Lecture#1&2

Business Organization Accounting

and Financial Decisions
Engineering and Economics
Economics is the study of social behavior guiding in
the allocation of scarce resources to meet the unlimited
need and desires of the individual members of a given
society

Engineering is application of the laws of Mathematics

and natural sciences to transform the scarce resources of
nature for the benefit of the human race. These resources
include every thing from ores and crops to information
and energy
What is Engineering economics
Engineering economics is the application of economic
techniques to the evaluation of design and engineering
alternatives. The role of engineering economics is to assess
the appropriateness of a given project, estimate its value,
and justify it from an engineering standpoint

To be economically acceptable, solutions must demonstrate

a positive balance of longterm benefits over longterm
costs,
What is Engineering economics
Engineering economics involves formulating,
estimating, and evaluating the expected economic
outcomes of alternatives designed to accomplish a
defined purpose.
Mathematical techniques simplify the economic
evaluation of alternatives.
The formulas and techniques used in engineering
economics are applicable to all types of money
matters.
they are equally useful in business and government, as
well as for individuals
 Role Engineering Economics in
Decision Making
Decisions are made routinely to choose one alternative
over another by individuals in everyday life:
by engineers on the job;
by managers who supervise the activities of others;
by corporate presidents who operate a business;
by government officials who work for the public good.
Most decisions involve money, called capital or capital
funds , which is usually limited in amount.
Decisions are based on a combination of economic and
noneconomic factors.
Engineering economics deals with the economic factors.
Role of Engineer in Business
Yahoo, Google, Apple Computer, Dell, Microsoft
Corporation, and Sun Microsystems produce computer
products each having market value of several billion
dollars each
All started by young college students with technical
backgrounds
These students initially organized their companies as
proprietorships.
As the businesses grew, they became partnerships, and
Finally converted to corporations.
Steps in an engineering economy study
Identify and understand the problem; identify the
objective of the project.
Collect relevant data and define viable solution
alternatives.
Make realistic cash flow estimates.
Identify an economic measure of worth criterion for
decision making.
Evaluate each alternative;
Select the best alternative.
Implement the solution and monitor the results.
Types of Business Organization

1. Proprietorship
2. Partnerships
3. Corporations
 Proprietorship
A Proprietorship is a business owned by one
individual
The owner is responsible for the firms policies, owns all
its assets, and is personally liable for its debts
The owner acts as the Manager
From accounting point of view proprietorship is
regarded as business entity separate from other affairs of
the owner
From legal viewpoint the business and its owner are not
regarded as different entities
Advantages of Proprietorship
Ease of formation
Owner owns all of the business assets
The business pays no income tax. The earnings of a
proprietorship are taxed at the owners personal tax
rate, which may be lower than the rate at which
corporate income is taxed
The business pays no salary to the owner
The owner is personally liable for all debts of the
business
Disadvantages of proprietorship
Proprietorship cannot issue stocks and bonds,
making it difficult to raise capital for any business
expansion

The owner is personally liable for the debts of the

business. If the business becomes insolvent, creditors
can force the owner to sell his or her personal assets to
pay the business debts
 Partnerships
A partnership is an unincorporated business owned by
two or more partners. A Partnership often is referred to
as firm
Most partnerships are established by a written contract
between the partners prepared before the firm begins
operation
The contract normally specifies salaries, contributions to
capital, and the distribution of profits and losses
Owners of the partnership are personally responsible for
all debts of the business
From accounting standpoint, partnership is viewed as
business entity separate from the personal affairs of the
owners
 Advantages of Partnerships
Low cost and ease of formation.
Because more than one person makes contributions, a
partnership typically has a larger amount of capital
available for business use

Since the personal assets of all the partners stand behind

the business, a partnership can borrow money more
easily from a bank

The partnerships itself pays no income taxes, but the

partners include their respective shares of the firms net
income in their personal income tax returns.
Disadvantages of Partnerships
Under partnership law each partner is liable for a
businesss debts.
This means that the partners must risk all their personal
assetseven those not invested in the business
And while each partner is responsible for his or her
portion of the debts in the event of bankruptcy, if any
partners cannot meet their pro rata claims, the remaining
partners must take over the unresolved claims
A partnership has limited life. A partnership ends upon the
withdrawal or death of an existing partner
 Corporation
A corporation is legal entity, having an existence
separate and distinct from that of its owners. The owners
are called stock holders e.g IBM, GM, PTCL, AT&T, etc.

A corporation must obtain a charter from the state in which

it is formed, and also must issue authorization from that
state to issue shares of capital stock

The assets of the corporation belongs to the corporation

itself, not to the stock holders.

As a legal entity a corporation may enter into contracts, is

responsible for its debts, and pays income taxes on its
income
 Advantages of Corporation
It can raise capital from a large number of investors by
issuing stocks and bonds
It permits easy transfer of ownership interest by trading
shares of stock
Corporation may continue its business operations
indefinitely , without regard to changes in ownership
It allows limited liabilitypersonal liability is limited to
the amount of the individuals investment in the business
It is taxed differently than proprietorships and partnerships,
and under certain conditions, the tax laws favor
corporations
Management of corporation
Top level of corporations professional management is
Board of Directors

These directors are elected by stockholders and are

responsible for other professional managers

Stockholder or group of stockholders owning more than

50% of the companys stock effectively controls the
corporation
Disadvantages of Corporation
It is expensive to establish a Corporation

A corporation is subject to numerous governmental

requirements and regulations
Objective of the Company
Increase the market value of the company
Market value stock price reflected in the financial
market
Market values of some of well known U.S. firms
Company Stock Price Number of Market Value
Shares (mil)
Google $445.47 $141.13B
Dell $14.30 $27.96B
Coca Cola $48.78 $113.02B
Wal-Mart $51.49 $200.68B
Ford Motor $7.68 $24.74B
Factors that Affect Market Value
How is the company doing at a particular time?

What is happening to other stock prices, that is, how are

the competitors doing?

How do investors expect the company to perform in the

future Decisions to invest in various projects and the
actual performance of these projects
Why Engineers need to understand the
financial statements?
Understanding Financial
Statements
Accounting: The Basis
of Decision-Making
Financial Statements:
Financial Status for
Businesses
Financial Ratios: Using
Ratios to Make
Business Decisions
Accounting The Language of Business
Methods of Reporting Income

Cash Basis
method

Accrual Basis
method
 Financial Statements
Financial statements are accounting reports that
precisely convey to management and to interested
outsiders a concise picture of the profitability and
financial position of a business

Virtually all businesses and most individuals keep

accounting records to aid in making decisions
The four most widely used financial statements are:
The balance sheet
Income statement
Cash flow statement
Statement of retained earnings
Financial Status for Business
 Balance Sheet
Balance Sheet shows the financial position of a
given business entity at a specific date.
Normally every business prepares a balance sheet at the end
of the financial year.
A balance sheet consists of the listing of the assets, the
liabilities, and the owner equity.

A fundamental characteristic of a balance sheet is that the

total figure of assets always equals the total liabilities plus
owners equity
Assets are arranged in order of liquidity. The most liquid
assets appear at the top of the page, the least liquid assets at
the bottom of the page
The Basic Accounting Equation
For the Balance Sheet Presentation

Assets = Liabilities + Owners Equity

Resources = Claims on Resources by

Outsiders + Owners
For the Financial Analysis
Assets - Liabilities = Owners Equity
The Basic Accounting Equation
For every business enterprise, the sum of the cost of
assets is equal to the sum of rights/claims to those
assets at any moment
Cost of the Assets = Rights to the Assets
Rights to the Assets belong;
to the external entities, i.e., lenders of debts
and suppliers of goods on credit etc., up to
the extent they provide resources to the
business on credit called Liabilities.
to the owners of the business, i.e., proprietor,
partners and shareholders etc., up to the
extent of whatever remained after paying
external liabilities called Equity.
 Assets
Assets are economic resources that are owned by a
business and are expected to benefit future
operations
Assets may have definite physical form also called
tangible assets such as buildings, machinery or
inventory etc
Other assets may be in the form of valuable claims or
rights, such as amounts due from customers,
investment in government bonds or patent rights.
 Asset Accounts
Cash
Notes
Prepaid Current Receivable
Insurance
Prepaid
Accounts
Expenses
Receivable
ASSETS
Office
Supplies Land
Fixed
Store Buildings
Supplies
P&E
 Intangible Assets
Intangible assets have no physical form such as:
goodwill
copyrights
franchises, and so forth
Goodwill=going value-liquidating value
 Liabilities
The claims against assets are of two types: liabilities
and stockholders equity.

Liabilities are debts. The person or organization to

whom the debt is owed is called a creditor

The liabilities of a company indicate where the

company obtained the funds to acquire its assets and
to operate the business
 Current Liabilities
Current liabilities are those debts which must
be paid in the near future (normally, within one
year). The major current liabilities include:

Accounts Payable
Notes payable
Accrued expenses (wages, salaries, interest, rent,
taxes, etc., owed, but not yet due for payment)
Advance payments and deposits from customers also
called unearned revenue
 Long-Term Liabilities
long-term liabilities, are liabilities that are due and
payable more than one year in the future

Long term debts

Employee pension benefits
Mortgages etc.
Creditors claims have priority over those of the owners
Accounts Payable vs. Notes Payable
Businesses often purchase supplies , and services on
account. The liabilities arising from such
purchases are called accounts payable.

Similarly companies borrow money to finance

expansion or the purchase of high cost assets, for
which the borrower must sign a formal note
payable. A note payable is a written promise to
repay the amount owed by a particular date along with
payment of interest as well.
 Liability Accounts
Unearned Notes
Revenues Payable
Current
Accounts
Payable LIABILITIES

Accrued Long Term

Long-term Debts
Liabilities

Employees Long Term

Retirement Deposits
Benefits
 Stockholders Equity
Stockholders equity represents the amount that is
available to the owners after all other debts have been
paid.
preferred and common stock
treasury stock
capital surplus
and retained earnings
 Common Stock
Common stock is the aggregate par value of the
companys stock issued.

Common stock possesses the traditional rights of

ownership i.e voting rights, participation in dividends,
and a residual claim to assets in the event of
liquidation

Par Value (or stated value) is the legal capital per

share below which the stockholders equity cant be
reduced except by losses from business operation
 Preferred stock
When any of the rights of the common stock is
modified the term preferred stock is used to describe
the resulting type of capital stock.

Preferred stock is a hybrid between common stock

and debt
Has no voting power
Have fixed dividend
Preferred as to assets in the event of liquidation of the
corporation
 Capital Surplus
Paid-in capital (capital surplus) is the amount of
money received from the sale of stock that is over and
above the par value of the stock
 Treasury stock
Outstanding stock is the number of shares issued that
actually are held by the public

Treasury stock may be defined as shares of a

corporations own capital stock that have been
issued and later reacquired by the issuing
company, but that have not been cancelled.

Treasury shares may be held indefinitely or may be

issued again at any time
 Retained earnings
Retained earnings represent the cumulative net
income of the firm since its inception, less the total
dividends that have been paid to stockholders

Retained earning represent the increase in the

stockholders equity that is accumulated over the years as
a result of profitable operations

Dividends are distributions of retained earnings to

shareholders
 Equity Accounts

Paid-up
Capital Dividends

Owners
Equity
Revenues Expenses
Retained
Earnings

Reserves
 Sources of Equity

Owners Contributions
By issuing stocks through financial markets
Retained Earnings
By retaining operating profits instead of
paying
Complete Balance Sheet Equation
Balance Sheet
Balance Sheet
The Balance Sheet Statement for RIM, Ltd.
Four Quadrants of the Balance Sheet

ASSETS
LIABILITIES

Current Liabilities
Current Assets

= Long-Term Liabilities

Long-Term Assets Equity

1. Owner Contributions
2. Retained Earnings
 Income Statement
The second financial report is the income statement,
which indicates whether the company is making or losing
money during a stated period, usually a year
The companys accounting period refers to the period
covered by an income statement.
Income Statement (IS) lists the amounts of revenues
earned and expenses incurred during an accounting
period
IS shows profit (net income) if revenues exceed expenses
and shows loss if expenses exceed revenues
Profits add to the owners equity whereas losses reduce it
Basic Income Statement Equation

Revenue
-
Expenses

Net Income (Loss)

Why Gross Margin is a Critical Measure for
Engineers?

Sales

Cost of Goods Sold

Gross Margin
How Inventory Production Impacts Profit

Calculating the Cost of Goods Sold

Beginning Inventory

+ Additions to Inventory

- Ending Inventory

Cost of Goods Sold

How to Use Profit Check Points
ABC Company, Inc.
Statement of Operations (Year Ended December 31, 20xx)
Sales $5,000,000 100.0%

Less: Cost of Goods Sold 3,250,000 65.0%

Gross Profit (margin) 1,750,000 35.0%
Less: Selling, G&A Expenses 1,000,000 20.0%
Operating Profit (margin) 750,000 15.0%
Less: Interest 250,000 5.0%
Net Income Before Taxes (NIBT) 500,000 10.0%
Less: Taxes 175,000 3.5%
Net Income (margin) $325,000 6.5%

Bottom line
The Income Statement Research In Motion Ltd.
FY 2009

100.00% Revenue

46.07% Gross margin

24.60% Operating margin

17.10% Net margin

Relationship Between Balance Sheets
and Income Statement
Balance Sheet (12/31/09) Income Statement Balance Sheet (12/31/10)
(01/01/10 - 12/31/10)
Assets Net sales 300,000 Assets
Current assets 74,300 Cost of Goods Sold 208,000 Current assets 76,400
Fixed assets 95,000 Gross Profit 92,000 Fixed assets 84,000
Total 169,300 O&M Expenses 58,720 Total 160,400
Net Operating profit 33,280
Liabilities & Equities Liabilities & Equities
Non-operating Profit 5,200
Current liabilities 44,500 Taxable Income 28,080 Current liabilities 28,000
Other liabilities 32,000 Income Taxes 8,424 Other liabilities 30,000
Total 76,500 Net Income 19,656 Total 58,000

Preferred stock 10,000 Cash Dividends 10,056 Preferred stock 10,000

Common stock 40,000 Common stock 40,000
Capital surplus 10,000 Retained earnings 9,600 Capital surplus 10,000
Retained earnings 32,800 Retained earnings 42,400
Total 169,300 Total 160,400
 Cash Flow Statement
Cash flow statement provides information about a
companys cash receipts (inflows) and cash payments
(outflows).
The term cash flow denotes both inflows and outflows.

The difference between the sources (inflows) and uses

(outflows) of cash represents the net cash flow during
the reporting period

Cash flows are even more important, particularly because

the company needs cash to pay dividends and to purchase
the assets required to continue its operations
 Cash Flow Classification
Cash flows are classified into three sections;
CF from operating activities; Cash effects of
revenue and expense transactions related to primary
business activities
CF from investing activities; Cash effects
stemming from purchases and disposals of plant
assets/ investments
CF from financing activities: Cash effects of
transactions between the company and its
owners/creditors/borrowers
Business Operating Cycle
The business operating cycle: How a
business earns its cash
Sources and Uses of Cash

The operating cycle is the average period of

time required for a business to make an initial
outlay of cash to produce goods, sell the goods,
and receive cash from customers in exchange for
the goods.
Cash Flow Transactions within Business
Shareholders

To pay dividend,
From sale To purchase back
of shares shares Fixed Assets
Government To purchase

To pay taxes From sale

CASH To pay interest

From cash sales and principal
From sale
From credit of debt
Customers sales
To pay labor, Debt holders
materials, and
overhead

Inventory
 The Cash Flow Business Cycle
Changes in equity Pay taxes
Changes in liabilities Pay interest
Pay dividends
Cash
Collection of
receivable Cash
Accounts Sales
Production receivable Credit
Sales
Labor
Materials Inventory
Overhead
Depreciation

Investment Fixed assets

The Cash Flow Statement Research In Motion, Ltd.

Operating
Activities

Financing
Activities

Investing
Activities
Sources and Uses of Cash
Statement of
Changes in
Financial Financial Position Financial
position position

Balance Sheet Sources and Balance Sheet

March 1, 2010 Uses of Funds Feb. 28, 2009

Sources Uses
Increase in equity Decrease in equity
Decrease in assets Increase in assets
Increase in liabilities Decrease in liabilities
The Engineers focus on the Investing
Section: Capital Budgeting

Cash from Operations Cash from

operations (profit)
Cash spent on
Cash from Investments Property, Plant,
Equip.
Cash received from
Cash from Financing bonds and stocks
Q&A