BEC - Notes Chapter 1

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Sole Proprietorship and Joint Venture
Sole Proprietorship
• Filing not required - simplest form of business ownership
• Sole proprietor not considered a separate entity from the business, so will have to personally file for
bankruptcy
• Personally liable for all obligations of the business
• Life of entity limited to the life of the sole proprietor
• Sole proprietor can transfer interests at will

Joint Ventures
An association of persons or entities for a single transaction or project. JV's are treated as a partnership
(P/S)

General Partnership NO STATE FILING

General Partnership - an association of two or more persons who agree to carry on as co-owners of an ongoing
business for profit
• Filing not required
• At least two owners of the partnerships
• Personally liable for all obligations of the business
• A partnership may be dissolved after a partner dies or otherwise dissociates from the partnership unless
the partners have agreed otherwise, or vote to continue the partnership
• Taxes flow through the P/S to the partners (taxed at their rates)
• A partner cannot transfer his P/S interest without unanimous consent of the other partners
• A general P/S may file for bankruptcy as a separate entity

In a general P/S
• All partners are general partners
• All partners share equally in mgmt, profits and losses unless agreed otherwise (even when capital
contributions are not equal)
• Within the ordinary course of business a majority vote is needed
• Matters outside the ordinary course of business require unanimous consent
- Admitting new partners
- Confessing a judgement or submitting a claim for arbitration
- Making a fundamental change in the business (sale of goodwill)
- Changing the P/S agreement
- Assignment of P/S property to others
• All partners have unlimited personal liability for obligations of the P/S
• All partners (individually) have the actual or apparent authority to bind the P/S with respect to all
normal partnership business transaction (except when a third party knows the partner lacks actual
authority)
- Actual authority - all authority that a principal expressively gives to an agent plus any authority
that is reasonable implied from the express grant (Partner is store manager, reasonable to imply
the partner has the authority to hire employees, buy merchandise, etc)
- Apparent authority extends only to the ordinary course of business (sign a lease, hire/fire
employees, purchasing equipment, granting warranties)
- The P/S may ratify an unauthorized act (if the P/S likes an unauthorized act by partner)
• All partners must approve major business decisions
• A partner who acts outside the scope of his actual authority will be liable to the P/S for any damages
caused by the unauthorized act (breach of contract)

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Intent to form a P/S (either Express, orally or in writing, or Implied, in conduct) is the key to general P/S
formation. No express agreement is necessary. An agreement can be implied from conduct showing intent to
enter into a business for profit together. However, if the P/S wants to exist for mare than a year, an agreement is
required under the statue of frauds

Dissociation (P/S may or may not continue) of a partner does not necessarily cause a dissolution (business it
wound up and then terminated)

Events of a dissociation:
• A partner wants to withdraw
• An event set forth in the P/S agreement that causes a dissociation
• A partner is expelled by unanimous vote
• A partner becomes a debtor in bankruptcy
• A partner dies

When a partner dissociates actual authority ends but apparent authority continues for two years until 3rd party
is given notice.

For debts prior to dissociation, partners remain liable unless released by creditors (novation)
For debts incurred after dissociation, partners are not liable if notice is filled with the state or each 3rd party
Liability of an incoming partner is limited to financial contribution to P/S for debts prior to his/her arrival, and
is personally liable of all debts incurrent by the partnership after he becomes a partner

Events that may cause a dissolution:

• A partner withdraws
• A P/S lasts for a specified length of time
• An event set forth in the P/S agreement that causes a dissolution
• Issuance of judicial decree on application of a partner
• Issuance of a judicial decree on application of a transferee

Distribution of assets
• Step 1: Liquidate assets
• Step 2: Pay creditors (insiders or outsiders); if the liquidation of assets do not cover the costs to pay the
creditors, then the losses are split
• Step 3: If there is leftover after paying creditors, return capital to partners or split losses
• Step 4: If there is anything left, divide profits

Financial Structure of a general partnership

• Partners are not required to make any particular contribution to their P/S
• Unless otherwise agreed, partners are required to devote themselves full-time and are not entitled to
remuneration (salary)
• As a general rule, partners have no right to use P/S property for anything other than P/S business
• Partners do not have the right to assign P/S property
• An individual partner's creditors can not use P/S property to settle debts (credit card debt can't be settled
with P/S property)
• Partners right in a P/S do not pass to his estate
• P/S interest is completely different that P/S Property
- Interest in P/S (profit and losses) is assignable, but no mgmt right come with the assignment
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- Individual's creditors may go after the P/S interest, not the P/S property
- P/S interest is passes on to a partners heirs

Partners are generally liable for all contracts entered into and all torts committed by other partners within the
scope of the P/S business

The partners' liability is joint and several for the entire amount. Meaning if the other partners flee the country,
you are liable for all P/S obligations

Limited Liability P/S MUST FILE WITH STATE

A limited liability P/S (LLP) is similar to a G/P in most respects, including sharing of profits/losses, and all the
general advantages and disadvantages of a G/P

Differences
• Not personally liable for debts of the P/S or acts/torts committed by another partner, employee or agent,
but you can lose your investment. But you are still liable for your own acts\
• Must file with the sate

Limited Partnership
• Is comprised of at least 1 general partner who manages the business and is personally liable (for all P/S
debts) and at least one limited partner (whose liability is limited to capital contribution)
• Unanimous consent required for either the GP or LP to sell their interest, or a new partner be added
• Partners must make some type of capital contribution
• Absent an agreement, profit and loss allocation is based on capital contribution
• A LP is like a shareholder, no control power, may assign interest, does not owe fiduciary duty, is not an
agent, has not apparent authority
• A LP may be dissolved by
- Occurrence of time or stated time in the P/S agreement
- Written consent of all general partners
- Withdrawal or death of a general partner
- Judicial decree
• A LP has a right to vote on fundamental changes, inspect the P/S books, transact business with P/S,
bring derivative action
• A LP can lose limited liability is they do any 1 of the following
- Serve as a general partner
- Allowing name to be used in P/S name
- Participate in control (3rd party has reason to believe that the LP is a general partner)

A limited partnership and corporation are both created under a state statute and require filing with the state

Limited Liability Company/Corporation

• Must file with the state articles of organization which includes
- A statement that the entity is an LLC
- The name of the LLC
- The address of the LLC's registered office and registered agent (usually a corporate lawyer)
- Statement about management duties, otherwise all share equally in mgmt
[Similar to articles of incorporation except there is no stock information]
• The owners or members are not personally liable for the obligations of the company
• Income flows through to members
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• Members may not sell ownership interest in the LLC without consent of other members
• All members have right to manage, but may adopt agreement to centralize management (manager
managed)
• Like a corporation an LLC is a distinct legal entity, it can own land, sue, file for bankruptcy
• Each member is an agent and has the actual and apparent authority to bind the LLC.
• Members owe a fiduciary duty
• If the LLC is Manager managed, each manager is an agent, but the other members are not agents
and does not have the power to bind the LLC
• Voting strength based on capital, ownership interest [while in GP, LLP, LP voting strength is
equal unless agreed otherwise]

Events that may cause a termination or dissolution [similar to a GP]:

• Consent of all members
• A partner withdraws, death, retirement, bankruptcy (this cause dissociation and may lead to dissolution]
• A P/S lasts for a specified length of time
• An event set forth in the P/S agreement that causes a dissolution
• Issuance of judicial decree

Profit and loss allocated based on members contributions

Corporation
• Must file with state called articles of incorporation
- Name of corporation
- Name and addresses of the corporations registered agent
- Name and addresses of each of the incorporators
- Number of shares authorized to be issued
- One of more classes of shares must have unlimited voting rights
• Directors are elected by shareholders, directors select executive officers to manage day-to-day operations
• Stockholders, directors, and officers are not personally liable for obligations of the corporation (just lose
investment), but may be liable for torts the individual commits
• Perpetual life, can continue after the death of resignation of owners or managers
• Stock holders free to transfer ownership interest whenever they want to whomever they want\

C Corp - double taxation (if income is distributed to stockholders), corporate tax rates lower than personal rates
S Corp - taxed like a partnership, flowthrough; however there are restrictions on S Corps
- Stock can not be held by more than 100 persons
- Shareholders must be individuals, estates or certain trusts
- The corporation must be domestic
- Can only be one class of stock
- Foreign shareholders are generally prohibited

Certain types of businesses (insurance companies and savings institutions) cannot file for bankruptcy regardless
of what type of entity they are formed as

Most aspects of corporate law are governed by state law, but some aspects (federal tax, securities regulation)
are governed by federal law. The state statue is called Revised Model Business Corporation Act (RMBCA)

Promoters, who raise capital for the corporation, enter into contracts with third parties who are interested in
becoming shareholders (stock subscription)
- Promoters are generally personally liable on the contracts (B1-33 more detail on this)
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- Even if the corporation adopts a promoters contract, the promoter remains liable unless the promoter is
released by the third party (novation)

Ultra Vires Act - If the corporation has a narrow purpose cause (some states do not require it) and the
corporation undertakes business outside the clause, it is said to be acting "ultra vires" and may effect the firm.
• A shareholder may seek an injunction (order from the court) prohibiting the corp from the action
• The corp or shareholders may sue to recover damager from the directors or officers who authorized the
ultra vires act
• The state (usually the attorney general) may bring an action to have the corp dissolved for committing the
act

Bylaws - rules for running the entity. They are not part of the articles of incorporation and are not required to be
filed with the state
• Bylaws may not contain rules that conflict with the articles of incorporation
• Can be amended by board of directors or the shareholders

De jure - all of the requirements for incorporation are met and it will be recognized for all purposes

De facto corporation doctrine - requirements for incorporation are not met, but the business might still be
treated as a corporation, if the incorporators made a good faith attempt to incorporate and operated as if they
had incorporated, the business will be treated as a corporation in all aspects

Doctrine of incorporate Estoppel - requirements for incorporation are not met, but the business might still be
treated as a corporation, if a party who treats a business as if it were a validly formed corporation will be
estopped (legally barred) from claiming in a legal proceeding that the corporation was not validly formed
[if the 3rd party reasonably believes that they were dealing with a corp {not fraud}, then the party can not claim
the corp was not valid]

Defective corporation - entity did not make a good faith attempt to incorporate so shareholders are personally
liable

Piercing the corporate veil - courts hold shareholders, officers or directors, active in operation of the business,
of a de jure (properly formed) corporation will be held liable (because the legislative privilege of conducting
business is being abused). There are three reasons the corporate veil will be pierced:
1. Commingling personal funds with corporate funds
2. Inadequate capitalization - corporation is under capitalized at the time of formation
3. Committing fraud on existing creditors - if the corporation was formed to defraud existing personal
creditors

Foreign corporation - a corporation not incorporated within the state (Cali corp going to NY to do business)
Domestic corporation - incorporated within the state

A foreign corporation may not transact business (maintain an office within the state or conduct regular
intrastate business) within a state it has registered with the state and has obtained a certificate of authority. [So
you don't need to file twice for incorporation]

Quorum - a majority in attendance, so if there are 10 board members, 6 must be present at a meeting to have a
quorum

Operation of a corporation
• A corporation only needs only one director

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• The articles of incorporation usually name the initial director, who hold office until the first annual
meeting.
• Directors may be removed by shareholder vote with or without cause
• Director's meetings are only valid if a quorum is present, and action may be taken with a majority of vote
of those present, so if 4 of the 6 approve the action, it would be valid
• Individually, directors have no right or power to act, they are not agents, they owe a fiduciary duty
• Directors may not vote by proxy, must be there physically
• Individually, officers have powers, they are agents and have fiduciary duties

Fundamental changes require both board and shareholder approval, examples are:
• Amendments to the articles of incorporation
• Mergers
A+B=A; both A&B's boards and shareholders must approve the fundamental change
• Consolidations
A+B=C; both A&B's boards and shareholders must approve the fundamental change
• Share exchanges
A acquires all the outstanding shares of B; A needs only the board approval, B's boards and shareholders
must approve the fundamental change
• Sale of all or substantially all of the corporations assets (purchasing company, buy side, only needs board
approval)
• Dissolutions - termination of corporate existence (could be involuntary through judicial proceedings)

Procedures for fundamental changes

1. Board adopts resolution by majority vote, setting forth the proposed action for shareholder approval
2. Notice to shareholders given whether they are entitled to vote
3. Eligible shareholders vote, need majority
4. Filing of articles, setting forth the action taken, with the state

Merger of a subsidiary (parent owning 90% or more of a subsidiary) - Parent needs only boards approval.
Parent's board makes decision unilaterally

Authorized shares - shares described in the articles of incorporation

Outstanding shares - authorized shares issues to shareholders
Treasury shares - outstanding shares repurchases by the corporation

Par value - minimum price the stock can be issued for legally (to ensure the corporation would be capitalized to
a certain level

Under RMBCA, board of directors can issue the stock price at any level and be issued in exchange for any
benefit to the corporation (services rendered, services to be performed, real estate, etc)
If property is accepted for stock, the board must value the land in good faith
Unpaid stock - a subscriber has promised, but failed, to pay for stock, the subscriber may be liabel to either the
corporation or its creditors

Watered stock - stock that has been issued in exchange for property worth less than the part value

A corporation has no obligation to allocate profits and losses to among shareholders. However, if dividends are
declared by the board of directors, shareholders are treated as unsecured creditors

Cumulative Preferred shares - gets paid dividends in arrears. Gets paid before noncumulative preferred

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Noncumulative Preferred shares - gets paid before common stockholders, if a dividend is declared but not paid
within the year, the noncumulative shares lose out

Stock dividends - authorized shares owned by the corporation but unissued, because no assets are issued,
shareholder do not owe federal taxes

Cumulative voting - each share is entitled to one vote for each director position being filled in any way, so can
cast all votes for one single candidate (protects minority shareholder)
B1-46 example of cumulative voting

Shareholders may vote only is a quorum is present, and they may vote by proxy (appointment valid for 11
months)

Shareholders may enter into several agreements to protect voting power

• Voting trust - all shared owned by the party are transferred to a trustee, who votes and distributed
dividends in accordance with provisions of the voting trust
• Voting agreements - less formalistic, shareholders simple agree among themselves to vote a certain way

Shareholders in small corporations (closely held corporations) can put restriction on the transfer of stock, but
they can not put an absolute bar against selling shares. Examples of restrictions include:
• Right of first refusal - giving specified persons the option to buy shares before selling to an outsider
• Requiring that specified persons approve the transfer of stock
• Prohibiting the transferring of shares to a certain type of persons, such as competitors

Shareholders have the right to inspect the books and records upon request if its for a proper purpose. Improper
purposes to personally benefit the inspecting shareholder include obtaining the contact information of
shareholders to create a commercial mailing list

Pre-emptive rights - the right to purchase additional shares to maintain their proportionate voting strength.
No pre-emptive right unless articles of incorporation provide for them

Dissenting shareholder - vote on a fundamental change and lose. The shareholder may dissent and demand that
the corporation pay them fair value of their shares (buy them out)

Derivative action - the corporation has legal cause of action but refuses to bring action, the shareholder may
that the right to bring derivative action to enforce the corporations rights if three prerequisites are met:
1. Shareholder must have been a shareholder during time of the alleged wrong
2. The shareholder must be suing in the best interests of the corporation
3. The shareholder must have made a demand on the board

Board of directors
• Job to initiate fundamental changes
• Declare dividends
• Uses good faith (talks and relies on the officers, auditors, consultants to make decisions)
• Should not profit from material inside information
• Can not serve on the board of a competitor
• Should disclose conflicts of interest and abstain from voting
- Only liable of the deal is unfair and causes damage to the corporation
• Directors may remove officers with or without cause. The removal can occur even if it breaches the
officers' contract, but the corporation may be liable for damages (not the stockholders or directors)

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Corporations are allowed to indemnify (repay) directors for expenses for any lawsuit (for accidents or
negligence, not intentional torts) brought against them in their corporate capacity

Limitation on director's liability - breach of fiduciary duty intentional act

• Financial benefits received by the director for which he was not entitled
• Intentional harm inflicted upon the corporation or shareholders
• Unlawful distributions authorized by the director (pay dividends which renders the corp. insolvent)
• Intentional violations of criminal law
• Breaches of duty of loyalty

For tax purposes, if a company desires a fiscal year (instead of calendar year), that year end must be approves
by the IRS

Corporations may defer taxes, up to three months, by switching from calendar year end to fiscal year end, must
be approves by IRS

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Chapter 3
Factors affecting financial modelling and decision making
Relevant data - data, such as future revenues or costs, that change as a result of selecting different alternatives
• Can either be fixed or variable, but usually variable
• Direct costs - costs that can be identified with or traced to a given cost object
• Prime costs - DM & DL
• Discrentionary costs - costs arising from a periodic or annual budgeting decision (i.e. landscaping)
• Incremental/differential costs - additional costs incurred to produce an additional unit over current
output
• Avoidable - costs or revenues resulting from choosing one course of action instead of another

Not Relevant data

• Unavoidable - costs or revenues that will be the same regardless of the chosen course of action
• Absorption costs - represent the allocated portion of fixed mfg OH, and therefore are not relevant

Objective probability - based on past outcomes (like returns on the stock market
Subjective probability - based on an individuals belief about the likelihood of an event occurring (a lawsuit)

Expected value - is the weighted avg of the probable outcomes

Expected value = (probability of each outcome * its payoff) then sum the results

Financial modelling for capital decisions

Cash flow direct effect - a company pays out or receives cash
Cash flow indirect effect - transactions either indirectly associated (sale of old assets) with a capital project or
that represent non-cash activity (depreciation) that produce cash benefit (reduces taxable income)

Invoice price + cost of shipping + cost of installation

+/- Working capital [such as increase in payroll, supplies expenses or inventory requirements]
- Cash proceeds on sale of old asset net of tax
= net cash outflow for new PPE

Tax depreciation on new PPE

* Marginal tax rate
= Depreciation tax shield

After-tax cash flow on operations

+ Depreciation tax shield
= Total after tax cash flow on operations
* present value of annuity
- initial cash outflow
= Net Present Value (NPV)

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Discounted cash flow (DCF) methods are considered the best methods to use for long-run decision because it
accounts for time value of money. However, it only uses a single growth rate, which is unrealistic as interest
rates change over time.

Payback period - is simple to understand and focuses on the time period for return of investment (liquidity).
However, it ignores the time value of money. It shows the return of investment not the return on investment
(ignores cash flows occurring after initial investment is recovered)

Net initial investment [cash outflow + change in WC - sale proceeds on old PPE]
÷ increase in annual net after-tax cash flow [After-tax cash flow on operations + Depreciation tax shield]
= payback period

The larger the denominator the shorter the payback period

Discounted payback method - computes payback period using expected cash flows that are discounted by the
projects cost of capital

NPV uses a hurdle rate to discount cash flows

NPV = or > than 0, make the investment because the rate of return is = or > than the hurdle rate/discount
rate/required rate of return

NPV is superior to IRR because it can still calculate when there are uneven cash flows or inconsistent rates of
return.

Use Present value of $1 when the cash inflows are different

Use Present value of an Ordinary Annuity of $1 when the cash inflows are same across all years

NPV is considered the best single technique for capital budgeting, however, NPV does not indicate the true rate
of return on investment, just merely if it is less than or greater than our hurdle rate.

Internal rate of return (IRR) is the expected rate of return of a project

NPV calculates amounts, while the IRR calculates percentages

Reject IRR if it is less than or equal to the hurdle rate

How to calculate the IRR

Determine the life of the project
Use the payback period (net increment investment ÷ net annual cash flows) as the present value factor
Use the table to calculate IRR
B3-27 example of how to calculate the IRR

Limitations
IRR assumes cash flows from reinvestment are reinvested at the IRR %
Less reliable when there are differing cash flows
Does not consider the amount of profit

Want profitability index over 1.0 which means that the PV of inflows is greater than the PV of outflows
PV of net future cash inflows
÷ PV of net initial investment
= Profitability index
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The profitability index measures the cash-flow return per dollar invested; the higher the better

Strategies for short-term and long-term financing

• Risk indifferent behaviour - increase in risk does not increase management's required rate of return
Certainty equivalent = expected value
• Risk averse behaviour - increase in risk, increases management's required rate of return
Certainty equivalent < expected value
• Risk-seeking behaviour - increase in risk, decreases managements required rate of return
Certainty equivalent > expected value

• Diversifiable risk, unsystematic risk, non-market risk - risk that is firm specific and can be diversified
away
• Nondiversifiable risk, systematic risk, market risk - risks that can not be diversified away

As any risk factor increases (interest rate risk, market risk, credit risk, default risk) the required rate of return
increases, which causes the PV or an asset to decrease
Projected cash flow ÷ required rate of return = PV of asset

Stated interest rate (nominal interest rate) - is the interest rate charged before any adjustments for market
factors [rate shown in the debt agreement]

Effective interest rate = the actual interest rate charged with a borrowing after reducing loan proceeds for
charges and fees related to a loan origination.
Effective interest rate = coupon ÷ proceeds

Annual percentage rate = effective periodic interest rate * number of periods in a year
The annual % rate is the rate required for disclosure by federal regulators

Simple interest = original principal * interest * number of periods

Compound interest = original principal * (1 + interest rate) number of periods

Operating Leverage - the degree to which a firm uses fixed costs (as opposed to variable costs) for leverage
Fixed (i.e. Executive salaries) - risk and potential return increases
Variable (i.e. commissions) - risk and potential return decreases

% change in EBIT
÷ % change in sales
= Degree of Operating Leverage
If the numerator changes by a bigger amount than the denominator, that firm is employing leverage
So if a firms EBIT increases by 21% as sales increase by 7% then the DOL is 3. Meaning for every 1% increase
in sales, profit increases by 3%

Higher DOL implies that a small increase in sales will have a greater affect on profits and shareholder value.
But more risk.

Financial leverage - the degree to which a firm uses fixed financial costs for leverage
% change in EPS [or net income
÷ % change in EBIT
= Degree of financial leverage

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Total combined leverage - the use of fixed costs resources and fixed cost financing to magnify returns to firm
owners
% change in EPS
÷ % change in sales
= Degree of total combined leverage
Or
Degree of total combined leverage = DOL * DFL

The optimal capital structure is the mix or debt and equity that produces the lowest WACC which maximizes
firm value

WACC = (Cost of equity * % of capital structure) + (Cost of debt * % of capital structure)

Cost of debt must be after tax so, cost of debt = effective interest rate * (1 - tax rate)
As a general rule, as a firm raises more capital either equity or debt, the WACC increases

As the WACC or discount rate decreases, the PV increases

Debt carries the lowest cost of capital and is tax deductible
The higher the tax rate, the more incentive to use debt financing

After tax cost of debt = pre-tax cost of debt * (1 - tax rate)

Cost of preferred stock = dividends ÷ net proceeds

B3 44-45-47 examples of how to calculate cost of debt, preferred stock, and equity (retained earnings)

Cost of Equity (or Retained earnings)

A firm should earn at least as much on any earnings retained and reinvested in the business as stockholders
could have earned on alternative investments of equivalent risk, otherwise they should pay dividends

3 common methods of computing cost of equity

- Capital Asset Pricing Model (CAPM)
- DCF
- Bond Yield plus Risk Premium

CAPM = risk free rate + beta *(expected return on market - risk free rate)
[market risk premium]

B =1 as risky as market
B> 1 more risky than market
B< 1 less risky than market

Short-term financing is classified as current and will mature within 1 year

Short-term financing rates are lower than long term rates, which increases profitability
However, increased interest rate risk (didn’t lock in a rate), and increased credit risk

Debentures are unsecured, while bonds are often secured

ROI - ignores cash flows and uses GAAP income

ROI = income ÷ investment capital [avg assets] [which is avg PPE + avg WC]
or
ROI = profit margin * investment turnover
[NI ÷ sales] [sales ÷ investment]
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ROA = NI ÷ assets

Net Book value = historical cost - accumulated depreciation

Net book value is affected by age and method of depreciation so it can be a misleading indicator

Gross book value - historical cost

Ignores depreciation

Replacement cost = cost to replace asset

Ignores both age and method of depreciation

The method used to value the investment affect the ROI. As the denominator increases the ROI decreases

ROI focuses on short term results and my cause a disincentive to invest because the short-term result of the new
investment may reduce ROI

Residual income measures the excess actual income earned by an investment over the required rate of return,
while ROI provides a % return

Required return = net book value * hurdle rate

[Equity] [CAPM]
Residual income = NI - Required return

Debt to total capital ratio or assets = debt ÷ assets

Debt to equity = debt ÷ equity

Financial Statement and business implications of liquid asset management

Working Capital (WC) = Current assets - current liabilities
High WC, less risk, lower expected return

Current ratio = current assets ÷ current liabilities

High current ratio shows more solvency

Quick ratio = (cash + marketable securities + A/R) ÷ current liabilities

[inventory and prepaids not included]

Transaction motive - cash to meet ordinary course of business

Speculative motive - enough cash to take advantage of temporary opportunities
Precautionary motive - enough cash to maintain safety cushion/ liquidity

Primary method to increase cash levels is to either speed up cash inflows or slow down cash outflows

Annual cost of payment discount = 360 ÷ (pay period - discount period) * discount % ÷ (100 - discount %)
[works from either perspective, buyer or seller]
B3-62 has an example of payment discount calculation

Lockbox at bank may speed up cash inflow, however only worth it if the additional interest income earned on
the prompt deposit exceeds the cost of the lockbox

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Disbursement float (positive) - occurs when checks have been written but not received by vendor and recorded
by the bank
Collection float (negative) - occurs when deposits have been recorded on the company's books but not recorded
by the bank

The shorter a cash conversion cycle the better

Cash conversion cycle = inventory conversion period + A/R collection period - Payables deferral period
[avg inventory ÷ avg cost of sales per day] [avg payables ÷ avg purchases per
day]
[avg receivables ÷ avg sales per day]

Credit period is the length of time buyers are given to pay for their purchases

Accounts payable or trade credit, provides the largest source of short term financing for small firms. Defer, try
to pay your bills at the end of the pay period

Re-order point = safety stock + (lead time in days or weeks * units sold per days or weeks)

Inventory turnover = COGS ÷ avg inventory

Cost savings = inventory turn over * APR

Economic Order Quantity (EOQ) attempts to minimize ordering and carrying costs
EOQ = .5(( 2 * annual unit sales * cost per order) ÷ carrying cost per unit)

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Cost measurement and cost measurement concepts

Cost measurement concepts is associated with managerial accounting and internal reporting.
- Future orientation and usefulness characterize managerial accounting
- Meant for internal users

Cost drivers (a factor that has the ability to change total costs) may be based on
- Volume (output)
- Activity (value added)
- other

Types of theoretical cost drivers

• Executional (short-term) - cost drivers that are helpful to the firm in managing short term costs
(relationship with suppliers, improvements to the production process)
• Structural (long-term) - cost drivers that have long term effect on cost (experience, available technology,
complexity)

Types of operational cost drivers

• Volume based - associated with traditional cost acctg systems. Based on aggregate volume output (# of
direct labor hours used, # of production units)
• Activity based - associated with contemporary cost acctg systems. Based on an activity that adds value to
output (packaging, inspection)

Cost objects - resources or activities that serve as the basis for management decisions. Cost objects require
separate cost measurement and may be products, product lines, departments, geographic locations, or any other
classification that aids in decision making.

A single cost object can have more than one measurement. Inventory (product) costs for financial statements
are usually different than costs reported for tax purposes. These costs differ than the inventory (product) costs
that management uses to make decisions

Prime costs (direct costs) = DM + DL

Conversion costs = DL + Factory overhead

Product costs = DM + DL + Mfg OH applied. These costs are not expensed until the product is sold
(inventoriable)
Period costs = non mfg costs (SG&A). Are expensed in the period they are incurred and are not inventoriable.

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Cost accounting systems are designed to meet the goal of measuring cost objects or objectives. The most
frequent objectives include:
- Product costing (inventory and COGS)
- Efficiency measurements (comparisons to standards)
- Income determination (profitability)

Examples of indirect costs - not easily traceable to a cost pool or cost object (B5-7)
Indirect costs are allocated to a single cost pool called overhead, i.e. manufacturing overhead
Indirect costs in mfg OH consist of both fixed and variable components (such as rent and indirect materials).
Total overhead cost is a mixed cost because it includes both fixed and variable costs
Depreciation is a fixed cost

In a standard costing system, standard costs are used for all mfg costs (DM, DL, mfg OH)

Joint product costs - costs incurred in production up to the split-off point. Only allocated to the main products.
By-products do not receive an allocation of joint costs.

Separable costs - costs incurred on a product after the split-off point.

3 methods to allocate joint product costs

Method 1: Volume allocation
(Volume product A ÷ Total volume) * joint costs = portion of product A joint costs

Method 2: Net realizable value (value at split-off point), used for inventory costing only
(Sales value of product A at split-off ÷ Total sales value at split-off) * joint costs = portion of product A
joint costs

Method 3: Sales value not available at split-off, subtract separable costs from final selling price to find net
realizable value at split-off
Final sales value of product A - Separable costs = sales value of product A at split-off
(Sales value of product A at split-off ÷ Total sales value at split-off) * joint costs = portion of product A
joint costs

*subtract value of byproduct from joint costs when allocating. Because proceeds from by-product reduce costs.

The lowest unit price acceptable is the variable cost of the product (DL + DM + Var mfg OH) plus the
contribution margin of the alternative use for the production capacity.

Accumulating and assigning costs

• Full absorption costing - treats fixed manufacturing costs as product costs, while variable costing
expenses these as period costs.
• Job costing - custom orders
• Process costing - mass produced homogeneous product
• Operations costing - uses components of both job order costing and process costing
• Back flush costing - accounts for certain costs as the end of the process
• Life cycle costing - monitors costs throughout the products life cycle and expand on the traditional costing
systems.

Beg materials + net purchases = available for use

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Available for use - ending materials = materials used

Beg WIP + total mfg costs [DL + DM used + mfg OH applied] - ending WIP = COGM

Application of overhead
Overhead rate = Budgeted overhead costs ÷ Estimated cost driver [such as labor hrs or costs, machine hrs]
Overhead applied = Actual cost driver * overhead rate
[based on actual production]

Overhead applied consists of both variable overhead and fixed overhead. The calculation is as follows (with
direct labour hours as the cost driver):

Variable overhead rate = budgeted variable mfg OH / budgeted direct labor hours
Fixed overhead rate = Budgeted fixed mfg OH / budgeted direct labor hours
Total overhead rate = Variable overhead rate + Fixed overhead rate
Overhead applied to the job = Total overhead rate x actual direct labor hours = $5,625

Normal spoilage is an inventory cost and is included in the standard cost of the manufactured product
Abnormal normal spoilage is a period expense and is charged against income of the period as separate
component of cost of goods sold.

Weighted Avg method to find equivalent units

Equivalent units = Units completed + (Ending WIP * % completed )
Weighted average = (beginning cost + current cost) ÷ equivalent units

FIFO method to find equivalent units

Equivalent units = (Beginning WIP * % to be completed) + (units completed - beginning WIP) + (ending WIP *
% completed)
FIFO = current costs only ÷ equivalent units

Activity based costing (ABC) uses multiple OH rates to assign indirect costs to products (cost objects) based on
the resources a product consumes.
An ABC system will apply high amounts of overhead to a product that places high demands on expensive
resources

Factors affecting productions costs

Factors contributing to economies of scale include:
- Labor specialization
- Managerial specialization
- Utilization of by products (or joint products)
- Efficient use of capital equipment
- Volume discount purchasing

Financial models used for operating decisions

Revenue
Less: Variable Costs (DM + DL + Variable OH + Variable SG&A)
Contribution Margin
Less: Fixed Costs (Fixed OH + fixed SG&A)
Net Income

Absorption approach (GAAP)

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Revenue
Less: COGS (DM + DL + Variable OH + Fixed OH)
Gross Margin
Less: Operating Expenses (Fixed SG&A, Variable SG&A)
Net Income

Variable costing and absorption costing are the same except that all fixed mfg costs are treated as period costs

Under the contribution approach (variable costing), all fixed mfg OH is treated as a period cost and expensed
immediately. i.e. COGS includes only variable mfg costs. Not GAAP

Under the absorption approach (absorption costing), all fixed mfg OH is treated as a product cost and included
in inventory values. i.e. COGS includes both fixed and variable costs. GAAP

Net income effect between variable and absorption costing

Fixed cost per unit = fixed mfg OH ÷ units produced
Change in net income = change in inventory units * fixed cost per unit

No change in inventory: absorption NI = Variable NI

Increase in inventory: Absorption NI > Variable NI [because less fixed OH expensed under absorption]
Decrease in inventory: Absorption NI < Variable NI [because more fixed OH expensed under absorption]

Contribution margin ratio = contribution margin ÷ revenue

Breakeven in units = total fixed costs ÷ contribution margin per unit
Break even in dollars = total fixed costs ÷ contribution margin ratio
Break even in dollars = unit price * break even point in units

Required sales volume for target profit

Sales = (Fixed cost + target profit) ÷ contribution margin ratio
Target profit before tax = target profit after tax ÷ (1 - tax rate)

Margin of safety = total sales in dollars - breakeven in dollars

Margin of safety % = margin of safety in dollars ÷ total sales

Target costing - the selling price of the product determines the production costs allowed

Economic value added (EVA) - measures the excess of income after taxes earned by an investment over the
return rate defined by the company's cost of capital.
Investment * cost of capital = required rate of return
Income after taxes - required return = economic value added

When considering alternatives, such as discontinuation of a product line, management should consider relevant costs.
Relevant costs are those costs that will change under different alternatives.

Forecasting and projection techniques

Regression analysis - statistical model that can estimate the dependent cost variable based on changes in the
independent variable.

Learning curve analysis - used to determine increases in efficiency or production as experience is gained. Both
products have long production runs, making learning curve analysis the best method for estimating the cost of
the competitive bid.
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Attainable standards are used with flexible budgets

Authoritative standards are set exclusively by management, while participative standards are set by both
managers and employees

Planning/budgeting overview and planning/budget techniques

A master budget - an overall budget, consisting of many smaller budgets, that is based on one specific level of
production (usually begins with sales budget)

A flexible budget - a series of budgets based on different activity levels within the relevant range.

The production budget - begins with sales budget and then adds in the effect of any changes in inventory levels

Standard costs usually means that a flexible budget is being used. Standard costs per unit can be used to adjust
the flexible budget to the actual volume.

Budget Variance Analysis

DM price variance = actual quantity purchased * (actual price - standard price)
DM quantity variance = standard price * (actual quantity used - standard quantity allowed)
DL rate variance = actual hours works * (actual rate - standard rate)
DL efficiency variance = standard rate * (actual hours worked - standard hours allowed)
Standard quantity allowed (SQA) = actual output * standard allowed output

B5-63 variance chart

Sales volume variance = (actual units sold - budgeted unit sales) * standard contribution margin per unit

Sales mix variance = (actual product sales mix ratio - budgeted product sales mix ratio) * actual sold units *
budgeted contribution margin per unit of that product

Sales quantity variance = (actual units sold - budgeted unit sales) * budgeted sales mix ratio * budgeted
contribution margin per unit

Market size variance = (actual market size in units - expected market size in units) * budgeted market share *
budgeted contribution margin per unit weighted avg

Market share variance (actual market share - budgeted market share) * actual industry units * budgeted
contribution margin per unit weighted avg

Selling price variance = (actual SP per unit - budgeted selling price per unit) * actual units sold

Variable overhead efficiency variance - computed as budgeted variable overhead based on standard hours
minus budgeted variable overhead based on actual hours.
Budgeted variable OH = standard direct labor hours allowed x standard variable overhead rate
Budgeted variable OH = actual direct labor hours x standard variable overhead rate
Production volume variance component for overhead variances is computed as applied overhead minus
budgeted overhead based on standard hours

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Applied Overhead
(Std Var OH Rate x Std DLH Allowed) + (Std Fixed OH Rate x Actual Production)
Budgeted overhead based on standard hours
(Std Var OH Rate x Std DLH Allowed) + (Std Fixed OH Rate x Standard Production)
The fixed overhead rate is $5 per machine hour [$1,200,000 / 240,000 = $5].
• The amount of FIXED manufacturing overhead planned for November is $100,000.
• Therefore, the standard production for FIXED overhead is 20,000 machine hours [$100,000/$5 = 20,000.]

Organizational performance measures

Strategic business units (SBU), are generally classified around 4 financial measures
- Cost SBU
- Revenue SBU
- Profit SBU
- Investment SBU (most like and independent business) (highest level)

Critical success factors to accomplish a firm strategy are FICA:

- Financial
- Internal business processes
- Customer Satisfaction
- Advancement of innovation and human resource development

Benchmarking Techniques and best practices

Control chart - determine zero defects, shows quality performance trends
Pareto diagrams (histogram) - used to determine frequency of quality control issues
Cause and effect (fishbone) - analyze the source and location of a problem

Conformance costs - costs to ensure products conform to quality standards

- Prevention costs - incurred to prevent production of defects (employee training, engineering)
- Appraisal costs - remove defects before they reach customer (testing, inspections)
Non-conformance costs - costs that result from lost sales or reputation damage
- Internal failure - cost of defective parts or lost production time (scrap, rework)
- External failure - cost of returns and lost customer loyalty (warranty, liability)

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