Hydro Utility Hydro Utility Power Generation Costs

• A small hydro utility has two hydro-electric power 14

plants. The fixed cost of Plant 1 is $4,000,000 per year TC1

12
and at Plant 2, it is $2,500,000 per year. The variable
cost of producing electricity at Plant 2 is TC2
10

Cost ($000,000)
8
VC(x) = $(31x + 0.0002x2 )
6
where x is the yearly electricity output of the power plant
measured in megawatt hours (MW-hr). At Plant 1, the 4
variable cost of producing each MW-hr of electricity is
$55. The current demand for electricity is 100,000 2

MW-hr. The utility produces 40,000 MW-hr at Plant 1

0
and 60,000 MW-hr at Plant 2. 0 20 40 60 80 100 120 140
MW-hr (000)

• A large new subdivision has increased the demand for

TC1 (x1) = 4,000,000 + 55 x1
power to 140,000 MW-hr of electricity. At what output
TC2 (x2) = 2,500,000 + 31 x2 +0.0002 x22
level should the utility run each plant to minimize costs?
TCu (x1, x2) = 6,500,000 +55 x1 + 31 x2 + 0.0002 x22
Assume each plant has the capacity to produce the
additional 40,000 MW-hr.
Current Operating Point

AC1 (40,000) = $155.00/MW-hr

AC2 (60,000) = $84.67/MW-hr
ACu (40,000; 60,000) = $112.80/MW-hr

Week 2 - 1 Week 2 - 2

Project Estimation
Hydro Utility Operating Point
Goal: Select the “best” of the competing engineering
Increased demand: 40,000 MW-hr project alternatives.
Which plant should produce the additional power? Evaluation process is based on estimates of future:
100 • revenues
MC2
90 • savings
Plant 2
80
Plant 1 • recurring costs
70 • life of the project
60 • salvage value of project equipment
MC1
MC ($)

50 Therefore, be careful of “GIGO”.

40
1. Order of magnitude estimates
30
• quick estimate based on judgement and experience
20 • accuracy of + 50%
10 2. Preliminary estimates
0
0 20 40 60 80 100 120 140
• more consideration given to detail
MW-hr (000)
• some sub-elements of projects specified and
MC1 = $55 estimated
• often cost estimates before final designs completed
MC2(x2) = 31 + 0.0004x2
• accuracy of + 20% is typical
MC2(60,000) = $55
3. Detailed estimates
140,000 mWh: x1 = 80,000 MW-hr • every sub-element of the project is specified and
x2 = 60,000 MW-hr estimated
• recommended for pricing a product or contract
ACu(80,000; 60,000) = $96.29 MW-hr bidding
• accuracy level of ± 5% expected
Week 2 - 3 Week 2 - 4
Tradeoff: Estimation Accuracy versus
Cost-Capacity Relationships
the Cost of the Estimate
A company has recorded its experience with small steam
turbines in the following chart:
CT
Capacity (KW) Cost ($)
Cost $

CM(D) 130 7,100

160 7,500
205 8,900
CE(D) 290 10,700
D optimum 400 12,000
435 12,500
Amount of detail D

The company has a new requirement for a 350 KW steam

turbine and needs a quick assessment of estimated cost.
CT = Total cost of making the estimate
CM = Cost of preparing the estimate Use the Cost-Capacity Relationship to estimate the cost.
CE = Cost of errors in the estimate

Week 2 - 5 Week 2 - 6

Cost-Capacity Relationships Steam Turbine

Cost-Capacity Relationships
To determine M:
1. use least-squares curve fitting software; or,
2. calculate the slope of the line using a pair of points

⎛C ⎞ ⎛Q ⎞
M = log⎜⎜ X ⎟⎟ / log⎜⎜ X ⎟⎟
⎝ B⎠
C ⎝ QB ⎠
⎛ 14,000 ⎞ ⎛ 500 ⎞
= log⎜ ⎟ / log⎜ ⎟ = 0.5162
⎝ 6,100 ⎠ ⎝ 100 ⎠
Capacity Actual Predicted Error
(kW) Cost ($) Cost ($) (%)
100 6,100 6,100 0
130 7,100 6,985 -2
M
⎛Q ⎞ 160 7,500 7,775 +4
C X = C B ⎜⎜ X ⎟⎟ 205 8,900 8,836 -1
⎝ QB ⎠ 290 10,700 10,568 -1
CX = Cost of equipment of capacity QX 350 - 11,646 -
CB = Cost of equipment of capacity QB 400 12,000 12,477 4
M = Cost - Capacity Factor 435 12,500 13,029 4
500 14,000 14,000 0
0 < M < 1 (typical)
M = 0.6 (average) The cost estimate for the 350 KW steam turbine is $11,646.

Week 2 - 7 Week 2 - 8
 Price Indexes Historical CPI – Canada
120
1915 – 2008
Base Year 2002 = 100
115

110
Historical Consumer Price Index - Canada
105

120
100

95
100

90

85 80

80

75 60

70
Ja n -9 5
M a y-9 5

Ja n -9 6
M a y-9 6

Ja n -9 7
M a y-9 7

Ja n -9 8
M a y-9 8

Ja n -9 9
M a y-9 9

Ja n -0 0
M a y-0 0

Ja n -0 1
M a y-0 1

Ja n -0 2
M a y-0 2

Ja n -0 3
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M a y-0 4

Ja n -0 5
M a y-0 5

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M a y-0 6

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M a y-0 7

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M a y-0 8

Ja n -0 9
M a y-0 9
S e p -9 5

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S e p -9 9

S e p -0 0

S e p -0 1

S e p -0 2

S e p -0 3

S e p -0 4

S e p -0 5

S e p -0 6

S e p -0 7

S e p -0 8
40
Consumer Price Index - Canada

20
• Cost data quickly become out of date due to inflation
• Cost index - relative cost of an item in terms of its cost in
the base year. 0

- base year value = 100

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Base Year 2002 (100)
• Statistics Canada
Statistics Canada
– CPI - Consumer Price Index (base year 2002)

Week 2 - 9 Week 2 - 10

Construction Price Index (Toronto)

(Non-residential buildings) Basic Accounting Principles
• The accountant and engineer may work with the same
2004 2005 2006 2007 2008
Total 109.7 115.9 124.9 136.8 150.8
financial data, but they do so for different purposes.
Commercial • Each view a firm’s profitability from a different
structures 109.4 115.5 124.6 137.2 151.3
perspective.
Industrial
structures 111.0 118.0 127.3 138.4 154.2 • The accountant is concerned with evaluating the results
Institutional
structures 109.5 115.3 124.0 135.0 147.9
of how profitable the firm has been as a result of past
decisions.
Statistics Canada
• The engineer attempts to predict what the profitability of
• Factory and land purchased for $5 000 000 in 2004 a current or future decision will be.
• Structure appraised at $3 000 000 in 2004 • If the engineer has done his/her job, the accountant will
• Appraisal fee $1 500 eventually find a profit.
• How much building insurance should be purchased in • The primary function of an accounting system is to
2008? record, classify, summarize, and interpret the financial
• Pay for another appraisal? data of an organization.
• Use the Construction Price Index? • A prime source of data for engineering economics is the
records of a firm.
IX 1 5 4 .2 • The engineer must be careful in the use of this financial
C X = C B × 4 .2 = 3 .0 ×
1 1 1 .0 data.
IB
• Average costs and allocated costs must be recognized for
what they are.
$4.2 million reconstruction cost estimate is
• Engineering economic analysis generally concerns itself
probably sufficiently accurate. with incremental costs.

Week 2 - 11 Week 2 - 12
 Sample Balance Sheet
Balance Sheet
Assets - everything of value owned by a firm or owed to it. Datacomm Company
Liabilities - debts or obligations which must eventually be paid Balance Sheet
December 31, 200x
Assets - Liabilities = Owners’ Equity
OR Assets Liabilities + Owners’ Equity
Current Assets Current liabilities
Assets = Liabilities + Owners’ Equity
Cash 25,000 Accounts payable 32,000
Accounts receivable 115,000 Taxes payable 15,000
The Balance Sheet is a snapshot of the firm on a particular Total C/A 140,000 Total C/L 47,000
date.
Fixed Assets Long-Term Liabilities
Land 30,000 Mortgage loan 130,000
• All entries are at book (original cost) value Building 200,000 Bond issue 350,000
• GAAP - Generally Accepted Accounting Principles Less: Acc. Total LT/L 480,000
• Accrual Basis versus Cash Basis depreciation 50,000 Total liabilities 527,000
150,000
Owners’ Equity
Equipment 750,000 Common stock 325,000
Less: Acc. Retained earnings 68,000
depreciation 150,000
600,000 Total equity 393,000
Total F/A 780,000

Total assets 920,000 Total liabilities & OE 920,000

Week 2 - 13 Week 2 - 14

Income Statement
• Shows the revenues and expenses incurred by the firm
Balance Sheet “Worksheet 1”
during a stated period of time
Assets = Liabilities + Owners’ Equity
Profit = Revenues - Costs
Datacomm Company
Current Long-term Current Long-term
Income Statement
Year Ending December 31, 200x
“Double Entry System”
Sales $1,200,000
Less cost of goods sold
1. $50,000 investment by owner
Direct labour $420,000
Direct material 302,000
Indirect labour 112,000
2. $20,000 bank loan - one-quarter due in 6 months
Depreciation 98,000
Repairs and maintenance 41,500
Utilities 11,500 985,000
3. Purchase of equipment for $40,000. - COD (Cash on
Gross profit 215,000 Delivery)
Less other expenses
Administration 76,000
Marketing 49,000 4. Purchase of computer for $5,000.
Interest Payments 35,000 160,000 -Net 30 days.
Net profit before tax 55,000
Less income taxes 27,500
Net profit 27,500

Week 2 - 15 Week 2 - 16
 Balance Sheet “Worksheet 2” Completed Balance Sheet
Small Business
Assets = Liabilities + Owners’ Equity Balance Sheet
Sept 30, 200x
Current Long term Current Long term
Assets Liabilities + Owner’s Equity

Current Assets Current Liabilities

5. Purchase of materials for sale

-$4,000 on net 10 day terms Total Current Assets Total Current Liabilities .

Fixed Assets Long-Term Liabilities

6. Pay for materials - $4,000 to vendor

Total Fixed Assets Total L-T Liabilities .

Total Liabilities ______.

7. Sell $2,000 worth of inventory to customers for $4,000 on
a net 30 day basis during the month of September. Owner’s Equity

Total Assets Total Liabilities + OE .

Fundamental Accounting Equation:

Assets = Liabilities + Owner’s Equity

Week 2 - 17 Week 2 - 18

Financial Statements
Completed Income Statement Lightening Electronics Limited manufactures disc drives and sells its products to a
number of large computer manufacturers. The manufacturing and office facilities of the
Small Business company are located in a rented three story building in Woodbine. The Company was
founded seven years ago. During the past seven years it purchased machines and
Income Statement equipment to aid its production and office operations. The company pays income tax at a
42% rate. The financial year of Lightening Electronics Limited ends on June 30 each year.
Month Ending September 30, 200x All items appearing in the last balance sheet and income statement of the company are
listed below.
Accounts receivable 762,000 *
Sales $4,000 Accounts payable *
Accumulated depreciation on equipment and machinery 1,280,000 *
Costs of Goods Sold
Bank loan, due Dec. 31, 2009 1,600,000
Materials 2,000 2,000 Bank loan, due Oct. 31, 2015 1,320,000
Cash on hand *
Gross Profit $2,000 Cost of goods sold 9,450,000 **
Depreciation 40,000 **
Income before tax *
Income tax **
Accounting Definition: Income tax payable 160,000 *
Inventory 3,610,000 *
Cost of Goods Sold: Net profit (after tax) 614,000 **
Beginning of year inventory 0 Owners’ equity *
Prepaid expenses 54,000 *
Plus: Purchases during year 4,000 Retained earnings *
Less: End of year inventory 2,000 Sales **
Selling and administrative costs 1,650,000 **
Stocks 200,000 *
Cost of goods sold during Total assets 4,994,000 *
Total current assets *
accounting period 2,000 Total current liabilities 2,907,000 *
Total value of machinery and equipment at cost 1,620,000 *

Note: * on June 30, 2009

** during the financial year from July 1, 2008 to June 30, 2009
Determine the missing items and prepare the balance sheet as of June 30, 2009 and the
income statement for last financial year for the company.
Week 2 - 19 Week 2 - 20
 Preliminary Balance Sheet
Lightening Electronics Balance Sheet Worksheet
Balance Sheet
June 30, 2009 Assets
1. Total Long -Term Assets
Current Assets Current Liabilities = First Cost of Assets - Accumulated Depreciation
Cash ? Bank Loan 1,600,000 = 1,620,000 - 1,280,000 = 340,000
Accounts Rec. 762,000 Accounts Payable ?
Inventory 3,610,000 Income Tax Payable 160,000 2. Total Assets = Current Assets + Long -Term Assets
Prepaid Expenses 54,000
⇒ TCA = TA - LTA
Total Current
= 4,994,000 - 340,000 = 4,654,000
Total Current Assets ? Liabilities 2,907,000

3. Cash = TCA - A/R - Inventory - Prepaid Expenses

Long-term Assets Long-term Liabilities = 4,654,000 - 762,000 - 3,610,000 - 54,000
Assets (at cost) 1,620,000 1,320,000 = 228,000
Less: Accumulated Owners Equity
Depreciation 1,280,000 Stocks 200,000
Retained Earnings ? .
Total Long-Term
Assets ? Total Owners’ Equity ?

Total Assets 4,994,000 Total Liabilities & OE ? .

Week 2 - 21 Week 2 - 22

Balance Sheet Worksheet Completed Balance Sheet

Liabilities and Owners’ Equity: Lightening Electronics
Balance Sheet
4. Total Assets = Total Liabilities + Owners’ Equity June 30, 2009
TL + OE = 4,994,000
Current Assets Currents Liabilities
5. Owner’s Equity = (Total Liabilities and OE) - Current Cash 228,000 Bank Loan 1,600,000
Liabilities - Long-Term Liabilities Accts Receivable 762,000 Accounts Payable 1,147,000
= 4,994,000 - 2,907,000 - 1,320,000 Inventory 3,610,000 Income Tax Payable 160,000
= 767,000 Prepaid Expenses 54,000
Total C/A 4,654,000 Total C/L 2,907,000
6.Owner’s Equity = Stocks + Retained Earnings
⇒ Retained Earnings = Owners’ Equity - Stocks Long Term Assets Long Term Liabilities
= 767,000 - 200,000 Assets (at cost) 1,620,000 1,320,000
= 567,000 Less: Acc. Depr. 1,280,000 Owners’ Equity
Stocks 200,000
7. Accounts Payable = TCL - Bank Loan Retained Earnings 567,000
- Income Tax Payable Total LTA 340,000 Total OE 767,000
= 2,907,000 - 1,600,000 - 160,000
= 1,147,000 Total Assets 4,994,000 Total Liab. & OE 4,994,000

Week 2 - 23 Week 2 - 24
 Preliminary Income Statement Income Statement Worksheet
Lightening Electronics Tax Rate = 42%
Income Statement Income Statement:
Year Ending June 30, 2009
1. Net Profit = Income Before Tax (1 - Tax Rate)
Sales ?
Net Profit
Cost of Goods Sold 9,450,000 ⇒ Income Before Tax =
(1 - 0.42)
Depreciation 40,000 614,000
Selling and Administrative Costs 1,650,000 = = 1,058,620
0.58
Income Before Tax ? 2. Tax = Income Before Tax × Tax Rate
Tax at 42% ? = 1,058,620 × 0.42
Net Profit (after tax) 614,000 = 444,620

3. Income (b.t.) = Sales - CGS - Depr. - S & A Costs

⇒ Sales = Income + CGS + Depr. + S & A Costs
= 1,058,620 + 9,450,000 + 40,000 + 1,650,000
= 12,198,620

Week 2 - 25 Week 2 - 26

Valuation
Completed Income Statement Value is a measure of the worth of something in terms of money.
Book Value
Lightening Electronics
• the worth of an asset for accounting purposes
Income Statement
• based on historical cost
Year Ending June 30, 2009
• is the lesser of acquisition cost or current market value
Market Value
Sales 12,198,620
• the price at which an asset can be sold
Cost of Goods Sold 9,450,000
Going Concern Value
Depreciation 40,000
• how much the assets of an organization are worth as an
Selling and Administrative Costs 1,650,000
operating unit
Income before tax 1,058,620
• reflects profitability of a company, experience of the
Tax at 42% 444,620 employees, established customer base, value of
Net profit (after tax) 614,000 proprietary technology
Liquidation Value
• amount that could be realized if the assets were sold
separately from the organization using them
• usually (going concern value) > (liquidation value)
Goodwill
• In accounting, Goodwill is the difference between the
value of a business enterprise as a whole and the sum of
the current fair market value of its net assets
• Goodwill is an intangible asset
• An accounting entry for Goodwill is made when a
company is purchased at a price above the fair market
Week 2 - 27
value of its net assets. Week 2 - 28
 IBM Consolidated Statement of Financial Position IBM Consolidated Statement of Earnings
(IBM 1990 Annual Report) (IBM 1990 Annual Report)

Week 2 - 29 Week 2 - 30

Financial Statement Interpretation

Financial Statement Interpretation
Working Capital Quick-Asset Ratio (Acid-Test Ratio)

– funds used to meet the daily financial obligations of – a more conservative liquidity ratio
the company – goods in inventory might not sell

WC = current assets - current liabilities

= 38,920 - 25,276
= 13,644 current assets - inventories - prepaid expenses
ATR =
current liabilities
Current Ratio
38,920 - 10,108 - 1,167
=
– working capital ratio 25,276
= 1.08
current assets
CR =
current liabilities

38,920
=
25,276

= 1.54

Week 2 - 31 Week 2 - 32
 Financial Statement Interpretation Financial Statement Interpretation
Equity Ratio
Operating Ratio
– financial strength of the firm
• operating ratio greater than 1.0 indicates a net profit
owner' s equity • comparison of different product lines or plants
ER = total assets
total revenues
OR = (before income tax)
42,832 total expenses
=
87,568
69,018
= 48.9% =
30,723 + 27,263 + 829
Debt to Equity Ratio = 1.17
– relative magnitude of debt to equity
Income Ratio
– leverage - use of debt financing
• net after-tax profit margin on gross revenues
– financial risk of the company
net profit
IR = × 100%
long - term liabilitie s total revenue
DER =
owner' s equity 6,020
= × 100%
69,018
11,943
= = 8.7%
42,832
= 27.9%

Week 2 - 33 Week 2 - 34

Operating Ratio By Business Financial Statement Interpretation

IBM 1990 Rate of Return on Investment
($ Billions) • rate of return on the asset base
Support Rentals &
net profit
Sales Services Software Financing RRI = ×100%
total investment
Revenue 44 11 10 4
6,020
Cost 19 7 3 2 = ×100%
87,568
Alloc.Cost* 18 4 4 2
= 6.8%
Total Cost 37 11 7 4
Inventory Turnover Ratio
OR 1.19 1.00 1.43 1.00
• the number of times a company has sold its entire
inventory during the accounting period
*Costs allocated on a percentage revenue basis:
cost of goods sold
% of Sales 64% 16% 14% 6% ITR =
inventory

Cost to be allocated = Op Expenses + Net Interest Cost 30,723

=
= 27,263 + 829 10,108
= 28,092
= 3.0

Week 2 - 35 Week 2 - 36
IBM Financial Statistics by Value Line (1993)

Financial Statement Interpretation

International Business Machines

1990 1993 Estimated*

Stock Prices ($US) 95-123 42-57
Working Capital ($million) 13,644 3,380
Current Ratio 1.54 1.09
Acid Test Ratio 1.08 0.71
Equity Ratio 48.9% 31.8%
Debt-Equity Ratio 27.9% 60.3%
Operating Ratio 1.17 0.94
Income Ratio 8.7% -0.45%
Rate of Return on Investment 6.8% -0.38%
Inventory Turnover Ratio 3.0 2.1

*1993 Estimates by Value Line

Week 2 - 37 Week 2 - 38

IBM Stock Price (1991-1993)

IBM Stock Price (1992-1999)

Two “Two for One” Stock Splits

Technical Analysis IBM price forecast?
• 1997
• 1999

2009-08-28 Share Price: $120.23

52-Week High: $125.45
Week 2 - 39 Week 2 - 40
Nortel Networks – An IBM Parallel? Nortel Networks – 2002 Stock Price

History does not always repeat itself !!!!

What to do now?
Will IBM’s performance improvement be repeated at Nortel?
Delisted at TSX close on June 26, 2009.
1-Year High: $6.68
1-Year Low: $0.08
But 10 to 1 Reverse Stock Split

Week 2 - 41 Week 2 - 42

IBM Consolidated Balance Sheet – 2008 IBM Consolidated Income Statement - 2008

Week 2 - 43 Week 2 - 44
 Cost Accounting Cost Accounting - Job Costing
• The Balance Sheet and Income Statement summarize a Manufacturing Firm’s Previous Year’s Costs
firm’s financial activities
• At the engineering project level, considerably more detail Total direct labour hours 48,000
is required Total direct labour cost $480,000
Total direct material cost $600,000
TOTAL COSTS = DIRECT MATERIAL COST + DIRECT Total overhead cost $360,000
LABOUR COST + OVERHEAD
Job Direct Resource Requirements:
• The primary purpose of cost accounting is to allocate
costs to a specific project or job Direct labour hours 40
Direct labour hourly rate $12.50
• Overhead costs cannot be allocated as direct charges to
any single project or job Direct materials cost $850
• Overhead costs must be prorated among all projects on
some, more or less, arbitrary basis How much should this job contribute to the cost of
running the factory?
• Popular distribution methods
– 1. Rate per direct labour hour. Use one of three overhead allocation methods.
– 2. Percentage of direct labour cost.
– 3. A percentage of prime cost. The direct costs plus the allocated overhead cost will
• Prime cost = direct material plus direct labour cost. establish the minimum price to charge the customer for
this job in order to “cover all of the costs”.

Week 2 - 45 Week 2 - 46

Direct Labour Hour Method Percentage of Direct Labour Cost Method

Factory Overhead Costs Factory Overhead Costs
Total direct labour hours 48,000 Total direct labour hours 48,000
Total direct labour cost $480,000 Total direct labour cost $480,000
Total direct material cost $600,000 Total direct material cost $600,000
Total overhead cost $360,000 Total overhead cost $360,000
Job Direct Costs Job Direct Costs
Direct labour hours 40 Direct labour hours 40
Direct labour hourly rate $12.50 Direct labour hourly rate $12.50
Direct materials cost $850 Direct materials cost $850

Method 1: Rate Per Direct Labour Hour Method Method 2: Percentage of Direct Labour Cost Method

overhead cost $360,000 overhead $ 360 ,000

rate = = % = = (100 %)
direct labour hours 48,000 hours direct labour cost $ 480 ,000

= $7.50 per direct labour hour

= 75 %
JOB COST:
Direct material cost $850 JOB COST:
Direct labour cost (40 × $12.50) 500 Direct material cost $ 850
Overhead cost (40 × $7.50) 300 Direct labour cost (40 x $12.50) 500
$1,650 Overhead cost (0.75 x $500) 375
$1,725

Week 2 - 47 Week 2 - 48
 Percentage of Prime Cost Method Cost Accounting Caveats
Factory Overhead Costs
Total direct labour hours 48,000
• The accountant and engineer may work with the same
Total direct labour cost $480,000
financial data, but they do so for different purposes
Total direct material cost $600,000
Total overhead cost $360,000
• Must understand these costs carefully
Job Direct Costs
Direct labour hours 40
• Cost data giving average values can be misleading for
Direct labour hourly rate $12.50 engineering economic analysis
Direct materials cost $850 – e.g. hydro utility power increase decision
Method 3: Percentage of Prime Cost Method
• For example, a reduction in labour costs will not result in
overhead cost a corresponding proportionate decrease in overhead costs
% = (100%)
direct labour cost + direct material cost
$360,000 • Must search for true incremental costs and incremental
= (100%)
$480,000 + $600,000 benefits to evaluate projects effectively
= 33 1/3%

JOB COST:
Direct material cost $ 850
Direct labour cost (40 × $12.50) 500
Overhead cost (0.33 × $1,350) 450
$1,800
Week 2 - 49 Week 2 - 50