INFO 631 Prof . Glenn Booker

www.ischool.drexel.edu

INFO 631 Prof. Glenn Booker

Week 5 – Chapters 13-15

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Inflation and Deflation

Chapter 13

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Question• Think about the last time you bought

something you’ve bought before– How much did you pay?– How much did you pay the first time it was bought?– Was it the same price both times?

• Most likely not• Prices change over time

– Short term– Long-term

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Outline• Inflation and deflation, defined• Price indices, Consumer Price Index,

Produce Price Index• Inflation rate• Purchasing power and inflation• Accounting for inflation

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Inflation and Deflation• Refer to long-term trends in prices

– Inflation same things cost more than before– Deflation same things cost less than before

• Generally refer to the overall economy, not specific products and services– Long term changes in the “purchasing power” of money

• Tendency for inflation over last 50+ years but significant deflation has happened– Note: General trend in 1800’s was deflation (caused by

industrial revolution),

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Possible Causes - Inflation and Deflation

• Inflation– Government price support polices (subsidies)– Deficit spending– Higher production costs

• Wage increase of workers– Lower availability of resources

• Deflation– More efficient production methods

• Lowers production cost– Higher availability of resources

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Average Relative Price Level (CPI), 1913-2002

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

180.0

200.0

1900 1920 1940 1960 1980 2000 2020NOTE: Shows a substantial change in relative prices over time. Something that sold for about 10 cents in 1910 would go for nearly $2 today.

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So what does it mean to us?

• If planning horizon is long or high annual inflation rate– Can cause noticeable change in value of

proposal– Might need to address during decision

• If planning horizon is short or inflation is weak– Might be able to just ignore

• Overall it is a judgment call on the decision makers part

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Price Indices:- Measuring Inflation and Deflation

• Ratio (expressed as percentage) of historical price to price at another time

• Example– Gas in 2005 ($2.00) vs. gas in 1999 ($1.40)

100PricePrice PriceIndex

then

nownow

%143100$1.40$2.00 dexGasPriceIn

1999

20052005

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Creating a Price Index

• Define a “market basket”– Reference shopping list with kinds and amounts

• Choose a reference date• Price the market basket on the reference

date• Price the market basket today• Price index = ratio of current price to price

on reference date

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Common Price Indices

• Consumer Price Index (CPI)– Change from retail purchase’s perspective

• Producer Price Index (PPI)– Change from sellers perspective

• Complied by Department of Labor and Department of Commerce

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Consumer Price Index (CPI)

• Measures price change from retail purchaser’s perspective– Based on spending habits of average household consumer

• Market basket of about 400 goods and services– Housing– Food and beverage– Apparel– Transportation– Medical care– Recreation– Education– Utilities and fuels, etc.

• Reference date for CPI isn’t a single point in time– Based on average of three years (1982-1984)

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Producer Price Index (PPI)

• Family of price indices– Measures change in selling prices for domestic goods and

services before they reach the retail consumer– Used for adjusting business-to-business contracts for inflation

(long term)• Prices to be paid for in the future

• Over 500 industry-level price indices and 10,000+ specific product line and product category sub-indices– Manufacturing, Agriculture, Forestry, Fisheries, Mining, Scrap, …– Transportation, Utilities, Finance, Business services, Health,

Legal, Professional services, …

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Inflation Rate

• Measures rate of increase of corresponding price index– Usually stated as an annual percentage

• Deflation rate is negative inflation rate– 1.4% deflation = -1.4% inflation

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Single-Year Annual Inflation Rate

• Examples1)-Year(i

1)-Year(iYear(i)Year(i) PriceIndex

PriceIndexPriceIndex AnnualRate

%9.231.5

31.532.4 AnnualRate1966

%4.3166.6

166.6172.2 AnnualRate2000

CPI (1966) = 32.4

CPI (1965) = 31.5

CPI (2000) = 172.26

CPI (1999) = 166

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Annual Inflation Rate, 1914 - 2002

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1900 1920 1940 1960 1980 2000 2020

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Average Annual Inflation Rate

• Example

1CPI

CPI f n

t

nt

%46.21130.7166.6 f 10

1990

1999

Note: For decisions spanning over 1 year, use Average Inflation Rate applied over entire planning horizon.

CPI (1999) = 166.6

CPI (1990) = 130.7

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Purchasing Power and Inflation• Inflation means

– Purchasing power if money is going down.– “Same amount of money later on doesn’t buy as much as it did

before”– Inflation rate – tells how much more is

• Purchasing Power means – “How much can I buy for a given amount”

• Example– 1970 candy bar = 25 cents– 1997 = $1.00

• Purchasing power and inflation are closely related but not equivalent

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Purchasing Power

K = PurchasingPower year(1) = PriceIndex year(0)

------------------PriceIndex year(1)

K = PurchasingPower 1976 = PriceIndex (1975) = 53.8

------------------ ------ = 0.946 PriceIndex (1976) 56.9

Means: it would take $1 (end 1976) to buy same goods that could be bought for 94.6 cents (end 1975)

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Purchasing Power and Inflation

• Average loss in purchasing power over multiple years

n

nt

t

CPICPI-1 k

%40.2166.6130.7-1 k 10

1999

1990

Example

Average annual loss in purchasing power was 2.4% in the ’90s

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Purchasing Power and Inflation


• Example

nn

)k(11 )f(1

1010

2.40)(11 2.46)(1

Note: f-bar (annual inflation rate) thru 1990’s (above) and k-bar (average loss in purchasing power) thru 1990’s (above)

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Recap - Purchasing power and inflation


• Use Inflation rate when– Ask “How much will <x> cost at <time>?”

• Use Purchasing Power when– Ask “How much can I buy for <amount of

money> at <time>?”

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Accounting for Inflation• Actual dollar analysis

– Cash-flow instances represent actual out-of-pocket dollars paid/received at that time

– A.k.a. current dollars, escalated dollars, inflated dollars, …

• Constant dollar analysis– Cash-flow instances represent hypothetical

constant purchasing power amounts– A.k.a. real dollars, deflated dollars, today’s dollars,

…

Two Methods

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Actual-Constant Dollar Analogy

Boat speed through water (Interest)

River speed (Inflation)

Rock on shore (Beginning of planning horizon)

Ball

Distance between boat and ball (Actual dollars)

Distance between boat and rock (Constant dollars)

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Converting Actual Dollars to Constant Dollars

• Example

Dollars Actualf)(1

1DollarsConstant n

47.11$12.95$0.0246)(1

1DollarsConstant 199551990

Note: Remember we calculated earlier that f-bar thru the ’90s was 2.46%. $12.95 in 1995 was worth the same as $11.47 in 1990.

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Converting Constant Dollars to Actual Dollars

• Example

DollarsConstant 1Dollars Actual nf

63.14$12.95$0246.01Dollars Actual 19905

1995

Note: Remember we calculated earlier that f-bar thru the ’90s was 2.46%. So $12.95 in 1990 was worth the same as $14.63 in 1995.

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Actual Dollar vs. Constant Dollar Analysis

• f is the inflation rate (speed of current in river)

• i is the market interest rate (speed of boat through water)

• i’ is the inflation-free interest rate (speed of boat relative fixed point)

11

i1i'

f

%88.31

03.010.071i'

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Relationship Between Actual and Constant Dollar Analysis

0 1 2 3 n-1 n

(1 + i)n

(1 + i)n1

P

FActual Dollars

0 1 2 3 n-1 n

(1 + i') nP'

F'Constant Dollars

1(1 + i') n

(1 + f)n1

(1 + f)n

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Simple Example of Actual and Constant Dollar Analysis

0 1 2 3 9 10

P=$10,000F=$19,670

Actual Dollars

0 1 2 3 9 10

Constant DollarsP'=$10,000F'=$14,630

F/P,7,10 (1.967)

P/F,7,10 (0.5084)

P/F,3,10 (0.7441)

F/P,3,10 (1.344)

F/P,3.88,10 (1.463)

P/F,3.88,10 (0.6835)

At 7% market interest, $10k grows to $19,670 after 10 years—this is actual dollarsAt 3.88% inflation-free interest, $10k grows to be worth $14,603 base-year dollars in year 10—this is constant dollarsNote that $19,670 actual dollars in year 10 = $14,630 constant dollars.

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Key Points• Inflation refers to long-term increases in prices• A price index is the ratio of the price at one time to the

price at another• The inflation rate is the rate of increase in a price index• Purchasing power and inflation are related but different• Inflation can be addressed using actual dollar or

constant dollar analysis

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Depreciation

Chapter 14

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Depreciation

Outline• Introducing depreciation• Value-time functions• Book value• Depreciation methods

– Before 1981– 1981 through 1986– 1987 and beyond

• Units-of-production depreciation

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Depreciation

• Depreciation addresses how investments in capital assets are charged off against income over several years– Important part of calculating after-tax cash

flow

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• Two different meanings– Actual depreciation

• How an asset loses value over time– Physical depreciation

» Literally means asset is wearing out» Wear and tear, etc.

– Functional depreciation» Environment where asset is operating has changed and asset is

not well matched to the new environment.» Obsolescence

– Depreciation accounting• How the organization accounts for that loss in value

• Note: – Actual deprecation (real loss in value) is rarely the same as depreciation

accounting (how loss accounted for by organization).– For actual depreciation – need to sell asset and see what someone will pay for it

Introducing Depreciation

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• Corporations are taxed on profit, not income– Profit = Income - Expenses

• Expenses claimed in a tax year should reflect actual expenses incurred– Including actual depreciation, as best as it can be estimated

• Tax authorities are trying to force accounting and recognition of an asset’s loss in value to be as close as possible to when that loss actually happens (make each years income tax as realistic as possible)– Alternatives to depreciation

• Write off in year of acquisition• Write off in year of disposal

Key Ideas in Depreciation Accounting

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• Depreciation amounts aren’t actual cash-flow instances– Actual cash flow happened on acquisition– Depreciation amounts are allocation of actual expense over time

• Force company to spread recognition of original expense over asset’s assumed life

• Depreciable assets (required to be treated as):– Used in business or trade– Used for producing income– Have a known lifespan >1 year

Key Ideas in Depreciation Accounting (cont)

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• Mathematical function that models how an asset loses value over time

• Two types– Straight-line

• Simplest• Asset loses value at a constant rate

– Declining value• Asset loses value as a fixed percentage of its

remaining value over its lifetime.

Value-Time Function

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Value-Time Function

Time

Value

•

•Time

Value

•

Straight-line Declining-balance

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Book Value

• Tax authorities’ best estimate—based on depreciation accounting—of an asset’s actual value– May or may not reflect the true value

1)-year(t 1)-year(tyear(t) onDepreciati-ValueBook ValueBook

t

i 1year(i)year(t) onDepreciati -CostAcquision ValueBook

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• Before 1981 – Straight-line– Declining-balance– Declining-balance switching to straight-line– Sum-of-the-years-digits

• 1981 through 1986– Accelerated cost recovery system (ACRS)

• 1987 and beyond– Modified accelerated cost recovery system

(MACRS)

Depreciation MethodsNote: Method stays until disposal – doesn't change with laws

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Why Care About Old Methods

• Broad survey of different methods• Good foundation for today’s method• When laws change, old method might

come back to use– You never know……

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• Before 1981 company could choose– Straight-line– Declining-balance– Declining-balance switching to straight-line– Sum-of-the-years-digits

• Steps1. Choose method2. Estimate asset useful life

1. Based on organizations past history2. Class life asset depreciations range (CLADR)

See book pg 217, Figure 14.1 IRS approved useful life range

Depreciation Methods

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• “Class Life Asset Depreciation Range”– Defined lower, recommended, and upper

limits on asset life spans• Business aircraft: 5, 6, 7 years• Autos & taxis: 2.5, 3, 3.5 years• Agriculture equipment: 8, 10, 12 years• Computers: 5, 6, 7 years• Furniture: 8, 10, 12 years• …

CLADR System

Note: IRS likes recommended (ADR)

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Straight-line Depreciation• Assumes value of asset decreases at constant rate over

its useful life• Asset loses fixed percentage of original value each year

YearsLifetimeInueSalvageValnCostAcquisitio

onDepreciati

onDepreciati *t-CostAcquision BookValue year(t)

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• Example asset– Acquisition cost = $34,000– Salvage value = $2000– Useful life = 5 years = n

Example of Straight-line Depreciation

End of Depreciation Book Value at Year in that year end of year 0 -- $34,000 1 $6400 $27,600 2 $6400 $21,200 3 $6400 $14,800 4 $6400 $8,400 5 $6400 $2,000

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Declining-Balance Depreciation

• Value decreases at fixed percentage of remaining (book) value over useful life– Depreciation amount is based on fixed

percentage of book value (a a 2/n, n=years)• Double declining-balance means a = 2/n• 150% declining-balance means a = 1.5/n

)1(year(t) *onDepreciati tyearBookValuea

ta-1*CostAcquision ValueBook year(t)

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• Same asset– Double declining-balance, a = 2/5 = 0.40

Example of Declining-balance Depreciation

End of Depreciation Book Value at Year in that year end of year 0 -- $34,000 1 0.40 * $34,000 = $13,600 $20,400 2 0.40 * $20,400 = $8160 $12,240 3 0.40 * $12,240 = $4896 $7344 4 0.40 * $7344 = $2938 $4406 5 0.40 * $4406 = $1763 $2644

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• Same asset– 150% declining-balance, a = 1.5/5 = 0.30

Example of Declining-balance Depreciation

End of Depreciation Book Value at Year in that year end of year 0 -- $34,000 1 0.30 * $34,000 = $10,200 $23,800 2 0.30 * $23,800 = $7140 $16,660 3 0.30 * $16,660 = $4998 $11,662 4 0.30 * $11,662 = $3499 $8163 5 0.30 * $8163 = $2449 $5714

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Declining-balance Switching to Straight-line Depreciation

• Declining-balance used initially– Switch to straight-line when declining-balance

amount is less than straight-line amount– Mathematically – when slope of declining-

balance curve becomes less then slope of straight line.

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Declining-balance Switching to Straight-line Depreciation (cont)

)()(year(t) ,maxonDepreciati tyeartyear neStraightLialanceDecliningB

t

i 1year(i)year(t) onDepreciati-CostAcquision ValueBook

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Time

Value

•

Straight-line

Declining Balance

Switch

Note: Ignores salvage value


• Same asset– 150% declining-balance, a = 1.5/5 = 0.30– Straight-line = $6400

Example of Declining-balance Switching to Straight-line

Depreciation

End of Depreciation Book Value at Year in that year end of year 0 -- $34,000 1 0.30 * $34,000 = $10,200 $23,800 2 0.30 * $23,800 = $7140 $16,660 3 0.30 * $16,660 = $4998, Switch to $6400 $10,260 4 $6400 $3860 5 $3860 $0

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Sum-of-the-Years-Digits Depreciation

• Depreciation amount determined by rule:– List years in order, compute sum– List years in reverse order– Depreciation amount is (reverse order / sum)

• Note: Recognizes salvage value

Year in Depreciation Year reverse order factor 1 5 5/15 2 4 4/15 3 3 3/15 4 2 2/15 5 1 1/15Sum = 15

(k/K, K= Sum,

k = rev. year)

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• Same asset

Example of Sum-of-the-Years-Digits Depreciation

End of Depreciation Book Value at Year in that year end of year 0 -- $34,000 1 5/15 * ($34,000 - $2000) = $10,667 $23,333 2 4/15 * ($34,000 - $2000) = $8533 $14,800 3 3/15 * ($34,000 - $2000) = $6400 $8400 4 2/15 * ($34,000 - $2000) = $4267 $4133 5 1/15 * ($34,000 - $2000) = $2133 $2000

Note: Yr 0 = k/K * (acquisition cost – salvage value)

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• Used from 1981 to 1986• Two variants

– Prescribed method• All depreciable assets are assigned to 1 of 4

separate classes of property– Alternative method

• Organization chooses 1 of 3 possible periods

Accelerated Cost Recovery System (ACRS) Depreciation

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• Depreciable assets assigned to classes:– 3-year property– 5-year property– 10-year property– 15-year property– (see text for property class descriptions)

• Note: uses half-year conversion– Assume asset start service midyear (Jul 1)

and ends service midyear (Jun 1)

ACRS Prescribed method

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ACRS Prescribed Method Depreciation Schedule

Recovery year 3-Year 5-Year 10-Year 15-Year 1 0.25 0.15 0.08 0.05 2 0.38 0.22 0.14 0.10 3 0.37 0.21 0.12 0.09 4 0.21 0.10 0.08 5 0.21 0.10 0.07 6 0.10 0.07 7 0.09 0.06 8 0.09 0.06 9 0.09 0.06 10 0.09 0.06 11 0.06 12 0.06 13 0.06 14 0.06 15 0.06

Each year’s depreciation amount = scheduled factor * acquisition cost

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• Same asset

Example of ACRS Depreciation Prescribed

End of Depreciation Book Value at Year in that year end of year 0 -- $34,000 1 0.15 * $34,000 = $5100 $28,900 2 0.22 * $34,000 = $7480 $21,420 3 0.21 * $34,000 = $7140 $14,280 4 0.21 * $34,000 = $7140 $7140 5 0.21 * $34,000 = $7140 $0

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• Used since 1987– Derived from ACRS– Two new classes, 7- and 20-year property– 3-, 5-, 7-, and 10-year classes use 200% declining-balance– 15- and 20-year use 150% declining-balance– No distinction between new and used property

• See text for MACRS Prescribed Method depreciation schedule– Table 14.11 on page 227– Also half year convention but this time entire depreciation shifted

right (6 months in 1st yr, 6 months in last year)

Modified Accelerated Cost Recovery System (MACRS) Depreciation

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• Same asset

Example of MACRS Depreciation

End of Depreciation Book Value at Year in that year end of year 0 -- $34,000 1 0.2000 * $34,000 = $6800 $27,200 2 0.3200 * $34,000 = $10,880 $16,320 3 0.1920 * $34,000 = $6528 $9792 4 0.1152 * $34,000 = $3917 $5875 5 0.1152 * $34,000 = $3917 $1958 6 0.0576 * $34,000 = $1958 $0

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Units-of-Production Depreciation

• Not allowed under current US tax code• Depreciation is based on use, not time

sepacityforULifetimeCaueSalvageValnCostAcquisitio

onPerUseDepreciati

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Key Points• Actual depreciation refers to how assets lose value over

time• Depreciation accounting refers to how the organization

estimates that loss• Value-time functions model the rate of loss• Book value is the estimated remaining value of an asset

due to depreciation• A number of depreciation methods have been used,

MACRS is used today

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General Accounting and Cost Accounting

Chapter 15

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General Accounting and Cost Accounting

Outline

• Balance sheet• Profit and loss statement• Cash-flow statement• Cost accounting• Cost of goods sold statement• Determining unit cost

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• Shows the financial position of a company at a moment in time– “Snap shot” or “freeze frame”– “How much is the company worth right now?”

• Assets– Things of value the company owns or is owed by others

• Liabilities– Opposite of assets, what the company owes others

• Owner’s equity– The company’s net worth

Balance Sheet

Assets = Liabilities + Owner’s Equity

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Acme Corp Balance SheetAssets 20x5 20x4 Cass & equivalents $198 $161 Accounts receivable 28 14 Inventory 53 36 Property 52 47 Plant & Equipment 46 66 Investments 26 16 Total Assets 403 340

Liabilities Accounts payable 73 50 Debt 36 41 Declared dividends 0 0 Total liabilities 109 91

Owner’s Equity Stock 121 121 Retained earnings 173 128 Total equity 294 249

Total liabilities and equity 403 340

Note: Assets = Liabilities + Owner’s equity

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• Summarizes income and expenses between balance sheets– “How quickly is the company gaining or losing value?”– Accumulation over a period of time

• Operating income– Gross income minus cost of goods sold

• Operating expenses– Costs to run the company

• Investment-related expenses– Costs to finance the company

• Income taxes– Federal, state, and local taxes

• Net earnings after taxes

Profit and Loss Statement

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Acme CorpProfit & Loss Statement

Operating Income 20x5 20x4 Sales & operating income $784 $721 Cost of goods sold 470 423 Net operating income (loss) 314 298

Operating Expenses Selling expenses 36 34 General & administrative expenses 62 60 Research & development 99 115Investment Related Expenses Interest expense 7 14 Investment expense 1 3 Depreciation 36 35Net earnings before income taxes (loss) 73 37

Income Taxes Federal, state, and local 28 14

Net Earnings After Taxes (loss) 45 23

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• Details actual flow of cash– Some P&L isn’t real cash, some real cash isn’t P&L– “How much more or less cash does the company

have now?”• Cash from operating activities• Cash from investing activities• Cash from financing activities• Net change in cash

Cash-Flow Statement

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Acme CorpCash-Flow Statement

Cash from Operating Activities 20x5 20x4 Net earnings $45 $23 Depreciation 36 35 Changes in accounts receivable(14) 8 Changes in accounts payable 23 (4) Changes in inventory (17) 7Net cash from operating activities 73 69

Cash from Investing Activities Capital expenditures (24) (17) Acquisitions (11) 0 Proceeds from dispositions 4 26Net cash from investing activities (31) 9

Cash from Financing Activities New borrowing 8 4 Debt repayment (13) (14) Net stock 0 0 Dividends paid 0 0Net cash from financing activities (5) (10)

Net change in cash 37 68 Cash at beginning 161 93Cash at end 198 161

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Relating the Three Statements

Balance Sheet

for time T+1

Balance Sheet

for time T

Profit & Loss

Statement for time

T+1 to T+2

Cash Flow Statement for time

T+1 to T+2

Profit & Loss

Statement for time

T to T+1

Cash Flow Statement for time

T to T+1

Balance Sheet

for time T+2

T T+1 T+2

• Balance Sheet - company’s financial position at a give point in time• P&L Statement –shows company financial position changed over time• Cash-Flow Statement - shows how the company’s cash position changed over time

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• Production cost has a major influence on profit– Cost accounting helps manage that cost– Find out how much it costs to provide product

or service– Show in Cost of Goods statement

Cost Accounting

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Cost Accounting

Work in Process

Direct Material

Indirect Material

Direct Labor

Indirect Labor

Finished Goods

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• Details cost of producing goods and services– “How much did it cost to provide the goods and services sold during a

reporting period?”– Forwards to Cash-flow Statement

• Direct Material– Cost of material that can be directly allocated to units of production

• Direct Labor– Cost of labor that can be directly allocated to units of production

• Manufacturing Overhead– Cost of material and labor that can’t be directly allocated to units of

production • Cost of Goods Made

– Total cost of good produced during this period• Cost of Goods Sold

– Total cost of goods sold during this period

Cost of Goods Sold Statement

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Acme CorpCost of Goods Sold Statement

Direct Material In process Jan. 1, 20x5 $5 Applied during year 59 Total 64 In process Dec 31, 20x5 7 57

Direct Labor In process Jan. 1, 20x5 6 Applied during year 129 Total 135 In process Dec 31, 20x5 8 127

Manufacturing Overhead In process Jan. 1, 20x5 23 Applied during year 282 Total 305 In process Dec 31, 20x5 32 273

Cost of Goods Made 457 Finished goods Jan. 1, 20x5 49 Total 506 Finished goods Dec. 31, 20x5 36

Cost of Goods Sold 470

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• “How much does it cost to produce each unit?”– Trivial for direct costs– Difficult for indirect costs

• Traditional unit-costing methods– Direct-material-cost method– Direct-labor-hour method– Direct-labor-cost method

• Activity-based costing

Determining Unit Cost

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• Direct costs

• Indirect costs

Acme CorpCost Allocation Case Study

$178.50$25.507.0$82.21Whatzit$143.55$21.756.6$65.35Gizmo

Direct-labor dollars per unit

Direct-labor cost per hour

Direct-labor hours per unit

Direct-material dollars per unit

Manufacturing overhead $273Selling expenses 36General and administrative expenses 62Research & development 99Interest 17Investments 1Depreciation 36Total overhead 524

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Direct-Material-Cost Method• Overhead is allocated in proportion to the

cost of direct materials

• For Acme Corp

osttMaterialCTotalDireceadTotalOverh terialCostRaDirectMate

19.9$57K$524K terialCostRaDirectMate

Gizmo Direct material $65.35 Direct labor 143.55 Overhead, $65.35 * 9.19 600.57 809.47

Whatzit Direct material $82.21 Direct labor 178.50 Overhead, $82.21 * 9.19 755.51 1016.22

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Direct-Labor-Hour Method• Overhead is allocated in proportion to the

number of direct labor hours

• For Acme Corp

stLaborHourTotalDireceadTotalOverh rHourRateDirectLabo

hr/89.93$5581hrs$524K rHourRateDirectLabo

Gizmo Direct material $65.35 Direct labor 143.55 Overhead, 6.6 * $93.89 619.67 828.10

Whatzit Direct material $82.21 Direct labor 178.50 Overhead, 7.0 * $93.89 657.23 917.94

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Direct-Labor-Cost Method• Overhead is allocated in proportion to the

cost of direct labor

• For Acme Corp

tLaborCostTotalDireceadTotalOverh rCostRateDirectLabo

13.4$127K$524K rCostRateDirectLabo

Gizmo Direct material $65.35 Direct labor 143.55 Overhead, 143.55 * 4.13 592.86 801.76

Whatzit Direct material $82.21 Direct labor 178.50 Overhead, 178.50 * 4.13 737.21 997.92

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Activity-Based Costing (ABC)

• Traditional cost – Gather all overhead cost in a single large pool

then allocate across company’s products and services

• ABC – Entire cost of each activity is averaged out

across all occurrences of that activity and is then allocated to individual products based on how much that activity occurs for that product

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Activity-Based Costing

ProductActivity 1

Activity 2

Activity n...

Direct material

Direct labor

Overhead

Direct labor

Direct labor

Direct material

Direct material

Overhead pool

Overhead Overhead

1

1

1

2

2

2

n

n

n

ProductActivity 1

Activity 2

Activity n...

Direct material

Direct labor

Overhead

Direct labor

Direct labor

Direct material

Direct material

Overhead Overhead

1

1

1

2

2

2

n

n

n

81INFO631 Week 5


1. Identify the activities2. Determine total cost for each activity3. Define a measure and quantity for each

activity4. Calculate the average cost per output for

each activity5. Specify the activity quantities for each

product6. Calculate unit costs

Activity-Based Costing (cont)

82INFO631 Week 5


Caution on Unit Costing• Might seem reasonable to use unit cost to

calculate total cost for any arbitrary production rate

• Not that simple– Variable costs

• proportional to the rate of production (raw materials, direct labor, …)

– Fixed costs• Independent of the rate of production (facilities

rental, loan interest, property tax, …)– Unit cost = slope of dotted line.

• Doubling production rate will probably not double total cost!, therefore not unit cost either

83INFO631 Week 5


Caution on Unit Costing

Total cost

Production rate

Fixed Cost

Variable Cost

•Slop

e = U

nit co

st

84INFO631 Week 5


Key Points• Balance Sheet shows financial position of a company at a point in

time • Profit & Loss Statement explains how financial position changed

over time• Cash Flow Statement shows details actual flow of cash between

company and outside• Cost accounting finds cost to provide products and services that

were sold• Unit cost shows cost to produce one instance of each product or

service– Direct-material-cost method– Direct-labor-hour method– Direct-labor-cost method– Activity-Based Costing (ABC)

• Be careful to not misinterpret unit costs

85INFO631 Week 5

Documents

INFO 631 Prof . Glenn Booker