engineering economics ise460 session 2 chapter 2, may 28, 2015 geza p. bottlik page 1 outline...

ENGINEERING ECONOMICS ISE460SESSION 2

CHAPTER 2, May 28, 2015

Geza P. Bottlik

OUTLINE

• Questions?

• News?

• Chapter 2 – Financials

• Chapter 8 - Costs



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Why study financials?



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Chapter 2 – Understanding Financial Statements

• If someone gave you $100,000, what would you do with it?



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CHAPTER 2 - FINANCIAL STATEMENTS

• ACCOUNTING - KEEPING TRACK OF MONEY

• FISCAL PERIOD - A 12 MONTH PERIOD SELECTED FOR

ANALYSIS

• INCOME STATEMENT - HOW MUCH PROFIT (LOSS)?

• STATEMENT OF RETAINED EARNINGS - WHAT DID YOU DO

WITH THE PROFIT?

• STATEMENT OF CASH FLOWS - HOW MUCH CASH WAS

GENERATED?

• BALANCE SHEET - WHERE DO YOU STAND FINANCIALLY?

• STOCK PRICE DEPENDS ON WHAT PEOPLE THINK OF THE

COMPANY’S FUTURE



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Things to do with profits?



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Things to do with profits

• Buy back stock

• Expand product line

• Pay investors dividends

• Profit sharing and raises

• Research

• Hire more labor

• Acquisitions

• Infrastructure

• Retire loans



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How is the price of a stock determined? (08/16/05)



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How do stocks look in the aggregate? (8/16/05)



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•



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CHAPTER 2 - FINANCIAL STATEMENTS (CONTINUED)

• USING RATIOS TO MAKE DECISIONS

• ABSOLUTE NUMBERS OFTEN ARE NOT MEANINGFUL - e.g.

YOUR SCORE ON THE EXAM HAS ONLY MEANING WITHIN

THE CONTEXT OF HOW IT COMPARES TO YOUR

EXPECTATIONS AND THE PERFORMANCE OF OTHERS

• PERCENTAGES ARE THE MOST COMMON RATIOS

• THE BOOK LISTS 12 RATIOS THAT ARE USED

FREQUENTLY



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CHAPTER 2 - CATEGORIES OF RATIOS

• DEBT MANAGEMENT - HOW DO YOU GET YOUR CAPITAL?

• LIQUIDITY - CAN YOU PAY YOUR DEBTS?

• ASSET MANAGEMENT- INVENTORY AND RECEIVABLES

• MARKET VALUE - HOW REALISTIC IS THE VALUE OF THE

STOCK?

• PROFITABILITY - HOW WELL ARE YOUR INVESTMENTS

GENERATING PROFITS?



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CHAPTER 2 - DEBT MANAGEMENT

• DEBT RATIO = TOTAL DEBT / TOTAL ASSETS

HAVE YOU BORROWED TOO LARGE A PART OF YOUR

ASSETS?

• TIMES INTEREST EARNED RATIO =

EARNINGS BEFORE INTEREST AND INCOME TAXES /

INTEREST EXPENSE

CAN YOU EARN ENOUGH TO PAY THE INTEREST?



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CHAPTER 2 - LIQUIDITY

• CURRENT RATIO =

CURRENT ASSETS / CURRENT LIABILITIES

DO YOU OWE MORE THAN YOU HAVE?

• QUICK RATIO =

(CURRENT ASSETS - INVENTORIES) /

CURRENT LIABILITIES

HOW FAST CAN YOU PAY YOUR DEBTS?



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CHAPTER 2 - ASSET MANAGEMENT

• INVENTORY TURNOVER =

SALES / AVERAGE INVENTORY BALANCE

ARE YOU MOVING YOUR INVENTORY FAST ENOUGH?

• ACCOUNT RECEIVABLE TURNOVER (DAYS SALES

OUTSTANDING) =

RECEIVABLES / DAILY SALES

ARE YOU COLLECTING FROM YOUR CUSTOMERS?

• TOTAL ASSET TURNOVER =

SALES / TOTAL ASSETS

ARE YOUR ASSETS GENERATING SALES?



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CHAPTER 2 - MARKET VALUE

• PRICE EARNING RATIO =

STOCK PRICE / ANNUAL EARNINGS PER SHARE

LIKE INTEREST (JUST A LOT LOWER)

• BOOK VALUE PER SHARE

(TOTAL STOCK HOLDER EQUITY - PREFFERED STOCK) /

SHARES OUTSTANDING

USUALLY MUCH LOWER THAN THE STOCK PRICE



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CHAPTER 2 - PROFITABILITY

• PROFIT MARGIN ON SALES =

NET INCOME / SALES

HOW EFFECTIVE ARE YOUR SALES IN GENERATING

INCOME?

• RETURN ON TOTAL ASSETS =

NET INCOME + TAXED INTEREST EXPENSE) /

AVERAGE TOTAL ASSETS

ARE YOUR INVESTMENTS GENERATING ENOUGH

INCOME?



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Is any of this applicable to personal finances?



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CHAPTER 8 - COSTS

• IMPORTANT TERMS:

– MANUFACTURING COSTS

» DIRECT MATERIALS

» DIRECT LABOR

» INDIRECT LABOR

» OVERHEAD

• MATERIAL

• REGULAR

– SALES AND ADMINISTRATIVE COSTS

– RESEARCH, DEVELOPMENT, DESIGN COSTS



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CHAPTER 8 - COSTS

• INVENTORY

– RAW

– WORK IN PROCESS (WIP)

– FINISHED GOODS (FG)

– TRANSIT

– EXCESS AND CANCEL



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CHAPTER 8 - COSTS

• COSTS

– FIXED (Independent of the volume of production)

– VARIABLE (Increase as volume increases)

» Generally linear

– MIXED COSTS - Ignore



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CHAPTER 8 - COSTS

• UNIT COSTS = UNITS PRODUCED / TOTAL COST

• VOLUME - NUMBER OF UNITS PRODUCED

• BREAK EVEN VOLUME – VOLUME NEEDED TO RECOVER

INVESTMENT COSTS

• MAKE OR BUY

• SUNK COSTS - CAN’T BE RECOVERED

• MARGINAL COSTS - COST TO PRODUCE THE NEXT UNIT



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Break Even Volume

• Initial investment = $20M

• Fixed operating cost per year = $5M

• Unit cost to manufacture = $50

• Selling price = $200

• Expected Life 4 years

• Ignoring the time value of money and assuming equal volumes per year, how many units per year must I make in order to break even

• 20M + 5M(4) +4(50)v = 200(4)v

• v= 66,667



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Adding up the costs (example)

• A plant generates 270,000 earned hours (established by standards for each of the products produced). 85% efficiency is assumed.

• The cost of an hour of labor, including benefits, is $30

• Indirect labor totals $30M

• Materials cost $70M

• Material overhead costs are $4M

• What is the cost of a product containing 0.8 hours of standard labor and $20 of material?

• We first calculate the total labor rate as (30,000,000+270,000*30/0.85)/270,000=$146.40/hour



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Adding up the costs (example continued)

• Material overhead = $4M/$70M= 5.7%• Direct and indirect labor =0.8* $146.40=$117.12• Material =$20.00• Material Overhead= 0.057*20 =$1.14• Total Cost =$138.26• We can separate the direct and indirect labor into:• Direct labor = 0.8*30 =$24• Indirect =$93.12• And you can see why everyone attacks overhead• If you are independent, the profit would add another 10% or

so. It is very dependent on the industry and level of investment



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Cost Distribution

Direct Labor16%

Labor OH61%

Material13%

Material OH1%

Profit9%

Cost Distrubution @ 10% Profit



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Make or Buy

• If a supplier bid $130 on the product from the last example,

how would you decide whether to make it yourself or buy it

from the supplier?



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Adding up the costs (Second example)

• Labor = 0.2 hours, material = $200• Direct and indirect labor =0.2* $146.40=$29.28• Material =$200.00• Material Overhead= 0.057*200 =$11.40• Total Cost =$240.68• We can separate the direct and indirect labor into:• Direct labor = 0.2*30 =$6• Indirect =$23.28• And you can see why everyone attacks Material Costs• If you are independent, the profit would add another 10% or

so. It is very dependent on the industry and level of investment



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Cost Distribution (second example)

Direct Labor2% Labor OH

9%

Material76%

Material OH4%

Profit9%

Cost Distrubution @ 10% Profit



Geza P. Bottlik

engineering economics ise460 session 2 chapter 2, may 28, 2015 geza p. bottlik page 1 outline...

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