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Table of Contents
Title I: Management Advisory Services and Professional Ethics
MAS in the CPA Profession .......................................................................................... 1
Systems Development Life Cycle.................................................................................. 1
Moral Philosophies .................................................................................................... 2
Resolution of Ethical Dilemmas in Engagements ............................................................... 2
IMA Ethical Standards ................................................................................................ 3
Organizational Considerations for Ethics ......................................................................... 3
Title II: Management Accounting
Strategy and Management ........................................................................................... 4
Strategy Formulation ............................................................................................... 4
Functions of Management .......................................................................................... 6
Objectives of Management Accounting .......................................................................... 6
Roles of Management Accountants ............................................................................... 6
Management Regimes .............................................................................................. 6
Management Information Systems ................................................................................ 6
Management Accounting vs. Financial Accounting ............................................................. 7
Treasurership vs Controllership ................................................................................... 7
Responsibilities of Management Accountants ................................................................... 7
Functions of Managers .............................................................................................. 7
Costs and Cost Behavior ............................................................................................. 8
Cost Accounting ..................................................................................................... 8
The Income Statements ............................................................................................ 9
Cost Behavior Concerns ............................................................................................ 9
Variable and Absorption Costing ................................................................................. 10
Other Costing Regimes ............................................................................................ 10
Reconciliation of Net Income ..................................................................................... 10
Cost-Volume-Profit Analysis ...................................................................................... 11
Assumptions of CVP ................................................................................................ 11
General Formulas in CVP Analysis ............................................................................... 11
The Margin of Safety and the Shutdown Point ................................................................. 11
CVP Analysis for Multiple Products .............................................................................. 11
Operating Leverage ................................................................................................ 12
The Indifference Point ............................................................................................ 12
Other Considerations in CVP Analysis ........................................................................... 12
Forecasting Tools (Quantitative Techniques) ................................................................. 13
Linear Regression and Correlation Analysis..................................................................... 13
Probability Analysis and Decision Tree Diagrams .............................................................. 14
Learning Curve Analysis ........................................................................................... 14
Appendix: Computing Logarithms with Basic Calculators .................................................... 15
Exponential Smoothing ............................................................................................ 15
Linear Programming ............................................................................................... 15
Forecasting Models Summary ..................................................................................... 15
Profit Planning and Budgeting .................................................................................... 16
Budgeting Process .................................................................................................. 16
What Makes a Good Budget? ...................................................................................... 16
Budgeting Concepts ................................................................................................ 17
Flexible vs Static Budgets ......................................................................................... 17
General Budgeting Concepts ..................................................................................... 17
Budgeting Best Practices .......................................................................................... 18
A Master Budget Sample .......................................................................................... 19
A Cash Budget Sample ............................................................................................. 19
Standard Costing .................................................................................................... 20
Standard Setting.................................................................................................... 20
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Applying the Standards ............................................................................................ 20

Variance Analysis ................................................................................................... 21
Flexible and Static Budgets ....................................................................................... 21
Mix and Yield Variance ............................................................................................ 23
Overhead Variances ................................................................................................ 23
Overhead Variances – Summary .................................................................................. 24
Sales Variances ..................................................................................................... 25
Journal Entries on Variance Analysis ............................................................................ 25
Other Concerns ..................................................................................................... 26
Activity-Based Management ...................................................................................... 27
Cost Behavior in AB Costing vs Traditional Costing ............................................................ 27
Responsibility Accounting and Segment Reporting ........................................................... 28
Advantages and Disadvantages of Decentralization ........................................................... 28
Segment Reporting ................................................................................................. 28
Responsibility Centers ............................................................................................. 29
Profit Center Evaluation .......................................................................................... 29
Evaluation of Investment Centers or Stand-alone Responsibility Centers .................................. 29
Managing Common Costs .......................................................................................... 30
Indirect Common Costs ............................................................................................ 30
Shared Resources or Outsourced Costs .......................................................................... 30
Special Considerations for Joint Cost ........................................................................... 30
Special Considerations for By-products ......................................................................... 31
Capacity Planning .................................................................................................. 31
Transfer Pricing and External Pricing Decisions .............................................................. 32
Why is Transfer Pricing Done? .................................................................................... 32
Transfer Pricing Schemes ......................................................................................... 32
Maximum and Minimum Transfer Prices ........................................................................ 32
Negotiated Transfer Prices ....................................................................................... 32
Dual-rate Transfer Price .......................................................................................... 33
International Considerations for Transfer Pricing ............................................................. 33
Pricing Decisions ................................................................................................... 33
Pricing Concepts (not Exhaustive) ............................................................................... 34
Customer Profitability ............................................................................................. 34
Product Profitability ............................................................................................... 35
Proper Performance Evaluation .................................................................................. 35
Relevant Costing and Non-routine Decision Making .......................................................... 36
Tactical Decision Making .......................................................................................... 36
Activity Resource Planning Model ................................................................................ 36
Summary of the Tactical Decision-making Processes: ........................................................ 38
The Indifference Point or Curve ................................................................................. 38
Cashflow versus Profit Decision .................................................................................. 38
Balanced Scorecard ................................................................................................ 39
Gross Profit Variances and Strategic Analysis ................................................................. 40
Strategic Analysis of Operating Income ......................................................................... 41
Title III: Modern Business Practices
Strategic Cost Management ....................................................................................... 42
Product Lifecycle Costing or Super Absorption Costing ....................................................... 42
Total Quality Management ........................................................................................ 43
Six-Sigma Quality................................................................................................... 43
Kaizen Costing ...................................................................................................... 44
Supply Chain and Operations Management .................................................................... 44
Business Process Outsourcing and Shared Services ............................................................ 44
Enterprise Resource Planning .................................................................................... 44
Materials Resource Planning ...................................................................................... 45
Just-in-Time Production System (JIT) ........................................................................... 45
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Lean Methodology .................................................................................................. 45

Theory of Constraints and Throughput Costing ................................................................ 45
Business Transformation .......................................................................................... 47
Business Process Management .................................................................................... 47
Benchmarking ....................................................................................................... 47
Business Process Reengineering .................................................................................. 47
Title IV: Financial Management
Financial Management ............................................................................................. 48
The Ten Axioms .................................................................................................... 49
Financial Statement Analysis ..................................................................................... 50
Ratio Analysis ....................................................................................................... 51
Earnings Quality .................................................................................................... 53
Integrated Reporting .............................................................................................. 55
Analysis Limitations and Best Practices ......................................................................... 56
Economic Profit .................................................................................................... 57
Working Capital Management ..................................................................................... 58
Cash Management .................................................................................................. 58
Trading Securities Management .................................................................................. 59
Receivables Management ......................................................................................... 59
Inventory Management ............................................................................................ 61
Appendix: Computing non-base 2 nth Roots using Basic Calculators ....................................... 62
Cost of Short-term Credit and Time Value ..................................................................... 63
Current Asset Financing ........................................................................................... 63
Other Financial Instruments and Arrangements ............................................................... 64
Secured Sources of Short-term Credits (Asset Management for Credits) ................................... 64
Unsecured Sources of Short-term Funds ........................................................................ 64
Appendix: The Effective Annual Rate ........................................................................... 64
Risks and Returns ................................................................................................... 65
Measures of Risk or Volatility ..................................................................................... 65
Valuation of Securities ............................................................................................ 66
Portfolio Theory, Correlation Matrix, and the SML ............................................................ 68
Derivatives and Hedging .......................................................................................... 69
Capital Structure and Long-term Funding ...................................................................... 71
Factors Influencing Capital Structure ........................................................................... 71
Theories on Capital Structure .................................................................................... 71
Sources of Intermediate and Long-term Funds ................................................................ 72
Hybrid Instruments ................................................................................................. 73
Weighted Average Cost of Capital ............................................................................... 73
Dividend Policy ..................................................................................................... 74
Rationalization of Dividend Policy ............................................................................... 74
Recapitalization and Stock Repurchases ........................................................................ 75
Additional Funds Needed Analysis for Financial Forecasting ................................................. 75
Sustainable Growth for Capital Structure ...................................................................... 75
Capital Budgeting ................................................................................................... 76
Non-Discounting Methods ......................................................................................... 77
Discounting Methods ............................................................................................... 78
Project Screening, Ranking and Capital Rationing ............................................................ 79
Sensitivity Analysis ................................................................................................. 79
Long-term Decisions for Capital Budgeting ..................................................................... 79
NPV Appraisals vs IRR Appraisals ................................................................................. 80
Special Techniques in Capital Budgeting ....................................................................... 80
Other Considerations for Capital Budgeting .................................................................... 80
Financial Markets, Corporate Restructuring, and Valuation ................................................ 81
Mergers and Acquisitions .......................................................................................... 81
Corporate Defenses to M&As ..................................................................................... 82
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The M&A Process ................................................................................................... 84

Divestitures, Restructuring, and Liquidation ................................................................... 84
Valuation Models ................................................................................................... 86
Discounted Cashflow Model for Business Valuation ........................................................... 87
International Finance .............................................................................................. 88
Direct Foreign Investments ....................................................................................... 88
International Buying and Selling of Currency .................................................................. 88
Exchange Rate Systems............................................................................................ 89
Foreign Financing .................................................................................................. 89
Appendix: Review of Terminologies in Statistics ............................................................. 92
Appendix: Project Feasibility Studies ........................................................................... 93
Title V: Economics
Microeconomics ..................................................................................................... 94
Demand, Supply, Price, and the Market ........................................................................ 95
Market Equilibrium ................................................................................................. 97
Market Structures .................................................................................................. 98
Macroeconomics .................................................................................................... 99
National Income Accounting ...................................................................................... 99
Gross National Product .......................................................................................... 101
Consumption and Income ....................................................................................... 102
The Business Cycle ............................................................................................... 103
Keynesian Economics ............................................................................................ 103
Investment and Income ......................................................................................... 104
Sources and Uses of Money ..................................................................................... 104
Sources and Uses of Public Funds .............................................................................. 105
Sources and Uses of Dollars/Foreign Currencies ............................................................. 106
Inflation and Unemployment ................................................................................... 106
Fiscal Policy ....................................................................................................... 107
Monetary Policy .................................................................................................. 107
Trade Policy....................................................................................................... 108
Title VI: Technology, Data, and Analytics
Accounting Information Systems ................................................................................ 109
Finance Transformation Tech Enablers........................................................................ 110
Enterprise Resource Planning .................................................................................. 110
Database Management Systems and Data Warehousing .................................................... 110
Enterprise Performance Management Systems............................................................... 110
Robotic Process Automation .................................................................................... 111
Artificial Intelligence ............................................................................................ 111
Cloud Computing ................................................................................................. 111
Blockchain ......................................................................................................... 112
Data Governance ................................................................................................... 112
Aspects of Data Governance .................................................................................... 112
Data Governance Frameworks .................................................................................. 112
Data Lifecycle .................................................................................................... 113
Information Security ............................................................................................. 113
Data Analytics and Business Intelligence ...................................................................... 113
Data Mining ....................................................................................................... 114
Analytic Models ................................................................................................... 114

**For purposes of the October 2022 CPALE Syllabus, Strategic Cost Management is now replaced
with Modern Business Practices, covering some of the same topics but possibly adding IT concepts
already seen in Auditing in CIS. Project Feasibility Studies and MAS in the CPA Profession are now
removed; furthermore, a full emphasis on Standard Costing and AB Costing are placed into MS as it
has now been deemphasized in AFAR. Kindly refer to the revisions separately.
Happy learning! I wish you all the best. -- GJM
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Title I: Management Advisory

Services and Professional Ethics
MAS in the CPA Profession
Management Advisory Services – the area of accounting concerned with providing advice and technical
assistance to help clients improve the use of their resources to achieve their goals. This is also called
Management Consulting Services/Business Advisory Services/Management Services.
Management Consulting – an independent and objective advisory service provided by qualified persons
to clients in order to help them identify and analyze management problems and opportunities
Activities include:
• Consultations – providing advice and information during a short time frame
• Engagement – An analytical approach and process applied in a study or project
o Ascertaining facts and circumstances
o Seeking and identifying objectives
o Defining the problem or rooms for improvements
o Evaluating and determining possible solutions
o Presenting findings and recommendations
o Implementing appropriate solutions
Professional Attributes
• Technical Skills (Accounting and Financial know-how, Administrative Knowledge, Tech Savvy)
• Interpersonal Skills (Communication and Relationship Skills)
• Consulting Process Skills (Creativity and Analytical Skills, Problem Solving)
Consulting Process

Identify Selecting
Define the Pitch the Implement
Alternative the Best
Problem Solution the Solution
Solutions Alternative

***MECE Model from McKinsey Consulting – MECE stands for Mutually Exclusive, and Collectively
Exhaustive; the MECE principle suggests that to understand and fix any large problem, you need to
understand your options by sorting them into categories that are: Mutually Exclusive– Items can only fit
into one category at a time and Collectively Exhaustive – All items can fit into one of the categories.
Systems Development Life Cycle
Closely tied to the consulting process is the SDLC, which is the bread and butter of any Transformation
Engagement that consultants are usually hired for.
Conceptual Design Operation and
System Analysis Physical Design Implementation
and Documentation Maintenance

• The SDLC is concerned with generating business improvements. Thus, Business Process Analysis
is conducted to determine business needs, gaps, and their appropriate solutions. Diagrams and
Flowcharts are a staple in consulting work; hence it is necessary that the basics are mastered.
• Some examples of BPA include:
o Inquiry, Observations, and Inspection of Documents, Reperformance, Analytical Procedures,
Materiality assessments, (like in audit) and Maturity assessments
o Flowcharting and Process Mapping
o Identifying value-adding and non-value-adding activities
o Time-and-motion studies
• In some cases, the usual steps in SDLC are not done in order or that there are innovations that
are implemented. The typical SDLC is considered a ‘Waterfall’ approach to managing projects
for consulting. New ways of working such as the ‘Agile’ methodology are quickly catching pace.
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Moral Philosophies
Ethics can be learned, and practiced, much like any other skill. We do it subconsciously to some degree,
but being intentional with living through an ethical life is actually challenging, especially when we
consider that we have to consider the information available to us, and that we must account for things
even beyond our control; and so it becomes difficult to be conscientious about moral decisions. Here are
some guides:
Morality ≠ Virtue
• Morality is the rule that we apply. It answers what we ought to do.
• Virtue is the character traits. It answers who we ought to be.
Teleology Deontology Virtue Ethics Utilitarianism Relativism Justice
Purpose- Duty-driven, How a virtuous Which choice Individual – Platonic –
driven, end categorical person would benefits the you create Case-by-case
goal imperative decide most good for your codes. justice
the most Cultural – your
people culture Aristotelean –
decides your Consistently
code applied across
any case
Decision-making is a process and not an outcome. There are qualities listed below:
• Fairness – A decision involves a transparent process that emphasizes empathy for all those
affected. It makes any decision sustainable enough that those involved will understand and
support the decision in the future.
• Integrity – A rule is consistently applied to an individual’s moral philosophy. Hypocrisy is not
tolerated, and a process is holistic and complete.
• Due Diligence – A decision is very well-informed by facts and circumstances surrounding the
decision. It means to consider perspectives that one may overlook. It also means to operate
around a compliance framework.
• Fiduciary Responsibility – This is particular for finance professionals, whose duty are to the
stakeholders of the firm.
Resolution of Ethical Dilemmas in Engagements
The IMA sets out a guideline that Management Accountants must follow in performing engagements,
these were also adapted by the Philippine Standards on Auditing concerning Consultancy engagements.
(See Auditing Theory – Code of Ethics of Professional Accountants)

In the face of an ethical dilemma, these are the steps to take:

•Take action over the Fraud (Be rational and thoughtful; do not ignore the situation)
1
•Evaluate Personal Risks
2
•Follow your organization's policies (Determine internal ethics or whistleblowing mechanisms
3 internally first)
•Discuss with an immediate supervisor
4
•Involvement in fraud by the supervisor means to go up one level
5
•Use the IMA Ethics Hotline
6
•Consult your own attorney
7
•If needed, resign from your organization
8
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IMA Ethical Standards

The Ethical standards governing the Management Accounting profession is provided by the Institute of
Management Accountants (IMA). It provides the following principles and standards:
Principles Standards
Honesty – staying true to what actually Competence – having the skills and
happened in an event in their capabilities to deliver quality work
communications, analyses, and work and leadership
Fairness – balanced without bias in Confidentiality – judgment on
work and professional relationships appropriate disclosure of information
Objectivity – analysis should be Integrity – standing firm on what is
reasoned, thorough, and dispassionate right
Responsibility – Upholds the standards Credibility – conformance to ethical
herein stated and professional standards
Principles are to be understood as the reason why the standards are in place. In other words. Principles
set the direction, while standards are the driving force toward quality and professional work ethics.
Quite essentially, adherence to ethical standards is a very personal endeavor. It affects even our personal
relationships, our personal ‘brand’ or name, and the world around us.
Some considerations to look into when making decisions:
‘Will my loved ones be honored ‘How will my reputation be ‘How will the people around me
when this choice is made?’ impacted when this decision is take or perceive the decision I
made made?’
Organizational Considerations for Ethics
Compliance Considerations Business Sustainability Social Responsibility
Compliance with Laws and Business sustainability Carroll’s CSR Pyramid mainly
Regulations should always be contemplates which concerns talks about the order of priority
considered in decision-making should take priority over for an organization wanting to
Compliance with Ethical others. When people needs, expand. In a nutshell, as an
Standards such as thru the IMA planet needs, and profit needs organization becomes more
and the Ethics Committee of are all met, the business is said successful, it starts to add
the Professional Regulation to be sustainable. This further responsibility to itself
Commission objective is known as the triple to comply with corporate social
Other pertinent rules and bottom line. responsibility.
regulations

Carroll’s CSR Pyramid

The triple bottom-line
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Title II: Management Accounting

Strategy and Management
• Management – A coordinating function that combines limited human and material resources in
production of goods and services to meet the objectives of the organization.
• Strategy – a framework for an organization’s goal-setting and feedback which spans over the
long-term life of an organization, usually for about 3-5 years.
Strategy Formulation
Environmental Strategy Evaluation and
Vision and Mission Strategy Design
Scanning Implementation Control
Vision and Mission
A good vision and mission statement is easy to understand and to communicate. This enables the
proliferation of the values that form these throughout the organization.
Vision Mission
The future of the firm Defines the company
What is the company in n years What is the purpose of the company?
• To bridge the mission and the vision, company values must be consistently practiced.
Therse are stages in formulating company values:
1. Clarify the Vision by setting objectives; the processes required to achieve; adjusted for success.
2. Gathering and Analyzing Information available to the firm thru SWOT analysis and understanding
Internal and external forces influencing the firm
3. Formulating the Company strategy by understanding the business environment and the issues therein
4. Consistent implementation and coordination
5. Goal Congruence between middle line management and top management
6. The values serve as a reference point for action and evaluation
7. Feedback, Evaluation, and Control and appropriate Incentives that tie back to Strategy
Environmental Scanning
This deals with the understanding of the firm’s internal and external environment. A well-understood
map of every aspect of the firm enables it to make better decisions about its direction, goals, whether
on an immediate span of time or on a long-term span of time
1. SWOT Analysis
Deals with identifying internal and external factors that influence the direction of the firm.
It is important to note that SWOT analysis
Strengths Weaknesses
does not presuppose that all 4 aspects are
•Internal •Internal
equal. Some may be of more emphasis than
•Positive •Negative
others.
SWOT
Analysis Identifying the appropriate course of action
requires an appreciation of accurate facts
Opportunities Threats about the firm
•External •External
•Positive •Negative

2. PESTLE MODEL
This outlines the factors that may influence the environment surrounding a firm.
P E S T L E
Politics Economy Social Technology Legal Environment
Stability, Inflation, Demographic, Disruption, Intellectual Sustainability,
Taxes, Unemployment, Culture, Cost of Property, Climate
Government Stability of Attitudes Capital Compliance Conditions,
Currency Footprints
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3. Porter’s 5 Forces Model

Barriers to Entry
Porter’s 5 Forces Model distinguishes 5 external
Number and Size of
Suppliers Threat of Economies of Scale
forces that influence the firm’s strategy
Uniqueness of Supplier
New
Capitalization Req. • The threat of new entrants and
Product Entrants
Experience substitutes relate to competition
Switching Costs
Switching Costs resulting in a loss of market share.
Considerations include barriers to entry
and exit, price relations, etc.
Bargaining Bargaining
Power of
Industry
Power of • Bargaining powers influence mostly
Rivalry
Suppliers Buyers product and price factors. Supplier
relations can drive inputs up, while
Substitutes Available Customer Size
Customer relations influence output.
Buyer Propensity to Order Sizes • Rivalry is formed when the other 4
Switch
Threat of Customer Quantity forces are close enough as threats to
Cross Elasticity
Switching Costs
Substitutes Price Elasticity the firm considerations such as barriers
Degree of Differentiation
Switching Cost
to exit, brand loyalty, industry
concentration, growth, etc.
Strategy Design
1. Porter’s Generic Strategy Model
In order to meet organizational objectives, a strategy is developed to which management is concerned:
in the Business world, there are three generic options available according to Michael Porter:
• Cost Leadership – having the least cost of
business among the competition to arrive
at a margin
Overall Cost Overall • Differentiation – having and protecting a
Leadership Differentiation
unique product/service that is essential
for sustaining profits and company value
• Managerial Focus – imposing action upon
either of the two strategies above
mentioned as a response to the market
environment
Focused Cost Focused
Leadership Differentiation Effective strategy is one that can accommodate
changes and disruptions. A firm may change
strategy depending on what it deems best
answers its Vision and Mission.
Generally, the longer the span of time, the more
specific the time-frame of the strategy.
2. BCG Growth Matrix
BCG is a consulting firm that identified this tool for designing responses to a firm’s market positioning.
Cow Star Question Marks Dogs
Market Share High High Low Low
Market Growth Low High High Low
Response Harvest Value Invest Value Explore Value Divest Value
Remarks Harvesting Value Investing Value Exploring Value Divest Value means
means to maximize means to maximize means to maximize to invest elsewhere
market share both growth & share growth
Strategy Implementation
This spans Planning, Budgeting, and Forecasting which will be explained in detail later in the text.
Evaluation and Control
This spans Variance Analysis, Responsibility Accounting, and the Balanced Scorecard which will
also be explained later in the text.
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Functions of Management
setting goals of the firm, evaluating various ways to meet goals, picking out
Planning
the best choice
Controlling evaluation of whether actual performance conforms with goals
Decision Making determination of predictive information for making business decisions.
Organizing/Directing alignment of resources into pursuit of goal
Communicating Relaying information across all levels of the organization effectively
Objectives of Management Accounting
1. Information for all levels in management needed in:
Planning, Controlling, Safeguarding Organizational Communicating with Interested
Evaluating Operations Assets Parties
2. Participate in management process: strategic, tactical, operational
**The techniques in MAS are tools for functions of Management. As users of these tools, it is imperative
to be guided by intuition as to why information is arranged, rearranged & presented as they are.
Roles of Management Accountants
Management Accountants are key to any business organization. They are essential for strategy
formulation and internal control. They have these key tasks which overlap:
Problem Solving Scorekeeping Attention Directing
Suggesting Solutions to Accumulating Data for business Alerting Management to
Management intelligence and compliance problem areas
Management Regimes
Management by Objectives Management by Exception
A procedure in which a subordinate and a A technique of highlighting those which vary
supervisor agree on goals and methods of significantly from plans and standards in line with
achieving them, wherein both develop a plan in the management principle that executive time
accordance with that agreement. Afterwards, the should be spend on items that are non-routing and
subordinate is evaluated with reference to that are identified as top priority
agreed plan at the end of the period
Management Information Systems
Management Information Systems are tools used to support processes, operations, intelligence, and IT.
They are the core of the information management discipline.
Types of MIS
Operational Level Management Level (Tactical) Decision Support (Strategic) Level
Structured decisions based on Semi-structured decisions that Unstructured decisions that require
rules that are repetitive/routine involve some judgment expertise and wisdom
e.g., Knowledge Mgmt Systems e.g., Supply Chain Mgmt, e.g., Enterprise Performance
Customer Relations Mgmt, etc. Management
Reports made by MIS
• Scheduled – those produced on a regular basis It allows analysis over time based on various
parameters
• Ad-hoc – One-off reports that a user creates to answer a question. These are specific for the
need and are usually requested first before produced.
• Real-time – This report allows a user to monitor changes as they occur; a dynamic dashboard is
a good example for this type of report.
Enhancing the Management Information System
Closely tied to achieving organizational goals is the capability of producing this information. To that end,
a Management Information System should be able to exhibit the following features:
1. Provide a capability to Understand Customer Values and Focusing on how to achieve that value
2. Providing a Value-chain and Supply-chain analysis
3. Determining Key Success factors such as: Cost & Efficiency, Quality of Output, Time, Innovation
4. Continuous Improvement, benchmarking, and innovation to keep the market interested.
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Management Accounting vs. Financial Accounting

Management Accounting Financial Accounting
Internal use of data and information External use of data and information
Future-oriented Past-oriented or Historically-oriented
Emphasis on Relevance Emphasis on Objectivity
Emphasis on Precision Emphasis on Timeliness
Understands the Company as a whole Understands the Company in Parts
Non-GAAP GAAP
Optional Mandatory
**It is important to note that the accumulation of Management Information occurs simultaneously with
the accumulation of information for External Reporting (This includes GAAP/IFRS reporting as well as
Tax and other Compliance Reporting processes.) This would mean that once a transaction occurs in an
accounting information system, it can possibly have three versions of the same transaction; one for IFRS
reporting, another for Management Information, and another for Tax compliance.
Treasurership vs Controllership
These two functions may sound similar, but are actually quite different when understood. Management
Accounting is applied to both disciplines.
Controllership – The practice of established science of control which is the process by which management
assures itself that resources are procured and utilized according to plans in order to achieve objectives.
Treasurership – Concerned with the acquisition, financing and management of assets of a business
concern to maximize the wealth of the firms for its owners
Treasurership Controllership
Provision of Capital Planning and Control
Investor Relations Reporting and Interpretations
Short-term financing Evaluating and Consulting
Banking and Custody Tax administration
Credit Collection Government Reporting
Investments Protection of Assets
Insurance Economic Appraisal
Financial Management Managerial Accounting
**Throughout the study of MAS, Treasurership and controllership functions will most usually appear in
all management issues. Hence, it is necessary to distinguish the two to acquire an appreciation for how
the data provided by management accountants are used.
Responsibilities of Management Accountants
1. Reporting – Providing reports to management as well as shareholders, creditors, & the government
2. Interpretation – Interpreting and providing internal as well as external information pertinent to the
various segments of the organization
3. Resource Management – Establishing systems which facilitate planning & control of a firm’s resources
4. Information Systems Development – Designing & developing overall management information systems
5. Technological Implementation – Familiarization with modern equipment and techniques appropriate
to controlling & using information
6. Verification – Application of Internal Audit procedures to assure the accuracy and reliability of
information derived from the accounting system and related services
7. Administration – Development & maintenance of effective & efficient management accounting
Functions of Managers
• Line Function – The authority to command or give orders to subordinates. It exercises direct downward
authority over line departments. Line Managers are directly involved in provision of goods/ services
• Staff Function – The authority to advise but not to command others; the function of providing line and
staff managers with specialized service and technical advice for support. It is exercised laterally or
upward. Managers in staff positions supervise activities that support the organization’s overall mission,
but they are only indirectly involved in operational activities. These include the general counsel, the
executive VP for government relations and CFO among others. (Staff Function supports Line Function)
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Costs and Cost Behavior

Cost – The cash or cash equivalent value sacrificed for goods and services that are expected to bring a
current or future benefit to the organization
Cost Definition
Product/Inventoriable Cost Those attached to inventories, usually spanning more than one period
Period Costs Identified with accounting periods
Variable Cost Change directly in proportion to changes in volume
Fixed Cost No change given change in volume
Semi-Variable or Semi- Costs that contain both fixed and variable components
fixed / Mixed Cost
Raw Materials Purchased but not used at period end
Work in process Processed but not finished at end of period
Finished Goods Finished but not sold at end of period
Direct Cost Directly traceable to production
Indirect Costs Not easily traceable to production
Controllable Costs Subject to influence of manager
Noncontrollable Cost Manager has no control over such
Standard Cost Predetermined cost estimate that is a goal, in terms of cost per unit
Budgeted cost Expresses planned cost for a period
Costs that
Absorbed Cost/Full Cost
absorb/matches all manufacturing cost in production with sales
Direct cost/Variable Cost All fixed costs are directly charged against revenue as an expense
Information Cost Cost to obtain info
Ordering Cost Costs that increase with number of orders
Out-of-pocket costs Costs that must be met with current expenditure or cash outlay
Committed Cost Inevitable consequence of a previous commitment
Discretionary Cost Cost for which size or time of incurrence is a matter of choice
Historical Cost Costs incurred in the past
Future costs Budgeted cost, expected to be incurred
Relevant Costs Future costs that are different under one decision alternative
Difference in cost between two or more alternatives. The additional
Incremental Cost revenue to determine the feasibility of an alternative. A future cost,
and differs across alternatives
Sunk Costs Past costs incurred and irrelevant to a future decision
Opportunity Cost Value of the best alternative forgone as the result of selecting another
Costs associated with the next unit or next project or incremental costs
Marginal Costs associated with an additional project as opposed to the next discrete
unit
Costs that add value to the product. These costs result from activities
Value-added costs
needed to satisfy the requirements of the consumer
Cost Accounting
Cost Accounting – a system that uses only unit-based activity drivers to assign costs to cost objects. This
system assumes that all costs can be classified as fixed or variable with respect to changes in the volume
of units produced. Labor hours and Machine Hours are given importance
• Normal Costing System – The Direct Materials and Labor are actually incurred, but the overhead
is predetermined, and adjusted to actual cost at the end of the period.
• Standard Costing System – All manufacturing costs are applied at their predetermined standard
rates, and adjusted accordingly.
• Traditional Costing System – All manufacturing costs are at their actual costs. This is usually
difficult to achieve since overhead costs cannot be actually traced to any single activity.
Cost Accumulation – the process of collecting cost data as a product progresses through a production
system, enabling the total cost to be built up in a sequential fashion
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Cost Driver – the unit of an activity that causes changes in the activity’s cost.
Cost Assignment – the allocation of costs to the activities or objects that trigger the incurrence of costs.
The concept is heavily used in Activity-based costing, where overhead costs are traced back to the actions
causing the overhead to be incurred. Cost Assignment is based on one or more cost drivers.
Cost Control – the practice of identifying and reducing business expenses to increase profits, and it starts
with the budgeting process.
• Budgeting – the process of creating a plan for the use and outcomes of a certain activity. It
begins by establishing assumptions for the upcoming period. These include accumulating data for
demand forecasts, and supply & capacity studies to effectively control projects or activities.
• Standard Budget – it is the plan adjusted for the single best estimate of the future performance
of an activity for the period. It is pegged at a single level called the Static Budget.
• Flexible Budget – it is the application of standard rates such as prices on units at any given level
of activity. It is the best the activity could achieve if it were to be adjusted to the actual level.
Cost Object – Any item for which costs are measured and assigned, including such things as products,
plants, projects, departments, and activities
The Income Statements
For Management Accounting, there are two forms of the same statement: the Contribution Margin
Format, and the Gross Margin Format; each have their own use. For most of MAS, the Contribution Margin
Format will be used.
Gross Margin Format Contribution Margin Format
Net Sales XX Net Sales XX
Cost of Sales** (XX) Variable Product Costs (XX)
Gross Margin XX Gross Profit or Product Margin XX
Operating Expenses (XX) Variable Period Costs (XX)
Operating Income before Tax XX Contribution Margin XX
Total Fixed Costs (XX)
Operating Income before Tax XX
Cost Behavior Concerns
Cost Behavior- How costs react to changes in the level of business activity
Relevant Range – The range of activity in which assumptions about cost behavior are valid
High Low Method – Utilizes two points, the highest and lowest points within the relevant range where:
𝐻𝑖𝑔ℎ𝑒𝑠𝑡 𝐶𝑜𝑠𝑡 − 𝐿𝑜𝑤𝑒𝑠𝑡 𝐶𝑜𝑠𝑡
𝑎=
𝐻𝑖𝑔ℎ𝑒𝑠𝑡 𝑉𝑜𝑙𝑢𝑚𝑒 − 𝐿𝑜𝑤𝑒𝑠𝑡 𝑉𝑜𝑙𝑢𝑚𝑒
Scatter-graph method – derive elements by visual inspection
Least Sum of Squares regression: most accurate ∑Y = na + b∑(x); ∑(XY) = ∑(x)A + b∑(x 2)
• Regression analysis provides a function that determines the cost relationship between a level of
activity, and a trend regarding cost.
• Various cost drivers might be the reason for an increase in cost; typically, a regression analysis
is performed on multiple cost drivers such as labor hours, machine hours, batch production, total
overall production, competitor’s behavior, customer demand, and many more.
• In Cost behavior analysis, determining a variable component comes down to the analysis of the
coefficient of determination (r-squared); the largest r-squared cost relationship is taken as the
variable cost per unit.
• Sometimes, just the correlation coefficient is given; simply square this figure because it is
represented by the letter r.
• After performing regression analysis and deciding on a relatively strong cost driver, the cost is
then assigned to the outputs of production
Stepped-Cost Analysis – At a certain level of activity, the fixed costs will increase by a factor. The factor
is applied to the y-intercept of the Cost Function, after which, the new cost function is acquired.
• The Incremental Fixed Cost factor = (New FxC – Old FxC)/Old FxC
• A New cost function is acquired; perform algebraic elimination with the old cost function
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Variable and Absorption Costing

The concept of cost control, and how well it is executed is a question of which costs can be traced at all
to the controller. The most obvious measure of how costs are controlled are through the income
statements. In the traditional income statement or the absorption income statement, fixed costs are
capitalized, while in the direct costing income statement, they are fully expensed.
• Fixed costs are difficult to control, and those that are controlled should be the only measure of
performance; i.e., Direct Labor** and Direct Materials (Prime Cost)
• Absorbing fixed costs in the balance sheet will misstate performance in the income statement.
• Although this is not to be conflated with misstating the balance of inventory
• More fixed costs absorbed will actually reduce sales volume. This is because more costs absorbed
simply means more ending inventory; thus, less sales activity.
• This will lead managers to inflate ending inventory, and avoid selling further if they have not
made enough sales during the period
In order to remedy the temptation to misstate profits, expensing all fixed costs immediately will
incentivize managers to empty their inventories every period and to fully cover the actual period costs.
Variable Costing – Based on Contribution Margin Income Statement; based on Cost Behavior
• It clearly misstates the balance of inventory, and it treats fixed overheads as a period cost,
exactly because all production performance should relate to that period only.
• However, other financial measures such as current ratio, working capital, etc. are understated
since inventory is understated
Absorption Costing – Based on Gross Margin Income Statement; based on Cost Function
Other Costing Regimes
Throughput Costing or Super Variable Costing – Conversion Costs are expensed outright
• It is believed under throughput costing that not even direct labor can be used to measure performance.
This is because labor rates are actually arbitrary in this point of view. Highly technical skills cannot be
truly measured in terms of labor rates.
Super Absorption Costing – All costs that add value to the product throughout its life-cycle
• Super Absorption Costing considers all costs incurred for a product line. It ignores time period
assumptions; therefore, it includes R&D, Marketing, etc. over the life-cycle of the product.
Budgeted Fixed Manufacturing Cost Rate Basis
Capacity Supplied, Theoretical Practical Capacity Output Demanded, Normal Capacity, Master budget
Factors in choosing capacity level
o Effect on product costing and capacity management o Effect on Financial Statements
o Effect on pricing decisions o Regulatory Requirements
o Effect on performance evaluation o Difficulties in forecasting
***Raising Selling price should not be a remedy for businesses with high fixed costs and unused
capacity, this reduces overall demand; instead, increasing production would be more feasible for
absorbing Fixed Cost.
***Standard Costing uses Absorption Costing, in that case, Inventories are applied at standard, and the
variance is disposed at the end of the period.
Reconciliation of Net Income
Sales XX IF THEN INCOME IN…
Cost of Sales (XX) COGM > COGS (BI > EI.) Abs. > Var. > Thr.
Gross Profit XX COGM < COGS (BI < EI.) Abs. < Var. > Thr.
Selling and Admin Expenses (XX) COGM = COGS (BI = EI.) Abs. = Var. > Thr.
Net Income, Absorption XX **Throughput Costing presumes that all
Fixed Overhead in BI XX manufactured goods are sold. If the presumption is
Fixed Overhead in EI (XX) ignored, in Case (3), Var. Costing income should be
Net Income, Variable XX equal to Thr. Costing Income
Conversion Costs BI, net of Fixed OH XX Fixed Overhead Applied to BI or EI =
Conversion Costs, EI net of Fixed OH (XX) (Total Overhead/Units Manufactured) *Units Sold
Net Income, Throughput Costing XX
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Cost-Volume-Profit Analysis
Helps managers to understand interrelationship between cost, volume, profit by analyzing 5 components
a. Prices of products 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = 𝑈𝑛𝑖𝑡 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 – 𝑈𝑛𝑖𝑡 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡
b. Volume or activity level 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝐶𝑀 𝑟𝑎𝑡𝑖𝑜 = =
c. Per unit variable cost 𝑆𝑎𝑙𝑒𝑠 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠
d. Total fixed cost The Contribution Margin Income Statement is used for this analysis
e. Sales mix because it highlights cost behavior over cost nature.
Assumptions of CVP
• Analysis applies to relevant range only
• All costs are only either fixed or variable; such can be segregated
o Variable costs change directly with volume
o Fixed costs are constant within a relevant range (Stepped-costs are assessed on a per-level basis)
• Revenues always change proportionately to cost if selling price is also constant in a relevant range
• Product Mix is constant
• Changes in volume ALONE are responsible for changes in cost and revenues
• There is no significant change in inventories
• Operation Leverage can be dealt with CVP framework
• Analysis is deterministic and data can always be found
• **There is no mention whether CVP recognizes curvilinear or non-linear relationships.
• Technology and Productive Efficiency are constant; the learning curve is ignored
• Time Value is ignored
**For each revenue-producing activity, the breakeven quantity may differ. This means that CVP
Analysis must be applied independently across each investment considered. As such, Factory 1 may
have a different capacity vs Factory 2, hence, each investment unit should ideally be disaggregated.
General Formulas in CVP Analysis
Sales XX 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
Cost of Sales (XX) 𝐵𝐸𝑃 𝑈𝑛𝑖𝑡𝑠 =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
CM – manufacturing XX 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐵𝐸𝑃 𝑝𝑒𝑠𝑜𝑠 =
Variable Expenses (XX) 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠
1−
CM – final XX 𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡
Traceable fixed costs (XX) 𝑇𝑎𝑟𝑔𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑈𝑛𝑖𝑡𝑠 =
Segment Margin XX 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
Allocated Fixed Costs (XX) 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡
𝑇𝑎𝑟𝑔𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑃𝑒𝑠𝑜𝑠 =
Income before taxes XX 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑅𝑎𝑡𝑖𝑜
The Margin of Safety and the Shutdown Point
The Margin of Safety is the difference between the Sales and Breakeven Sales; it is the allowable degree
of reducing sales before reaching breakeven. The Shutdown point on the other hand, is when only the
variable cost is covered by the sales, it can no longer cover the Fixed Costs and the Costs to Shut down.
𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦 = 𝑆𝑎𝑙𝑒𝑠 − 𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑃𝑒𝑠𝑜𝑠
𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦 𝑖𝑛 𝑝𝑒𝑠𝑜𝑠 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = =
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 𝑜𝑟 𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 − 𝐶𝑜𝑠𝑡 𝑡𝑜 𝑆ℎ𝑢𝑡𝑑𝑜𝑤𝑛
𝑆ℎ𝑢𝑡𝑑𝑜𝑤𝑛 𝑃𝑜𝑖𝑛𝑡 =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
CVP Analysis for Multiple Products
There is no limitation for CVP Analysis to only cover single products. Apparently, multiple products may
be considered. This is true because overall, CVP Analysis is an investigation of cost behavior with respect
to revenues, and not necessarily cost relationships between goods.
Product Contribution Margin Sales Mix Package CM BEP Units A = BEPackages × SMa
A XX 2 2XX BEP Units B = BEPackages × SMb
B XX 3 3XX CM/U priority to larger -> BEP Decrease
Total XX 5 YY CM/U priority to smaller -> BEP Increase
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𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡

𝑃𝑎𝑐𝑘𝑎𝑔𝑒 𝐵𝐸𝑃 =
𝑃𝑎𝑐𝑘𝑎𝑔𝑒 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐵𝐸𝑃 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑒 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑠 =
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝐴 ∗ 𝑄𝑡𝑦𝐴 + 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝐵 ∗ 𝑄𝑡𝑦 𝐵 + ⋯
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐶𝑀/𝑢𝑛𝑖𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑈𝑛𝑖𝑡𝑠 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐵𝐸𝑃 𝑆𝑎𝑙𝑒𝑠 𝑓𝑜𝑟 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑠 =
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐶𝑀 𝑅𝑎𝑡𝑖𝑜
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐶𝑀 𝑖𝑛 𝑃𝑒𝑠𝑜𝑠
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐶𝑀 𝑟𝑎𝑡𝑖𝑜 =
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝑃𝑒𝑠𝑜𝑠
**If the sales mix is based on total sales, use the CM ratio; if the sales mix is based on volume, use CM/u
**It is worthy to note that the BEP itself is a level of activity; a problem will always imply at least 2
levels of activity
Operating Leverage
Operating Leverage – It is the ratio of the contribution margin to profit. Higher operating Leverage
means that profits are more sensitive to a change in sales. Strong sales should be favorable for high
operating leverage, weak sales are favorable for lower operating leverage. This indicates the risk-reward
situations for firms.
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = =
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠
Operating Leverage also implies that the level of Fixed Cost either makes or breaks a firm’s profitability.
This is because Fixed Costs may be difficult to control, this in the sense that they are usually allocated
costs by upper management and are not typically directly influenced by the immediate line management.
It is in essence, an indicator of the cost structure of the production firm. The associated risk with fixed
costs stems from the bare minimum a firm has to achieve in terms of activity to cover fixed costs; i.e.,
the breakeven point. A High break-even point will usually mean a high operating leverage.
The Indifference Point
This is the quantity or sales level that indicates where 2 alternatives produce the same effect in the
income statement. Indifference analysis is done in order to assess alternatives based on qualitative
aspects of the change condition. This is in regard to the fact that two alternatives produce the same
results quantitatively, hence the focal point of analysis should be the qualitative consideration such as
strategic goals, customer goodwill, and supplier relations.
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
𝐼𝑛𝑑𝑖𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑃𝑜𝑖𝑛𝑡 =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
Other Considerations in CVP Analysis
• Income taxes do not affect BEP Analysis. Income taxes are only considered if any aspect of the
given problem provides after-tax figures. Exclude tax effects before performing the analysis.
• Only Absorption Costing applies in CVP Analysis (See Variable and Absorption Costing).
• Aggregation and Disaggregation principles are applicable; hence Profit and Investment Centers
have their own levels of CVP Analysis. The preferred level of analysis is on the lowest cost
center level, after which, Fixed Costs are rolled-up until the highest level of aggregation is
achieved. That is, as if the assigned fixed cost were not allocated at all (i.e., firm-wide level).
o Disaggregation – Take for example, two different machines. The breakeven point for
each machine would be based on their individual depreciation, the sum of the individual
BEPs would be their overall BEP as a production Unit. This is because taking the total
productivity of both machines disregards the difference in features each may offer. This
is usually the case when Cost Centers are used for Planning and Forecasting.
o Aggregation – If instead some machines operated in sequence, i.e., Machine A operates
first and passes on units to Machine B then to C, the BEP of the entire production line
would be based on the either slowest machine’s capacity or the Machine with the least
capacity. This is because only the final goods contribute to revenue, not the WIPs.
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Forecasting Tools (Quantitative Techniques)

• The use of Quantitative models in hopes of capturing relevant data in order to inform decisions
for planning, controlling, and execution of business policies
• Impose mathematical rigor into real-life decisions to arrive at deterministic solutions
• Are usually oversimplifications, thus assumptions are made
• Some relevant variables are not realistically quantifiable or are virtually inaccessible, hence
excluded from consideration
Linear Regression and Correlation Analysis
• Used to determine a relationship among two or more variables.
• Regression analysis supposes a relationship (linear, curvilinear, etc.) among two or more
variables; composed of independent variables and dependent variables (The board exam only
includes linear relationships)
• Correlation analysis tests the closeness of the same two variables
Least Sum of Squares Regression
• Construct a scatter-graph with random points in
the first quadrant
• Impose a straight-line across the random points
(fitted values), trying to minimize the distance
(residual) from the line to the points (observations)
∑𝑦 − 𝑏∑𝑥 ∑
𝑛 𝑥𝑦 − (∑ 𝑥 𝑦)∑ • Compute the distance from the points to the line
𝑎= 𝑏= 2 2 • Using the Pythagorean Theorem and the General
𝑛 𝑛 ∑ 𝑥 − (∑ 𝑦)
Distance Formula, work out a square from the
diagonal formed from the scattered point to the
√∑ 𝑷((𝑹 − 𝑬𝑹)𝟐 ) = 𝑺𝒕𝒅 𝑫𝒆𝒗 (𝜹)
line
𝜹 ∗ √𝟑𝟔𝟓 = 𝑽𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚 • Compute for the area of each square formed
Volatility is the Sd that is projected. For example,
• The line that generates the least-sum of the area
assuming a daily Sd, projecting it over a month, the of squares is the best-fitting linear relationship
formula would be: between x and y
𝜹 ∗ √𝟑𝟎 = 𝑽𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚 • x is the independent variable, y is the dependent
Over a year: variable, n is the number of observations
𝜹 ∗ √𝟑𝟔𝟓 = 𝑽𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚 • a indicates the slope, b indicates the intercept
Correlation Analysis
𝑟(∑𝑥𝑦) − (∑𝑥)(∑𝑦) • r =1 DIRECT RELATIONSHIP
𝑟=
2 2 2
√[𝑛∑𝑥 − (∑ 𝑥) ][𝑛∑𝑦 − (∑ 𝑦) ] 2 • r = -1 INVERSE RELATIONSHIP
• r = 0 NO RELATIONSHIP

p value A measure of probability that an observed difference Lower p-value indicates that an
could have just occurred on a random chance event is less likely to be by chance.
A p-value below 0.1 is considered
statistically significant.
R2 A statistical measure used to determine the R2 values range from 0 to 1. Closer
goodness of fit, by indicating the degree of to 1, means a better fitting
variation is explained by an independent variable. regression model.
Confidence The mean of an estimate plus or minus the standard A shorter interval indicates a more
Intervals error (Sd/Sqrt of Sample) rigorous/strict statistical test.
t-value/ t & z values are based on standardized tests based t/z- values should be ideally large
z-value on sample data for a hypothesis test. They indicate (above 3). As if the sample were an
the difference between the sample and the null alternate hypothesis being tested
hypothesis (based on a random sample of for differences from the
observations following t or z distributions). distribution.
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Probability Analysis and Decision Tree Diagrams

Commonly used in planning and decision-making
• Conditions of certainty – an event is certain to occur
• Conditions of risk – the probability distribution of a future state is known i.e., events have the
appropriate probabilities of occurring
• Conditions of Uncertainty – the probability of a future state is unknown, and a decision is
subjectively determined
Expected Value – The probability of each event multiplied by its payoff, taking the sum of each instance
Cost of Information – The amount of money a firm should be willing to pay to acquire a piece of certain
information to maximize a profit position.
Cost of Information = Expected Value under Certainty – Max Expected Value under Uncertainty
• Simply put, the Expected Value under Certainty is the amount of profit a firm could realize
if the events in a decision scenario would be certain. Therefore, this is the EV of the highest
profit situation in each course of action or situation.
o This means that if an event (or State of Nature) is known by the decision-maker, then the
decision-maker should take the action that maximizes benefits under those circumstances.
o Hence, the best option in EACH state of nature (event/probability) is added to acquire EV
under certainty. This runs on the premise that even if it has a low change of happening,
it occurred.
• The Cost of Information should literally be the amount of additional benefits acquired by
taking the best decision and foregoing the best estimates under uncertainty (Max EV)
o This is situation that the firm is most likely to encounter, that saves or earns the most
profit.
Decision Tree Diagrams – explore the same understandings as with Expected Value. These provide insight
as to which decision should be taken under event scenarios.
EV under Uncertainty/Risk EV under Certainty

Alternative S1 S2 S3 EV S1 S2 S3 EV
Option 1 5 6 7 5.7 5 6 7 1.4
Option 2 6 -2 3 3 6 -2 3 3
Option 3 -4 8 4 1.2 -4 8 4 2.4
Probability 50% 30% 20% 9.9 50% 30% 20% 6.8
Under risk, a rational person would consider option 1 to be most relevant. Under Certainty, they would
consider option 3 to be most relevant. In this case, the cost to acquire perfect information would be:
Sn is the state of nature;
EV of Perfect Information or Cost of Information = |EV with PI – EV without PI| = 3.1
𝑛
𝑃 = 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑽𝒂𝒍𝒖𝒆 = ∑(𝑃𝑖 × 𝐸𝑖 )𝑛 𝐸 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐶𝑜𝑠𝑡
𝑖=1 𝑛 = 𝐸𝑎𝑐ℎ 𝐼𝑛𝑠𝑡𝑎𝑛𝑐𝑒𝑠 𝑜𝑓 𝐸𝑣𝑒𝑛𝑡𝑠

Learning Curve Analysis

A mathematical expression of the phenomenon that incremental unit costs to produce decrease as
managers and labor gain experience from practice
• In other words, continuous gains in experience from doing a task will make any person work more
efficiently for the next time the task is done (i.e., the cost is minimized each doubling time.)
Incremental Unit-time Model will look at the Changes between the doubling times of amounts
• Answers questions about how much MORE costs are needed between two doubling times
• The buzz words for this type of analysis would be “increments”, “the next unit”, “additional
cost”, “marginal”, etc.
• Only the increments can be derived. The cumulative time taken cannot be inferred with basic
operations. (Non-base 2 numbers such as 3,5,6,7,9 etc. require logarithmic functions.)
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Cumulative Average-time Learning Model will look at the overall amounts after the nth doubling time
• These will usually ask questions about how much cost is incurred after the nth doubling time
Cumulative Incremental Doubling Cumulative Total Average Cumulative
Units Time Time Time/UNIT
1 100 3. Cumulative
100 100
2 60 Time 160 2. Avg/u * nth 80 1. Apply Learning Curve
4 96 256 unit 64 here.
less Last
8 36.9 Incremental 295.2 51.2
• Buzz words for this typeTime
of analysis would be: “total”, “overall”, “cumulative”, “average”, etc.
• All basic information can be inferred with this type of analysis.
Appendix: Computing Logarithms with Basic Calculators
𝑛 n = can be any amount, the larger, the more precise the computation;
√𝐵𝑎𝑠𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 − 1
𝑛 = 𝑙𝑜𝑔 𝑋 for simplicity, apply both the base and X at nth root by pressing the
√𝑋 − 1 sqrt button 15 times while the base or x is engaged in the calculator.
Blog X = Ave. Cumulative time; B = initial time (to convert log x to ln x, substitute B with e (2.718…)
Exponential Smoothing
A forecasting tool that uses a weighted moving average of past data as the basis of the new forecast.
The more recent a piece of information is, the more valuable it is for forecasting.
𝑁𝑒𝑤 𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝐷𝑎𝑡𝑎 ∗ 𝛼 + (𝑂𝑙𝑑 𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡 ∗ (1 − 𝛼))
Linear Programming
A mathematical tool that is used to deterministically formulate a solution given some constraints without
heeding to any order of priority. Constraints such as profit maximization and cost minimization are of
particular interest
May use the Simplex Method (Linear Algebra and Matrix Manipulation) or Graphical Method
1. Determine the Objective Function (Minimum Cost? Maximum Profit? Given available
resources/activity) Source A + Source B + Source C = Max CM; or Min Cost
2. Identify the constraints (Minimum inputs required for each resource/product allocated,
restricted for capacity) A requires (=) X1 resource and (+) Y1 resource; B requires X2 resource
and Y2 resource
3. Fit the constraints into the objective function by performing Elimination or Substitution
Max Profit = Profit A + Profit B
Constraint X = Inputs A + Inputs B in terms of X Eliminate/Substitute
Constraint Y = Inputs A + Inputs B in terms of Y
Forecasting Models Summary
Pros Cons
• Flexible and applicable to all patterns that • Inputs must be correct
Regression
occur in data • As more variables are introduced, the less
Analysis
• Easy to understand reliable the model is
• More Possibilities or States of Nature • Underlying probabilities are not entirely
Expected creates a more representative model objective as its selection is subjective
Value Analysis • EV computations reduce outcomes down to • The EV is not the most likely outcome. It is
a single value that is easy to understand a weighted average probability.
• Accounts for efficiency changes when • Learning is assumed to be constant.
Learning regression does not Disruptors may change this rate
Curve Analysis • Stretch targets are highlighted due to • Focused on human behavior and may not
accounting for declining costs be appropriate for machine-intensive units
• It is logical and can accommodate multiple • It becomes too mathematically complex
Linear
dimensions of constraints and intensive as the number of constraints
Programming
• It determines the optimum mix of resources increase
• It is easy to learn and apply • It lags behind actual trends as it ignores
Exponential
• It grants significance to more recent variation
Smoothing
observations • Trends are dampened using this tool
**N.B. Further review of statistical terms under Title IV: Financial Management of this text.
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Profit Planning and Budgeting

Budgets – a detailed plan outlining the acquisition, allocation, and use of financial and other resources
over some time period. It represents a plan for the future expressed in formal quantitative terms
Benefits of Budgeting
• Budgets provide a means of communicating management’s plans throughout the organization
• Budgets force managers to think about and plan for the future
• The process of such provides a way to allocate resources where they can be most efficiently used
• The budgeting process can uncover potential bottlenecks before they occur
• Budgets coordinate the activities of the entire organization by integrating the plans of its various
parts. It helps to ensure that everyone is pulling in the same direction
• Budgets define goals and objectives that can serve as benchmarks for evaluation
Disadvantages of Budgeting
a. Budgets are based mostly on approximations
b. It is time consuming
c. Success largely still depends on control, coordination, and execution
d. Budgeting is only a guide and not a substitute for management
Master Budget – a summary of all of management’s plans and goals for the future and outlines the way
in which these are to be accomplished.
Budgeting Process
Establish a Establish Submit Budget Negotiate Review and Approve
Budget Budgeting Proposals Proposals and the Budget
Committee Guidelines Consolidate
• Composed of • Sets Objectives • All Directors • Shared resources • Budgets are
the CFO, • Goals Identification shall submit are aligned to approved and
Controller, Key • Incentives Tie-back proposals achieve Goal reported to
Directors, and to the strategy and after Congruence Higher
Experts/ the budget identifying • Avoiding Executives
Consultants sub-unit goals Suboptimization such as BoD
• Bottom-up
Approach

Revision Revision

What Makes a Good Budget?

All budgets have one or more limitations that make it challenging to establish. Things to note as follows:
• Complexity and Size of the Organization will make it more crucial to have a clearer and
comprehensive budget
• Divisions create their own expectations of resource allocation and use based on the budget. In
an ideal world, all departments operate uniformly toward a goal, however, that is not realistic.
Departments may further their own interests over other departments and even the entire
organization as a whole if expectations are not established initially
• Budget Information must be carefully captured and communicated. It is crucial to establish
accuracy as the main driver of budgeting rather than conservatism
Considering the above limitations, a good budget espouses the following traits:
• Avoids Budgetary Slack and Promotes Goal Congruence
• The Budget’s ‘subtext’ or ‘message’ remains consistent regardless of the timeframe. This means
that Operational and Project/Capital Budgets always have for their purpose, the fulfillment of
the Strategic Budgets and Objectives. That is, it is always tied to strategy
• It achieves a balance between firmness and flexibility to accommodate changes or disruption
• Informed or Data-driven by accurate forecasts
• Inclusive, and all levels in the organization are committed to a master budget
• It is an effective Motivating Tool
• There is continuous Learning and Feedback
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Budgeting Concepts
Type Definition
Budget Income Statement Projection of revenues and expenses
Cash Budget Period-by-period statement of cash
Financial Budget Budget of financial resources
Fixed Budget Projection of cost at a single level of production
Flexible Budget Projection of cost at multiple levels of production
Participative Budget Prepared using employees at all levels of organization
Physical budget Expressed in physical units, not money
Planning budget Master budget, static
Production budget Resources needed to meet current demand & ensure adequate inventory
Program Budget For major programs or projects
Operating budget Plans for the conduct of business for the period
Responsibility Budget Budget for responsibility center
Rolling budget Prepared throughout the year, as one elapses, another is prepared
Traditional budgeting Concentrates on incremental change from previous year assuming the
previous year’s activities are essential and must be continued
Zero-based budgeting A system of establishing financial plans beginning with an assumption of
no activity and justifying each program level
Incremental Budgeting Setting Budgetary allowances using prior year expenditures
Life-cycle Budgeting A tool or process in which estimates of revenues and expenses are
prepared with a product’s lifecycle and development phase, traced
through customer support phase
Kaizen Budgeting A tool or process where the budget is based on minimal, but continuous
changes or improvements to be made, instead of it being based on the
existing system
Top-down Budget Top Management sets the budget for everyone else to comply, quicker to
implement
Bottom-up Budget Managers are motivated to meet estimates. Encourages participation
Lateral / Parallel / A combination of Top-down and Bottom-up budgets, a superior sets targets
Negotiated Budget for subordinates to follow; the subordinates then negotiate shared
resources and determine the iterations for approval
Flexible vs Static Budgets
a. Flexible budgets allow comparisons between the budget and actual performance
b. If budgets are pegged at a single level of production, i.e., the budgeted production then the
results would be less reliable since the production levels are not the same, and thus incomparable
c. Flexible Budgets are what-if scenarios if the same level of production was able to produce in its
most efficient conditions. (Standards)
d. Budget vs Standard
• Budgets are the planned units of production, these are allowed for standard hours or for
actual hours (Only accounts for levels, not rates)
• Standards are the best-case scenarios for production (Accounts for both levels and rates)
General Budgeting Concepts
1. The Budget Cycle
a. The Top Level sets the goals and objectives of the firm
b. A basis for performance evaluation is set
c. Execution of Budget and Plan
d. Investigating Deviations and Variances from Plans (Management by Exception)
e. Planning in light of Feedback is made for subsequent period
2. Budget Administration
a. The advantages of Budgeting are attained in all levels of the organization only if all levels
support the budget and the existing internal controls
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b. Top management should spearhead the preparation to inspire line-management and all
other levels of the organization
c. The budget may be revised as it is being implemented, provided:
i. The revision is with notice
ii. The consent by the budget committee is secured
3. A long-term budget is considered a Strategic Budget, while a short-term budget is a.k.a. Tactical
Budget.
4. The Master Budget is regarded as the Ideal Financial Statement and is STATIC.
5. Operational Budget – contains all operations of the firm; note that Interest Expense is part of
the operating budget.
a. Operational Budgets begin with the Revenue Budget (Cash, A/R, Sales Allowances),
expressed in terms of sales quantities
i. Strictly, the Sales Forecast or the Demand Study is the starting point for
budgeting because it forms the primary basis for revenues. On the other hand,
the projected volume of assets and their capacities, in turn, influences virtually
every aspect of the firm’s activities, both operating and financial. (This is called
the Supply Study)
b. Production Budgets follow, expressed in production units (DM, Cash, A/P, Purchase
Allowances, DL, Manufacturing Overhead, Final Goods Budget i.e., COGS, COGM, M/I)
i. Labor and Overhead Rates are usually determined
ii. Either Activity-Based Costing or Standard Costing figures are prepared for
budget; NORMAL COSTING IS ONLY APPLIED IF EXPRESSED IN THE PROBLEM
c. Non-Production Budgets
i. Selling and Administrative Expenses
ii. General Overheads
iii. Also budgeted in the same manner as production budgets
d. Budgeted Income Statement – An aggregation of all the aforesaid budget data
6. Financial Budget – contains all modes of cash financing including
Cash Budget Capital Budgets
Generally, for budgeting, all concepts in Cash flows and Account Balances apply here; save for some
exceptions such as the policies affecting the accounts, which shall require an analysis of opportunity
cost of holding the account in place of cash, as well as the projected net benefit in the Income
statement for the following period.
7. Goal Congruence – employees all work toward a common goal with the organization
8. Budgetary Slack – Making the budget look good by understating sales and overstating expenses.
Slack is the result of assigning costs to managers that have no control over it. Resulting in
muddled performance indicators that impair decisions.
Budgeting Best Practices
• All budgets are linked to strategy; therefore, the strategy objectives are always indicated in a
Budget Proposal
• Resource Allocation is Negotiated between, and all departments involved
• Budgets are realistic and can stretch goals enough to achieve a balance of motivation and realism
• The budgeting process must be simple to follow, with reduced red-tape between the
departments and the budget committee
• The budgeting process must also minimize budget cycle time to increase reliability
• The budget is a bottom-up budget or a lateral budget
• Performance Evaluation is limited to Controllable Cost
• Performance is consistently reviewed
• Budget Information is motivated by Data-driven Forecasts using reliable forecasting tools
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A Master Budget Sample

Period 1 Period 2 TIP: Start from the Bottom-line then work back into
Budgeted Sales Revenue (Units) the components; assumptions are always given
Budgeted Production 1,000.00 1,100.00 If a budget is not approved for the period, the prior
Multiplied by: Budgeted Sales Price 45.00 50.00 period’s budget is used; hence, in the absence of
Budgeted Sales Revenue 45,000.00 55,000.00 information, each quarter’s budget assumptions
Budgeted Purchases (Units) will be applied to the succeeding year’s quarterly
Budgeted Production 1,000.00 1,100.00 budget.
Required Ending Raw Materials 200.00 150.00 On Planning and Control – Budgets encompass both
Total Required Units 1,200.00 1,250.00 Planning and Control Functions of management.
Estimated Beginning Inventory - (200.00) Although similar, planning and control are different,
Raw Materials to be Purchased 1,200.00 1,050.00 although similar in a few aspects. Planning involves
Multiply by: Cost of Raw Materials 10.00 11.00 the development of future objectives and the
formulation of steps to achieve those objectives,
Cost of Raw Materials to be Purchased 12,000.00 11,550.00
while control involves the means of assuring and
Budgeted Conversion Costs (Units) attaining those objectives set down by planning. In
Budgeted Production 1,000.00 1,100.00 this regard, budgeting exhibits the planning function
Labor Hours Required per Unit 0.50 0.45 when it is being established, considering all
Total Labor Hours Required 500.00 495.00 available data; while control is exhibited during the
Cost of Direct Labor Required 7,500.00 7,920.00 operations, seeing to it that costs are controlled and
Variable Overhead Rate 5.00 4.00 limited to be within the range of the budget’s
Cost of Variable Overhead 2,500.00 1,980.00 projections. Variance Analysis is a consequence of
budgeting and setting standards and is thus a
Budgeted Fixed Overhead 10,000.00 10,000.00
feedback mechanism; it is used more extensively
Budgeted Cost of Goods Sold (Pesos) with Flexible Budgets.
Raw Materials 12,000.00 11,550.00 Top Management’s Participation – Top
Direct Labor 7,500.00 7,920.00 management provides guidelines and statistical
Variable Overhead 2,500.00 1,980.00 input; and are tasked to review the budgets to
Fixed Overhead 10,000.00 10,000.00 minimize the possibility of budgetary slack and
Total 32,000.00 31,450.00 ensure that the budget is compatible with the
Budgeted Profit 13,000.00 23,550.00 strategic objectives of the firm; it uses the budget
Budgeted Period Costs (Pesos) to provide incentives such as bonuses to top
Budgeted Production 1,000.00 1,100.00 management, more independence for lower
Variable Period Cost Rate 2.00 4.00 departments through decentralization, etc.
The Static Nature of the Master Budget – The
Variable Period Costs 2,000.00 4,400.00
master budget must be static because it enforces
Fixed Period Costs 5,000.00 5,000.00
managerial focus and direction; it is not used to
Budgeted Period Costs 7,000.00 9,400.00
measure past performance, rather, it is used to
Budgeted Net Income 6,000.00 14,150.00 amalgamate the smaller budgets into one, and thus
Budgeted Income Tax (30%) (1,800.00) (4,245.00) it sets the direction of operations as a tool to impose
Budgeted Final Income 4,200.00 9,905.00 strategy.

A Cash Budget Sample

Period 1 Period 2 Period 3 Period 4 • Collections and Payments from
Budgeted Credit Sales 35,000 30,000 40,000 30,000 Production are not always completely
Collections during the period 24,500 21,000 28,000 21,000 collected in only one period.
Collections 1 month after sale - 8,750 5,250 7,000•
Collections 2 months after sale - - 1,400 840• For Financing Concerns, Borrowings,
Credit Collections 24,500 29,750 34,650 28,840 Repayments, Reinvestments, and
Budgeted Cash Sales 10,000 25,000 20,000 15,000 Interest Income usually do not follow any
Total Collections 34,500 54,750 54,650 43,840 discrete pattern since borrowings
Payments during the Period 4,200 4,042.50 3,955.00 3,832.50 naturally depend on the remaining
Paid 1 month after purchase - 6,600 6,352.50 6,215 balance from operations, and
repayments thereto should follow suit.
Paid 2 months after purchase - - 1,200 1,155
Reinvestments should ideally be based on
Total Payments for Raw Materials 4,200 10,642.50 11,507.50 11,202.50
the Ideal Cash Balance.
Budgeted Conversion Costs 20,000 19,900 21,500 20,500
•
Budgeted Period Costs 7,000 9,400 8,120 7,500
• If the given information indicates Net
Budgeted Income Tax 1,800 4,245 5,724 1,815 Income under normal accounting, add
Total Disbursements 33,000 44,187.50 46,851.50 41,017.50 back Depreciation Expense and Bad Debts
Budgeted Cash Balance from Expense to the Net Income to arrive at
Operations 1,500 10,562.50 7,798.50 2,822.50 the Disbursements.
Borrowings 5,000 - - 5,000
Repayments - (2,500) (2,500) (3,500)
Interest Income - 1,200 1,200 1,200
Ending Cash 6,500 9,262.50 6,498.50 5,522.50
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Standard Costing
Standard Cost – a carefully determined cost based on efficient operations. It excludes past inefficiencies
and considers changes expected to occur during a budget period
Management by Exception – Managers focus attention on operating results that deviate from
expectations. Investigation of significant variances and deviations only, whether favorable or
unfavorable. Insignificant variances are not given much attention.
Standard Setting
The Cost per unit is composed of two inputs, namely the price input and the physical input (such as
labor or machine hours, liters, pounds, etc.) A given quantity of inputs is required to produce one output.
Some things to note for cost assignment using standard costing:
• The price input is straightforward; some factors that may affect it would be whether a cash
discount is taken on the purchase of a few goods, tax treatments, commissions paid, etc. for
materials; shift differentials, hazard pay, overtime, etc for labor; depending on company policy.
It is a simple matter of assigning costs to each unit of input
• The quantity input is not actually the full quantity, as it is unadjusted for expected spoilage,
evaporation, and theft for direct materials; as to direct labor, the input is not adjusted for slack
time, and mandatory breaks such as lunch time, etc. This involves basic unit conversion first
before the cost assignment.
Unadjusted Inputs XX
Divided for Adjustments for Quality Check (Before and or after production); (1- Reject Rate) 0.X
Divided by Adjustments for Evaporation (1-Evaporation rate) 0.X
Divided by (and so on.) … 0.X
Adjusted Inputs as to Materials XX

Unadjusted Inputs XX
Divided for Adjustments for Quality Check (Before and or after production); (1- Reject Rate) 0.X
Divided by Adjustments for Slack Time 0.X
(Productive Hours – Slack – Idle time)/Productive hrs
Divided by (and so on.) … 0.X
Adjusted Inputs as to Labor XX
The Standard Cost per unit of DM is as simple as the Adjusted Material Input × Adjusted Price Inputs
The Standard Cost per unit of DL is as simple as the Adjusted Labor Input × Adjusted Labor Inputs
The Standard Cost per unit of OH will depend on company policy as to the Capacity basis; it may be
as simple as a percentage of Direct Labor inputs, and as complex as having been assigned in AB Costing.
• The Standard Cost of Overhead actually depends on if the Overhead is Fixed or Variable
• If the Overhead is Variable, its treatment is in the same manner as Labor and Materials; the
standard is applied on a per unit basis (Indirect Materials and Indirect Labor)
• If the Overhead is Fixed, its treatment is based on the absolute peso amount planned to be
incurred in the period. It is based on the planned capacity, and it may be based on:
o Normal Capacity or Practical Capacity – A capacity level that is the usual adjusted
expectations of management. It is usually near and below the full capacity of the
company, and typically reflects consumer demand, it does not reflect non-routine
orders.
o Full Capacity – A capacity level where all fixed costs are minimized on a per unit level.
It can no longer accommodate any new, sudden, and unplanned orders.
Applying the Standards
Ideal/Theoretical/Perfect Operations are perfect and offers no allowance for any form of failure
Practical/Budgeted Operations are adjusted for internal factors and human error (slacks,
Standards delays, breakdowns) – for AB Costing
Normal/Realistic Standards Operations are adjusted for both internal and external factors (customer
demand or market growth/share)
*Basic Standards Static and Unchanging across time-periods
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Variance Analysis
Variance – Difference between the planned or expected and what was actually accomplished. It relies
on accumulated and curated data that has been communicated through the master budget.
Responsibility for Variance
a. Materials Price – Purchasing Manager
b. Materials Quantity – Production Manager and Supervisors
c. Labor Efficiency – Production Manager and Supervisors
d. Overhead Variances – No single department or manager can be held singly responsible
Different treatment of Overhead and Materials, Labor
a. Size of individual overhead does not justify individual control
b. Behavior of individual overhead account is difficult to trace
c. Various overhead is responsibility of different people
Direct Materials/ Direct Labor Variance
𝑃𝑟𝑖𝑐𝑒 & 𝐿𝑎𝑏𝑜𝑟 𝑅𝑎𝑡𝑒 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝐴𝑄 ∗ 𝐴𝑃) – (𝐴𝑄 ∗ 𝑆𝑃)
𝑉𝑜𝑙𝑢𝑚𝑒 & 𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝐴𝑄 ∗ 𝑆𝑃) – (𝑆𝑄 ∗ 𝑆𝑃)
Purchase Price Variance – quantity is based on purchase, not production
Disposition of Variances – The Disposition of Variances is also called the Actualization of Variances; this
is because the variance is actually applied and allocated to the Cost of Sales and the various ending
inventories. Be especially alert to the disposition of the Price Variance (which is allocated to Accounts
Payable only.)
Flexible and Static Budgets
The Flexible Budget is typically applied to any level of production, and a Static Budget only for
one. Whatever the volume of activity, the Inputs will determine the Flexible Costs.) This is achieved
by not imposing any Volume of Activity as the period goes by and accumulating Standard Cost Data. At
the end of the period, the level of activity determined will be the basis for the Static Budget (Whatever
volume of activity, the Outputs will determine the Standard Cost).
Flexible Cost Segregation
Actual Cost Budgeted Cost Standard Cost
Actual Input at Actual Actual Input at Standard Output at
Price of Input Standard Price of Input Standard Price of Inputs
This is the actual outlay of This is the actual goods used at This is the ideal scenario given the
cash or goods actually used the preset price level of activity.
• Pre-setting a price enables an apples-to-apples comparison between activity levels. This
prevents performance from being distorted by uncontrollable factors; attributing performance
entirely to the responsible person/manager.

Illustration:
You are an aspiring baker. As such, you create a layout of the budgeted costs for making bread. A friend,
who is an expert at the trade, gives out their recipe and the usual costs they incur for a single loaf of
artisanal bread as follows:

Ingredients Cost of Ingredients Cost per Loaf

2 cups flour P54.00 per box (1 box is good for 8 cups of flour) P13.50 per loaf
2 eggs P6.00 per egg P12.00 per loaf
1 cup of melted butter P34.00 per stick (1 stick is 1 cup of melted butter) P34.00 per loaf
½ cup of sugar P27.00 per bag of sugar (1 bag is good for 4 cups) P3.38 per loaf
½ teaspoon of salt The cost of salt is negligible P0.00 per loaf
Recommended Cost of Output P62.88 per loaf
The cost per loaf is considered to be the standard price of inputs.
You plan to bake the bread on a batch basis. You currently own an oven that can bake 4 loaves of bread
in each instance. To make the most of the oven, you maximize the ingredients purchased.
You were able to purchase the above ingredients at these prices:
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Ingredient Cost per Unit Qty Purchased Actual Cost

of Input and Used of Inputs
Flour P64.00 2 Boxes P128.00
Eggs P7.50 16 Pcs P120.00
Butter P32.00 8 Sticks P256.00
Sugar P25.00 1 Bag P25.00
Actual Cost P529.00
To your surprise, the ingredients were only able to create 7 loaves of bread. You take into account some
wastages of ingredients due to your lack of experience. Prepare a flexible variance schedule.
Actual Cost Budgeted Cost Standard Cost
Total Actual Cost Flour (2* P54) P108.00 Loaves baked 7.00
P529.00 Eggs (16 * P6.00) P96.00 Multiplied by:
Butter (8 * P34.00) P272.00 Input Cost per
Sugar (1 * P27) P27.00 Loaf P62.88
Total Budgeted Cost P503.00 Standard Cost P440.16
Price Variance = P26.00 UF Efficiency Variance P62.84 UF

Suppose further that you also accounted for a rent stall. Your friend disclosed that they currently spend
P100.00 per month on a small stall downtown. You do not expect to last more than a month in this gig,
so the rent will be a one-time cost. You further subdivide the rent into weekly use, since you expect to
produce 2 batches (4 loaves each) per week.
You found a small space near your friend’s stall that offered P95.00 per month.
A flexible variance analysis would reveal the following:
Actual Cost Budgeted Cost Standard Cost
Monthly Rate P95.00 Monthly Rate P100.00 Standard Cost P100.00
Divided by: 4 weeks Divided by: 4 weeks Multiplied by:
Actual Cost P23.75 Budgeted Cost P25.00 Loaves baked 7/8
Divided by: 4 weeks
Standard Cost P21.88
Budget Variance P1.25 F Capacity Variance P3.13 UF

For this variance analysis, the measure of capacity maximized is assessed. It would be false to say that
the capacity is fully realized if in reality, the true output included spoilage. Furthermore, the budgeted
cost is always pegged at a single level of activity because unlike variable costs, fixed costs are taken only
at a single level of activity every period.
Key Inferences:
• In order to have a goal post for the Variable Costs, the level of activity determined at the end of
the period (this is in terms of the units of output, rather than units of input) will be the basis for
the Standard Cost, (also note that the end of the period may be any point in time) hence:
o The Price or Spending Variances are revealed by comparing the actual cost incurred to
the flexible cost (Actual quantity is held constant, and the Standard Price is applied) The
Quantity is isolated to reveal the possible issues of materials requisition, supplier
relations, ordering errors, etc.
o The Efficiency Variances are revealed by comparing the applied cost and the standard
cost. The Standard Cost is isolated since it is indeed the value of inventory; the
difference between actual input at standard price and the standard input at standard
price may possibly reveal issues in productive efficiency, labor, skill, and effort
allocation, materials quality, etc.
• The Volume Variance is revealed by Determining the Budgeted Fixed Overhead versus the
Standard Fixed Overhead (This is the Budgeted amount compared to the Fixed overhead per unit,
or actually just the static budget for the overhead for the year.) It is not controllable; hence, it
cannot be used to assail poor performance in execution, rather it is used to assess the degree of
planning taken to control the activity or the accuracy of existing information in terms of activity.
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Mix and Yield Variance

The mix and yield variances are further analyses of the efficiency/input/quantity variance.
Actual Inputs of Ingredients Actual Inputs applied at Flexible Cost of Outputs
Standard Mix
This is the actual mix of goods This is the recommended mix of This is the standard cost of input
per single unit of output. goods given aggregated inputs applied per unit of output.
In the foregoing illustration, assume instead that you are revising the recipe. You were able to take
note of the following actual usage of the ingredients in one of your experiments in contrast to your
friend’s recipe:
Actual Mix In grams Mix Standard Mix In grams Mix
Flour 1.75 Boxes per 7 loaves 1,430 g 29.96% 2 Boxes per 8 loaves 1,610 g 28.96%
Eggs 15 Pcs per 7 loaves 812.0 g 17.01% 16 Pcs per 8 loaves 845.0 g 15.20%
Butter 7.80 Sticks per 7 loaves 881.4 g 18.46% 8 Sticks per 8 loaves 904.0 g 16.26%
Sugar 0.75 Bags per 7 loaves 1,800 g 36.56% 1 Bag per 8 loaves 2,200 g 39.58%
**It is essential for this variance analysis that the units of measure for each input is consistently applied.
Actuals Std. Mix Actuals at Actual Yield Actual Output
Ratio Standard Mix @ Std Input
Flour 1,430 g 28.96% ---->1,382.4 g 7/8 --->1,408.75 g
Eggs 812.0 g 15.20% ----> 725.6 g 7/8 ---> 739.375 g
Butter 881.4 g 16.26% ----> 776.2 g 7/8 ---> 791 g
Sugar 1,800 g 39.58% ---->1,889.3 g 7/8 ---> 1,925 g
Total 4,773.4 g = 4,773.4 g 7/8 4,864.125 g

Standard Cost per gram: P62.88 per loaf; 4,773.4 grams of input per 8 loaves
4,773.4 grams per 8 loaves = 596.68 g per loaf;
P62.88 per loaf ÷ 596.69 g per loaf = P0.105 per gram

Flour 47.6 g * P0.105 = P5.00 UF 26.35 g * P0.105 = P2.77 F

Eggs 86.4 g * P0.105= P9.07 UF 13.78 g * P0.105 = P1.45 F
Butter 105.2 g * P0.105= P11.05 UF 14.80 g * P0.105 = P1.55 F
Sugar 89.3 g * P0.105 = P9.38 F 35.70 g * P0.105 = P3.75 F
Total P15.74 UF P9.52 F
**N.B. this recent illustration is a separate case from the previous illustration. Their efficiency variances
are not expected to be equal.
**To check correctness, compute for the Efficiency Variance:

Flour (1,430 g – 1,408.75 g) * P0.105 P2.23 UF Mix Var P15.74 UF

Eggs (812 g – 739.38 g) * P0.105 P7.63 UF Yield Var 9.52 F
Butter (881.4 g – 791 g) * P0.105 P9.49 UF Eff. Var P6.22 UF
Sugar (1,800 g – 1,925 g) * P0.105 P13.13 F 6.22 UF
Overhead Variances
The overhead variances are typically a combination of fixed and variable elements. Unlike Direct
Materials and Direct Labor, these variances are difficult to trace to either the product or any specific
person or department. However, variance analysis allows to splitting of information to isolate amounts.
Assessing Inputs
For Variance Analysis, note the use of the Budget Allowed for Standard Hours (BASH) and Budget Allowed
for Actual Hours (BAAH). These two amounts determine the variance of activity inputs, whether too
much time is placed into producing a unit or not, based on actual or standard productivity.
BAAH = Budgeted Fixed Overhead (Normal Capacity) + Budgeted Variable Overhead %*Actual Hours
BASH = Budgeted Fixed Overhead (Normal Capacity) + Budgeted Variable Overhead %*Standard Hours
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Assessing Outputs
Contrast the above two measures with the Actual Factory Overhead and Standard Overhead, SORAH and
SORSH are determined based on outputs. Standard Overhead is applied based on the Absorption Fixed
Overhead Rate plus Variable Overhead Rate times units of output. Recall that the activity level in terms
of output determined at the end of the period sets the goal post for the year.
SORAH = Standard Overhead Rate per unit of Output * Actual Hours incurred for total Outputs
SORSH = Standard Overhead Rate per unit of Output* Standard Hours required for total Outputs
**Absorption Fixed Overhead Rate = Fixed Overhead based on Normal Capacity / Units of Output
Overhead Variances – Summary
1-Way 2-Way 3-Way 4-Way
Actual OH Actual OH Actual OH Actual Var. OH
(Applied OH) (BASH) (BAAH) (BAAH)
Total OH Variance Budget Variance Spending Variance Var. Spending Variance

Fx OH% or Absorption% BASH BAAH Fixed Actual OH

Var. OH% (SORSH) (BASH) (Budgeted Fixed OH)
Total OH % Volume Variance Efficiency Variance Fixed Spending Variance

Budgeted Fx OH Budgeted Fx OH = BASH SORAH

Var. OH%*Actual Hrs Var. OH%*Std Hrs (SORSH) (SORSH)
BAAH BASH Volume Variance Var. Effcy Variance
BAAH
=
Total OH%*Std. Hrs TotalOH%*Act. Hrs Fixed OH/Total Units (SORAH)
SORSH SORAH Absorption % Capacity Variance
**The volume variance can be computed either on the basis of actual or standard hours allowed.
Right to Left; Right > Left = UF
Actual Budgeted Standard

Direct Materials XX Price Variance XX Efficiency Variance XX

Direct Labor XX Rate Variance XX Efficiency Variance XX
Variable Overhead XX Spending Variance XX Efficiency Variance XX
Fixed Overhead XX Spending Variance XX Volume Variance XX
• Controllable and Uncontrollable Variances – These variances are determined from the 2-way
analysis of variances. They are used to determine which factors were due to a manager’s
discretion versus factors beyond their control (such as through allocation to their department
that may cause slack).
o The controllable variance is also called the Budget Variance as it directly relates to the
budgeted amounts.
o Splitting the Controllable Variance further reveals the Spending and Efficiency Variances
• Spending and Efficiency Variances – These variances are determined from the 3-way analysis of
total overhead variance and 4-way analysis of the variable overhead variance. Like their prime
cost counterparts, they provide insight on spending behavior and productivity that can be traced
to direct decisions made by managers.
o The spending variance is determined by getting the following:
▪ The 2-way budget variance of fixed overhead
▪ The Actual Variable Overhead versus the Budget at Actual Hours
o Discretion is found on how the managers decide which service to acquire for instance, or
the degree of output they need for the period.
• The Volume Variance or Uncontrollable Variance – This variance is determined based on the
difference of a static version of an overhead budget and its flexible version. No manager has
control over the overhead input incurred, and so on the budget level, it is fixed to a single level
of activity. The cost, however, can be absorbed per unit produced hence, the input is only for a
single level of activity for any given level of productive output. It only relates to fixed costs.
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Other Formulas
𝐴𝑐𝑡𝑢𝑎𝑙 𝐼𝑛𝑝𝑢𝑡 𝐴 𝐼𝑛𝑝𝑢𝑡 𝐴 𝑎𝑡 𝑆𝑡𝑑 𝑀𝑖𝑥
𝑀𝑖𝑥 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = ( − ) × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑡𝑢𝑎𝑙 𝐼𝑛𝑝𝑢𝑡 × 𝑆𝑡𝑑 𝑃𝑟𝑖𝑐𝑒.
𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑡𝑢𝑎𝑙 𝐼𝑛𝑝𝑢𝑡 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑝𝑢𝑡 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑀𝑖𝑥
𝑌𝑖𝑒𝑙𝑑 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑡𝑢𝑎𝑙 𝐼𝑛𝑝𝑢𝑡 − 𝑇𝑜𝑡𝑎𝑙 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐼𝑛𝑝𝑢𝑡) × 𝑆𝑡𝑑. 𝑀𝑖𝑥 × 𝑆𝑡𝑑 𝑃𝑟𝑖𝑐𝑒 = 𝑂𝑢𝑡𝑝𝑢𝑡 𝑉𝑎𝑟.
In terms of Yields or Batches (especially if the Standard Input is not applied to a determined level of output, in
other words, standard cost is not determined; if the problem is silent, standard yield = 1)
𝑌𝑖𝑒𝑙𝑑 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝐴𝑐𝑡𝑢𝑎𝑙 𝑌𝑖𝑒𝑙𝑑 − 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑌𝑖𝑒𝑙𝑑) × 𝑆𝑡𝑑. 𝑀𝑖𝑥 × 𝑆𝑡𝑑 𝑃𝑟𝑖𝑐𝑒 = 𝑂𝑢𝑡𝑝𝑢𝑡 𝑉𝑎𝑟.
𝐴𝑐𝑡𝑢𝑎𝑙 𝑂𝑢𝑡𝑝𝑢𝑡 𝐴𝑐𝑡𝑢𝑎𝑙 𝐼𝑛𝑝𝑢𝑡𝑠
𝐴𝑐𝑡𝑢𝑎𝑙 𝑌𝑖𝑒𝑙𝑑 = ; 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑌𝑖𝑒𝑙𝑑 =
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑂𝑢𝑡𝑝𝑢𝑡 𝑝𝑒𝑟 𝑏𝑎𝑡𝑐ℎ 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐼𝑛𝑝𝑢𝑡 𝑝𝑒𝑟 𝑏𝑎𝑡𝑐ℎ
Sales Variances
Much like any Variable Cost Variance, the Sales Variance is essentially the same, only that the object of
interest is the Sales Performance. For any sales variance to be useful, the information is segmented in
the same way as markets may be segmented, it may be based on Customer Groups or Product Lines.
Actual Budgeted Standard
Right to Left; Right < Left = UF

Sales XX Price Variance XX Efficiency Variance XX

• A deeper appreciation of the sales variances will alert any investor over the quality of the report.
High volume in terms of Sales is not indicative of true Growth since the same relationship is
expected in terms of cost (to some degree), hence the Efficiency Variance should ideally be
determined on the basis of Standard Contribution Margin (Std. SP – Std. VC), which returns the
Bottom-line Effect of operations.
• Determine the Differences in quantity first, then apply the proper rate. The Price Variance uses
only Sales Rates, while the Efficiency Variance may use the Std. CM, or the Std. Sales as required
• In the like manner as with DL and DM, Sales Variances may also be split-up based on Sales Mix (In
the same basis as discussed in Multiple Product CVP Analysis)
Journal Entries on Variance Analysis
• Generally, the amount used to recognize inventory should be standard cost or standard amount.
• The variance must be disposed through Cost of Goods Sold and through Control Accounts.
• The actual amounts are still determined through the Subsidiary records.
Raw Materials Inventory (Actual Qty Purchased * Std. Price) WIP Inventory (Actual Hours * Standard Rate)
Materials Price Variance – UF Labor Rate Variance – UF
Materials Price Variance – F Labor Rate Variance – F
Accounts Payable (Actual Qty Purch * Actual Price) Wages Payable (Actual Hours* Actual Rate)
WIP Inventory (Standard Qty * Standard Price) WIP Inventory (Standard Qty Purchased * Std Price)
Quantity Variance – UF Efficiency Variance – UF
Quantity Variance – F Efficiency Variance – F
Raw Materials Inventory (Actual Qty Used Purchased * Wages Payable (Actual Hours * Standard Price)
Standard Price)
Factory Overhead – Control
Wages, Depreciation, Indirect Materials
to charge actual costs for overhead at the end of the period.
Work-in-Process Inventory Work-in-Process Inventory
Applied Factory Overhead Raw Materials Inventory
to apply WIP at their Standard Costs. Variance UF
to transfer RM to WIP at Standard Cost
Applied Factory Overhead** (**Accounts can be interchanged depending on the balance)
Variance - UF
Variance - F
Factory Overhead Control**
to charge the variances against the standards to bring them to actual costs.
Disposition of Variances
If the Variances are immaterial: If the Variances are material:
Cost of Goods Sold Raw Materials (For Materials Price Variance only)
Variance – UF Work-In-Process
to close the Variance to Cost of Goods Sold Finished Goods (unsold goods)
COGS (sold goods)
Variance – UF (Pro-rated to WIP, FG and RM)
to close the Variance to Inventory Balances pro-rata
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Other Concerns
Role of Top Management in Setting Standards
• Top Management is not involved in standard setting because cost estimation is a lower-level
operating activity (Assigned by Line Management); Participation by affected employees in all
control systems permits all concerned to understand both performance levels desired and the
measurement criteria being applied. This is also to append the fact that Variance Analysis
concerns Flexible Budgets over Master Budgets (master budgets are for top management)
On Setting Standards
• Setting Standards at a practical level can motivate employees. However, if the standards are too
high, employees may get discouraged. If the standards are too low, employees will not be
competitive or driven. Setting the correct level of standards is difficult but is a powerful force
for the organization when achieved. It is also quite time consuming to set standards and to
identify variances.
Controllability
• The concept of controllability applies also in variance analysis. Typically, a person who is neither
accountable nor responsible over a cost or profit center will not be investigated regarding the
variance.
• Unassigned Fixed costs are generally not controllable. Large, fixed overhead variances are not
attributed to any local department or cost center. These are attributed to the ones assigning the
cost elsewhere in the firm’s structure. Assignable Fixed Costs are controllable by way of
discretion.
• The standard cost of goods is always used as the basis for transfer pricing. If the actual cost of
goods were transferred to other centers thru sales that compensate this loss, the inefficiency is
‘sold-off’ to the receiving cost center/department. This is called Cross-Subsidization.
• Conceptually, a Fixed Overhead Efficiency Variance should not exist. Although one may think of
it as the same as the volume variance, it should not be the case since the connotation of
efficiency pertains to controllable activity, which is incompatible with the nature of fixed
overhead. Hence, only Capacity Variance and Volume Variance should be used.
Past Performance vs Budget Targets
• In setting standards, Budgeted targets are preferred over past performance. Budgeted
performance is constructed around current economic conditions rather than from past economic
conditions. Furthermore, it is more likely to be free from inefficiencies that is present in the
past performance data. Budget targets for variance analysis is used under Flexible Budgeting
rather than Master Budgeting, which is the interest of immediate middle line managers (detailed
data analytics) over top management which are concerned w/ KPIs and analytics)
When to Use Static Budgets for Variance Analysis?
• A static budget is mostly used for targeting performance or its Effectiveness. It may not be useful
for Management by Exception, but rather for Management by Objectives.
• A Flexible Budget is used to assess Efficiency.
Investigating Variances
• Variances are signals to the actual issue at hand, but they are not the issues themselves. They
are symptoms that should be given attention
• If a variance is material or significant, it should warrant investigation; otherwise, investigation
may not be needed. This applies whether a variance is favorable or not
• A significant favorable variance may open up opportunities to look-up best practices to adopt
elsewhere in the organization
• A significant unfavorable variance may indicate a pain point that needs to be addressed, and
whether this is due to constraints or due to inefficiencies
• A variance needs to be both material and controllable to be acted upon. Uncontrollable variances
cannot be attributed to activity and should not be used to evaluate performance.
• Frequency should have no bearing over variance; management by exception to standard applies.
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Activity-Based Management
Designed to provide strategic cost information that potentially affect capacity and fixed costs. It is used
as a supplement to usual cost system. This is the costing system for firms with diverse inputs & outputs.
a. Process Value Analysis – Creating flowcharts or workflow diagrams and evaluating whether the
activity is Value-adding or Not Value-adding.
• Analyze activities required to make or perform manufacturing
• Separate value adding from non-value adding activities
• Identify ways to eliminate or reduce non-value adding activities
b. Identify Activity Centers – Separate cost reporting for any sets of activities is possible, hence
should be specifically identified or traced. ABC systems will identify Activity Centers by the
wideness of an activity’s scope. (Activity Centers may be Supplier-based, Customer-based, or
Process-based.)
• Unit-level activities – performed for each unit, e.g., Mixing, Packaging
• Batch-level activities – performed for each batch, e.g., Moving, Storing, Baking in batches
• Product-level/Department-level activities – performed for each product line, e.g., Specific
Chemicals or dyes for each type of product, Specific services for specific customers
• Used for: Homogenous product workflows
• This is the default rate for variable costs in normal costing
• Facility-level/Plant-level activities – performed for each facility, e.g., Administrative Work,
Factory Support, Selling functions
• Used for: Highly automated workflows, where Overheads are significant
• This is the default rate for Predetermined Overhead in normal costing
c. Assigning Costs to Activity Centers – Ideally, each activity center should have a specific Cost
Pool Rate assigned to each activity. Those Costs that are shared by multiple activity centers
should be allocated appropriately.
d. Selecting Cost Drivers – Each activity center will have cost-drivers, these are the bases for which
cost will be accumulated and assigned.
• A labor-intensive activity may have labor hours or units of output as their cost-driver
• Each activity will have its own Predetermined Overhead rate
e. Incorporating Performance Measures, Profitability Analysis, and KPIs
AB Management will expand
this model from Cost into any
activity in the firm, checking
which activities add value.

Cost Minimization: Elimination of Costs, Selection of Costs, Reduction of Costs, Sharing of Costs
Budgeted Activity ÷ Budget Cost = Activity Rate Activity Cost Units FOH/U
Activity X Units of Output XX X XYZW AA A
Activity Y Machine Hours YY Y XYZW BB B
Activity Z Labor Hours ZZ Z XYZW CC C
Activity W Periods Covered WW W XYZW DD D
Process Value Analysis --> (Apply to actual Cost Drivers of each product) --------------->Cost Assignment
Cost Behavior in AB Costing vs Traditional Costing
AB Costing applies accuracy so that the units with more production activities (instead of volume)
gets to be assigned with more costs, and the units with less production activities gets to be assigned
with less cost which allows the firm to remove non-value adding activities in the production process.
This enables management to create better decisions in terms of long-term pricing, incremental
analysis, and total quality management.
Traditional Costing AB Costing
Fixed Cost to Volume Inverse Subdivided to reveal Direct behavior
Accuracy Less Volume = Overstated Cost Direct Relationship = More Accurate
Sales Mix More Profitable = Less Volume More Profitable = Higher Volume
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Responsibility Accounting and Segment Reporting

Organizations are subdivided into smaller units, each having responsibilities to fulfill. These subunits are
called divisions, segments, or departments. Each department is composed of different individuals who
are responsible for specific tasks and functions.
• The main goal is to ensure that people in each department strive toward the same goals set by
Top Management, this is referred to as Goal Congruence
• Decentralization – Refers to the separation or division of the organization into more manageable
units, under the guidance and management of an individual who is given decision authority being
held accountable thereto
o It is beneficial because it creates greater responsiveness to the needs of local customers,
suppliers, and employees.
o Decentralization allows for more flexibility to business conditions
o It is susceptible to duplication of work and effort and lack of goal congruence
• Responsibility Accounting – Is a system that is implemented to an organization so that
performance in terms of cost, revenues, are recorded, reported and evaluated by levels of
responsibility within an organization
• Controllability Principle – Managers should be held responsible only for what they can control,
and that they are generally interested firstly in what they control before whole firm’s concern.
Accountability vs. Responsibility
Refers to immediate interest over an activity Refers to the immediate action over an activity
Results-focused Task-focused
Cannot be delegated Can be Delegated
Asset/Project Performance Manager/Employee Performance
Determined at the End of the project Determined routinely
Done in the Evaluation Phase Done throughout the Control Phase
Advantages and Disadvantages of Decentralization
Advantage Objective Trait Disadvantage
Motivational Tool Competitiveness Lack of Coordination among segments
Top-level focuses on strategy
Reliability and Mid-level Suboptimization or Focus on
Mid-level gain detailed
Independence Departmental Goal over Organizational Goal
information and flexibility
Faster Response to Operation Focus Management Short-sightedness or Myopia
Training ground for lower- Managerial
In-breading or lack of Managerial Innovation
level management Consistency
Segment Reporting
a. Direct Costs – costs that can easily be traced to a cost object
b. Indirect Costs – not easy to trace back to cost object
c. Common Costs – Cost incurred for the benefit of more than one cost object, also called joint cost
d. Controllable Cost – directly regulated by a manager of a department
e. Non-controllable Cost – not directly regulated by a manager, other than by top management
A B C Required: Use:
Contribution Margin XX XX XX For Controlling Responsibility over Controllable
Controllable Fixed Costs (XX) (XX) (XX) Segment Performance, i.e., Margin
Controllable Margin XX XX XX Manager’s Performance:
Direct Uncontrolled Fixed Costs (XX) (XX) (XX) When Evaluating Accountability over
Segment Margin XX XX XX Segment Performance, i.e., Segment
Indirect Uncontrolled Fixed Cost (XX) (XX) (XX) Investment Object’s Performance, Profit
Segment Profit XX XX XX ROI, RI
Income Tax (XX) (XX) (XX) For Planning and Decision making for
EBIAT or NOPAT XX XX XX Segment OR
projects. i.e., Capital Budgeting,
Project
Add: Depreciation, Amortization XX XX XX Capital Structure, Working Capital
Cashflows
Cashflow from Operations XX XX XX
**Segment Margin is used to assess product or customer profitability and accountability over
those dimensions of performance. This is where non-routine decisions apply.
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Responsibility Centers
a. Cost Center – Managers are responsible for incurring and controlling costs. Evaluated by
comparing Actual Costs with Budgeted Costs
b. Revenue Center – Managers are responsible for generating revenues. Evaluated by sales targets
or quotas, an obsolete responsibility center
c. Profit Center – Managers are responsible for both revenues and costs. Evaluated by Variance
analysis (Standard Costing and Gross Profit Variance)
d. Investment Center – Managers are authorized to make decisions about how and where to invest
company assets to drive long-term profitability, having the largest scope of responsibility among
all types of responsibility centers
Profit Center Evaluation
a. Controllable Margin – for the short-run; use if ALL FIXED COSTS ARE AVOIDABLE/ CONTROLLABLE,
shutdown the segment if the CM is negative
b. Segment Profit – for the long-run, used if there are SOME avoidable fixed costs; continue the
segment if there is income, evaluate segment CM if segment income is negative
Evaluation of Investment Centers or Stand-alone Responsibility Centers
𝑁𝑂𝑃𝐴𝑇 (𝑛𝑜 𝑓𝑖𝑛𝑎𝑛𝑐𝑒 𝑐ℎ𝑎𝑟𝑔𝑒𝑠)
𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕𝒔 = 𝑂𝑅 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 ∗ 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑑 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝑹𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆 = 𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐼𝑛𝑐𝑜𝑚𝑒
𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝑰𝒏𝒄𝒐𝒎𝒆 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 ∗ 𝐻𝑢𝑟𝑑𝑙𝑒 𝑅𝑎𝑡𝑒
𝑨𝒔𝒔𝒆𝒕 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 = 𝑆𝑎𝑙𝑒𝑠 ÷ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑬𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝑽𝒂𝒍𝒖𝒆𝑨𝒅𝒅𝒆𝒅
= 𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 − ([𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠] ∗ 𝑊𝐴𝐶𝐶)
Hurdle Rate a.k.a. minimum rate of return
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 – 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑁𝑜𝑛 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠; or
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔 = 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
**Invested Assets are at Fair Value, and Variances are applied to Net Income only if Material
PROS CONS
Return on Focus on Sales, Expenses, and Investments Narrows focus on division alone
Investment over overall firm profits
(Based on Segment Focuses on Operational Efficiency (Cost and Assets) Focus on Short-term rather than
Profit) long-term goals
Residual Income Measured in dollar amounts instead of percentages Short-run oriented
(Based on Segment Focuses on Operational Efficiency (Cost and Assets), Absolute measure of
Profit & ROR only) or minimum Rate of Return profitability, not relative to size
Economic Value Relates Profit to amount of investment needed by Absolute measure of
Added using WACC or CoC, and actual Capital Employed profitability, not relative to size
Emphasis on After-tax Profits Not based on GAAP, application
may differ per Organization
• When Performing Performance Evaluation, it is important to normalize the performance,
meaning, Net Income must be adjusted for unusual gains or losses from property disposals,
performance bonuses of key management personnel, etc. but still applying taxes.
• Also remove the cost of financing for performance evaluation as these are not typically
controlled by the manager overseeing the profit/investment center. Cost of Financing or Capital
is used for Planning and Screening purposes.
• It is preferable to use Residual Income as the basis for performance evaluation over the ROI
because it objectively takes projects that have large returns. ROI is prone to rejecting projects
that have low ROI, but otherwise high or suitable Residual Income.
• Centralization may be preferred over Decentralization if a task or business process is repetitive,
and rule based. This is akin to when no department ought to be responsible for maintaining books
of accounts if other activities deserve more attention. (When no department wants to be
responsible, the cost is centralized.)
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Managing Common Costs

Capacity Management is done to ensure that the cost allocation of uncontrollable cost toward profit
centers and cost centers are fair and reasonable. This is because managers between centers may need
to negotiate a basis for which common costs are allocated, since these costs have no direct activity driver
Indirect Common Costs
1. Stand-alone Cost Allocation – This implies that cost is allocated to each cost center or business
unit based on some common base, such as activity, units, hours, headcounts, dollar value, etc.
• The variety in cost bases may not create a standard that not a single manager may
agree on, if the other sees that another basis would benefit them. For example,
allocating based on Units of Output vs Units of Input alone would cause disagreement.
2. Contribution Margin Method – This implies that indirect costs should be allocated based on
the contribution margin of a segment. (This only applies if the segment is a profit center. It
does not apply to cost centers)
• This will cause more allocation toward the good performing centers and may negatively
affect goal congruence as it encourages budgetary slack.
3. Incremental Method – This method assigns common costs based on historical trends. It
associates the increases in fixed cost with the establishment of the new center.
• Older centers will benefit more from this approach.
For external reporting concerns, this remains to be a minor issue. However, for internal control and
proper compensation toward strategic alignment, managers must negotiate available resources fairly.
Shared Resources or Outsourced Costs
Shared services are administrative services that are provided by a central department to the company’s
operating units. Shared services are usually services such as human resources, information technology,
maintenance, legal, and many accounting services such as payroll processing, invoicing and accounts
payable. Usage of the services by the individual departments (cost objects) can be traced in a meaningful
way based upon a cost driver that fairly represents their usage of the service. These can be allocated
using a Budgeted Rate at either Actual or Budgeted Activity using:
1. Single Rate method – Variable and Fixed Costs are allocated based on an activity driver
2. Dual Rate method – Variable and Fixed Costs are allocated based on different cost pools
For Multiple Service Department Cost Allocation, (see more in AFAR)
Special Considerations for Joint Cost
Although Joint Costs are typically accounted for under IAS 2 (Inventories), internally, there comes an
issue with regards two departments sharing a single joint cost. Undeniably, a product/department that
could sell at a sell as-is basis rather than a process-further basis will want to keep its costs low to boost
profitability (The inverse is also true), in this case, managers usually negotiate the allocation basis of
the Joint Cost (Separately of course, from the proper accounting treatment). (See more in AFAR)
• First, the Product Prioritization Matrix is Determined (The product that produces the most
contribution margin per unit of scarce resource)
Determine the Costs Allocated: Product A Product B
Contribution Margin/u (based on Prioritization Matrix) AA BB
Revenues (XX) (XX)
Total Costs AA BB
Process Further Costs - (BB)
Allocated Joint Cost AA BB
• This arrangement makes sure that the Process Further Costs are properly accounted for and are
directly related to the Product in question, avoiding the need for negotiation over the segments.
• Note that the Joint Cost Allocation will be based on the NRV; that is, the Realizable Value that
reflects the proper management decision (whether to Sell as is or to Process further.)
o If the product is to be Sold as is: Allocate based on NRV @ Split-off point
o If the product is to be Processed further: Allocate based on NRV @ Final Sales
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Special Considerations for By-products

By-products are usually not reported separately as it distorts the impression of a management report. It
is unusual to see distant numbers in a single report, hence, it is best practice to ‘bury’ the By-product in
either Total Joint Costs or Cost of Goods Sold unless it is so material that it warrants its own column in
a profit statement, hence:
Product A Product B Total
Contribution Margin/u (based on Prioritization Matrix) AA BB AB
Revenues (XX) (XX) (XX)
Total Costs AA BB AB
Process Further Costs - (BB) (BB)
Allocated Joint Cost AA BB AB
By-product Cost - - (ZZ)
Final Joint Cost AA BB AB
• This avoids dampening the profit statement and properly attributes the cost to a non-
responsibility level. (See more in AFAR)
• This further emphasizes the fact that if no department wants responsibility over a task or
measure, it should be centralized to avoid accounting for slack.
Capacity Planning
Capacity Planning is a matter of determining which basis is most useful for which situation.
Budgeted Capacity Practical Capacity Normal Capacity Theoretical Capacity
A.k.a. Master Budget Or Realistic Capacity Or Historical Capacity Or Ideal/Perfect
Capacity or Planned Capacity
Capacity
Used for Master Used for Pricing as it Used for Long-term It is the least useful
Budget Planning and avoids the Price Death Planning and Working capacity basis as it
Motivation Spiral (It is customer Capital Forecasts. allows no slack,
demand agnostic) breakage, external
demand adjustments.
Based on Capacity Based on Available Based on Historical Based on perfect
budgeted capacity and ignores Average of Capacity performance
drops in sales volume
Ideal Capacity adjusted Budgeted capacity Practical capacity
to external limitations adjusted to external applied over time
and internal limitations

Budgeted Practical Normal Theoretical

Capacity Capacity Capacity Capacity
Fixed Overhead XX XX XX XX
÷ Capacity Basis BC PC NC IC
Overhead Rate BC% PC% NC% IC%
× Budgeted Capacity AA AA AA AA
Applied Overhead XX XX XX XX
Budgeted Overhead (BC) (BC) (BC) (BC)
Cost of Planned Idle Capacity - XX XX XX
Budgeted Overhead BC
Actual Overhead (XX)
Cost of Unplanned Idle Capacity XX
The purpose of managing Common Costs is for management to properly price their products, and to
facilitate fair evaluation of performance of SBUs. As these costs are already beyond the control of the
line, they must be measured reliably in order to aid in decision making, whether routine or not.
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Transfer Pricing and External Pricing Decisions

Transfer Price – The amount charged by one segment of a firm for products or services that are supplied
to another segment of the same firm. It is also known as the intersegment price
• An inefficient producing division will pass on the excess production cost/inefficiencies to the
buying division in the transfer price if it uses Actual Cost; using Std. cost prevents this.
• The goal of Transfer Pricing is to simulate a perfect open-market scenario within the
organization. This creates conditions that:
o Optimize product price and quality in a Selling Division and
o Minimize Cost of Production in a Buying Division
o Impose competitive pressure on External Sellers and Buyers
Sub-optimization – Occurs when a segment is so self-interested that it compromises the best interests
of the firm as an entirety.
Objectives:
a. Primary – to evaluate performance by virtually transforming cost centers into profit centers so
that performance of the manager of cost centers can be measured reliably in terms of income
b. Secondary – to save on costs involved in producing or buying by insourcing vs outsourcing
c. Others – motivation, basis for rewards, incentivize goal congruence, implementing
decentralization and autonomy
Why is Transfer Pricing Done?
It is done to achieve Management by Objectives, where the objective is cost minimization and quality
maximization by simulating an open market economy. It charges at the ideal price (usually the market
price) even if the eventual accounting effect would offset as a control tool to prevent the buying division
from incurring more cost, in this case, the selling division is usually a home office or parent company.
Transfer Pricing Schemes
Cost-based Methods Market-based/Autonomy Method Negotiated Price
Variable Cost: Regular Selling Price This is the Variable Cost plus
Manufacturing Costs (This is the best transfer price any opportunity cost foregone.
Other relevant Variable Period because it simulates actual Used when there is no ready
Costs (e.g., Transport, Selling) market conditions). Used when market price, or when cost
available and profitable. savings are anticipated.
Full Cost (Absorption Cost) Modified Market (Adjusted SP) It is anywhere between the
Cost-plus (Includes Mark-ups) price ceiling or price floor.
a.k.a. Internal Cost a.k.a. External Cost
Maximum and Minimum Transfer Prices
Minimum Price Price Floor GENERAL RULE Set by the Selling Division
Maximum Price Price Ceiling COST OF PURCHASING FROM OUTSIDERS Set by the Buying Division
Perfectly Competitive
Take Market Prices Selling Division competes with Market
Markets (Selling division compensates with quality and minimal price)
(higher quality, lower price)
Imperfect External Selling Division does not compete with Market
Markets Negotiate the Price (No ready comparison available and buying division is controlled
(lower quality, higher price) by supplier forces)

Negotiated Transfer Prices

Negotiated transfer prices are used when no quotations are reliable, or if there is excess capacity, but
not enough to accommodate the entire order, considering the Opportunity Cost of Idle Capacity.
General Rule: Follow the Transfer Pricing Matrix, unless capacity for goods is indicated.
Transfer Price = Additional Outlay Cost per Unit + Opportunity Cost per Unit
Transfer Price = Standard Variable Costs per unit + Opportunity Cost per Unit
• Additional Outlay Costs are the usual Variable Costs connected to the Product. Product costs and
sometimes, Variable Period Costs are included. These remain constant regardless of capacity.
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Opportunity Costs
• With Excess Capacity – Zero, since the selling department would satisfy EXTERNAL DEMANDS even
while accommodating the special order from other departments
• Without Excess Capacity – The foregone contribution margin if the Selling division opts to provide
for the special order
Opportunity Cost = Units sacrificed to accommodate the special order * Contribution Margin
• Be mindful, however, that if there is no indication of capacity, always prefer the range of prices
over the single price given.
Dual-rate Transfer Price
A Dual-rate transfer price is based on two prices, one price set by the selling division (which is recorded
in the buying divisions books as the purchases), and the other price is the actual cost incurred by the
selling division (which is kept in the selling division’s own records as goods shipped to branch). This allows
a few things to occur:
1. The buying division does not know the true price of the shipments from the selling division and
will be forced to make pricing decisions to fit what it had recorded.
2. The difference, which is not a ‘real’ amount, will have to be maintained as an overvaluation
account that will only be eliminated once the actual sale is made by the buying division to
outsiders.
International Considerations for Transfer Pricing
• Transfer pricing is also done to maximize tax breaks and cost arbitrage. This means that if costs
are cheaper elsewhere, then a firm should participate in that cheaper market considering
differences in quality, pricing, and market entry
• Large Government Barriers are usually set-up to prevent international firms from exploiting
minimal costs of entry to keep their own local industries safe from unwarranted competition
• Those that can participate against International Competition makes everyone better-off by
imposing competition for the same degree of quality at possibly, a lower price
Pricing Decisions
• Generally, pricing decisions deal with the firm’s questions as to what price should the firm sell
its goods; accordingly, these are influenced by the firm’s overall strategy and how it can manage
to acquire and preserve its market share.
• This includes cost management across the value-chain and over the product’s life cycle, as well
as the type of market it plans to enter.
Short-run Pricing – Short-run prices are more influenced by profit positions rather than long-term return
positions since these generally encompass relevant costs (see Relevant Costing) that do not have a lasting
impact over earnings. In other words, these are brief profit engagements that are not really expected to
occur often. As such, the decision rules for short-run pricing should be to take the option that
maximizes contribution margins.
Long-run Pricing – Long-run prices on the other hand, are influenced by the firm’s strategic position.
That is, it is heavily influenced by either Focus, Cost Leadership, or Differentiation to achieve the
intended returns that shareholders expect in order to perpetuate the firm’s going-concern.
• Buyers prefer stable and predictable prices over the long-term
• The company must be able to manage costs over the long-run, and must be able to deliver goods
to customers consistently
• As such, many costs are considered relevant, so long as the add value to the firm.
o In order to achieve this, in terms of the outputs, the Profits must be able to cover all
costs of development and continuing operations.
• The act of setting prices to achieve a firm’s strategic goals is called Target Costing
• Costing may be based on Full Absorption Costing plus other Value-adding Costs or also known
as Super Absorption Costing/Product Lifecycle Costing, although a balance must be stricken in
order to make the product viable to customers/make the customers willingly pay for the good.
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• It may also be based on a Market-based Approach, that is, a sufficient study of Demand (from
the Customer) and existing supply (from the Competitors and Internal data) must be conducted,
from which, a Price could be established.
o It begins with the external and then ends with the internal; It begins with determining a
product that the customers value, and how much they would be willing to pay for the
thing, sans information competitor’s existing supply and productive capacity.
• It could also be based on a Cost-based Approach, that is, its costs begin from the costs incurred
by the firm to manage production and is later adjusted to the market’s demands.
o It begins with the internal and then ends with the external. Cost plus a Target Return
on Investment is a usual basis; however, some other pricing methods are available such
as Cost-plus pricing, and simple mark-ups.
In Pricing Decisions, the Price should always cover all costs first. The Mark-up is only added and
will be exclusively based on the basis a problem provides. The final price would be for controlling
and ignores volume or absorption assumptions since the pricing regime focuses more on a product’s
lifecycle that may even outlast the shareholders; as such it is viewed more as a strategic tool, rather
than a tactical tool.
Pricing Concepts (not Exhaustive)
• Competitive Pricing – setting a price based on what the competition charges
• Price Skimming – setting high prices upon introduction, and lowering the same price as the
market evolves
• Penetration Pricing – setting a low price to enter a competitive market, then raising it later
• Predatory Pricing – setting prices at the lowest possible amount to force competitors to lose
market shares if they do not drop their own price
• Peak-load Pricing – the pricing strategy wherein prices are increased when demand for the good
increases. This considers the elasticity of the demand of a good sold
• Bundled Price – selling two products for the price of one to stimulate sales
• Retail Pricing – selling through a middleman to reach markets
Customer Profitability
The natural progression of profitability analysis from Responsibility Centers and Product Lines would
eventually involve External factors such as customer segments whose information are captured through
CRM Modules or Customer Relations Modules in ERPs.
CRM Modules produce information that typical financial statements may not be able to highlight, e.g.:
Warehousing, Showrooms, Ordering Processes, Change Discounting, Private Labelling,
online shopping Orders Special Orders
Delivery, Setup, Training In-person, telephone, online- Returns, Refunds, and Restocks
after sales support, Dunning
Attributing revenues to customer groups and their typical costs would grant insight on customer
profitability, as highlighted in the Customer Whale Curve Chart:
The top of the whale demonstrates a cross-
over point for individual customer
profitability. Based on the Pareto Principle,
(only for this scenario at least), 20% of
customers represent a minimal return after
all costs through the value-chain are
considered.

Likewise, only 20% as well, represent highly

profitable customers that the company
ought to emphasize services to or to retain.

Acquiring New Customers will also be of paramount concern. This also considers the customers that
change over time. Hence, the customer migration chart below:
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The same cross-over point is seen in the

chart. It emphasizes the nature of
customers’ cost behavior. Whether these
incur significant R&D, Customer Service, or
Selling cost.

It is therefore also essential, to keep a tab

on other operating expenses that drive
customer relations in order to inform
strategic positioning.

To Assess customer profitability,

Class A Class B Class C
Contribution Margin XX XX XX
Controllable Fixed Costs (XX) (XX) (XX)
Controllable Margin XX XX XX
Direct Uncontrolled Fixed Costs (XX) (XX) (XX)
Customer Segment Margin XX XX XX
Product Profitability
Another dimension of profitability would be toward product profitability. In the like manner as with
Customer Profitability, it is assessed this way:
Class A Class B Class C
Contribution Margin XX XX XX
Controllable Fixed Costs (XX) (XX) (XX)
Controllable Margin XX XX XX
Direct Uncontrolled Fixed Costs (XX) (XX) (XX)
Product Segment Margin XX XX XX

However, it would differ in a sense that sometimes, lifecycle costs are included in the Uncontrolled fixed
costs, as considered in pricing strategies. It may choose to cover Upstream and Downstream Value-chain
costs within the DIRECT uncontrolled fixed costs.
This would be because Direct Costs are usually relevant or avoidable once a manager decides to drop a
product or adjust offers to a specific customer group. To maximize goal congruence, top-level
management and to some extent, mid-level management should decide on whether it affects the entire
firm adversely or positively.
Given this, if a non-routine decision is executed by a manager, the impact to the firm would be
considered in their performance evaluation.
Proper Performance Evaluation
• Tie-back the performance measure to the strategy
• Decide a proper compensation package for each goal post
• Appropriately assign responsibility and accountability over a KPI
• Avoid the Bias of Measurement Surrogation (This is when the metric itself becomes the goal,
when in fact, it is only but an indicator. Remember, the ultimate driver of a firm’s vision and
mission are its company values.)
• Apply a Balanced Scorecard Approach
• Do not use uncontrollable costs to assess performance to avoid slack and employee frustration
• Consider a bottom-line approach for performance evaluation of middle to high management
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Relevant Costing and Non-routine Decision Making

Relevant Costs – future costs that are expected to be different among alternative courses of actions.
• For a cost to be relevant:
o It must differ across alternatives
o It must be incurred in the future
Irrelevant Costs – costs that will not influence a decision
Opportunity Costs – any INCOME sacrificed when a certain alternative is chosen over another.
Avoidable Costs – costs that can be eliminated or reduced when a course of action is taken
Sunk Costs – Costs already incurred; no decision can be made whether these could be eliminated
/reduced.
Out-of-pocket Costs – costs that will require expenditures of cash or incurrence of liabilities because of
a decision made by management.
Differential Costs – Increases or decreases in total costs that result from selecting one alternative instead
of the other; it is in other words, the net advantage of choosing a decision over the other.
Approaches in Analyzing Alternatives in Non-routine Decisions
a. Total Approach – Use of Total Amounts
b. Differential Approach – Only Differences and changes are considered.
Types of Decisions:
a. Make or buy – Should a product be manufactured or bought outside?
b. Accept or Reject a Special Order – These involve selling at discounts. Is the order worth
accepting? Are regular sales affected?
c. Continue or Shutdown a Segment – Should a business be discontinued? How will it affect the
overall profit of the firm?
d. Sell or Process Further a Product – Should a product, after undergoing the joint process, be sold
at the split-off point or processed further?
e. Product Combination – Which Product Mixes can maximize profits given constraints in resources?
f. Profits & Pricing – How should the profit factors be manipulated to influence profits and demand?
g. Capacity Bases – How should common costs be allocated to fairly assess performance?
Tactical Decision Making
Tactical Decision Making – Consists of choosing among alternatives with an immediate or limited end
Recognize and Define the Problems
1) Identify alternatives as possible solutions, and eliminate those that are not feasible
2) Identify Predicted Costs and Benefits associated with each feasible alternative; eliminate costs and
benefits that are not relevant to the decision
3) Compare relevant costs and benefits for each alternative and relate each to the overall strategic
goals and other important qualitative factors
4) Select the alternative with the greatest benefit, supporting the organization’s strategic objectives
Activity Resource Planning Model
This planning model is used to decide whether some resources are worth pursuing or disposing of in view
of tactical advantages. It classifies resources into two types:
Flexible Resources – Resources that can be easily purchased in the amount needed and at the time of
use, such as additional goods for manufacturing
• If there are changes in demand, it becomes relevant.
• if there are no changes in demand, it becomes irrelevant.
Committed Resources – Resources that are purchased before they are used, i.e., salaried employees.
• If Increase in Demand is smaller than Unused Capacity, the Committed Resource is not relevant
• If the Increase in Demand is larger than Unused Capacity, the Committed Resource is relevant
• In case of Decreases in Demand:
o If the Activity Capacity is reduced, the committed resource becomes relevant
If the Activity Capacity is unchanged, the committed resource becomes irrelevant
Bottleneck Resources – Any resource or operation where the capacity is less than the demand placed
upon it
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Important Formulas:
Accept or Reject Special Orders:
Incremental Contribution Margin (Loss) XX
Opportunity Costs for no excess capacity XX
Additional Fixed Cost from Special Order XX
Incremental Profit (Loss) XX
Make or Buy Decisions:
Cost to Make Cost to Buy
Avoidable Variable Costs: Purchase Price XX
Direct Materials XX Materials Handling XX
Materials Handling XX Relevant Costs to Buy XX
Direct Labor XX
Variable Overhead XX XX Opportunity Cost of Capacity
Avoidable Fixed Costs XX Reduces relevant cost to buy or
Opportunity Costs XX increases relevant cost to make
Relevant Costs to Make XX
Continue or Shutdown a Segment
Avoidable Revenues: Avoidable Costs:
Sales Revenue XX Variable Costs XX Contribution Margin XX
Opportunity Costs XX Traceable Fixed Costs XX Traceable Fixed Expenses (XX)
Total XX Avoidable Common Fixed Costs XX Segment Margin XX
Other Avoidable Costs XX Common Fixed Expenses (XX)
Total XX Net Income XX
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 − 𝐶𝑜𝑠𝑡 𝑡𝑜 𝑆ℎ𝑢𝑡𝑑𝑜𝑤𝑛
𝑆ℎ𝑢𝑡𝑑𝑜𝑤𝑛 𝑃𝑜𝑖𝑛𝑡 =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
Sell or Process Further
Selling Price after Processing Further XX
Revenue at Split-off (XX)
Additional Revenue XX
Cost of Processing Further (XX)
Incremental Revenue XX
Best Product Mix
Product A Product B
Contribution Margin per Unit XX XX
Divided by: Cost Driver (Inputs Required per Unit) X X
CM per Constrained Resource XX XX
Profits and Pricing – Different Bases
𝑇𝑎𝑟𝑔𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 = 𝐹𝑢𝑙𝑙 𝐶𝑜𝑠𝑡 𝑝𝑙𝑢𝑠 𝑀𝑎𝑟𝑘𝑢𝑝
𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑅𝑒𝑢𝑡𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑎𝑛𝑑 𝐺𝑒𝑛𝑒𝑟𝑎𝑙 𝐴𝑑𝑚𝑖𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝑀𝑎𝑟𝑘𝑢𝑝 𝑜𝑛 𝐴𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡 =
𝑀𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡
𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝑀𝑎𝑟𝑘𝑢𝑝 𝑜𝑛 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 =
𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑀𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠
Changing the Overhead or Common Cost Allocation Basis
***The fairest manner of allocating common costs (at least for internal reporting) such as joint cost,
shared resources, or overhead should be based on performance measures (i.e., controllable margins, or
contribution margin), and not merely on quantity used as this does not fully account for profitability.
• Consider what the common cost is
• Consider how best to allocate it
• Consider if managers are willing to take-in the cost
• Evaluate managers based on their controllable costs
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Summary of the Tactical Decision-making Processes:

Problem Approach Recommendation
Make or buy a product List relevant costs and get the differential The alternative with lesser
input **Selling and Admin Costs are not avoidable relevant cost should be taken
Accept or Reject a Compare revenue scenarios from each Accept if the revenue exceeds
Special Order (Rework instance available. Consider Excess incremental costs
or Junk Inventory) Capacity
Compare operating losses if operations are Continue if the loss is lesser
Continue or Shutdown continued or not than shutting down
operations Compute the Shutdown point and compare If demand exceeds shutdown
with demand point, continue operations
Compare incremental revenue in each Take the option with more
Sell as is or process scenario (consider joint cost allocation) revenue/Do not process
further further if it results in a
differential loss
With Single resource Choose best combination that
a. CM unit/driver will maximize CM given
b. Rank according to CM unit/driver appropriate constraints.
(highest to lowest) (That is, the product with
c. Consider limitations the highest CM per unit of
Best Product Mix inputs.)
d. Compute units to be produced
based on ranking
e. Compute total margin
With several sources: use linear Choose best combination that
programming (Quantitative Techniques) will maximize CM
Apply Cost plus pricing formula
Absorption Approach, cost base includes the
Choose the SP that will cover
cost to manufacture one unit
Pricing and Profits all operating costs as well as
Contribution Margin Approach, cost base
returns on invested capital
will include all variable costs associated
with the product (Expenses included)
Apply CVP Analysis Choose the decision that
Changes in Profit
increases overall profit; ignore
Factors
implications on per unit bases
• As a general rule, if the decision involves responsibility centers, consider solving for bottom-
line effects (Segment Profit or Income and Total Profit or Income) to account for
sunk/unavoidable costs. If the decision does not involve responsibility centers, solve for the
variable rates such as Selling Price, Variable Cost, Contribution Margin, Avoidable Costs/unit.
• Problems are usually explicit with Avoidable Costs. However, in some cases, they are not. For
example. Selling and Administrative Expenses are generally avoidable in a make or buy or
accept/reject special order in transfer pricing, since selling internally will typically forego the
need for packaging or in some cases, significant transport costs.
The Indifference Point or Curve
When multiple courses of action yield the same result, a decision-maker will be indifferent to all options.
This is called the indifference point. In order to decide, the manager must consider the qualitative factors
such as supplier or customer relations, expediency or urgency of need. Sometimes, ethical dilemmas may
even be encountered when pondering on whether a decision should be taken.
Cashflow versus Profit Decision
Making this decision will depend on the needs of management. A higher cashflow is desired if the firm
wants to avoid liquidity risk. A higher profit is desired if the firm wants to improve shareholder wealth.
If the problem is silent, the preference in Management Accounting is Profit, while in Finance, it is
cashflow.
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Balanced Scorecard
An approach to performance measurement that combines traditional financial measures with non-
financial measures
• A balanced scorecard begins with the determination of a firm’s long-term goals. These goals are
usually financial in nature, such as financial growth; when a firm determines what it must be
currently doing to meet its long-term goals, then it uses the Balance Scorecard.
• The Balanced Scorecard must identify with some components:
o Strategic Objectives – Statement of what the strategy must achieve, and why it is critical
to success
o Strategic Initiatives – Key action programs required to achieve strategic objectives
o Performance Measures – Describes the indicators for success, and how it measures up
to the overall strategy of the firm
o Baseline Performance – Current level of performance for the performance measure
o Targets – Level of performance or rate of improvement needed
• Lead Indicators – guides management in making decisions that will result in desirable results
(Looking up to the future and to today)
• Lag Indicators – measures of financial outcomes of earlier management decisions (Looking back
to the past)
• The Balanced Scorecard is characterized by:
Strategy Focus and proper Strategy Map Cause-and-effect Linkages
Balance Uniquely adapted to overall Strategy
Inclusion of both Financial & Non-financial Incentives
Measures
• Challenges in building a Balanced Scorecard:
o Determining non-strategic, non-value adding activities and eliminating them
o Tying a qualitative measure of performance to monetary compensation
Business Process Learning and Growth Customer Perspective Financial
Operations and Employees, and Human Customers Shareholders and
Improvements Resources, and R&D Efforts Owners
Efficiency, Productivity Employee Relations and Customer relations and Profit Variances &
and Innovation Trainings the Market Share Financial Ratios
Internal Business Process Performance Measures/KPIs
=Wait Time + Process Time + Amount of time from which the
Inspection Time + Move Time + customer places their order
Delivery Cycle Time
Queue Time until it reaches the point of
shipment
=Total Production Time per
Batch/Units per Batch OR Amount of time required to
Manufacturing Cycle Time or
=Process Time + Inspection produce a unit until it reaches
Throughput Time
Time + Move Time + Queue the point of shipment
Time
Units per Batch/Total Number of units given an
Velocity
Production Time per Batch amount of time
Processing Time/Delivery Cycle Compares time invested in
Manufacturing Cycle Efficiency Time value-adding activities and non-
value-adding activities
Total Productivity Total Output/Total Input
Total Output Units/Total Input
Partial Operational Productivity How much outputs are yielded
Units
by a single output
Total Output Pesos/Total Input
Partial Financial Productivity
Pesos
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Gross Profit Variances and Strategic Analysis

Gross Profit Variation Analysis – is done to examine the sufficiency of gross profit. Management will be
able to assess the effectiveness of its operating policies, pricing policies, and other investment and plant
utilization. Various factors come into consideration to isolate the variances; these will also point to the
responsible department where the variance may be attributable to.
Factors
Change in volume of sales Change in cost of goods
Change in selling prices Changes in sales mix
Rule of Thumb:
• Last Year’s Volume is the standard for volume LYP*(QLY – QTY)
• This Year’s Price is the standard for price TYQ*(TYP – LYP)
When data is incomplete, relative changes are used.
1) Sales/COGS TY at LYP = Sales/COGS LY at TYP
2) Sales/COGS TY at LYP = 100%; Sales/COGS TY = 100% +x%
3) Sales TY at LYP = X/(100% +x%)
4) Use CHANGES in QTY to bridge Cost to Sales and Sales to Cost
5) Use CHANGES in PRICE to bridge Cost to Sales and Sales to Cost
3 – way Variances 4 – way Variances
Increase (Decrease) in GP Due to: F(UF) Sales Volume Variance F(UF):
Quantity Factor (ΔQty*GP/unit Last year) XX Qty This Year at Last Year’s Price XX
Sales Last Year XX XX
Increase (Decrease) in GP Due to: F(UF) Sales Price Variance F(UF):
Sales Price Factor (ΔPrice*Qty This Year) XX Sales This Year XX
Cost Price Factor (ΔPrice*Qty This Year) (XX) XX Qty This Year at Last Year’s Price XX XX
Increase (Decrease) in GP F(UF) XX Change in Sales F(UF) XX
3-way variance Multiple Products COGS Volume Variance UF(F):
Qty This Year at Last Year’s Price XX
Sales Quantity Variance F(UF) COGS Last Year XX XX
∑Sales QTY @ LYP XX COGS Price Variance UF(F):
∑Sales QLY@LYP XX XX COGS This Year XX
Cost Qty Variance Qty This Year at Last Year’s Price XX XX
∑Cost QTY @ LYP XX Change in Cost UF(F) XX
∑Cost QLY @ LYP XX XX
4-way variance Multiple Products
GP Qty Variance XX
Cost price Variance UF(F)
Sales Mix Variance (Aggregate of All Products) ∑Cost QTY @ TYP XX
Average GP QTY @ LYP XX ∑Cost QTY @ LYP XX XX
Average GP QLY @ LYP (XX) Cost Price Variance UF(F)
Increase in GP per Unit XX ∑Cost QTY @ LYP XX
Multiply by: Total QTY XX ∑Cost QLY @ LYP XX XX
Sales Mix Variance F(UF) XX Change in GP due to COGS XX

Final Sales Volume Variance (Aggregate of All

Cost price Variance UF(F)
Products)
QTY XX ∑Cost QTY @ TYP XX
QLY (XX) ∑Cost QTY @ LYP XX XX
Increase (Decrease) in Units XX Cost Price Variance UF(F)
Multiply by: Average GP LYP XX ∑Cost QTY @ LYP XX
Final Sales Volume Variance F(UF) XX ∑Cost QLY @ LYP XX XX
Change in GP due to COGS XX
6-way Variance Increase (Decrease) in Sales Due to F(UF):
Quantity (ΔQty*Last Year’s Price) XX
Price (ΔPrice*Last Year’s Qty) XX
Quantity Price(ΔQty* ΔPrice) XX XX
XX
Increase (Decrease) in Cost due to UF(F):
Quantity (ΔQty*Last Year’s Price) XX
Price (ΔPrice*Last Year’s Qty) XX
Quantity Price (ΔQty *ΔPrice) XX XX
Increase (Decrease) in GP: F(UF) XX
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Strategic Analysis of Operating Income

The strategic analysis of the profit variances refers to balanced scorecard financials perspective. This is
an analysis of how the firm generally fared with the overall market. Though it is a variance analysis, it
is more concerned in Evaluation rather than controlling. In this regard, Product Differentiation, Market
Size, and Cost Leadership are applied. Notably, these relationships hold true in analyzing these variances:
Product Differentiation Cost Leadership and Market Share Market Size
Targets large and Targets effects on Productivity External factors influencing the
significant effects on price- Components. Including efforts to firm’s growth; for instance, the
recovery components maximize economies of scale and overall local economy’s own
cost arbitrages GDP growth
Price effect on Variable Price Effect on Selling Price, Market Size Effect applied to
Cost only Total Productivity, and Market Share Operating Income

Revenues Variable Costs Fixed Costs

STY VCTY FCTY
Price Productivity Price
STYLYP VCTY FCTYLYP
Act Cost Total Price Effect:
*RTY/RLY (Rev. F – VC F – FxC F)
Growth Price Productivity
SLY VCLY FCLY Total Productivity
Std Cost Effect:
*RTY/RLY (VC F + FxC F)
Growth
VCLY Total Growth Effect:
• The Growth Effect can be further subdivided into the Market Share (Rev F - VC F)
Effect and Market Size Effect.
Market Size Effect: Actual Change in Units XX
=
𝑶𝒃𝒔𝒆𝒓𝒗𝒆𝒅 𝑮𝒓𝒐𝒘𝒕𝒉 𝑹𝒂𝒕𝒆 ∗ 𝑼𝒏𝒊𝒕𝒔 𝑳𝒂𝒔𝒕 𝒀𝒆𝒂𝒓 Market Size Effect (XX)
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑼𝒏𝒊𝒕𝒔 Market Share Effect XX
• For strategic analysis of variance, productivity is measured based on past performance. Hence,
the Variable Cost of the current and previous years are applied the same rate of productivity as
the last year, provided by the formula:
𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑇ℎ𝑖𝑠 𝑌𝑒𝑎𝑟 − 𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝐿𝑎𝑠𝑡 𝑌𝑒𝑎𝑟 𝑜𝑟 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑈𝑛𝑖𝑡𝑠 𝑅𝑇𝑌
= =
𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝐿𝑎𝑠𝑡 𝑦𝑒𝑎𝑟 𝑅𝐿𝑌
• Much like there is no efficiency variance for Fixed Costs for Cost Control, the same is true with
Strategic Variance Analysis. Here, the Growth Effect on Fixed Cost does not exist since, in a
short time horizon, fixed costs are not expected to change significantly.
Product
Cost Leadership
Differentiation Market
Total Market Size
Price Effect – VC Price Effect – SP
Productivity Share
Revenue - XX - XX XX
VC XX - XX XX XX
FC - - XX XX XX
Effect in OI XX XX XX XX XX

** N.B. Favorable Revenues less Favorable Costs; Favorable Revenues plus Unfavorable Costs
(flip the signs to determine effect in net income. For Net Benefit, do not flip the signs.)
*** As a shorthand, it would be sufficient to keep in mind the Product Differentiation Effect and
Market Size Effects. All the other variances are applied as cost leadership.
**** The Observed Growth rate is usually the same as the Growth rate of the economy’s GDP, if
otherwise stated, it is generally determined by the sales volume forecasts of the company.
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Title III: Modern Business Practices

Strategic Cost Management
• Application of Management techniques to achieve cost leadership, improving the firm’s strategic
positioning. It involves the recognition and management of important cost relationships along
the value chain.
Product Lifecycle Costing or Super Absorption Costing
Under this cost regime, production cost is not determined in the short-term sense of the production of
one unit. A company takes a longer view to the cost of production and attempts to allocate all the
available resources along a product’s life cycle or value-chain (from R&D to Customer Support, and
everything in between)
• Super Absorption is done to attribute a product’s performance over its life cycle since:
o Capital Investments were placed into its inception
o Returns need to be monitored
• Hence, product life-cycle costs are used for Capital Budgeting, Customer and Product Evaluation,
and Strategic Variance Analysis.
The Value-chain (by Michael Porter) begins with Upstream Costs, then follows Manufacturing Costs,
and finally Downstream Costs (Both Upstream and Downstream Costs are conceptually expensed under
GAAP. For Internal Reporting, these will be costs that have to be recovered.)
• Upstream Costs – Before Production – Research and Development, Design
• Downstream Costs – After Production – Selling, Advertising, Servicing and Warranties
Firm Infrastructure (Administration & Governance)
Human Resource Management
Support

Technology, Research and Development

Margin
Procurement
Post-
Inbound Outbound Sales and
Primary

Operations Sales or
Logistics Logistics Marketing
Servicing
Stages in the Product Lifecycle
• Introduction Stage – Slow sales growth, lack of profits (high R&D, High Advertising)
• Growth Stage – High Production Volume and High Demand, fixed costs are absorbed
• Maturity Stage – Sales growth declines, new competitors enter the market
• Decline Stage – Price Cutting, narrowing product line, reduction in promotion budgets\
High Investment Cost Improving Product Cost Production Costs are Cost Inefficiency
Introduction

Growth

Decline
Maturity

Budding Competition minimized Competition is Very

High Operations Cost
Premium Pricing and Capacity is Maximized Strong
Low Competition
Bundling are common Variable Cost-based Significant Disruption
Inelastic Price pricing is common Elastic Price
Strong Competion

During the Decline Phase, a company may choose

to:
• Restart the Life Cycle and remarket the good
• Harvest the Product line and Close-out prices
• Discontinue the product naturally and Divest
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Total Quality Management

• Aims to improve Product Quality by Reducing and eliminating errors, streamlining activities, and
continuously improving productions. The Cost of Quality is Emphasized in this system.
• Cost of Quality – based on the philosophy that failures have an underlying cause, prevention is
cheaper than failures, and cost of quality performance can be measured. (Includes good and
bad quality costs)
• Quality of Design – A fairly accurate impression
of what the customer requires of the supplier
• Elements:

Participative Management – a deemphasis of top-down

management
Continuous Improvement/Kaizen
Teamwork
Emphasizing Delivering Value to Customers
Reducing Waste and Defects

Prevention Cost Appraisal Cost Internal Failure Cost External Failure Cost
Quality Engineering Testing and Inspection of Scrap Cost of Field Servicing
incoming materials
Quality Training Testing and Inspection of Spoilage Handling Complaints
in-process goods
Quality Circles Final Product Testing and Rework Product Recalls
Inspection
Statistical Process Supervision of Testing and Rework Labor and Warranties Expense
Control Inspection Activities Overhead
Supervision of Depreciation of Test Retesting Reworked Lost Sales from
Prevention Activities Equipment Products reputation and quality
Quality Data Maintenance of Test Reinspection of Reworked Non-value adding
Gathering, Analysis, Equipment Products Activities/Wastage
and Reporting (Not necessarily Failure Cost)

Quality Improvement Plant Utilities in the Disposal of Defective • Transport

Projects Inspection Area Goods • Inventory
Technical Support Field Testing and Appraisal Downtime caused by • Operator Motion
provided to Suppliers at the Customer Site Quality Problems • Idle time
Audits on effectiveness Analysis of cause of
• Overproduction
of Quality System Quality Problems
Reentering Data because • Overprocessing
of Keying Errors • Defects
Debugging Software Errors

Six-Sigma Quality
A statistical measure expressing how close a
product approaches its quality goal. One-sigma
means that 68% of products are acceptable; three-
sigma means 99.7%; Six-sigma is 99.999977%
perfect. In other words, 3.4 defects per 1 million
parts of products (Sigma denotes the standard
deviation from the mean in a normally distributed
population)

• In other words, it is a statistical measure of how a production process consistently achieves

quality standards in terms of its products (There are deviations in production that impair the
goods or even render them useless, requiring product recalls.)
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Kaizen Costing
The Japanese term for Improvement; it is used to mean continuous improvement (slow, but constant)
incremental improvements made in all areas of business operations “Always looking to improve”
• For ABC Systems – improve quality and or reduce the cost of business processes
• For Target Costing – Determining IDEAL STANDARD COSTS, and how to achieve standard costs by
developing new manufacturing methods and techniques
• For Budgeting – Developing budgets on kaizen principles will result in decreasing costs of
production over the budget period
A company following the Kaizen Philosophy will typically have an actual income statement as shown:
Year 1 Year 2 Year 3 Standards
Sales P7M P7.1M P7.15M P9M
Cost of Sales (2.20M) (2.15 M) (2.00 M) (1.5M)
Gross Profit 4.30M 4.95 M 5.15 M 7.5M
R&D (1 M) (1.10 M) (1.20 M) (2.2M)
Selling Costs (0.5 M) (0.49 M) (0.48 M) (0.35M)
Admin Costs (0.22 M) (0.21 M) (0.20 M) (0.15M)
Net Income P2.58 M P2.15 M P3.27 P4.8M
Small Incremental changes can be observed in the amounts. It can be expected as well that the standards
encompassing all the years (throughout Years 1 to 3) that the Standards are so Ideal, and the variances
very significant.
A Kaizen Philosophy will also emphasize continuous learning and research in order to drive innovation
within the firm. What ultimately matters in the Kaizen Philosophy is that there is incremental progress
toward a goal, not necessarily the variances that would normally alert management to an issue.
Supply Chain and Operations Management
• Supply Chain Management is the management of the flow of goods, services, and information
that includes all processes that transform resources into outputs. It involves the active
streamlining of a business’ supply-side activities to maximize customer value and gain a
competitive advantage in the marketplace
Business Process Outsourcing and Shared Services
• Business Process Outsourcing (BPO) – the delegation of IT-intensive business processes to an
external provider that, in turn, owns, administrates, and manages the selected processes based
on defined and measurable performance metrics.
• Shared Service Centers – the creation of an autonomous business unit, based on-site, which
carries out these processes for multiple functions within an organization
• Global Business Services – an evolved form of shared services which incorporates international
considerations in cost centralization
• Offshoring – transferring activities or ownership of an end-to-end business process to a different
country from the countries where the company receiving the services is located; in other words,
it is a captive service center located abroad.
Regardless of the location, all the above have the same goal, which is to reduce cost and exploit
economies of scale and labor arbitrage in the Firm’s Support Activities in the Value-chain without
obsolescence risk. All of which have a varying degree (limitation) of Information Sharing, Reporting,
Employee Morale, and Performance Monitoring (thru Service Level Agreements or SLAs)
Enterprise Resource Planning
• ERPs are software enablers that organizations use to manage business operations such as
accounting, procurement, project management, risk management, compliance, and supply-chain
operations.
• These include all the transaction cycles that are compiled into a suite of modules designed to be
centralize business capabilities
• These are ideally comprised of different user-interfaces (or different users around the
organization), a centralized database or a data warehouse, a query engine (to retrieve data and
gather insights therefrom), and their corresponding internal controls.
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Materials Resource Planning

• Materials Requirements Planning – a system for calculating the materials and components needed
to manufacture a product. It consists of the following steps:
o Take note of Inventory on Hand or Stock
o Identify how much more is needed (or how much need to be sold first)
o Schedule the production or purchase of the goods
• It considers complex scheduling algorithms based on codependent business modules (i.e.,
business operations that cannot be done without accomplishing the prerequisite first) to produce
a comprehensive production or procurement plan.
• Business Modules may either be Independent Demand or Dependent Demand
o Dependent Demand are the requirements internal to production, these are ingredients
so to speak; or in accounting parlance: Direct Materials, and WIP
o Independent Demands are the outputs available to be sold out, menu items so to speak;
or in accounting parlance: Finished Goods or Ending Inventory
• Cost-Push System – A department pushes the cost onto another without any regard for demand,
increasing unliquidated inventories.
• MRP is a Push System or a Make-to-Stock end-to-end process
Just-in-Time Production System (JIT)
• Aims to reduce carrying costs by eliminating inventories and increasing delivers made by
suppliers. Shipments of raw materials are received JUST IN TIME to be incorporated in the
manufacturing process. It stresses primarily Preventive Controls over Inventory Quality; so that
the responsibility for quality is shouldered by the Supplier instead of the firm (Suppliers are
chosen very carefully)
• Purchase just at the right time & quantity to fill-in customer orders, minimizing inventories
• A JIT Production Environment adopts specific plant layouts informed by Industrial Engineering to
streamline productions. Arranged by manufacturing cells instead of functional departments.
• Demand-Pull JIT System – There is no production without demand (Customer order)
• It is used in tandem with the Economic Order Quantity Model, and the Reorder Point Model
• JIT is a Pull System based on system-built triggers
• JIT also incorporates Kanban Systems which emphasize process transparency and goals
monitoring for production environments
• Scrum is an Agile Project Management Methodology that seeks to approach tasks in solution
sprints to deliver results quickly, allowing an in-development product to be released while
creating test environments for continuous improvements or refinements until a final and
complete version is rolled-out.
• Kanban is a way to visualize Scrum Methodology, hence the tool Kanban Boards
Lean Methodology
• Lean Methodology aims to minimize inputs for maximum output; in other words, eliminate waste.
• It is based on a horizontal design or results-oriented system rather than a vertical one or ‘business
unit system’ that incorporates a process realignment toward Total Quality Management
• Lean Manufacturing – Achieving the shortest possible cycle time by eliminating waste, reducing
non-incidental work thereby decreasing the time between a customer order and shipment;
designed to improve profitability, customer satisfaction, throughput time, and employee morale
Theory of Constraints and Throughput Costing
It is the methodology for identifying a constraining factor that slows down or impedes production
processes and managing the same by improving any aspect of the business process.
Constraint – A constraint is a limitation that a firm has no other choice but to be subject to whilst needing
to meet existing goals.
• The constraint is called the Bottleneck (the Labor & Overhead are applied in the Process).
• Under this method, Throughput Contribution Margin is used (only Sales less Direct
Materials), Opportunity Costs committed to productions are also considered, and finally the
costs of all operations are measured.
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The theory of constraints, JIT, and Lean all consider non-productivity as an illness, specifically idle
inventory. This is because Inventory has tied-up costs that need to be minimized, as such:
Merchandize Inventory is not Quality Declines as Inventory If we choose to reduce decline in
considered an Asset, unless it is stays in stock due to wear and quality, we incur costs to
immediately considered sold tear, exposure to elements, etc. maintain that quality which are
from the time it is available. also costly, if not, more.
In as much as Quality should be managed, its costs should technically still be minimized.
As such constraints are eliminated or minimized as much as possible
Constraints can come from:
Internal Process Internal Policy External Material External Market
The Theory of Constraints identifies 4-constraints to minimize waste and maximize output quality
Drum Buffer Rope
The scheduling System or Limits what is fed into the Bottleneck The Rope pulls the output in
the Order Feed to minimize waste and to prevent the through the bottleneck at a
bottleneck or constraint from constrained speed, it is also to
overloading the entire process prevent overloading bottlenecks.
Limits Downstream Limits Downstream Limits Upstream
Sets the velocity or Prevents the bottleneck from Allows the bottleneck to deliver
pacing of the system, starving or being idle; it is a just enough input to prevent idle
which is why it is the deliberate delay or stock-in to keep capacity. It is the buffer’s signal to
slowest sub-process, inventory flowing at pace, thereby release the material from the
which is called Takt Time avoiding variably changing lead times buffer which encapsulates the ‘pull
(minimizing waste & stock-out cost) system’ in Lean.
• Determining the bottleneck includes acknowledging the fact that any changes to it may change
the overall throughput of the system as a whole
This requires determining a common input measure such as time, units needed, etc. and determining the
relative throughput margin per resource. The constraint can be identified relative to the total available
common resource. For example, if in a week a department takes 2,500 hours, then all products can only
be produced within that timeframe. The process that consumes the most time is usually the bottleneck.
• Bottlenecks should ideally be busy and should be prioritized
To prioritize which aspect of the bottleneck needs to be addressed, the throughput margin must be
determined for the products. This is a straightforward process for a single production line; however, it
becomes a bit more complicated when multiple product lines are considered. Hence, a matrix
computation using linear algebra may be required to determine the optimum mix of production needed
to prioritize the bottleneck. (See Linear Programming)
• Eliminate Idle Time in the Bottleneck (the Buffer deliberately imposes minimal and optimized
idle time and the Rope generates the Reorder Point). To eliminate the idle time in the
bottleneck, buffers before or after the bottleneck must be set.
The buffers and ropes are placed to stock the inventory in a phase, enough to prevent it from both being
idle and overloading. The opportunity costs of keeping stock in buffers are determined and deducted
from the throughput margin determined in the bottleneck.
• Process only goods that increase throughputs, shift other goods that do not need bottlenecking
elsewhere, and repeat the process until satisfied. (Conduct Differential Analysis)
Example: A certain end-to-end process goes through the following steps A to E. The time taken by each
of the WIP goods go through each step is as follows (in minutes):
WIP A WIP B In any given week, 100 units of WIP A are required to satisfy demand,
A 18 16 while WIP B requires 150 units.
B 15 14 In a week, only 2,760 minutes are available for manufacturing.
C 17 15 WIP A sells for P67.00, B for P75.00;
D 12 11 DM costs for WIP A is P40.00, WIP B is for P52.00
E 10 9 Weekly DL and OH Costs P5,000.00
Total 72 65
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Apply Theory of Constraints:

4. The bottleneck is Step A for WIP A & B
5. Throughput Margins are as follows:
WIP A WIP B
Margin P27.00 P23.00
6. Determine the Throughput Margin per Bottleneck Minute
Margin/Min P1.50/min P1.44/min
7. Determine the Profit Maximization Function (In this case, time is the constrained resource)
Max Profit = P1.50A + 1.44B where Max Profit is subject to time constraint as follows:
2,760 mins = 1,800 mins for A, and 960 mins for B.
8. Determine Income Impact and decide.
WIP A WIP B Total
Sales P6,700.00 P3,900.00 P10,600.00 (960/2,760)*150*P75.00
DM (4,000.00) (2,704.00) (6,704.00) The bottleneck is not recovering overall
Margin P2,700.00 P1,196.00 P3,896.00 costs. It must be reviewed for improvement.
OPEX (5,000.00)
Income (P1,104.00)
Business Transformation
It is a term that encompasses change all throughout an organization.
Business Process Management
• Views processes as strategic assets that must be understood, managed, and improved.
• It is necessary to understand how a Business Process is conceptualized before it is to be managed
and improved, hence its life cycle.
o Design – Identifying existing processes and creating design improvements
o Modelling – Simulating the process in a test environment and considering its possible
implications to the business environment
o Execution – Installing software, training personnel, & implementation of the new process
o Monitoring – Tracking processes with performance statistics
o Optimization – Retrieving performance statistics from modelling and monitoring to
identify bottlenecks or other problems; realizations for organizational structures such as
centralization and decentralization are discovered in this phase
Benchmarking
Benchmarking is concerned with determining best practices in other firms and comparing existing firm
performance and capabilities. It is not necessarily concerned with competitors and industry, but rather,
a mix of both to achieve a basis for improvement. It is composed of the following steps:
Document the Current
Select the Project and Identify and Research the Analyze Data and Identify
State and Conduct a Gaps Implementation
Team Target Improvement Points
Analysis
• Cost, Quality, Timeliness

Business Process Reengineering

• A fundamental rethinking and redesign of business processes to achieve improvements in critical
measures of performance such as cost, quality, service speed, and customer satisfaction. Its
scope includes anything from operations and production to administrative functions
• It is akin to Systems Analysis and Design
• It is a Radical Approach to Change compared to Kaizen which focuses on small increments over
time
• It often involves a large investment to implement, hence it is usually hounded with issues
surrounding retrenchment, employee motivation, and company culture
• Proper change management must be undertaken to avoid the issues as above mentioned
• It seeks to discard and replace inefficient, outdated, and redundant procedures in the business
o Reengineering looks at outcomes of the new process instead of the new tasks themselves
o It begins with the customer-level, not with the product
o Technology is not meant to add to old procedures, but rather to find new ways of working
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Title IV: Financial Management

Financial Management
• An area of financial decision-making, harmonizing individual motives and enterprise goals. It is
mainly concerned with the effective fund’s management in business.
• It deals with the procurement of funds and their effective utilization in the business as an
application of general managerial principles in the area of financial decision making
Finance – The art & science of managing money; deals with how good decisions on money are made
Areas of Finance
Corporate Finance How a firm should make good financial decisions
Personal Finance How an individual should make good financial decisions
Investments and
Portfolio The selection of Investments and combining such to create a portfolio that has
Management attractive risk-return characteristics
Financial Markets How financial markets ought to be organized, and how financial institutions
and Institutions ought to be managed to provide the most benefit to the economy
Public Finance Deals w/ taxes, spending, balancing the public budget, & financing public debt
Organization of the Finance Functions
1. Investment Decisions – relates to the selection of assets in which funds are invested by the firm
a. Long-term assets yield returns over a period of time in the future
b. Short-term assets are convertible into cash in the normal course of business, normally
within a year
c. Asset Selection
i. Capital Budgeting – most crucial financial decision of the firm relating to the
selection of an investment proposal whose benefits are likely to arise in the
future over the life of the project
ii. Liquidity – concerned with the management of current assets which is a
prerequisite to the long-term success of the firm
2. Financing Decision – decisions as to how to raise funds to pay for investments in assets
a. Capital Structure Theory
b. Capital Structure Decisions
3. Dividend Decisions – decisions as to how much, how frequently, and in what form to return cash
to owners. An optimum dividend policy maximizes the market value of the share
Objectives of Financial Management
PROS CONS
Concerned with earning profits Ignores time value
Profit is the parameter of operations Ignores Risk
Profit Profit Reduces risk of the business Ignores Cash flows
Maximization Profit is the main source of finance Susceptible to Profit Manipulation
Profitability meets social needs Susceptible to inequalities among
stakeholders
A more recent innovation to business Merely prescriptive
Managers are constrained to accept Susceptible to the Agency Problem
Wealth outcomes that increase shareholder
Maximization wealth
Considers time value and risk Wealth is made to maximize profits
anyway
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The Ten Axioms

The 10 Axioms of Financial Management are generally observed phenomena that are held to be true
ceteris paribus. Accordingly, these are the usual justifications for financing decisions in general; and are
the basis for which the rational, and well-informed financial manager bases their decisions. Furthermore,
basic theories used in finance are derived from these 10 assumptions.

1. The Risk-Return Trade-off

The more risk an investment has, the higher its expected return should be

2. The Time Value of Money

A dollar received today is worth more than a dollar received in the future
If you receive a dollar today, you can invest it and earn more
So the sooner you get the money, the better

3. Cash, not Profits, is King

You cannot spend “profit” or “net income”. These are paper figures only
Cash is what is received by the firm and can be reinvested or used to pay bills
Cash flow does not equal net income; there are timing differences in accrual accounting between when
you record a transaction and when you receive or pay the cash

4. Incremental Cash Flows

It’s only the increase or decrease in cash that really counts
It’s the difference between cash flows if a decision is done versus if the decision is not done

5. Curse of Competitive Markets

It’s hard to find and maintain exceptionally profitable projects
High profits attract competition, so prices will tend to drop once many realize that an investment is
profitable

6. Efficient Capital Markets

The markets are quick, and the prices are right
Information is incorporated into security prices at the speed of light!
Assuming the information is correct, then the prices will reflect all publicly available information
regarding the value of the firm; this means that the market equilibrium tends to minimize prices

7. The Agency Problem

Managers are typically not the owners of a company
Managers may make decisions that are in their best interests and not in line with the best interests of
the owners, so businesses must find ways to align company interests with personal employee interests

8. Taxes Bias Business Decisions

Because cash is king, we must consider the after-tax cash flow on an investment (Even when taxes are
based on income and non-cash line items such as depreciation and gains/losses.)
The tax consequences of a business decision will impact (reduce) cash flow

9. All Risk is Not Equal

Some risk can be diversified away, and some cannot
Diversification creates offsets between good results and bad results
When a certain risk generates more impact than others, it might be best to prioritize addressing it

10. Ethical Behavior Means Doing the Right Thing

Ethical Dilemmas are everywhere in finance
Unethical behavior eliminates trust, results in loss of public confidence
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Financial Statement Analysis

Primarily done to determine the extent of a firm’s success in attaining its financial goals
To earn Max Profit To maintain solvency To attain financial stability
Vertical Analysis
Focuses on relationships between items on the same Financials (Common-size FS)
Balance Sheet Line Item / Total Assets; Income Statement Line Item / Net Sales
Balance Sheet Vertical Analysis
• Based on Total assets, it is a useful tool to measure against competitors/industry leaders. It is
also useful in determining Capital Structure and Working Capital Structure.
Income Statement Vertical Analysis
• Based on Net Sales, it is a useful tool to measure against competitors/industry leaders. It is also
useful in determining Cost Structure.
Horizontal Analysis
Aids users to recognizes important financial changes over time
(Current Year – Base Year) / Base Year
Base Year Analysis – This means to construe analysis based on any given year. This is usually the most
normalized year based on historical data, disregarding impacts of inflation.
• If the problem is silent, assume that the base year is the immediately preceding year
• If the base is given, the Base year is consistently used throughout the entire set of data
YOY/QOQ/MOM – This means to construe an analysis based on the immediately preceding year, e.g.,
• The Year-on-Year sales growth projected for CY 2023 is 3%; this means that 2023 sales figures
will increase by 3% based on 2022 figures.
• A YoY analysis is useful for removing the impact of business cycles or seasons on figures
• Comparing QoQ means to compare, for example, this year’s Q1 with last year’s Q1, with the prior
year’s total as the Base year.
YTD/QTD/MTD – This means to construe an analysis of developing figures based on a term post, e.g.,
• The YTD figures for the 3rd Quarter shows that Sales from Segment X comprise of 5% of Total
Sales; this means that Segment X forms 5% of current year sales based on total cumulative figures
from the beginning of the year.
• The YTD analysis is useful for determining market trends, business cycles, etc.
• Comparing QTD means to compare, for example, January Performance against Q1 performance.
Ratio Analysis
• Profitability Ratios – relate to company’s performance for the current period; shows the
company’s ability to generate income
• Activity Ratios – Relates to the firm’s ability to efficiently manage its resources, specifically its
net working capital
• Liquidity Ratios – Relates to the company’s short-term survival
• Solvency Ratios – Relates to the company’s long-term survival
• Valuation Ratios – Relates to the company’s financial structure
Profit and Earnings Terminologies:
• EBIT or Operating Income – used for performance evaluation, profits that are controllable by a
manager
• EBT, EAT or Accounting Net Income – Used for Return on Equity and Return on Sales
• EBIAT or Net Cash Inflows After Tax or NOPAT – Used for Returns on Assets since it ignores
financing sources; used for Capital Budgeting and computing tax savings
• EBITDA or Cash Inflows Before Tax – Used for profitability analysis of segments
Analysis Terminologies
• Turnovers – These are generally the ‘velocities’ of the accounts. They are called turnovers
because these indicate the number of times an account in the balance sheet turns over into the
income statements. The General formula is any nominal account divided by the average real
account.
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• Days in Account – These indicate the number of days an account stays in the balance sheet. The
General formula is the Real Account multiplied by 360 or 365 all over the Nominal Account
• Leverages – these indicate the measure of the sensitivity of Net Income to changes in certain
costs (interest charges, fixed charges, etc.)
• Coverages – Indicates the number of times earnings can cover a specific debt/allowances
• Gearing - Literally the debt-to-equity mix required to finance the entity’s operations;
information therefrom will be the basis for the risk assessment of a business
• Yields – Anything used to quantify a relationship with the fair value of the shares of an entity.
Ratio Analysis
Profitability Ratios – These are ratios usually associated with margin analysis of the income statement.
• External analysts usually do not have access to information relating to profitability of the firm
as these are usually not available from the financial statements (much so when multiple sales
come from different sources, and variable costs are aggregated with fixed costs; especially when
the Publicly issued financial statements do not disaggregate based on nature or activity, but
rather based on function.
• A good measure of analysis considers variance disposal to investigate causes for the relationships
observed in the financial statements.

The ability of sales to cover fixed manufacturing costs; can be used for
Gross Profit Margin
auditing purposes
Operating Profit Margin The ability of sales to cover fixed manufacturing and non-manufacturing costs
The ability of all gains and revenues to cover all expenses and period costs;
Net Profit Margin
(may include comprehensive income that do not recycle to equity)
Measures the firm’s earnings ability; it does not equal cashflows. It may be
used to misrepresent operations, but are typically used for aggressive, short-
***EBITDA Margin
term, yet confident earnings projections. To be useful, it must be presented
alongside other relevant margins, usually the Operating Margin.
***Disregarding depreciation, amortization, and other fixed charges means that the company also
disregards the need for cash to cover investment costs or capital charges.
Other Profitability margins include the Returns Ratios. These are analyzed from the lenses of Investors,
and not from the lenses of managers. Hence, uncontrollable costs are attributed to the assets. These are
indicators of asset quality and to some extent, managerial performance or effectiveness.
This measures the company’s success in using financing to
Return on Assets
generate profits. It is also a good measure for solvency and risk.
Return on Equity These measure the company’s return to equity holders in the
Return on Common Equity business. This is in consideration of leverage, after all debts are
theoretically liquidated at any given date, only equity remains.
In properly assessing returns, income figures must be annualized, but asset bases or investment bases
must by only averaged within the time period. For example:
𝑸𝒖𝒂𝒓𝒕𝒆𝒓 𝟏 𝑰𝒏𝒄𝒐𝒎𝒆 ∗ 𝟒
𝑹𝑶𝑨 𝒐𝒓 𝑹𝑶𝑰 𝒐𝒓 𝑹𝑶𝑬, 𝒒𝒖𝒂𝒓𝒕𝒆𝒓𝒍𝒚 𝒑𝒓𝒐𝒋𝒆𝒄𝒕𝒊𝒐𝒏 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑨𝒔𝒔𝒆𝒕𝒔 𝒐𝒓 𝑬𝒒𝒖𝒊𝒕𝒚 𝒂𝒕 𝑸𝟏
• For Return on Assets specifically:
o Only operating assets can be included as Average Assets (This means that Investment
securities, Intangibles and Goodwill, Other Assets are excluded
o Unproductive and Idle Assets are not considered
o Accumulated Depreciation can be discarded for analysis
o Current Liabilities must be deducted from Invested Assets Figure
• For Return on Equity:
o Debt and Preferred stock can be discarded to include only common equity
• For Invested Assets (ROA, ROI, RI) – Fair Value should be used to reflect accurate returns
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• Income Figures in Returns Ratios

o If invested capital is defined as Total Assets, use EBIT to avoid accounting for interest from
financing
o If invested capital is defined as Common Equity, use EBIT less Preferred Dividends to avoid
accounting for cost of financing through preferred capital
o If the analysis is for a Parent Company, exclude NCINIS figures in net income and asset or
equity figures. Otherwise, if it is for Overall Company, include NCI figures in the analysis.
o NCINAS is a sub-figure of Retained Earnings, and will have already been included
in the Common Equity
o Income taxes are ALWAYS removed from the income figure; however, this is based already
on taxable amounts, per cashflow rules.

Activity Ratios – These are ratios associated with working capital, Cash Conversion Cycle and invested
capital such as Asset Turnover. (For an in-depth analysis of the CCC, see Working Capital) These involve
the Turnovers and Days in Accounts. Some special considerations are highlighted for brevity:

• General Considerations – instead of calculating the simple or daily Average of accounts, some
companies use the operating cycle days as a basis for averaging, that is, a period ending where
all inventories are depleted, and A/R is fully collected. (Based on long-term historical data)
• If data are available, it is preferred to generate averages on the most granular level. i.e., daily
balances averaged for each day of the year
• For projections on a quarterly basis or even monthly basis, the annualization above also apply.
• Some comparability issues must also be considered; for example, one must assess the impact of
using FIFO, Average, or LIFO in inventory valuation or Revenue Recognition. Adjust as necessary
• The Days in Account figures are staples in Incremental Analysis. Compute the Days in account
for each case to determine opportunity costs.

Liquidity Ratios – These ratios are related to a firm’s resiliency. This is regarding its current liabilities,
which is why these ratios are some measure of relatively quick liquidating assets over all current
liabilities. Some special things to note regarding these ratios are as follows:
• These are determined in points in time, so they reveal the firm’s resilience at a given point only,
and not over a period; as a theoretical representation of the sudden absence of further cashflows,
only those that remain will be used to settle dues.
• In relation to the Liquidity ratios, the activity ratios can be used to consider the ‘speed’ at which
a firm may be able to recover footing given a point in time.
• It begins with the Current Ratio, involving only the current assets. Removing liquid assets such
as inventory and prepayments (which are unrecoverable) will reveal the Quick Ratio, further
removing Receivables (which must cover a period before cash can be collected) will reveal the
Cash Ratio (an exception would be Receivables that are planned to be factored as these will still
be included)
• Cashflow Ratio – much like the returns ratios, this measures how much cashflows are attributed
to current liabilities. However, unlike the returns, it does not average the liabilities to provide
a conservative measure and express the worst-case in terms of available operating cash. (Care
must be exercised when using this ratio, as the period coverage decreases, the ratio increases.)
• Net Working Capital to Total Assets – This most useful as a trend analysis on a YoY basis to analyze
profit behaviors. As a liquidity measure, a declining YoY figure spells-out weakening resiliency.

Debt Priority for Current Liabilities – Consider:

Urgency Claims Covenants Currently due Long-term debts
Taxes first, Payroll next, Secured portions Violated loan covenants and currently maturing long-
Supplier Payables last or claims come term obligations must be observed closely
(for MS purposes only) after urgent dues
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Solvency Ratios – These ratios are related to a firm’s overall health, as these relate to its going-concern.
Some special considerations include:
• Capital Structure – More Debt vs Equity implies more risk and thus lower solvency.
• Leverage or Gearing – Total Assets over Equity – determines the amount of assets covering each
peso of equity. The larger the assets, the more debt is used to finance the firm, the larger the
earnings capacity per equity peso. Leveraged Firms have a gearing greater than 1 while
Unlevered Firms have a gearing equal to 1 (usually start-ups raised from personal equity).

If a Leveraged firm’s ROA > Cost of Debt, it is If a Leveraged firm’s ROA < Cost of Debt, it is
successfully trading on equity, or financing its unsuccessfully trading on equity, not financing its
assets well, and adds on shareholder wealth. assets well, and impairs shareholder wealth.
• Degree of Leverage vs Leverage – the Degree of Leverage is an assessment of its IMPACT on the
performance of the firm, while Leverage is an assessment of the firm’s STRUCTURE.

Market Valuation Ratios – These ratios are related to a firm’s value or desirability as an investment from
a common shareholder’s point of view. These are only meaningful for publicly-held corporations. (See
BVPS, BEPS and DEPS in FAR/AUD for in-depth discussions)
• These ratios are sensitive to earnings and accounting policy assumptions. It is essential that these
ratios are regulated and monitored closely to protect shareholder interests.
• The effect of dilution is a measure to reflect conservatism in shareholder returns

Earnings Quality
Earnings Quality – is the characteristic of a report that is measured by its capability to predict future
earnings of a firm. One must consider the following to express a quality report:
• Relevance and Faithful Representation
• The Company’s Business Environment
o Inflation will cause inventory profits or understated expenses such as Depreciation
o Surrounding political climate
• Character of Management
• In this regard, it is the same concept in Financial Accounting, only that we consider accuracy
over conservatism. This way, we assess the propriety and relevance of some aspects in reporting
i.e., Accounting Policies and Estimates/:
o Proper Revenue Recognition (IFRS 15)
o Proper Depreciation that best reflects underlying economic events/transactions
o Proper Asset Maintenance (Proper R&D Accounting and Expensing)
o Appropriate Disclosures
o FOREX Fluctuations
o Adjustments for Accuracy over Conservatism (e.g., Pension Fund Valuations)
o US GAAP to IFRS consolidation
Generally, Earnings Quality can be either Conservative (As required by Standard) or Aggressive (As
proliferated in Internal Reporting Practice.) In MAS, prefer an accurate representation of economic
events, which may not always be either conservative or aggressive reporting.
Earnings Persistence – Earnings are composed of various considerations called persistent components or
‘predictable’ attributes which allow an analyst to recast earnings for meaningful insights (i.e.,
normalization adjustments or fairness/basis adjustments)
• Earnings Variability – earnings fluctuations caused by business cycles are averaged over a long
time to ‘stabilize’ earnings for analysis.
• Earnings Trends – observing trends in earnings or patterns over periods of time
• Management Incentives – must be discarded in earnings figure to normalize income
• Earnings Management – Management’s discretion over accounting principles
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PROFITABILITY RATIOS
Gross Margin Pesos remaining after covering
Gross Profit/Gross Sales
cost
Profit Margin Net Income after Interest and Pesos remaining after
Tax/Net Sales discounts, interest, and taxes
Operating Profit margin (EBIT) Pesos remaining after all cost
Operating Profit/ Net Sales and expenses other than
interest & tax
Return on Assets or Earnings Net Income/Average Total Assets Income returned for each asset
Power OR Asset Turnover*EBIT purchased; a leverage measure
Return on Equity Income returned for each share
Net Income/ Average SHE of stock owned; a leverage
measure
Cash Flow Margin Cashflow from Ops/Net Sales Ability to convert sales to cash
ACTIVITY RATIOS
Receivable Turnover Net Credit Sales/Average AR Times AR is collected
Average Collection Period/ How long before AR is collected
Average AR*365/Net Sales
Days AR
Inventory Turnover COGS/Average Inventory Efficiency of Inventory activity
Days of Sales in Inventory How long before Inventory is
Average Inv*365/COGS
sold
Fixed Asset Turnover Efficiency of Fixed asset
Sales/Average Net Fixed Assets
activity
Total Asset Turnover Efficiency of how assets are
Sales/Average Total Assets
managed
Working Capital Turnover Net Sales/Working Capital or Adequacy of Working Capital
Operating Cashflows
Current Asset Turnover How fast current assets are
(COGS + OPEX)/Ave. Curr. Assets
realized
Return on Current Assets (RoCA) How much current assets are
NOPAT/Ave. Curr. Assets
returning in profits
Return on Fixed Assets NOPAT/Ave. Fixed Assets Asset Quality of Fixed Assets
Return on Curr. Asset Turnover RoCA/Curr. Asset Turnover The Profitability of each return
LIQUIDITY RATIOS
Current Ratio Pesos in liabilities covered by
Current Assets/Current Liabilities
assets
Quick Ratio (Cash+Receivables+ST Conservative measure of
Investments)/Current Liabs current ratio
Cash Ratio C&CE/Current Liabilities More Conservative version of CR
Payable Turnover Efficiency in managing
Net Purchases/Average AP
purchases
Days in AP Average AP*365/Net Purchases
Operating Cycle Days in Sales + Days in Inventory Length of time from sale to
+ Days in Cash goods to cash
Cash Conversion Cycle Amount of time it takes for
Days in Sales + Days in Inventory –
cash to be realized through
Days in Payables
operations
Days in Cash Ave. Cash Balance*365/Cash Cost Availability of Cash
Free Cash Flow Net Cash from Ops. – Cash used Free Cash for other needs
for Investments and Dividends
Capital Intensity Ratio Efficiency of firm to generate
Total Invested Assets/Net Sales
sales
Liability Intensity Ratio Total Debt/Net Sales Debt required to generate sales
Cash-Debt Coverage Ratio Net Cash from Ops./Ave. Liabs Indicator for Liquidity Issues
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SOLVENCY RATIOS
Debt to Asset Ratio Mix of Liab for each peso of
Total Liab/Total Assets
asset
Debt to Equity Ratio Total Liab/Total SHE Dependency for credit or equity
Times Interest Earned Ability to make interest
EBIT/Interest Expense
payments
Times Fixed Charges Earned Net Income Before Taxes and Measure of coverage capability
(Lease Pmts., etc.) Sunk Costs/Sunk Costs
Working Capital to Total Assets Relative liquidity of total assets
(C. Assets – C. Liab)/Total Assets
and distribution
MARKET VALUATION RATIOS
Price to Earnings Ratio How a stock earns vs to what it
Stock Price/EPS
costs
Book Value per Share Ordinary SHE/WAOCS Outstanding Measure of performance
Earnings per Share How much a common share
Net Income/Outstanding OCS
earns
Dividend Payout Dividend paid in relation to
Ordinary Cash Dividend /EPS
earnings
Dividend Yield Dividend paid in relation to
Annual Dividends/MV of Shares
current price
Shareholders’ Returns These are the total gains a
Holding Gains + Dividends /
shareholder may realize from
Acquisition Cost
holding a share.
Holding Gains These are gains that are not
Change in Stock Price realized until the share is
resold at a secondary market
Other Concerns for Ratio Analysis
Du Pont Disaggregation Analysis – Shows the return on equity as described by asset management,
financial leverage, and profitability of the firm
Return on Equity = Net Income/Average SHE = Profit Margin * Asset Turnover * Equity Multiplier
𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 𝑜𝑟 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝐴𝑠𝑠𝑒𝑡𝑠/𝐸𝑞𝑢𝑖𝑡𝑦
• The Return on Equity is used to value firms that use Financial Leverage (External)
Return on Assets = Net Income/Average Assets = Profit Margin*Asset Turnover
• The Return on Assets is used to value firms/entities that are not financed with debt/not levered.
(i.e., Profit Centers/branches); and are indicators of Asset Quality (Internal)
Financial Liquidity – Relationship of Cash to Assets and Liabilities
𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐶𝑎𝑠ℎ 𝐷𝑒𝑏𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑟 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝑟𝑎𝑡𝑖𝑜 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑡𝑖𝑖𝑒𝑠
Financial Flexibility – Ability to adapt to financial adversity
𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐷𝑒𝑏𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑡𝑖𝑖𝑒𝑠
Free Cash flow – Cash from Operations – Capital Expenditures – Dividends = Net FCF
Integrated Reporting
Integrated Reporting adds to the traditional FS Disclosures by considering other dimensions or ‘Capitals’
of the firm. These are:
Financial Intellectual Social and Human Manufacturing Natural or
Relationship Environmental
Each of these Capitals are integrated to contain 8 Content Elements:
Organizational
Overview and External Governance Business Model Risks and Opportunities
Environment
Strategy and Resource Basis of Preparation
Performance Outlook
Allocation and Presentation
As it is a new framework (recently established last 2013), it is dubbed as ‘<IR>’
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It is <IR because it aims to produce reports that are clear and concise; however, it is also IR> because it
aims to be as broadly encompassing and comprehensive as possible by considering 6 Capitals. All this is
because it aims to produce reports that cover Value-creation.
It has its pros and cons still:
Pros Cons
• It is quite a complex challenge to roll-up
this information following this framework
as subsidiaries may not be able to
• The most important points are
capture comprehensive information for
highlighted for all users of information in
higher levels.
relation to the firm, not just covering
• It is burdensome to comply with,
financials.
especially for smaller firms
• It reduces information asymmetry for
• There are no reporting standards that
individuals that rely on these reports,
enforce its practice
hence the efficient allocation of
• It has no quantifiable benefits whilst
resources
costing significant investment
• Forward-looking reports breed litigation
risk (showing plans or outlooks)
Analysis Limitations and Best Practices
A well-informed analyst can still miss-out on accounting for the effects of some factors that they have
no control over and may not even be known explicitly due to information asymmetry. Certain limitations,
both mandatory (such as Laws on Data Privacy and Insider Trading) as well as implicit ones, can distort
a proper view over a company. One must be on the lookout for the following:
• Analysis should be comprehensive and robust. All proper dimensions of analysis should be taken
into consideration in order to have a full appreciation of the information available. One must
have the due diligence to investigate financial situations that reflect both the quantitative and
qualitative aspects of the enterprise.
o Comparing across time-periods throughout all dimensions (vertical, horizontal, ratio)
• Comparing across industries and across firms will have to be consistent; thus, adjustments for
valuation methods as well as accounting policies must be accounted for in FS Analysis
• One must be on the lookout for impaired Earnings Quality as discussed above (One aspect for
instance, would be EPS Manipulation)
o Accounting Errors and Cut-off considerations
o Adjust by the Inflation Factor (n/1+i)
o OCI Recycling to Equity (Affects Gearing)
o FOREX Fluctuations (Affects all dimensions of analysis, see AFAR)
o Gearing or Leverage (depending on the investment type; to be discussed later)
o Determine changes in Estimates
o Determine Changes in Policies
o Determine M&A’s, Divestitures, and other extraordinary events
o Sufficiency of disclosure and considering Off-balance sheet accounting
o The proper Consolidation Approach in Due Diligence Valuation (See AFAR)
o The proper Ownership Attribution or Capital Attribution basis (See AFAR)
• All information acquired must be contextualized to real-world events. These can be gathered
from the news and other watchdogs which keep a tab on firms and corporate activity.
o Observe Industry Trends and set benchmarks for comparisons
• Due diligence must be considered in making sure that the analysis is in good faith and most
importantly, accurately reflects the underlying event that causes the figure.
• Apply innovative analytics such as determining:
o Economic Value-added
o Economic Profit (Accounting Profit less Opportunity Costs)
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Economic Profit
Economic Profit – the amount by which total revenue exceeds the total economic costs of the company.
Total economic costs include all explicit costs that are paid by the firm as well as the relevant implicit
costs (opportunity costs.)
Accounting Profit – the profit that is calculated on the income statement. It is calculated as revenues
minus explicit costs. These are the costs for which the company actually has to make a payment to
another party. However, a company also has implicit costs, and implicit costs are not presented anywhere
in accounting profit or formally in any financial statement.
Opportunity Costs – These are the forgone best alternatives that had to be dismissed in order to achieve
a goal. For example, in order to make a deal, a businessperson has to devote time to prepare for the
contracts and negotiations, and that is forgone time that can no longer be used for another deal. Hence,
the cost of this lost time is one of the costs that should be considered. Similarly, a truck that is carrying
aluminum cannot simultaneously carry iron if it is already full. Comparing how much a company is giving
up if it chooses to transport one over another is part of the determination of opportunity cost and
economic costs in general.
***Economic profit will never be higher than accounting profit because both use the same basis of
revenue, but Economic profit includes implicit costs which Accounting profits omit.
Kinds of Economic Profit
Interest Lost This is the cost of placing money in another
investment costing the same to fund. Considering
any amount of cash that can be invested in two
projects that earn different incomes, the interest
lost is the cost of funding the alternative,
assuming it would have been chosen instead.
Alternative Accounting Profits This is the net benefit of taking an alternative
decision that is lost by taking a chosen option,
provided that this decision is mutually-exclusive
from the chosen option.
Normal Profit or Un-booked profits Normal profit is the value of entrepreneurial skills
an individual possesses. These are wages an
individual sacrifices in order to choose an
alternative.
Economic Depreciation Economic Depreciation is the depreciation of
Assets at fair value; it is likened to Revaluation
adjustments. This is considered an opportunity
FV of Asset at the beginning of the year ÷ cost because it is the cost of choosing an asset to
Remaining Useful Life = Economic Depreciation be used today instead of the past. If the market
value of the underlying asset is lower than book
value, the opportunity cost is actually a benefit.
Computation:
Revenue XX
Explicit Costs: (All Payments and book value depreciation) (XX)
Accounting Profit XX
Lost Interest (XX)
Lost Wages (XX)
Lost Accounting profit (XX)
Economic Depreciation differential (XX)
Economic Profit XX
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Working Capital Management

• Concerned with the determination of the optimal level, mix, and use of current assets and
current liabilities
• Objective – to minimize cost of maintaining liquidity while guarding against insolvency, and
increasing profitability
• Management of Current Assets – requires the determination of the appropriate mix of components
considering safety, liquidity, and profitability
• Permanent Current Assets VS Temporary Current Assets – Businesses experience cyclical
fluctuations; hence some periods of the year are devoted to liquidating inventories and
receivables, some others are devoted to stocking-up.
Gross Working Capital Net Working Capital
Current Assets Current Assets less Current Liabilities
Working Capital Policies
Maturity Matching Aggressive or Restricted Funds Conservative or Lax Funds
• Permanent Current • Some Permanent assets • Long-term capital is
Assets and Fixed Assets are financed with used to finance all
are matched with Long- Short-term Debt permanent assets and
term Capital • Working Capital is to meet some seasonal
• Temporary Assets are minimal, hence has low needs
matched with Short- interest expense but • Minimizes liquidity risk
term Debt high profits and ROI by increasing Net
• Draws importance from • Usually for start-ups Working Capital, hence
the analysis of the • Maximizing Return on high interest expense
Operating Cycle or Cash Investment but exposed and low profits and ROI
Conversion Cycle liquidity • Scores High on Acid-test
STD, CA; LTD, NCA STD, NCA & CA; LTD, NCA STD, CA; LTD, CA & NCA
Cash Management
Motives for holding Cash
Transactional Precautionary Speculatory Regulatory/Contractual
For Operations For Emergencies For Investments For Banking relations
Floats – The difference between a bank’s balance to the book’s balance to cash
• Positive Float – Bank > Book; encouraged; Payable Float
• Negative Float – Book > Bank; minimized or eliminated; Receivable Float
Idle Cash should be invested into Marketable Securities
Accelerate Cash Collections Slow down disbursements
• Bill Promptly • Stretch Payables
• Grant Cash Discounts • Maintain zero-balance accounts (no
• Use Lockboxes maintaining or compensating balance)
• Ease out the collection process in terms of • Maximize the float
logistics • Forego cash discounts if the cost of holding
cash is greater than the implicit cost of credit
In Summary, Decrease the Cash Conversion Cycle
Baumol Cash Management Model
o Concerned with identifying the optimal cash balance provided, that marketable securities are
available for immediate disposal. Ideally, marketable securities should be easily salable, but also
slow to mature even if these are held for sale.
o T = Cost of selling the securities or Transaction Cost of obtaining the loan
o i = Opportunity Cost – Cost of holding cash AND income foregone by not investing in securities OR
Cost of Capital
Total Cost = Transaction Cost + Opportunity Cost or Holding Cost
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T = Transaction Cost (Marginally

decreases for every peso borrowed in a
transaction)

i = Cost of Borrowing Cash + Interest

Income foregone – Interest Income
incentive

D = Demand for Cash over a period of

time (adjust all other rates to match
the period of time)
**The relative minimum of the Total
2𝑇𝐷 Cost function is the optimal balance of
𝑂𝑝𝑡𝑖𝑚𝑎𝑙 𝐶𝑎𝑠ℎ 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 = √ cash since it minimizes cost
𝑖 **2 indicates that the opportunity cost
is actually averaged over the period
Differential Analysis for Systems Implementation
Effect Formula Remarks
Accelerated Collection Daily Collections * Peso Value Not time valued, as benefits are
* Days Saved instantaneously realized once.
Cost of Implementation Daily Transaction Cost Time valued, usually at perpetuity,
÷ Daily Opportunity Cost since systems improvements are
(frequency should match) generally permanent.
If the requirement is the net savings, apply Future Value for costing.
(Annual Savings = FVOA of Benefit less Annual Costs = FV of Transaction Costs)
Trading Securities Management
• Trading securities are generally managed for working capital concerns.
• They are generally purchased to avoid having idle resources, and as much as possible, must be
sold for gains.
• Ideal securities would be those from the government such as treasuries, and those that maximize
the entire fiscal year considering:
Yield or Profitability upon realization Safety from Decrease in Value
Maturity Period Marketability
• Generally, the further away these are from becoming cash equivalents, and the less exposed
these are from risk, the more beneficial it is to acquire these securities. Essentially, the effect
will be to hold on to the securities until they reach their maximum maturity.
Receivables Management
Credit Policy – the primary determinant of Accounts Receivable
Credit Period Discounts Credit Standards Collection Policy
• Customers prefer • Discounts stimulate • Strict – eliminates • For Past due
longer credit sales non-payment but accounts
periods, longer = • Discounts shorten decreases potential • Credit Terms –
stimulate sales the cash conversion sales statement of credit
• Lengthen credit cycle • Liberal – increases period and discount
period = larger cash • Peso revenues may sales but higher bad policy (Cash
conversion cycle be lower, more debts discounts and
• Longer receivable goods sold • Factors: Character, collection costs
outstanding = more Capacity, Capital should also be
likely to default (Collateral), considered)
Conditions
Overall, Reducing AR balance will require:
Shorten credit terms, offer cash discounts, minimize the float, administer collection centers
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Policy Effect
Sales Volume will Increase Net Income will Increase
A/R will Increase Net Income will Decrease
Relaxing Credit Terms
Bad Debts will Increase Net Income will Decrease
**in bold are the benefits of each
Collection Costs will Increase Net Income will Decrease
policy
Opportunity Costs will Increase Net Income will Decrease
Sales Discounts will Increase Net Income will Decrease

Sales Volume will Increase Net Income will Increase

Increasing the Credit Period A/R Balance will Increase Net Income will Decrease
Bad Debts will Increase Net Income will Decrease

Sales Volume will Increase Net Income will Increase

Cash Sales and Undiscounted Net Income will Increase
Sales will Decrease
Increasing the Discount Period
Credit Sales and Discounted Sales Net Income will Decrease
will Increase
Bad Debts will Decrease Net Income will Increase

Sales Volume will Increase Net Income will Increase

Cash Sales and Undiscounted Net Income will Increase
Sales will Decrease
Increasing the Cash Discount
Credit Sales and Discounted Sales Net Income will Decrease
will Increase
Bad Debts will Decrease Net Income will Increase

Sales Volume will Decrease Net Income will Decrease

A/R Balance will Decrease Net Income will Increase
Stringent Collection Policy
Bad Debts will Decrease Net Income will Increase
Collection Expenses will Increase Net Income will Decrease
Incremental Analysis of Accounts Receivable Policies
Net Incremental Profit:
Increase in Contribution Margin due to Increase in Sales Volume XX
Decrease (Increase) in Bad Debts (XX)
Decrease (Increase) in Collection Costs (XX)
Decrease (Increase)in Sales Discounts (XX)
Total XX
Increase in Cash Balance or Decrease in A/R or Savings from Opportunity Cost:
A/R from Old Policy XX
A/R from New Policy (XX)
Incremental A/R XX
Multiplied by Opportunity Cost X% XX
Incremental Benefit XX
Increase in A/R Balance or Opportunity Cost due to relaxed Credit or Discounts:
A/R from Old Policy XX
A/R from New Policy (XX)
Incremental A/R XX
Multiplied by Opportunity Cost X% (XX)
Increase in A/R Balance or Opportunity Cost due to Increase Sales Volume:
Incremental A/R XX
Multiplied by Variable Cost X
Multiplied by Opportunity Cost X% (XX)
Net Incremental Benefit (Cost) XX
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• Do note that the incremental analysis will certainly differ across all the credit policies. Some
policies will require the analyst to use the aggregate A/R from the new policy, and some others
require just the incremental or decremental amount.
o For instance, lengthening the credit or discount period of receivables will most likely require
that all of them be subject to discounts. Some problems may indicate that only new and
projected balances will be under the new policy, while old balances follow the old policy.
As such, the incremental analysis will only apply to the incremental amount, i.e., the
projected or budgeted receivables only.
• Also note that the Opportunity Cost must be net of Tax effects.
• If the Policy involves increases in Sales Volume, the Variable Cost is considered; if there are no
indications for increases in sales volume, ignore Variable Costs.
• Segregate the Effects the policies according to the factors applicable: i.e., variable costs and
opportunity costs.
• Income Statement amounts do not apply opportunity costs
• Balance sheet amounts apply opportunity costs
• It is also worth to note that collection periods may also differ across problems. Some may be
expressed in days, others in months or years. This will influence the level of receivables.
o E.g., A credit policy was relaxed. The collection period was extended from 10 days to 15
days. This means that Accounts Receivables are expected to stay in the balance sheet for
fifteen days before being converted into cash. An Incremental amount of receivables within
5 days are effectively considered Opportunity Costs since these were not converted into
cash as early as before
o Also, the receivables will necessarily be affected by sales volume increases, hence the
incremental receivables due to increase in volume will also add to the cost savings of having
a faster turnover of receivables for that time
• It is very useful to identify the Days in Sales Outstanding and Accounts Receivable Turnover
for Incremental Analysis as it reveals the difference in the volume of receivables going in and
out of the balance sheet. Express the same in terms of the problem’s units
Inventory Management
Economic Order Quantity – A deterministic model that calculates the ideal order quantity given a
specified demand, ordering and carrying costs.
Assumptions:
o Fixed quantity for every order
o Purchase costs are unaffected by quantity ordered
o Purchase order lead-time is known with certainty
o Adequate inventory is always maintained to avoid stockouts
Ordering Costs – Transportation Costs, Carrying Costs – Storage, Opportunity Cost or Cost
Administrative Costs (Receiving and Inspecting) of Capital, Spoilage, Insurance, Capitalizable Cost

No. of Orders = Annual Demand/Order Quantity Average Inventory = Order Quantity/2; Total
Total Ordering Costs = No. of Orders * Cost per Carrying Costs = Average Inventory * k
order (Freight-in, although also an ordering cost, is
capitalizable)

2𝑎𝐷
𝑂𝑝𝑡𝑖𝑚𝑎𝑙 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 = √
𝑘
a = Ordering Cost; k = Carrying Costs; D = Inventory Demanded over a period of time
Essentially, what the Economic Order Quantity attempts is to determine is the minimum combination
of Carrying and Ordering Costs, enough so that a Stock-out Cost could also be avoided. Hence, the EOQ
will yield a quantity wherein the Carrying Cost formula and the Ordering Cost formula intercept in a
graph.
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Reorder Point Model – required to avoid stock-out problems. Ordering at a point in time not to run
out of stock before receiving new orders, but not so early such that excesses are incurred

Lead Time = Period between time of placing the order and receiving the order
Normal Lead Time Usage = Normal Lead Time * Average Usage
Safety Stock = (Max Lead Time - Normal Lead Time) *Average Usage

No Safety Stock: Reorder point = Normal Lead Time Usage

With Safety Stock: Reorder Point = Safety Stock + Normal Lead Time Usage OR
Reorder Point = Max Lead Time * Average Usage
Average Usage = Annual Demand/Any unit of Time

Observe that at the minimum point, carrying or

holding costs and ordering costs are equal.

When the inventory incorporates the safety stock, the amount of the safety stock becomes the minimum
amount, while the EOQ becomes the maximum amount. In this case, the average inventory changes, and
the Carrying cost must also change. Necessarily, the change in the carrying cost will also result in a
change in the overall ordering costs.
The EOQ Model is always used under JIT Systems of production as it shares similar characteristics of
matching demand strictly and acquiring strong favorable relationships with the supplier in order to fully
ensure quality and predictability of stock-outs and reordering needs.
Appendix: Computing non-base 2 nth Roots using Basic Calculators
Steps Sample output Reasoning
1 - type in the amount on the calculator 4096 For any natural number only
2 – tap the (sqrt) symbol 12 times 1.00203… This gives the degree of
approximation. Any amount
less than 12 will return a less
precise amount.
3 – deduct 1 0.00203… This gives the rooted factors of
4 – divide by n (for example, 4th root) 0.000508191… the amount provided. It is
5 – add 1 1.000508… important that the amount is
6 – tap the multiply sign (‘x’) first then the equal 1.0010… multiplied to the previous
sign (‘=’) successively 12 times 1.00203… amount to replicate a
successive multiplication back
… ~8 into the root.
For base 2 nth roots (2,4,8,16), simply tap the (sqrt) symbol n 2 times
Try this out for the Miller-Orr cash balance model with this formula:
3 3𝐹𝛿 2
F = Transaction Cost L = Lower control limit
𝑍 ∗ 𝑜𝑟 𝑆𝑝𝑟𝑒𝑎𝑑 = √ +𝐿 δ2 = Standard Deviation or Safety stock of Cash,
4𝑖 of Cashflows if silent, assume no
1 i = Interest rate control limit
𝑅𝑒𝑡𝑢𝑟𝑛 𝑃𝑜𝑖𝑛𝑡 = 𝐿 + 𝑍
3
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Cost of Short-term Credit and Time Value

Current Asset Financing
Criteria Short-term Financing Long-term Financing
Cost Lower Higher
Interest Rate Risk Fluctuates widely Relatively Stable
Bankruptcy Risk Recessions may make it difficult Recessions may not affect it
to repay adversely
Negotiation Faster Slower i.e., Credit Screening
Flexibility Easier to Refinance Difficult to Refinance
Provisions Fewer Restrictions More Restrictions

Source Description Cost of Financing

Free Trade Credit – Credit With Trade Discount
Received During Discount Incur a Cost of Credit if a trade discount is given, but not
Period taken (Same as Cost of Commercial Paper)
𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕 ′𝒇𝒐𝒓𝒆𝒈𝒐𝒏𝒆′ 𝟑𝟔𝟓
Accounts ×
Payable Costly Trade Credit – 𝑵𝒆𝒕 𝑷𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔 𝑫𝒂𝒚𝒔 𝑪𝒓𝒆𝒅𝒊𝒕 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈−𝑪𝒓𝒆𝒅𝒊𝒕 𝑷𝒆𝒓𝒊𝒐𝒅

Credit taken beyond Free The interest is actually the discount foregone; it is the
Trade Credit (Discount ‘penalty of not taking a discount’ so to speak.
Lost) No Trade Discount
Invoice Price – Cash Paid = Implicit Cost of Credit
Discounted Interest Regular Interest Rate: (Problem is silent, regular i%)
Increases Borrowing Cost Interest/Borrowed Amount
(Since interest is deducted
in advance) Discounted Interest Rate:
Interest/ (Borrowed Amount – Interest)
Commercial Effective Interest Rate (If Discounted w/ CB)
Bank Loans Compensating Balance ->
Increases Borrowing Cost Interest/ (Borrowed Amount – Interest – CB)
(Since Compensating If Compounded:
𝑛
Balance is unusable 𝐸𝐴𝑅 = (1 + )𝑓 − 1
𝑓
elsewhere)
Where n is the Nominal Rate, and f is the # of compounding
periods.
Commercial Short-term, unsecured 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
×
𝟑𝟔𝟓

Paper note payable 𝑼𝒔𝒂𝒃𝒍𝒆 𝑨𝒎𝒐𝒖𝒏𝒕 𝑫𝒂𝒚𝒔 𝒕𝒐 𝑴𝒂𝒕𝒖𝒓𝒊𝒕𝒚

Accrued Expenses are Liabilities that have been provided to the company, not yet paid. They have no
implicit cost of credit.
Deferred Income and Advances from Customers are services or goods that considered sold but not yet
delivered. They have no implicit cost of credit
Time Value of Money
• Lump-sums – A single sum of money earns uniform interest until maturity
• Installments – Multiple sums of money earn different proportions of interest until maturity;
accordingly, interest is expected to decline, and that the balance in an amortization schedule
should be zero
• Present Value of Money – Deals with discounting, given a rate of interest to be earned, a peso
tomorrow is actually worth less today
o Determine the point where the money is paid; the farther it is from the current date, the
smaller the discount factor. This applies to installment payments and lumpsums.
• Future Value of Money – Deals with compounding, given a rate of interest to be earned, a peso
today is worth more tomorrow
**Use Lump-sums for amounts that are paid once, use Installments for amounts paid in serial
**If the installments are not even, use a lump-sum Present Value or Future Value for each uneven payment
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Other Financial Instruments and Arrangements

• Serial Notes or Add-on Interest Loans
2 ∗ # 𝑜𝑓 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 ∗ 𝑖%
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑟𝑒𝑑𝑖𝑡 =
(𝑇𝑜𝑡𝑎𝑙 # 𝑜𝑓 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 + 1) ∗ 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
• Loan with Existing balance for compensating balance – the cost of credit is adjusted only for
the additional amount missing from the compensating balance already in the accounts with the
bank. In case the account exceeds the compensating balance, ignore the excess and the
compensating balance requirement.
o Since the proceeds will essentially be covered by an existing balance, there is no more need
to maintain a different compensating balance when the bank already has a balance to claim
funds from.
• Revolving Credits – A Committed line of credit that involves a commitment fee to compensate
the bank for setting aside funds to commit to finance a company’s needs (Apply effect of
compensating balances and discounts if provided for)
𝑖% + 𝐶𝑜𝑚𝑚𝑖𝑡𝑚𝑒𝑛𝑡 𝐹𝑒𝑒
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑟𝑒𝑑𝑖𝑡 =
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑜𝑓 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑃𝑜𝑟𝑡𝑖𝑜𝑛 − 𝐶𝑜𝑚𝑚𝑖𝑡𝑚𝑒𝑛𝑡 𝐹𝑒𝑒
• Line of Credit – Maximum Credit an account may avail; same with any commercial paper, except
that the principal pertains to the amount currently borrowed, and not the entire credit line that
the bank promises to provide in the future
Secured Sources of Short-term Credits (Asset Management for Credits)
• Receivable Financing – Pledging and Assignment only
• Inventory Financing – using inventory to collateralize loans
• Floating Liens – The Inventory in a private space is the entire collateral for a loan, i.e., Trust
Receipt Loans, Warehouse Receipt Loans, Terminal Warehouse Receipts, and Field
Warehouse Receipts
• Chattel Mortgage – Mortgages on Movables and personal properties
𝐹𝑖𝑛𝑎𝑛𝑐𝑒 𝐶𝑜𝑠𝑡𝑠 𝑖. 𝑒. 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡𝑠, 𝑒𝑡𝑐.
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑒𝑐𝑢𝑟𝑒𝑑 𝐶𝑟𝑒𝑑𝑖𝑡 =
𝑁𝑒𝑡 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝑓𝑟𝑜𝑚 𝑡ℎ𝑒 𝑡𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛
Unsecured Sources of Short-term Funds
• Trade Credit or Spontaneous Sources of Financing – These are the Cash Discounts taken for
prompt payments. Discounts are foregone if storing cash away is costlier than losing discounts
• Commercial Bank Loans – A loan given by banks. These are taken usually to weather the seasonal
peaks in financing due to inventory build-up and accounts receivable piling up. These are taken
to meet working capital requirements in other words.
• Commercial Papers – Short-term, unsecured promissory notes issued by firms with high credit
ratings. These usually range from 90 to 270 days.
Appendix: The Effective Annual Rate
𝑃𝑉 𝑜𝑓 𝑋−𝑃𝑉 𝑜𝑓 𝐻𝑅
𝐼𝑛𝑡𝑒𝑟𝑝𝑜𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡ℎ𝑒 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑅𝑎𝑡𝑒 𝑔𝑖𝑣𝑒𝑛 𝑃𝑋𝑋 = 𝐻𝑅 − [(𝐻𝑅 − 𝐿𝑅) ∗ ]
𝑃𝑉 𝑜𝑓 𝐿𝑅−𝑃𝑉 𝑜𝑓 𝐻𝑅
**Begin the estimation from the Nominal Rate of the Debt. The Effective rate must certainly be higher
than it if the debt is acquired at a discount, lower if it is acquired at a premium
**If the instrument is compounded more than once a year, then apply the same PVs but divided according
to the number of periods applicable
**Repeat the interpolation process as necessarily as possible to acquire an accurate result
𝑛 ‘f’ is usually given. For Trade Credit however,
𝐸𝐴𝑅 = (1 + )𝑓 − 1
𝑓 f=365/(n-d) days; for annualizing, n = discount%.
Generally, when the credit compounds annually, the nominal rate is the same as the effective rate,
otherwise, annualizing the rate is necessary. First, get the nominal amount and divide it by the
frequency, then add 1. Store the amount using (‘M+’). Press (‘MR’) and multiply it by itself then press
(‘=’) successively for f times. If f is fractional, convert it to a mixed fraction. Apply these steps to the
Whole number component, and add it to the same base but using the nth root computation shown earlier.
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Risks and Returns

Risk and Returns – Business and Financial Risk combine to determine the total risk of a future RoE.
Business Risk – Risk faced by a firm if it had no debt; inherent to its operations
e.g., Variability in product Demand, Exposure of sales price and costs, Ability to bring in new products,
International Operations, Operating Leverage
Financial Risk – Additional risk placed on shareholders as a result of the decision to finance w/ debt
Investment Behaviors
Risk Averse Risk Neutral Risk Seeking
Conditionally accepts risk Unconditionally ignores risk Only accepts high returns
Estimating Returns
Arithmetic Average Return – Add the historical Geometric Average Return – Compounded
returns for n periods divided by n periods used for returns for n periods. Used for longer periods.
shorter n periods
Measures of Risk or Volatility
• Standard Deviation – Measures the tightness of the probability distribution; a tighter bell curve
entails smaller risk (compute for each scenario)
P = Probability, R = Rate of Return, ER = Expected Rate of Return, 𝝁= Population Mean, 𝑥̅ = Sample Mean
𝒙−𝝁
∑ 𝑷((𝑹 − 𝑬𝑹)𝟐 ) = 𝑽𝒂𝒓𝒊𝒂𝒏𝒄𝒆 √∑ 𝑷((𝑹 − 𝑬𝑹)𝟐 ) = 𝑺𝒕𝒅 𝑫𝒆𝒗 (𝜹) 𝑺𝒕𝒅. 𝑺𝒄𝒐𝒓𝒆 (𝒛) =
𝝈
• Value at Risk – the potential loss in value of a portfolio given a time period and confidence level.
𝑽𝒂𝑹 = 𝝁 − 𝜹𝒛
𝑽𝒂𝑹 = 𝑨𝒎𝒐𝒖𝒏𝒕 ∗ 𝒛 ∗ 𝜹, 𝑔𝑖𝑣𝑒𝑛 𝑛𝑡ℎ 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑖𝑙𝑒
The VaR is taken from the distribution of returns
in a portfolio. Under the variance-covariance
method (using any probability distribution of
returns), it is a one-tailed curve that shows the
worst-case loss given a confidence level (usually
at 95%). (The Sd may be applied as Volatility for
projecting VaR.)
**Given a std. score, a corresponding z-value
is acquired using a standard z-table. The area under the bell curve corresponding to
the significance level in the given probability
distribution will return the VaR.
• Coefficient of Variation – shows risk on a per unit basis, allowing for comparability across two
alternatives (It is a relative measure that allows a per unit of return comparison of deviation).
This is used in assessing individual securities.
𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝑫𝒆𝒗𝒊𝒂𝒕𝒊𝒐𝒏
= 𝑪𝒐𝒆𝒇𝒇𝒊𝒄𝒊𝒆𝒏𝒕 𝒐𝒇 𝑽𝒂𝒓𝒊𝒂𝒕𝒊𝒐𝒏
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑹𝒆𝒕𝒖𝒓𝒏𝒔
N.B. It is worth to note that though risk & return are directly related, this does not mean a unitary
relationship. It simply means that a unit of return will always be positive relative to a unit of risk.
• Covariance – shows the direction of variables of two samples, relative to each sample
• Correlation – or r measures the strength of the relationship between variables in a sample (x) or
between samples (x, y).
∑[(𝒙 − 𝒙𝝁 ) ∗ (𝒚 − 𝒚𝝁 )] ∑(𝒙 − 𝝁)𝟐
𝑷𝒐𝒑𝒖𝒍𝒂𝒕𝒊𝒐𝒏 𝑪𝒐𝒗𝑵 (𝒙, 𝒚) = 𝒐𝒓 𝒓(𝒙) =
𝑵 𝑵
∑[(𝒙 − 𝒙𝝁 ) ∗ (𝒚 − 𝒚𝝁 )] ̅) 𝟐
∑(𝒙 − 𝒙
𝑺𝒂𝒎𝒑𝒍𝒆 𝑪𝒐𝒗𝒏−𝟏 (𝒙, 𝒚) = 𝒐𝒓 𝒓(𝒙) =
𝒏−𝟏 𝒏−𝟏
𝑪𝒐𝒗(𝒙, 𝒚) ∑(𝒙 − 𝝁)𝟐
𝑪𝒐𝒓𝒓𝒆𝒍𝒂𝒕𝒊𝒐𝒏 𝝆(𝒙, 𝒚) = 𝒐𝒓 𝒓(𝒙) = √
𝝈𝒙 𝝈𝒚 𝑵

r = 1; perfect r = -1; inverse correlation r = 0; no correlation; hence, the risk is determined

correlation = no hedge = perfect hedge based on weighted average SD of all securities.
• Coefficient of Determination or Variance – Or r-squared, measures the differences of the
observations from the sample or population average.
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𝑻𝒐𝒕𝒂𝒍 𝑽𝒂𝒓𝒊𝒂𝒕𝒊𝒐𝒏 𝒏 ∑(𝒙𝒚) − ( ∑ 𝒙) ∗ (∑ 𝒚)

𝒓𝟐 = 𝟏 − ( ) 𝝆(𝒙, 𝒚) =
𝑼𝒏𝒆𝒙𝒑𝒍𝒂𝒊𝒏𝒆𝒅 𝑽𝒂𝒓𝒊𝒂𝒕𝒊𝒐𝒏
𝑺𝒖𝒎 𝒐𝒇 𝑺𝒒𝒖𝒂𝒓𝒆𝒅 𝑹𝒆𝒈𝒓𝒆𝒔𝒔𝒊𝒐𝒏 √[𝒏 ∑(𝒙𝟐 ) − (∑ 𝒙)𝟐 ][𝒏 ∑(𝒚𝟐 ) − (∑ 𝒚)𝟐 ]
𝒓𝟐 =
𝑺𝒖𝒎 𝒐𝒇 𝑺𝒒𝒖𝒂𝒓𝒆𝒅 𝑻𝒐𝒕𝒂𝒍 r= correlation; r2=coefficient of determination
• Sharpe Ratio – Shows the average returns earned in excess of a risk-free rate per unit of volatility
or total risk. The return of the portfolio less the risk-free returns all over the standard deviation
of the portfolio’s returns
(𝑹𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 − 𝑹𝒓𝒊𝒔𝒌−𝒇𝒓𝒆𝒆 ) ÷ 𝛿 = 𝑺𝒉𝒂𝒓𝒑𝒆 𝑹𝒂𝒕𝒊𝒐
• Alpha – Measures the risk relative to the market or a selected benchmark index. It is used to
describe the edge of a portfolio over the market. It is also called excess return or abnormal RoR
𝑨𝒄𝒕𝒖𝒂𝒍 𝑹𝒆𝒕𝒖𝒓𝒏𝒔 − 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑹𝒆𝒕𝒖𝒓𝒏𝒔 = 𝜶
• Beta – Measures the systematic risk of the market or the selected benchmark index. It allows the
comparison of the movement of an investment’s returns relative to the market’s own movement
of returns. This is used for portfolios with varied securities. It is the slope of the line of best-fit
of covaried securities to the market or the SML. (A stock is covaried with the market return)
𝑪𝒐𝒗𝒂𝒓𝒊𝒂𝒏𝒄𝒆
𝒐𝒓
𝑪𝒐𝒓𝒓𝒆𝒍𝒂𝒕𝒊𝒐𝒏 𝑪𝒐𝒆𝒇𝒇𝒊𝒄𝒊𝒆𝒏𝒕 ∗ 𝑺𝒅 𝒐𝒇 𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐
=𝜷 If 𝛃 > 𝟏; Investment is volatile and riskier;
𝑽𝒂𝒓𝒊𝒂𝒏𝒄𝒆 𝑺𝒅 𝒐𝒇 𝑩𝒆𝒏𝒄𝒉𝒎𝒂𝒓𝒌 𝒐𝒓 𝑴𝒂𝒓𝒌𝒆𝒕 otherwise, it is less volatile and less risky
• Degree of Combined Leverage – The sensitivity of a firm towards changes in Business risk
DOL DFL DCL
CM/EBIT EBIT/(EBIT - Interest Expense) DOL * DFL
When to Use these Formulas:
• For a Single Security or Stand-alone Investment – the Coefficient of Variation is used to assess
individual securities. The smaller the Coefficient, the less risky the security.
o Investors are typically risk averse and will typically choose an investment with a low CoV.
• For a Portfolio of Securities or Diversified Investment – the portfolio’s beta is used assess across
portfolios. It is simply the weighted average Beta of each security in the portfolio.
o The overall risk in a portfolio is typically the Systematic Risk plus the Diversifiable Risk; the
Systematic Risk is represented by the Beta, and the Diversifiable risk is represented by the
Hedged returns across investments.
o Generally, the rule is that an additional Portfolio risk is not taken if it is not compensated
enough by an additional return. Therefore:
𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑹𝒆𝒕𝒖𝒓𝒏𝒔 𝒐𝒇 𝒆𝒂𝒄𝒉 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
> 𝑺𝒕𝒅. 𝑫𝒆𝒗𝒊𝒂𝒕𝒊𝒐𝒏 𝒐𝒇 𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 𝒐𝒓 𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑩𝒆𝒕𝒂
Valuation of Securities
For all forms of securities, their value begins with their cost. A premium or gain is added on top of this
cost to realize a benefit from disposing or holding a security at a given point in time.
Disambiguation
• Price – Actual, observed, exchange price used in the marketplace
• Worth – relates to the advantages of ownership based on the perceived benefits at point in time
and for a particular use
• Value is based on the amount that would be received in exchange for an asset or settlement of
a liability between willing parties in an arm’s-length transaction where both parties had acted
with knowledge, with prudence, and without compulsion
• Premise of Value – there are two bases for which value is derived:
Under Going-concern – Cashflows are projected Under Quitting Concern – No Projections
• Due Diligence – evaluating assumptions considering:
Fair Value of Net Assets Discounted Cashflows and Risk-Returns
Value of Debt
Generally, the Interest Rate is the basis for valuation of Debt Securities. The true cost of debt is
comprised of the following: The Risk-free Rate plus the Inflation Adjustment plus the Default Risk
Premium plus the Maturity Risk Premium plus the Liquidity Preference.
• Risk-free Rate – the rate at which a security is at theoretical zero risk; this is usually the national
government’s/BSP’s offer rate to sell its securities. For International benchmarks, it is the LIBOR.
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• The Inflation Premium – Applied to debts and generally increases the interest rate. This is
because if a security does not return above inflation, all other commodities will essentially be
more expensive to have cash be spent on.
• Default Risk Premium – The risk that a borrower may not be able to pay the obligation. It
considers credit ratings of each borrower, a credit grade in terms of interest. The more compliant
a borrower, the cheaper the debt.
• Maturity Risk Premium – A Maturity risk is the risk that an investment faces when as it matures,
being unable to change the security as interest indexes change with it. The longer the maturity,
the higher the maturity risk, and usually, a premium is provided to investors for holding onto the
investment until its maturity.
• Liquidity Preference Premium – The Liquidity Preference is the Creditor’s premium placed on
being in a liquid position. In simpler terms, the creditor’s desire to be liquid. If the creditor
prefers to have more cash, it will be reluctant to place these items of cash in a longer maturing
security; to compensate for this concern, the Creditor requires a premium to cover their cost.
• The Yield Curve - Risk generally increases in investments the longer they mature. This is called
Maturity Risk and is represented by the Yield curve.
Normal Yield Curve Abnormal Yield Curves Flat Curves Humped Curves
S-shaped, increases Inverted, decreases All rates yield similar Intermediate term
over time over time returns rates yield the most
Longer term Bonds are Shorter term bonds are Maturity does not Middle Term Bonds are
more valuable more valuable influence Bond Price most valuable
The Yield curve is mainly influenced by the Maturity Risk premium. This is because investors tend to
expect that they must be compensated for taking a long position with their fixed returns. This behavior
is theorized to be due to:
• The Liquidity Preference Theory – Naturally, an investor prefers to acquire returns in the short
term since this allows them to save on opportunity cost. Foregoing the opportunity cost of a
shorter-term investment for a longer-term one is rightfully compensated by a higher rate.
• The Market Segmentation Theory – Some Investors are naturally inclined to acquire long-term
rated investments due to the requirements of their industry. They are compelled to take safe,
and fixed interest rates, for instance, life insurance and pension funds companies prefer long
term rates. On the other hand, Commercial Banks and Savings and Loaning Associations prefer
short term rates to match the maturity of their short-term lending activities.
• Expectations Theory – Long-term rates reflect the average of short-term expected rates over
time. This means that an annual rate of 5% for instance, is a semi-annual rate of 10%. Long-term
rates tell of the expectation over short-term rates.
LTR < STR Short-term Rates will decline Inflation will decrease; investors will start to save
LTR > STR Short-term Rates will increase Inflation will increase; investors will start to spend
The Fischer Effect – An economic theory by Irving Fischer (Economist) that describes the relationship
between inflation and both real and nominal interest rates
𝑹𝒆𝒂𝒍 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑹𝒂𝒕𝒆 = 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑹𝒂𝒕𝒆 − 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆
If the Real Interest Rate is positive, the bondholder will beat inflation and the bonds will not lose in
value; the opposite is also true
Real Interest Rates = Shifts the Yield Curve Up or Down (Direct Relationship)
Expected Returns = Influences the Steepness of the Curve (Direct Relationship)
Interest Rate Risk = Varies with time and determines the shape of the curve as above discussed
Macaulay Duration – Since the market value or price of a fixed income security is inversely affected
by changes in market interest rates, we can determine the rate at which a bond is exposed to interest
rate risk (The longer you wait, the more potential for the security to be affected by market rates, the
closer to maturity, the less sensitive the bond price is to market rates). This is denoted by the weighted
average of the times until the receipt of both interest and principal weighted according to the
proportion of the total present value of the security represented by the PV of each cash flow to be
received.
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Total Proportion to Proportion ×

Nth year Cashflows PV of 1 @ i% PV of CF
(Interest + Principal)
PV nth year
1 XX (1+i%)^-1 XX X% X%
2 XX (1+i%)^-2 XX 2Y% Y%
3 XX (1+i%)^-3 XX 3Z% Z%
4 XX (1+i%)^-4 XX 4W% W%
Macaulay
Total XX XX 100%
Duration
Modified Duration or Bond Volatility – Since the Macaulay Duration captures the rate at which a bond
is exposed to interest rate risk, dividing it by its Yield will denote the bond’s value at risk per dollar
yield. Shown as:
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝑜𝑟 𝐵𝑜𝑛𝑑 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 =
1 + 𝑌𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
Duration is lower if the Nominal Rate is higher, because more returns are received earlier along the
bond’s life, reducing volatility.
Value of Equities
The Value of Equity, compared to debts, is based on the expected return on an investment, plus or minus
a capital gain or loss upon ultimate disposal of the equity. This involves the External Market Valuation:
Based on Risk, Equity can be valued based on the CAPM approach:
𝐸𝑅𝑖 = 𝑅𝑓 + 𝛽𝑖 (𝐸𝑅𝑚 − 𝑅𝑓)
𝐸𝑅𝑖 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡; 𝑅𝑓 = 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑅𝑎𝑡𝑒; 𝛽𝑖 = 𝐵𝑒𝑡𝑎 𝑜𝑓 𝑡ℎ𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(𝐸𝑅𝑚 − 𝑅𝑓) = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
The Dividend Model (To be expounded later on in this text), and
Internal Business Valuation or the EPS Pricing Model. That is, the basis for the valuation of the
securities is the Present Value of Cashflows realized from Operations of a Company. In this case, the
growth rate is directly related to the growth of sales. (Expounded under Discounted Cashflows Valuation)
Dividend Pricing EPS Pricing
Based on Forecasted Dividends Based on Forecasted Sales and Revenues of a Firm
FV = PV of Dividends + Capital Gains FV = PV of Operational Cashflows + Capital Gains
Portfolio Theory, Correlation Matrix, and the SML
Modern Portfolio Theory – an investment theory that allows investors to assemble an asset portfolio that
maximizes expected returns for a given level of risk. The theory assumes that investors are risk-averse;
that is, for any given level of expected return, investors will always prefer the less risky portfolio. In
reality, stocks rarely possess the proper risk-return value, hence, investors turn to creating asset
portfolios to balance and optimize the risk-return trade-off (i.e., acquiring different investments),
denoted by the correlation matrix and the Security market line, and considering hedging/derivatives.
Variances Security A (𝑋𝑎 𝜎𝑎 ) Security B(𝑋𝑏 𝜎𝑏 ) Security C (𝑋𝑐 𝜎𝑐 )
Security A (𝑋𝑎 𝜎𝑎 ) (𝑋𝑎 𝜎𝑎 )2 (𝑋𝑎 𝜎𝑎 )(𝑋𝑏 𝜎𝑏 )𝜌𝑎𝑏 (𝑋𝑎 𝜎𝑎 )(𝑋𝑐 𝜎𝑐 )𝜌𝑎𝑐
Security B(𝑋𝑏 𝜎𝑏 ) (𝑋𝑏 𝜎𝑏 )(𝑋𝑎 𝜎𝑎 )𝜌𝑎𝑏 (𝑋𝑏 𝜎𝑏 )2 (𝑋𝑏 𝜎𝑏 )(𝑋𝑐 𝜎𝑐 )𝜌𝑏𝑐
Security C(𝑋𝑐 𝜎𝑐 ) (𝑋𝑐 𝜎𝑐 )(𝑋𝑎 𝜎𝑎 )𝜌𝑎𝑐 (𝑋𝑐 𝜎𝑐 )(𝑋𝑏 𝜎𝑏 )𝜌𝑏𝑐 (𝑋𝑐 𝜎𝑐 )2
Grand Total = Overall Covariance; Sqrt of
Grand Total = Overall Correlation
Undervalued Securities
Risk Premium

The point of minimum risk for each curve of

securities ideally should be tangent to the security
market line (SML) or Beta line or Risk Premium
Line. An investment that intercepts the line is said
Overvalued Securities
Rf% to be in equilibrium.
Each hyperbole sketches an area called the
If the stock is outside the SML – it is Undervalued Efficient Frontier, that expresses the security’s
If the stock is inside the SML – it is Overvalued risk profile in terms of Risk-Return trade-off,
The horizontal line is actually the Risk-free Rate. Higher SD means disproportional or unoptimized
risk-return trade-off.
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Types of Risk
• Market Risk – Changes in a stock’s price will result in a change in the market as a whole
• Liquidity Risk – Possibility that an asset cannot be sold on short notice for market value
• Political Risk – Risk that a foreign government may act such that it reduces the firm’s investment
• Exchange Rate Risk – Possibility of a loss because of fluctuations in the value of currencies
• Security or Standalone Risk – Risk of a single stock
• Portfolio Risk – Combined Risk of multiple stocks managed under a single strategy
• Company Risk – Inherent Risk towards a particular security, can be offset by Diversification
• Interest Rate Risk – Risk that values of investments will fluctuate due to changes in interest rate
• Systematic Risk/Market Risk – relates to market factors that cannot be diversified away;
illustrated by CAPM
• Unsystematic Risk/Stand-alone Risk – Risk that exist for one particular investment
• Credit or Default Risk – Risk that the firm will default on payment
• Basis Risk – Risk of loss from ineffective hedging activities (FV of hedged item – FV of derivative)
• Legal Risk – Risk of loss from a regulatory action that invalidates the performance of a derivative
Decision Guides relating to Risk Evaluation
• Relative Risk is determined through the Unit of Standard Deviation per Unit of Expected Return
• An investment from a portfolio is sold if it is directly related to the Beta, more so if it has a low
return; furthermore, an investment in a portfolio that is inverse to the Beta is retained.
• Deciding to expand a portfolio – observe the resulting return and risk. A preferred investment is
one whose return increases and risk decreases. A preference is observed over size of returns over
size of risk.
Derivatives and Hedging
• A Derivative is a financial instrument whose value is derived by some other financial measure
• THESE ARE NOT CLAIMS TO BUSINESS ASSETS UNLIKE BONDS AND STOCKS
Forwards
Negotiated contracts to purchase and sell a specific quantity of a financial instrument, foreign currency,
or commodity at a price specified at origination of the contract, with delivery and payment at a specified
future date. Gains or losses are measured through the Difference between the Ultimate Market Price
and the Contract Price set in the forward contract.
Futures
Forward-based standardized contracts in public exchanges to take delivery of a specified financial
instrument, foreign currency, or commodity at a specified future date or during a period at the then
market price.
Forwards Futures
Primary Market is through: Dealers Exchanges
Secondary markets None Exchanges
Contract terms Negotiated, per contract basis Standardized per exchange
Delivery Upon expiration of contract Delivery is rare: positions are
offset by delivery date
Collateral None Requires initial margin
Credit risk Depends upon parties None (the Exchange is
counterparty to every trade,
and ‘underwrites’ everyone in it
Market Participants Large Firms only Wide variety of firms.
Options
Allow, but do not require, the holder to buy (call) or sell (put) a specific or standard commodity or
financial instrument, at a specified price during a specified period of time.
• Long Position – The party selling the Contract • Call Option – vests to the holder a right to buy
• Short Position – The party buying the Contract • Put Option– vests to the holder a right to sell
• Strike Price or Exercise Price – The price stated in the contract that determines the ultimate
price the security could be bought or sold
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• Option Premium – the Minimal price at which the option contract could be purchased
• Expiration Date – the date the option matures, either the option is exercised or not; this is
essentially the difference between the Option (Right, not obligation, to deliver at a date) and
the Forwards (Obligation to deliver at a date) as the option could be unexercised without any
breach of contract
• In the Money – the Option will turn in a profit upon exercising the contract
• Out the Money – the Option will not be exercised; when the loss results in only the premium
• Covered Options – Options where the stocks are already held for sale
• Naked Options – Options where the stocks are yet to be acquired, but are still promised for sale
• European Options – Options that may only be exercised at the expiration date
• American Options – Options that can be exercised any time before the maturity date
Position Type Upon Issue of Option: Upon Exercise Use when
Long Position in: Call Option You Sell a Right to Buy You are obligated to sell FV will drop
Short Position in: Call Option You Buy a Right to Buy You have the right to buy FV will rise
Long Position in: Put Option You Sell a Right to Sell You are obligated to buy FV will rise
Short Position in: Put Option You Buy a Right to Sell You have the right to sell FV will drop
**N.B. The fair value in question pertains to the underlying stocks and not the options themselves.
Investment Models for Options Pricing
Black-Scholes-Merton (BSM) Model Binomial Options Pricing Model
Pricing options at lognormal distribution for The binomial option model is iterative, allowing
European options for the specification of points in time during the
time span between valuation date and expiration
date
Assumptions: Assumptions:
• Stock does not pay any dividend during • The investor is risk-neutral (usually
option life assumed for employees with stock
• The option is a European Option, i.e., the compensation)
option can only be exercised at maturity • The underlying stock price can only either
• Stock is traded in an efficient market (no decrease or increase with time (never
asymmetry) constant, i.e., the vesting period)
• No transaction Costs, Taxes, or • The possibility of arbitrage is zero;
Commissions (immediate buying and selling of the asset
• Risk-free rate exists, is constant across in different market to earn a profit)
the life of the option, and is the same for • The market is perfectly efficient
all maturity dates • The duration of the option is shortened
• The underlying stock returns are normally
distributed.
Currency swaps
Forward-based contracts in which two parties agree to exchange an obligation to pay cash flows in one
currency for an obligation to pay in another currency.
Interest rate swaps
Forward-based contracts in which two parties agree to swap streams of payments over a specified period
of time. An example would be an interest-rate swap in which one party agrees to make payments based
on a fixed rate of interest and the other party agrees to make payments based on a variable rate of
interest. Generally, for Swaps, the gains or losses are the cashflows sustained in each alternative scenario
Uses of Derivatives
• Speculation – Anticipating gains due to price changes in various markets
• Hedging – To mitigate BUSINESS RISK faced by the firm. Hedging is an activity that protects the
entity against adverse changes in Fair Value or Cashflows of assets, liabilities, or provisions.
* N.B. For a technically rigorous analysis of the procedures regarding Derivatives and Hedging, see AFAR
(Accounting for Derivatives and Hedge Accounting)
* N.B. For a technically rigorous analysis of other securities, see FAR (Accounting for Stock Rights,
Warrants, Compound Financial Instruments, Leases, Share-based Payment, and Shareholders’ Equity)
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Capital Structure and Long-term Funding

• Capital – Investor-supplied funds comprising of debt, preferred stock, common stock and R/E
• Capital Structure – The percentage of each type of investor supplied capita
• Optimal Capital Structure – Maximizes Intrinsic Value and Minimizes WACC
Source of Fund Fair Value (Peso or %) Weight Weighted Value
Cost of Long-term Debt After Tax BB% BB/GG BB*BB/GG
Cost of OSC and R/E CC% CC/GG CC*CC/GG
Cost of PSC DD% DD/GG DD*DD/GG
Total GG 100% WACC
• Short-term Debt may be included in the capital structure, especially if the company needs funds
for generating returns (via Aggressive Financing)
• Marginal Cost of Capital vs Historical Cost of Capital
Marginal CoC Historical CoC
A future-oriented measure and is ideal for future A lag indicator and presupposes consistent
investment ventures behavior from past business conditions
Preferred Not Preferred
Difficult to capture data Easy to capture data
Factors Influencing Capital Structure
• Sales Stability – Stable sales = allows higher debt and other charges
• Asset Structure – More Cash or Liquid Assets = allows higher debt and other charges
• Leverage – Less Operating Leverage = More Financial Leverage
• Business Risk – the risk of not meeting business objectives
• Growth Rate – Faster Growth = Must rely on external capital
• If Flotation cost of equity > Flotation cost of debt; then incur more debt over equity
• Profitability and Sales – Working Capital and Internal Financing are directly influenced by it
• Tax Position – Higher in the tax bracket, the more debt issued, since interest is tax deductible
• Control – indicates capacity in which an entity may incur equity. More control = More debt
• Market Conditions
• Internal Environment
• Financial Flexibility
• Managerial Aggressiveness
• Inflation – Generally, for inflation, it encourages debt financing as bonds are generally cheaper
due to increasing yield rates. (PV of 1% > PV of 5%). This in turn will make equity financing more
costly, discouraging IPOs. However, existing shareholders will benefit from leverage created by
debt financing
• Convertibles and Warrants – These will involve transfers within and among components of WACC.
Theories on Capital Structure
a. Traditional Theory – A certain mix of debt to equity will eventually minimize WACC, and thus
maximize the market value of assets
b. Modigliani & Miller Theory or Dividend Irrelevance Theory (MM Theory) – The market value of
a company is entirely independent of its capital structure, absent of tax. If there were costs to
raise capital, i.e., taxes, commissions, and floats, then this would decrease WACC over a rate of
decline (Tax rates and flotation costs), debts would be preferred.
c. Pecking Order Theory – Funding tends to be sourced in order: Spontaneous Credit, Internal
Funds, then Debt, then New Equity
d. Dividend Signaling Theory – An issuance of dividends, or even its mere announcement of increase
in dividend payouts, is a good indication of positive investment outcomes. This occurs when
investors and managers ae responding to having identical information about both of their
investments. This implies that:
a. There is leveraging of asymmetric information
b. A firm with unfavorable prospects will issue stocks to dilute loss per share and its stock
prices will decline
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c. A firm with good prospects will issue out dividends to stockholders and bonds to other
investors to leverage earnings per share resulting to its stock prices rising. The firm will
maintain a Reserve Borrowing Capacity to safely issue out credits.
e. Trade-off Theory – A certain mix of tax benefits from debt issuance comes at the risk of
bankruptcy; the trade-off scenario is simply to maximize the amount of returns or benefits from
issuing debt (such as tax shields) relative to the degree of risk assumed in loaning out to a
company.
Sources of Intermediate and Long-term Funds
Equity Financing through Common Stocks
Common Stocks are purchased by shareholders who want to share in the firm’s profits through dividends,
which are not mandatory to be repaid; however, increasing issuance of shares dilutes the existing
interest that existing shareholders already possess and comes with it the share issuance costs to be
paid, making additional financing difficult; furthermore, the dividends are not tax deductible. This
means that a firm reliant of this form of Financing will have an Inflated or costly WACC but preserving
profitability as the income statement is not affected. This is also called the Marginal Cost of Common
Equity (i.e., it comes from external sources after all Retained Earnings are exhausted) It is generally
preferred for its flexibility in terms of provisioning for returns to shareholders.
Equity Financing through Retained Earnings
As for Retained Earnings, these are generally exhausted to meet contractual commitments,
appropriations, obligatory payments, and dividends; any remaining excess may be plowed-back in the
form of stock dividends that encourage potential shareholders to acquire shares from the firm. As these
are pre-committed, these are the easiest to exhaust; but is the cheapest equity funding to acquire.
The Costs of Equity Financing are the cost that the firm takes to make the shares attractive to
shareholders in the first place. Hence, the cost of Equity financing must come from the dividends, or
alternatively, the cost to acquire the shares back through Repurchases (Treasury Shares). Dividends will
tend to drop the stock prices, while Repurchases into Treasury will tend to raise stock prices.
Debt Financing
This includes loans from all sources. It is an injection of funds that is expected to be repaid in the
future along with interest. It is the cheaper source of capital between it and equity because it is tax-
deductible and cheapens as the economy inflates. It signals that the firm is ready to commit to raising
profitability, or that the firm must leverage the debt to return more than its cost, which is the interest.
It comes with liquidity risk and may jeopardize the firm’s growth if it is too heavily relied on,
cheapening the WACC, but also reducing profitability.
Summary of Sources of Funds
Criteria Debt Financing Equity Financing – CS Hybrid Financing – Preferred SH.
Control Not shared with creditor Control is usually No voting rights except in special
diluted cases when options are stricken
Cost After Tax Interest CAPM or Growth** Separate Debt and Equity
Components
Tax Effect Interest is tax deductible Not Tax Deductible Not Tax Deductible
Obligations Fixed No specific obligations Cumulative PS are entitled to
dividends, unless otherwise
Inflation Debt may be paid with None (existing holders None (Existing holders may benefit
cheaper pesos in the may benefit from from increase returns via leverage)
future, exposing the debt increased leverage)
to reinvestment risk
Default High risk Uncertain, paid only No Risk
Risk when available
Maturity Yes No Fixed Maturity No Fixed Maturity
Limitations Limited, creditors do not CS grows with firm’s Dividend is limited to stated
participate in earnings success amount
Flexibility None, unless Hybrid Inst None Callable, Redeemable, Convertible
**Growth may either be determined by the country GDP, as industries tend to rise along with the market,
influencing forecasts and projections for Sales and Working Capital, or the firm’s own reinvestment
behavior, that is, the amount of net income returned as stock dividends which go together.
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Hybrid Instruments
• Preference Shares
o Debt Characteristic – Limited Claim on firm’s earnings and assets
o Equity Characteristic – Represents a stake in the firm
o Priority to assets and earnings
o Either Cumulative or Non-cumulative; may or may not have Convertibility feature
Cost of PSC = Preferred Dividends per Share/Current Fair Value (No Growth)
• Lease Financing
o A rental agreement that typically requires a series of annuities that extend over several
periods; may come in the form of Direct Leasing, Sale and Lease-back, and Leveraged
Leasing (Leveraged Leasing involves additional debt financing to acquire the underlying
asset at the end of the lease term)
o More flexible than loans because of the variety in contractual arrangements available
o Known cost of maintenance of lease and Lower Admin Costs
o Tax Shield from Lease Payments (appears on balance sheet only and avoids tax) over
Depreciation (increases tax)
Cost of Leasing = Effective Interest Rate, net of taxes
• Convertible Securities
o PSC that can be convertible into OSC
o Bonds that can be convertible into OSC or PSC
o The Cost of Equity and Hybrid Capital changes as the securities are converted. Generally,
these are dilutive, hence Earnings per share are reduced; but the exercise price raises funds
and raises WACC.
o Convertible securities are only ever converted if the cost of financing through the
alternative becomes cheaper than its default form. The basis for its contribution in the
weighted capital structure would be based on the default instrument, not on the combined
instrument (Share Premium – Conversion is not considered a source of funding)
• Options and Warrants
o Equity Instruments granted by the corporation to purchase specified number of OSC at a
stated price exercisable until the expiration date. Attached to Debt Securities as an
incentive to buy the combined issue at a lower interest rate. The Cost of Equity changes as
these are exercised. These are generally dilutive so the EPS will decrease, raising the WACC.
Weighted Average Cost of Capital
• Reflects the expected average future cost of funding over the long-term.
• The Optimum WACC is the smallest mix of Debt and Equity
• Marginal WACC – the differential WACC between two mixes of Debt and Equity, forms a curvilinear
function, after all internal sources of financing are exhausted.
• R/E Break-point – the total amount of new investments that can be financed and new capital that can
be raised before an increase in Marginal WACC
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐵𝑟𝑒𝑎𝑘 𝑝𝑜𝑖𝑛𝑡 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 ∗ 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 ÷ 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑖𝑥
N.B. the RE breakpoint is used to see if the cost of equity uses the RE formula or the OCS formula. If
the RE breakpoint is smaller than the required funding, new OCS need to be issued in proportion to the
amount not already covered by Debt or Retained Earnings.
Preemptive Right
• Provision that grants OSC holders a right to purchase, pro-rata, new issues of common shares to
prevent Dilution on the end of the holders, and Repurchasing and Reissuance thru Treasury Shares
Cost of Debt
• Ignore flotation costs because the bondholder generally assumes the flotation cost
• In periods of inflation, the cost of debt (i.e., the yield rate) increases, thus the bond price
decrease, encouraging debt financing.
Cost of Debt = Interest Rate * (1-Tax Rate) N.B. The approximation using
𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 +
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 the EAR formula can also be
𝑌𝑒𝑎𝑟𝑠 𝑡𝑜 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 used to value long-term debt.
𝑌𝑇𝑀 =
60% 𝑜𝑓 𝐼𝑠𝑠𝑢𝑒 𝑃𝑟𝑖𝑐𝑒 + 40% 𝑜𝑓 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒
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Cost of Equity
• Retained Earnings – Earnings after interest, taxes, and preferred dividends, and is the basis for
the value of OSC Dividends; can be reinvested into the firm thru STOCK DIVIDENDS
o After-tax Opportunity Cost is lower than for newly issued OCS (No Common Stock)
o Preserves present control structure of the Firm
o The cheapest equity to finance
o In the event of expansion, the retained earnings are the first to be exhausted. Thus, any
marginal change will involve its WACC to be 0. Check the R/E Breakpoint.
• Ordinary Share Capital – The Cost of the Dividends issued, depends on Dividend Policy
Dividend Policy
Dividend Policy - The decision by a firm whether to issue dividends to shareholders, what sorts of
dividends to issue, & when these dividends should be issued as a form of compensation for equity funding
• CAPM – Capital Asset Pricing Model
𝐸𝑅𝑖 = 𝑅𝑓 + 𝛽𝑖 (𝐸𝑅𝑚 − 𝑅𝑓)
𝐸𝑅𝑖 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡; 𝑅𝑓 = 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑅𝑎𝑡𝑒; 𝛽𝑖 = 𝐵𝑒𝑡𝑎 𝑜𝑓 𝑡ℎ𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(𝐸𝑅𝑚 − 𝑅𝑓) = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
• Dividend Growth Model (Gordon Model)
𝐷1 = 𝑁𝑒𝑥𝑡 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑵𝒆𝒘 𝑶𝑺𝑪 𝑜𝑟 𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚
𝑃0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 = [𝐷1/(𝑃0 ∗ (1 − 𝐹))] + 𝐺
𝐺 = 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 (1/𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡) 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 = (𝐷1/𝑃0) + 𝐺
𝐹 = 𝐹𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡
No Growth Normal Constant Growth Supernormal Growth
V= D1/k V= D1/ (k−g) 𝐷0 (1 + 𝑔𝑠 )𝑛 𝐷𝑛+1 (1 + 𝑔𝑚 )𝑚
V=Value V=Value ∑ +
(1 + 𝑘)𝑛 (1 + 𝑘)𝑛
Dn=Dividend in the next period D1=Dividend in the first period 𝑛
Where:
k=Required rate of return k=Required rate of return
m = Period of normal growth
g=Dividend growth rate
n = Period of Supernormal growth
**Note that the application of present value for supernormal growth applies on a lumpsum basis. This is
because a growing dividend cannot be applied in the same manner as a constant dividend which can use
ordinary annuity factors. This means that each year, the lumpsum PV is applied to the any growing
dividend regardless of if it is supernormal or constantly growing. For Non-growing dividends, an annuity
factor can be applied.
• Bond Yield plus Risk-premium – Since bonds are generally the safer choice of investment, it
would make sense to peg the cost of equity upon its cost, and then simply adding a risk-premium
to compensate the holders for investing in uncertain dividend returns
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑩𝒐𝒏𝒅𝒔 + 𝑹𝒊𝒔𝒌 𝑷𝒓𝒆𝒎𝒊𝒖𝒎
• Earnings Yield – The earnings yield depicts to cost of both Common Stock and Retained Earnings.
This is simply the EPS/FV of Shares. This runs on the assumption that the net income is
immediately paid-off as dividends to ordinary shareholders.
Rationalization of Dividend Policy
In general, stockholders have three motives for holding stocks, namely:
Corporate Control/Participation Dividends Capital Gains
Dividend policy attempts to balance out these interests for the firm to maximize its value.
Dividends Capital Gains
Dividends are typically committed once Capital Gains are typically subject to larger tax
announced for issue, while capital gains are not savings over the course of the life of the security
as predictable.
The capability of being able to approximate Dividends are issued at the discretion of the
returns by reinvesting the dividends is essential company, while capital gains are realized at the
in valuation discretion of the investor
Under MM Theory, risk on the cashflows is Under MM Theory, a low performing stock is entirely
determined by operations, and not payout. due to poor operations.
Transaction Costs of selling are avoided
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Recapitalization and Stock Repurchases

All these three interests are addressed by calibrating dividend policy and applying changes in equity
structures. The below tools are pertinent to equity:
Effect Recapitalization (Bonus Issues/Splits) Repurchases (Treasury)
Stock Price Rises shortly after announcement Declines upon announcement
Signaling Theory Good Performance Good Performance, but Undervalued
Corporate Valuation FV increases due to Increased Liquidity EPS Increases, but P/E drops
Capital Structure Changes in Capital Mix Rapid Changes in Capital Mix
Additional Funds Needed Analysis for Financial Forecasting
When an entity is looking to expand its business, it may go into AFN analysis. This tool involves preparing
forecasted income statements and balance sheets to estimate the additional funds needed. Entity must
raise sufficient assets in order to reach sufficient sales targets. Do note that forecasts are not necessarily
budgeted amounts.
𝐴0 𝐿0
𝐴𝐹𝑁 = ( − ) ∗ ∆𝑆 − (𝑎 ∗ 𝑏 ∗ 𝑆1 ); 𝑤ℎ𝑒𝑟𝑒 𝑆1 = 𝑆0 (1 + 𝑔)
𝑆0 𝑆0
AFN = Required Increase in Assets – Spontaneous Increase in Liabilities – Spontaneous Increase in Equity
A = Assets at time zero, A0 /S0 = Capital Intensity Ratio • Positive AFN = Additional Funds are Needed
L = Liabilities at time zero, L0 /S0 = Liability Intensity Ratio • Negative AFN = Extra funds are Available
S0 = Sales at time zero, S1 = Forecasted Sales • External Funding does not vary with the
g = sustainable growth rate, Δ = change in sales growth rate (i.e., OCS, LTD, Notes)
a = Profit Margin b = Retention Rate
𝐴0 𝐿0
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = ∗ ∆𝑆 ; 𝑆𝑝𝑜𝑛𝑡𝑎𝑛𝑒𝑜𝑢𝑠 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = ∗ ∆𝑆
𝑆0 𝑆0
𝑆𝑝𝑜𝑛𝑡𝑎𝑛𝑒𝑜𝑢𝑠 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = (𝑎 ∗ 𝑏 ∗ 𝑆1 )
Full and Partial Utilization of Fixed Assets
Forecasted Sales is less than or equal to Sales at Full Forecasted Sales is larger than Full Capacity
Capacity
Spontaneous increase in Assets/Capital Intensity will Spontaneous increase in Assets/Capital Intensity will
depend on Working Capital only depend on All existing and new Fixed Assets
• AFN of Fixed Assets is added to AFN at current capacity to arrive at the adjusted AFN if the full
capacity of fixed assets cannot accommodate the forecasted sales.
• Based on discrete analysis of AFN, these are the following steps:
e. Create a Projected Income Statement based on the assumptions provided
f. Create a Projected Balance Sheet based on assumptions provided (Do not fill-out the Fixed
Assets and Retained Earnings line yet)
g. Determine the Retained Earnings (Based on Projected Net Income and Planned Dividends)
h. Squeeze the figure for Fixed Assets based on Projected Sales vis-à-vis Full Capacity Sales
Determine Fixed Assets at Current Determine Adjusted Fixed Asset Determine Fixed Assets Required
Year’s Fixed Asset Intensity Ratio Intensity (i.e., at Full Capacity) given adjusted Fixed Asset Intensity
i. Solve for AFN using the new figures derived
𝐴𝐹𝑁 = 𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 − 𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝐸𝑞𝑢𝑖𝑡𝑦
**Discrete analysis of AFN will mean that variation of sales may only apply to specific accounts (usually
working capital accounts) and not Long-term Debt/Equity i.e., Fixed Assets are not working at full
capacity.
Sustainable Growth for Capital Structure
The Sustainable Growth Equation shows how much the firm may raise more funds without disturbing the
existing capital structure. This is especially useful for determining the maximum number of dividends a
firm can declare to signal a profitable stock, and strong leveraging position. It is considered sustainable
because it approximates the GDP growth of a stable economy, as it measures the Sales growth projections
and Working Capital based on expenditure behavior toward existing resources. (Akin to R/E Breakpoint)
𝑔 = 𝑅𝑂𝐸 ∗ (1 − 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑅𝑎𝑡𝑖𝑜)
Under AFN, it is essentially the opportunity cost of additional dividends to be issued to each shareholder
upon the required increase in assets, and the increase in sales and profits versus retaining the increase
in earnings, if an entity chose to raise external funding.
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Capital Budgeting
• The process of planning and controlling investments for long-term projects.
• Concerned with long-range decisions, such as to introduce new product lines, build new facilities,
lease or buy equipment.
Types of Capital Investment Decisions
o Screening Decisions – Whether an investment meets the minimum criteria established
o Preference Decisions – Evaluate and compare more than one capital investment alternative
• These decisions will also be influenced by Taxes and Inflation
o For Tax consideration, Debt is preferred as a source of financing for Investment decisions
o Returns will also be influenced with a Depreciation Tax Shield
o For Inflation, Cashflows increase which is a favorable indicator, but the Cost of Capital
increases as well, which is an unfavorable indicator, the impact on NPV may be minimal
o Any Interest Expenses are ignored in ascertaining the earnings of a project since these must
be incorporated into the costs of running the project. Hence, the figures to use are After
Tax, but Before Interest (EBIAT) and Net Cash Inflows Before Tax (CIAT)
• These decisions may also take into consideration a risk-adjusted discount factor or unlevered
Betas as Cost of Capital (Systematic Risk)
o Stand-alone Risk ignores diversification attempts
o Corporate or Internal Firm Risk is a type of Stand-alone risk on the side of investors,
assuming that the investors only own the stock of the firm
o Beta or Market Risk is the risk seen by a well-diversified portfolio
o Higher Risk = Higher Cost of Capital
Steps in Capital Budgeting
1. Identification Stage
2. Screening Stage (Proposals are sent to the Budget Committee)
3. Approval Stage (Approval by the Board of Directors)
4. Funding Stage – Through Loans and Operations
5. Implementation Stage
6. Post-audit or Monitoring Stage
Terminologies
• Net Investments – Cash Outflows and Cash Inflows incidental to the acquisition of the project
• Cash Outflows on acquisition:
o Initial cash outlay for all expenses (Purchase price, cost, freight, insurance, taxes)
o Working Capital Requirements - the opportunity cost of placing the funds elsewhere
o Market Value of an existing, idle asset, which will be transferred or reused in the project
(akin to purchasing a new facility)
• Cash Inflows on acquisition:
o Trade-in Value of an old asset (for replacements EXCLUDE TAX IMPLICATION)
o Cash Proceeds from Sale of Old Asset
o Less Tax from Gain on Sale
o Add Tax from Loss on Sale
o Immediate Repairs on the old asset NET OF TAX
• Opportunity Costs – These usually come in the form of idle assets that could either be used in
the project or be sold out instead. The sale of the idle asset is considered an opportunity cost.
In the same manner, this also applies to working capital.
• Tax Shields – A Tax shield is a form of savings acquired from deductible depreciation that had
no actual match in cash outlay. It is computed as the Tax-Deductible Depreciation multiplied by
the Tax rate.
• Sunk Costs – Any costs incurred in the past that will not bear in current financing models.
• Cost of Capital – Cost of using funds, WACC or Interest Rate, a.k.a. Hurdle Rate
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• Expected Cash Inflows and Outflows are Discounted at the Cost of Capital
Added Sales Savings
Sales XX Savings XX
Variable Costs (XX) Depreciation (XX)
Contribution Margin XX Pre-tax Income XX
Fixed Costs (XX) Taxes (XX)
Pre-tax Income XX After tax Income XX
Taxes (XX) Depreciation XX
After Tax Income XX After Tax Cash Inflow XX
Depreciation XX
After Tax Cash Inflow XX
**For cases that ignore income tax, simply remove taxes from the computations.
**Savings may apply a Future value factor given an estimated rate
**All cashflows occur at the end of the period (to be consistent with inflow realized form the project)
Non-Discounting Methods
As the name suggests, the methods do not involve any discounting. They are usually based on readily
available accounting information as regards an investment. However, this is not to say that projections
are not made.
1. Accounting Rate of Return
a. Based on Accounting Net Income
b. Readily available data
ARR = Average Net Income/ Net Investment OR
c. Ignores inflation, Time Value, Gains and
ARR = Average Net Income/Average Investment
Extraordinary Income (i.e., from disposal)
Average Investment = B bal. +E bal./2
d. Uses accrual basis, not cash basis, hence
cashflow is ignored
Accept if ARR > CoC; Reject if ARR < CoC
e. Uses the average of all projects, and cannot
evaluate any single project unless only one
project is committed
2. Payback Period and Bailout Period
a. Based on Cash Flow (Liquidity focused)
b. Shorter Paybacks are favored over longer Paybacks, ceteris paribus
c. Payback Reciprocal – approximates the IRR, if cashflows are uniform and the life is at
least twice the PBP
d. Bail-out period – Cash recoveries should also include Estimated Salvage Value each year,
applying non-uniform cashflows; only add the salvage value if the cashflows are negative
or zero. This is done because it is the point in time where the investor can bail-out of
the project having recovered the cost of investment.
In the bail-out year (when the balance goes negative, i.e., when the cost is recovered):
Unrecovered balance for the Bail-out Year XX (1) Accumulate the total cashflows to date
Salvage Value of the Bail-out Year (XX) (2) Deduct Acc. CF from Total Outlay
Remaining Balance XX (3) Deduct SV for year n
Divided by: Operating Cashflow during Bail-out Year XX (4) If still positive, repeat 1,2,3
Bail-out Months XX (5) If negative, do the computation
Prior Year XX N.B. The SV changes each year!
Bail-out Period XX
e. A Discounted PBP simply uses PV for Cashflows and Salvage Value
(NPV/Net Investment a.k.a. NPV Index) 𝑷𝑩𝑷, 𝒏𝒐𝒕 𝑼𝒏𝒊𝒇𝒐𝒓𝒎
𝑵𝒆𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 − 𝑪𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝑵𝒆𝒈𝒂𝒕𝒊𝒗𝒆
PBP, Uniform Cashflows = Net =
𝑪𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝒇𝒐𝒓 𝒕𝒉𝒆 𝑵𝒆𝒈𝒂𝒕𝒊𝒗𝒆 𝑷𝒆𝒓𝒊𝒐𝒅
Investment/Annual Cash inflow
For non-uniform cashflows, Deduct the Initial Investment by the Cash inflows per year. The year that the
Balance reaches zero is the PBP. **If the PBP is negative then the PBP happens in between periods.
**Add the number of Positive years, and the amount from the above
**If computing for bailout period, simply deduct the estimated salvage value in the numerator
Payback Reciprocal = 1/PBP
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Discounting Methods
Obviously, these involve discounting. These are, however, pieces of information that are difficult to
acquire. Sometimes, some appraisals using these methods require risk adjustment factors to properly
reflect the probable future cashflows relating to a project. It has the following assumptions:
• Cash inflows are immediately reinvested in another project, hence the either the WACC, CoC, or IRR
are the Reinvestment Rates used
• Lives of mutually exclusive projects may or may not be equal
• No annuity dues unless otherwise mentioned
• Cash flows are projected with 100% certainty
1. Net Present Value – PV of future cash flows compared to Net Investment in pesos
NPV = PV of Cash Inflows – PV of Cash Outflows
Cash Inflows: Cash Outflows:
• Even – PV of ordinary annuity Net Investment
• Uneven – PV of 1 for each lump-sum payment Any other outflows (Even or not, LS/Inst.)
Working Capital Requirement – PV of 1 i.e., Cost of Overhauls
*Salvage Value at – PV of 1 Annual Maintenance
*Check if included in computation for Depreciation Opportunity Costs
ACCEPT IF NPV >= 0; REJECT IF NPV < 0
Implication for: Used in Computation for DEPEX Not Used in Computation for DEPEX
Carrying Value at Life end CV = Salvage Value CV = 0
Gain on Disposal Gain = 0 Gain = SV
Discounted Amount SV SV net of Tax
PROS CONS
Emphasis on Cashflow Requires Predetermined CoC or WACC
Recognizes Time value Two Alternatives may not be comparable since NPV
is a Peso Measure which is absolute
Assumes Discount Rate as Reinvestment Rate
2. Profitability Index – The NPV/Net Investment is used when there is a limit in the use of funds
PV of FUTURE Cash Inflows/PV of Cash Outflows
ACCEPT IF PI > 1; REJECT IF PI < 1
(NPV + Net Investment)/Net Investment
3. Replacement Chain Analysis
A Common life between two mutually exclusive projects is determined; the projects will be
repeated enough times over the common life. In this case, the initial outlay is repeated
immediately at the end of the life of the shorter project enough times and is discounted from
the commencement of the project.
• If one project is twice as long as the other, the other is simply doubled.
• If the projects overlap, e.g., project A lasts only for 3 years, while project B lasts for 4, project
A will be repeated 4x, and project B will be repeated 3x, since the common life is 12 years.
4. Equivalent Annual Annuities Method
Stating the project NPV in terms of their Annuities. The project with larger EAA is preferred.
𝑾𝑨𝑪𝑪 ∗ 𝑵𝑷𝑽
𝑬𝑨𝑨 =
𝑷𝑽𝑶𝑨 𝒐𝒇 𝟏 @ 𝑾𝑨𝑪𝑪
Apparently, the Replacement Chain Analysis and the Equivalent Annual Annuities provide the same
decision. It is simply a matter of which information is provided.
5. Internal Rate of Return – The rate at which the PV of Future Cash flows equals Net Investment
PVF of IRR = Cost of Investment/Annual Cash ACCEPT IF IRR > WACC or CoC;
Inflow REJECT IF IRR < WACC or CoC
Trace the PVF in the Table of Values to get the IRR, interpolate if it is not in the table
PROS CONS
Emphasis on Cashflow IRR is assumed to be Reinvestment Rate (NPV=0=IRR)
Recognizes Time value Net Losses in a project may yield a misrepresentative IRR
Computes the True Return of a Project
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Uses of IRR
The IRR is notorious for being quite deceptive and being riddled with compatibility issues. However, this
is not to say that it is not useful. It may be used as yardstick against inflation. An IRR can reveal to an
investor how well a project may be doing, relative to the status of the economy the project is situated
in. It is mainly compared with the economy’s risk-free rate to assess if the project possesses a premium.
In a smaller scale, the IRR is compared against the Cost of Capital, and is assessed in tandem with Return
on Asset and Return on Equity. This is because the former assesses cashflow feasibility, while the latter
assess income.
6. Modified Internal Rate of Return
The adjusted IRR in cases where a project begins to post negative returns. Multiple IRRs are
computed under a curvilinear function that returns two real solutions (roots) from the IRR
function. The same criteria apply to the MIRR. In any case a problem presents negative
cashflows, yet presenting an NPV of 0, the IRR is modified.
Project Screening, Ranking and Capital Rationing
• Independent Projects – Unrelated to each other, use the Profitability Index for decision-making.
o Since the projects are unrelated to each other, these could be ranked depending on the
firm’s resources that are available
• Mutually Exclusive Projects – Competing alternatives one will exist in expense of the other
o Ranking or Screening projects will depend entirely on which method of screening is used.
o The NPV assumes that Inflows are reinvested at the Cost of Capital or WACC
o The IRR assumes that Inflows are reinvested at the IRR
o IRR method may rank small projects higher over larger projects
o Prefer the NPV method when screening these Projects
o The profitability index is preferred over the NPV since it allows comparability between
projects of different sizes and time horizons.
• Capital Rationing – A firm sets limits on the amount of funds to be invested during a period, thus
a firm cannot afford to undertake all profitable projects. Use the NPV as the main measure for
ranking, then PI, then IRR.
• Hard Rationing and Soft Rationing – Hard Rationing runs on limited budgets, Soft Rationing runs
on minimum criteria
Sensitivity Analysis
• Capital budgeting involves a lot of changes in assumptions about certain variables involved. It is
necessary to check if the assumption used in capital budget is indeed sensible.
• Use of Quantitative Techniques (Expected Value, Computer Simulations, Regression and
Correlation Analysis) to evaluate Risk and Returns.
• For the sake of demonstration, Sensitivity Analysis will generally look at how changes in periodic
cashflows affect the NPV, IRR, and PI.
Sensitivity = % change in output / % change in input
The following steps are done in sequence to measure sensitivity
1. Determine input and output variables.
2. Calculate the baseline value of the output variable using the baseline input variables value.
3. Change the value of one of the input variables while others remain constant and calculate the
new value of the output variable.
4. Calculate the percentage change of both output and input variable compared to baseline values.
5. Calculate the sensitivity of the output variable to the change in the input variable using the
formula
Long-term Decisions for Capital Budgeting
• Expand or Not? – Choose project that returns Highest NPV or PI that meets min. requirements.
• Which Equipment to purchase? – Choose investment that returns highest NPV or IRR
• Lease or Buy? – Buying Decision should have IRR or NPV higher than Cost of Financing the Lease
• Cost Reduction Adjustments to Buy or Not – Choose projects that reduce overall costs in the
long-run, i.e., take the project with the higher net savings
• Replace or Purchase?
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NPV Appraisals vs IRR Appraisals

Both Methods take into consideration the Time Value of Money. However, they differ as to what
the effective discount rate is. The NPV is applied at the Company’s Cost of Capital Adjusted by some Risk
Adjustment Factor. On the other hand, the Internal Rate of Return applies the discount rate of the
project’s returns, this means that the Internal Rate of Return will always make the returns equal the
initial outlay; it is the scenario where the NPV is zero.
Any project can return their initial cost of investment. However, the IRR is deceptively attractive
for investment prospects. However, as it is expressed in a rate, it reveals the incremental return over
the project’s life such that the total returns should recover the cost, in other words, it connotes the
‘acceleration’ of the project’s returns until it recovers its cost over its life. This does not always mean
that a relative measure should be the preferred appraisal. The NPV is generally preferred because it
expresses an absolute amount. Among projects, it will reveal the size of the return, regardless of how
fast their initial costs are recovered.
Furthermore, the IRR, being the project’s own rate of return, cannot be used as a basis of
switching between investments (reinvesting in another project). The returns among projects are
different, hence cannot be used consistently; using the IRR for switching between projects will reveal a
reinvestment risk or at least, will reveal the fact that equally highly profitable projects are difficult to
find (assume a 50% IRR, in a market that is difficult to access) making its use for decision making
unrealistic; unlike NPV, which is based on the WACC or CoC that is consistently applied for project
appraisals, as such, the same rate of returns from cashflows are expected. The IRR is also prone to
misrepresent projects if it returns a negative cashflow during its life. This will require multiple IRRs, and
a more complex computation for the Modified IRR is needed to remedy the appraisal of the project. (This
is usually done after the fact, but before the project ends).
Special Techniques in Capital Budgeting
• In a problem where projects are given only their IRR, Cost of Capital and Project Life, the
approach would be to compute the Present Value of Ordinary Annuities; and then imposing the
peso amounts to the cost of capital. This reveals the Profitability Index of each project.
o This is because it is well-established that the IRR is the NPV at 0. If the NPV is > 0, then the
IRR < Cost of Capital. In turn, the Profitability Index is the PVCF > Cost.
• Project Breakeven Analysis – This is generally an analysis of the margins a project has to make
in order to be generally safe. It considers the ff: Accounting, Cash, and Financial BEPs. In a
nutshell, it reveals the level of sales to acquire a desired result:
o Accounting BEP – See CVP Analysis.
o Used in the Early or Preliminary stages of the Feasibility Study
o Cash Breakeven Point – Occurs when the Operating Cashflows = 0 (Ignore Taxes)
Operating Cashflows = Net Income + Depreciation
o Financial Breakeven Point – Occurs when the NPV = 0.
𝑅𝑒𝑞𝑢𝑟𝑖𝑒𝑑 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑠 + 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐵𝐸𝑃 = 𝐺𝑒𝑛𝑒𝑟𝑎𝑙 𝑅𝐶𝐹 =
𝐶𝑀 𝑃𝑉 𝑜𝑓 𝑂𝐴 𝑜𝑓 1
The Financial Breakeven Point is the level of Cashflows that is required to return the NPV at zero. This
also indicates a Discounted Payback period equal to its life, a 0 NPV which is equal to its rate of return.
Other Considerations for Capital Budgeting
In capital budgeting, there is a strong emphasis for asset maintenance, however, most companies
nowadays not only invest on assets that produce financial returns, but also those that contribute
indirectly to the long run. Strategically, companies may consider capital budgeting for the following:
• Research and Development – in Financial Accounting, these efforts are typically expensed at
research phase, and capitalized upon satisfying development criteria.
• Market Capture by Patenting and Advertising – Patenting is an attempt to monopolize an
innovation, while advertising campaigns attempt to catch customer attention.
• Compliance Requirements – Such as employee training, environmental equipment, etc.
As such, Valuators use the Project portfolios of firms and use the valuation models previously discussed
to come up with a set of value-adding projects that comprise the company, creating income approach
valuations for each, and then consolidating the items to arrive at the overall implied equity.
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Financial Markets, Corporate Restructuring, and Valuation

Financial Markets – Markets where financial assets are traded, these facilitate borrowing and lending,
sale and resale of securities, and issuance of new shares.
• Brokers – Commissioned agents of buyers and sellers
• Dealers – Similar to brokers, who take positions in assets, & maintain their own stock of investments
• Investment banks – Assists in the initial sale of newly issued securities by providing advice,
underwriting, and sales assistance
• Financial Intermediaries – Borrows one form of financial asset, and resells it in another form
(funding for lending activities)
• LIBOR – (LONDON INTERBANK OFFERED RATE) an Interbank-standardized interest rate for which
other banks base their trading activities. This is usually the interest rate used as a benchmark for
the risk-free rate in variable rate loans.
Capital and Securities Markets
• Securities Markets facilitate investment by literally providing a convention for trading for
investors to pursue transactions efficiently (Axiom 6) which encourages liquidity of markets and
keeps prices stable due to smaller prices
Primary Markets Secondary markets OTC Markets
For new Issuances For resale of securities Those outside the PSE
Mergers and Acquisitions
Firms acquiring other firms for synergy and diversification.
Horizontal Mergers – in the same business line Vertical Mergers – Those in the same supply chain
Congeneric Mergers – Those somewhat related Conglomerates – Those completely unrelated
Friendly Takeovers
• This occurs when an acquiree allows an acquirer to overtake its operations amicably.
Hostile Takeovers
• This occurs when an acquiree resists a takeover, and generally manifests in 3 ways:
o Tender offer – an Acquirer offers to acquire a company applying full synergy to all its shares,
instead of taking only those that consist control (i.e., just 51%), thus preventing a devaluation
of the non-controlling stock. (In Philippine Laws, this is mandatory based on the Securities
Regulation Code)
o Creeping Tender-offer – purchasing enough stock on the open market to affect a change in
management. This is also known as a stepped-acquisition. (This is also covered under the
Securities Regulation Code of the Philippines)
o Proxy Fight – An acquirer hires proxies among the acquiree’s shareholders to vote in favor
of an acquisition
o Reverse Acquisitions – Smaller, and non-public entities are set-up legally as acquirees,
however, basing on substance over form, they are actually the acquirers (This occurs due to
a sale of stock by the acquirer to the shareholders of the acquiree.)
o Backflip Acquisitions – A large acquiring company enters into a reverse acquisition to expand
through a small company that is struggling that however, has a more sustained brand name
Forms of Acquisition
Stock Acquisition Asset Acquisition
Sellers Shareholders The Corporate Entity
Assets and All are ‘consolidated’. Consolidation Only those segments/CGUs with business
Liabilities causes the acquisition of either secret synergies can be acquired (Still qualifying as
reserves or unrecorded liabilities a Business Combination under IFRS 3)
Complexity Quick to Execute and relatively cheaper Complex and Time-consuming; Each asset
acquired is separately valued.
Tax Effect Cost Tax Basis FV Tax Basis of Acquired Assets (FVNA)
Liquidated No; Management & Employees retained; Yes; Business synergies are attributed to net
assets acquired only
Goodwill Goodwill can be retained at full basis Goodwill is typically partially valued
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Corporate Defenses to M&As

For one reason or another, a corporation may be prompted to accept a merger or acquisition, however,
it is not always in the best interest of the shareholders to accept such a tender offer. Corporations
typically engage in the below tactics to avert an acquisition.
Poison Pill Issuing share rights to potential shareholders that grant deep discounts
relative to the fair value of shares to drop the share price, and in turn,
the portfolio value of the firm.
Flip-in Poison Pill A poison pill issued to existing shareholders to retain control.
Flip-over Poison Pill Allows stockholders to purchase the acquirer’s shares after the merger
at a deep discount. It is the Equity version of a Macaroni Defense.
People Pill Skilled Management Personnel threaten to quit en masse pending a
hostile acquisition, taking down goodwill with them.
Jonestown Defense An extreme poison pill that kills the corporation when executed. It is
done on two layers. First is the typical poison pill provision, then next
is another wave of share rights to purchase below market. This dilutes
shareholder value and control, averting an acquisition. It essentially is
a deliberate attempt to make the company go bankrupt.
Macaroni Defense To discourage a hostile takeover, potential investors are issued bonds
that hold a high redemption price upon successful takeover. Its risk is
that it makes compromise toward friendly takeovers more difficult.
More bonds issued means a cheaper/riskier portfolio.
Suicide Pill A poison pill that grants shareholders the option to convert their
shares to bonds if a raider acquires control (or at least, 51%) over the
acquiree. This causes the acquiree to liquidate shortly after being
acquired.
Pac Man Defense This is when the acquiree attempts to become an acquirer over the
hostile corporation attempting to take it over.
Premium Raid The acquiree attempts to repurchase its shares at a high premium to
retain control over its board of directors, either by Vote or Veto.
Leveraged Buyout The acquisition (or reacquisition) of shares possessing control by a
group of private investors using funds sourced through debt such as
loans and bonds which are considered junk at this point. Bonds often
cause such high interest payments that kill operating cashflow.
Golden Parachute A lucrative compensation plan issued to top management (usually
those who are keen on keeping their positions in the firm) to
incentivize maintaining corporate control; otherwise, this agreement
will cause their termination.

If an acquisition becomes friendly, the provision can be annulled.

Silver Parachute Similar to the golden parachute, except that the plan is issued to most
employees, and not only top management
Staggered Board of Directors A staggered board offers a control against the ability to overtake and
to vote out a director keen on keeping control. It makes acquiring
control by representation difficult as it will prompt the acquirer to
gain favor over directors (thru proxy fights) that plan to be elected.
Supermajority Provisions This is a defense in the Articles of Incorporation that states that
corporate control must be voted by a supermajority, or a percentage
higher than a simple majority. Higher thresholds mean more shares
need to be purchased and higher costs to incur.
White Knight A pending acquisition may be allayed by a more amicable one. The
white knight is the acquirer that offers on better terms than the what
the adverse acquirer offers.
Black Knight This is the adverse firm threatening to acquire the acquiree
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Grey Knight A knight that offers better terms than the black knight, but worse
terms than the white knight. This is usually the case when the acquiree
is already struggling, and the knight intends to either resuscitate the
acquiree or integrate it into its own fold.
Greenmail or Target Repo A Repurchase term that includes the covenant to prevent the
shareholder from bidding control over the company. The repurchase
terms are made to be expensive to discourage a takeover, thus
allowing the company to retain control.
Share Buyback This is essentially purchasing shares in the market. It is not so much a
defense since it is expensive to carry-out, and that it resembles more
of a signaling tactic to raise share price.
Standstill Agreement Akin to a cease-fire. It is an agreement with the acquirer to not engage
in acquiring control given a limited period of time. The acquiree pays
a fee to the acquirer to allay the takeover. This however, prevents the
acquiree from offering to other parties during the standstill period so
as to honor the contract between the corporations.
Scorched-earth Pending a takeover, an acquiree attempts to liquidate or destroy its
assets leaving the acquirer with nothing to gain from the acquisition.
Crown Jewel The sale of important assets such as investments, patents, and
business segments to third parties to reduce the value of the acquiree.
Usually, the crown jewels are sold to a white knight. This results in
dilution of wealth.
White Squire The white squire is a version of the white knight. It acts as an allied
friend and buys a large number of shares from the target. It uses these
shares to vote against a hostile bid. This is usually done through
dispersed interest groups or a significant number of Non-controlling
Interest.
Killer Bees These are key individuals hired to fend-off takeovers. Skilled
Accountants, Lawyers, Consultants, etc. develop strategies and
techniques to prevent the takeover.
Lobster Trap The acquirer issues a charter that prevents persons with more than
10% interest of convertible securities from converting these to voting
stock. The charter/provision is usually buried in the fine print.
Nancy Reagan Defense The board simply says no to a formal bid. This is more of a symbol or
message rather than a formal defense.
Pension Parachute A mix of poison pills and parachutes that an acquiree takes. The
acquiree transfers cash to pension plans (since pension plans cannot
be disturbed by anyone else except the pensioners and the fund
managers) and deliberately reports unattractive cashflows in the
process (and in turn, liquidity and solvency).
Safe Harbor Provision A provision of law that reduces a party’s liability on the condition that
the party acts in good faith or performance of duties. This is
particularly applicable to Directors that act in the best interest of
shareholders, adding security against proxy fights.
Whitemail An acquiree will sell deeply discounted stock to a white knight. Since
the shares are controlled by a friendly party, the acquiree can safely
raise acquisition cost whilst increasing shares outstanding making it
difficult for its shares to be further purchased. If the hostile acquirer
already has shares, this has the effect of diluting its shareholdings.
Backend Plans Cash dividends are issued along with a right that grants the
shareholder the ability to exchange the right along with the share and
some cash under a specified back-end price. When an acquirer already
holds stock, this causes the stock to be repurchased at a lower price.
Dawn Raid A sudden entry in the stock market by an acquirer at a price above
market; it is akin to a blitzkrieg, which catches bidders off-guard.
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The M&A Process

1. Business Valuation – the process of examining both present and future market values of the target
company. Thorough research and due diligence is conducted at this phase of the process. Other
qualitative factors are also taken into account (i.e., goodwill) such as capital gains,
organizational credibility, market share, skilled workforce and management, etc.
2. Proposal Phase – A proposal is drafted explaining strategies, acquisition cost, commitments,
which are usually issued through a non-binding document
3. Planning Exit – Exit Planning is done by the acquiree and must be considered such that it can be
instituted in a profitable manner (whether it sells partially or fully)
4. Structuring Business Deal – After finalizing exit planning, the new entity has to take initiatives to
market the sale and create innovative strategies to enhance business and credibility.
5. Integration – This is the formal union or M/A. It includes the Formal Mandatory Tender Offer, the
Drafting of the Articles of Consolidation or Merger and issuance to the SEC.
6. Operations – This is now at the phase where the venture must sustain its combination synergies.
Divestitures, Restructuring, and Liquidation
Divestitures – Corporate restructurings include not only mergers. Sometimes, in order to create value for
shareholders, a company will divest part of the company or liquidate entirely. This is called a divestiture.
Partial Sell-off of Assets An asset sale is the sale of part of one company to another. This usually
enhances shareholder value for both buying and selling firms given
that the buying firm can manage the business unit better than the
selling firm.
Corporate Spin-off A spin-off is similar to a sell-off of assets, however, the Business unit
is not sold for cash or securities. Instead, common stock in the spin-
off is distributed to company shareholders on a pro-rate basis,
becoming its own company. This is also done in cases where existing
shareholders of the original company retain control, (80% in US), no
tax liabilities are accrued from the corporate ‘sale’ to the new spin-
off company (failure to retain control will result in a recapitalization
transaction subject to capital gains taxes. This is also characterized
by additional share-based compensation to the executives of the spun-
off company.
Equity Carve-out Carve-outs involve the divestiture of a part of the company like spin-
offs, however, it differs because shares in the new company are not
given to existing shareholders but are sold in a public offering (IPO).
In this case, the parent usually retains control over the carved-out
firm and sells-out only a part of the new stock (hence carving out).
Here, the claims of the shareholders are limited to the shares of the
carved-out company, and do not involve the parent’s shares. The
remaining shares held by the parent are also usually spun-out.
Tracking Stock A tracking stock is a stock tied to the performance of a particular
company division (a share-based payment). It does not involve
corporate divestiture, rather, it is the creation of a new class of
common stock in the same company that tracks the performance of a
division. Separating the stock classes of the company lets the company
see the market valuation for each business segment and structures
incentives for each group based on their stock’s performance.
Going Private Changing a publicly-owned company into a privately-owned company.
A group of investors purchase all stocks from the shareholders and
takes the company private. This usually includes the current
management of the company having a large stake. The existing
shareholders receive payment for their shares. The purchase is usually
through cash, but it may also utilize debt through a Leveraged Buy-
out.
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Leveraged Buyouts This involves the purchase of a company or segment using very little
equity to maximize leverage. The purchase is a cash purchase but is
sourced from large amounts of debt unrelated to the purchase. The
borrowers of the debts are from the company being purchased, and
the assets are the collateral for the purchase. These would require:
• Stable cashflows
• Very minimal debt prior to the LBO
• Unencumbered assets with high realizable values
This usually comes about when division managers want to take
ownership over the segment. Alternatively, when the company is sold
to management, it is called a Management Buy-out.

High risk debt is taken alongside secured debt for an LBO. This is due
to the high-risk debt resulting to large tax cuts. The fixed charges for
these debts are high and prioritized for payout over operations.
Meaning, it spends very little or none at all for expansion. The ultimate
goal for an LBO is for it to go public again, but is a often a risky move.
Mezzanine Financing The debt used to finance an LBO involves a senior debt and junior
subordinated debt. Senior debts are secured as to the assets under an
LBO, while junior debts are unsecured debts. It is called mezzanine
financing because it stands between Secured Debt and Preferred
Equity in terms of asset priority.
Debt Restructuring and Liquidation – In the event that a company is in financial distress, it has the option
to perform debt restructuring; to opt for loan forgiveness and extensions for payments. After exhausting
all available options, it must go into bankruptcy.
Reorganization Reorganization is an attempt to rehabilitate the company by changing
the capital structure. It may involve exhausting all reserves and
modifying the par value of common stocks, or even inducing the
conversion of debts into equity securities or vice-versa.
A debtor continues to operate, although a trustee may be appointed
to assume fiscal responsibility. For the debtor to obtain new financing,
post-petition creditors are given priority over pre-petition creditors if
bankruptcy proceeds to liquidation (petition refers to petition to enter
into new debts). If, after petition to apply for financing, post-petition
creditors to extend financing, the rehabilitation courts can authorize
post-petition creditors to take a lien on the debtor’s property
Cramdown A reorganization is usually required to be drawn-up and filed to court.
Creditors and stockholders must approve the reorganization plans. If
the court finds the plan fair, equitable, and feasible but creditors do
not approve it, the judge can impose a plan upon all claimholders.
This is called the Cramdown effect, which must be honored by all
parties to the restructuring/liquidation.
Voluntary Liquidation When the firm’s assets are more valuable to shareholders in
liquidation vs the present value of expected future cashflows, they
may elect to liquidate voluntarily. The Debts are paid-off at face
value.
Involuntary Liquidation When creditors take initiative to liquidate a business, a bankruptcy
proceeding is involuntary. Claims must be certain and is adjusted
equitably. The petition must include evidence of the debtor’s
equitable insolvency, and courts must decide if this petition has merit.
If the court accepts, it issues a Stay-order of creditor actions pending
a more permanent solution, preventing new actions from disturbing
the main suit. Debts are paid at face value.
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Valuation Models
Discounted Dividends Model – The value of the firm may also be used to approximate the value of the
stocks it offers. In this case, all the economic benefits realized throughout the expected life of the firm
or project is discounted. This is the Discounted Free Cash Flows of the Firm:
𝐷𝐹𝐶𝐹 = (𝐸𝐵𝐼𝑇(1 − 𝑇𝑎𝑥𝑒𝑠) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 − 𝐶𝐴𝑃𝐸𝑋
− 𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙) ∗ 𝑃𝑉𝑂𝐴 𝑜𝑓 1 𝑎𝑡 𝑡ℎ𝑒 𝑊𝐴𝐶𝐶
Approaches to Business Valuation
Cost Approach Market Approach Income Approach
Used for Liquidation, at NRV Used for Going-concern Used for Going-concern
Based on the historical cost or NRV Based on similar assets recently sold Based on benefit streams realized in
of assets in the open market. Business i.e., EVA.
Not ideal for going-concern Difficult to find a benchmark Also used for Capital Budgeting
Ideal for use in: Ideal for use in markets where Ideal for use when data about the
Liquidation, Asset rich entities, or comparative data are available benefit stream is available, or if
Businesses w/ no recent income substantial Goodwill is available.
Use Book Value Use CAPM and Gearing Use DFCF and Gordon Model
Quitting Concern or Actual Trading Concern or Statistical Merger Concerns or Intrinsic
Normalization Adjustments for Business Valuation
Non-operating Non-recurring Comparability Discretionary
Remove non-operating Remove infrequent items Converting FS based on E.g., Capitalizing R&D and
items another policy/basis Literal intangibles
Bonus to Executives Gains/Loss on Disposal IFRS to US GAAP EVA-items
Risk Adjustments for Business Valuation
Necessary for analyzing M&A’s and is concerned with providing a range of values for which a business
could be bought or sold because its main concern is providing a risk-adjusted valuation of cost of equity.
One may notice that the stages of valuation are concurrent with the level of information available. The
more rigorous the information, to more viable the approach.
o Income Approach/Maximum Value is derived from Cashflows and or Earnings under new ownership
o Deals with whether a business should be pursued for M&A, considering potential & synergy
o This considers the ‘value-adding’ process of the company.
o In Business Combination, this method approximates the Goodwill of the Company, the
unattributable portion of wealth that usually arises from quality employees, strong
management, and excellent customer relations.
• Free Cashflow is Discounted at WACC of the target company
𝐷𝐹𝐶𝐹 + 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 − 𝑁𝑒𝑡 𝐹𝑢𝑛𝑑𝑖𝑛𝑔 = 𝐼𝑚𝑝𝑙𝑖𝑒𝑑 𝐸𝑞𝑢𝑖𝑡𝑦 • Terminal Value is DFCF at Perpetuity
• Net Funding is all Financial Net Assets • Implied Equity is the Fair value
• Implied Equity divided by Shares Issued = Intrinsic Value
• Intrinsic Value – Market Value = Undervaluation (Overvaluation) of Shares
• Approach conservatively if a target company is unlisted. An Industry Average P/E
may be appropriate sometimes.
o Market Approach/Intermediate Value is derived from Dividend Policy under existing management
o Deals with whether a business is good on its own terms, use Asset Beta for CAPM
o Gearing and Re-gearing Beta/Levered (Equity) and Unlevered (Asset) Beta
o This is also called the Hamada Equation
o When a firm does not use any debt, the Unlevered Beta determines its value.
o When a firm issues debt, the Levered Beta determines its value
o This considers the ‘market outputs’ of the company, or risk incentive of debt.
𝑬𝒒𝒖𝒊𝒕𝒚 𝑩𝒆𝒕𝒂
𝑨𝒔𝒔𝒆𝒕 𝑩𝒆𝒕𝒂 =
[(𝟏 + (𝟏 − 𝑻𝒂𝒙 𝑹𝒂𝒕𝒆)(𝑫𝒆𝒃𝒕 𝒕𝒐 𝑬𝒒𝒖𝒊𝒕𝒚 𝑹𝒂𝒕𝒊𝒐)]
o Under this approach, considering Modigliani-Miller No Tax Theory (MM Theory),
Leveraging should not affect the cost of capital or Business Valuation; otherwise,
valuation be adjusted to get the Equity Beta
o Cost Approach/Minimum Value is the Asset Value of the Business (See AFAR Corporate Liquidation)
o Balance Sheet Value – Easy to compute/acquire information of
o Realizable Value – More difficult to acquire, but more reliable (Fair Value)
o This considers the mere net assets of the company. Akin to no one using the assets
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Discounted Cashflow Model for Business Valuation

The Discounted Cashflow Model is the most widely used valuation model for determining business value.
Oftentimes is it associated with feasibility studies as it serves as a ‘sanity check’ for market valuation.
Steps in DCF Model
1. Determine Cashflows and adjust based on normalization
2. Generate Financial Forecast up to some Horizon Date
a. Determine the Expected Growth Rate (Plowback Ratio not Given)
i. Rate of Reinvestment of Earnings
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 (𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒)𝑖𝑛 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 =
𝐸𝐵𝐼𝑇 ∗ (1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒)
**The reinvestment rate is patterned from the behavior of assets as they relate to profits; and profits as
it relates to sales (which determines working capital behavior)
ii. Rate of Return Earned on Capital Invested
𝐸𝐵𝐼𝑇(1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒)
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑜𝑟 𝑇𝑜𝑡𝑎𝑙 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠
iii. Determine the growth rate by working out equations:
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 (𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒)𝑖𝑛 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑜𝑟 𝑇𝑜𝑡𝑎𝑙 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠
b. Sustainable Growth Rate (See AFN Analysis, Plowback Ratio Given)
3. Generate Financial Forecast up to infinity using a single growth rate
4. Compute Discounted Values as shown:
Discounted Cashflows or DCF XX 𝐶𝐹0 (1 + 𝑔𝑠 )𝑛 Where:
∑ = 𝐷𝐶𝐹 CF = Cashflows
Discounted Terminal Value XX (1 + 𝑔)𝑛
𝑛 g = growth rate (may differ each
Enterprise Value XX 𝐶𝐹𝑚 (1 + 𝑔𝑚 )𝑚 year)
Net Funding or FV of Debt (XX) = 𝐷𝑇𝑉 n = periods of projected growth
(𝑊𝐴𝐶𝐶 − 𝑔)𝑛
Implied Equity or Intrinsic Value XX m = periods of terminal growth
a. Net Funding is the target company’s Net Financial Assets (Liabilities)
b. The Enterprise Value is also determined as the market value of debt plus the market
value of equity. The Market Value of Equity is unknown; hence it appears as the Implied
value of Equity after deducting net funding.
5. Determine FV per Share:
Implied Equity XX
Shares Issued X
Fair Value per Share XX
6. See if Shares are Overvalued or Undervalued
FV = Market Price = At the Market FV>Market Price = Undervalued FV<Market Price = Overvalued
7. Optional: Compute Goodwill
Consideration Transferred XX
Implied Equity (XX)
Goodwill (DCF Model) XX
8. Perform Sensitivity Analysis
Sensitivity Analysis can be performed on each step of the valuation model. Some factors include:
• Tax rates • Growth Rates
• Sales Volumes, Cost Structure, and Cash collection • Dividend Policy
estimations • Risk adjustments
• Available funding • Market quotations for Market Price
• Cost of Capital or WACC • Beta value
Other Considerations:
• It is best to perform sensitivity analysis through a dynamic and interactive model to be able to
see the possibilities related to the valuation.
• Sometimes, the DCF model is applied to different projects within a firm. The implied equity of
each is aggregated to arrive at the overall fair value.
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International Finance
International finance includes direct foreign investment as well as international buying and selling (both
may or may not include foreign-sourced financing)
Direct Foreign Investments
Direct Foreign Investments (DFI) – An investment in businesses or industries located in a country made
by a person (corporate or natural) or a country that is in another country. It involves investment in real
assets in foreign countries and direct management thereof. It includes Joint ventures, Acquisitions, and
new foreign Subsidiaries.
• It is different from foreign portfolio investment, as this is not merely represented by securities,
earning passively. In contrast, this is an actively managed investment.
• Funds are sourced through: Parent resources, Sales of Common stocks and Bonds in the foreign
country, and International Borrowing
• It is characterized by difficulty in both managing and disposing it, as it is complicated by anything
international, however, it entails significant returns both tangible and intangible (i.e.,
diversification, economies of scale, technology, cost arbitrages, etc.).

International Diversification – Despite further exposure to inherent risk, international projects can
reduce a company’s overall risk because of the nature of the new and diverse investment found only
abroad.
International Buying and Selling of Currency
For any firm to participate in global markets, it must be able to transact in new global markets. To do
so, it must acquire legal tender in those countries it plans to expand to. Hence, it must participate in
foreign exchange markets to gain access to currencies. (For more technical insights, see AFAR.)
However, for a simplified image of foreign exchange markets, think of the foreign currency as a
commodity to be purchased with local currency. For example, a kilo of pork costs P270.00, in this
analogy, the foreign currency would be the kilo of pork, expressed as 1 kg pork: P270.00; turn the pork
into dollars or another currency, and it becomes a direct FOREX quote. For MS, the following are areas
of interest for study:
Effect of Inflation If the rate of inflation is larger in one currency than the other, the more inflated
or Purchase Power currency reduces in supply, while the other (held constant) increases in demand.
Parity This causes the inflated currency to weaken relative to its counterpart.
Effect of Central If the Central Bank interest rate of a currency is larger than the other, the costlier
Bank Interest Rates currency reduces in supply, while the other (held constant) increases in demand.
or Discounting This causes the costlier currency to weaken relative to its counterpart. Since
interest rates are higher, funds to sell bonds in the Foreign Currency will cost less
due to discounting, and the periodic interest increases, creating an injection of
foreign currencies converted to local currency.
Effect of Income If the income levels of a currency is larger than the other, the expanding currency
Levels and will increase in supply as the general population gains access to more funds and
Employment thus appetite to buy imported goods, causing more dollars in circulation. The
demand for the foreign currency will stay the same.
Effects of Expected If the expected rates of a foreign currency will increase, the behavior will be to
Future Exchange save foreign currencies and to spend local currencies only. This will reduce
Rates foreign currencies in circulation, reducing supply. The demand for the local
currency will stay the same.
Government Controls such as:
Controls • Restricting currency – reduces supply for local currency
• Tariffs – reduces demand for foreign currency
• Exchange Rate Systems
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Exchange Rate Systems

A country’s exchange rate system can be classified according to the amount by which the government
controls the country’s exchange rates.
• Freely-floating exchange rate – Exchanges not controlled by government
• Fixed exchange rate system – Rates are held constant by governments. Various interventions
are placed by the government to make sure that exchange rates with that currency stay constant.
o A fixed rate set above the market equilibrium would overvalue that currency, causing a net
import of consumer goods, reducing foreign currency reserves.
o A fixed rate set below the market equilibrium would undervalue that currency, causing a
net export of goods, increasing foreign currency reserves.
• Managed floating exchange rates – This stand between a free market and a fixed system and
includes elements of both. The managed float system is similar to the freely-floating rate system
because exchange rates are allowed to fluctuate in response to market forces and there are no
officially fixed rates. It is similar to the fixed rate system because the government sometimes
does intervene to prevent its currency exchange rate from moving too far in one direction or the
other. Though the government does not fix the exchange rate specifically, it can strongly
influence the exchange rate through its actions.
• Pegged rates – Some countries peg their currency to a foreign currency or basket of currencies.
Used by smaller countries, whose major debts are denominated in to minimize foreign exchange
differentials on paying the debts.
• Cross-rates – When currency pairs are not frequent enough a quotation may not be available, an
interceding currency is determined to arrive at an actively traded conversion.

Foreign Financing
A firm may want to borrow in a foreign currency if interest rates on that currency are attractive. The
development of the Eurocurrency market has opened several financing options.
Effective Interest Rate on a Foreign Currency Loan:
𝑟𝑓 = (1 + 𝑖𝑓 ) × (1 + 𝑒𝑓 ) − 1 Where:
rf = Effective financing rate
𝑆𝑡+1 − 𝑆 ∆𝑆 if = the interest rate of the foreign loan
𝑒𝑓 = 𝑜𝑟
𝑆 𝑆 ef = the percent change in FCU against the LCU
S = spot rates, ΔS = Change in spot rates

Other Financing Activities

Accounts An export may take months to consummate, and so it exposes receivables to risk.
Receivable Aside from hedging, an exporter can apply for receivables to be loaned. The bank
Financing makes a short-term loan to the exporter, usually from one to six months, secured by
an assignment of the account receivable. The bank makes its loan decision on the
basis of the exporter’s creditworthiness and is looking to the exporter as the primary
source of repayment. If the importer (foreign buyer) fails to pay the receivable, the
exporter is still obligated to repay the loan principal as well as accrued interest until
the loan is paid in full.
The exporter can avail export credit insurance in the event of the importer defaulting
on the dues.
Cross-border As with any typical factoring transaction, this also applies in the international arena.
Factoring Since the foreign importer is the source of the factor’s repayment, cross-border
factoring is often used. The exporter’s factor works with a correspondent factor in
the buyer’s country, and the correspondent factor determines the importer’s
creditworthiness and handles the collection of the receivable from the buyer.
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Factors generally provide 70% of the face value within 3-5 working days. After final
payment is received from the buyer, the factor will pay the remaining 30% to the
exporter, less the service fee of 4% to 5%.
Factors often use export credit insurance because of the risk of the foreign receivable.
Letters of A commercial letter of credit is a guarantee by the buyer’s bank that the bank will
Credit pay for the merchandise, provided that the seller (exporter) can provide the required
documents in accordance with the terms of the commercial letter of credit. The
required documents are generally bills of lading and freight documents evidencing
shipment of the goods. Thus, a commercial letter of credit provides reasonable
assurances to both the buyer and the seller. The seller is assured of payment when
the conditions of the letter of credit are met; and the buyer is assured of receiving
the goods ordered.
Most commercial letters of credit are irrevocable, meaning they cannot be changed
unless the buyer and the seller agree to change them. A seller should have the
agreement for a commercial letter of credit reviewed by an experienced bank, a
knowledgeable broker, and its freight forwarder to make sure that all the letter of
credit’s terms can be reasonably met and that the commercial letter of credit itself
is legitimate.
In essence, the bank’s creditworthiness substitutes the importer’s own credit score.
If an exporter is not comfortable with the export, it may ask a local bank to confirm
the letter of credit.
Standby A standby letter of credit is a different type of letter of credit. A standby letter of
Letter of credit is more a guarantee by the buyer’s bank, saying that if the buyer fails to pay,
Credit the bank will pay. It is not usually used as the primary payment method. The terms of
a standby letter of credit are somewhat simpler and easier for the seller to comply
with.
Sight Drafts A sight draft is to be paid by the buyer as soon as he sees it. When used with a
commercial letter of credit, the sight draft is paid by the bank. When used with a
standby letter of credit, the sight draft is to be paid by the buyer, and if the buyer
does not pay, it must be paid by the bank. The exporter gets paid when shipment is
made and the draft is presented to the buyer or the bank for payment. The buyer’s
bank does not release the shipping documents to the buyer until the payment has
been made, and the buyer cannot claim the shipment until he has the documents.
Time drafts A time draft is similar to a sight draft, except that payment is demanded a specified
time after the buyer accepts the draft and receives the goods. The exporter instructs
the buyer’s bank to release the shipping documents when the buyer accepts the draft.
The buyer writes “accepted” on the draft and is then contractually liable to pay. The
accepted draft, which is called a trade acceptance, is a promise by the buyer to pay
the seller at a specified future date. The exporter is providing financing for the buyer
and is relying on the buyer’s integrity for the receipt of the payment. If the buyer
does not pay the draft on its maturity date, the bank does not have any obligation to
pay. In addition, the buyer can delay payment by delaying acceptance of the draft.
Banker’s A banker’s acceptance is a time draft that has been issued under a letter of credit
Acceptance and has been accepted by the importer’s bank. The draft represents the exporter’s
demand for payment. The time period of most time drafts is from 30 to 180 days.
When the importer’s bank accepts the time draft, a banker’s acceptance is created.
The bank that has accepted the draft is obligated to pay the amount of the draft to
the holder of the draft on the maturity date. If the exporter does not want to wait for
payment, the exporter may sell the banker’s acceptance at a discount in the money
market. The buyer of the banker’s acceptance will receive the full payment from the
bank on the maturity date. The interest on the banker’s acceptance is the difference
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between the face value and the discounted value. Thus, trade financing for the
exporter is provided by the holder of the banker’s acceptance.
Working Both importers and exporters may make use of working capital financing. For the
capital importer, the loan finances the working capital cycle that includes purchase of
Financing inventory, sale of the inventory and creation of an account receivable, and finally
conversion of the receivable to cash. For the exporter, the loan might finance the
manufacture of the goods that are to be exported, or it may finance the period from
when the sale is made until payment is received.
Forfaiting Forfaiting is the financing of medium-term capital goods sold internationally.
Forfaiting refers to the purchase of financial obligations such as bills of exchange
without recourse to the exporter. The importer issues a promissory note in favor of
the exporter for a period of three to seven years. The exporter then sells the note,
without recourse, to the forfaiting bank.
Forfaiting is similar to factoring in that the forfaiter is responsible for collecting from
the importer/buyer. The forfaiting bank must assess the creditworthiness of the
importer, because it is in effect extending to the importer a medium-term loan.
Forfait transactions generally require a bank guarantee or a letter of credit to be
issued by the importer’s bank for the term of the transaction to serve as a secondary
repayment source. The forfaiting bank places a lot of reliance on the bank
guarantee/letter of credit as a secondary repayment source, because financial
information is usually difficult to obtain on the foreign buyer.
Forfaiting transactions are usually in amounts greater than $500,000. The forfaiting
bank may sell the promissory note from the importer to other financial institutions,
but the forfaiting bank remains ultimately responsible for payment on the note if the
importer does not pay.
Countertrade Countertrade means that the sale of goods to one country is linked to the purchase or
exchange of goods from the same country and is both a means of paying for an
international trade transaction and a means of financing it. Countertrade may be used
if the buyer does not have access to currency conversion, if exchange rates are
unfavorable, or if the two parties can exchange goods or services on a mutually
satisfactory basis.
Barter Barter involves the exchange of goods or services between two parties without the
Countertrade use of any currency as a medium of exchange. Barter has been in existence for
thousands of years. It is not used very often, though, because it is difficult to find
goods of equal value.
Counter The seller gets paid the regular amount and agrees to purchase goods worth the same
purchase amount from the buyer. The delivery and payment for both goods are separate
transactions.
Compensation The sale is paid partially in cash and partially in goods, or it may be paid 100% in
deals goods. There is only one contract, and the value of the goods is expressed in monetary
terms. An example of a compensation deal would be a company in one country
exporting steel to a company in another country in exchange for purchasing a certain
amount of railroad ties from the company in the other country.
Buy-backs The seller agrees to supply technology, equipment or raw materials that will enable
the recipient to produce goods. The price of the supplied technology or equipment
will be paid to the seller from the proceeds of the sale of the goods produced with
the technology or equipment. Alternatively, the seller may agree to buy back the
equipment. This type of transaction is most often used in developing nations.
Transfer In international financing, transfer price setting should be considered, particularly for
Pricing tax settlement. Higher tax rate for importing country = Higher Transfer Price, Lower
tax rate for importing country = Lower Transfer price.
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Appendix: Review of Terminologies in Statistics

Measures of Central An attempt to describe a set of data by identifying the central position of that
Tendency data. They may either be the Mean, the Median, or the Mode
Mean or Average The sum of scores, divided by the number of observations.
Median The midpoint or number in a distribution having 50% of the scores above it and
50% below it. Ordering from data from least to most, it would be in the middle.
Mode The number that occurs most frequently in a distribution
Range The difference between the highest and lowest scores in a distribution
Standard Deviation The most stable measure of variability. It assesses how far individual scores
vary in standard unit lengths from its midpoint of 0.
Variance A measure of dispersion of a set of data points around the mean.
Nominal Data An attribute fitting into a category
Ordinal Data Quantities having a natural order or sequence (e.g., pain scales)
Ratio Data Any types of data with a Natural zero point.
Interval Data It is the same as ordinal data, only that it is subdivided into equal parts
Discrete Data Data that can only be integers or whole numbers
Continuous data Data that can be expressed in decimals
Parameter A number that describes a whole population
Statistic A number that describes a sample
Point Estimate A single value of a parameter
Interval Estimate A range of values where the parameter is expected to lie
Confidence Interval Quantifies the uncertainty in measurement. A 95% Confidence Interval for a
range of values means that any inference falling within the 95% range is certain
to be a true value where it lies.
The Central Limit A population given a mean and a standard deviation; with sufficiently large
Theorem and random samples, the arrived sample will approximate being normally
distributed
Normal Distribution A probability distribution that is symmetric about the mean, showing that data
or Gaussian Dist. near the mean are more frequent in occurrence, than far from it. It appears
as a bell curve.
Statistical A result from data generated by testing or experimentation is likely to be
Significance attributable to a specific cause; confined to the study. (t-scores, z-scores, p-
values)
Null Hypothesis A null hypothesis is a type of statistical hypothesis that proposes that no
statistical significance exists in a set of given observations. It is the status quo;
or that two parameters of different populations are not related significantly
Alternate Hypothesis The opposite of a Null Hypothesis
t-test A test that assesses whether two samples (ideally with fewer than 30
observations) are statistically different from each other.
z-test A test that assesses whether two samples (ideally with 30 or more
observations) are statistically different from each other.
Standard Score A standard score is a set of scores that have the same means and SDs that
allow cross-comparisons.
F-test A statistical test of the equality of the means of two or more samples. It
compares the means and variances between and within groups over time.
Regression Analysis A set of statistical methods used for the estimation of relationships between
a dependent variable and one or more independent variables.
p-values A number that describes the probability of obtaining results at least as
extreme as the observed results of a statistical hypothesis test, assuming that
the null hypothesis is correct. Small p-values mean that there is strong
evidence in favor of the alternative hypothesis.
TSS (Total Sum of ∑𝑛𝑖=1(𝑦𝑖 − 𝑦̅)2 It is the total difference of the observation from the mean; the
Squares) whole variance, in other words.
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SSR (Sum of Squares ∑𝑛𝑖=1(𝑦̂𝑖 − 𝑦̅)2 It is the degree in which a regression model represents the
Regression) modeled data. Higher regression means that the data does not fit well with
the model. It is also known as the Explained Variance.
SSE (Sum of Squares ∑𝑛𝑖=1(𝑦𝑖 − 𝑦̂)𝑖 It is the degree of error that cannot be explained by the
2

Error) regression model. A low SSE means that the data can be explained by the
model. It is also known as the Unexplained Variance.
Standard Error The standard error of a statistic is the approximate standard deviation of a
statistical sample population. It measures the accuracy that a sample
distribution represents the population using the SD.
Degrees of Freedom The maximum number of logically independent values in the data sample. This
means that for every observation, it must only be constrained to one outcome,
unless more constraints are considered for analysis.
Practical Significance The indicators of a statistic that explains goodness of fit; that if all variables
are taken into consideration at once, the overall result should vary, and the
insight gained is relevant to the real world. (R2, Adjusted R2 , Multiple R)
Appendix: Project Feasibility Studies
Project Feasibility Studies – The systematic investigation which ascertains whether a business
undertaking is viable, and if so, the degree of its profitability. It provides a basis- technical, economic,
commercial, and other factors such as organizational and socioeconomical considerations on a proposal.
Purpose – It is done to minimize the risk of failure of business ventures thereby reducing the waste of
valuable resources. It will define and analyze the critical elements relating to the project such as
production, technology, investment and production cast and sales revenue to yield a defined ROI.
Components:
• Organization and Management • Taxation • Profitability
• Marketing (Pricing, Demand, • Financing (Sources of • Social Desirability or
and Supply Projections, as well Financing i.e., Capital and Socioeconomic considerations
as the Marketing Scheme) Debt) o Taxes paid
• Technical (Production, and • Financing Projections (The o Employment Opportunities
Industrial Engineering, Projected Financial o Other Social Benefits such
Operating Requirements) Statements over 5 years as infrastructures (such as
roads)
Phases
Pre-investment Phase Investment Phase Operational Phase
Identify investment opportunities Project and engineering designs The Actual commencement
Preliminary project selection and Negotiations and contracting of the project, subdivided
definition Construction into:
Project formulation Training and Plant Commissioning Transitioning Phase and
Final Evaluation and investment
Stabilization Phase
decision
Forecasts and Projections – generally, all the concepts in Financial Accounting are taken into
consideration. This is typically program budgeting
Projected F/S Sales and Demand Forecast Market Supply Forecast
• A notable difference is seen for the Sales Forecast since this comes from external forces such as
consumer attitudes to the product or service and the rigor of the marketing campaign. Estimates
and statistical tools are particularly useful.
Analysis of Projections – Various tools are useful to generate and evaluate the projections such as:
• Breakeven Analysis • Horizontal, Vertical, Industry, Ratio Analysis
• Net Present Value, • Special Considerations such as EVA and Cost
• IRR, ARR Allocations must also be done for expansion
• Discounted Payback Period, Payback Period • AFN and Sustainable Growth Analysis
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Title V: Economics
Microeconomics
Economics – “Household Management”, and is applied as either:
a. Positive Economics – It is a study of the Status Quo and is Objective in nature
b. Normative Economics – It is an economic study of Proposals of what ought to be and supposes
Subjective evaluations of the economic environment.
In a nutshell, Economics is concerned with reconciling unlimited wants with limited resources.
Therefore, it is about Satisfying wants and needs, i.e., Giving a person goods and services. Goods and
Services come from economic resources which are also called the means of production
Capital Anything man-made used for making man’s work easier. This is NOT FINANCIAL
CAPITAL, rather it is more akin to Invested Assets (Properties, Inventory, etc.)
Entrepreneurship Capacity to take risks, innovation, strategy, management skill, intrinsic
Land Anything derived from nature, broadly, anything that could exist without man.
Think Land and Wasting Assets.
Labor Time and Manpower
Scarcity – is Humanity’s realization that apparently, unlimited wants cannot possibly match limited
resources; “no one has everything”. It is dubbed as the main problem of economics.
Solutions:
Determining needs wisely – Demand Using resources efficiently – Supply
• What to produce – What goods are needed? (Consumer Goods, Capital Goods, Essential Goods,
Luxury Goods, Economic Goods, Free or Government Goods)
• How to produce – How much is needed? What’s it worth? How to make it? How much can we make?
• For whom to produce – Who needs it? How to deliver the goods?
Economic Functions and Activities
• Production – creating goods or services for supply of the economy
• Allocation – determining to whom a good should be given to
• Distribution – delivering the goods or services to those demanding the good
• Exchange – a form distribution where those who demand a good give something in return to those
who supply the good demanded
• Consumption – the end goal of all goods or services where the need or want is satisfied
Economic Systems
Who makes the decisions to answer those questions?
• Traditional System - choices are decided by past events, past generations
• Command Economy - choices are decided by a powerful or influential person or institution
• Market Economy - choices are decided by people who participate in trade.
• Mixed Economy - a mix of controls each institution or participant in a society or economy has over
the actions in an economy.
Trade
Trade is where two entities decide that whatever resources they receive from the other are enough to
cover the cost of giving up what they had originally. It is assumed that upon trade, both parties believe
they made the best, optimum choice for themselves.
• Trade-offs and Opportunity Cost – Scarcity forces entities to make decisions, and to make the
most out of those decisions.
• Absolute advantage – No other economy can produce a good that another possesses or produces
• Comparative advantage – Other economies find it difficult to produce a good that one may
already produce so well and efficiently
This means that economy can choose to no longer make trade-offs on its own if it could simply buy it a
lot cheaper from a country that produces it more efficiently, in exchange of what I could produce a lot
cheaper itself. On a macro-perspective, there is always something to gain in Comparative Advantage,
which is why it is preferred over Absolute Advantage.
• Specialization is the Focus on developing a good or service; it is the main driver of advantage.
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Production Possibilities
The decision to
trade-off a good for
another determines
which areas an
economy has an
advantage. One good
at manufacturing
may not be so good at
delivering services,
hence it may devote
more resources to
manufacturing and
compensate the
demand for services
by outsourcing from
another that is more
specialized to deliver
that service.
Demand, Supply, Price, and the Market
Market – Where economic participants weld into one lump that decides for the economic questions of
the entire economy. Rather than as a singular entity, it is rather a force resulting from the individual
actions of demand (Consumers) and supply (Suppliers)
Law of Demand: Demand Increase implies a Price fall
• Demand – is the quantity of goods or utils required by consumers. It is expressed as a downward
slope in relation to the price or compensation for the goods required. It is important to bear in
mind, that price or more aptly, money, is also a resource. The consumer’s capacity to earn and
save is its ‘production possibility’ which will be used to trade-off for satisfying one of its needs.
• Diminishing Marginal Utility – The usefulness of a good will eventually come to a point such that
spending an additional peso for a good will not yield as much utils as it once had. An individual
already satisfied will no longer need to consume the same resource at the same level as it may
have once did.
Indifference Curve Marginal Utility and Total Utility

The indifference curve shows the utils a Marginal utility is the additional product
consumer has between two goods a consumer consumes to satisfy a need
• Non-price determinants of Demand:
Disposable Income or Savings Shift to the Right or Increases total Demand
Increases in the Price of Substitutes Shift to the Right or Increases total Demand
Increases in the Price of Complements Shift to the Left or Decreases Demands
Prices are expected to rise Shift to the Left or Demand Increases today
Increases in the Population Shift to the Left or Demand Increases
Improvements in Quality Shift to the Right or Increases total Demand
Favorable Preferences Shift to the Right or Increases total Demand
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Law of Supply: Supply increase implies a price hike

• Supply – Quantity of goods that suppliers are willing and able to sell. It is upward sloping to
reflect the Supplier’s interest in generating profits. Any supplier will be rightly compensated for
each unit of production. A productive supplier will have each unit of cost compensated by price.
• Diminishing Marginal Returns – Every supplier will encounter a point in production where the
cost of producing an additional unit eventually exceeds the marginal revenue realized from
selling the same unit. Usually, suppliers have a variable factor to production and a fixed factor;
returns will begin to diminish when productivity from variable factors and can no longer be
supported by the fixed factor of production in the short-run. For instance, there are too many
bakers and too few ovens to make bread efficiently.
• Law of Increasing Marginal Cost – as production capacities increase, the per unit cost of
increasing supply increases cost marginally the consideration of the both above will lead to
Cost Minimization.
Total Product is the actual total production for a
unit of input (i.e., labor) It will never go
negative nor will it decline further. However, it
tends to approach a maximum amount.

Average Product is the actual total production

divided by the units of input. It also will never go
negative, but it is exhibited to decline.

Marginal product is the additional units acquired

for additional units of input. It is exhibited to be
able to be negative and be able to decline once
the maximum point is reached.

As long as Average Product is less than Marginal

product, the total cost will rise. If the Average
product is more than the marginal product, the
total cost will begin to slow down and approach
its maximum amount. (Maximum Total Cost is
where the Marginal Cost intercepts the x-axis.
Non-price determinants of Supply
Producer is motivated to produce Supply shifts to the Left or Increase in total Supply
Technology Improves Supply shifts to the Left or Increase in total Supply
Increase in Competitor’s prices Supply shifts to the Left or increase in total Supply
Increase in Complement’s prices Supply shifts to the right or decrease in total supply
Unfavorable Natural Phenomena Supply shifts to the right or decrease in total supply
Tighter Competition Supply shifts to the left or increase in total supply
Taxes and Strict regulation Supply shifts to the right or decrease in total supply
Elasticity
It is the extent to which price changes with respect to the changes in supply, demand, or any other
factor, it is typically the slopes of the demand and supply curves for context.
∆𝑌 In a nutshell, elasticity can be the sensitivity of any variable given any changes in another
𝑦̅ variable. In this case, ∆𝑌 depicts the difference between two values of either x or y; and 𝑦̅
∆𝑋 depicts the average of the two given values. Do note that the values in both X/Y are absolute.
𝑥̅
• Y is said to be elastic relative to X if the formula returns an amount larger than 1
• Y is said to be inelastic relative to X if the formula returns an amount less than 1
• Y is unitarily elastic with X if the formula returns an amount equal to 1
• Perfect elasticity is represented by a horizontal line, while perfect inelasticity is represented by
a vertical line
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Market Equilibrium
Market Equilibrium – The best price for a good is determined by the market’s participants; it is where
Demand & Supply intersect.
Government may intervene and influence Market Equilibrium through Taxes, Subsidies, & Rationing
• Price Ceilings – A Specified Maximum Price charged which cause shortages
• Shortages – Suppliers devote resources to produce other goods since they anticipate making less
profit and volume with Price Ceilings imposed
• Price Floors – A specified Minimum Price charged which cause surpluses
• Surplus – Suppliers devote resources to the goods in question since buyers are forced to buy not
below the minimum price
• Externalities
o Describes damages to production of goods (i.e., Pollution, Competition, etc.)
o Imposing a tax too high will result in a Deadweight Loss, due to a price floor that appears
above the Market Equilibrium point
Costs of Production and Cost Behavior
Cost Formula Alternative Formula
Total Cost FxC+VC Average TC * Qty
Variable Cost TC – FxC Average VC * Qty
Fixed Cost TC – VC Average FxC * Qty
Marginal Cost TC/Qty TVC/Qty
Average TC TC/Q AfxC+AVC
Average VC VC/Q ATC-AfxC
Average FC FxC/Q ATC-AVC
Marginal Revenue SP/Qty -
Short-run Cost Behavior

Long-run Cost Behavior

Economies of Scale – When long-run average costs
fall. Expansion is cheapening since fixed costs are
absorbed. This phase is described as entry.

Constant Returns to Scale – Peak Efficiency is

reached and Fixed Costs can no longer be
reduced. This phase is described by competition.

Diseconomies of Scale – When long-run average

costs begin to rise and the production becomes
too inefficient to pursue. This phase is described
by obsolescence.
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Market Structures
Market Producers Products Control Entry Demand Curve
Pure Competition Many Virtually Price Very Easy Firm – Horizontal
Identical Takers Market – Downwards
Monopolistic/Imperfect Many Differentiated Limited Low Firm – Downwards
Competition Barriers
Oligopoly Few May be Limited or High Firm – Kinked
Identical or Wide Barriers
Differentiated
Pure Monopoly One Unique Price Blocked Firm - Downward
Makers
Monopsony Many; one Identical Price High **Supply Curve;
buyer Takers

Perfect Competition – described

by a perfectly elastic price. In the
Short-run, it has minimal profit;
in the Long-run it has zero profit.

Monopolistic Competition – The

goal of the competition is to
achieve monopoly; hence, profits
incentivize entry while losses
encourage exit.

Oligopoly – Producers tend to

cooperate to set prices. There
are substantive economies of
scale and significant barriers to
entry. Competing suppliers cause
the kink in the demand curve,
and will cause prices to be
inelastic, hence, Prices are
inflexible in the longterm.

Pure Monopoly – described by

patenting, and stringent
licensing. Though a monopoly
makes the price, it must set them
low to preserve order. As long as
MR > MC, a monopolist will drop
prices.
Cartels – the coordination of suppliers in fixing prices
• This is typically not allowed, or at least, is heavily regulated by the Philippine Competition
Commission and Department of Trade and Industry.
Collusion – a non-compete agreement among suppliers
• Any non-competition agreement is typically discouraged as it has the potential to disrupt
competition (that is beneficial to society). Although regulations must strike a balance to
preserve intellectual property rights and privacy rights with social benefit.
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Macroeconomics
Macroeconomics is the branch of economics concerned with performance, structure, behavior, and
decision-making of an economy as a whole.
• Circular Flow of Income - Institutions and key players in a market depend on each other to make
income. In this case, therefore, one entity's income is another's expenditure.
• Wealth - the total value of material things which possess economic value; these are tangible
goods or assets
• Claims of Wealth - the Financial Value of an asset; these are intangible assets such as
receivables, notes, and treasury bills and investments, which may also include equities.
• Income - productive activity. Rewards for production; rewards for utilizing economic means.
Flows of income create stocks of wealth the Stocks of wealth then also increase if Income is
increasing, or spending is decreasing. Upon use or consumption, on the other hand, wealth
decreases.
• Savings – The excess of the flow of income over consumption; it is the net inflow of wealth.
Economic Activities and Value-adding
• Among Business Firms, there are those that extract raw materials from Nature. Which then sell
them to Processors, which will then sell these half-finished goods to a Retailer. Retailers then
sell to Final Consumers. Every step in the process implies an increment in price of the Goods.
• This increment is drawn out from the utility of the Economic means of production. For goods to
be sold when they are needed, continuous selling is required. To reward this process, values
must be added to the new goods.
a. This implies that, the value of the good is as valuable as the Investment plus the
Consumption; hence in an economy, Income exactly should match Expenditure
b. In this case, the value of a good is counted only in its final form or as a Final Good.
Output = Expenditure = Income = Added Value
Outflow and Inflow
Realistically, an economy is not composed of only businesses and households, it is also composed of
governments, financial institutions, and its interactions with the international community; a nation tends
to save; and that some of the income flowing is not returned as immediately as they should
Effects:
1. Household savings go to banks as leakages out of the flow (if income meets consumption, any
excess is stored in banks). which will circulate back as injections via investments.
2. Firms and households pay taxes to government which leak money out of their own flow of
resources; the government will inject money via government expenditure/saving.
3. Firms and households also tend to buy imports which takes pesos out of the flow and into a
foreign country's own circular flow. As pesos are drawn out, this will theoretically be returned
as exports as other countries tend to buy our products as well because it's cheaper.
National Income Accounting
Income = Consumption = Y = C + I + G + (X-M)
All goods and services cannot be measured relatively. They have to follow a standard of Valuation, which
is the Fair Market Value, or Fair Value, or Market Value
Assumptions on National Income Determination
Aggregate Expenditure implies Aggregate Demand
a. Excess Capacity - When abnormally higher levels of demand are observed because of higher
income, output, expenditure, and added values, there is a possibility to increase overall
production, and thus, demand.
b. Prices are held constant - If demand increases due to increases in output and income, this
implies the efficient use of resources in theory. Macroeconomics assumes that if this is the case,
then prices have not been affected. Costs stay the same.
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c. There is a tendency towards Equilibrium - In a perfect economy, Aggregate Demand will always
match the output a nation report. Implying that Spending is always matched by Income at all
levels, this returns a graph that is perfectly bisected by a 45-degree angle.
d. Equilibrium implies that the Sector has planned its spending and that it has forecasted the income
it needs to match its spending.
e. The consumption function is the actual degree of consumption an economy attempts to control.
f. The Intersection of the Equilibrium Line and the Consumption Function is where savings begin to
accumulate. Before the equilibrium point is reached, savings are negative.
g. Marginal Propensities are rates at which spending or saving money the sector follows.
h. All Leakages should Equal All Injections (SAVINGS + IMPORTS = TAXES + EXPORTS)
i. TAXES, IMPORTS, SAVINGS all relate to INCOME at a certain rate.
j. At Full-Employment, or MAXIMUM CAPACITY, there is no longer Equilibrium; instead, a
Perpendicular Line to Income is generated. This is when Output no longer Increases, but
Expenditures continue to rise.
k. Inflationary Gaps are those changes in consumption that cannot be traced to productivity
a. Shifts Upward in Aggregate Spending Imply an Inflationary Gap
b. Shifts Downward in Aggregate Spending imply a Deflationary Gap
Approaches in National Income Accounting
Expenditure Approach – How each sector spends its stock of wealth will determine the overall income
of the economy.
• Final Consumption of Goods and Services
• Gross Domestic Investments (Private Construction, Inventories)
• Government Goods and Services (Public Construction)
• Net Exports
• The Expenditure Approach does not include disposals of securities and claims of wealth
Industrial Origin Approach – Determining income based on what type of industry produces these goods
or services (Agriculture Fisheries Forestry, Mining, Service, etc.)
• Consumption Goods – anything readily consumable.
• Investment Goods – goods used in production (a.k.a. Gross Private Domestic Investment)
• Public Goods and Services
• Net Exports/Imports - Any transaction that facilitates exchange between two countries
• Net Factor Income from Abroad - Earnings from OFW’s (Remittances, Repatriations to foreign
factors of production)
Agriculture, Aquaculture and Forestry XX
Mining and Quarrying XX
Manufacturing XX
Construction XX
Transportation, Communication, Utilities, and Storage XX
Commerce XX
Service Industry XX
Net Domestic Product XX
Net Factor Income from Abroad XX
Net National Product XX
Indirect Taxes XX
Depreciation Allowance XX
Gross National Product XX
Income Approach – National income may also be determined based on the income earned by all
participants in an economy.
1. Factor income of persons
Salaries and Wages – direct pay for labor Profits and Dividends – returns on investment/risk
Rents – use of land/spaces Interest – returns on financial assets/claims
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2. Government Income from Capital – Income from Government Corporations:

Income Tax Estate/Donor’s Tax Percentage Tax Local Taxes Fees, Licenses, Duties, & Tolls
3. Undistributed Corporate Income or Retained Earnings - earnings not assigned to funds, etc...
4. Indirect Taxes – All taxes that could be shouldered by consumers but are eventually paid by firms
(VAT, Local Amusement Tax, etc...) Net of Subsidies or Tax Credits
5. Depreciation Allowance – This is considered Income because Allowances allow further
recognition of stocks of wealth as if these were as good as new (this is because depreciation had
already been charged against overall consumption and retained earnings.)
Factor Income of Persons (Within and Abroad) Depreciation Allowances
Salaries and Wages XX are added because these
Profits and Dividends XX are estimates and can be
Rents XX far from reality of actual
Interest XX XX wear and tear. We could
use Net Domestic Product
Government Income from Capital XX
only if these would
Unappropriated Retained Earnings XX create reliable measures
Indirect Taxes, net of Tax Credits and Subsidies (or Value-add) XX of consumption. Hence
Depreciation Allowance or Capital Consumption Allowance XX the preference toward
Gross National Product XX Gross National Product.

This graph shows the sources of income or

injection function an economy has, in contrast to
perfect equilibrium of income and consumption.
The differences in consumption from each sector
of the economy reflect inflationary gaps and the
multiplier effect in Keynesian Economics.
• “C” represents the general consumers
• “I” represents Investment spending
• “G” represents government intervention
• “X-M” represents net exporting and trade
advantage
This graph shows the leakage function of an
economy. It also reflects the multiplier effect in
terms of the MPS.
• The function of S+T+M represents the leakages
in the economy in the form of Savings, Taxes,
and Imports
• Only upon matching minimum cost & inflation
premium will savings start to increase.

Gross National Product

GNP – Gross National Product – Total Market Value of all goods and services produced by the economy
in each period of time
GDP – Gross Domestic Product – Total Market Value of all goods and services within Philippine Territories
Problems with using GDP
1. Transactions that are useful, but do not appear in the market such as Housewives labor, unaccounted
profits of Small, Micro Business Entities, etc..., are not reflected in the GDP.
2. Some goods and services cannot be naturally accounted for personal use of crops by a farmer,
landlord's own payment for renting space in his own home are not reflected in GDP
3. Illegal, and even unregistered activities are not accounted for in GDP
4. GNP is hard to appreciate without a reliably normal base year. GNP on the current year is not
reliable, and does not reflect effective growth
**GNP per CAPITA = current output theoretically available for each person in society
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Value-added Approach
• Mainly done to avoid double-counting GDP, considering only Value-adding costs at each stage
from Extraction or Agriculture to Distribution, and redistribution up to final consumption.
Income from Stage 1
Value Added by Material Supplier XX
Wages and Salaries XX
Rents XX
Interest XX
Profits XX XX
Income from Stage 2
Value Added by Manufacturers XX
Income from Stage 3
Transportation XX
Wholesale XX
Resale XX XX
Value Added by All Sectors XX
Depreciation Allowance XX
Indirect Taxes XX
Gross National Product XX
Consumption and Income
Average Propensities to Consume or Save: How much of which you earn is spent/saved?
Average Propensity to Consume Total Consumption over Total Income
Average Propensity to Save Total Income less Consumption over Total Income
Marginal Propensity to Consume Change in Consumption over Change in Income
Marginal Propensity to Save Change in Savings over Change in Income
The propensities to consume and save determine the degree to which demand and supply in an economy
is effectively realized.
Gross National Product XX Aggregate Demand – Real Domestic Output
Depreciation Allowance (XX) Demanded or Needed at each possible Price
Indirect Taxes (XX) Level
National Income XX • Prices fall, purchasing powers increase
Retained Earnings (XX) (Higher Consumption)
Government Income from Capital (XX) • Increases in purchasing power is
Transfer Payments from Gov't and Abroad XX denoted by a decrease in inflation
Personal income XX • Decreases in purchasing power is
Personal Taxes (XX)
denoted by an increase in inflation
Disposable Personal Income XX
Aggregate Supply – Real Domestic Output
𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑷𝒓𝒐𝒑𝒆𝒏𝒔𝒊𝒕𝒚 𝒕𝒐 𝑪𝒐𝒏𝒔𝒖𝒎𝒆 (𝑴𝑷𝑪) Available at each possible Price Level
= 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏/𝑰𝒏𝒄𝒐𝒎𝒆 • Prices should not rise when resources are
𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑷𝒓𝒐𝒑𝒆𝒏𝒔𝒊𝒕𝒚 𝒕𝒐 𝑺𝒂𝒗𝒆 (𝑴𝑷𝑺)
underused
= 𝑺𝒂𝒗𝒊𝒏𝒈𝒔/𝑰𝒏𝒄𝒐𝒎𝒆
• Full Employment will make the price
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒓𝒐𝒑𝒆𝒏𝒔𝒊𝒕𝒚 𝒕𝒐 𝑪𝒐𝒏𝒔𝒖𝒎𝒆
= 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏/𝑰𝒏𝒄𝒐𝒎𝒆 level rise with no increase in output
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒓𝒐𝒑𝒆𝒏𝒔𝒊𝒕𝒚 𝒕𝒐 𝑺𝒂𝒗𝒆 **Changes in Taxes will either encourage or
= 𝑺𝒂𝒗𝒊𝒏𝒈𝒔/𝑰𝒏𝒄𝒐𝒎𝒆 discourage spending.
𝑲𝒆𝒚𝒏𝒆𝒔𝒊𝒂𝒏 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = 𝑴 **Changes in Policies will either encourage or
= 𝟏/(𝟏 − 𝑴𝑷𝑪) 𝒐𝒓 𝟏/𝑴𝑷𝑺 discourage more saving than spending
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The Business Cycle

a. Troughs – Low levels of economic activity and inefficiency of production

b. Recovery or Expansion – Increase in activity
c. Peak – Highest point of productivity
d. Recession – Economic Activity and Employment levels contract.
a. Resources are underused
e. Economic Depression – A long-lasting recession
a. Typically, this is characterized by 2 quarters of sustained recession
b. Characterized by high unemployment
c. Caused by overextending credit, large and sudden cuts in spending, accumulating but
unliquidated inventories (Surplus), Unutilized investments and Accumulating Savings
Keynesian Economics
Keynesian Multiplier – Real Income is increased by factors of autonomous injections. If any factors
(impediments to production) that prevent multipliers from operating exist, then the multiplier is not
really an income multiplier, rather a money multiplier.
• KE more aptly reflets the effect of multipliers on money, since it is actually the most
‘exchangeable’ resource in existence.
• KE typically relies on the assumption that there are various motives for using money, i.e.,
contingencies, transactions, and speculation
• Since Inflationary Gaps exist in instances of full capacity, then the income is no longer necessary
since people are willing to spend despite the lack in supply, hence:
o People will release more money to meet their demands, even if shortages exist,
artificially raising prices
▪ This will in turn, elicit the printing of lots of money
o Price flexibility is not reliable for providing full employment of resources
o Changes in price does not elicit significant impact in disposable wealth enough to create
a multiplier
o This is where Keynes’ famous phrase: “In the long-run, we are all dead” comes from,
emphasizing the need for intervention when economies can no longer revive themselves
naturally by shifts and changes in demand and supply.
• Equilibrium GNP does not provide full employment
• Irrespective of income, supply (of money) will still determine the spending patterns of people
Factors that Influence Consumption
• Habits and Preferences
• Size of the Population = Higher Population; Higher Consumption
• Changes in Income Distribution = More Income Available + Larger Allocated Income; Higher
Consumption
• Credit Availability = Higher Credit Availability; Higher Consumption
• Expectations of prices and income = More Income tomorrow; Less Consumption Today;
• Higher Prices Tomorrow; Higher Consumption today
• Interest Rates = Higher Interest Rates = More Savings = Less Consumption
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The Multiplier effect posits that an artificial injection by Government Spending induces a change in
income in the whole economy in order to stimulate activity. This is a function of disposable income.
𝑻𝒂𝒙 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = 𝑻 = – 𝑴𝑷𝑪 ∗ 𝑻𝒂𝒙 𝑹𝒂𝒕𝒆 /𝑴𝑷𝑺
Since the Government derives its investments from taxes, a tax multiplier is also expected to influence
marginal national income. The Tax multiplier is independent of personal consumption, and is a function
of consumption, rather than of income.
Hypotheses on Savings and Consumption
• Life Cycle = Younger = More Consumption
• Permanent Income (APC = MPC); Consumption becomes as permanent as Income tends to be.
Which is why it is not natural for deflation to occur.
• Relative Income = More difficult to reduce consumption than to reduce savings.
Investment and Income
• At Equilibrium, Planned investment = Planned savings
SAVINGS IS INCOME NOT SPENT. **[Savings of HH, BF and G = Domestic Savings]
Personal Savings XX
Corporate Savings XX
Government Savings XX
Net Domestic Savings XX
Depreciation Allowance XX
Gross Domestic Savings XX
Net Capital Transfer from Abroad (Foreign Investments) XX
Net Borrowings Abroad XX
Gross National Savings XX
Investment is generally the spending for goods used for future consumption.
Investment in Economics means the Spending on PPE, Wasting Assets, Inventories, etc., since these
accounts can produce a RETURN ON INVESTMENT, they do not include securities.
Net Investment = Gross Investment - Depreciation
Capital = Stock; Investment = Flow
Investment Process - An Injection of Funds into the flow that results to increases in income. Increases
in income decreases each round, the sum of all decreased income eventually leads to the original
investment by a multiplier. This Multiplier is caused by the payments done by a firm to sustain itself.
These payments recirculate into the flow until all injections are reabsorbed into the economy.
Investment and Profits - Firms are motivated by profits, that is why they invest, however, the cost of
investing on a rate of return is not constant. Which is why interest is termed as the cost of borrowing for
profits. Therefore, investment behavior is determined by the rate of return (r), and the interest rate (i).
• Investment & Interest = Marginal Efficiency of Investment [r vs i] in a function [I = f(i)]
Innovations - new good, new method of production, new market, new sources of materials, new
organizations/industries; HIGHLY PROFITABLE INVESTMENTS; DONE BY ENTREPRENEURS
Expectations on Investments – How likely is an investment going to match its cost?
Determinants of Investments
1. Changes in Inventory = Changes in stock of inventory, not level of quantity of inventory.
2. Residential Construction = demand for basic human needs.
3. Property, Plant, and Equipment
Investment Spending
a. Should be Productive - directed to areas that enhances output obtained in production
b. It should create additional external Economies - Aside from the focused area that deserves
productivity, the excess in output produced by productivity should be able to translate into additional
consumption by other sectors involved in a transaction
Sources and Uses of Money
Money – Medium of Exchange of Economic resources and Goods and Services; Unit of Account for Deferred
Payments; Store of Value
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Types of Money
a. M1 – Money for day-to-day transactions
b. M2 – Near-money, Money deposited, not immediately circulated + M1
c. M3 – Deposit substitutes, money meant for accretion of wealth by interest. + M2
d. M4 – Money that includes foreign exchange + M3
All currencies that any person holds are actually Liabilities to the Central Bank, Guaranteed by the
Government. All monies, therefore, is backed by the Central Bank, while Checking Accounts or Peso
Deposits are our liabilities to our commercial bank, backed by ourselves as debtors.
Uses of Funds
• For Investment Loans – guarantee against illiquidity, easily convertible to cash, earns interest
• The Long-term – credit use, for private use only
o Governments should never loan from commercial banks, as this is competition for credit
o Banks tend to secure themselves from bad debts, hence the use of credit scores
o Banks function to allow entities to enter trade via financing and commerce. Thus, are
production oriented.
Sources and Uses of Public Funds
Government is the country’s largest buyer, largest employer.
It has 5 roles in the Economy: Income earner, consumer, saver, borrower, investor
The Government has the power on deciding which projects needs loaning and investment. It doesn’t only
loan, but it also invests. It can borrow easily, and it has income through Taxes
Push-spending leads to reduced taxes Pull spending leads to increased tax
Sources
Taxes – The Lifeblood of the Government; it is the just and equitable contribution paid by a state’s
constituents to its government and forced charged, levied by its legislative, to defray the government’s
expenses.
“Who should shoulder the tax burden?”
Impact of Taxation – the Person liable to the tax
Incidence of Taxation – the Person liable to pay the tax
• Benefits received – How many have we given you?
• Ability to pay – How many can we get from you?
• Regressive taxes – Taxes decrease as Income Increases
• Progressive taxes – Taxes Increase as Income Increases
• Proportional taxes – Everyone gets the same rate of Tax in their income
• Direct Taxes – You shoulder the burden immediately
• Indirect Taxes – Your burden could be shifted elsewhere
Ideally, taxes should collect more from income and business taxes than sales and production taxes.
Public Debt - If Taxes are not enough, the Government may borrow internally and externally.
• Government may borrow as far as its taxes allow it. It will think about how it will repay Interest.
National Debts – internal debts held as bonds by the native community. It transfers debt from the
taxpayers to bondholders in theory (even if the community is both) (G borrows from BF and HH)
• Cost of Borrowing – Public debt is not shifted to future generations. Therefore, there is no
opportunity cost in employing the unemployed because there is no sacrifice in so doing.
Burdens only manifest in losses incurred today.
• Deficits shift from private to public sector. If the government does not absorb the deficit,
opportunity cost will be taken-in by the present generation in terms of reduced consumption and
increased savings and will tend toward deflation. If these leakages/savings are not used to invest
in capital, the deficits will leak into the future causing a deflationary spiral.
• Creation of Money – Increase in prices, lowering purchasing power, inflation losers bear costs.
• Size of Debt – It should at least be 40% of GDP to be sustainable and to foster growth.
Uses of Funds
a. Nation Building
b. Social Investments
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c. Consumption Expenditures
d. Capital Outlays – Public works, Infrastructure
e. Security and Defense
f. Social Services
g. Emergency funds
Sources and Uses of Dollars/Foreign Currencies
Why the Dollar? – interdependence makes everyone better-off; The dollar is the strongest currency.
• Currency represents Philippine Wealth with respect to other Currencies.
• The Dollar as an ingredient for Growth - comparative advantage allows countries to trade
resources efficiently. The same principle applies as well for money. This is because Exports and
Imports are investments as well. (These are sources of productivity and efficiency outside the
local economy.)
Sources of Dollars
a. Exports - Our goods and services are translated into dollars. These dollars are deposited to
commercial banks, and commercial banks may either exchange these dollars with BSP to meet
reserve requirements.
b. Gold - Dollars are able to come into the economy via purchases. These purchases increase dollars
simply because Gold prices may rise.
c. Dollars from the U.S. Government - Their government still has expenditures in our economy
(veteran’s payment, education, cultural exchange programs, military spending, etc...)
d. Invisibles - Remittances sent in, Dividends declared by Filipino Companies abroad, Interest
payments and income from foreign property, Investments to external businesses by Filipino
Nationals. (They cannot be handled by the Bureau of Customs)
e. Foreign Borrowing - Foreign Credit extended by foreign banks (but also has to pay interest by
Forex currency)
f. Transfer Payments in Dollars - Donations, grants by foreign Entities
g. Direct Foreign Investments - Investments by foreigners into our economy (MCDONALD’s)
Uses of Dollars
a. Imports - We pay out goods from outside in our currency, but these equivalents are paid.
a. Imports also follow bills.
b. Government spending abroad = pensionados, state visits
c. Invisible payments = Remittances by foreigners here in the Philippines
Trade Balance = Net Exports – Net Imports
Payments Balance = All Dollars out – All Dollars In
Inflation and Unemployment
Inflation - A sustained and general increase in prices in all or nearly all of the markets in an economy
• Not generally adverse. Must be maintained steadily.
• Sudden Increases or Decreases are adverse
• Those earning fix income sustain losses in periods of inflation
• Those earning variable income sustain gains in periods of inflation
Deflation - A sustained and general decrease in prices in all or nearly all of the markets in an economy
Adverse Effects of Inflation
a. Difficult to negotiate credit
b. Efficiency is reduced
c. Discourages borrowing if the cost of debt is too high
d. Rate is difficult to predict
e. Breaching contracts is encouraged or even necessary
f. Creditors and fixed-income earners are disadvantaged
Types of Inflation
a. Demand-pull – Excess demand forces a pull of supply and thus a pull-up of prices, use fiscal
policy to control national spending
b. Cost push – Increased cost to produce such as through labor and materials input
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c. Structured Inflation – Bottlenecks in the economic system due to inadequate social overhead
capital. Usually experienced by Developing Countries; this means that there are lacking social
infrastructures that populations may not be able to realize.
Consumer Price Index – Measures Pricing of items
CPI = 100*Price of Market Basket in a Year/Price of Same Basket in the Base Year
Unemployment
• Individuals willing and able to work cannot find work
• Frictional Unemployment – Inherent Unemployment in the Labor Market; the period of time an
employable individual spends looking for jobs or taking further studies without working
• Structural Unemployment – Aggregate Demand can employ workers, but distribution of demand
does not accommodate the entire labor force; either wages are too low, or labor unions are
rejecting working conditions
• Cyclical Unemployment – Caused by insufficient Aggregate Demand; there are too few employers
or rather, too few jobs that humans can fill. This is currently occurring in industries that are
getting replaced by digitized and automated processes
• Seasonal Unemployment – Certain periods cause unemployment such as holidays
• Okun’s Law – An empirical observed relationship between unemployment and GDP. It predicts
that a 1% increase in cyclical unemployment will usually be associated with a 2% drop in GDP.
𝒚 − 𝒚′ Where: y= actual GDP y’= potential GDP Β= Okun’s coefficient
= 𝒌 − 𝜷(𝒖 − 𝒖′ )
𝒚′ u = current unemployment rate u’ = potential unemployment rate
In this case, Β is almost always 2, expressed by the relationship of Okun’s Law; and k is the observed
growth rate in Employment output.
Fiscal Policy
Progressive Tax System - has automatic stabilizing effect, inhibits rapid growth
More taxes to more income mean disincentives to spending, while tax revenues decrease slowly
• Government Spending is rigid because it has guarantees to the public to provide daily services.
• Taxation is the most flexible tool used by government to influence people’s spending patterns.
• In times of Inflation, Taxes increase to discourage spending, Contractionary Fiscal Policy
• In times of recession, Taxes decrease to encourage spending, Expansionary Fiscal Policy
• For Economic Growth; Short-term oriented
Tools of Fiscal Policy
• Changes in Government Spending – very rare, structural, dependent on budget conditions
(deficits or surplus)
• Changes in Tax Rates
• Borrowing from BSP, Abroad, Domestic Money Market
o Borrowing from BSP - Increase in Money Supply
o Borrow Abroad - Expands Imports, increasing dollars that are used to translate into peso,
neutral effect
o Borrow from Domestic Institutions - discourages spending, Government displaces private
sector in credit availability for investments.
▪ This crowds out investors, and forces investors to invest outside the domestic
market (Competition occurs due to the government being a virtually secured
debtor, being able to pay to any extent, all its obligations.)
Monetary Policy
Monetary Policy comes from the notion that Supply of Money is virtually perfectly elastic to interest
rates, since the BSP can print-out enough bills to pay-off all of its debts. This does not mean, however,
that it should.
• The BSP Control volumes of money
Lower Interest Rates = Expansionary Policy = Higher Interest Rates = Contractionary Policy =
borrowing or spending period = Inflation savings period = Deflation
• Demand for Money – Transitionary, Precautionary, Speculative (in increasing slope)
• Government could only control M1; Less supply means higher interest rates
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• Supply for Money is more or less, assumed as always elastic

• For Economic Stability, Long-term oriented monetary policy is preferred
Tools of Monetary Policy
• Purchase of Forex
o The BSP purchases Dollars using pesos. This reduces local pesos in exchange for more
dollars. Resulting to Increases in Interest Rates.
• Open-market Operations
o BSP engages in open market for securities, allowing credit encouraging spending.
o This is the BSP’s primary economic tool for monetary policy
Repurchasing Government Securities Selling Government Securities
Increase Money Supply Decrease Money Supply
Prices of other Securities rise Prices of other Securities fall
Interest rates decline Interest rates rise
• Reserve Requirements
o A relaxation of requirements leads to more multiplier, more money, more spending
o A stringent reserve requirement leads to smaller multipliers, less money, more saving
o The BSP seldom uses this tool since its effect is too difficult and unpredictable to control
➢ BSP controls discretions on reserve requirements
➢ Defines Deposit substitutes and reserves
➢ Sets interest rates against deposits
• Rediscounting: When Banks borrow money from Central Banks
o If the rediscount rate that the C. Bank offers is relatively small, money is expanded,
encouraging more spending
o If the rediscount rate that the C. Bank offers is relatively large, money is limited,
encouraging more savings
• Non-quantitative Controls
o Selective Controls - balance Marginal Deposits, control value of imports (Administrative
Control in Trade Policy)
▪ This means selectively choosing which entities or even countries get easements
o Moral Suasion - Governor of Central Banks persuades commercial banks to gear
themselves towards monetary policy goals.
Trade Policy
𝑆+𝑇+𝑀 =𝐼+𝐺+𝑋 𝑀 = 𝑛 + 𝑚𝑌
𝐶 = 𝑏 + 𝑐𝑌𝑑 𝑌𝑑 = 𝑌 – 𝑇
𝑇 = 𝑠 + 𝑡𝑌 ∗∗∗ 𝑌 = (𝑏 − 𝑐𝑠 − 𝑛 + 𝐼 + 𝐺 + 𝑋) / (1 − 𝑐 + 𝑐𝑡 + 𝑚)
Price Effects - Imports Stabilize the Economy, Exports destabilize the Economy
Determinants of Imports and Exports
• Exports determine how much we are to participate in determining the value of the dollar.
Demand is less of a problem; devaluation of pesos promotes exports -> more incentive for
exporters to produce more since dollars are more valuable than pesos.
• Imports determine how much we are to participate in determining internal supply of goods
• Devaluation implies that domestic goods have income increased. Foreign goods therefore become
more attractive if they are less common.
• Protectionism – preferring local labor and goods over imports. It is proven that in the long-run,
protectionism does not generate more labor or jobs in a country
External Equilibrium - equilibrium required in foreign transactions in an economy. (inclusive of capital
transactions and trade dynamics)
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑭𝒍𝒐𝒘 + 𝑵𝒆𝒕 𝑬𝒙𝒑𝒐𝒓𝒕𝒔 + 𝑵𝒐𝒏 − 𝒕𝒓𝒂𝒅𝒆 𝒔𝒐𝒖𝒓𝒄𝒆𝒔 = 𝑬𝒙𝒕𝒆𝒓𝒏𝒂𝒍 𝑬𝒒𝒖𝒊𝒍𝒊𝒃𝒓𝒊𝒖𝒎
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Title VI: Technology, Data, and

Analytics
Accounting Information Systems
Accounting Information Systems – a structure that a business uses to collect, store, manage, process,
retrieve, and report its data to be used by Accounting, Business Analysts, Managers, Controllers, CFOs,
Auditors, Regulators, and Tax agencies.
• It is important to note that AIS (under the IT Function/Department) is a support activity in the
value-chain that enables acquisition of relevant information for decision making.
Functions of AIS
• Efficient and Effective Capture and Storage of Data
• Supplying Information that is useful for decision making, including producing managerial reports
and financial statements
• Ensuring controls are in place to accurately record and process data
Business Mega-processes or Transaction Cycles

Business Support

Strategy and Tactics

Bookkeeping
Tax Report Preparation
Operations
Compliance Reporting Financing Cycle
FS Close and Consolidation Investing Cycle
Source to Pay
Financial Planning and Analysis Insurance and Hedging
Hire to Exit
Environmental, Safety, and Quality Portfolio Management
Assurance Order to Cash
Project Management
Information and Privacy Management Treasury Process
Government Contracts
IT Systems Management Supply Chain Process
Strategy and Governance
Asset Custody and Security Logistics and Shipment Process
Business Continuity Marketing and Customer Experience
Professional Services

Types of AIS
Manual Systems Legacy Systems Modern or Integrated Systems
Primarily by small organizations Old virtual interfaces that keep New virtual interfaces that are
with no tech integration; low on business data. It lacks flexibility user-friendly and are
complexity & reliability to keep up with comprehensively flexible to suit
change business needs
AIS and Non-financial Information
• Historically, only financial information were captured by AIS, a separate system or stand-alone
module was set-up in order to capture non-financial information which often was a costly
endeavor.
• Modern AIS have integrated the capture of non-financial information into its activities. This
boosts reliability and allows businesses to capture greater insights that financial reports are
unable to clearly deliver on.
• CRM modules for instance, captured descriptive profiles of customers enabling strategic focus
for some firms in the recent years
• AIS now have also integrated test facilities and development modules to accommodate changing
business needs that allow its users to change the system safely without interrupting operations.
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Finance Transformation Tech Enablers

Enterprise Resource Planning
ERPs – The integration of core business processes into a single suite of modules under a shared database
structure. To facilitate shared use, they are Modular so that they can be adapted to companies at
different sizes and industries. As such, this allows greater synchronization of information across the firm.
Benefits of ERPS
• Real-time access to information rather than waiting for data to be shared out
• Increased standardization
• Increased Regulatory Compliance
• Improved Financial Reporting
• Improved Customer Experience and Satisfaction (Customer here refers to the recipient of reports
that the ERP is set-up for; it may be the C-suites, users themselves, etc.)
• Collaboration and Teamwork is encouraged because of wide information distribution
• Employees only need to learn how to use one module over the entire thing, reducing learning
curves
• Although initially expensive, it can reduce operating costs by eliminating redundant tasks and
systems and simplifying maintenance
• Improved tracking of organizational outcomes
Database Management Systems and Data Warehousing
DBMS – The interface or program between a company’s databases and the application programs that
access the programs.
• The DBMS defines, reads, manipulates, updates, and deletes data in the database
• The DBMS also controls data access and maps each user’s view of which data they can access
• The DBMS optimizes how the data is stored and retrieved. Facilitating everything from backup
recovery to reports generation and performance monitoring
• DBMS also spans controls to ensure quality data. This ensures that the system facilitates data
integrity, confidentiality, and availability
Data warehouses - where a database is focused on processing transactions or taking row-data, a data
warehouse consolidates databases to allow blended analysis of data. It collects and stores data from
disparate or diverse sources which can be used for business intelligence and analytics that will be
discussed later.
Enterprise Performance Management Systems
EPM – Also known as CPM or BPM; Corporate Performance Management or Business Performance
Management, allows for data-driven decision and strategy development.
• Given the wealth of data available to the organization, the next intuitive step would be to find
ways to exploit this information. It is a key enabler for:
o Planning, Budgeting, Forecasting
o Performance Reporting (KPI, SLA, and OLA Monitoring)
o Profitability Analysis
• This allows better communication throughout the organization of strategic objectives
• For instance, it improves advertising by monitoring web-traffic, visitors, and sales information
• It summarizes information to facilitate contextualized insights and analytics through dashboards
• It summarizes & blends information from disparate sources and automatically consolidates
reports
• In requires periodic reviews and updates to keep information fresh
• It improves planning, budgeting, and review turnover
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Tech-enablers at a glance
Robotic Process Automation
RPA – a software for completing routine and repetitive rule-based tasks. RPA is used in settings with high
volumes of transactions.
• Rather than employing labor for these functions, a robot can be used to manipulate data, record
transactions, process information, and perform business and IT Processes.
• It is a matured form of organizations that initially ventured into outsourcing and shared services
Benefits Drawbacks
• Greatly increases efficiency • High initial cost of investment
• Increases consistency and eliminates • Some tasks are not good candidates for
human error in processing and outputs RPA such as those that are irregular
(not appliable for inputs) (inefficient) or those that require
• Leads to cost savings significant judgment and risk to execute
• For rule-based and routine tasks that (ineffective)
employees find boring • It requires updating, time and energy to
• Allows the direction toward value-adding accommodate disruptions
tasks for human labor such as decision-
making and strategic planning
Artificial Intelligence
AI – the ability of a computer or a robot controlled by another computer to do tasks that are usually done
by humans because they require human intelligence and discernment.
• AI is used for tasks that perform critical analysis and patter-recognition.
• AI also ‘learns’ to generate conclusions to some degree. It makes it an adaptive tool that learns
to accommodate or handle exceptions
• Unlike humans, AI does not suffer fatigue and do not typically wear down. However, in the face
of ethical issues, it may start to ‘create’ behaviors that are unwarranted on its own. It still prone
to bias based on historically fed information and may form conclusions based on behaviors or
statistical figures in the real-world.
Cloud Computing
Cloud computing – is a shared-resource setup that allows improved processing of electronic information.
It is a network of remote serves connected by the internet allowing virtual workflow processing regardless
of physical boundaries. A Cloud server joins many computers and manages access to a cloud database. It
helps avoid data loss due to localized hardware failure and malfunctions enabling better backup needs.
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Blockchain
Blockchain – is a distributed ledger of economic transactions. It is a decentralized, public database. The
ledger keeps track of all transaction within a peer-to-peer network. This means that a single participant
or user holds key information over other users in the chain.
• This ensures that changes in the key data apply to all other users in the chain; maximizing
transparency over transactions, making any attempt to hack or defraud any information futile
• It also grants validity to data since it makes all information publicly available
• This led to the proliferation of digital currencies or crypto currencies and smart contracts.
• Smart Contracts are unalterable contracts that no longer require attestation from third parties
that any usual business document may possibly need in the physical world
Data Governance
Data Governance – A set of policies, procedures, rules, and processes that oversee the attributes of an
organization’s data.
Aspects of Data Governance
• Availability – Data Access is monitored to see that it is used only when it is needed and for what
purposes it is used for. This dimension includes Capturing Data, Storing Data, Access Controls,
and Backup Controls
• Usability – Data delivery to users in formats and structures that facilitate its purpose fulfillment.
This dimension includes Input, Processing, Output, and Application Controls as well as Systems
Integration (considering Change Management in evolving business environments and IT
environments)
• Integrity – Data is consistent and accurate. It relates to reliability for decision making and
communication. This dimension of governance includes Compliance to Laws, Regulations, and
Quality Standards.
• Security – Data is protected and is considered a valuable asset to the organization. It includes
prominently, Physical and Cybernetic Access Controls
Data Governance Frameworks
• Basic Objectives of Data Governance
o Enabling management to make informed and intelligent decisions on how to manage data
o Realize value from the data
o Minimize cost and complexity of data collection, use, and storage
o Manage data-related risks
o Ensure compliance with relevant regulations (such as data privacy and e-commerce)
• COSO Internal-control Integrated Framework
The top dimension of the Cube represents why controls are
needed. These are the motivations for maintaining strong
internal control (in meeting business objectives)

The facing dimension of the cube represents the elements of a

strong internal control system. (See Auditing Theory – Internal
Control)

The right dimension represents in which levels of the

organization needs control. Apparently, all levels will need
strong controls to deliver the promises of the integrated
framework.
• ISACA COBIT – ISACA (or Information Systems Audit and Control Association) created a best
practice framework called the Control Objectives for Information and Related Technologies
(COBIT)
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Governance has to do with meeting

stakeholder needs; thus, it is imperative to Meeting Stakeholder Needs
supplant these needs with strong internal
Covering the enterprise end-to-end
controls by setting the direction of the entire
organization (TCWG) Applying a single, integrated framework

Management includes the planning, Enabling a holistic approach

execution, and monitoring needed to support
governance initiatives. Separating Governance from Management

Data Lifecycle

Data Capture Data

Data Analytics
(Extraction) Publication/Reporting

Data Pre-processing
• Extract
Data Archiving (Record
• Transform Data Usage
• Reduce Retention)
• Load

Data Maintenance
Data Synthesis Data Purging/Deletion
(Cleansing)

Information Security
Proper Information Security adheres to the following principles:
Confidentiality Integrity Availability
Authorized Access Protected from Unauthorized Accessible only when and where
Changes needed
Types of General Controls
Organizational, Systems Development Network, Hardware, Disaster Recovery and
Operations & Personnel Controls and Facility Controls Business Continuity
Controls Controls
Types of Application Controls
Input Controls Process Controls Output Controls
Approvals Standard Procedures Edit logs
Batch Controls Increase Automation Reconciliation
Well-designed/formatted Predefined Values Discrepancy Reports/Defect
source Documents Sanity Checks (Processing totals Tracking
Character Checks with other source information) Limited Access
Completeness Checks Reconciliation
Reasonableness Checks Cross-referencing/Redundant
Validity Checks Processing (more in Auditing in CIS)
Data Analytics and Business Intelligence
Data Analytics – the science of analyzing raw data to make conclusions about that information. In today’s
world, everything is captured in data form. The wealth of data is now usable in many forms and will
definitely shape the decision making of an organization.
Big Data – Any data that contains great variety, arriving in increasing volumes and velocity. It is simply a
large, complex compilation of data from diverse data sources.
The main challenge for Data Analytics is Data Integration (gathering information from disparate sources)
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Volume Velocity Variety Veracity

The sheer size of The speed in which big The forms that data can The truthfulness or
memory consumed to data grows come into the form of accuracy of data
store and process the
data
Data Structures
Structured Semi-structured Unstructured
Those found in forms; with a Data that have fields, but Data that are not easily
specific data format and are contain organizing features such searchable; it is often text-
easy to organize as tags or hashtags. based like human speech
Searchable and Identifiable by It does not have a formal Difficult to categorize and
queries structure of a relational organize into sets or fields.
database, but can be grouped These includes large texts,
via XML for machine reading photos, videos, etc.
Data in itself has very little usability or meaning without it having context. It evolves in this way for
business use:
Data Points Information Data Analytics Knowledge Business Intelligence

• Data turns into information if it is contextualized

• Information undergoes analytics to reveal patterns and behaviors in the data
• After knowing of patterns and behaviors, knowledge is created from understanding
• And when knowledge is acted upon or consumed, there is business intelligence
Data Mining
Data Mining – a tool used to reveal patterns and insights from large data sets. It involves statistical
analysis, computer learning, artificial intelligence and large-scale computing power to analyze large data
sets in order to extract useful information about trends, patterns, and anomalies.
Challenges to Data Mining
Data Quality Cross-sourced Data Voluminous Data Sets Specialized knowledge
Not only in how the Blended data come Large data sets require A statistical output may
data is inputted, but from disparate sources strong computing not be appreciated by
also by how bias is that may not have a power and large sums someone who has little
involved in discerning primary key for of investments to knowledge over the
which data to collect. relational analysis. process data gathered and
processed.
Analytic Models
Analytic Models – empirical or data-driven approach to understanding connections, effects and outcomes;
it mainly involves validating relationships with statistical techniques.
Descriptive Analytics Diagnostic Analytics Predictive Analytics Prescriptive Analytics
‘what is or what was’ ‘why it happened’ ‘what will happen’ ‘what should we do’
Measures of Central Hypothesis Testing Regression Optimization
Tendency Functions and
Sensitivity Analyses
Mean, Median, Mode t-tests, z-tests, Goodness of Fit, Simulation Models
significance standard error, Time (Monte Carlo)
series
Limitations to Data Analytics:
Not Asking the right Inability to interpret Poor Data Quality Models that are overly
questions results complex
Models that do not Over or under reliance on data models to the exclusion of intuition and
account for natural common sense
variations in data
Nothing Follows