financing – debt and equity – hence, the computation:
Less: Controllable Direct Fixed Costs (320K) (TOTAL ASSETS – CURRENT LIABILITIES) being equal to (LONG-TERM LIABILITIES AND
Controllable or Performance Margin (2) 200K EQUITY)
Less: Non-Controllable Direct Fixed Costs (280K) *Operating Income After Tax is based on the formula: EBIT = (100% - TAX RATE)
Segment Margin (3) (80K)
Less: Allocated Common Costs (120K) ILLUSTRATION
Profit (loss) (200K) X Co. presents the following year-end data:
Book Value Fair Value
2A) Manager: Performance Margin: 200K Current Assets 800K
2B) X branch: Segment Margin: (80K) Non-Current Assets 3.2M
Current Liabilities 400K
RETURN ON INVESTMENT (ROI) Non-Current Liabilities (10% interest rate) 1M 1M
Stockholder’s Equity 2.6M 3M
ROI = MARGIN X TURNOVER
↓ ↓ ↓ Additional data:
OPERATING INCOME OPERATING INCOME SALES ▪ Income before interests and taxes: 520K
= = ▪ Income tax rate: 20%
OPERATING ASSETS SALES OPERATING ASSETS
(ROA) (ROS) (ATO) ▪ Cost of equity capital: 12%

Du Pont Technique REQUIRED:

RI vs. EVA
ROS x ATO = ROA 1. Weighted Average Costs of Capital (WACC)
RI = EBIT – REQUIRED INCOME
2. Economic Value-Added (EVA) EVA = INCOME AFTER TAX – REQUIRED INCOME
MARGIN TURNOVER
CASE 1 HIGH LOW REALISTIC Source Weight (FV) Cost WACC
CASE 2 LOW HIGH REALISTIC DEBT 25% (1M) 10% (1 – 0.2) = 8% 2%
CASE 3 HIGH HIGH MONOPOLISTIC EQUITY 75% (3M) 12% 9%
CASE 4 LOW LOW PROBLEMATIC 4M 11%
*25% x 8% = 2%; 75% x 12% = 9%
RAHYNE, CPA [@rrhdamcpa]
 *Weight is based on the FV: 1M/4M & 3M/4M Or,
*Cost of Interest should exclude tax savings, thus it should be net of tax. Kasi yung Interest is Tax A) Minimum TP = UVC + Lost UCM A) Minimum TP = 30 (4/10) + 50 (6/10) = P42
Deductible Expense, pero yung Dividend hindi sina-subject sa kahit anong tax since hindi siya = 30 + (120K* ÷ 10K) = P42
pwedeng i-claim as tax deductible expense. *Lost CM: 6K u (50 – 30) = 120K
*Tax Deductible Expense yung Interest since pinababa niya yung cost of tax na babayaran.
B) Supplier: PP = 48 vs. Division S: TP = 42
EVA: 416K* - 396K** Make & Transfer:
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
➢ MINIMUM PRICE (SELLING DIVISION): Outlay cost + b) 45 – 8 – 25 (1.4) = P2
Opportunity Cost c) 45 – 8 – 28 = P9
❖ ARBITRATRY PRICE d) 45 – 8 – 30 = P7
✓ Imposed by the corporate headquarters to promote over-all
company goals. BALANCED SCORECARD
LIMITATIONS OF TRANSFER PRICE (TP) ▪ BALANCED SCORECARD – an approach to performance measurement that combines
❖ UPPER LIMIT (Buyer’s MAXIMUM TP) traditional financial measures with non-financial performance measures.
→ Purchase price from outside supplier o Created by David Norton and Robert Kaplan
❖ LOWER LIMIT (Seller’s MINIMUM TP) ▪ VALUE-BASED MANAGEMENT – performance evaluation technique which focuses on
• FULL CAPACITY traditional financial measures.
→ Regular Selling Price
• EXCESS CAPACITY ✓ BSC translates an organization’s STRATEGY into a comprehensive set of financial
→ Unit Variable Cost (lagging indicators) and non-financial (leading indicators) performance metrics
classified into four (4) perspectives:
MINIMUM TP = UNIT VARIABLE COST + LOST UNIT CM 1. FINANCIAL PERSPECTIVE (“How do we look to shareholders?”)
→ EXCESS Capacity: Minimum TP = Unit VC + 0 = Unit Variable Cost 2. CUSTOMER PERSPECTIVE (“How do customers see us?”)
→ FULL Capacity: Minimum TP = Unit VC + (SP – Unit VC) Regular SP 3. INTERNAL BUSINESS PROCESSES PERSPECTIVE (“What must we excel
*Unit Variable Cost – Outlay cost; Lost Unit CM – Opportunity cost at?”)
*Excess capacity – unsold units; can be produced without ready buyer yet 4. LEARNING AND GROWTH PERSPECTIVE (“Can we continue to improve and
*Full capacity – sold out create value?”)

▪ SUB-OPTIMIZATION – when managers of both selling and buying divisions act in their own ▪ STRATEGY MAPPING – links the four BSC perspectives with company strategies based on
individual interests. cause-and-effect pattern.
▪ GOAL CONGRUENCE – occurs when division managers make decisions that are
consistent with the goals and objectives of the entire organization. ✓ A typical BSC report contains:
▪ OUTLAY COST - includes selling division’s variable production costs plus any additions a) OBJECTIVES – statements of what the strategy must be achieved.
costs incurred. b) PERFORMANCE MEASURES – described how success in achieving the
▪ OPPORTUNITY COST – margin or profit sacrificed by transferring units internally rather strategy will be measured.
than selling them to external customers. c) BASELINE PERFORMANCE – the current level of performance.
▪ DUAL PRICING – an attempt to eliminate the internal conflicts associated with transfer d) TARGETS – the level of performance needed in the performance
prices by giving both the buying and selling divisions the price that works best for them. measure.
e) INITIATIVES – key action programs required to achieve strategic
ILLUSTRATION objectives.
TRANSFER PRICING  Objectives focus on what is to be achieved. Performance measures,
baseline performance and targets relate to how it will be measured. Initiative
X Company’s Division ‘S’ (selling division) produces a small tool used by other companies as a key focus on how it will be achieved.
part in their products. Cost and sales data related to the small tool are given below:
THE FOUR PERSPECTIVES IN MORE DETAIL
Selling price per unit 50 PERSPECTIVE FOCUS EXAMPLE KPIs
Variable costs per unit 30 Financial Financial Performance ROI; Operating Margin
Fixed costs per unit* 12 Customer Customer Satisfaction Level of Returns; Service Rating
*based on capacity of 40K tools per year. Internal Processes Business Efficiency New product lead time; Unit Costs
Organizational Capacity Knowledge and Innovation Employee retention; Flow of NPD ideas
The company’s Division ‘B’ (buying division) is introducing a new product that will use the same tool
being produced by Division S. An outside supplier has quoted the Division B a price of 48 per tool. Which among the four BSC perspectives is/are:
Division B would like to purchase the tools from Division S, only if an acceptable transfer price can • The 2 Controllable factors?
be worked out. → Internal processes, Learning & Growth
• The 2 Non-Controllable factors?
REQUIRED: Consider the following independent cases: → Customer, Financial
1. Division S has ample idle capacity to handle all the Division B’s needs: • The Leading Indicators/ Lead Measures?
a.) What is the maximum transfer price for Division S? → Learning & Growth, Customer Internal Processes
b.) What is the maximum transfer price for Division B? • The Lagging Indicator/ Lag Measure?
2. Division S is presently selling at all the tools it can produce to outside customers: → Financial
a.) What is the minimum transfer price? • Also called “Organization Capacity” Perspective?
b.) Shall the Division B purchase the tools from Division or from the outside supplier? Why? → Learning & Growth
3. Division S is presently selling 36K tools per year to outside customers while Division B requires
10K tools per year:
a. What is the minimum transfer price for Division S?
b. Shall the company make-and-transfer 10K tools or buy the tools from outside supplier? Why?

1) EXCESS CAPACITY 2) FULL CAPACITY

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

• Division S’s Excess Capacity: 40K – 36K = 4K units

• Division B’s Demand: 10K units

A) Minimum Transfer Price

EXCESS: 4K u x 30 = 120K
FULL: 6K u x 50 = 300K
420K ÷ 10K = P42

RAHYNE, CPA [@rrhdamcpa]

 ECONOMICS *The demand for badly needed goods like ‘maintenance’ medicine tends to be perfectly inelastic.

▪ ECONOMICS – study of the allocation of scarce resources. ▪ UTILITY – satisfaction derived from the acquisition or consumption of a particular good.
✓ From a business perspective, economics is concerned with studying the production, ▪ LAW OF DIMINISHING MARGINAL UTILITY – the marginal (additional) utility from
distribution and consumption of goods and services to maximize desired outcomes. consuming each additional unit usually decreases.
▪ DISPOSABLE INCOME – amount of income consumers have after paying taxes. When
DIVISION DEFINITION MAJOR AREAS personal disposable income goes up, consumers buy more.
Study of choices that Demand and supply, → MARGINAL PROPENSITY TO CONSUME (MPC) (or Marginal Propensity TO SPEND)
MICROECONOMICS individuals, households and prices and outputs, describes how much of each additional peso in personal disposable income that the
business firms make. market structures consumer will spend.
National income, → MARGINAL PROPENSITY TO SAVE (MPS) – percentage of additional income that is
Study of the effects on the aggregate supply and saved.
national economy and the aggregate demand, → Since consumers can either spend or save money: MPC + MPS = 100%
MACROECONOMICS
global economy of these employment and
choices. inflation, governmental
Where:
policies and regulation
MPC = ∆ IN CONSUMPTION ÷ ∆ IN DISPOSABLE INCOME
Balance of payments,
INTERNATIONAL Study of economic activities MPS = ∆ IN SAVINGS ÷ ∆ IN DISPOSABLE INCOME
currency exchange
ECONOMICS that occur between nations.
rates, globalization
SUPPLY
CAPITALISM: FREE-MARKET ECONOMY  POV: Producer/ Manufacturer/ Seller

▪ CAPITALISM – “free market” economic system where individuals & business firms ▪ SUPPLY – relationship between the price of a good and the quantity supplied.
determine production, distribution and consumption. ▪ QUANTITY SUPPLIED – amount of a good that producers plan to sell at a particular.
✓ Resources are privately-owned. ▪ LAW OF SUPPLY – the higher the price of a good, the greater is the quantity supplied.
✓ Economic decisions are made primarily by individuals and business firms. ▪ SUPPLY CURVE – shows the positive relationship between the quantity supplied and
✓ The price is based on supply and demand in the general market. price. Supply curves are positively sloped.

❖ FACTORS OF PRODUCTION are the scarce economic resources needed to produce WHAT HAPPENS? OTHER NAMES
goods and services. CHANGE IN MOVEMENT ALONG THE CHANGE IN QUANTITY
PRICE SUPPLY CURVE SUPPLIED
FOUR MOST COMMON FACTORS OF PRODUCTION ↑ IN SUPPLY DRIVES THE
SHIFT IN THE
SUPPLY CURVE TO SHIFT CHANGE IN SUPPLY
1. LAND – Natural resources e.g., Land, water, mineral, timber SUPPLY CURVE
RIGHTWARDS
2. LABOR – Human resources e.g., Human works, human skills, human efforts
3. CAPITAL – Financial resources e.g., Savings and Man-made resources e.g.,
FACTORS AFFECTING SUPPLY EFFECT ON SUPPLY EXAMPLE
Equipment
As production costs go up, fewer
4. ENTREPRENEURSHIP – Human resource that organizes land, labor and
products will be supplied at a given
capital. PRODUCTION COSTS INVERSE
price. If costs go down, more
products will be produced.
DEMAND An increase in the number of
 POV: Consumer producers will cause an increase in
NUMBER OF PRODUCERS DIRECT
the amount of goods supplied at a
▪ DEMAND – The relationship between the price of a good and the quantity demanded. It certain level of price.
is also defined as the schedule of quantities of a good that people are willing to buy at If other products can be produced with
different prices. PRICE OF SUBSITUTE GOODS INVERSE greater returns, producers will
▪ QUANTITY DEMANDED – amount that consumers plan to buy at a particular price. produce those goods.
▪ LAW OF DEMAND – the higher the price of a good, the smaller the quantity demanded. A rise in the price of a complement in
PRICE OF COMPLEMENTARY
▪ DEMAND CURVE – shows the inverse relationship between the quantity demanded and DIRECT production increases supply and
GOODS
price. Demand curves are negatively sloped. shifts the supply curve rightward.
If it is expected that prices will be
EXPECTED FUTURE PRICES DIRECT higher for the good in the future,
WHAT HAPPENS? OTHER NAMES
production of the good will increase.
CHANGE IN MOVEMENT ALONG THE CHANGE IN QUANTITY
Technological advancement
PRICE DEMAND CURVE DEMANDED
TECHNOLOGY DIRECT increases supply and thus shifts the
↑ IN DEMAND DRIVES THE
SHIFT IN THE supply curve rightward.
DEMAND CURVE TO SHIFT CHANGE IN DEMAND
DEMAND CURVE Subsidies reduce the production
RIGHTWARDS
cost of goods and, therefore,
GOVERNMENT SUBSIDIES DIRECT
increase the goods supplied at a
FACTORS AFFECTING given price.
EFFECT ON DEMAND EXAMPLE
DEMAND Increase in taxes would raise
PRICE OF SUBSTITUTE If the price of pork increases, the GOVERNMENT TAX AND
DIRECT INVERSE production costs, thereby
GOODS demand for beef may increase. TARIFFS
decreasing supply.
PRICE OF COMPLEMENTARY If the price of gasoline increases, the Government Unexpected storms may destroy
INVERSE
GOODS demand for cars tends to decrease. restrictions, weather farms, decreasing the supply of
If the price of the good is expected to conditions, and certain crops.
EXPECTED FUTURE PRICES DIRECT increase in the future, there will be an SPECIAL INFLUENCES
innovations or new
increase in demand. method may affect
As consumer income goes up, the supply of goods.
DIRECT FOR
CONSUMER WEALTH/ INCOME demand for many products (normal
NORMAL GOODS
goods) increases. EQUILIBRIUM
Demand for inferior goods (e.g.,
instant noodle, sardines) increases as
INVERSE FOR ▪ EQUILIBRIUM – state wherein the demand and supply are in balance.
CONSUMER WEALTH/ INCOME consumer income decreases since
INFERIOR GOODS ▪ EQUILIBRIUM PRICE – price at which the quantity demanded equal quantity supplied.
consumers buy more inferior goods
when they are short of money. Also known as MARKET-CLEARING PRICE.
An increase in population increases ▪ EQUILIBRIUM QUANTITY – is the quantity bought and sold at the equilibrium price.
POPULATION GROWTH DIRECT
number of potential buyers.
As market size expands, demand for ✓ Equilibrium is a MARKET-CLEARING situation where no surplus or shortage exists.
SIZE OF MARKET DIRECT WHERE THEREFORE CAUSE
the product also increases.
The effect depends on whether the PRICE CEILING
CONSUMER TASTES/ shift in taste or preference is favorable - Maximum price
INDETERMINATE that a seller may
PREFERENCE or unfavorable to the demand for the MARKET
product. ACTUAL PRICE < EQUILIBRIUM PRICE QD > QS charge for a good
SHORTAGE
*Substitute goods – goods that can be used in place of another. and is normally
*Complementary goods – one usually cannot function without the other. set below the
equilibrium price.
ELASTICITY OF DEMAND (ED) PRICE FLOOR
- Minimum price
that a seller may
✓ Measures the sensitivity of quantity demanded to any change in price. MARKET
ACTUAL PRICE > EQUILIBRIUM PRICE QD < QS charge for a good
SURPLUS
and is normally
ED = ∆% IN QUANTITY DEMANDED ÷ ∆% IN PRICE set above the
equilibrium price.
Where,
∆% IN QUANTITY DEMANDED = ∆ IN QUANTITY DEMANDED ÷ AVERAGE QUANTITY ✓ GOVERNMENT INFLUENCES may change market equilibrium through various means:
∆% IN PRICE = ∆ IN PRICE ÷ AVERAGE PRICE
EQUILIBRIUM PRICE
ILLUSTRATION: IF THEREFORE
WILL
DAY 1 – unit price was set at P1.00 each, the sales reached 100 units. TAXES HIGHER ↑ PRODUCT INPUT COSTS HIGHER
DAY 2 – unit price was increased to P1.50 each, the sales decreased to 60 units. SUBSIDIES - ↓ PRODUCTION COSTS LOWER
RATIONING - CURB [control] DEMAND LOWER
Average Quantity = (100 + 60) ÷ 2 = 80* Government can affect price of commodity through price fiat by
REGULATION
Average Price = (1 + 1.5) ÷ 2 = 1.25** establishing an artificial price ceiling or price floor.
*Externalities – Another factor that causes inefficiencies in the pricing of goods, which is the damage
ED = [(100 – 60)/80*) ÷ [1.5 – 1) ÷ 1.25** to environment caused by production.
ED = 0.50 ÷ 0.40
ED = 1.25 COSTS OF PRODUCTION

ED ELASTICITY QUANTITY DEMANDED (degree of reaction) The analysis of PRODUCTION COSTS distinguishes analysis in the short run vs. analysis in the long
>1 ELASTIC Reacts MORE proportionately to changes in price run:
=1 UNITARY Reacts proportionately to changes in price ✓ In the short run, at least one input of production is fixed (e.g., plant depreciation).
<1 INELASTIC Reacts LESS proportionately to changes in price ✓ In the long run, no inputs are fixed -- all inputs are variable (e.g., additional plant can be built).
=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
goods.
RAHYNE, CPA [@rrhdamcpa]
  While business firm can vary all inputs in the long run, they must nevertheless operate in the short (CPI this year) - (CPI last year)
INFLATION RATE = X 100
run. Hence, analysis of production costs tends to focus on the SHORT RUN where total production CPI last year
costs are separated into fixed costs and variable costs:
2. WHOLESALE PRICE INDEX (WPI) – measures the price changes at the wholesale
COST FORMULA LEGEND level, specifically finished goods, intermediate goods and crude materials.
1 TC FC + VC (= ATC x Q) TC = Total Cost ATC = Average TC 3. GDP DEFLATOR – measures the changes in price for goods and services included
2 VC TC – FC (= AVC x Q) FC = Fixed Cost AVC = Average VC in GDP.
3 FC TC – VC (= AFC x Q) VC = Variable Cost AFC = Average FC Nominal GDP
4 MC ∆TC ÷ ∆Q (=∆TVC ÷ ∆Q) MC = Marginal Cost Q = Quantity GDP DEFLATOR = X 100
Real GDP
5 ATC TC ÷ Q (= AFC + AVC) ∆TC = Change in total Cost
6 AVC VC ÷ Q (= ATC – AFC) ∆Q = Change in Quantity ▪ DEFLATION – decrease in the average price level.
7 AFC FC ÷ Q (= ATC – AVC) ∆ATC = Change in Total Variable Cost ▪ DISINFLATION – decline in inflation rate.
▪ DEFLATIONARY SPIRAL – when prices are falling, consumers delay purchase and
▪ LAW OF DIMINISHING RETURNS – cause of inefficiencies; an economic theory that businesses delay investments, both in anticipation of lower future prices.
predicts that after some optimal level of capacity is reached, adding additional factor of ▪ HYPERINFLATION – very high rate of inflation.
production will actually result in small increases in output. ▪ STAGFLATION – occurs when an economy’s output (real GDP) decreases and its price
level rises – production stagnates while prices go up.
▪ LONG-RUN production costs are all variable costs.
→ ECONOMIES OF SCALE (a decline in ATC) [Advantage] ✓ There is an inverse relationship between inflation and unemployment rate.
Example: ↑ Labor hours by 10%, ↑Output by 50%. Hence, ATC decreases.
→ DISECONOMIES OF SCALE (an increase in ATC) [Disadvantage] NUMBER OF PEOPLE UNEMPLOYED
Example: ↑ Input by 60%, ↑Output by 3%. Hence, ATC increases. UNEMPLOYMENT RATE = X 100
LABOR FORCE
→ CONSTANT RETURNS TO SCALE (long-run ATC does not change)
Example: Doubling production by doubling production facility. → LABOR FORCE = EMPLOYED + UNEMPLOYED

PROFIT AND MARKET STRUCTURES ILLUSTRATION

Europa has a total population of 20M, and of these, 420K are currently out of work and another
• TWO CONCEPTS OF PROFIT 400K are actively searching for new employment. A further 1M are retires, 1.2M are students
To an accountant: ACCOUNTING PROFIT = TOTAL REVENUE – EXPLICIT and 1.2M choose to not work. What is Europa’s current unemployment rate?
COSTS
To an economist: ECONOMIC PROFIT = TOTAL REVENUE – EXPLICIT COSTS – LABOR FORCE = 20M – 1M – 1.2M – 1.2M = 16.6M
IMPLICIT COSTS UNEMPLOYMENT RATE = 820K ÷ 16.6M = 4.94%

▪ EXPLICIT COSTS – expenses incurred or to be paid. THREE (3) TYPES OF UNEMPLOYMENT RATE
▪ IMPLICIT COSTS – opportunity costs and do not involve actual payments. 1. CYCLICAL – ↑ Recession, ↓ Expansion
2. FRICTIONAL – new college graduates or newly resigned employees (temporary)
FOUR BASIC MARKET STRUCTURES 3. STRUCTURAL – mismatch between the kind (location) of jobs available and the skills
(location) of those who are unemployed.
PRICE EASE OF COMMON
MARKET # OF FIRMS PRODUCTS
CONTROL ENTRY EXAMPLES FISCAL POLICY vis-à-vis MONETARY POLICY
PURE Identical or Very Easy Agricultural
VERY MANY None
COMPETITION Homogenous (No Barrier) Products
MONOPOLISTIC Similar but Fairly Easy Fast Food, ▪ FISCAL POLICY – refers to government actions to achieve economic goals.
MANY Limited
COMPETITION Differentiated (Low Barrier) Cosmetics ▪ FISCAL EXPANSION – an increase in deficit.
Standardized ▪ FISCAL CONTRACTION – increase in taxes to reduce a deficit.
Limited or Appliances, Oil
OLIGOPOLY FEW with Hard
Wide Cars, Computers ▪ MONETARY POLICY – changing interest rates and the money supply in the economy.
Differentiation
Government
PURE MONOPOLY ONE Unique Wide Blocked Franchise, Utility ECONOMIC THEORIES
Companies
▪ CLASSICAL ECONOMIC THEORY – market equilibrium will eventually result in full
▪ MONOPSONY – market where only one buyer exists for all sellers. employment over the long-run without government intervention.
▪ BLACK MARKET – illegal market. ▪ KEYNESIAN THEORY – economy does not necessarily move towards full employment on
its own.
GROSS DOMESTIC PRODUCT ▪ MONETARIST THEORY – focuses on the use of monetary policy to control economic
growth.
▪ GROSS DOMESTIC PRODUCT – market value of all the final goods and services produced ▪ SUPPLY-SIDE THEORY – bolstering [strengthening] an economy’s ability to supply more
by a country. goods is the most effective way to stimulate growth.
▪ FINAL GOOD – an item that is bought by its final user. ▪ NEO KEYNESIAN THEORY – focuses on using a combination of fiscal and monetary
▪ INETERMEDIATE GOOD – produced by one firm; component of the final good. policy.
TWO PRINCIPAL METHODS OF CALCULATING GDP
EXPENDITURE (EXPENSE) APPROACH INCOME APPROACH INTERNATIONAL TRADE AND FOREIGN CURRENCY
GDP = C + I + G + (X – M)
COMMON REASONS FOR INTERNATIONAL TRADES
Where: GDP = WAGES + SELF-EMPLOYMENT ▪ EXPANSION – to develop new markets.
C → HOUSEHOLD CONSUMPTION INCOME + RENT + INTEREST + PROFITS ▪ OUTSOURCING – to obtain commodities.
I → BUSINESS INVESTMENT + INDIRECT BUSINESS TAXES (e.g., VAT) ▪ COST-CUTTING – to obtain goods and services at lower costs.
G → GOVERNMENT SPENDING + DEPRECIATION & AMORTIZATION +
X → EXPORTS INCOME OF FOREIGNERS
M → IMPORTS ▪ COMPARATIVE ADVANTAGE – one country has the ability to produce a good or service
(X – M) → “NET EXPORTS” at a lower opportunity cost.
*GDP is measured either in current prices (nominal GDP) or in prices of a given year (real GDP) ▪ OPPORTUNITY COST – money value benefits lost.
▪ BALANCE OF TRADE = EXPORTS – IMPORTS
▪ ECONOMIC GROWTH – happens when there is an increase in real GDP in an economy. → TRADE SURPLUS – Exports > Imports
▪ RECESSION – happens when there is a decline in real GDP growth (i.e., negative GDP → TRADE DEFICIT – Imports > Exports
growth) ▪ TARIFF – tax on an imported product.
▪ GROSS NATIONAL PRODUCT (GNP) – market value of all the final goods and services ▪ QUOTA – a restriction on the amount of a good that may be imported during a period.
produced by citizens of a country. ▪ FOREIGN EXHANGE MARKET – currency of one country is exchanged for the currency of
another.
BUSINESS CYCLES ▪ EXCHANGE RATE – price of one currency unit expressed in units.
✓ DIRECT – domestic price of one unit of foreign currency.
▪ BUSINESS CYCLES – refer to cumulative fluctuations in real GDP over a period of time. ✓ INDIRECT – foreign price of one unit of domestic currency.
✓ SPOT – for immediate delivery.
STAGES IN ONE COMPLETE BUSINESS CYCLE ✓ FORWARD – for future exchange or delivery.
I. Peak
II. Recession → aka CONTRACTION EFFECTS OF CURRENCY APPRECIATION EFFECTS OF CURRENCY DEPRECIATION
III. Trough Cheaper foreign goods Cheaper domestic goods
IV. Expansion → aka BOOM or RECOVERY More domestic employments due to higher
Downward pressure of inflation
V. Peak exports
Competition problems for domestic Higher cost of imported materials and other
producers inputs
▪ DEPRESSION – prolonged form of recession; major downsizing in the economy.
WORKING CAPITAL MANAGEMENT
✓ Economists use ECONOMIC INDICATORS to forecast turns in the business cycle.
❖ LEADING INDICATORS – building permits, new orders for consumer
▪ WORKING CAPITAL MANAGEMENT (WCM) – managing the firm’s current assets and
goods, stock prices
current liabilities to achieve a balance between risks (i.e., liquidity risks) and returns (i.e.,
❖ COINCIDENT INDICATORS – level of retail sales, current unemployment
profitability)
rate, level of industrial production
→ Liquidity risks – risks of not meeting short-term financial obligations due to insufficient
❖ LAGGING INDICATORS – duration of unemployment, loans outstanding,
cash.
ratio of inventories to sales
▪ WORKING CAPITAL FINANCING – optimal level, mix and use of current assets and current
liabilities.
INFLATION AND UNEMPLOYMENT
▪ PERMANENT (FIXED) – minimum working capital requirement regardless of the seasonal
variations.
▪ INFLATION – sustained increase in an economy’s average price level.
▪ SEASONAL (VARIABLE OR INCREMENTAL) – additional working capital is needed during
the more active business season.
PRIMARY CAUSES
❖ DEMAND-PULL INFLATION – happens when too much demand are not met by a
corresponding increase in the supply. POLICY OTHER NAMES MEANING
✓ Maintains high level of working capital.
❖ COST-PUSH INFLATION – happens when there is an increase in production costs
✓ Reduces liquidity risks but is
or higher cost of raw materials and other inputs (supply-shock theory)
CONSERVATIVE RELAXED POLICY considered less profitable due to more
reliance on long-term financing, which
MOST COMMON INDICES TO MEASURE INFLATION incurs relatively higher financing costs.
1. CONSUMER PRICE INDEX (CPI) – measures price changes for goods and services AGGRESSIVE RESTRICTED POLICY ✓ Minimum amount of working capital.
purchased by consumers.

RAHYNE, CPA [@rrhdamcpa]

 ✓ Enhances profitability by relying more D) Average cash balance: 30K ÷ 60 = 15K
on short-term debts rather than long- E) Transaction (“Ordering”) cost: 60 (25) = 1.5K
term debts but is considered risky due to Opportunity (“Carrying”) cost: 15K (10%) = 1.5K
higher chances of short-term Total Costs: 1.5K + 1.5K = 3K (lowest possible cost)
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
CONSERVATIVE
the accounts receivable.
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
MATCHING produces then sells inventory, and receives cash.
HEDGING POLICY assets are financed with short-term
liabilities.
NORMAL OPERATING CYCLE & CASH CONVERSION CYCLE
ILLUSTRATION
WORKING CAPITAL POLICY: CONSERVATIVE VS. AGGRESSIVE NOC = AVE. AGE OF INVENTORY + AVE. AGE OF RECEIVABLE
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.
Plan B – Australia finances all fixed assets and permanent assets plus half of its temporary current Requires customers to mail payments
to a post office box, a local bank then
assets with long-term financing. LOCKBOX
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
B.) Which working capital policy between Plan A and Plan B is considered conservative? Aggressive? LINE OF CREDIT Predetermined borrowing limit.
idle cash
Requires checks to be written from
TOTAL ASSETS: 1.5M PLAN A special disbursement accounts
▪ FIXED ASSETS: 500K ▪ 10% (500K + 200K) ZERO-BALANCE
Slowing disbursements having zero-peso balance with no
▪ CURRENT ASSETS: 1M ▪ 5% (200K + 600K) ACCOUNT (ZBA)
minimum maintaining balance
PERMANENT (40%): 400K TOTAL INTEREST CHARGES: 110K required.
TEMPORARY (60%): 600K
PLAN B ▪ FLOAT – difference between cash balance per bank and cash balance per book
▪ 10% (500K + 400K + 300K) ✓ POSITIVE/ DISBURSEMENT FLOAT: bank balance > book balance
▪ 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
TAX (20%) (18K) TAX (20%) (13K) ▪ MARKETABLE SECURITIES – short-term money market instruments that can easily be
NET INCOME 72K NET INCOME 52K converted to cash.

A) 72K – 52K = 20K COMMON EXAMPLES

❖ CERTIFICATES OF DEPOSITS (CD) – saving deposits at financial institutions (e.g.,
B) Time Deposit)
→ CONSERVATIVE: PLAN B (LOW RISKS, LOW RETURNS) ❖ MONEY MARKET FUNDS – commercial paper, and other large-denomination, high-
→ AGGRESSIVE: PLAN A (HIGH RISKS, HIGH RETURNS) yield securities.
 Mas maraming chinarge sa short-term financing. ❖ GOVERNMENT SECURITIES
TREASURY BILLS – debt instruments representing obligations of the
CASH AND MARKETABLE SECURITIES National Government and usually sold at a discount through competitive
bidding.
 Managing cash and its temporary investment efficiently. CB BILLS OR CERTIFICATES OF INDEBTEDNESS (CBCIs) –
indebtedness by the Central Bank.
FOUR (4) REASONS FOR HOLDING CASH ❖ COMMERCIAL PAPERS – short-term, unsecured, material promissory notes issued
1. TRANSACTION MOTIVE (LIQUIDITY MOTIVE) – to facilitate normal transactions of the by private corporations.
business. ❖ REPURCHASE AGREEMENTS – Commitment to resell the security at the original
2. PRECAUTIONARY MOTIVE (CONTINGENT MOTIVE) – to provide for buffer [protection] contract price plus an agreed interest income.
against contingencies. ❖ BANKERS’ ACCEPTANCES – a draft drawn which is accepted by the bank becomes
3. SPECULATIVE – to avail of profit-making opportunities e.g., sudden price drop a negotiable instrument and is available for investments.
4. CONTRACTUAL MOTIVE – required by contracts or covenants e.g., compensating
balance RECEIVABLE MANAGEMENT

▪ OPTIMAL CASH BALANCE (OCB) aka ECONOMIC CASH QUANTITY (ECQ) or  Refers to set of policies, procedures and practices with respect to managing collectibles.
ECONOMIC CONVERSION SIZE (ECS)
 based on the following formula under the BAUMOL model (named after the American ▪ CREDIT STANDARD: consider the “5 C’s” in determining which customer shall be granted
economist William Baumol) credit and how much will the credit limit be.
➢ Character – willingness to pay
OPTIMAL CASH BALANCE (OCB) ➢ Capacity – ability to generate cash flows
WHERE: ➢ Capital – financial sources (i.e., net worth)
2DT D → Annual Demand for Cash ➢ Conditions – economic or business conditions.
OCB = √ T → Costs per Transaction ➢ Collateral – pledges to secure debt.
O
O → Opportunity Cost of Holding Cash
WHERE: ▪ CREDIT TERM – (1)credit period and (2)cash discount offered.
OPPORTUNITY COSTS = (OCB ÷ 2) x O
(OCB ÷ 2) → AVERAGE CASH BALANCE
WHERE: ILLUSTRATION
TRANSACTION COSTS = (D ÷ OCB) x T
(D ÷ OCB) → NUMBER OF TRANSACTIONS PER YR AVERAGE INVESTMENT IN ACCOUNTS RECEIVABLE
*OCB – optimal amount of cash to be raised by selling marketable securities
*D – total amount of new cash needed SG Co. sells on terms of 2/10, n/30. 75% of customers normally avail of the discounts. Annual sales
*T – fixed costs of trading securities are 9M, 80% of which is made on credit. Cost is approximately 80% of sales.
*O – rate of return forgone on marketable securities
REQUIRED:
▪ BAUMOL MODEL – assumes the demand for cash is spread evenly throughout the year. A) Average balance of AR. B) Average investment in AR.
▪ CASH BREAK-EVEN POINT (BEP) – sales level at which total cash inflows equal to total
cash outflows. • Credit Sales: 9M (80%) = 7.2M
• Average Daily Credit Sales: 7.2M ÷ 360 days = 20K
FORMULA: • Average Collection Period: 75% (10 days) + 25% (30 days) = 15 days
CASH BEP IN UNIT SALES = FIXED PAYMENTS ÷ UNIT CONTRIBUTION MARGIN
• Average AR balance: 20K x 15 days = A) 300K
CASH BEP IN PESO SALES = FIXED PAYMENTS ÷ CONTRIBUTION MARGIN RATIO
AR BALANCE = DAILY CREDIT SALES x COLLECTION PERIOD
• Average Investment in AR: 300K x 80% = B) 240K
ILLUSTRATION
OPTIMAL CASH BALANCE – BAUMOL MODEL
ILLUSTRATION
COLLECTION POLICY – CASH DISCOUNT
Korea Co. is expecting to have total payments of P1.8M for one year, cost per transaction amounted
to P25 and the interest rate of marketable securities is 10%.
Taiwan Co. presents the following information:
• Annual credit sales: P36M AR BALANCE = DAILY CREDIT SALES x COLLECTION PERIOD
A) What is the company’s optimal initial cash balance that minimizes total costs?
• Collection period: 2 months
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? • Rate of return: 14%
D) What will be the average cash balances for the period? Taiwan considers changing its credit term from n/30 to 2/10, n/30 with the following expected results:
E) How much is the total cost of maintaining cash balances? (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.
A) OCB (“EOQ”): √2 (1.8M)25 ÷ 0.10 = 30K
REQUIRED:
B) Number of transactions (“orders”): 1.8M ÷ 30K = 60 transactions What is the net advantage (disadvantage) of implementing the proposed discount?
C) Frequency (in days): 360 days ÷ 60 = every 6 days
RAHYNE, CPA [@rrhdamcpa]
 • Average Daily Credit Sales: 36M ÷ 360 days = 100K ILLUSTRATION
• AR Balance (Now): 100K x 60 days = 6M REORDER POINT AND SAFETY STOCK
• AR Balance (New): 100K x 30 days = 3M
• Annual Return: 14% (6M – 3M) = 420K Gong Yoo purchases 7.2K units of its product every year. Gong Yoo works 360 days per year. The
• Discount To Be Taken: 50% (36M) x 2% = 360K normal purchase lead time is 10 working days while maximum lead time is 15 working days.
• Net Advantage: 420K – 360K = 60K
REQUIRED:
ILLUSTRATION A) Safety (Buffer) stock B) Reorder point
CREDIT POLICY – RELAXATION OF CREDIT STANDARDS & EXTENSION OF CREDIT
PERIOD Average Inventory Average Daily Demand
(EOQ ÷ 2) + Safety Stock 7.2K units ÷ 360 days = 20 units
UK Co. reports the following information:
A) Safety (Buffer) Stock
Selling price per unit P 10 VCR: 80%* (15 days – 10 days) 20 = 100 units*
Variable cost per unit P8 CMR: 20%**
Total Fixed Costs P 120K B) Reorder Point
Annual credit sales 240K units AR BALANCE = DAILY CREDIT SALES x COLLECTION PERIOD
(15 days) 20 = 300 units
Collection period 3 months
Rate of return 25% Alternative solution:
UK considers relaxing its credit standards and extending its credit period. The following results are (10 days) 20 + 100* = 300 units
expected: (1) sales will increase by 25%; (2) collection costs will increase by P40K; (3) bad debt
losses are expected to be 5% on the incremental sales; and (4) collection period will increase to 4 ILLUSTRATION
months. SAFETY STOCK & STOCK-OUT COSTS
REQUIRED:
What is the net advantage (disadvantage) of implementing the relaxation of credit standards and Each stock-out of a product sold by X Co. costs P2K per occurrence. The carrying cost per unit of
extension of credit period? inventory is P5 per year and the company orders 18 times a year at a cost of P200 per order.
Unit of Safety Stock Probability of a Stock-Out
• Increase in Sales: 25% (240K units x P10) = 600K 0 50%
• Annual Benefit (Increase in CM): 600K x 20%** = (1) 120K 200 40%
• Increase in Collection Costs: (2) 40K 400 30%
• Incremental Bad Debt Losses: 5% (600K) = (3) 30K 600 20%
• AR Balance (Now): (2.4M ÷ 360 days) x 90 days = 600K 800 10%
• AR Balance (New): (3M ÷ 360 days) x 120 days = 1M What is the optimal level of safety stock?
• Opportunity Costs: (1M – 600K) x 80% x 25% = (4) 80K
• Net Disadvantage: 120K – (40K + 30K + 80K) = 30K Safety Stock Carrying Cost + Stock-out Costs = Total Costs
0 0 36K (50%) 18K
INVENTORY MANAGEMENT 200 200 (5) 36K (40%) 15.4K
400 400 (5) 36K (30%) 12.8K
ECONOMIC ORDER QUANTITY (EOQ) 600 600 (5) 36K (20%) 10.2K
800 800 (5) 36K (10%) 7.6K (lowest)
▪ EOQ – refers to the order size (number of units) that minimizes the sum of ordering costs
and carrying costs. • Unit Carrying Costs: P5 (given)
❖ CARRYING COSTS - ↑Order Size, ↑Total Carrying Costs • Maximum stock-out cost: P36K  2K x 18 orders
Examples: Storage, insurance, spoilage, obsolescence, security, record-keeping,
interest foregone ECONOMIC LOT SLOT (ELS) WHERE:
❖ ORDERING COSTS - ↑Order Size, ↓Total Ordering Costs P → ANNUAL PRODUCTION IN UNITS
Examples: Delivery, inspection, handling, purchasing, processing, receiving, quantity 2PS S → SETUP COSTS PER BATCH OF
ELS = √ PRODUCTION
discount lost C
C → COST OF CARRYING ONE UNIT FOR
ONE YEAR
ECONOMIC ORDER QUANTITY (EOQ)
✓ OCB → When used for cash management, EOQ becomes OPTIMAL CASH
WHERE:
2DO D → Annual Demand or Usage in Units BALANCE (OCB).
EOQ = √ O → Costs of placing one Order
C
C → Cost of Carrying one unit for one year ILLUSTRATION
WHERE: ECONOMIC LOT SIZE
CARRYING COSTS = (EOQ ÷ 2) x C
(EOQ ÷ 2) → AVERAGE INVTY IN UNITS
WHERE: X Bookstore publishes a book about RFBT. X Co. prints 20K copies of the book evenly throughout
ORDERING COSTS = (D ÷ EOQ) x O
(D ÷ EOQ) → NUMBER OF ORDERS PER YR the year. The set-up cost is P600 while the optimal production run (economic lot size) is 2K.
If Safety Stock is maintained, AVERAGE INTY = (EOQ ÷ 2) + SAFETY STOCK
REQUIRED:
ILLUSTRATION How much is the unit carrying cost of the book per year?
ECONOMIC ORDER QUANTITY, CARRYING COSTS AND ORDERING COSTS
ELS = √2PS ÷ C
Squid Game Co. requires 40K units for its signature product “4-5-6”. The units will be used evenly 2K = √2 (20K) 600 ÷ C
throughout the year. The cost to place one order is P250 while the cost to carry the inventory for one
year is P5 per unit. (2K)2 = (√2 (20K)600 ÷ C)2
4M = 24M ÷ C
REQUIRED:
C = P6.00
A) Determine the optimal order quantity (EOQ).
B) How many and how often orders should be placed within a year?
SHORT-TERM CREDIT FINANCING
C) Determine the average inventory in units.
D) Determine the annual inventory carrying costs.
FACTORS COSIDERED IN SELECTING
E) Determine the annual inventory ordering costs. SOURCES OF SHORT-TERM FUNDS
SOURCES OF SHORT-TERM FUNDS
UNSECURED CREDITS COST
A) EQ = √2 DO ÷ C = √2 (40K) 250 ÷ 5 = √4M = 2K units  e.g., accruals, trade credit and commercial  Effective costs of various credit sources.
B) Number of orders: 40K units ÷ 2K units = 20 orders = D ÷ EOQ papers. AVAILABILITY
Frequency: 360 ÷ 20 orders = every 18 days = 360 ÷ No. of orders SECURED LOANS  Readiness of credit as to when needed and
C) Average inventory: EOQ ÷ 2 = 2K units ÷ 2 = 1K units (Simple Average)  e.g., receivable financing – pledging and how much is needed.
D) Carrying Costs: (EOQ ÷ 2) C = 1K (5) = 5K factoring; inventory financing – blanket lien, INFLUENCE
E) Ordering Costs: (D ÷ EOQ) O = 20 (250) = 5K trust receipts, warehouse receipts  Influence of use of one credit source and
TOTAL COST 10K BANKING CREDITS availability of other sources of financing.
 e.g., term loan, line of credit, revolving REQUIREMENT
credit agreement  Additional covenants e.g., loans.
▪ 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.
COST OF SHORT-TERM FUNDS (Assume a 360-day year)
o STOCK-OUT COSTS – opportunity costs and other costs incurred when inventory
units run out-of-stock e.g., lost contribution margin on sales.
COST OF TRADE CREDIT WITH SUPPLIER
REORDER POINT DISCOUNT RATE 360 DAYS
COST= X
100%-DISCOUNT RATE CREDIT PERIOD-DISCOUNT PERIOD
REORDER POINT = DELIVERY TIME STOCK + SAFETY STOCK
COST OF BANK LOANS (EFFECTIVE ANNUAL RATE)
Alternatively: REORDER POINT = MAX LEAD TIME x AVE. USAGE PER UNIT OF TIME INTEREST 360 DAYS
WHERE: COST = X
NET PROCEEDS LOAN TERM
DELIVERY TIME STOCK = NORMAL LEAD TIME x AVE. USAGE PER UNIT OF TIME
SAFETY STOCK = (MAX. LEAD TIME – NORMAL LEAD TIME) AVE. USAGE PER UNIT OF TIME ➢ If loan does not require a compensating balance:
Alternatively, DEMAND-BASED = (MAX. USAGE – NORMAL USAGE) X NORMAL LEAD TIME → Non-discounted: Net Proceeds = Face Value
→ Discounted: Net Proceeds = Face Value Less Interest
▪ LEAD TIME – period from the time an order is placed until such time the same order is ➢ If loan requires a compensating balance:
received. → Non-discounted: Net Proceeds = Face Value Less Compensating Balance
➢ NORMAL/ AVERAGE LEAD TIME – refers to the usual delay. → Discounted: Net Proceeds = Face Value Less Interest Less Compensating Balance
➢ MAXIMUM LEAD TIME – add to normal lead time.
COST OF COMMERCIAL PAPERS
▪ SAFETY STOCK (aka BUFFER STOCK) – extra number of units maintained to protect
against stock-out costs. INTEREST + ISSUE COSTS 360 DAYS
COST = X
✓ Alternatively, safety stock may be computed using the demand-based formula: FACE VALUE - INTEREST - ISSUE COST PAPER TERM
(MAX. USAGE – NORMAL USAGE) x NORMAL LEAD TIME
COST OF FACTORING RECEIVABLES
• Applications of EOQ: '
INTEREST + FACTOR SFEE 360 DAYS
✓ When used for production, EOQ becomes the ECONOMIC LOT SIZE (ELS): COST = X
FACE VALUE - INTEREST - FACTOR' S FEE - FACTOR' SHOLDBACK REMAINING MATURITY PERIOD

RAHYNE, CPA [@rrhdamcpa]

 ILLUSTRATION
SHORT-TERM CREDIT FINANCING – TRADE CREDIT EBIT or Operating Income P500K
- Interests (8%) (48K)
SOURCE OF CAPITAL COST OF CAPITAL
El Nido Trading purchases merchandise for P200K, 2/10, n/30 Profit before tax 452K Long-Term Debt Yield Rate (100% - Tax Rate)
- Taxes (30%) (135.6K) Preferred Stock Yield Rate
REQUIRED: Profit after tax 316.4K Common Stock Yield Rate + Growth Rate
- Preferred dividends (10%) (20K) Retained Earnings Yield Rate + Growth Rate
A) The annual cost of trade credit; B) The annual cost of trade credit if term is changed to 1/15, n/20. Follow this formula to compute for the costs.
Income available to common shares 296.4K
4K 360 A) (2 ÷ 98) x [360 ÷ (30 – 10)]= 36.73%
X 296,400
196K* 20 days B) (1 ÷ 99) x [360 ÷ (20 – 15)] = 72.73% EPS = = P29.64
10,000
= 2.04…% (18 times) = 36.73%
*Payment within Discount Period (98%)
Cost of Debt: Interest – Tax Savings = 48K – (150K – 135K) = 33.6K
ILLUSTRATION
SOURCES WEIGHT COSTS
SHORT-TERM CREDIT FINANCING – BANK LOANS
Bonds 30% 8% (1 – 0.3) = A) 5.6% 1.68%
Preferred Stock 10% 10% (100) ÷ 100 = B) 10% 1%
Bora Trading was granted a one-year P200K bank loan with 12% stated interest.
Common Stock & RE 60% (2 ÷ 40) + 4% = C) 9% 5.4%
WEIGHTED AVERAGE COST OF CAPITAL (WACC) D) 8.08%
REQUIRED: The effective annual rate, under the following cases:
*600K x 5.6% = 33.6K → should be the final cost of debt
A) Bora receives the entire amount of P200K.
B) Bora granted a discounted loan.
DIVIDEND PER SHARE
C) Bora is required to maintain a compensating balance P10K. DIVIDEND YIELD (%) =
MARKET PRICE PER SHARE
D) Bora is required to maintain a compensating balance of 10% under a discounted loan.
COST OF LONG-TERM DEBT → KD
Interest: P x R x T A) 24K ÷ 200K = 12%
200K x 12% x (360/360) = 24K B) 24K ÷ (200K – 24K) = 13.64%
▪ YIELD RATE – based on a debt instrument’s EFFECTIVE interest rate.
C) 24K ÷ 190K = 12.63%
D) 24K ÷ (180K – 24K) = 15.38%
To approximate the YIELD-TO-MATURITY (YTM) rate on debt instrument:
Alternative Solutions
B) 12% ÷ (100% - 12%) = 13.64% INTEREST ± DISCOUNT (PREMIUM) AMORTIZATION
YTM =
D) 12% ÷ (100% - 12% - 10%) = 15.38% (NET PROCEEDS + FACE VALUE) ÷ 2

ILLUSTRATION Alternatively,
SHORT-TERM CREDIT FINANCING – COMMERCIAL PAPER Express the denominator as a weighted average based on “60-40”:
DENOMINATOR = (NET PROCEDS x 60%) + (FACE VALUE x 40%)
Elyu Co. plans to sell a 180-day commercial paper amounting to 100M, which it expects to pay a
discounted interest of 12% per annum. Elyu expects to incur 100K in dealer placement fees and CURRENT YIELD RATE
ANNUAL INTEREST
paper issue costs. CY =
CURRENT MARKET PRICE
REQUIRED:
*Cost of long-term debt is expressed as after-tax since interest charges are tax deductible
Determine the effective cost of Elyu’s credit.
expenses.
Interest: P x R x T
ILLUSTRATION
100M x 12% x (180/360) = 6M
6M+100K 360 COST OF DEBT: CURRENT YIELD vs. APPROXIMATE YIELD-TO-MATURITY
EAR = X
100M-6M-100K 180
Cici Co. has an outstanding P1K par value bond with 20 years to maturity. The bond carries an
6.1M annual interest payment of P110 and is currently selling for P1,080.
EAR = X 2=12.99%
93.9M
REQUIRED: Determine the following:
ILLUSTRATION A) Current Yield
SHORT-TERM CREDIT FINANCING – RECEIVABLE FACTORING B) Approximate Yield-to-Maturity (using simple average).
C) Approximate Yield-to-Maturity (using weighted average).
Panglao Co. has 200K in receivable that carries 30-day credit term, 2% factor’s fee, 6% holdback
reserve and an interest of 12% per annum on advances. Interest – Premium Amortization: A) 110 ÷ 1,080 = 10.19%
110 – (80 ÷ 20) = 106* B) 106* ÷ 1,040 = 10.19%
C) 106* ÷ 1,048 = 10.11%
REQUIRED:
Simple Average:
A) How much is the cash proceeds from factoring the receivable?
(1,080 + 1K) ÷ 2 = 1,040
B) What is effective annual rate of financing thru factoring the receivable?
Weighted Average:
A) 200K 1,840+4K 360 1,080 (60%) + 1K (40%) = 1,048
(4K)  Fee (2%) B) X
182,160 30
(12K)  Holdback (6%) = 3.205…% (12) COST OF PREFERRED STOCK (PS) → KP
184K = 38.47%
(1,849)  Interest: 184K x 12% x (30/360)
✓ The yield rate that must be used for preferred shares is the DIVIDEND YIELD.
182,160

COST OF CAPITAL, LEVERAGE & CAPITAL STRUCTURE DIVIDEND RATE DIVIDEND PER SHARE

DIVIDEND PER SHARE PRF. DIV. RATE X PAR VALUE PER SHARE
▪ COST OF CAPITAL – rate of return necessary to maintain market value or stock price of a DIVIDEND RATE =
MARKET PRICE PER SHARE
firm.
✓ Computed as a weighted average of the various long-term capital sources such *Market price per share – should be net of any flotation or issue costs.
as: Long-Term Debt, Preferred Stock, Common Stock and Retained Earnings
✓ OTHER NAMES: Minimum Acceptable Rate of Return, Required Rate of ▪ FLOTATION COST – cost of issuing or floating securities in the market.
Return, Hurdle Rate, Desired Rate, Standard Rate, Cut-Off Rate
ILLUSTRATION:
SOURCE OF CAPITAL COST OF CAPITAL COST OF PREFERRED STOCK
Long-Term Debt Yield Rate (100% - Tax Rate)
Preferred Stock Yield Rate
Aamon Co. pays an annual dividend of P10 per share for its preferred stock with a P100 par value.
Common Stock Yield Rate + Growth Rate
Retained Earnings Yield Rate + Growth Rate Aamon can sell each share of preferred stock for a price of P125.

ILLUSTRATION REQUIRED: Determine the following:

WEIGHTED AVERAGE COST OF CAPITAL A) Cost of preferred stock (assuming a tax rate of 25%).
B) Cost of preferred stock (assuming a flotation cost of P25 per share).
Suyou co. wants to determine the weighted average cost of capital that it can use to evaluate capital
investment proposals. The company’s capital structure with corresponding market values follows: A) 10 ÷ 125 = 8%
B) 10 ÷ (125 – 25)
8% Term Bonds 600K (30%)
10% Preferred stock (P100 par) 200K (10%) COST OF COMMON STOCK (CS) & RETAINED EARNINGS (RE) → KE
Common stock (no par, 10K shares outstanding) 400K (20%)
Retained Earnings 800K (40%) ✓ Yield rate is the Dividend Yield.
TOTAL 2M (100%) ✓ Dividend per share must be based on the next dividend to be paid i.e., expected dividend.
EXPECTED DIVIDEND PER SHARE = PAST/PRESENT DIVIDEND PER SHARE X (100% +
Additional data: GROWTH RATE
1) Current market price per share: 2) Expected common dividend: P2 per share ✓ In computing cost of CS & PS, market price per share should be net of any flotation or
➢ Preferred stock: P100 3) Dividend growth rate: 4% issue costs.
➢ Common Stock: P40 4) Income tax rate: 30% ✓ In computing cost of RE, flotation cost should be ignored as RE is neither sold nor issued.

REQUIIRED: ILLUSTRATION
A) Cost of bonds COST OF COMMON EQUITY: GORDON GROWTH MODEL (GGM)
B) Cost of preferred stock
C) Cost of common stock and retained earnings Joy Co.’s common stock is selling for P50 per share with 20% flotation cost and a dividend per share
D) Weighted average cost of capital of P2. Both earnings and dividends are expected to grow by 5%. Tax rate is 30%.

Additional Question: REQUIRED: Determine the following.

What is the EPS if EBIT is P500K? A) Cost of common stock (assuming the P2 dividend is yet to be paid).
Net Income - Preferred Dividends B) Cost of common stock (assuming the P2 dividend was just paid recently).
EPS =
Weighted Average CS Outstanding (WACSO) C) Cost of retained earnings (assuming the P2 dividend is yet to be paid).
D) Cost of retained earnings (assuming the P2 dividend was just paid recently).

RAHYNE, CPA [@rrhdamcpa]

 *Expected Dividend: 2 (1.05) = 2.1 A) (2 ÷ 40**) + 5% = 10% D) What happens to DOL, DFL and DTL if sales increase by 50%?
*Price (net of FC): 50 (80%) B) (2.1* ÷ 40**) + 5% = 10.25%
C) (2 ÷ 50) + 5% = 9% 50K units CM 100K
EBIT
D) (2.1* ÷ 50) + 5% = 9.2% CM 100K FC (50K) 2x (DOL) 2.5x (DTL) - INTEREST
- FC (50K) EBIT 50K 1.25x (DFL) EBT
ILLUSTRATION EBIT 50K *FFC(10K) - TAX
COST OF COMMON EQUITY: CAPITAL ASSETS PRICING MODEL (CAPM) 40K NET INCOME
75K units CM 150K 1.5x (DOL) - PS DIVIDENDS
Use the Security Market Line equation for CAPM in each of the following independent cases. CM 150K FC (50K) 1.67x (DTL) NET INCOME FOR CS
- FC (50K) EBIT 100K 1.11x (DFL)
REQUIRED: EBIT 100K *FFC (10K)
A) Determine the required rate of return for an asset with a beta 0.75 when the risk-free rate and 90K
market return are 8% and 12%, respectively.
CAPITAL STRUCTURE
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 – refers to the mix of the long-term financing that comprises a
C) Determine the market return for an asset with a required rate of return of 16% and a beta of 1.20
firm’s sources of funds that mature beyond one year.
when the risk-free rate is 10%.
CAPITAL STRUCTURE = FINANCIAL STRUCTURE – CURRENT LIABILITIES
D) Determine the risk-free rate for a firm with required rate of return of 15% and a beta of 1.25 when
▪ OPTIMAL CAPITAL STRUCTURE (TARGET CAPITAL STRUCTURE) – mix of debt and
the market return is 14%.
equity financing that maximizes a firm’s market value while minimizing its overall cost of
A) Ke = 8% + 0.75 (0.12 – 0.08) β = 2.0
Ke = 11% C) 16% = 10% + 1.2 (Km – 10%) capital.
B) 15% = 10% + β (12.55 – 10%) Km = 15% ▪ MARGINAL COST OF CAPITAL (MCC) – cost to the firm of the next peso of new capital
β = 2.0 D) 15% = KRF + 1.25 (14% - KRF) raised after exhausting internal source of financing (e.g., retained earnings).
KRF = 10% ▪ DEBT FINANCING – offers the lowest cost of capital due to its tax deductibility.
▪ TRADITIONAL THEORY OF CAPITAL STRUCTURE – when WACC is minimized and the
CAPITAL ASSET PRICING MODEL (CAPM): A RISK-BASED APPROACH market value of assets is maximized, an optimal capital structure exists.

• A security risk consists of two components: (1) Diversifiable risks and (2) Non- VALUE OF THE FIRM = MARKET VALUE OF DEBT + MARKET VALUE OF COMMON EQUITY
diversifiable risks. OR, EBIT ÷ WACC

TYPE MEANING CATEGORIES WHERE,

BUSINESS RISK MARKET VALUE OF DEBT = INTEREST ÷ COST OF DEBT
 Caused by fluctuations of MARKET VALUE OF COMMON EQUITY = (EBIT – INTEREST) ÷ COST OF COMMON EQUITY
earnings before interest and
taxes [EBIT]. CAPITAL BUDGETING WITH INVESTMENT RISKS AND RETURNS
DIVERSIFIABLE RISK LIQUIDITY RISKS
Portion of a security’s risk
(Controllable or  Possibility that an asset may ▪ CAPITAL INVESTMENT – long-term commitment of significant funds to meet certain
that can be controlled
Unsystematic Risk or not be sold on short notice. objectives such as acquiring additional plant assets for business expansion.
through diversification.
Company-Specific Risk) ▪ INDEPENDENT CAPITAL INVESTMENT (for SCREENING DECISIONS) – projects that are
DEFAULT RISK
evaluated individually against predetermined corporate standard of acceptability.
 Risk that a borrower will be
▪ MUTUALLY EXCLUSIVE CAPITAL INVESTMENT (for PREFERENCE DECISIONS) –
unable to make timely interest
and principal payments. projects require choosing from among alternatives.
MARKET RISK ▪ CAPITAL BUDGETING – process of measuring, evaluating, and selecting capital
 Stock’s price will change investments.
due to changes in stock
market. SIX (6) FORMAL STAGES OF CAPITAL BUDGETING
I. Identification and definition stage
NON-DIVERSIFIABLE
INTEREST RATE RISK II. Search stage
RISK
Results from forces  Resulting from fluctuations III. Information-acquisition stage – both qualitative and quantitative information is
(Non-controllable risk or
outside the firm’s control. in the value of an asset as considered.
Systematic Risk or
interest rates change. IV. Selection stage – choosing projects after cost-benefit evaluation
Market-related risk)
V. Financing stage
PURCHASING POWER RISK VI. Implementation and control stage – conduct of post-audit
 A rise in price will reduce
the quantity of goods that can
be purchased. CAPITAL INVESTMENT FACTORS

✓ Using the CAPM approach in computing cost of common equity and retained earnings, ▪ NET INVESTMENTS
the formula is:  Primarily computed for investment decision-making purposes.
KE = KRF + β (KM – KRF)  Refer to COST (cash outflows) LESS SAVINGS (cash inflows) incidental to the
WHERE, acquisition of the capital investment projects.
KE → EXPECTED/ REQUIRED RATE OF RETURN COSTS (Cash Outflows) SAVINGS (Cash Inflows)
 Used as cost of equity capital.
✓ Purchase price of the asset, net of cash ✓ Proceeds from sale of an old asset, net
KRF → RISK-FREE RATE
discount. of related tax.
 Based on Treasury Bill (T-Bill) rate. ✓ Freight, insurance, handling, ✓ Trade-in value of the old asset (in case of
β→ BETA COEFFICIENT installation, test runs. replacement)
 Measure the volatility (sensitivity) or systematic risk of a security compared to the stock market. ✓ Market value of existing idle assets. ✓ Avoidable cost of immediate repairs on
✓ Training cost, net of related tax. the old asset replaced, net of related tax.
β>1 Stock price is more volatile than the stock market.
β=1 Stock price is as volatile as stock market. ILLUSTRATION:
β<1 Stock price is less volatile than stock market. NET INVESTMENT FOR DECISION-MAKING
*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 Whitney Company, wanting increase production capacity, plans to replace an old machine with a
new one:
LEVERAGE I) The old machine was acquired three years ago. Its carrying value now is P 60,000, but it can be
sold for P 70,000. Tax rate is 25%.
▪ LEVERAGE – In business, it refers to the usage of fixed costs, representing risks to the II) The new machine can be acquired at a list price of P 500,000. A 10% cash discount is available if
firm. paid for within 30 days from acquisition date. Excluded from the list price are following: shipping
▪ OPERATING LEVERAGE – represents risk of being unable to cover fixed operating costs. charges of P 25,000, installation charges of P 18,000 and testing charges of P 15,000.
III) Other assets with a book value of P 12,000 that are to be retired because of the acquisition of the
CM ∆ % IN EBIT new machine can be salvaged and sold for P 10,000.
DEGREE OF OPERATING LEVERAGE (DOL)= OR
EBIT ∆ % IN SALES IV) Additional working capital of P 20,000 will be needed to support operations planned with the new
WHERE, equipment.
CM (CONTRIBUTION MARGIN) = SALES – VARIABLE COSTS V) The annual cash flow from the use of the new machine is P 50,000. At the end of its useful life of
EBIT (EARNINGS BEFORE INTEREST AND TAXES) = CM – FIXED OPERATING COSTS 5 years, the new machine must be disposed of with a zero-book value but with an expected salvage
value of P 4,000.
▪ FINANCIAL LEVERAGE – represents risk of being unable to cover fixed financial
obligations. REQUIRED:
A) What is the initial cost of net investments for decision-making purposes?
EBIT ∆ % IN EPS B) What is the terminal cash flow expected at the end of life of the project?
DEGREE OF FINANCIAL LEVERAGE (DFL)= OR
EBIT - FFC ∆ % IN EBIT
WHERE, COSTS (Cash Outflows) SAVINGS (Cash Inflows)
FFC (FIXED FINANCING CHARGES) = INTEREST CHARGES + PRE-TAX PREF. DIVIDENDS (II) *450K (I) 70K Tax on Gain on Sale
(II) 58K (2.5K)  10K x 25%
▪ TOTAL LEVERAGE – measure of total risk, determines how EPS is affected by a change (IV) 20K (III) 10K Tax Savings/ Shield
in sales. 528K 500  2K x 25%
CM ∆ % IN EPS 78K
DEGREE OF TOTAL LEVERAGE (DTL) = OR
EBIT - FFC ∆ % IN SALES
*Net Method: Net Investments: Costs – Savings
Alternatively, DTL = DOL x DFL 500K (90%) = 528K – 78K = A) P450K

ILLUSTRATION Timing of Cash Flows Terminal Cash Flow

LEVERAGE: DOL, DFL & DTL  Net Investment → Present (Year 0) (V) 4K Tax on Gain
 Net Returns → Future (Years 1 to 5) 1K  4K x 25%
(IV) 20K
Novaria Co. sells 50K units of a product at P10 each. The unit variable cost is P8 while the fixed
B) P23K
operating costs amounted to P50K. The co. has current interest charges of P6K and preferred
*Terminal – will be received at the end of the life of an asset e.g., Salvage Value; One-time only
dividends of P2.4K. The corporate tax rate is 40%.
Fixed Financing Charges*
→ Interest: 6K ▪ NET RETURNS
REQUIRED: Determine the following: Fixed Costs (given) → P. Div.: 4K  Refer to either net income (under accrual basis) or net cash flows (under cash basis),
A) Degree of operating leverage (DOL) → 50K 10K* the latter may be computed under direct or indirect method:
B) Degree of financial leverage (DFL)
✓ DIRECT METHOD: NET CASH INFLOWS = CASH INFLOWS – CASH OUTFLOWS
C) Degree of total leverage (DTL)
2.4K ÷ (100% - 40%)
RAHYNE, CPA [@rrhdamcpa]
 ✓ INDIRECT METHOD: NET CASH INFLOWS = NET INCOME + NON-CASH EXPENSES Net Cash IN before tax 40K
e.g., depreciation Less: Depreciation (10K)
Profit before tax 30K
ILLUSTRATION Less: Tax (40%) (12K)
NET RETURNS – INCREASE IN REVENUES Net Income 18K***
Add: Depreciation 10K
Net Cash IN after tax 28K*
Mariah Cinema plans to install coffee vending machines costing P 200,000. Annual sales of coffee
are estimated to be 10,000 cups to be sold for P 15 per cup. Variable costs are estimated at P 6 per
ILLUSTRATION
cup, while incremental fixed cash costs, excluding depreciation, at P 20,000 per year. The machines
PAYBACK PERIOD & ARR (UNEVEN CASH FLOWS)
are expected to have a service life of 5 years, with no salvage value. Depreciation will be computed
on a straight-line basis. The company’s income tax rate is 30%.
Katy P Co. has an investment opportunity costing P90K that is expected to yield the following cash
flows over the next five years:
REQUIRED: Determine the following:
Year 1 Amount DECISION RULES (Acceptable)
A) The increase in annual net income.
1 40K → PB period ≤ Life ÷ 2
B) The annual net cash inflows that will be generated by the project. 2 35K → ARR ≥ Costs of Capital
3 30K
Sales 150K CASH INFLOWS 150K 4 20K
- VC (60K) - CASH OUTFLOWS (60K) 5 10K
CM 90K (20K) P135K
- FC (cash) (20K) (9K)
- FC (depreciation) (40K) B) NET CASH INFLOWS B) 61K (Direct Method) REQUIRED: Assuming the hurdle rate of 30%, determine:
Profit before tax 30K A) Payback period in months
- Tax (30%) (9K) B) Book rate of return
Net Income A) P21K + 40K = B) P61K (Indirect Method)
A) Payback Period BB) ARR (Average)
ILLUSTRATION 90K  Year 1 (1 year)
NET RETURNS – COST SAVINGS (40K) 9K*
50K = B) 20%
(90K+ 0) ÷ 2
Celine Company is planning to buy a high-tech machine that can reduce cash expenses by an (35K)  Year 2 (1 year)
average of P80,000 per year. The new machine will cost P 100,000 and will be depreciated for 5 15K Net Income 9K*
years on a straight-line basis. No salvage value is expected at the end of the machine’s life. Income (15K)  Year 3 (0.5 year) + Depreciation 18K  90K ÷ 5
tax rate is 25%. 0 A) 2.5 years Net Cash IN 27K  135K ÷ 5
= 30 months
REQUIRED:
Determine the net cash inflows that will be generated by the project.
▪ PAYBACK RECIPROCAL – provides a reasonable estimate of the internal rate of return
(IRR) provided that the following conditions are met:
Net cash IN before tax 80K ✓ Alternative Solution
- Depreciation (20K) 80K (75%): 60K
Profit before tax 60K 20k (25%): 5K NET CASH INFLOWS 1
PAYBACK RECIPROCAL = =
- Tax (25%) (15K) ✓ P65K NET INVESTMENT PAYBACK PERIOD
Profit after tax 45K
+ Depreciation 20K *Payback reciprocal is a non-discounted technique used to estimate a discounted technique
Net Cash IN after tax 65K ✓ (IRR).

▪ COST OF CAPITAL – used as a discount rate in discounted capital budgeting techniques ILLUSTRATION
like NPV and IRR.
X Co. is planning to buy an equipment costing P640K with an estimate life of 30 years and is expected
▪ PAYBACK PERIOD – measures the length of time required to recover the full amount of to produce after-tax net cash inflows of P128K per year.
initial investment.
→ NON-DISCOUNTED TECHNIQUE REQUIRED: Without using present value factors, what is the best estimate of the IRR?

NET INVESTMENT Payback period: 640K ÷ 128K = 5 years Payback reciprocal is a reasonable estimate of the
PAYBACK PERIOD = Payback reciprocal: 1 ÷ 5 years = 20% internal rate of return (IRR) provided that the
NET CASH INFLOWS
following conditions are met:
▪ BAILOUT PAYBACK PERIOD – is a payback method wherein cash recoveries include not  Payback period is at most half of the economic
only the annual net cash inflows but also the estimated salvage value realizable at the life of the project [i.e., 5 years ≤ (30 ÷ 2)]
end of each year of the project life.  Net cash inflows are uniform throughout the life
of the project.
Test of Reasonableness:
ILLUSTRATION
 PV Factor (20%, 30 years): 4.979 (rounded)
BAIL-OUT PAYBACK PERIOD
 PV, Cash In: 128K (4.979) = 637,312
 NPV: 637,312 – 640,000 = (P2,688)
A project costing P180K will produce the following annual cash flows and year-end salvage values: 2,688
= 0.42%
640,000
Year 1 Cash Flows Salvage Value
1 P50K P60K ▪ NET PRESENT VALUE – measures the difference between the present value of cash
2 P50K P55K inflows generated by the project and the amount of initial investment.
3 P40K P50K
4 P40K P45K
NPV = PRESENT VALUE OF CASH INFLOWS – PRESENT VALUE OF CASH OUTFLOWS
REQUIRED: Bail-out payback period.
Y1 Y2 Y3 ✓ CASH INFLOWS – include annual net cash inflows and any cash realizable at the end of
Investment 180K 180K 180K the project life e.g., salvage value, return of working capital requirements
Cash Flows (50K) → (50K) → (50K) Y1 (1) ✓ CASH OUTFLOWS – based on the net investment cost required at the inception of the
Salvage Value (60K) (50K) → (50K) Y2 (1) project.
70K (55K) (30K) Y3 (0.75) = 30K ÷ 40K
25K (50K) SV 2.75 years ILLUSTRATION
0 NET PRESENT VALUE (EVEN CASH FLOWS)

▪ ACCOUNTING RATE OF RETURN – measures the capital project’s profitability from Ariana Company plans to buy a new machine costing P28K. The new machine is expected to have
accounting standpoint by relating the required investment to the annual net income. salvage value of P4K at the end of its economic life of 4 years. The annual cash inflows before
→ NON-DISCOUNTED TECHNIQUE income tax from this machine are estimated at P11K. The tax rate is 20%. The company desires a
OTHER NAMES: Book Rate of Return, Simple Rate of Return, Unadjusted Rate of Return, minimum return of 25% on investment capital.
Financial Statement Rate of Return, Return on Capital Employed (ROCE)
REQUIRED: Rounding-off present value factors to three decimal places, determine the net present
AVERAGE ANNUAL NET INCOME value.
ACCOUNTING RATE OF RETURN (ARR) =
ORIGINAL OR AVERAGE INVESTMENT
Alternatively:
ILLUSTRATION Cash inflows before 11,000 PV, Cash IN
PAYBACK PERIOD & ARR (EVEN CASH FLOWS) tax
Less: Depreciation (6,000) 10,000 (2.362) 23,620
Lady G Company plans to replace its old equipment. The cost of the new equipment is P 90,000, Earnings before tax 5,000 4,000 (0.410) 1,640
with a useful life estimate of 8 years and a salvage value of P 10,000. The annual pre-tax cash Less: Tax (20%) (1,000) 25,260
savings from the use of the new equipment is P 40,000. The old equipment has zero market value Earnings after tax 4,000 PV, Cash OUT
and is fully depreciated. The company uses a cost of capital of 25%. Add: Depreciation 6,000 28,000 (1.000) (28,000)
Cash inflows after tax 10,000 NPV = (P2,740)
REQUIRED: Assuming that the income tax rate is 40%, determine: DECISION RULES (ACCEPTABLE)
→ PB period ≤ Life ÷ 2 DECISION RULE Alternatively,
A) Payback period
→ ARR ≥ Costs of Capital (Acceptable) 11,000 x 80% → 8.8K
B) Accounting rate of return on original investment NPV ≥ 0 6,000 x 20% → 1.2K
C) Accounting rate of return on average investment 10K

NET INVESTMENTS 90K-0 Present Y0 PV factor Y1 Y2 Y3 Y4 TOTAL

A) PAYBACK PERIOD = = = A) 3.21 years
NET CASH INFLOWS 28K* Y0 (28K) (28K)
NET INCOME 18K***
B) ARR = = = B) 20% Y1 8K 0.800 10K  8K x 1.25
NET INVESTMENT (Original) 90K Y2 6.4K 0.640 10K  6.4K x 1.25 x 1.25 Vs.
NET INCOME 18K*** 2.362
C) ARR = = = C) 36% Y3 5,120 0.512 10K
NET INVESTMENT (Average) 50K** Y4 4.1K 0.410 10K 44K
Y4 1,640 0.410 4K
Simple Average = (Beg. Balance + End. Balance) ÷ 2
NPV = (2,740)
= (Cost + Salvage Value) ÷ 2 = (90K + 10K) ÷ 2 = 50K**
Computing PV factors using basic calculator
• SIMPLE (Year 4): 1.25, ÷, ÷, = [press 4x or 5x] until “0.4096” appears
• ANNUITY (4 years): “0.4096”, -, 1, ÷, 0.25, = until “2.3616” appears

RAHYNE, CPA [@rrhdamcpa]

 ILLUSTRATION
▪ PROFITABILITY INDEX J-Lo Co. is considering five investment opportunities. The cost of capital is 12%.
 Expresses the present value of the cash benefits as to an amount per peso of investment
in a capital project. Project Investment PV – Cash Flow NPV IRR (%) [Link]
 Used as a measure of ranking projects in descending order of desirability. 1 P35K 39,325 P4,325 16 1.12
2 20K 22,930 2,930 15 1.15
PRESENT VALUE OF CASH INFLOWS 3 25K 27,453 2,543 14 1.10
PROFITABILITY INDEX =
PRESENT VALUE OF CASH OUTFLOWS 4 10K 10,854 854 18 1.09
*A project is acceptable if its profitability index is more than 1.0. 5 9K 8,749 (251) 11 0.97

▪ INTERNAL RATE OF RETURN (IRR) REQUIRED:

 Equates the present value of cash inflows to present value of cash outflows. A) Rank the projects in descending order of preference according to NPV, IRR and profitability index.
 IRR is the discount rate at which the NPV is zero. B) If only a budget of P55K is available, which projects should be chosen?
 IRR must be distinguished from CROSSOVER RATE (NPV Point of Indifference, Fisher
Rate), which is the discount rate at which NPV of two capital investment projects are equal. Project NPV IRR PI B) Limited Budget: P55K
OTHER NAMES: Time-Adjusted Rate of Return, Discounted Cash Flow Rate of Return, 1 1st 2nd 2nd → 1ST Combo: Projects 1 & 2
Sophisticated Rate of Return, Break-Even Cash Flow Rate or Return. 2 2nd 3rd 1st → 2ND Combo: Projects 2, 3 & 4
3 3rd 4th 3rd → 3RD Combo: Projects 1 & 4 
ILLUSTRATION 4 4th 1st 4th Basis for selecting Projects 1 & 2
CROSSOVER RATE – NPV POINT OF INDIFFERENCE 5 5th 5th 5th Profitability Index!

Olivia Co. has a weighted average cost of capital of 12% and is evaluating two mutually exclusive ▪ REAL OPTIONS – alternative actions that become available over the life of a capital
projects (Newton and Rodrigo), which have the following projections: investment.

Project Newton Project Rodrigo COMMON EXAMPLES

Investment P1,000 P800 1. Option to delay
After-tax cash inflow P400 P400 2. Option to expand
Asset life 4 years 3 years 3. Option to abandon
4. Option to scale back
The crossover rate for the two projects is closest to: 5. Option to vary inputs/ output
6. Option to enter new market
PV Factors 20% 19% 18% NPV Profile 20% 19% 18% 7. New product option
4 years 2.589 2.639 2.690 NEWTON P35.6 P55.6 P76
3 years 2.107 2.140 2.174 RODRIGO P42.8 P56 P69.6
▪ RISK ANALYSIS – in capital budgeting attempts to measure the likelihood of the variability
ILLUSTRATION of future returns from the proposed investment.
NPV, PROFITABILITY INDEX & IRR (EVEN & UNEVEN CASH FLOWS)
APPROACHES IN ASSESSING RISK IN CAPITAL INVESTMENTS
Madonna Co. gathered the ff. data on two capital investment opportunities: Technique that adjusts the discount rate upward as
RISK-ADJUSTED DISCOUNT RATE
investment becomes riskier.
Project 1 Project 2
Assumes a higher discount rate in later years of a
Cost of Investment P195,200 P150,000 TIME-ADJUSTED DISCOUNT RATE
project’s life to uncertainties (e.g., inflation)
Cost of Capital 10% 10%
Considers multiple possible outcomes to determine
Expected useful life 3 years 3 years
SCENARIO ANALYSIS the overall expected outcome based on weighted
Net cash inflows 100,000 100,000* average of all possible outcomes.
*This amount is to decline by P20K annually thereafter. Uses forecasts of may NPVs under various “what-if”
SENSITIVITY ANALYSIS assumptions to see how sensitive NPV is to
REQUIRED: Round-off present value factors to three decimal places. changing conditions.
NPV = PV, CASH IN – PV, CASH OUT DECISION RULE (acceptable) Computer-based analysis that considers
PI = PV, CASH IN ÷ PV, CASH OUT PI ≥ 1 uncertainties and probability distributions for
IRR: PV, CASH IN = PV, CASH OUT IRR ≥ COST OF CAPITAL MONTE CARLO SIMULATION
inputs and uses random number of inputs to map
range of possible outcomes.
A) Project 1’s NPV C) Project 1’s PI: Probability-based technique used when
PV, Cash IN 248,700  100K (2.487) 248,700 management needs to decide through a series of “if-
= 1.27x DECISION TREE
PV, Cash Out (195,200) 195,200 then” scenarios that describe how the firm might react
P53,500 based on future events.

B) Project 2’s NPV D) Project 2’s PI: INVESTMENT RISKS AND RETURNS
202,040
Y1: 100K (0.909): 90,900 = 1.27x
150,000 ▪ INVESTMENT RISK - possibility that actual investment returns will differ from expected
Y2: 80K (0.826): 66,080 E) Project 1’s IRR: return, which could result to either gain or loss.
Y3: 60K (0.751) 45,060 PV, Cash In = PV, Cash Out OTHER NAMES: Security Risk & Speculative Risk
PV, Cash In 202,040 100K (PV Factor) = 195.2K
PV, Cash Out (150,000)
COMPONENTS OTHER NAMES MEANING
P52,040 Target PV Factor → 1.952
Life: 3 years, Discount Rate: 25% (IRR) → Unique to a given security.
UNSYSTEMATIC/
DIVERSIFIABLE RISK → Default risk, business risk, liquidity
CONTROLLED RISK
TRIAL & ERROR METHOD fall under this category.
Life: 3 years Target PV Factor → Not unique to a given security.
A) 23% → 2.011  1.952 SYSTEMATIC/ NON- → Market risk, political risk,
NON-DIVERSIFIABLE
B) 27% → 1.896 CONTROLLABLE purchasing power risk, foreign
RISK
F) Project 2’s IRR: RISK exchange risk normally would fall
under this category.
PV, Cash In = PV, Cash Out
??????? = 150,000 ▪ STANDARD DEVIATION (SD)
 Measure of dispersion of potential returns from average returns.
Choice A: 30% Choice B: 31%  Commonly used to quantify risk of investment.
Year 1: 100K (0.769) Year 1: 100K (0.763)  The higher the SD, the higher the risk of an investment.
Year 2: 80K (0.592) Year 2: 80K (0.583)
Year 3: 60K (0.455) Year 3: 60K (0.445) ▪ STANDRAD ERROR OF THE MEAN
151,560 149,640 → closer to P150K  Always smaller than SD.
 Measures how far a sample mean (e.g., expected return) deviates from the actual mean
Target: 150K
of a population.
▪ DISCOUNTED PAYBACK – length of time required to equalize the discounted cash flows
▪ When comparing investments that have different expected returns, the more appropriate
(using the cost of capital as a discount rate) and initial investment of a capital project.
measure of investment’s relative risk is the COEFFICIENT OF VARIATION, a measure of risk
OTHER NAME: Break-Even Time
per unit of return.
▪ EQUIVALENT ANNUAL ANNUITY (EAA) – an NPV-based technique used to compare
STANDRAD DEVIATION (σ)
capital investment projects with unequal lives. COEFFICIENT OF VARIATION =
EXPECTED RETURN (μ)
OTHER NAME: Annualized NPV
*The higher the coefficient of variation is, the riskier the investment is relative to its expected
ILLUSTRATION
return.
Project Cost Life Annual Cash Inflow
Miley P50,000 10 years P9,000
Selena P50,000 15 years P7,500 ILLUSTRATION
CAPITAL BUDGETING UNDER RISK: COEFFICIENT OF VARIATION
REQUIRED: Assuming a cost of capital of 10% (round-off factors to four decimal places): Based on
the equivalent annual annuity, which project is more attractive? 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
Project Cash IN PV Factor PV, Cash In Cost NPV EAA in each of the next 5 years. Consider the following probability distribution:
MILEY 9,000 6.1446 55,301 50,000 5,301 862.77
SELENA 7,500 7.6061 57,046 50,000 7,046 926.33 State of Economy Probability Project Chris Project Brown
Recession 30% P1K P500
EAA = NPV ÷ PV Factor Normal 40% P2K P2K
Prosperity 30% P3K P5K
Miley: EAA = 5,301 ÷ 6.1446
Selena: EAA = 7,046 ÷ 7.6061
REQUIRED: Determine the following:
▪ CAPITAL RATIONING – is, given a constraint on capital budgets, the selection of
Project Chris Project Brown
investment proposals that would maximize the over-all NPV of the firm.
Expected Return A 2K D 2,450
Standard Deviation (rounded, whole amount) B 775 E 1,781
Coefficient of Variation C 0.39 F 0.73

RAHYNE, CPA [@rrhdamcpa]

 Assuming Rihanna is a conservative, risk-averse type of investor, which project is likely to be RATIO FORMULA
chosen? INVENTORY TURNOVER COST OF GOODS SOLD
(FOR MERCHANDISERS) AVERAGE INVENTORY
Project (1) (2) (3) = (1) x (2) (4) = (2) – (A) (5) = (4)2 x (1) NET CREDIT SALES
RECEIVABLE TURNOVER
Chris Probability Cash Flows Expected Return Cash Flows – ER Variance AVERAGE RECEIVABLES
Recession 30% 1,000 300 - 1,000 300,000 NET CREDIT PURCHASES
PAYABLE TURNOVER
Normal 40% 2,000 800 0 0 AVERAGE PAYABLES
Prosperity 30% 3,000 900 1,000 300,000 FINISHED GOODS TURNOVER COST OF GOODS SOLD
(A) ER = P2,000 600,000 (FOR MANUFACTURERS) AVERAGE FG INVENTORY
WORK-IN-PROCESS TURNOVER COST OF GOODS MANUFACTURED
B) SD = Square root of variance C) Coefficient of Variation (FOR MANUFACTURERS) AVERAGE WIP INVENTORY
= SD ÷ ER RAW MATERIALS TURNOVER COST OF MATERIALS USED
SD = √600,000
= 775 ÷ 2K (FOR MANUFACTURERS) AVERAGE RM INVENTORY
SD = P775 (rounded)
= 0.39 (rounded) INVENTORY TURNOVER FG TURNOVER + WIP TURNOVER + RM
(FOR MANUFACTURERS) TURNOVER
AGE OF INVENTORY 360 days
Project (1) (2) (3) = (1) x (2) (4) = (2) – (A) (5) = (4)2 x (1)
Brown (INVENTORY CONVERSION PERIOD) INVENTORY TURNOVER
Probability Cash Flows Expected Return Cash Flows – ER Variance
AGE OF RECEIVABLE 360 days
Recession 30% 500 150 - 1,950 1,140,750
(RECEIVABLE COLLECTION RECEIVABLES TURNOVER
Normal 40% 2,000 800 - 450 81,000
PERIOD)
Prosperity 30% 5,000 1,500 2,550 1,950,750
AGE OF PAYABLE 360 days
(D) ER = P2,450 3,172,500
(PAYABLE DEFERRAL PERIOD) PAYABLES TURNOVER
SALES
E) SD = Square root of variance F) Coefficient of Variation G) Project Chris ASSET TURNOVER
= SD ÷ ER (LOWER Coefficient Of AVERAGE TOTAL ASSETS
SD = √3,172,500 SALES
SD = P1,781 (rounded) = 1,781 ÷ 2,450 Variation) FIXED ASSET TURNOVER
= 0.73 (rounded) AVERAGE FIXED ASSETS
NORMAL OPERATING CYCLE AGE OF INVENTORY + AGE OF RECEIVABLES
NORMAL OPERATING CYCLE – AGE OF
CAPITAL BUDGETING TECHNIQUES CASH CONVERSION CYCLE
PAYABLES
DECISION RULE
TECHNIQUE FORMULA *Age of Receivable – also known as Receivable Collection Period, Days Sales Outstanding (DSO),
( ACCEPTABLE)
Number of Days Sales in Receivable, or Days Receivable
NET INVESTMENTS
PAYBACK PERIOD ❖ PROFITABILITY RATIOS (PERFORMANCE RATIOS) – used to determine how well
NET CASH FLOWS PB PERIOD ≤ LIFE ÷ 2
an entity can generate profits from its operations.

ACCOUNTING RATE OF NET INCOME RATIO FORMULA

RETURN (ARR) NET INVESTMENTS ARR ≥ COST OF CAPITAL GROSS PROFIT
GROSS PROFIT MARGIN
SALES
NPV PV, CASH IN – PV, CASH OUT NPV ≥ 0 EBIT
OPERATING PROFIT MARGIN
SALES
PV, CASH IN NET PROFIT
PI NET PROFIT MARGIN
PV, CASH OUT PI ≥ 1 SALES
INCOME*
RETURN ON SALES
IRR PV, CASH ON = PV, CASH OUT IRR ≥ COST OF CAPITAL SALES
INCOME*
RETURN ON ASSETS
FINANCIAL STATEMENT ANALYSIS AVERAGE ASSETS
INCOME*
RETURN ON EQUITY
▪ FINANCIAL STATEMENT ANALYSIS – involves evaluation of an entity’s past performance, AVERAGE EQUITY
present condition, and business potentials.
▪ HORIZONTAL ANALYSIS *WHY INCOME FIGURE TO USE?
 Shows changes of corresponding FS items over a period. ✓ If the intention is to measure operational performance, income is expressed as before interest
 Changes in the value of a particular FS item can be analysed in terms of amount or in and tax. Alternatively, income before ‘after-tax’ interest may be used to exclude the effect of
percentage. capital structure.
✓ The percentage change is calculated using: ✓ If the intention is to evaluate total managerial effort, income is expressed after interest and
tax.
MOST RECENT VALUE - BASE PERIOD VALUE ✓ Expressing income after interest but before tax is now rarely applied in business practice.
PERCENTAGE CHANGE (∆%) = ✓ Income should include dividends and interest earned if the said investments are included in
BASE PERIOD VALUE
asset base.
▪ VERTICAL ANALYSIS – process of comparing figures in the FS within a single period. ✓ If used in the context of “Du Pont” technique, income must be expressed after interests, taxes
▪ CASH FLOW ANALYSIS – detailed study in the net change in cash and cash equivalents and preferred stock dividends. The Du Pont technique is based on the following formula:
because of operating, investing and financing activities during the period.
▪ RETURN ON EQUITY = RETURN ON SALES x ASSETS TURNOVER x EQUITY MULTIPLIER
ACTIVITIES MEANING RELATED TO
Principal revenue-producing Changes in current assets and current ❖ MARKET VALUE RATIOS (MARKET PROSPECT RATIOS) – used to help potential
OPERATING investors make equity investment decisions using trends in earnings, dividends and
activities. liabilities.
Acquisition and disposal of stock prices.
INVESTING long-term assets and Changes in non-current assets. ✓ Market value ratios are anchored on Earnings per Share (EPS), which is
investments. considered profitability ratio:
Result in changes in the size
and composition of the Changes in long-term liabilities and NET INCOME - PREFERRED DIVIDENDS
FINANCING EPS =
contributed equity and equity accounts. WEIGHTED AVERAGE COMMON SHARES OUTSTANDING
borrowings.
✓ EPS must be distinguished from common shareholder’s Book Value per Share
(BVPS), which is based on:
▪ FINANCIAL RATIOS – relationships among the accounts found in the FS.
COMMON SHAREHOLDERS' EQUITY
❖ LIQUIDITY RATIOS – measure an entity’s ability to meet short-term obligation and BVPS =
NUMBER OF COMMON SHARES OUTSTANDING
provide insights on present cash solvency.
ILLUSTRATION:
RATIO FORMULA EPS, DIVIDEND & IPO SHARES
NET WORKING CAPITAL CURRENT ASSETS – CURRENT LIABILITIES
CURRENT RATIO CURRENT ASSETS Hulk Co. decided to go public when its net income available to common shareholders amounted to
(WORKING CAPITAL RATIO) CURRENT LIABILITIES P300K while the number of common shares issued and outstanding is 125K.
QUICK RATIO QUICK ASSETS
(ACID TEST RATIO) CURRENT LIABILITIES REQUIRED:
*Quick assets are cash items and other current assets than can be quickly converted into cash i.e., 1. Assume that pay-out ratio is 80%, how much of the total dividends shall a shareholder owning 5K
cash, receivables, marketable securities. common shares receive?
2 Assume that the pay-out ratio is 80% and the price per share is P12, what is the dividend yield?
❖ SOLVENCY RATIOS (LEVERAGE RATIOS) – measure an entity’s long-term 3. Assume that the price-earnings ratio will be set 15 times and 25K new shares will be issued:
financial viability. A) How much is the initial public offering (IPO) per share of the share of the 25K new shares?
B) How much is the net proceeds from issuance if flotation cost is 4%?
RATIO FORMULA
TOTAL LIABILITIES EPS = 300K ÷125K = 2.40* 2) Dividend Yield = Dividends Per Share ÷
DEBT RATIO
TOTAL ASSETS Market Price Per Share
TOTAL EQUITY 1) Payout Ratio = Dividends per share ÷ EPS Dividend Yield = 1.92** ÷ 12 = 16%
EQUITY RATIO
TOTAL ASSETS 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-EQUITY RATIO
TOTAL EQUITY 5K shares x 1.92** per share = P9.6K PE Ratio = Price Per Share ÷ EPS
1 15 times = Price Per Share ÷ 2.00***
EQUITY MULTIPLIER 3A) Price Per Share: 2 (15) = P30
EQUITY RATIO
TIME INTREST EARNED EBIT 3B) Net Proceeds: (25K shares x 30) x 96% =
(INTEREST COVERAGE RATIO) INTEREST PAYMENTS P720K
*Equity multiplier aka equity ratio reciprocal may be computed based on formula: ASSETS ÷ EQUITY
RATIO FORMULA
❖ EFFICIENCY RATIOS (UTILIZATION RATIOS/ ACTIVITY RATIOS) MARKET PRICE PER SHARE
PRICE-EARNINGS RATIO
 Measure an entity’s ability to use its assets and manage its liabilities effectively EPS
in the currently period. DIVIDEND PER SHARE
DIVIDENDS YIELD
 How quickly various accounts are converted into sales or cash. MARKET PRICE PER SHARE
DIVIDEND PER SHARE
DIVIDEND PAYOUT
EPS
RETENTION RATIO
100% - DIVIDEND PAYOUT
(PLOWBACK RATIO)

RAHYNE, CPA [@rrhdamcpa]

▪ OTHER FINANCIAL RATIOS The company has been requested to prepare a bid for 350 units of the same product. If an 80%
learning curve is applied, what is the total cost on the bid-order for 350 units?
RATIO FORMULA
CASH + MARKETABLE SECURITIES TOTAL (DL
CASH RATIO 50 units 350 units UNIT(S) AVERAGE
CURRENT LIABILITIES & VFOH)
QUICK ASSETS DM P1.5K P10.5K 50 250 12,500
DEFENSIVE INTERVAL
AVERAGE CAPITAL EXPENDITURES DL 8.5K 100 200 20,000
OPERATING CASH FLOW (CF) *38.7K 350 38,700*
VFOH *4K 200 160 32,000
CASH FLOW MARGIN
NET SALES TOTAL VC P14K P49.2K 400 128 51,200
TIMES PREFERRED DIVIDENDS NET INCOME AFTER TAX (10%) FFOH **1.4K 4,920
EARNED PREFERRED DIVIDENDS TOTAL
TOTAL ASSETS P15.4K P54,120
CAPITAL INTENSITY RATIO COSTS
NET ASSETS
OPERATING CF + AFTER-TAX INTEREST – ▪ FINANCIAL MARKET – marketplace (physical or cyberspace) where trading of securities
FREE CASH FLOW
CAPITAL EXPENDITURES occurs.

▪ ADDITIONAL FUNDS NEEDED (AFN) Financial markets may be broadly classified into MONEY MARKETS and CAPITAL
FS Analysis helps in making financial forecasts, particularly the required ADDITIONAL MARKETS:
FUNDS NEEDED (AFN), determined based on entity’s capital requirements and from a
variety of financial ratios. TYPES MEANING EXAMPLES
BSP Treasury Bills
Required increase in assets → ∆ in Sales x (Assets ÷ Sales) Commercial Papers
- Spontaneous increase in liabilities → ∆ in Sales x (Liabilities ÷ Sales) Certificate of
- Increase in retained earnings* → Earnings after tax – Dividend payment Where short-term debt Deposits
ADDITIONAL FUNDS NEEDED from external sources (e.g., creditors, investors) MONEY MARKETS
instruments are traded. Banker’s Acceptance
Repurchase
AFN, aka External Funds Needed (EFN), may alternatively be computed using the following Agreements
formulas: Mutual Funds
➢ AFN = Total Changes in Equity – Internal Financing PRIMARY MARKET
➢ AFN = (Assets – Liabilities) (% ∆ Sales) – (Projected Sales x Profit Margin x Plowback → Trade of new securities
Ratio) by mostly large investors.
Long-term debt or equity
CAPITAL MARKETS
Sales: P1M (∆ = 20% increase) Alternative Solutions securities are traded. SECONDARY MARKET
Assets: (3M/5M) x 1M = P600K  3M x 20% → Trade of existing
Liabilities: (500K/5M) x 1M = (100K)  500K x 20% securities by mostly small
Retained Earnings: (6M x 10%) x 25% = (150K) investors.
AFN: 350K
NI: 600K ▪ BOND VALUATION – process of determining the fair price or market value of bonds based
✓ Capital Intensity Ratio: 60% = Assets ÷ Sales on the present value of the regular interest payments and the face value at the maturity date.
✓ After-Tax Profit Margin: 10% = Net Income ÷ Sales
✓ Dividend Payout: 75% = Dividend Per Share ÷ EPS ILLUSTRATION
✓ Retention/ Plowback Ratio: 100% - Payout = 25% A firm has given the following information for each of its outstanding bonds:

VARIOUS TOPICS IN MANAGEMENT SERVICES Face Value Annual Coupon Interest Years to Maturity Required Return
P1,000 9% 5 6%
▪ LEARNING CURVE
 Assumes that labor time decreases in a definite pattern as labor operations are What is the current value of each bond?
repeated. Current Value of Each Bond (discounted @6%)
 Describes the inefficiencies arising from experience – with experience comes increased  Principal (Year 5): 1,000 (0.747)
P1,126
productivity.  Interests (5 years): 90** (4.212)
 This is based on statistical findings that as the cumulative output doubles, the
cumulative average labor input time required per unit will be reduced by some **Annual Interest: 9% (1,000) = 90
percentage.
 The learning curve is usually designated by the complement of the rate of reduction ▪ STOCK VALUATION – process of determining the theoretical value of companies and their
e.g., if the rate of reduction 20%, then there is 80% learning curve. stocks based on different methods such as the Gordon Dividend Growth Model.

ILLUSTRATION ILLUSTRATION
Orange Company expects 90% learning curve. The first batch of new product required 100 hours. A firm has issue of preferred stock outstanding that has a stated annual dividend of P4. The required
The second batch should take: return on the preferred stock has been estimated to be 16%. The value of the preferred stock is:
Batch(es) AVERAGE TOTAL
1 100 100 Current Value of Preferred Stock
90% 80
2 90 180 Dividend Yield: Dividend ÷ Price
16% = 4 ÷ Price
ILLUSTRATION Price = 4 ÷ 0.16
The average labor cost per unit for the first batch produced by a new process is P120. The cumulative Price = P25 per share
average labor cost after the second batch is P72 per product. Using a batch size of 100 and assuming
the learning curve continues, what is the total labor cost of four batches? ILLUSTRATION
A firm has experienced a constant annual rate of dividend growth of 9% on its common stock and
Batch(es) AVERAGE TOTAL expects the dividend per share in the coming year to be P2.70. The firm can earn 12% on similar risk
1 120 120 investments. The value of the firm’s common stock is:
60%
2 72 144
4 43.2 172.8 x 100 = P17,280 Current Value of Common Stock
Cost of CS: Yield % + Growth %
ILLUSTRATION 12% = (2.7 ÷ Price) + 9%
Banana Inc. finds that production is affected by an 80% learning effect. The company has just Price = 2.7 ÷ (12% - 9%)
produced 50 units of output at 100 hours per unit. Costs were as follows: Price = P90 per share

First 50u Next 50u ILLUSTRATION

Materials @ P20 P1,000 P1,000 A common stock currently has a beta of 1.7, the risk-free rate is 7% annually, and the market return
Labor and labor-related costs: is 12% annually. The stock is expected to generate a constant dividend of P6.70 per share. A pending
Direct Labor (100 hours at P8) 800 lawsuit has just been dismissed and the beta of the stock drops to 1.4. The new equilibrium price of
Variable OH (100 hrs at P2) 600*
200 the stock shall be:
Total P2,000 P1,600 x 1.50 = 2.4K
Capital Asset Pricing Model
The company has just received a contract calling for another 50 units of production. It wants to add Cost of Equity: Risk Free % + Risk Premium %
a 50% mark-up to the cost of materials and labor and labor-related costs. Determine the contract Cost of Equity: 7% + 1.4 (12% - 7%) = 14%*
price.
Direct Labor and VFOH Gordon Growth Model
UNITS AVERAGE TOTAL Cost of Equity: Yield % + Growth %
1 20 1K 14%* = (6.7 ÷ Price) + 0%
50 units 80% 600*
2 16 1.6K Price = 6.7 ÷ 14% = P47.86

ILLUSTRATION - END -
Fruit Manufacturing recently completed and sold an order of 50 units that had the following costs:
- REMINDER -
Direct Materials P1.5K “During these moments, it's important to take a step back and remember why we started in the
Direct Labor 8.5K first place. Think about the effort that you have put in so far. All the late nights, early mornings,
Variable OH* 4K and sacrifices you've made. Consider the progress you've made towards your goal, no matter
Fixed OH** 1.4K how small it may seem.”
TOTAL 15.4K
*Applied on the basis of direct labor hours. “For I consider that the sufferings of this present time are not worth comparing with the glory that is
**Applied at the rate of 10% of variable cost. going to be revealed to us.” – Romans 8:18

RAHYNE, CPA [@rrhdamcpa]