Ch.3 Financial Analysis and Life Cycle Costing. - IEMS. Financial Analysis.pdf · Ch.3 Financial Analysis and Life Cycle Costing. ... An Operating cost that varies directly with a

Part 1 : System Management.

Ch.3 Financial Analysis and Life Cycle Costing.

Edited by Dr. Seung Hyun Lee (Ph.D., CPL)IEMS Research Center, E-mail : [email protected]

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Cost/Benefit Analysis.[Other Resource]

Classification of Costs Direct Costs. Variable costs that can be directly attributed to a particular job or operation. Direct material(purchased) and direct labor costs are traditionally considered direct costs. ․ Direct costs generally serve as the basis from which suppliers make their allocation of overhead costs. ․ A reduction in the direct costs of a supplier is generally worth more to the purchaser than a major reduction in the supplier's profit percentage, an important factor to be used in the negotiation process.

Indirect Costs. Costs that are not directly incurred by a particular job or operation. Certain utility costs, such as plant heating, are often indirect. An indirect cost is typically distributed to the product through the overhead rates. The three basic categories of indirect costs are : fixed, variable, and semi-variable costs.

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Classification of Costs (cont). Fixed Costs. An expenditure that does not vary with the production volume : for example, rent, property tax, and salaries of certain personnel.

Variable Costs. An Operating cost that varies directly with a change of one unit in the production volume, e.g., direct materials consumed, sales commissions.

Semi variable Costs. Semi-variable costs are those costs that display both fixed and variable characteristics. Examples of semi-variable costs include salaries of supervisors and purchasers, pension plans, utilities, and fuel.

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Classification of Costs (cont) Overhead Costs. The costs incurred in the operation of a business that cannot be directly related to the individual goods or services produced. The costs are grouped in several pools (e.g., department overhead, factory overhead, general overhead) and distributed to units of goods or service by some standard allocation method such as direct labor hours, direct labor dollars, or direct material dollars.

* Allocation of Overhead Costs.

Total plant indirect costs

= X indirect per direct labor dollar. Total plant direct labor dollars

Total plant indirect costs

= X indirect per machine hours.Total plant direct machine hours

Total company general & administrative costs

= X indirect per direct labor dollar. Total company sales

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Classification of Costs (cont) Standard Costs. The target costs of an operation, process, or product including direct material, direct labor, and overhead charges.

* Cost Variance Analysis. Analysis for the cost difference between the standard cost and the actual cost.

Life-Cycle Costing. The identification, evaluation, tracking, and accumulation of actual costs for each product from its initial research and development through final customer servicing and support in the marketplace. Life-cycle costing considers the purchase price of equipment, plus all operating and usage costs of the items over its life. These costs include maintenance, downtime, scrap or loss, energy, training, installation as well as salvage, and disposal costs.

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Classification of Costs (cont) Opportunity Cost. This cost represents the "lost opportunity" to the organization by spending money or tying up money in one investment opportunity rather than the other.

Product Cost. Costs allocated by some method to the products being produced.

Job order Costing. A cost accounting system in which costs are assigned to specific jobs. This system can be used with either actual or standard costs in the manufacturing of distinguishable units or lots of products.

Process Costing. A cost accounting system in which costs are collected by time period and averaged over all the units produced during the period.

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Classification of Costs (cont) Activity Based Costing (ABC). A cost accounting system that accumulates costs based on activities performed and then uses cost drivers to allocate these costs to products or other bases, such as customer, markets, or projects. It is an attempt to allocate overhead costs on a more realistic basis than direct labor or machine hours.

Landed Cost. The total cost of a product delivered at a given location; the production cost plus the transportation cost to the customer's location.

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Financial Tools. Return on Investment (ROI)

ROI = Annual Operating Income

or Net Present Value of Cash Flow from Project

Total Capital Invested Capital Invested in the Project

Return on Assets employed (ROAE). Measure of how the organization is using its assets.

ROAE = Net income + Interest Expense after Tax

Average Capital Employed

Return on Total Asset (ROTA).

ROTA = Net IncomeTotal Assets

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Financial Tools (cont). Margin Analysis. Margin analysis represents the profitability of an organization in relation to its sales. This is also known as "net operating margin"

Net Operating Margin = Total Operating Income

Total Sales

Payback Method.

Payback period = Required investment

Annual receipts - Annual disbursements

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Financial Tools (cont). Break-even Analysis.

B = FP-V where P-V is called the contribution.

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Financial Document.[Other Resource]

Balance Sheet.

Assets Liabilities

CashAccounts receivableInventoryFixed assets

$ 100,000$ 300,000$ 500,000

$ 1,000,000

Note PayableAccounts PayableLong-term debt

$ 5,000$ 20,000

$ 500,000

Total Liabilities $ 525,000

Owners' Equity

CapitalRetained earnings

$ 1,000,000$ 375,000

Total Assets $1,900,000 Total Liabilities and Owners' Equity $ 1,900,000

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Financial Document.[Other Resource]

Income Statement.

Revenue $ 1,000,000

Cost of goods sold

Direct laborDirect materialFactory overhead

$ 200,000$ 400,000$ 200,000 $ 800,000

Gross margin (profit) $ 200,000

General and administrative expenses $ 100,000

Net income (profit) Before Tax $ 100,000

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Life Cycle Cost.[Blanchard, pp204-214]

Cost Effectiveness and Life-Cycle Cost (LCC). Cost effectiveness involves measuring a system, in terms of mission fulfillment and total life cycle cost. Cost effectiveness is a function of system effectiveness and total life-cycle cost. LCC involves all costs associated with the system life cycle, to include the following :

1. Research and development (R&D) cost. Feasibility studies; system analysis; detailed design and development, development, fabrication, assembly, and test of engineering models; initial system test and evaluation and associated documentation.

2. Production and construction costs. Fabrication, assembly, and test of operation systems; operation and maintenance of the production capability; associated initial logistics support requirements(Test and support equipment development, spare/repair parts provisioning, technical data development, training, entry of items into the inventory, facility construction, etc.)

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Life Cycle Cost.[Blanchard, pp204-214]

Cost Effectiveness and Life-Cycle Cost (LCC).

3. Operation and maintenance costs. The costs of sustaining operation, personnel and maintenance support, spare parts and related inventories, test and support equipment maintenance, transportation and handling, facilities, modifications and technical data changes.

4. System retirement and phased cost. The costs of phasing the system out of the inventory due to obsolescence or wear out, and subsequent equipment item recycling, disposal, and reclamation as appropriate.

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Time Value Analysis. [Langford, pp245-290]

Time-Value Analysis. Financial analysis concerns the prediction and analysis of monetary dynamics in terms of defined time parameters and interest or discount rates. There are nine methods of financial analysis which are commonly used in engineering economics : ․ Future value ․ Present value ․ Uniform series compound amount ․ Annuity value ․ Uniform series present worth ․ Capital recovery ․ Effective annual interest ․ Cost gradient : equivalent uniform periodic cost ․ Cost gradient : present-value cost

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Financial Formula 1.

Formula Financial term for formula Constituent factors

F = P [(1+ i) n] Future Value ․ F = Future Value.

․ P = Present Value.

․ n = Number of periods.

․ i = Interest rate per period ( decimal equivalent to %)

P = F [ 1

(1+ i) n ] Present Value

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Financial Formula 2.

Formula Financial term for formula Constituent factors

F = A [ (1+ i)n-1

i ] Uniform Series

Compound Amount ․ F = Future Value.

․ A = Periodic Input Amount.

․ n = Number of periods.

․ i = Interest rate per period ( decimal equivalent to %)

A = F [ i

(1+ i) n-1 ] Annuity Value

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Effective Interest Analysis Effective interest analysis focuses on the effective annual interest rate. This rate is based on the interest accumulated per year when the interest is compounded on a daily basis.

Effective Annual Interest Rate (EAI) = e i-1

where i = True annual interest rate.

e = Base number for the natural logarithm

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Depreciation of Assets. [Langford, pp245-290]

Depreciation of Assets. Depreciation is the financial management discipline whereby investments in capital assents are amortized over a defined fiscal period. The predominant factors constituent to the depreciation process are : - Acquisition value - Salvage value - Service life - Periodic book value - Periodic depreciation allowance - Reserve for depreciation

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Depreciation Methods and Calculation. The basic methods of depreciation with which the logistician should be familiar are 1. Straight-line method 2. Declining-balance method 3. Sum-of-the-years'-digits method

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Straight-line method. Straight-line depreciation is the simplest method to apply and the most widely used.

- DC( n) = P-SN

(where DC( n) = annual depreciation charge in year n)

- BV( n) = P - nN

(P-S)

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Straight-line method : Example. - A new machine costs : $10,000, - Estimated salvage value : $1,500 - Expected life : 5 years.

Sol)

- Annual depreciation charge (DC( n)) = P-SN

=$10000-$1500

5= $ 1700.

End of year Cost or remaining basis

Depreciation allowance Reserve

Start12345

$ 8,500 6,800 5,100 3,400 1,700 0

-$ 1,700 1,700 1,700 1,700 1,700

$1,500 3,200 4,900 6,600 8,30010,000

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Straight-line method.

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Declining-balance method - The declining-balance method is a means of amortizing an asset at an accelerated rate early in its life, with corresponding lower annual charges near the end of service. This method uses the basic equation.

- DC( n) = RN

BV(n-1)

where R may be determined by the taxpayer.

- Depreciation ratemax = R = 200%N

This is called the double-declining-balance(DDB) method of depreciation. It has the same characteristics as the declining-balance method.

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Declining-balance method : Example. - A new machine costs : $10,000 - Estimated salvage value : $1,500 - Expected life : 5 years. - DBR = 2

Sol)

․ Depreciation ratemax = R = 200%N

= 200%

5 = 40%

End of year Cost or remaining basis Rate Depreciation

allowance Reserve

Start12345

$ 10,000 6,000 3,600 2,160 1,500 1,500

- 40%40%40%40%40%

-$ 4,000. 2,400. 1,440 660 0

$ 0 4,000 6,400 7,840 8,500 8,500

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Declining-balance method : Example.

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Sum-of-the-year's-digits for the Y th year method of depreciation (SOD). - SOD method reflects a compromise in the pace of depreciation between the conservative straight-line method and the more liberal declining-balance method.

- SOD( Y th year) = (n-y)

∑n

x=1x×(100%- estimated salvage%)

where n = expected life in years.

. y= number of years in service before Y th year. ∑n

x=1x=

n(n+1)2

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SOD : Example. - A new machine costs : $10,000 - Estimated salvage value : $1,500 - Expected life : 5 years.

Sol)

․ ∑5

x=1x =

5(5+1)2

= 15

End of year Cost or remaining basis Rate Depreciation

allowance Reserve

Start12345

$ 8500 . 5667 . 3400 . 1700 . 567. 0

- 5/154/153/152/151/15

-$ 2,833 2,267 1,700 1,133 , 567

$ 1,500 4,333 6,600 8,300 9,433

10,000

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Inventory Valuation. [Langford, pp245-290]

Definition and Purpose of Inventory Valuation. The value of the inventory can be determined by using either cost or market value. Because inventory value can change with time, some recognition is taken of the age distribution of inventory. - Raw materials, WIP, and Finished goods - The short term asset. - MRO - Expenses. - Equipments and vehicles - The long term asset.

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Types of Inventory Valuation. FIFO (First-in, First-out). In FIFO, The oldest items in inventory are the first ones being issued. In a period of changing costs, this would tend to keep the total inventory value on the balance sheet close to the current market value.

LIFO (Last-in, First-out). The latest items in inventory are the first ones being issued. This method assigns cost of goods sold based on the most recent cost incurred.

Standard Cost. A single value is selected for an inventory item that is reasonable, often based on an average of historical or anticipated costs. This technique consistently reports the inventory asset and the cost of goods sold.

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Types of Inventory Valuation. Actual Cost. To be realistic about cost requires that some form of lot control be in place so that materials withdrawn from inventory can be traced directly to a specific purchase order or production run.

Project Cost. When estimating the project cost, an accounting method of assigning valuation is generally used in industries where services are performed on a project basis. Each assignment is unique and costed without regard to other assignments.

Process Cost. A cost accounting system is used to collect costs by time period and averaged over all the units produced during the period.

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Types of Inventory Valuation. Job-order Cost. A cost accounting system in which costs are assigned to specific jobs. This system can be used with either actual or standard costs in the manufacturing of distinguishable units or lots of products.

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Example. Input data.

Record of purchase.

AprilMayJune

100 units.100 units.100 units.

$ 10.00 each 12.00 each 14.00 each

Standard cost : $ 12.50 each.Expected price in July : $ 16.00 each.Ending 1st quarter inventory : 0 units.Ending 1st quarter unit cost : $10.002nd quarter usage : 210 units at 70/month.

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Example. Output.

Method Inventory Cost of Goods Sold

FIFO $ 1,260.00 $ 2,340.00

LIFO 900.00 2,700.00

Average 1,080.00 2,520.00

Standard 1,125.00 2,625.00

Replacement 1,440.00 3,360.00

Actual(assume 70 from each lot) 1,080.00 2,520.00

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Performance Check.

1. Budgeting and accounting function is designed to provide A. Information to stockholders, creditors, the government, etc. B. Information for the control of on-going systems. C. The basis for performance evaluation and control of approved systems or projects. D. All of the above.

2. Opportunity costs are A. Costs that vary with the output of the system. B. Costs connected with foregoing other alternatives. C. Sunk costs. D. Net present values.

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Performance Check.

3. Marginal costs are A. Those costs having to do with a decision made now that will result in new costs. B. Those costs that are a by-product of the major system outputs. C. Less important costs. D. One time costs.

4. The time value of money concept involves A. A dollar in hand now is worth less than a dollar to be received at a future time. B. Money has the same value at all times. C. A dollar in hand today is worth more than a dollar to be received a year from now. D. All investments will be worth more in the future.

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Performance Check.

5. When comparing different alternatives against one another we will usually find that the different alternatives have A. Different streams of dollar costs spread out through the lifetimes of the alternatives being evaluated. B. Different streams of benefits that might be directly measured in dollar terms. C. Different lifetimes. D. All of the above.

6. A present value is A. A future value that has been discounted. B. The book value of an asset. C. The current value of the business. D. The value of inventories on hand.

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Performance Check.

7. Net present value is A. The breakeven dollar amount for an alternative B. The value of the one time initial investment in a system or program. C. The difference between the present value of benefits and the present value of costs for an alternative. D. The discount rate required to have lifetime benefits just equal to lifetime costs.

8. The payback method involves Ⅰ. Using discounting future values to provide present values. Ⅱ. Using undiscounted dollars. Ⅲ. The time it takes until all costs have been recovered.

A. l, ll B. ll, lll C. l, lll D. All of the above

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Performance Check.

9. The discount rate used in assessing alternatives should be A. Based on the cost of the organization's assets B. Based on a weighted cost of new capital, i.e. weighted cost of incremental capital. C. Whatever the industry average cost of capital is. D. The prime interest rate.

10. An investment of $100,000 based on annual interest of 6% for five years will provide the following total (principal plus interest) A. $130,000 B. $133,822.56 C. $130,918.27 D. None of the above.

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Performance Check.

11. It is designed to invest a sufficient sum to have $25,000 in three years. Based on projected 5% annual interest, the following sum would be required for immediate investment. A. $21,596. B. $21,250 C. $24,250 D. $22,150

12. If $100,000 is required for capital equipment by the end of a five year period, how much should be investment at the end of each year, based on 6% guaranteed annual return, in order to provide for the capitalization ? A. $17,470 B. $17,740 C. $20.000 D. $18,250

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Performance Check.

13. Given the following asset data : ․ Acquisition value : ＄15,000 ․ Expected life : 5 years ․ Salvage value : ＄3,000Pursuant to the straight-line depreciation method, the reserve for depreciation at the end of the third is : A. ＄2,400 B. ＄10,200 C. ＄7,800 D. ＄4,800

14. An asset has the following attributes : ․ Purchase Price : ＄20,000 ․ Salvage Value : ＄2,000 ․ Projected Service life : 5 years ․ DBR : 200%Pursuant to the DBR depreciation method, depreciation allowance at the end of the fifth is : A. ＄1,728 B. ＄592 C. ＄2,880 D. ＄4,500

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Performance Check.

15. If the sum-the-years digits method were applied to an asset with 10 years expected service life, the effective depreciation rate the end of the fourth year would be : A. 9/15 B. 8/55 C. 7/55 D. 6/15

16. The simplest depreciation method to calculated and administrated is : A. Based on zero salvage value. B. Sum-of-the-years-digits method. C. Double-declining balance method. D. Straight-line method.

17. For a company spending $100 million on materials and generating $165 million in sales revenue, a 1% reduction in the cost of raw materials would be approximately the same as generating $_______million in additional sales revenue to produce the same 10% profit margin. A. $ 1M B. $10 M C. $100 M D. None of the above

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Solutions.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17D B A C D A C B B B A B B B C D B

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Ch.3 Financial Analysis and Life Cycle Costing. - IEMS. Financial Analysis.pdf · Ch.3 Financial Analysis and Life Cycle Costing. ... An Operating cost that varies directly with a