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Accounting summary year 1 e&bi
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Accounting SummaryChapter 1
1.1 Profit
Profit measures the economic value generated by an activity and is defined as the
difference between revenues and costs (Profit = Revenues - Costs). Profit is a key criterion
for allocating resources in market economies. For-profit organizations that consistently
generate losses (when Costs > Revenues) tend to fade away over the long term because
they destroy value and turn away stakeholders. There are two basic types of organization:
for-profit and nonprofit. Non-profit organizations generally provide products or services to
people who don’t have the resources to pay for them. These organizations don’t generate
any profits. Ethics is also an important pillar of doing business.
To calculate profits start by (1) recording all transactions that happened over a period of time
and (2) identify them as either revenues or expenses. Then (3) add up all the revenues and
subtract the expenses. Finally, (4) determine if the result is a profit or a loss.
1.2 Opportunity cost
Identify, compare, and evaluate the alternatives that can be pursued before making a
decision. How much money each alternative generates is called cash flow. The
opportunity cost is the economic value (cash flow) of the best alternative that wasn’t
chosen. Opportunity cost can also come in different forms, like enjoyment. When analyzing
the economics of a decision, only measurable factors are taken into account.
To calculate opportunity cost, (1) list all the alternatives to a decision and (2) estimate the
cash flow that each alternative generates. Then (3) decide if the selection is based only on
the economic criterion and (4) identify the best and second-best alternative based on the
level of cash flows. (5) The cash flow of the second-best alternative is the opportunity cost of
pursuing the best alternative.
1.3 Cost behavior
In the profit equation, costs are often the main element under management’s control, while
revenues depend on market conditions. Fixed costs occur no matter how many products
are sold. Variable costs change with the level of activity. Semi-variable or mixed costs
are a combination of fixed and variable costs; a minimum amount is incurred regardless of
the level of activity, but the costs rise as the volume of production increases. Costs are
variable or fixed over a certain range called the relevant range. Outside that range, their
behavior changes. For example, the cost of having one server is fixed. But if traffic
increases, you may need to buy another server. Fixed costs that can be changed (for
example through negotiation) are called discretionary costs. Fixed costs that are very hard
or impossible to change, are called committed costs.
,1.4 Contribution margin
Managers use the contribution margin in 3 different ways: (1) as an absolute amount of
money for a certain number of units, (2) as the contribution margin per unit, or (3) as a
percentage of revenues.
(1) Total contribution margin = Revenues - Variable costs;
(2) Contribution margin per unit = Price per unit - Variable costs per unit;
(3) Contribution margin ratio (%) = (Revenues - Variable costs)/Revenues = (Price per unit -
Variable costs per unit)/Price per unit.
For a company with multiple products, the contribution margin per unit is different for each
product. This information can be used to assess how attractive each product is. The total
contribution indicates the amount of money that a company generates before having to pay
for fixed costs. On a per-unit basis, it indicates how much money a company makes each
time it sells a unit and highlights the importance of gaining additional business volume. The
relationship between fixed and variable costs is called operating leverage and is very
important. Operating leverage = Total fixed costs/Total costs
The contribution margin ratio and per unit can be calculated by (1) identifying the costs and
revenues and (2) separating fixed from variable costs. Then you can (3) apply the formulas
1.5 Break-even analysis
Break-even analysis is a management tool widely used by managers to assess the
attractiveness of various scenarios. Break-even is the number of units that must be sold to
have zero profit and can be calculated in different ways
Break-even point (in # of units sold) = Fixed costs/Contribution margin per unit
Break-even point (in € sold) = Fixed costs/Contribution margin ratio (%)
Break-even point (in € sold) = Number of units at the break-even point*Sales price per unit
In a break-even chart, costs and sales lines are drawn. The break-even point lies on the
overlap of these two lines. At the break-even point there are no profits or losses. Sensitivity
or what-if analysis is changing the values of equation variables. If fixed or variable costs
can be reduced, the break-even point will go down. If sales prices can be increased without
impacting volume or costs, the break-even point will go down.
The break-even point can be calculated by (1) identifying costs and revenues and (2)
separating fixed from variable costs according to their behavior with sales or production
volume. (3) Calculate the contribution margin and (4) apply one of the break-even point
formulas.
, Chapter 2
2.1 Indifference point
Alternatives can be compared using the indifference point. It can be found in the same way
as the break-even point. The indifference point is based on being indifferent between two
alternatives, but without the constraint of having zero profit. The indifference point can be
found where the profit lines of two alternatives overlap.
2.2 Costs, assets, and expenses
Cost is the value of a resource. Resources that are fully consumed in a period are called
expenses. Resources that are not fully consumed in a period are called assets. The costs
of resources become assets of the company when they are acquired. This results in a new
formula for profit: Profit = Revenues - Expenses
2.3 Depreciation
Over time, assets become expenses through depreciation. The usual approach called the
straight-line depreciation method is to assume that an asset loses the same amount of
value each year of its life. With this method, an asset loses the same amount of value each
year until it reaches a price floor. For example, a €16,000 car might be sold for scrap for
€4,000. So if this car is used for eight years, it will depreciate by €1,500 every year.
Depreciation is a non-cash related expense.
To determine costs, assets, and depreciation, (1) find out if a resource will last beyond the
current period. (2A) If the resource lasts more than the current period, it’s an asset. (2B) If it
doesn’t, it’s an expense. (3) Determine what the expected life of the asset is and (4)
calculate the depreciation expense every period. (5) Record the depreciation expense every
period until the end of the asset’s life.
2.4 Cost systems
Prices over the long term have to be higher than the full cost. The full cost reflects the value
of all resources used to make a product or serve a customer. Fixed costs should be traced to
the products in a meaningful way to know whether the selling prices are higher or lower than
the full cost of the product. To estimate the full manufacturing cost of a product, we need a
cost system that allocates the costs of resources to products. A cost system consists of
variable costs of a unit and the fixed cost per unit, estimated as the division of the
manufacturing fixed cost by a measure of the volume that can be produced. Adding variable
and fixed costs per unit gives the full cost of a unit.
To estimate the manufacturing cost per product, start by (1) identifying the variable costs per
unit associated with manufacturing and (2) the total fixed costs associated with
manufacturing. Then (3) divide the total fixed costs by volume to get the fixed cost per unit
and (4) add variable costs and fixed costs to get the full manufacturing cost of the product.
2.5 Death spiral
When using actual volume produced as the denominator when tracing fixed products, cost
estimates will fluctuate with this volume. If volume drops, fixed costs per unit increase. To
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