BEC CPA Review Course

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in this BEC CPA Review course, we're going to be talking about costs and managerial accounting. So let's dive right in and let's start with cost accounting. And as you probably know, the whole point of cost accounting, the objective of cost accounting is to tell management. What it costs to produce one single unit. We want an accounting system that accounts for the basic elements of production, direct material, direct labor and factory overhead.

We want to account for those basic elements of production in such a way that we're able to tell management what it costs to produce one single unit. And you know why management has to have that information. It's all about billing and control. If management doesn't know what it costs to produce a unit, they don't know what to bill for their work.

They don't know how to value their inventory on the balance sheet member, the inventories, work in process, finished goods. They have to be valued for the balance sheet. So the real issue in this discussion is billing and control. So let's get right into it. If you're a manufacturing company and you're trying to determine.

What it costs to produce one single unit. There are basically two ways to go. This is how cost accounting breaks down. If a factory is involved in special orders, if a factory does any sort of special orders, they're basically forced to use some sort of job order system. They're going to use some sort of job order approach, but if they're involved in any sort of mass production, any kind of mass production, It has to be some sort of process approach.

So that's how it breaks down. Now we're going to begin our discussion with mass production and process costing.

Now follow me closely. If you get any kind of problem in the BEC CPA Exam on process costing. Remember there are three primary steps. There are three primary steps to breaking down any process. Problem. The steps are account for all units, calculate EFU and unit costs. Those are the three steps calculate accounts for all units, calculate EFU and calculate unit costs.

If you can do those three steps, you can break down any process problem they could throw at you. Now, before we start the steps, I have to warn you about one little wrinkle and it's this. One thing that complicates process costing is that in process costing, we have to make a cost flow assumption we have to, and there's only two, it's either going to be first in first out or weighted average.

There's no third possibility. We're going to begin with weighted average. And I will say that's what you're more likely to see in the exam. They ask weighted average more than they ask FIFO. We will talk about Pfeifle later. But make sure you get weighted average down. Cause that's what you're more likely to see now to get us into weighted average.

And to get us into these three steps, we're going to go right to a problem. I'd like you to go to your viewers guide and I want you to go to the problem, joy manufacturing and your viewers guide. You should have a big problem. It takes up a whole page joy manufacturing company. Now you'll notice at the top of joy manufacturing company, we're given some information.

We're told that. Joint manufacturing had 25,000 units in the beginning. Work in process. January one, work in process represents partially completed goods that they didn't have time to finish. There were 25,000 units in the beginning work process, 35,000 units in the ending work in process.

During the year they started 80,000 new units into production. And during the year they finished and transferred 65,000 units. Let's do step number one, the first of the three steps is to account for all units. What I'm suggesting is you've got to be able to take information like we have on the top and break it down and account for all units.

And in your mind, I want you to think of accounting for all units as basically a two column reconciliation. Let's start with the first column in the first column. We're going to say that in the beginning, work and process. There were 25,000 units. So they started the year with 25,000 partially completed units in beginning, work in process.

Then what happened? Then they started 80,000 new units into production. If you add that up, that gives you 105,000 units to account for now. Stop and think what that's telling you now, how many units. They were working on in the factory. We now know they were actually working on 105,000 units. Now, once you have that, you basically sit back and ask yourself a question physically, logically, what can happen to units?

If I gave you time to think about it, I think you'd agree. There's only three physical things that can happen. Two units. You can either finish them. You can still be working on them or you can ruin them. There's no fourth possibility. There's only three physical things that could happen to any unit you're working on.

You can either finish it. You can still be working on it or you can spoil it. And if that makes sense to you, what that does is set up your reconciliation column. Let's set it up. We're going to put down finished how many units they finished, how many units are in the ending work and process and how many units were lost?

How many were spoiled? Now let's fill it in. And remember, we're trying to reconcile back to that 105,000 units. We know they were working on 105,000 units, so let's fill it in of that 105,000 units. How many were finished while we're told they finished in transfer at 65,000 units. So we're done with those.

How many units are in the ending work and process? We'll notice there's 35,000 units in the ending work in process. Those are units we're still working on at the end of the period. We're not done with those. And I'm sure you noticed. That only adds up to a hundred thousand units. So we plug it in, they must have lost, they must've spoiled 5,000 units.

And normally what the BEC CPA Exam will do is leave the spoilage blank. That's why it's good to have this first step. It's good to be able to account for all units because so often they will leave the spoilage blank. And if you know my two column reconciliation, you can plug the spoilage. Let me say this.

They could leave any piece of information blank. True. They could leave the number of units in the beginning, work in process blank. They can leave the number of units in the ending work and process blank. And if you know my two column reconciliation, you should be able to find it. That's what I'm telling you.

the BEC CPA Exam loves missing information. As I say, it's usually spoilage, but with my two column reconciliation, If any piece of information is missing, you should be able to find it. So try to remember that if you're in the BEC CPA Exam and you've got a process problem, and something's missing a count for all units, you'll find it.

No, let's go to step two. The second step is to calculate EFU stands for equivalent finished units. Now let me say what we're going to do in the second step. We're going to take their production. And convert it into finished whole units. Now, before I get into how we do the calculation, let me take a moment and make sure you understand the concept of whole unit equivalents works like this.

If I were to tell you that there were a million units in this room, and then I tell you each one of them is 75% complete that's equivalent to what that's equivalent to having 750,000 units in this room that are finished. That's the thinking in this step or about to do, if there's a hundred thousand units in this room and each one is 87% complete well that's equivalent to having 87,000 units in this room that are finished.

That's the thinking we have to go through. Now. What I'm going to show you next is the format for calculating EFU equivalent finished units under weighted average. Remember, we're starting with weighted average. We're assuming a weighted average cost flow. Now, one thing before I start. Remember this normally in a process problem, you're going to have to do a separate EFU calculation for raw material and a separate EFU calculation for labor and overhead.

Why? Because the problem with mass production is that you could have units that are 36% complete in terms of material, but 28% complete in terms of labor and overhead. So you'd have no choice. But to do a separate EFU for raw material and a separate EFU for labor and overhead. That's what you'd normally expect in the exam.

As I say, you can have units that are 92% complete in terms of material, but 84% complete in terms of labor and overhead. So you'd have no choice. You'd have to do a separate EFQ calculation for raw material and a separate EFU calculation for labor and all that. That's what you would normally expect to have to do one more thing about terminology before I show you the calculation.

Remember in the exam. Labor and overhead are referred to together as your conversion costs. That's a term the BEC CPA Exam uses all the time. Labor and overhead are referred to together. As your conversion costs. Maybe I should ask you, what are your prime costs? Prime costs are direct material and direct labor.

That's a prime costs, but conversion costs would be direct labor and factory overhead. You know what I'm saying? I'm saying that normally in process costing, we're going to have to do a separate EFU calculation for raw material and a separate EFU calculation for conversion costs, labor and overhead.

Let's do the EFU for material. Here's the format. If you're going to do. The EFU for raw material under weighted average, the format is take the number of units that were finished. You want to take what they finished? How many units did they finish and transfer and add to that what they did to the ending work in process.

And you can stop right there. That's the format, it's the number of units that you finished, take what they finished. And you're going to add to that what they did. What they accomplished to the ending work in process. So if we have the format down now, let's fill it in this problem. How many units were finished?

They finished and transferred 65,000 units. They finished and transferred 65,000 units. So we put that in. Now, we're going to add to that what they did, what they accomplished to the ending work in process. Now look at the problem. How many units are in the ending working process? They tell us that there are, they tell us that there are 35,000 units in the ending work in process.

Now, if you look at the problem, look at the degree of completion, how complete is the ending work in process in terms of raw material, 50%. So that 17,500 whole unit equivalents, the add that up. The answer is 82,500 whole units. That's the EFU that's how many equivalent whole units of raw material were produced.

This period underweighted average, let's do labor and overhead or conversion costs. We're going to follow the same format for version costs. We're going to take the number of units that were finished again, 65,000. And then we're going to add to that what they did, what they accomplished in the ending work in process.

And again, there were 35,000 units in the ending work in process. If you look at the completion table, it says we got them 30% complete in terms of labor and overhead before we ran out of time. So that's another 10,500 whole unit equivalents. So we're going to add that up. The EFU for conversion costs would be 75,500 whole unit equivalents.

The purpose of the step is to take the production and convert it into whole units, equivalent whole units.

Now let's go to step three. The third step is to calculate unit costs and here your best approach is to memorize a format. Let me show you the format under weighted average to calculate unit costs. Along the top line. You're going to take costs, take the costs from the beginning, work in process. Plus the current costs added up.

That'll give you a total. Then you're going to divide by EFU divided by equivalent finished units and that'll equal unit costs. So that's what you want. Along the top line, you're going to take costs from the beginning, work in process. You're going to add the current production costs. And that'll give you a total and then divide by EFU equivalent, finished units, and that'll give you unit cost.

Now let's get the unit cost for material let's put material in. I'm sure you notice the cost information. There was $95,000 of raw material in the beginning work and process. The current raw material costs were 400,000. So if add that up. That's 495,000 of raw material in total. Now we're going to divide that by the number of equivalent, whole units of material.

We produce this period that was 82,500 units. And the unit cost for material comes out to $6. That's how you get the unit cost. That's how you'd get the unit cost for raw material. It's taking the material costs from the beginning, work and process that 95,000 plus the current raw material, 400,000.

Giving you a total. I think a total column is a good idea, gets an organized 495,000. That's the total material for this company for this period, we're going to divide by the number of whole units of material produced 82,500. And the unit cost for raw material comes out to $6. Same thing with conversion costs.

We're going to take the conversion costs in the beginning. We can process that 78,007 50. Plus the current conversion costs 110,000. That adds up to a total conversion costs of 188,007 50. Now it's a matter of dividing by the number of equivalent, whole units of labor and overhead produced. Our EFU was 75,500 whole units.

And the unit cost for conversion costs comes out to $2 and 50 cents. If he added up, you told you in the cost comes out to. $8 and 50 cents. And while that is on the screen, if you look at that schedule, the unit cost schedule, it shows you why it's mass production. Remember we use process costing when it's mass production and you can see mass production in that schedule.

Do you see what we do in mass production? We keep track of all the costs for a department divide by the number of equivalent whole units produced. And that tells you what each one costs. Cause they're all the same. Every widget costs, $8 and 50 cents. Every gallon of solvent costs, $8 and 50 cents. You can see the mass production in that third step.

Now I want to go back to our second step now, our second step is to calculate EFU equivalent finished units. And now that normally. We do a separate EFU calculation for raw material and a separate EFU calculation for conversion costs. And I want to go back to the EFU calculation that we make for raw material.

Why? Because I want to warn you that sometimes in the exam, they can make different assumptions about when they add the material. For example, they could say all the materials added at the beginning of the process. And you have to know what that means to your EFU calculation, or they could say all of the materials added at the end of the process, and you have to know what that does to your EFU calculation.

So let me use the same problem, joy manufacturing, and let's go back to the calculation we did before just to refresh your memory. Here's what I did in this problem, because the way they presented it, I said, all right, EFU for material, I'm going to take the number of units. They finished 65,000.

And add what they did to the ending work and process. Remember there were 35,000 units in the ending work in process table said they got them 50% complete in terms of material before they ran out of time. So that was 17,500 whole unit equivalents. We added it up and we said, Hey, the EFU for raw material comes out to 82,500 units.

Now I did it that way because they gave me the percent of collegiate completion. Now I want to do the same problem. But what if they said this, instead of giving me that 50% telling him the material was 50% complete, what if they just said in the problem, all the materials added at the beginning now, what would you do?

You'll follow the same format. If they say all the materials added at the beginning. If you're in weighted average, it's the same format. You'd take the number of units that you finished and add what they did to the ending work and process. Let's fill it in. We know they finished and transferred 65,000 units.

But now I look at it this way, if all the materials added at the beginning, that would mean those 35,000 units in the ending work in process must be a hundred percent complete in terms of material because I put it on immediately. The first thing I did in the process was add all the material. So those 35,000 units in the ending work in process must be a hundred percent complete in terms of material, add it up the EFU for material.

Would now be a hundred thousand. It's not that it's difficult, but it's something you have to watch out for in the exam. Now let's do this same problem. What if they said all the materials added at the end let's work it out? It's weighted average. So I follow the same format. I'm going to take the number of units they finished, and I'm going to add what they did to the ending work and process.

Let's fill it in. I know that there were 65,000 units that they finished and transferred. But now, how do I look at the bottom piece? 35,000 units in the ending work in process. If we add all the material at the very end of the process, I have to assume there's 0% complete in terms of material. I have to assume there's no material till they're finished.

Do you see the way you look at that? Those 35,000 units in the, any work and process must have no material because I put all the material on at the very end at the that's my very last step. So if I'm still working on the units, There's zero material in the ending work and process. So that means the EFU for material.

If that's the assumption just would be the 65,000 units. As I say, it's not that it's difficult, but always watch out for that exists in the exam. When they start making different assumptions about when they add the material.

Now I want to make a couple points about spoilage notice when we accounted for all units. There were 5,000 lost units in this problem. Enjoy manufacturing. Let me say a couple of words about spoilage. Theoretically, there are two types of spoilage. There is normal spoilage and there is abnormal spoilage.

Let's talk about normal spoilage. Normal spoilage is inevitable, a certain amount of spoilage. Is the natural result of trying to produce anything in this world. And there's nothing management can do about it. A certain amount of spoilage is inevitable. So what you normally do with this sort of spoilage, normal spoilage, generally speaking, you ignore it.

Generally. You ignore it. Just ignore normal spoilage, generally speaking. And that has the effect of spreading the cost of the normal spoilage. Among the remaining surviving good units. And that makes a lot of sense. When you just remember this normal spoilage is a product cost. Remember that for the exam, normal spoilage is a product cost.

Why? Because it ends up being part of the unit cost of all the good units, all the remaining surviving units. That's generally what you do with normal spoilage. Generally you ignore it. And that has the effect of spreading the cost of the normal spoilage among the remaining good units. Think of normal spoilage.

As a product cost. Another point, if the BEC CPA Exam is silent, you assume spoilage is normal. Notice, enjoy manufacturing. They never said anything about the spoilage. We had 5,000 loss units, nothing was said about it. I assume it's normal spoilage. Generally, I ignore it. So notice when I did all my EFU calculations, I didn't worry about that.

Spoilage. I know you might've been wondering about that, but when I did those EFU calculations, I ignored the spoilage because if they're silent, I assume it's normal spoilage and generally normal spoilage is ignored. You don't put it in the EFU calculation. Generally speaking. Now let me also mention rework costs once in a while with spoilage.

They will meet with normal spoilage. They will mention rework costs. In other words, you have some normal spoilage and you incur costs to rework the units. And then they're okay. I'll just give you one quick point on it. If you see rework costs, just assume that rework costs would be charged to factory overhead.

That's the, there's a, there's more than one way to handle it, but that's always safe. If you see rework costs. Just assume they're charged to factory overhead. And then when you allocate some overhead to all the good units, notice it becomes a product cost. It becomes part of the unit cost of all the remaining surviving good units.

Now let's talk about abnormal spoilage. Abnormal spoilage is a little different abnormal spoilage is management's fault. It's spoilage. That is management's fault. Somebody's messed up. It's spoilage. That should not have happened. Two big things to remember about abnormal spoilage. Number one, abnormal spoilage belongs in your EFU calculation.

If in other words, if there was abnormal spoilage in this problem, now the format for EFE would have three lines. It would be what I finished. Plus what I did to the ending work in process. Plus the abnormal spoilage is added to your equivalent finished units, by the way, for material labor and overhead.

For material land for conversion costs. So as I say, abnormal spoilage. Now my format for weighted average would have three lines. What I finished plus what I did to the ending work and process, plus the abnormal spoilage. So abnormal spoilage is always put in the EFU calculation for material and conversion costs.

And then one more thing. What we finally do with abnormal spoilage is add up all the production costs related to the abnormal spoilage. And show it as a loss on the income statement. It's a loss for the period. That's why the BEC CPA Exam will say abnormal spoilage is a period cost. So that's the fundamental thing that you want to learn about spoilage?

Normal spoilage is a product cost. Why? Because normal spoilage ends up being part of the unit cost of all the remaining surviving good units. Abnormal spoilage is a period cost. Why? Because it gets reported as a loss for the period. That is the essential difference. I'd like you to try some questions.

And remember now when you do questions, don't just wait for me to solve them. You've got to use this, like you're in class. So when I asked you to do questions, the best thing to do is turn your tape off, do the questions, and then come back and go over them with me. But don't just wait for me to solve everything.

The way you learn is by doing them yourself. And especially, even though it's frustrating, getting them wrong, get them wrong now. So you won't get them wrong on the test. That's the theory of this thing. I've always said you learn more by getting questions wrong than maybe any other thing so that people who try to avoid pain like that, we all want to avoid pain, but if you want to avoid that pain you're not doing yourself any good, the phrase, no pain, no gain.

And it's true in the CPA exam. I'd like you to turn your tape off and do one, two, and three, do the first three questions and then we'll go over them.

Let's do number one together. I'm sure you noticed the number one at the bottom. They say that the cost flow assumption is weighted average. Of course, in the exam. You'd circle that you're always looking for that in process costing, you have to make a cost blow assumption. It's either FIFO or weighted average.

So you circle that and notice they want the EFU. The equivalent finished units for what? For labor and overhead for conversion costs. So let me ask you something. If they want the EFU for conversion costs, how important is it that materials added at the beginning of the process? Notice that's in there. It doesn't matter at all.

I only worry about at what point they add the material. If I was doing the EFU for raw material, but if I'm doing the EFU for labor and overhead, it does matter when we add the material. So that's just there to. Get you to read extra words, it's meaningless, let's do the calculation. And of course the key to this whole thing is get the format right now in weighted average, we're going to take the number of units that they finished, and we're going to add what they accomplished, what they did to the ending work and process.

In this question, they finished and transferred 10,000 units. Now we're going to add to that what they accomplished in the ending work and process notice there are 4,000 units in the ending work in process. They say they got them 75% complete in terms of conversion costs. That's 3000 whole unit equivalence.

We add it up. The EFU for conversion cost is 13,000 and the answer is a let's do number two. And number two, again, the cost low assumption is weighted average. You circle that and notice what they want. They want cost per equivalent unit. They want my third step. If you're with me down at this point, I think you can see really what the key to process costing is in the CPA exam.

You have to sit there. If you get questions on process costing and ask yourself two things. What's the cost flow assumption weighted average. And what step do they want? Which a Bob's three steps. And they asked me to do here. They're asking for step three unit cost. Now you might remember the format with the unit cost.

I take costs from the beginning, work in process. Add the current period cost gives me a total divide by EFU equals unit costs. And if you know the format, you notice something I have to do step two in order to solve step three. Isn't that true in order to get unit cost, step three, I have to divide by EFU.

So anytime they ask me for step three, unit cost, I'm forced to do step two because in step three, I divide by equivalent finished units. And very often in the exam, they make you work backwards like that. So let's get it. Let's get the equivalent finished units. Now they're asking for the cost per unit for material.

So let's get the EFU for material. We're going to take in weighted average, the number of units they finished. And we're going to add to that what they did to the ending work in process. In this question, they finished and transferred 42,500 units. We're going to add to that what they accomplished in the ending work in process.

There are 12,500 units in the end, the work in process, they must be a hundred percent complete germs material. Why? Because we add all the material at the beginning of the process, notice that's in there. So those 12,500 units must be a hundred percent complete Durham's material. That's 12,500 whole unit equivalents added up.

The EFU for raw material is 55,000 whole units. Now having done step two, we can do step three. Remember the format we're going to take costs from the beginning working process. Plus the current costs gives me a total divide by the EFU gives me the unit cost. Let's get the unit cost for raw material.

We're going to take the raw material costs from the beginning. Work can process 5,500. Add the current raw material 18,000. That gives you a total of $23,500 of total material. Divide by the number of whole units and material, they produced 55,000. The unit cost for material, which is what they wanted is 43 cents.

And that gives you answer D so don't be surprised if they make you do that. If they ask for step three, you're forced to do step two because in step three, you divide by EFU. That's why I say if you know the three steps you're on your way now let's do question number three. In question number three, again, the cost flow assumption is weighted average.

Now what do they want? They ask at the bottom, how much conversion cost was transferred to the second department. In this question, we have two departments and forming is the first of two stages and they want to know what forming would send to the second department. In terms of conversion costs. You got a lot to do here first.

Let's get the unicorn. Let's get the equivalent finished units for labor and overhead for conversion costs. So we're going to take the number of units. They finished, add what they did to the ending work in process. We start with our format. Now in this question, they finished and transferred 7,000 units.

We put that in. Now, we're going to add to that what they did to the ending work and process. And I'm sure you noticed there's 2,500 units in the ending work in process. They got them 80% complete in terms of conversion costs. So that's 2000, the whole unit equivalents. And I know this is going to drive you crazy, but I have to put the abnormal spoilage in, excuse me.

I have to put the normal spoilage in earlier. I said, you might remember that generally speaking, normal spoilage is ignored. Remember that? I did say generally speaking, we ignore normal spoilage. We don't put it in the EFU calculation and that has the effect. Of spreading the normal spoilage among the remaining good units.

It's a product cost. Why do I have to put the normal spoilage into this calculation? Because they went out of their way to say the spoilage is normal. What's different in this question is a couple of things in this question. Forming is the first of two departments. And if you look in the first paragraph they said, and you might want to underline this is what makes it different.

They said cost of spoiled units. Are assigned to units completed and transferred to the second department in the period. The spoilage is identified. That sentence tells me it's completely different. What they're going to do is keep track of spoilage in the first department, forming, send it to the second department and more than likely the second departments go to rework the units and salvage them somehow.

That's why we're not just ignoring it. So that's, what's different about this question. Forming is the first of two departments and they said that the spoilage is going to be kept track of sent to the second department. And as I say, what's going on here is the second department probably reworks the units and makes them.

So that they're salvageable. So in this case, even though the spoilage is normal, we're going to put those 500 units in. So the EFU the equivalent finished units of conversion cost is not 9,000. It's 9,500. The normal spoilage has to be in there. Now let's get the unit cost for labor and overhead for conversion costs.

We use our format. Step three, we're going to take costs from the beginning working process. Plus the current period costs gives you a total divided by EFU equals unit costs. Let's fill it in. We're going to take the conversion cost from the beginning. We're can process 10,000 plus the current conversion costs 75,500.

That gives you a total of 85,500 of total conversion costs. Divide by the number of whole units produced 9,500. The unit cost, the labor and overhead for conversion costs is $9. Now I can solve it. What were the conversion costs sent to the second department? How many finished units were sent to the second department?

7,000, right? And wasn't there $9 of labor and overhead on every one of those. So that's $63,000 of conversion costs sent to the second department, but I'm not done. We also transferred 500 spoiled units to the second department. Maybe they keep track of it. There's $9 with conversion costs on each one of those.

That's another 4,500 of conversion costs. So he added up the total conversion costs. We are sending to the second department, 67,500. So the answer let's see

now, so far, we've only been talking about. Weighted average. But once in a while, the BEC CPA Exam does hit FIFA. Remember in process costing could be weighted. Average could be five fold. As I said earlier, they do ask way to average more. That's true, but you don't want to ignore five focus. It does come up. So let's go back to joy manufacturing, and now we're going to solve joy manufacturing.

Under first in, first out, we're going to take the same problem, join manufacturing and your viewers guide, but change the cost flow assumptions. Now we'll make it first in, first out. I don't care whether it's five for a weighted average, you're going to follow the same three steps account for all units.

EFU unit cost count for all units. EFU unit cost let's count for all units while not. I'm not going to make us do it again. Accounting for all units is done exactly the same way. I don't care whether its Five-O or weighted average accounting for all units is always done exactly the same way. We're going to come up with 5,000 lost units.

So that schedule would be no different at all. We won't even go through it again. And by the way, all the notes I gave you on spoilage would still be true. Normal spoilage is generally ignored. If the BEC CPA Exam is silent, you assume it's normal. Abnormal spoilage is a period cost. All those notes that give you on spoilage would still apply as well.

Now let's go to step two. This is where phyto is different. The format for calculating EFU equivalent finished units. Is different under Pfeifle. Let me give it to you under Five-O. We're going to take the number of units they finished. We're going to add to that what they did, what they accomplished in the ending work in process.

So notice you start the same way down to there. It's just weighted average, but in Five-O you have to do one more thing in . You then have to subtract what was already done to the beginning, work in process before you started. So it's a little different. So that's the format for Fibo you take what they finished, add what they did to the ending work in process, just like weighted average, but then in  you've got to subtract what was already done to the beginning, work in process before you started, let's do joy manufacturing and let's do the EFU for raw material.

How would I do it under Five-O I'll put it on the screen under Five-O. We're going to take the number of units they finished. Remember that 65,000. We're going to add to that what they did, what they accomplished in the ending work in process. Remember there was 35,000 units in the ending work in process table says we got them 50% complete before we ran out of time.

So remember that was 17,500 whole unit equivalents. Now notice down to there. It's just weighted average. But as I said in  we do one more thing. We now have to subtract. What was already done to the opening work in process before we began, there was 25,000 units in the beginning working process.

January 1st table says we got those units 10% complete. They were already 10% complete before we started the year. That's 2,500 whole unit equivalents. We backed that out. The EFU for FIFO for raw material is 80,000 whole units. Let's do. Labor and overhead, our conversion costs will follow the same format under FIFO.

Again, we take the number of units that were finished, 65,000. We're going to add to that what they did, what they accomplished in the ending work in process. There were 35,000 units in the ending work in process table said we got them 30% complete in terms of conversion costs. So that was 10,500 whole unit equivalents.

And again, down to there, it's just weighted average. But now in FIFA, we subtract what was already done to the opening work and process. Before we began, there were 25,000 units in the beginning working process, January one, they said they were already 20% complete in terms of conversion costs. Before we started back out 5,000 whole unit equivalents and the EFU for labor and overhead for conversion costs under Five-O.

Is 70,500 whole units. Now let's do step three. It's a little different in step three, unit costs. Notice in FIFO, we take current costs only don't pick up the costs in the beginning work process. We're going to take current costs, only divide by EFU equals unit costs. So let's work it out. We're going to take the current raw material cost again.

Don't pick up the costs. In the beginning working process, knowing FIFO pick up just the current raw material costs 400,000 divide by the number of whole units and material produced 80,000. The unit cost for raw material, $5 under Five-O for conversion costs. We just pick up the 110,000 of labor and overhead incurred in the current period.

Divide by the number of whole units produced 70,500. The EFU for conversion cost. The unit cost for conversion costs, a dollar 56 total unit cost. If you add it up $6 and 56 cents, I would like you to try a question on FIFO. I'd like you to turn your tape off, try number four, and then come back.

For the cost flow assumption is first in, first out and we have to do the EFU for conversion costs. So my point is in the test, first thing you do is put the format. Now it's what we finished. Plus what we did to the ending work in process minus what was already done to the beginning. Work in process. So we started to fill it in this question.

Notice they finished and transferred 160,000 units. That's how many they finished. Now, we're going to add to that what they accomplished, what they did in the ending working process. There are 20,000 units in the ending working process. They say they got them 40% complete in terms of conversion costs before they ran out of time.

That's 8,000 whole unit equivalence. And as I said before, down to there, it's just weighted average. But in FIFO, you've got to do one more thing. You've got to subtract what was already done to the beginning work and process before they started the period notice there were 10,000 units in the beginning working process.

They said they were already 60% complete in terms of conversion costs before they started back out 6,000 whole unit equivalents. And the answer is 162,000 whole units. The answer is B.

Now, before we leave process costing,

I want to deal with one more issue that does come up in a process costing system. And that is the issue of joint products and byproducts. I'm sure you've heard the terms before and you know what? They are, joint products are two or more. Main products, two or more products that produce significant total revenue that are produced together in the same department.

Those are joint products, two or more. It could be three, could be five to a more products that produce significant total revenue material, total revenue, and are processed together in the same department. They process jointly a by-product. Is a product of insignificant value, immaterial value that is produced incidental to the production of a main product.

So that's a byproduct. Byproduct is a product of immaterial, insignificant total revenue that is produced incidental to the production of a main product. Now what the BEC CPA Exam tests most often on this area? Is making sure that you know how to allocate joint costs. Remember that these are two or more main products processed together in the same department.

So that department, those costs called joint costs have to somehow be allocated to the main products. And that's what they test you on. How do we allocate these joint processing costs to the main products, to the joint product? And what you have to know for the BEC CPA Exam is the relative sales value method of allocating joint costs.

Let's go right to a problem. We'll do this one together. I'd like you to go to question number five.

Number five says Allie company produces main products, K and J the process also yields a by-product B and. They say the net realizable value of the by-product is subtracted from joint processing costs, K and J the following information pertains to the production in July and notice the joint costs in total 54,000.

You might want to circle that. So our joint costs are 54,000 at the bottom. It says if Allie uses the net realizable value method of allocating joint costs. What were the joint costs allocated to product? K. Now notice you might want to underline the method. They said the net realizable value method. Now the BEC CPA Exam kind of plays around with this wording.

They, what they call the net realizable value method. They also sometimes call the relative sales value method, and sometimes they call it the relative sales value at split off method. That's three ways of saying the same thing. the BEC CPA Exam has just not been consistent. They'll call this the net realizable value method.

They'll call it the relative sales value at split off method. And sometimes they just call it the relative sales value method. Now to solve this first, we have to deal with the by-product. They said that the net realizable value the by-product is going to be subtracted from the joint costs. So let's work out the net realizable value.

The by-product. If you notice in the problem, the rev, the revenue we expect a yield from the by-product is $9,000. We expect to yield $9,000 of revenue from product B the by-product, but to get that extra revenue, we incur some additional costs of 5,000. So what I expect to net out of that byproduct is 4,000.

So what I have on the screen right now, that's how you get the net realizable value of a by-product it's the revenue you expect to yield from the by-product minus any additional costs that you can trace to the by-product. There could be additional processing costs for the by-product additional marketing costs, additional promotion costs, but that's what you do to get the net realizable value.

The by-product it's the revenue you expect to yield from the by-product minus. Any additional costs that you can trace to that byproduct. Again, additional processing costs, additional production costs. And they gave me that at 5,000. So the net realizable value of the by-product is 4,000. Now, getting back to the question, what did they say that they do with that net realizable value?

They use it to lower the joint costs. So I'm going to take the joint costs, 54,000. I'm going to back out the net realizable value. The by-product the 4,000 that we just calculated. That brings my joint costs down to 50,000. And let me just make a point that's what they do most often in the exam.

Most often in the exam, they will take the net realizable value, the by-product and back it out of the joint costs. That's not the only way to handle byproducts though. Some companies would treat that $4,000, the net realizable value of the by-product as other income, some companies would treat that 4,000 as.

A reduction of cost of goods sold. Remember a by-product by definition is in material. So you get, you have, you're given a lot of latitude on how you handle byproducts because by definition they're insignificant, they're immaterial. But as I say, more often than not, the BEC CPA Exam will use this method. And by the way, there's a name for this.

This method we're using is called the net realizable value method of accounting for byproducts. If you see that phrase, the net realizable value method of accounting for byproducts. You're supposed to do what I've done here, back out the net realizable value from the bi-product back it out of joint costs.

So now our joint costs are 50,000. Now let's apply the relative sales value method to our main products. Let's start with product K can be sold for $40,000. Notice there are no additional costs. There are no additional processing costs. By the way, if there were you'd back them out in this method, if they said that there were a thousand dollars of additional processing costs for K you'd back out a thousand here, there are nuns.

Back out zero. So the, what they call the sales value at split off for product K is 40,000. Now let's do J can be sold for 60,000. And again, there are no additional processing costs to finish J. And again, if they were, you would back them out in this approach, you're supposed to subtract additional processing costs to get sales value.

It's split off. The sales value split off for J would just be the 60,000. Now you add it up. My total sales value, its split off is a hundred thousand. That's the total sales value that we produced this period, by the way, it doesn't matter how many units you've sold. Sometimes the example, throw that in, they actually sold this many units.

Okay. They actually sold this many units of J it doesn't matter. You're after the theoretical sales value of all the good units produced. So don't let them throw you off. They start telling you how many units were actually sold. You couldn't care less. What you want in this method is the theoretical sales value of all the good units produced.

So the theoretical sales value doesn't matter. What I sold the theoretical sales value of my main products, J and K is a hundred thousand. Now I strike a ratio. I say since K makes up 40,000, over a hundred thousand 40% of the sales value it's split off in this approach, K would get 40% of the joint costs, which remember down to 50,000, 20,000 of joint costs would be allocated to product.

K. So the answer is sick. Notice. We are literally using relative sales values to allocate those joint processing costs. Now we've covered process costing.

Now let's get into job order costing. Remember when a factory is involved in special orders, they're basically forced to use some sort of job order approach. And I think you see why if every order is a special order, it's custom made the only logical way to work out what that unit costs. Is to keep track of the material, the labor and the overhead I put into that unit or that job.

In other words, in a job order system, when we start a custom-made job, when we start a special order, we start a job order cost sheet or a job order cost card. And on that sheet, we simply keep track of the material, the labor, and the overhead we put into that unit or that job. Now, if you, with me on the basic approach, I'll say this.

There's one big thing to remember about job order costing and it's this in job order costing direct material and direct labor are charged each job based on actual direct material and direct labor will be charged each job based on actual, based on the actual amounts they incurred on the job, but overhead is different.

Overhead gets applied to a job based on a predetermined rate. So overheads handle the different way overhead gets applied to a job based on a predetermined rate. Let me illustrate, let's say in a job order system, we're working on a customer job. We're working on a special order and the actual material costs for that order.

$48. That's how much raw material I put into that job. Here's my entry. I would debit work in process $48. And I would credit material inventory, $48. Furthermore, let's say we've actually spent $99 of labor. We've actually spent $99 of labor on this job. That's the actual labor that we spent on this job.

What's my entry. I would debit work in process $99 and I'd credit wages payable. $99. Notice direct material. Direct labor charge to work in process based on actual, based on the actual amounts you incurred on the job. Now, following you with our on overhead gets applied to jobs based on a predetermined rate.

Let's say my predetermined rate for overhead in this problem is $8 per labor hour. And let's say they spent nine hours on this job. I would take $9 times fee. I would take. Excuse me, nine hours of labor times my predetermined rate, which is $8 an hour. I'm going to apply $72 of overhead to this job. My entry, I'm going to debit work in process for $8.

My predetermined rate times the nine hours I spent on the job, $72 and notice I credit overhead applied C in a factory like this. There's going to be an overhead applied account. Overhead applied has a credit balance. And what do we use it for? It keeps track of all the overhead we've estimated for jobs.

That's why we have overhead applied. It's going to keep track of all the overhead we've estimated for jobs. Now I'm not done. Ultimately all we care about is actual costs. So I have to have a way to keep track of actual overhead. So let me give you an actual overhead cost. Let's say this factory goes out and buys a hundred dollars worth of supplies.

Okay. This factory actually goes out and purchases. $100 with the supplies now, supplies would be indirect material. It would be a factory overhead item. So what's my entry. I would debit stores control a hundred and I would credit cash a hundred. Now why stores control? The reason stores control is used is because it supplies.

Presumably they'd have some sort of inventory of supplies. That's why I'm debiting stores control because it's supplies. I'm assuming they'd have some sort of inventory of supplies. All right. Now, one more point. Now let's assume they actually send $25 worth of supplies to production. Okay. Now they're actually sending $25 with the supplies to work in process.

What do I do? Debit work in process? No, you're not listening carefully enough. Now you would never charge work in process with actual overhead costs, no direct material direct labor charge to work in process based on actual amounts, overhead gets applied based on a pre-determined rate. So notice that with overhead work in process is always charged for the estimate for the predetermined rate.

No. If I actually send $25 with the supplies to production, I'm going to debit overhead control 25 and I'll credit stores control 25. See you in a factory like this, they have an overhead control account. Overhead control has a debit balance, and that's where we keep track of the actual overhead costs. My point is you cannot go into that exam and not know the difference between overhead control versus overhead applied.

Overhead control always has a debit balance. It's where we keep track of actual overhead costs. Overhead applied has a credit balance. So where we keep track of all the overhead we've estimated for jobs with our predetermined rate. And of course the difference in those two numbers, they're never going to come out the same, no matter how carefully you set up the system at the end of the period, there's going to be a difference between overhead control, what you've actually spent on overhead items, overhead applied all the overhead you've estimated, and that difference.

That's your overhead variance, which we're going to talk about later in this BEC CPA Review course, just to give you something to look forward to. We'll be getting into overhead variances, but let's try a couple of these. I'd like you to stop your tape and try six, seven, and eight, and then come back.

Okay. Let's do this set together.

Six says in a job order system using predetermined factory, overhead rates, indirect materials, like supplies usually are recorded. Initially as an increase in I'd circle the word initially, where would something like indirect materials, like supplies be recorded. Initially, remember initially things like supplies go to stores control.

The answer is D and then as you use them, they go to overhead control. Remember initially they go to storage control. That's why the answers did keyword there as initially. And then as you use. The supplies it would go to overhead control. So be careful number seven in a job order system, the use of direct I'd circled the word direct.

Now we're talking direct material, not indirect, not supplies. This is direct material previously purchased gets recorded. Where will the answer is a member direct material, direct labor get charged to work in process based on actual. That just goes. Directly to work in process based on the actual amount you spend on the job.

When they talk direct material goes right to work in process based on actual. That's why the answer is a eight in a traditional job order system. The issue of indirect I'd circle, the word issue, and I'd circle the word indirect. You're issuing indirect material to production. Remember, as you actually issue.

Something like supplies. When you issue indirect material to production, you debit, overhead control and you credit store's control. Remember initially it goes to storage control, but as you issue the supplies to production, that's when you debit overhead control. And the answer is C because in this question, you're actually issuing the indirect material to production.

That's going to go to overhead control. Answers. See now notice they said in that question that we're talking about a traditional job order system.

I want to say a couple of words about adjust in time costing system in a, just in time cost accounting system. As much as we can, we try to eliminate something like storage. We try to, we try not to carry inventories of supplies as much as possible. We try to eliminate something like storage. Why? Because storage does not add value to our product.

Customers are not willing to pay for storage. Storage is what they call a non-value adding activity. So with a just-in-time system, we don't keep inventories of supplies. We order things like supplies. Just in time to use them. We don't have inventories. We don't have storage. We're going to order something like supplies just in time to use it.

That's a just-in-time system. So the entries I gave you, these job order entries would be a little different. If this were a just-in-time system, we wouldn't have storage control. Now don't get me wrong. We could still charge work in process. For predetermined rate for overhead would be applied to jobs based on a predetermined rate we'd estimate overhead for jobs.

So you'd still debit work in process for the predetermined rate you'd credit, overhead applied, but then when you go out and order supplies, just in time to use them, you would debit, overhead control and you would credit cash at when you order something just in time to use it. You would debit, overhead control.

So we had overhead control, keeps track of the actual overhead costs and you'd credit cash notice there's no stores control. You sorta take out that first entry where we went to stores control. First in a just-in-time system, you wouldn't have storage control you'd order, something like supplies just in time to use them.

And you would debit overhead control and credit cash. Let me say a couple of words about activity-based costing ABC costing now in an activity-based costing system. What you're trying to do is come to grips with the fact that it's activities that consume costs and here again, in an ABC and an activity-based costing system, we want to try to eliminate if we can, any non-value adding activities, customers, activities that customers aren't willing to pay for activities that don't add don't add value to our product and.

As I say, the fact is that activities consume costs. So what we try to identify in an ABC costing system is appropriate cost drivers.  What are the activities that really drive costs? So you would try to identify appropriate cost drivers and trace them to your product. Something like, purchasing materials, what's the cost driver.

Purchasing transactions, purchasing transactions, generate purchasing costs. What is the cost? What would be the cost driver for the repair cost? The cost driver is machine hours. That's the cost driver for the cost of repairs. Now, something to keep in mind in an ABC system, direct materials are handled exactly the same way.

Direct labor handled exactly the same way.

All that's different is trying to identify those activities that drive costs and eliminate as much as you can. Non-value adding activities. Let's just do one question on this. Yes.

Question number nine together. Number nine says in an activity-based costing system, cost reduction is accomplished by identifying and eliminating. First column is all cost drivers. No, you can't. You can't eliminate all cost drivers. You're going to have some, no, you're trying to eliminate non-value added activities.

The answer is C the answer is no. Yes. You're trying to eliminate activities that customers aren't willing to pay for activities that don't add value to the product. Now, another thing that comes up in cost accounting is sometimes in the exam. They will ask you to work out cost of goods, sold for a manufacturing company.

And I want to make sure you know how to do this. So we'll do a question together. Let's go to question number 10. Question 10 says Baker, a manufacturer had inventories at the beginning and end of its current year as follows and they give us the opening balances and the closing balances for the three inventories raw material work in process finished goods.

It says during the year, the following costs. And expenses were incurred. They give us a long list. And at the bottom it says, what is Baker's cost of goods sold for the year? Now what I'm going to show you on, this is a little shortcut. If you've studied this before, you know that this is a very long schedule, it's got, it's got, if you do out the whole schedule, you get three sections, cost of materials, use cost of goods, manufactured, cost of goods sold.

And if you're not careful a question like this can take 10 minutes. But what really shortens it is if a little shortcut, here's the fast way to get the answer. If you're in the exam, you just want to get the answer, it's a multiple choice. No one's ever going to see your work that no, one's going to see how you got the answer anyway, it's graded by a machine.

So here's the fast way to get the answer. Start by adding up the beginning inventories. So we're just going to add them up. Add up 22,000 plus 40,000 plus 25,000. Notice all the beginning inventories, all three. Add up to 87,000 now, add in what happened in the current period. Current raw material purchases, 300,000 current direct labor, 120,000 now overhead.

They made you think about a little bit. Let's go through this list. Let's identify the factory overhead items. How about indirect labor in the factory? You put a check Mark there that's 60,000 indirect labor in the factory. That's a factor of it. Overhead item. How about taxes and depreciation on the factory building?

Yeah. Just put a check Mark by that 20, that depreciation on the factory. That's a factory overhead item. How about taxes and depreciation on the sales room and office? No, that's a selling expense. It belongs below gross profit, but a no there, same thing with salesman salaries, same thing with office salaries.

These are not factory overhead items. How about the utilities? Just the 60% that apply to the factory. Pick up the 30,000. So let me summarize. My total factory overhead, 60,000 of indirect labor in the factory, like supervisors, 20,000 of depreciation in the factory and 30,000 of utilities, total factory overhead.

If you work it out is 110,000. Now, if you add up all the numbers that adds up to $617,000, notice all I've done to this point is add now, what do I do? I bet you guess you subtract the total of all your ending inventories. So we're going to add up. 30 plus 48 plus 18 subtract 96,000. The total of all your ending inventories and you get 521,000.

The answer is be about as fast as a human being can do it. That's just a fast way to get that answer. Now I gotta warn you on this same problem sometimes instead of asking you for cost of goods sold, they'll ask you for cost of goods manufactured. You can use the sh the same shortcut. Be careful.

Are they asking for costs of goods sold, which we just went over or are they asking for cost of goods manufactured? You gotta be careful if they want cost of goods manufactured, the same shortcut will work, but now you just deal with the first two inventories, knock out, finished goods. So let's do it.

I'll add up beginning inventory of raw material and work in process 22 plus 40. That adds up to 62,000. Then again, I add in the current cost. Current raw material purchases, 300,000 current direct labor, one 20 current overhead I'd have to still work out. Remember came out to 110,000, add all that up. It adds up to 592,000.

Now back out the total of the ending inventory, just for raw material work and process, add up 30 plus 48, which is 78,000. And that would give you cost of goods, manufactured 514,000. So the same shortcut will work. Just use the first two inventories don't put in the finished goods.

Now, the next thing I want to get into in cost accounting is a standard cost accounting system in a standard cost accounting system. What we're basically going to do is set up a budget. Where we put a standard amount of material, a standard amount of labor and a standard amount of overhead into every unit we produce.

That's why it's called standard costing. In other words, Now all elements of production will be charged to a job based on a predetermined rate, I'm going to have a predetermined rate for raw material or a standard amount of material. We apply to every unit we produced. I'm going to have a predetermined rate for labor or a standard amount of labor.

I apply to every unit I produce and of course, a predetermined rate for factory overhead. Or a standard amount of overhead. I apply to every unit I produced. That's why they call it standard costing. Now, one thing to keep in mind as you go and standard costing in this area, standard means budget.

You might want even write that down somewhere. Standard equals budget. Anytime they talk about standard, they mean budget. So if I say you have a standard for material, you have a budget for material. So really use the words interchangeably. But they call it standard costing. Now, you know why we're setting up these standards, why we're setting up these budgets, because ultimately we're going to compare budget to actual, we're going to compare standard to actual, and we're going to come up with these variances.

The whole reason we do this is as a yardstick to measure performance by the whole point is to judge management performance. And again, the way we judge management performance. Is with these variances and that's what I want to go over next. We're going to go over the variance is that you have to know for the BEC CPA Exam and we're going to go right to a problem in your viewers guide.

You should take out the major problem Armando corporation. It takes up a full page. It's a full problem. Let's take a look at it. It says Armando corporation manufacturers, a product with the following standard costs. Notice here are your standards. What standard mean budget? Here's your budget direct material.

They put 20 standard yards into every unit. They produce a dollar 35 is the standard price per yard. So they're applying $27 of material to every unit. They produce labor. They put four standard hours in every unit. They produce $9 is the standard rate per hour. They're applying $36 of labor. Every unit they produce notice their budget for overhead.

They apply overhead at five, six of direct labor. Don't let that bother you. If you take five, six of 36, that's what they get the 30 that's all they're saying. Notice they put $36 of labor on every unit they produce. And if you apply overhead at five sixths of labor, you take five, six of 36. You get that 30, they gave you.

So they're putting $30 of overhead on every unit they produce at the added up. That total standard, their total budget for every unit is $27 material. $36 of labor. $30 of overhead. The budget for every unit is $93. Then it says the standards are based on normal monthly production involving 2,400 direct labor hours or 600 units of production.

Armando actually produced 500 units. Notice they produced under budget. The fixed factory overhead budget is 6,000. The variable overhead rate is $5 per direct labor hour. And then they give us the actual information. And at the bottom it says, prepare the following schedules for the month of July and indicate whether each variance is favorable or unfavorable.

And you'll notice they're asking for six variances and I'll tell you, these are the big six. These are the six. They asked for all the time, if they're going to get into , they'll probably ask it for these six material price, material usage, labor rate, labor efficiency, and they want controllable and volume overhead variances.

Now I'll tell you that with variances, there are basically two ways to go. You can memorize formats or you can take some shortcuts. And I know you're not going to like this. But I think you really have to know both. I think the best thing for the BEC CPA Exam is to know the format's cold and there aren't that many, so it's not as bad as you think.

But I think the best thing, the safest thing for the BEC CPA Exam is to know the format's cold. And then I'll go over the shortcuts too, because sometimes the shortcuts come in handy. What I'm trying to tell you in so many words is that different approaches. Help with different types of questions. Sometimes the formats, you really need them.

They, the formats never let you down, but then sometimes the shortcut comes in handy. Let's start with the format.

We're going to start the first one, the material price variance. And before I start it just one little wrinkle. When I do the material price variance notice, they said based on purchases, and that tells me I'm going to base that price variance on all 18,000 yards. They purchased not the 9,500 yards they actually used.

So that's what that's telling you. They want to based on purchases. So that tells you've got to base the price variance on all 18,000 yards. They purchased not. The 9,500 yards they actually used. And by the way, that's almost always the case. Usually the BEC CPA Exam wants you to calculate a price variance on all the gallons, all the yards, all the units purchased, not what was used.

Now I'm going to start with the format. What I'm going to give you now is the format for the material, price variance. I'll put it on the screen for the material price variance. It's a times a. Compared with a times. S and let me say what the letters mean. We're going to take the actual yards purchased times, the actual price known as eight times eight it's actual yards purchased times actual price.

We're going to compare that with the actual yards purchase times the standard price. So it's eight times a compared with eight times S and as you noticed on the screen, what's going to help is we can use the same format. Later when we do the labor rate variance, this one, format's going to get you to, it's going to get you the material price.

It's also going to get to the labor rate variance. We'll do that later. Let's get the material price variance. Let's fill it in. We're going to take the actual yards. They purchased 18,000 times the actual price per yard. A dollar 35. If you multiply that out, that's $24,840 a material. We're going to take the 18,000 yards that we actually purchased.

Time's the actual price per yard at all 38. That comes out to $24,840 a material. Now we're going to compare that with the 18,000 yards, we actually purchased times the standard price. We should have paid per yard. The budget dollar 35, that comes out to 24,300. What we have here is a $540 material price variance.

Now, one thing I want to say, you never put a variance down without thinking right away. Hey, is it favorable or unfavorable? This one is on favorable and this one's pretty obvious. Why is it unfavorable? Because you're over budget. You spent too much, but I'll give you a shortcut so that I hope you're never wrong on this.

Just remember this. I'm hoping this will settle once and for all, whether something's favorable or unfavorable, because some get tricky, this one's obvious, but just so you'll know. In every variance we do in this BEC CPA Review course, all of them, if the top number is higher than the bottom number, it's automatically unfavorable.

That, that way it's quick. You'll hopefully you'll never get it wrong in every one we do in this BEC CPA Review course. If the top number is higher than the bottom number, it's automatically on favorable. If you ever see a bottom number higher than the top number, it's automatically favorable that way. It's quick. You never get it wrong.

Another point unfavorable variances are always debits. Favorable variances are always credits. Sometimes they get into that. So what are we now going to know for the rest of our natural lives? When you do a variance, if the top number is higher than the bottom number, what do you know automatically a debit it's automatically unfavorable every time.

If you ever see a bottom number higher than a top number automatically a credit automatically favorable every single time. Now what I've gone over so far is the format. What's the shortcut. What's the quick way to get this. I'm sure you see it. The other way to get the $540 is to focus on the 3 cents.

That's the other way. Look, our budget said we were supposed to spend a dollar 35 a yard. We actually spent a dollar 38 turns out we spent 3 cents more than budget. We were 3 cents over budget on every yard we purchased. So if you multiply that 3 cents times, 18,000 yards, that'll give you $540. Also sometimes that'll come in handy.

Now let's do the second variance. The material usage varies. Let me give you the format for the material usage variance. We're going to take the actual yards they used not purchased careful that first day. Actual yards used time, standard price compared with what's the first S the standard yards they should used to think of should it's an S the standard yards.

They should have used time's standard price and that get it for you. And as you can see on the screen, what's going to help is that we're going to be able to use the same format later for labor efficiency as well. And we'll do that later, but let's get. The material usage variants, we're going to take the actual yards.

They used 9,500 times the standard price, a dollar 35. If you multiply that out, that comes out to $12,825. Now we're going to compare that what, with a standard yards they should have used. Now listen carefully. They're not, they're probably not going to give you this number. You have not to get this number.

How do I get the standard yards they should have used? We'll look at the problem. How many units did they actually produce fire? You I'd circle it always a critical piece of information in a variance question. I'll say this to you right now. There are many variances you cannot do. If you don't have that information, how many units did they actually produce?

You're always looking for that in a variance question in this case 500. All right. They actually produced 500 units. Notice I don't use the 600 more students get caught on that. Don't use the 600, the standard units they normally make. I'm going to say something to you. I hope it makes you feel better.

This is going to make you feel better. That's 600 units that they normally produce. That's not used in any variants. Does that help? Because a lot of stuff to keep looking back at it, what do I do with that 600? What do I do with that 600 nothing it's not used in any variance, in a variance question. It's always critical to know how many units were actually produced.

So let's work it out. They made 500 units. That's how many they actually produced. Now look at your budget at the top of the problem, how many standard yards should be put into every unit 20? So they should have used 500 times 20 10,000 yards. That's the standard yards. They should have used 10,000 times the standard price of dollar 35 that comes out to 13,500.

What you have here is a material usage variance. Of $675 and it's automatically favorable. Isn't it? It's automatically a credit it's automatically favorable. Cause the bottom number is higher than the top. Number minute, you see the bottom number higher than the top number. It's automatically a credit it's automatically favorable.

Now that's the format. What would be another way to get that one? What's the shortcut focused on the yards. Look at the yards. Our standards say our budget says we should have used 10,000 yards. We made 500 units. We only use 9,500 yards somewhere. We saved 500 yards. That's the shortcut. If you take 500 yards saved times the standard price, a dollar 35, that would also give you six 75.

That's the other way to do it. Now, another variance they could ask. What's the total material variance. Make sure you know how to get this one. I have a $540. Unfavorable material, price variance. That's a debit. I have a $675 favorable usage variance. That's a credit Mike total material variance is $135 credit.

Sometimes they ask for that one and I hate you to miss that because it's an easy one. I've got a, Hey, I've got a $540 unfavorable price. That's a debit. I've got a six 75 favorable use of that. Your credit? My total material variance is one 35 credit favorable. Just combine the two you have

now let's do three and four. We'll start with number three, labor rate variance. Remember the same format we use for material price. We now can use for labor rate variance. We're going to take a times a compared with a times S eventually you're going to memorize these formats. Now, if I'm going to use this, the labor, what's it.

Stand for. I bet, we're going to take the actual hours, worked times actual price and compare that with actual hours work times standard price. Let's fill it in. We're going to take the actual hours. They worked 2,100 times the actual rate per hour, $9 and 15 cents. They actually spent $19,215 on labor.

Now we're going to compare that with. The actual hours, they worked 2,100 times the standard, the budget what's the standard rate per hour nine that comes out to 18,900. What you have here is a $315 unfavorable. The top number is higher than the bottom number. It's a $315 unfavorable labor rate variance automatically unfavorable automatically a debit because the top number is higher than the bottom number.

We've got that one and I'll bet you're getting better and better at this. What's the shortcut focus on the 15 cents. Hey, our budget says we should have paid $9 an hour. We paid nine 15. Turns out. We spent 15 cents over budget for every hour we work. And if you take 15 cents times 2100 hours, that would also give you three 15.

And sometimes that comes in handy. Let's do the labor efficiency, variance, or the labor usage variance. Remember the same format we use for material usage we can use for labor usage or labor efficiency. A times S compared with S times S but I know you with me, if I'm going to use it for labor, what are the letters stand for?

I'm going to take actual hours, worked times standard price, right? That's the eight times S actual hours work, time, standard price compared with what? What's the first S the standard hours they should've worked. I like the word should, because it's an S the standard hours. They should have worked times standard price.

Let's fill it in. We take the actual hours, they worked 2,100 times the actual price per hour. Times the standard price per hour, $9. And of course, we'll take now that $18,900 and compare it with the standard hours. They should have worked times the standard price. Now, how do you get the standard price?

They should have worked. Remember, this is a number they're probably not going to give you. You have not to get it. Remember, go to the actual units they produced, we don't care the units they normally produce. We always judge management on what they actually did. We don't judge management on what they should have done.

That's a very different issue. We judge management, these variances are all about telling management. Did they do a good job or a bad job on those 500 units? They actually produced. It isn't about what they normally produce. So let's take the 500 units they actually did produce. And if you look at the budget, how many standard hours should they put into every unit?

They produce four. So they should've worked 2000 hours. That's the standard hours. They should have worked for what they produced. Four hours, times 500 units. 2000 hours you multiply that 2000 times the standard rate nine that's 18,000. We have a $900 on unfavorable, a debit, an unfavorable labor efficiency, variance.

Hey, top number is higher than the bottom number automatically a debit automatically on favorable. How about the shortcut? We've done the format. What's the other way to get that one? I bet you see it focus on the hours, right? Didn't they waste a hundred hours. Look, your budget says if you make 500 units, it ought to take 2000 hours.

We made 500 units, but for some reason it took 2,100 hours. So somewhere along the line, we wasted a hundred hours. And if you take a hundred hours wasted times the standard rate nine, that'll also give you 900. What if they wanted the total labor variance? They asked for that sometimes. I hate you to miss it.

Just combine the two you have. You've done the hard work you've got a $315 unfavorable rate. That's a debit, a $900 unfavorable efficiency. That's a debit totally. Bavarians 1000 to 15 debit.

Now let's get into the overhead variances. And if you go back to the problem, notice requirements five and six. They want the controllable, overhead variance, and they want the volume of a head variance. You might want to just for your own purposes, bracket five and six together, right in their two way analysis.

What they're asking for here is the two way analysis of analyzing overhead. And I'll say this, I'd say maybe 50% of the time in the exam. They want the two way analysis. And 50% of the time they want the three-way analysis of analyzing overhead. Now, you know me, I'm going to cover both because you really have to be ready for both.

So we're going to start by solving this problem, Armando, under the two way analysis. Now, before we start one more piece of advice with overhead, don't take shortcuts. I think more often than not, they get you into trouble with overhead. You should use a format. The format is the way to go. As I say shortcuts.

Sometimes you will sit and examine, go, Oh, if I take this plus this, I've got the volume variance. Almost always. They're trying to lead you down the path. I think you're always safe with a format. Let me show you my format for the two way analysis at the top, we put the actual overhead cost. Now that's given, if you look in the actual cost information, they actually spent 16,000.

$650 on actual overhead items. That's what they actually spent on variable event items like supplies, fixed overhead items like depreciation. That's what they actually spent on overhead items. Now at the bottom, we'll leave a space. And at the bottom we put in the overhead applied to work in process.

Now we're going to do this together. You're going to have to be able to get this number again, more than likely. They're probably not going to give this to you. How do you get the bottom number, which is overhead applied to work in process? Go back to the problem. Look at your budget at the top of the page, what's their predetermined rate for overhead aren't they applying $30 of overhead to every unit they produce.

Look at those, look at that budget. We know that in the budget, they're applying $30 of overhead to every unit they produce. Now I asked you how many units did they actually produce 500. If you take 500 times 30. They must've applied $15,000 of overhead to work in process. Now, if you take the difference between what they spent, 16,006 50 and what they applied 15,000, that 1006 50 difference, that's called the total overhead variance.

They didn't ask for that here, but they do very often that 1006 50 difference between what they spent. And what they applied, that's called the total overhead variance. And you have to not to get that one, by the way, that total overhead variance it's unfavorable. Why? Because the top number is higher than the bottom number that shortcut will always work for you because 16,006 50 is higher than 15,000.

That 1006 50 is automatically a debit it's automatically unfavorable. And I'll tell you this. That's where that shortcut really helps out a lot. A lot of people in the exam. With overhead, they get the numbers, but they just aren't sure whether it's favorable or unfavorable, but this little shortcut just solves it for you.

Hey, 16,006 50 is higher than 15,000. That 1006 50, which again, they call the total overhead variance. It's gotta be a debit. It's gotta be unfavorable. And again, they didn't ask for that here, but they do ask for that often. All right now, to get the two way analysis, let's go back to the format. I put what they spent at the top, what they applied at the bottom.

And now in the middle, I want an overhead budget based on standard hours. If I do that in the middle between what they spent and what they applied, if I put in an overhead budget based on standard hours, that'll give me what I need. So what I have to work on now is that middle line, the overhead budget based on standard hours.

Now, first of all, what do I mean by standard hours? Make sure you know how to get this. How many units they did. They produce Bob I'm so sick of that question. In a bearings question, you've got to know it doesn't matter how many items they normally produce. It's how many units they actually produced 500.

Now, if you look at your budget, how many standard hours should they put into every unit for? So the standard hours, they should have worked for what they accomplished 2000. I'm now going to do a budget for overhead based on those 2000 standard hours. Now, if you look at the problem, what's the fixed budget.

Notice the fixed budget is $6,000. Would that be any different depending on what hours you work? No. Remember that's the nature of fixed costs. Fixed costs are fixed. They're set in amount, fixed costs that represents things like depreciation, property taxes. These costs do not rise and fall with activity.

So presumably if they worked one hour, the fixed budget would be $6,000. If they worked. 4,000 hours, they fixed budget would be $6,000 because that's the nature of fixed costs. They're fixed. They're set in amount again, that's 6,000 of depreciation, property taxes, insurance, that's the nature of fixed costs.

They're set in amount, which always have to be careful about is the variable budget. If you go back to the problem, notice the variable budget, the variable overhead rate is $5 per direct labor hours. See, that's telling you. Every time they work a direct labor hour. What happens every time they work a direct labor hour?

Of course they incur more labor that's obvious, but over and above labor, they incur another $5 of variable, overhead items, things like supplies, oil for the machines. So follow what I do. I'm going to take that $5, the variable rate for overhead $5 times the standard hours, they should've worked 2000. The variable overhead budget is 10,000.

A budget based on standard hours is 16,000. And while I've got that on the screen, you can see how overhead always breaks down. You got to get used to this about overhead. Overhead always has two components. There's always a fixed budget, which represents things like depreciation, property taxes. And there's always a variable budget, which represents things like supplies, oil for the machines.

And as I say, it's that variable budget you've got to be careful about. They said every time they work an hour in, they incur another $5 of purely variable overhead. So I take the $5 times, the 2000 hours they should have worked. The variable budget should have been 10,000. The fixed budget should have been, should have stayed 6,000 a budget based on standard hours comes out to 16,000.

Now let's go back to our two way analysis and let's put it in. I take that 16,000 that I just calculated. Let's go back to our format. Remember I have the actual overhead cost at the top 16,006 50 at the bottom. I have what they applied 15,000. We went over how you get that number? $30 a unit times 500 units.

And we know the total overhead variance is 1006 50 on favorable. We've got that. Now that budget based on standard hours, I put in the middle. That's 16,000 that I just calculate that goes in the middle. Now I've got it. The difference between what they spent 16,006 50 and the budget based on standard hours, 16,000, that's called the overhead controllable variance.

And of course it's unfavorable. Why? Because the 16,006 50. Is higher than the 16,000. If the top number is higher than the bottom number, it's automatically a debit to automatically unfavorable. Now let's go back to the schedule, the difference between the budget based on standard hours, 16,000, and what they applied 15,000, that thousand dollars difference that's called overhead volume variance or overhead capacity variance.

the BEC CPA Exam uses both terms, overhead volume, variance, or overhead capacity variance. And of course that's unfavorable because the 16,000 is higher than the 15,000. Never let you down. It's a debit it's unfavorable. So that answers requirement five and six. The answer to five requirement, five, six 50 unfavorable.

The answer to six, 1000 on favorable. Let me make a couple points about the volume variance, a volume variance, or a capacity variance represents purely fixed costs. Volume Barry's always represents purely fixed costs. You get a volume variance because you either produced over normal and you over applied your fixed overhead, or like in this problem you produced under normal.

Normally they produce 600 units here. They produce 500, you produce under normal. So you under apply your fixed overhead. That's why you get a volume variance. You either produce over normal. So you. Over apply your fixed factory overhead, or you produce under normal and you under apply your fixed factory overhead.

In other words, volume variances are caused by volume of production and volume of production is not necessarily under the control of management because volume of production can be affected by outside factors. A downturn in the economy, a change in the interest rates, increased competition. Volume variances are caused by volume of production and volume of production is not necessarily within the control of management because volume of production can be affected by a recession, increased competition, a change in interest rates.

Now the controllable variance is made up of fixed and variable costs. It's fixed and variable. The controllable variance is made up of a spending problem and an efficiency problem, and theoretically spending and efficiency are under the control of management. So that's what the control variance is all about.

It's got fixed, it's got a fixed cost component and a variable cost component. And even though it's made up of fixed and variable costs it is caused by spending and efficiency and spending and efficiency are theoretically within the control of management. So you see what the two way analysis does?

The two way analysis says, look, you told a problem with overhead 1006 50. We try to break it up into what management can control six 50 and what's outside the control of management one, the 1000. That's what the two way analysis is all about. What is controllable by management and what's not management's fault.

No, let's take the same problem and solve it under the three-way analysis. As I said about half the time and the exam, they want the two way analysis and about half the time and the exam, they want the three-way analysis. Now let's solve the same problem under the three-way analysis. Now, what's nice.

What's nice. Is. If they want the three-way analysis, you use the same format I gave you, but you add one more thing. You're going to take the same exact format, but now you have to add on overhead budget based on actual hours, based on the actual hours, they work. Go back to the problem. How many actual hours do they work?

2,100. They didn't work 2000 standard hours. Remember they wasted a hundred hours. Remember that they wasted a hundred hours. They didn't work 2000 standard hours. They actually worked two. They actually worked 2,100 hours. Now we're going to do a flexible budget for factory overhead based on the 2,100 hours, they actually worked.

I'll put it on the screen. Remember a budget for overhead. Always has two parts. There's a fixed budget. Which represents things like depreciation and there's a variable budget, which represents things like supplies. What would the fixed budget be? That's right. 6,000. That's not going to change. Fixed is fixed.

It's set in amount. This budget does not rise and fall with hours. If they worked one hour, presumably that fixed budget would be 6,000. If they work 10,000 hours, presumably the fixed budget would be about $6,000, which always have to be careful about is the variable budget. They said. Every time they work an hour, they incur another $5 of variable overhead.

So we're going to take the $5 variable rate times the 2,100 hours, they actually work. The variable budget should be 10,500. The fixed budget, 6,000 a budget based on actual hours comes out to 16,500. Now we can do the three-way analysis. Let's start again. At the top of the page, we put the actual overhead costs.

What they actually spent 16,006 50. Then we leave a space at the bottom. We put in what they applied the overhead, applied to work in process 15,000. And here again, the difference between what they spent and what they applied that 1006 50, that's called the total overhead variance. And it's unfavorable.

And as I say, I'd like to give you that because they asked for that one a lot. Now, what do I put it in next? I still put in the budget based on standard hours, the same 16,000 I did before I still need that. I've got to put in that 16,000, that budget based on standard hours. And then I add the budget based on actual hours as well.

But I've got to put in that budget based on standard hours, that 16,000 notice the volume variance stays the same. I put it that same 16,000 I worked on before the budget, based on the standard hours, they should have worked. I still need that. I put that 16,000 in. So notice when I go from the two way analysis to the three-way analysis, the volume variance stays the same.

It's still a thousand dollars on favorable. See what the three-way analysis does. The three-way takes the controllable and divides it up into two into its spending problem. And it's efficiency problem. And the way you do that, let's go back to the schedule. Now we put in the budget based on actual hours, that 16,500.

Now I have what I need the difference between what they spent 16,006 50 and a budget based on actual hours, 16 five, that $150 difference. That's called the overhead spending variance. And of course it's unfavorable because 16,006 50 is higher than 16 five. It never misses top numbers higher than the next number down.

It's a debit it's unfavorable. Finally, the difference between the budget based on actual hours, 16, five. And the budget based on standard hours, 16,000, that $500 difference. That's called overhead efficiency variance. And of course that's unfavorable because 16,500 is higher than 16,000. Never let you down.

So you see what they mean by the three-way analysis. When they want the three-way analysis, they want overhead spending overhead efficiency, overhead volume. What's the two way analysis, controllable and volume. What's the three-way analysis spending. Efficiency volume. So anytime the BEC CPA Exam mentions the three-way analysis, that's what they're looking for.

They're looking for overhead spending, overhead efficiency, overhead volume. That's the three-way analysis, overhead spending overhead efficiency, overhead volume variance. Now there is a four-way analysis. Now, if they want the full way analysis, which the BEC CPA Exam has asked for. Use the same basic format at the top of the page, put their actual overhead costs, 16,006 50.

They have to give that to you. Leave a good amount of space at the bottom, put in the overhead, applied to work in process. We know that's 15,000 and as always the difference between what they spent 16,006 50 and what they applied 15,000, that 1006 50 that's called the total overhead variance or the net overhead variance unfavorable.

We got that. Then you put in a budget based on standard hours. That's 16,000. So the volume variance stays the same difference between the budget based on standard hours, 16,000. And what was applied 15,000 overhead volume. Barron's 1000 unfavorable that hasn't changed. Then I put in a budget based on actual hours, 16, five.

We've got that. Notice the efficiency variance stays the same. That's the difference between the budget based on actual hours, 16, five, and a budget based on standard hours, 16,000. So notice when you go from the three-way analysis to the four way analysis, volume variance stays the same efficiency, variance stays the same.

What's different in the four-way analysis is that in the four-way analysis, they take the spending variance and divide it into two. They have to come. You have to come up with a fixed spending variance and a variable spending variance. And the only way to come up, the only way to do the four way analysis is they have to break down that 16,006 50.

What they actually spent on overhead costs that 16,006 50, they have to tell you how much they spent on fixed items, how much they spent on variable that was not given in the Armando problem, but let me just make it up. Let's say the 16,006 50 broke out this way. Let's say they spent 6,200 on fixed items, 10,004 50 on variable items.

And again, the BEC CPA Exam would have to give you that. So let's say that's how the 16,006 50 broke down. They spent 6,200 on fixed items, 10,004 50 on variable items. Now you can do it. They spent 6,200 on fixed items, depreciation and so forth on the factory. What was their fixed budget at any level 6,000?

Don't forget their fixed budget. What's 6,000 at any level. So they have a $200 unfavorable. Top number is higher than the bottom number. They spent too much. They have a $200 unfavorable fixed spending variance. How about the variable spending variance? They actually spent 10,004 50 on variable items.

What should they have spent? They worked 2,100 hours. Every time they work an hour, they're supposed to incur $5 of variable factor overhead. Take $5 times 2100 hours. They should have spent 10,500. They spent 10,004 50. They have a $50 favorable variable spending variance. So there's your four way analysis.

You have a $200 unfavorable fixed spending variance, a $50 favorable variable spending variance 500 unfavorable. Efficiency variants, a thousand unfavorable volume bearings, and notice all the variances combined. Get back to the net. The 1006 50 unfavorable. You can actually give five overhead variances, fixed spending variable spending efficiency, volume, and net.

You've got five overhead variances, strike some questions on this. I'd like you to stop your tape. Try 11 to 14 to 11, 12, 13, and 14, come back and we'll go through them.

Okay, let's do number 11 together. I wanted you to do one, like number 11, because I know these. People in the exam. If you go to the bottom, it says, what was the actual price per unit? And maybe you have to actually be in the test to know what I mean, but people go to the BEC CPA Exam and if they've studied there already for variances and you get there, they don't want the variants.

They gave you that. Now they want something else. They want the actual per purchase price per unit. I think of these as missing information questions what's missing is we don't know the actual purchase price per unit. So I want to give you an approach to these, which I will tell you right now is absolutely foolproof.

If you get one of these, a missing information question, that's a variance. The key to the whole thing is to right away, put down the format of the variance they give you. So I'm saying right away. In the, in your example, you would right. Put it right away. You've memorized it by the time the BEC CPA Exam comes, you'll have these formats memorized.

I know you don't yet, but you will. You'll get them down. So let's use them. You've got these formats, use them. Now, what variants was given here, the variants they gave you was the material price variance. Remember, that's a times a compared with a times S and like I say, by the time the BEC CPA Exam comes, you'll have it memorized.

So in your example, you'd write that down eight times a compared with eight times S. Now, what do you do fill in, fill it in as far as you can. Do we know the actual number of units they purchased? Yes. 1600. Put that down. I know that. Do I know the actual price per unit? No, that's what's missing, but I do know at the bottom, I know the actual units, they purchased 1600 and I know the standard price, right?

The standard price is the $3 and 60 cents. And of course, you've got a calculator in the exam. It's no big deal. You multiply 1600 times, three 60. That comes out to 5,007 60. But I say the key to the whole thing is we know the variance. Didn't they say the variance was $240 favorable. Didn't they say that.

So I asked you if the variance is $240 favorable, what does the top number have to be? Does the top number have to be higher or lower than 57? 60? It has to be lower, right? Cause if it's favorable, the bottom number is $240 higher than the top number. So the top number has to be just put it in 55 20. And now you just sit there in the BEC CPA Exam with your little calculator and you divide 55, 20 by 1600.

And the answer is C $3 and 45 cents. It is absolutely foolproof. Let's do another one. Same idea. Number 12. They're asking for the actual hours that were worked, they gave us the labor efficiency, variance. They don't want the variance. They want to know the actual hours that work that's what's missing. So I say, Oh, you're in the exam.

They give you this, put down the format of the variance that's given member. What's the format for labor efficiency. It's just the same as material usage. It's eight times S. Compared with S times S just get that down right in your exam. Booklet eight times S compared with S times S now let's fill it in.

As far as we can. Do we know the standard price, the budgeted price per hour, we do $6. We can put that in under both S's can't we know the budgeted price per hour, $6, and they did give me the standard hours. They should have worked. That helps a little bit, that 1500 didn't they give me the standard hours.

They should have worked for what they did. 1500. So you multiply 1500 times six comes out to 9,000 and I still say the key to the whole thing is they told us the variance it's $600 unfavorable. If the Barron's labor efficiency is $600 unfavorable, what is the top number? Have to be? It's gotta be 9,600.

The top number must be $600 higher than the bottom number. So the top number must be 9,600. Now you just sit there with your little calculator. You divide 9,600 by six, the actual hours they worked. Must've been 1,600 and the answer is D now in 13 and 14, I'm sure you noticed that Beth uses the two way analysis of analyzing overhead.

If you were in this exam, the first thing you do is put down the format for the two way analysis. And again, I know you have memorized it yet, but you will have, so you'd put that down. Remember at the top of the page, you put the actual overhead costs, then you leave some space at the bottom. You put in the overhead applied to work in process and remembering the two way analysis.

What you want in the middle is an overhead budget based on. Standard hours. That's what goes in the middle. Now look at those three lines. Think they gave us enough information in the set to figure out which of those three lines that's right. The budget didn't they give you all the budget information. So right away let's work on the budget based on standard hours.

Didn't they say the fixed budget was 50,000 at any level. And then they said the variable overhead budget for the standard hours allowed was 72,000. So you've got it. The budget based on standard hours is 122,000. Really all you had to do to solve this set was get the budget done 122,000. Now let's put in the rest of what we know don't we know that the controllable variants it's given.

Is a thousand dollars unfavorable. That was given to us. If controllable is a thousand dollars on favorable, then they must've actually spent 123,000 because the top number must be a thousand dollars higher than the next number down. So the answer to 13 is D we've got that. And if the volume variance is $500, Unfavorable, excuse me.

If the volume variance is $500 favorable, that's given in the question, that means the bottom number must be $500 higher than the next number up. They must have applied 122,500. So the answer to 14 is C

I hope you've noticed something. I hope you've noticed. How powerful it is with variances. If two things, if formats, plus what top number higher than bottom number unfavorable, bottom number higher than top number favorable. It is amazing how many variants questions you can do if you just know those two things got the formats down and you also know top number higher than bottom number is unfavorable.

Bottom number higher than top number is favorable. It'll really help you in that exam.

Now we've been talking about fixed and variable costs, and I know, you know what, they are a variable cost. Of course, when we have a cost that's purely variable, the amount of cost incurred is directly related to the number of units we produce or the number of hours we work. That's the definition of a variable cost.

When a cost is purely variable. The amount of costs we incur is directly related to the number of units we produced or the number of hours we work. So of course, direct material, direct labor. Those are purely variable costs. Now a fixed cost is a cost that is set in amount. We're going to incur the same amount of costs.

It doesn't matter how many hours we work. Or how many units we produce within a relevant range,  within a reasonable range of activity, some costs stay fixed. Doesn't matter how many hours we work within that range. It doesn't matter how many units we produce within that range. Some costs stay fixed.

They're set in amount. I brought this up because sometimes in the BEC CPA Exam they'll give you a mixed cost, a cost that's considered partly variable. And partly fixed. And what you have to know for the BEC CPA Exam is the high, low method of breaking down a mixed cost. Let's do a set together. I'd like you to go to 15 and 16.

Okay.

They say 15 and 16 are based on the following information. Maintenance expenses of a company are to be analyzed for purposes of constructing a flexible budget examination of past records disclose the following cost and volume measures. Now you'll notice when. This company works 32,000 hours. They spend $39,200 on maintenance, but when they work 15,000 hours, they only spend 24,000 on maintenance.

Then they say using the high, low method of analysis, what's the estimated variable cost per machine hour. Here's how you solve it. By the way, always start with the variable part. We're gonna do the fixed part second, but in the high, low method, always start with the variable part. I'm going to take this information right out of the schedule.

They gave me, they said that when they work 24,000 hours, they spend $39,200 on maintenance. But when they work 15,000 machine hours, they spend $32,000 on maintenance. Now listen carefully. The secrets of the high low method is to take the change in costs. And divide by the change in production. That's the key to the whole thing.

You take the change in cost and you divide by the change in production. So to summarize, when machine hours went up, 9,000 maintenance went up to 7,000, $200. You take the change in cost and you divide by the change in activity. And the fact is when machine hours went up, 9,000 maintenance went up 7,200.

80 cents every hour. It must be purely variable. See what you're doing with that formula. When you take the change in cost and divide by the change in activity, you are isolating the variable part of the cost. It's gotta be 80 cents an hour. So we've answered number 15, the answer to 15 to see we've got the first part.

All right. Now, 16 sets using the high, low technique. What is the estimated end? You'll well, I'd circle that word. What's the nuo fixed cost for maintenance. All right. And how do we get that? My point is, once you have the variable part, you can plug the fixed. Now, how do you get the fixed to get the fixed?

You have to focus on one of the levels of activity they gave you the problem. It doesn't matter which one you use. You get the same answer. I'll start with 24,000 hours and I'll put it on the screen. What do we now know happens at 24,000 hours? We now know at 24,000 hours, 80 cents, every hour is purely variable maintenance.

So if you multiply that out at that level, they spend $19,200 on purely variable maintenance. What's fixed. It's gotta be 20,000. Why is fixed 20,000? Because that gets you back to the 39,200. They spent on maintenance at that level. So you can plug the fixed. Now just to show you, it comes out either way.

What if I had used 15,000 hours, you wouldn't do this cause it's gonna come out either way, but just to show you, it doesn't matter which one you use at 15,000 hours. We now know 80 cents every hour is purely variable maintenance. So you multiply that out at that level, we're spending 12,000 on variable maintenance while 20 thousands gotta be fixed, plug it right in that gets you back to the 32,000.

They spend on maintenance at that level. Now be careful. What's the 20,000. Monthly fixed maintenance. It's easy to lose sight of the fact in the heat of the exam. You can lose sight of the fact that everything in this question is a monthly number. These are all monthly numbers. So that 20,000 is monthly fixed.

If you want annual you multiply by 12 it's 240,000. And the answer is B. Answer is B and I'll just warn you. They do that a lot. That's something you have to watch out for in the exam. They give you monthly numbers and then they ask for an annual figure. And all it means is you've got to multiply by 12 and that's not difficult, but you got to notice it.

So it's 240,000 answer B. I'd like you to try one of these. I'd like you to stop your tape, try number 17, and then we'll go over it.

Let's do number 17 at the bottom. They're saying, what does it really cost Matt to handle 75,000 kilos. So let's work it out. I'm sure you noticed when Matt handles 60,000 kilos. Matt spends 132,000 on handling costs. But when Matt handles 80,000 kilos, Matt spends 160,000 on handling costs. Remember the secret to the high, low method is to take the change in cost and divide by the change in activity.

So let's do that. What you had to notice is that when the kilos went up 20,000 handling costs went up 28,000. When kilos went from 60,000 to 80,000, when kilos went up, 20,000 handling costs went up $28,000. The only thing that explains that he divided out is that a dollar 40, every kilos must be purely variable handling costs.

Now what's your next step? Do you know, get the fixed now? How do you get the fixed part? Remember the way you get the fixed part. And again, always do the variable first. Once you have the variable part of the cost, then you can plug the fixed the way you get. The fixed is zero in on any level of activity they gave you.

It doesn't matter which one you use. You get the same answer. I'll use 80,000 kilos. What do we now know had happens at 80,000 kilos. We now know that a dollar 40, every kilo is purely variable handling. So you multiply that out at that level. Matt spends 112,000 on variable handling.

What's fixed. We plug it in has to be 48,000. Cause that gets you back to the 160,000. They spent on handling costs at that level. Now we can solve it. What does it really cost Matt to handle 75,000 kilos? And by the way, we don't want to think about what business Matt is in and you get what you got to wonder, whether.

Drug dealers really do this kind of sophisticated analysis. What does it cost Matt to really handle 75,000 kilos? We now know that a dollar 40, every key, low is purely handling costs. So you multiply 75,000 times a dollar 40. At that level. Matt spends 105,000 on variable handling. What's fixed.

That's right. 48,000 fixed is fixed. It's set in amount. It's not going to, it's not going to fluctuate with how many kilos Matt handles. That gives you 153,000. And the answer is B.

What we're going to do next is move on to managerial accounting. But let me just say one last thing about cost accounting. And that is that I want you to be aware that all through our discussion on cost accounting. What we've been talking about is what they call absorption costing is what you're taught in any cost accounting course.

And let me define that under absorption costing the units that you produce absorbed all manufacturing costs, both the variable and also the fixed. That's what we mean by absorption costing that the units we produce. Absorbed all manufacturing costs, both the variable and also the fixed. In other words, in absorption costing both the variable and the fixed manufacturing costs are considered.

Part of unit costs, both the variable and the fixed manufacturing costs are considered inventorial. They find their way to inventory. And as I say, all through cost accounting, What you're dealing with is absorption costing. Absorption costing is generally accepted accounting principles, but when you get into managerial accounting introduces another method of costing units it's called direct costing or variable costing.

Let me define it under direct costing. Only the variable manufacturing costs. Are considered part of unit cost. Only the variable manufacturing costs are considered inventorial. They find their way to inventory. That's what we mean by direct costing. Under direct costing. Only the variable manufacturing costs are considered part a unit cost.

Only the variable manufacturing costs find their way to inventory. Now the fixed manufacturing costs in direct costing. What are fixed manufacturing costs. Depreciation on the factory insurance on the factory in direct costing, the fixed manufacturing costs will be treated as a period expenditure, not a product cost.

The fixed manufacturing costs will be treated as an expense of the period, not a product cost. That's the essential difference now to make sure you understand the difference between the two approaches. We're going to do a comparison. If you look in your viewers guide, There is a direct cost in comparison sheet.

I want to take a look at it. Notice on that page, we have some information and we've set up a column for absorption. We've set up a column for direct together. Let's work out the inventory. Bill unit costs under absorption costing, and then we'll take the same information and work out the inventory. We'll unit cost onto direct costing.

But let's do absorption costing. First, first information, direct material. They put five pounds of direct material into every unit they produce at $2 a pound. I think, that $10 would be part of unit cost under absorption costing, same thing with labor, they put four hours of direct labor and every unit they produce the two 50 an hour.

That $10 will be part of unit cost under absorption. Now, how about overhead? Remember we said that overhead is always split into two parts. There's a fixed part of overhead, which represents things like depreciation, property taxes, but there's always a variable part of overhead, which represents things like supplies, oil for the machines.

Overhead is always made up of those two components. There's a fixed part of overhead, which represents things like depreciation. And there's a variable part of overhead. That represents things like supplies in the factory and the BEC CPA Exam will break it out for you. And notice that the fixed factory overhead is applied at, excuse me, the variable factory overhead.

The next item is applied at 50 cents per direct labor hour. And if you take that 50 cents times the four hours they spend on the unit, that $2 is part of unit cost. Under absorption, the fixed factory overhead is applied at a dollar per direct labor hour. If you take that dollar times, the four hours, they spend on a unit that comes out to $4.

And yes, that belongs as part of unit cost under absorption because in absorption costing the unit, you produce an absorb, all manufacturing costs, both the variable and also the fixed. So we put that in there. How about variable selling? We put that in there now. Put a no there. It's not a manufacturing cost.

It's not an inventory bill item. That's a no. And of course, same thing with fixed selling. No, it's not a manufacturing cost. It's not an inventory bill item. So if you added up the unit cost under absorption is $10 of material, $10 of labor, $2 of purely variable, overhead $4 a fixed overhead, that's it.

It's $26. And as I say, if you think about it, That's consistent with everything you do in cost accounting. Now, by comparison, let's work out the unit cost under direct costing or variable costing the direct material. That's a purely variable costs. You put that $10 in there. The direct labor it's a purely variable cost.

This is variable costing. Put that $10 in there. The $2 of overhead that represents purely variable costs. Of course, you put that in there and now we're back to variable selling and people sit in the BEC CPA Exam and think it's variable costing. Now I've got variable selling, working on variable costing.

Now I've got variable selling. Put it in. No. Now don't fall for that. That's an easy place to make a mistake. No, it's not a manufacturing cost. It's not an inventory item. That's a no. For variable selling. And of course the fixed part of overhead also, no, the fixed part of overhead. No. When you really look at it, this is the difference in the methods.

The only difference between direct and absorption costing is how the methods treat this one item fixed factory overhead is part of unit cost under absorption. It's not under direct. So try not to complicate it in your own mind when you boil it down. The only difference in the two methods is how they treat that one item fixed factory overhead.

It's part of unit cost under absorption. It's not under direct. And like I say, don't make a mistake on that variable selling. It's not a manufacturing cost. It's not an inventory bill item. That's gotta be no also. And of course the fixed selling, no, it's not a manufacturing item. It's not an inventory item.

So if you add it up, the unit cost under direct costing is $22. $10 of material, $10 of labor, $2 of purely variable overhead. And that's it. 22. Let's do a quick question together. Number 18,

18 sets using the variable costing method, which of the following costs are assigned inventory. First column variable selling no, that's a no under that column. They know what I know, and that is the people are going to sit in that exam and they're going to see the word variable and lose control. Hey, it's variable costing variable selling, and they want to jump for it.

It's not a manufacturing item. It's not an inventory bill item, put a no in that column. How about variable factory overhead? Of course that's a variable manufacturing item. That's a yes. And the answer is D no. Yes. Answer will be D to that one. Indirect costing only the variable manufacturing costs are considered of cost.

What they test the most on this. If you're with me on the difference in unit cost, in both methods, we haven't really got to what they hit the most. What they test the most is whether or not you understand the impact on financial statements. From using these methods and what I want to do to get us into this is do some income statements.

So let's assume that year one is the first year of operation. Okay. I'm going to assume. Year one is the first year of operation. If you look in your viewers guide, you will see the outline, the format of an income statement under absorption costing. For year one, it's in your viewers guide. And I want you to go to that page.

And as I started to say, we're going to assume that in this problem, year one is the first year of operation. And you'll notice the assumption is that in year one, they produce 2000 units, but they sell a thousand and we're going to assume that they sell units for a hundred dollars each together. Let's do the income statement for year one under absorption costing.

Now, before I start. Let me just say that I think you will be comfortable with this right off the bat, because this is the format we're all used to. This is generally accepted accounting principles member absorption is gap. So let's go through it. The sales of course are pretty easy. They sold a thousand units for a hundred dollars each.

So sales would be 100,000. Now let's work on cost of goods sold. What would be beginning inventory? Zero, right? I'm assuming year one. Is the first year of operation. So beginning inventory would be zero. How about cost of goods manufactured now be careful. Everything I'm doing is based on that comparison sheet that we just did that comparison sheet, where we came up with unit cost under absorption $26 unit costs under direct costing $22.

Everything I'm about to do is based on that comparison. So you might want to look back on that sheet. How would I get cost of goods manufactured? In year one, They produced 2000 units. And going back to that comparison page, what's the unit cost under absorption 26. So if you multiply 2000 units, times 26 cost of goods, manufactured would be $52,000.

Add that up. That gives you goods available for sale $52,000. Now how about ending inventory? If we produce 2000 units and we sell a thousand. There must be a thousand units in finished goods, valued at $26 each under absorption. So ending inventory value to 26,000, that gives you a cost of goods, sold 26,000.

And that'll give you gross profit, 74,000, in a traditional income statement under gap. You work down to gross profits, 74,000. Now, how do we finish now? We put in selling general administrative expenses. What are our selling expenses here? Again, everything I'm doing is based on that comparison page and your viewers guide weren't we told that the variable selling is $1 for every unit they sold.

So I'm going to take a dollar times a thousand units. They sold variable selling is a thousand what's fixed selling again, back on that page, we're told that fixed selling is 6,000 per year. So I put that in and that gives me profit before tax. Of 67,000 putting in the variable, selling a dollar per unit sold times the thousand units they sold variable selling is a thousand.

The fixed selling we're told in that comparison page is 6,000 per year. So when I take that gross profit of 74,000 and I back out the variable selling of a thousand and the fixed selling of 6,000, that gives me the profit before tax of. 67,000 now, by comparison, let's do the income statement for year one under direct costing.

We know on a direct cost thing and you have a page in your viewers guide, all set up with the format of an income statement under direct costing. And it is a little different. That's why it's important to go through it. Sometimes in the exam, they ask you questions just about the format. So we'll start with sales.

Of course that would be no different. They sold a thousand units at a hundred dollars each. So sales would be a hundred thousand. Now let's work out variable, cost of goods sold again. Beginning inventory would be zero year. One is the first year of operation. So beginning inventory zero. How about cost of goods manufactured?

Didn't they produce 2000 units and the unit cost under direct costing from that comparison page is 22. So cost of goods, manufactured is 44,000. That gives you goods available for sale 44,000. How about ending inventory? If you produce 2000 units and you sell a thousand, there must be a thousand units in finished goods.

They're valued at $22 each on a direct costing. So ending inventory value to 22,000. That gives you what they call variable cost of goods sold 22,000. Now be careful when you subtract variable cost of goods sold from sales, you don't get gross profit. You get a subtotal called contribution margin from manufacturing, and that's something you should be aware.

You might want even write it on this page in direct costing. There is there's no gross profit in an income statement under direct costing. There's no gross profit. And they've asked that several times. So you should know that when you subtract variable cost of goods sold from sales, it gives you, as I say, a little subtotal called contribution margin from manufacturing.

There's no gross profit on an income statement under direct costing. Now follow through with me on the approach. Once I get down to that sub total contribution margin for manufacturing. Now, what I want to do is subtract any other variable costs. That's in the problem. The only other variable costs we have in this problem is the variable selling.

I'm going to take the variable selling number. It's a dollar for every unit sold times the thousand units they sold. The variable selling is a thousand. That's what you would do at this point. You would subtract any other variable costs you have in the problem. You could have seven of them here. You just have one, the variable selling.

And when you subtract that, that gives you the most important number on the screen contribution margin. 77,000 what's your sales have contributed to the recovery of fixed costs, contribution margin. What's your sales have contributed to the recovery of fixed costs. Before we finish this little income statement, you might want to just write this down, get down the definition of contribution margin.

What is the definition of contribution margin? I just write it down. The definition of contribution margin is your sales minus all variable costs. That's the definition of contribution margin. It's your sales minus all variable costs. And I'll tell you why. I had you write that down. A lot of students in the BEC CPA Exam make a mistake.

Just trust me that I know this happens when a lot of students do in the BEC CPA Exam is just look at the 22,000. Just the very moment. Just that variable manufacturing. No, you don't have a contribution to fixed costs until you cover all your variable costs. Even that variable selling. So that's the definition of contribution margin.

It's your sales minus all the variable costs, even that variable selling. So that gives you what you need. 77,000 contribution margin. What your sales have contributed to the recovery of fixed costs. Now, before we finished this income statement, let me emphasize that direct costing is not acceptable under generally accepted accounting principles.

Why does it survive? It's not gap, but it survives because it reflects how every business person thinks every business person in the universe thinks like this method. If I take my sales minus all my variable costs, I know what's being contributed to the fixed costs, which eat me alive. There isn't a business person in the universe that doesn't know their fixed costs.

Fixed costs are frightening. They're frightening why to business people wake up in the middle of the night, screaming about their fixed costs because they go on whether you find a customer, whether you make a sale, fixed costs, eat you alive. So every business person knows that, Hey, if my sales are contributing seven 77,000 to the recovery, my fixed costs.

If my fixed costs are less than 77,000, I have a profit. And I don't care what accountants say. Accountants can take that same information and show it's a technical loss. I don't care if my fixed costs are less than 77,000, I'm going to survive. That's where I live. That's a profit my book. And if my fixed costs are more than 77,000, I have a loss.

I don't care what accountants say. Accounts could show me the technical. It's a profit. I'm not going to listen. If my fixed costs more than 77,000 I've got problems. And if my fixed costs are exactly 77,000. That's the breakeven point. That is the point of sales where there's no profits and there's no losses.

So that's how all business people think. So let's get back to the income statement. We take our sales minus all our variable costs, and that gives us contribution margin, what your sales have contributed to the recovery fixed costs. And now obviously the way you finish the statement, you back out the fixed costs, fixed factory overhead.

I'm going to give you that it's 8,000 a year fixed factory overhead. Let's just say it's given 8,000 a year. The way you could get it, by the way, they probably give it to you, but the way you could get it, if you go back to that comparison page in absorption, aren't we putting $4 of fixed overhead on every unit.

And I'm assuming 2000 units of production is normal activity. So that's how you would do that. Look, if I know you're putting $4 of fixed overhead on every unit you produce, and then I say normal production is 2000 units that would let you back into what the fixed overhead budget must be $8,000. At any level of activity within the relevant range, because fixed is fixed, it's set in them out.

But I think they probably just give it to you. The fixed selling is what 6,000 it was given in the problem on that comparison page. And if you work it out profit before tax comes out to 63,000. Now I want you to listen to me very carefully. We're at an important point. If you're in the BEC CPA Exam and they want that profit.

On a direct cost thing. That's 63,000. We just calculated. You don't have to do out a whole income statement. There's a shortcut and this shortcut will help you a lot in the exam. You want to get it down? I'll tell you what the key is. The key to the shortcut is to think in per unit terms, what does the sale of each unit contribute to the recovery of fixed costs?

If you can get that, you can work fast. Let me show you what I mean. Let's get contribution margin per unit. I'll do it on the screen. What's the selling price per unit? Of course it's a hundred now to get contribution margin per unit, I'm going to back out the variable costs. What are the variable costs?

22. No, be careful. No that 22 remember is just variable manufacturing. Let's do it again. What's the definition of contribution margin? What is it? It's selling price minus what minus all variable costs. Don't forget the dollar of variable selling. So my point is my variable costs per unit are not 22.

They're 23. So the contribution margin per unit is 77. That is very powerful information. Once I know that every time I sell a unit. It contributes $77 to the recovery of fixed costs. I can do a lot. I want you to think in per unit terms, it'll help you a lot in the exam, but be careful of that definition of contribution margin is your sales minus all your variable costs.

Don't forget that dollar variable selling. All right. Now, once I have that information, once I know that every time we sell a unit, it contributes $77 to the recovery of fixed costs. Do you see what I can do with it in year one? How many units did they sell?  didn't they sell a thousand. So if I take a thousand units sold times 77, there's the total contribution margin, 77,000.

Now I just back out their fixed costs, fixed factory overhead 8,000 a year, fixed selling 6,000 a year. And that gives you a profit before tax of 63,000. About as fast as a human being can do it is very powerful in that exam to think in per unit terms. And let me emphasize. That it goes beyond helping you with direct costing.

When the BEC CPA Exam wants you to do any sort of analysis on profit, that's the way you want to think, what am I getting for a selling price? Can I cover my variable costs? The rest is contribution margin. And once I cover my fixed costs, the rest is gravy. That's the way you want to think in the BEC CPA Exam when you do profit analysis as well.

And we'll do some of that later in this BEC CPA Review course. Now, before I leave here, one, I'm sure you noticed. I did out the income statement under absorption costing. And I got profit before tax of 67,000. Then I took the same information. Did the income statement under direct costing, and got profit before tax of 63,000.

Listen, very carefully, all else being equal. If you produce more units than you sell. And that was the case in year one, wasn't it, they produced 2000 units, but they sold a thousand. If you produce more units than you sell absorption will give you more profit than direct you memorize that relationship will help you in the exam.

All else being equal. If you produce more units than you sell absorption will give you more profit than direct. I would just memorize it. Cause that comes in handy in the exam.

Now let's go to year two. If you win your viewers guide, move on to year two. Noticing year two, once again, we produced 2000 units, but we sold 2,500. Now we're still selling units for a hundred dollars each now to save time, it's all filled in for you. Notice that under absorption costing profit before tax came out to 176,500.

And if you go to the next page and look at direct costing, it's all filled in profit before tax came out to 178,500. Why don't we do our shortcut? How could I prove out that? 178,500, remember thinking per unit terms, I'll put it on the screen the quick way to get that without doing an income statement.

If you want to get that profit under direct costing, you say I know they sell units for a hundred dollars each. What are the variable costs per unit? $22 variable manufacturing, a dollar variable selling the total variable cost per unit are 23. I know every time they sell a unit. It can, it contributes $77 to the recovery of fixed costs.

Then you can work fast. I take that $77 contribution margin per unit times the 2,500 units they sold in year two. That gives me a total contribution margin of 192,500. Then it's just a matter of backing out the fixed costs. Fixed factory overhead 8,000 fixed selling 6,000. Profit before tax notice, it comes out 178,500.

And I'm sure you've noticed the second relationship that you just have to memorize all else being equal. If you produce less units than you sell absorption gives you less profit than direct all else being equal. If you produce less units than you sell. And that was the case in year two. We produced 2000 units, but we sold 2,500 absorption gives you less profit than direct.

I would just memorize it. So remember, if you produce more than you sell absorption gives you more profit. If you produce less than you sound absorption gives you less profit than direct notice the morals and lessons go together. That's why I'm phrasing it the way I am. If you go to the next page in your viewers guide, it's now year three in year three.

Everything stays the same. We're still selling units for a hundred dollars each. And in year three we produced 2000 units and we sell 2000 units and it's all filled in for you to save time. Notice that under absorption, we get profit before tax of 140,000. And if you go to the next page on a direct costing, we get profit before tax of 140,000.

And that's the last relationship that you have to be aware of. All else being equal. If you produce the same number of units that you sell, absorption gives you the same profit as direct. If you produce more than you sell absorption gives you more profit. If you produce less than you sell absorbs can give you less profit.

And if you produce the same number of units that you sell, absorption gives you the same profit as direct, just flat out, memorized those relationships. Cause they'll help. I'd like you to try some questions. I'd like you to turn the tape down and. Try 1920 and 21. And then come on back

grouped together. 19 says that this company has done an income statement under both approaches and notice that the variable costing statement shows a profit. But the absorption costing statement shows a loss. You know what I'm going to ask. When is absorption less than direct if you produce what less than you sold.

And the answer is a, if absorption is less than direct, they must have produced less than they sold. I hope you tried 20 and 21. It's a really excellent set on direct versus absorption costing. I'll say this, if you. Can do this set, you understand direct versus absorption costing. And number 20, if you go to the bottom, they say, what is Sans operating income under direct or variable costing?

And one of the big things I hope you remembered is that you wouldn't sit in the BEC CPA Exam and do out whole income statement. Now use the shortcut. And remember the key to the shortcut is to think in per unit terms, what does the sale of each unit contribute to the recovery of fixed costs? Once you have that?

You can do a lot. First of all, what's the selling price per unit $20 it's given now what we're going to back away from that would be variable costs and they gave you a column of variable costs. We're going to back out the $4 of direct material. We're going to back out the $2 and 50 cents of direct labor.

We're going to back out the dollar 50 of purely variable overhead, right? We back out the $4 of material, the two 50 of labor, we're going to back out the dollar 50, a variable overhead. How about the variable selling? Yes. Yes. The variable cost per unit are 10, not eight. Remember the definition of contribution margin is your selling price.

Minus what all variable costs. Don't forget the variable selling. So the variable cost per unit are not eight. It would be 10. That $2 is included in there. So our contribution margin per unit is $10 20 minus 10. Now I can do a lot. Once I know every time they sell a unit, it contributes $10 to the recovery of fixed costs.

I can now work fast. How many units did they sell? 80,000. If you take the 80,000 units, they sold times 10. There's your total contribution margin? 800,000. Now it's a matter of backing out your fixed costs. Fixed factory overhead 240,000 fixed selling 140,000. And that gives you a profit before tax of 420,000.

Answer B. So the answer to number 20, as I say is B. Now in 21, they say, what would be saying is finished goods, inventory under absorption costing. That's why I like the set because now they switched the method. If I'm going to work out finished goods inventory under absorption costing, the first thing I have to do is calculate the inventory.

Double unit cost under absorption costing. Let's do it together. I'm going to pick up the $4 of direct material. I'm going to pick up the $2 and 50 cents of direct labor, the dollar 50 of purely variable overhead. How about the variable selling? Yes or no? No. No, it's not an inventory bill item.

It's not part of unit cost. If I'm doing an analysis of profit, I've got to consider it, but it doesn't belong as part of unit cost. Am I done? No. In absorption. Absorption would take the 240,000 of fixed factory overhead divided by a hundred thousand units produced and put. $2 and 40 cents a fixed factory overhead on every unit.

Remember that's what makes it absorption costing that the units that are produced absorbed all manufacturing costs, both the variable and the fixed. So that's what absorption's going to do. Absorption is going to take that 240,000 of fixed factory overhead divided by a hundred thousand units of production and put $2 and 40 cents a fixed factory overhead on every unit.

So we get that in there. How about the fixed selling? No, it's not a manufacturing item. It's not an inventory bill item. If we added up the unit cost under absorption, costing comes out to $10 and 40 cents. Now how many units are in finished goods? If they produce a hundred thousand units and they sell 80,000, there must be 20,000 units in finished goods.

Valued at $10 and 40 cents. Each finished goods is valued at 208,000. The answer is also B. Now, as we said in this BEC CPA Review course,

the break even point is defined as that point of sales, where there's no profits and no losses, you know that, and going into the exam, you want to be able to calculate the break, even point fairly quickly. And the way I cover this, I always tell my students. You flat out have to memorize one formula. It's not a hard one, but if you know this one formula, you can do a lot with it.

What I want you to memorize is the formula for determining the break, even point in units. That's what you want to do. Just flat out, memorize the formula for determining the break, even point in units. Let me give it to you. If I want to get the break even point in units in the numerator. I put the company's total fixed costs.

And in the denominator, I divide by our good friend contribution margin per unit. As I say, it's powerful to think in per unit terms. And we use it here as well. Now to illustrate this, if you go in your viewers guide, you'll see a page on break, even point. And if you look at the page, you'll see, it's the same problem we did before.

Where we calculated the unit cost under direct costing and the unit cost under absorption costing. It's really the same problem on that break even page. But I changed a couple of things. Notice now the selling price is $29 a unit and notice, remember it used to be a hundred now it's 29 and the fixed factory overhead is now 90,000 a year.

And the fixed selling expenses are 30,000 a year. Together for this company, let's calculate the break, even point in units in the numerator. I want to put the company's fixed costs. That's the fixed factory overhead of 90,000, the fixed selling of 30,000. I put in their total fixed costs, which are 120,000.

Now I have to divide by contribution margin per unit. What's that? The selling price per unit is 29. What do I back out from that 29 22? No, don't make that sloppy mistake. The definition of contribution margin is selling price minus all variable costs. Don't forget to pick up the dollar variable selling.

So the variable cost per unit, I'm not 22. They're 23. So the contribution margin per unit is $6. Every time they sell a unit, it contributes $6 to the recovery of fixed costs. And if you divide. The 120,000 by six, the breakeven point is 20,000 units. Please remember though that my formula gives your break even point in units.

It tells you how many units you have to sell to break. Even what if the BEC CPA Exam doesn't cooperate and it wants to break even point in dollars break, even point in sales. The way I look at it, you don't have to memorize another formula. As long as you can get break, even point in units, you should be able to get all our sales, how just multiply by the selling price.

So if they want breakeven point in dollars, I would just take the 20,000 units times. The selling price 29 breakeven point in sales is 580,000. So that's why I say this one formula is very useful because if you can get break even point in units, you can get breakeven point in dollars by just taking the break, even point in units, 20,000.

Times the selling price, 29 break even point in dollars in sales, 580,000. What if they asked this same problem? What if they ask, how many units would you have to sell to generate a $90,000 profit before tax? You just use the same formula. All you do. I'll put it on the screen is take the $90,000 profit you want to generate.

Plus the fixed costs one 20. And divide by good old contribution margin per unit. You're really using the same formula. Take their total fixed costs 120,000. Add the $90,000 profit before tax that you're looking for. That adds up to 210,000 divide by $6 contribution margin per unit. If they sell 35,000 units, they'll end up with a $90,000 profit before tax.

What if they want dollar sales? Just take the 35,000 units. Times the selling price 29. If they generate a million and $15,000 of sales, they'll end up with a $90,000 profit before tax. That's why I say, if you can get units, you can get dollars. Now what I want to go over next is definitional, but you have to know it.

They hit it a lot. Let's talk about the margin of safety. It's definitional. The difference between actual or budgeted sales. In this definition, you can use actual or budgeted sales, either one. I'm going to assume that million, 15,000 that we just calculated for sales that's my actual or budgeted sales, but I'll start again.

The difference between actual or budgeted sales, I'll use that million and 15,000 and the sales. At the breakeven point, we worked that out to be $580,000. That $435,000 difference. That's what they mean by the margin of safety. It's the difference between actual budgeted sales, the million and 15,000 and the sales at the break, even point 580,000, giving us a margin of safety of 435,000, which is defined as how far your sales would have to drop.

Before you incur losses, margin of safety, how far your sales would have to drop before you incur losses. I'd like you to try a set. I'd like you to shut your tape off, try 22 and 23, and then we'll do it together.

Let's do the set together

in number 22. They're just flat out asking you for the break, even point in units. And as that's the one formula that I want you to memorize. So you're in the exam. You write it down right away in the numerator, total fixed costs. Now that's pretty easy here. You've got fixed factory overhead, 70,000 fixed selling 60,000.

The numerator you want 130,000 total fixed costs. Now we're going to divide by contribution margin per unit. And that's what you had to work on. What's the selling price per unit? It's got to be 20. They sold 50,000 units for a million selling price per unit is 20. Now let's get the variable cost per unit.

They've got 300,000 of direct material and direct labor. That's purely variable. They've got 40,000 of overhead. That's purely variable. And don't forget, you've got to consider the variable selling of 10,000 because the definition of contribution margin is your sales minus all variable costs, even that variable selling.

So you add that up. The total variable costs are 350,000. That 350,000 spread over 50,000 units sold. The variable cost per unit are $7. So the contribution margin per unit is 13. Now you can solve it. If you take their total fixed costs, 130,000 divided by contribution margin per unit 13, you get answer, be break, even point in units, 10,000.

Now, you know this, what if they want to break even point in dollars? What would you do? Wouldn't you take the 10,000 units times the selling price. 20 breakeven point in dollars would be 200,000 just in case they ask that's breakeven point in dollar sales. Now in number 23, they want the contribution margin ratio, and you have to know what this is.

They ask about it a lot. Look at it this way in this problem, think of the selling price $20 as a hundred percent. If you think of the selling price, 20 as a hundred percent notice the variable cost per unit. Our seven variable costs are 35% of selling price. If you take 35% of 20, you get seven. So naturally contribution margin is 65% of selling price.

If you take 65% of 20, you get 13. And I want you to know that 65%, that's what they mean by the contribution margin ratio. In the answer to number 23 is also B. And you've got to be aware that's always a function of a hundred, the exam, just assume that you think like this. So for example, sometimes the exam, they just give you a little threads of information and you have to infer things they could say in a problem, variable expenses are 15%.

You are supposed to infer. Then contribution, margin ratio must be 85%. They do that a lot in the exam, they could do, they could go the other way. They could say contribution margin ratio is 32%. You got to sit in the BEC CPA Exam and go, I see then variable costs for this company. This company must be 68%.

It's always a function of a hundred. And as I say, sometimes they give you threads of information and make you infer things. So you're in the BEC CPA Exam and they say variable costs are 30% of sales, right away for that company. Contribution margin is 70%. That's what they mean by the contribution margin ratio.

Another point, what do we just say? That break even point in dollar sales would be didn't we take the 10,000 units. Break even point pointing units times the selling price 20 and say, Hey, break, even point in dollars is 200,000. The other way to get that, I'll just show you is if you take their fixed costs, the 130,000 divided by the contribution margin ratio of 65%, that'll give you a breakeven point in dollars.

Just another way to do it. If you take the total fixed costs, 130,000 divide by 65%. The contribution margin ratio. That'll give you a breakeven point in dollar sales as well. Now, sometimes in the exam, they will take break, even concepts, mix them up a little bit and ask some convoluted questions.

And I want to show you how to deal with a question like this

together. Let's go to number 24, 24 says Seahawk. He's planning to sell 200,000 units of product B. The fixed costs are 400,000 and the variable costs are 60% of selling price in order to realize a profit of a hundred thousand, what would the selling price per unit have to be? So you see, this is a little different, and of course, what this really is an algebra question.

And I know that not everybody's strong on algebra. And, algebra is one of those things. If you don't work with it all the time, you lose it right away. I'll show you how to solve a question like this without using any algebra. What, one way you can solve a question like this is with a technique that I call, test the answers.

See, I say, you're in the exam, go, Hey, I've got four answers. Why can't I sit there and go, what if it is $5? Does it come out? What, if it is $3 and 75 cents, does it come out? Just a good technique to know if you have a question that. Would take algebra and use that with you. I'm not good at algebra start testing the answers.

Now, when you test the answers like this, all we start with a round as dancer. Cause it's easy to work with. Let's go down to see, what, if it is safe, what if they sell units for $5 each let's work it out together. If they sell units for five didn't they say that variable expenses are 60% while the variable expenses are 60% contribution margin is 40%.

It's always a function of a hundred. So within the contribution margin per unit, be $2 at that level, I'll take the $2 times. The 200,000 units they told me they're going to sell. That gives me total contribution margin of 400,000. What are they fixed costs? They said 400,000 notice an answer. See, we break even there's no profit or loss.

So I ask you, is the answer C no, they wanted to know what the selling price per unit would have to be. To generate a profit of a hundred thousand. Now I know you with me. Don't I already know it's D once I know they break even at five, am I going to sit there and test $3 and 75 cents? I don't think so.

You gotta use your common sense to generate any profit. Nevermind. A hundred thousand. It's gotta be something more than five. So I already know it's D that's what's good about starting with a round answer. If it's not the answer very often, it tells you direction, but just to show you, it comes out, let's just show D if I sell four.

$6 and 25 cents. I know that variable costs are 60%. So contribution margin would be 40%. So contribution margin would be $2 and 50 cents a unit. I know they're going to sell 200,000 units, so that gives you a total contribution margin of 500,000 back out. The fixed costs would still be 400,000. Fixed is fixed, and that does give you exactly a hundred thousand of profit.

So it does work. Let me show you another one. I'll do it. We'll do it together. And it's maybe a little harder. Let's go to number 25 in number 25, they say Coby has sales of 200,000 with variable expenses of 150,000 fixed expenses of 60,000 and an operating loss of 10. By how much would Colby have to increase their sales to achieve operating income equal to 10% of sales by how much.

With Colby, I have to increase their sales. So operating income is 10% of sales. It's a nasty question. I say, try not to fight with it. You've got to answer is why not test the answers? And as I say, start with a round of stands for it's easy to work with. Now, I've got two round answers here, so I'll start with a, you just the first one.

What if it is a, what if it is 400,000 now I'll do it on the screen. What I'm going to do is a little income statement here and test out a, but before I do I have a question for you, if it is a, would sales be 400,000? No. No sales would be 600,000. Remember the question was by how much would Kobe half that increase their sales?

You have to read it carefully. I halfway think that's most of the battle right there is making sure students read the question carefully. If it is a, the sales wouldn't be 400,000, the sales would go from 200,000. Currently up 400,000 to 600,000. The question was by how much would they have to increase sales?

So if it is a sales become 600,000. Now you had to notice that when sales were 200,000 variable expenses were one 50, you had to notice variable expenses were 75% of sales and that relationship would hold. So variable expenses would be 75% or four 50, or you could just drop right down and say contribution margin is 25%, 150,000.

Now the fixed cost, would that still be 60? Yes. Fixed is fixed. Setting them out. It's not going to rise and fall with activity. Take out the fixed cost 60. That gives you a profit of 90,000. Now look, what I have on the screen is the answer a it's not, how do you know you sit in the BEC CPA Exam and say is 90 10% of 600.

It's not, they wanted profit to be 10% of sales. It's not, let's try D if it is D wouldn't sales, go up by 200,000 up to 400,000 variable expenses would be 75%. Or 300,000, or as I say, you can just drop right down and say contribution margin is 25%, a hundred thousand fixed costs would still be 60.

It's not going to change. It's setting them out 60,000. And if you take the 60,000 from the hundred, that gives you a profit of 40,000. So you sit in the BEC CPA Exam and say is 40010% of 400. It is. The answer is D it's just a, it's a good technique to know. So try to remember that, that if you're in the BEC CPA Exam and you get a question, say algae, I could solve it.

If I was really good at algebra test the answers, it gives you a really good shot at it. Especially if you are particularly weak at something like algebra,

what I want to get into next is profit analysis. And I know you've seen these kinds of questions before. Let me just tell you the way the BEC CPA Exam gets into this. They tend to get into profit analysis in one of two ways. One way they like to do it. They'll give you a special order. They'll say you run a factory, a customer gives you a special order.

They're willing to buy a hundred thousand units for $17. Should you take the order? How much profit would you make them out of order? Would you accept that order? Is it profitable? They love special orders. The other thing they like is make or buy decision. I'm sure you've seen them before. They'll say it costs so much to make a motor so much to buy a motor.

What should the company do? What's the best thing for the bottom line? Should they make it or buy it? So this is tends to be the two ways they get you into profit analysis. Now, before I have you try some I'll just say one quick thing. The key to all of these problems is to only look at what changes.

If you accept a proposal, that's the key to all of them. When you're doing any kind of profit analysis, only look at what changes. If you accept a certain proposal. In other words, only look at variable costs. Fixed costs are irrelevant to a decision like this. Why? Because fixed costs go on whatever you do, they have no bearing on the decision at all.

So when you make any kind of profit analysis decision like this, the secret is only look at what changes. If you accept a given proposal, which is to say only look at variable costs, the fixed costs they go on. Whether you make the part by the part, whether you accept the order, reject the order, therefore the fixed costs have no bearing on your decision.

Now, the best thing to do is try these and then we'll talk them through together, but try some first try 26, 27, 28 and 29, and then come back.

In number 26, Jordan makes calculators and Jordan says, sells calculators for $40 each. Now somebody comes along and they're willing to buy 40,000 calculators for $23 each and they want to know what the effect would be on profit. If Jordan takes this order now, before we solve it, I just want to mention to you how somebody could look at this.

If they had no business background. I know you didn't look at it this way, but I want you to appreciate if somebody has no business background, they're going to say, wait a minute, they're willing to pay $23 per calculator. What is it? What does it cost me to make a calculator? It cost me $16, a variable manufacturing, $10 a fixed.

It costs me $26 to make a calculator. You're willing to give me 23. No, thank you. I lose on everyone. But what we understand is that the fixed costs have no bearing on this decision. The fixed costs are going to go on whether we take this order or not. So it has no bearing on the decision at all. You've got to sit in that exam and say, what does it really cost Jordan?

To make each additional calculator. We'll put it on the screen. I've got to consider the $16. That's purely variable manufacturing. Every time Jordan makes another calculator. Jordan incur is another $16. They've got to consider that. What about the overtime? Sure. Because we only work the overtime.

If we take the order, maybe we'll only look at what changes if you accept a proposal. And the fact is we only work the overtime. If we take the offer. So we've got to consider the $3 of overtime. If I accept this offer, we'll get $23 for each calculator. It really costs Jordan $19 to make each additional calculator.

Isn't there $4 of contribution margin on every calculator. I'll take that $4 times 40,000 calculators Jordan's overall profit will go up 160,000 and the answer is B.

Remember, it's all gravy. Once you cover your variable costs, fixed costs are going to go on whatever you do. So if you're going to make $4 of contribution margin on every calculator, times 40,000 calculators, it's all gravy Jordan's overall profit will go up 160,000. Now let's try number 27. In number 27, it says Spencer has a regular selling price of $10 per unit variable costs are six fixed cost or a dollar per unit.

And they get a special order. Someone's willing to buy 10,000 units. And at the bottom they ask to increase operating income by $10,000. What price per unit should spend surcharge for this special order? One way you could solve this and maybe you tried it. You could test the answers. Let's go down to see, let me get some, you get some answers here.

What if Spencer charges $10 a unit? Spencer charges, 10 they'll cover their variable costs. Six. How about the fixed irrelevant fixed costs. Go on. Whatever you do have no bearing on the decision. There'll be $4 of contribution margin on every unit times. 10,000 units. No, the answer is not see, they make 40,000 profit.

If they charge 10. All right, let's go down. Let's try a, what if they charge $7 a unit, if they charge seven, that'll cover their variable costs six. So there'll be $1 of contribution margin, $1 of gravy. If you will, on every unit. Times the 10,000 units, the person is willing to buy. Yes. Overall profit will go up exactly by 10,000, which is what they want.

So the answer is a making a dollar profit. In other words, in these problems, think of contribution margin. As the same as profit, they make a dollar of gravy times, 10,000 units. They do make exactly $10,000 of profit. And that gives you answer a don't forget that test the answer approach in 28. We get into some make or buy decisions.

And I'm sure you noticed in number 28, Cardinal, they're not asking you to do a full analysis in the sense. They're not asking you, Hey, bottom line, should Cardinal make it or buy it. They didn't ask you to do a full analysis. All they asked in number 28 was what does it really cost to make it? If you go to the bottom, they say in deciding whether to make or buy the part what's the relevant cost to make it.

So they're just asking you to work out one part of the analysis. So let's do it together. What does it really cost Cardinal to make this part? You have to consider the $4 of direct material. You have to consider the $16 of direct labor. You have to consider the $8 of purely variable overhead.

You have to consider that $28. Cause it's all variable. Every time they make another unit, they incur that other $28. What you learn by doing these is you have to read very carefully what they say about the fit. In the problem, it does say, and you might want to underline it. 60% of the fixed will continue underlying will continue regardless of what decision is made.

So think about it. 60% of that 10, six notice the putting $10 of fixed whenever unit, they're saying 60%, six of the 10 will continue regardless of what you do. If six of the 10 will continue regardless, we're stuck with it. We don't worry about it. But isn't that another way of saying that 40%, four of the 10 won't continue.

If I buy the part only will continue. If I make the part for the 10 won't continue. If I buy the part only would continue. If I make the part that becomes another cost of making the part. So what does it really cost Cardinal to make it, if you add it up. Four plus 16 plus eight plus $4 of fixed that won't continue.

If I buy the part, we'll continue. If I make the part, it's another cost of making the part, it really costs $32 to make a part times 20,000 parts. It costs me 640,000 to make it. And the answer is B that's what it costs Cardinal to make it 640,000. Answer B now in 29. What's good. About 29. Is that they're having you do a full analysis.

They're saying, okay, you decide should motor make this part or buy it. There's no one way to do these. There are several ways you can approach this, but the approach I like, I do a calculation of what it costs to make it. Then I do a calculation on what it costs to buy it. And then I make a decision.

Let's start with what it costs to make it in terms of what it costs to make it. I've got to consider the 20,000 of direct material. I've got to consider the 55,000 of direct labor. I've got to consider the 45,000 of purely variable overhead. I've got to consider that 120,000 of costs because it's all variable.

When I make 10,000 motors, I incur that 120,000, the variable costs. But again, you have to read carefully what they say about the fixed. Read it with me. It says. If motor accepts the offer, some of the facilities presently use to manufacture part in one could be rented to a third party for rental of 15,000.

Additionally, $4 per unit of the fixed overhead applied to  would be totally eliminated. Notice $4 of the fixed overhead applied to  would be eliminated if I buy the parts. So follow me, I take $4. Times 10,000 parts. They're saying 40,000 of that 70,000 could be eliminated if I buy the part. Then I only incur it.

If I make the part, it's another cost of making the part. If 40,000 of the fixed could be eliminated. If I buy the part, then I only incur it. If I make the part, it's another cost of making the part. In other words, 30,000 of the fixed cannot be eliminated no matter what I do. So I'm stuck with it. I don't worry about it.

It's a fixed cost. But 40,000. I could eliminate if I buy the part, I only incur it. If I make the part, it's another cost of making the part. If he added up what it really costs me to make it's 160,000. All right. Now let's do a calculation. What does it cost to buy it? They said I can buy 10,000 parts for $18.

Each that's 180,000. Am I done? No, because if I buy the part, I can rent out the facilities for 15,000 cash. So the net cash my client has to come up with is 165,000. The answer is a no, I turned this down because it's 5,000 cheaper to make it. It cost one 60 to make it one 65 to buy it. I turned this off for down a because it's $5,000 cheaper.

Okay.

I want to do next with you is a schedule. And even though the schedule hits some basic points, the BEC CPA Exam plays a lot of games with these concepts. So I thought we should talk about them. If you go to your viewers guide, you will see a schedule all set up on fixed versus variable costs. Now you'll notice the basic premise.

I'm assuming that fixed costs are $10,000. The selling price per unit is $8 and the variable cost per unit or $2. And we're going to look at some categories under two levels of activity. First let's assume they produce and they sell one unit. You should fill this in with me as I go through it. If they produce them, they sell one unit.

What's their total fixed cost at that level 10,000. We put that in fixed is fixed. That's setting them out. How about fixed cost per unit? At this level, don't I have to spread 10,000 of fixed costs over one unit fixed cost per unit would also be 10,000. What about variable cost per unit at this level?

Still be $2. How about total variable costs? We made one unit times two would also be $2. How about total costs? The total costs would be at this level, 10,000 of fixed $2, a variable B 10,002. How about sales at this level? We sold one unit for $8 to be $8. And finally, what about the ratio of variable cost to sales?

If I take the total variable costs $2 over sales eight, it would be 25% now by comparison, let's assume they produce and they sell 10,000 units. Let's go through the same categories. If they produce and they sell 10,000 units, what's total fixed cost at this level. Still 10,000 fixed is fixed.

It's setting them out. What's fixed cost per unit. Now I've got to spread 10,000. The fixed costs over 10,000 units. Now fixed cost per unit would be a dollar notice fixed costs in total. Stay the same fixed cost per unit fluctuates. If you look at that schedule, what happens as production rises? Just look at the two columns schedule as production goes from one unit up to 10,000 fixed cost per unit goes down.

What happens as production falls, fixed cost per unit rises. the BEC CPA Exam plays a lot of word games with this. All right. Let's move on. What's variable costs per unit at this level, still $2. How about total variable costs? We made 10,000 units. Times two would be 20,000. How about total costs? That fluctuates, if this level would be 10,000, the fixed 20,000, the variable be $30,000.

How about sales? We sold 10,000 units at eight $80,000. And then finally, what's the ratio of variable cost to sales? If I take the total variable cost 20,000. Over the sales 80,000, it's still 25%. The big thing to notice in the schedule is that fixed costs in total stay the same fixed cost per unit fluctuate.

Look at variable costs per unit stays the same variable costs in total fluctuate. Let me show you one reason why I went through a schedule like that with you together. Let's do question. Number 30

number 30 says when production levels are expected to increase, I would circle two words, production and increase. All we know in this question is production is increasing within the relevant range and a flexible budget is used. What effect would be anticipated in regard to each of the following costs first column, what happens to fixed costs per unit?

Goes down. You want decrease, you know what they want you to pick? I think they want you to pick B or C no change. They want you to sit and examine gall we'll fix costs are fixed. No change, not per unit. If production is rising, fixed cost per unit would be falling. How about the other column?

Variable cost per unit? No change. Not per unit, no change. And the answer is D now the real reason I had you go through the schedule with me. Is that they like to ask these concepts in a graph. I'd like you to try a graph. I'd like you to try 31 and 32 and then come back.

I hope he tried number 31. I think it's important to dry a graph question. I know students don't like graphs. And let me say that. If you've done any graph work at all, you've probably seen this one before. This is a standard cost volume profit graph. It's the one the BEC CPA Exam hits the most. Why don't we label a couple of things before we solve it, that straight horizontal line that is your fixed cost line.

At any level of activity, you have the same fixed cost. They're fixing them out. Then the first diagonal line that starts on top of the fixed cost line. That's the total cost line, because if you go to zero activity, you start with your fixed costs. Then you add your variable costs. That first diagonal starting at the fixed cost line, that's the total cost line.

And then the other diagonal starting at the zero point. That's the revenue line. Now you can label a couple of other things, the little triangle between the revenue and the B point. That would be your profit area because revenue is higher than total costs. And then the little triangle below the, a point to the revenue line, that's the loss area, because revenue is below total costs.

So that's how you read the graph. And if you look at the graph, there's one thing, for sure. And that is that a sales are lower than B sales. Isn't that true? Now they happen to plot a and B on the total cost line. How would I find a sales? If you look at that graph? I would go to the a point, drop a line down to the revenue line and look over to the left.

And that would be the revenue for a, if you go to the, if you go to the B point, draw a line up to the revenue line and draw, look over to the left, that's the B sales level. But as I say, the one thing, for sure, looking at that graph is that a sales are lower than B sales. And if that's true, can't I think of that last schedule we did.

By using the one unit level as a and the 10,000 unit level is be that schedule. We just did where we compared one unit to 10,000 units, those different categories. If a sales are lower than B sales, can't I think of the one unit level is a, and the 10,000 unit level is B why don't we do that? And now let's read the question.

It says at point a compared to point B as a percentage of. Sales revenue. That's the killer at point a compared to point B as a percentage of sales revenue, variable costs are the same, right? If you look at that schedule, we just did at the one unit level, what were variable costs as a percentage of sales, 25% at the 10,000 unit level, the B level, it was still 25%.

So I hope you see why it's gotta be C your D as a percent of sales revenue, variable costs are still going to be 25% still going to be the same. How about fixed costs? Let me say, I think they want you to sit in the BEC CPA Exam and all fixed costs were always the same, not as a percent of sales revenue, they're not look at the B-level at the B-level on our analysis sheet.

What were fixed costs 10,000 at the B-level total fixed cost 10,000. What were sales? 80,000. So as a percent of sales fixed costs were 10,000 over 80,001 eight. How about at the level? The one unit level total fixed cost would be 10,000 over sales, eight, much larger. At the a level and the answer is D now, before we leave this graph, I'll say one more thing that you should be aware of when you do this graph work.

When you do break even analysis, you assume everything is linear. That's the assumption in these graphs that everything is linear. What's that mean? It means we assume fixed costs, approximate, a straight line. We assume revenue approximates a straight line. We assume total costs approximate a straight line.

Are they straight lines? No not in reality. If you carry activity out far enough to infinity all the lines curve, but the whole theory of break even analysis is if I look at a little slice of activity called the relevant range, they look like straight lines. We assume everything is linear. And that gets us to question 32, cause it bothers people 32 says break.

Even analysis assumes that over the relevant range, the answers a, we assume revenues are linear. You do assume everything is linear. And the answer is yes.

What I want to talk about next is strategic management. Concentrates on decisions that will map out the long run operations of a company, long run operations. And the basic benefits of strategic management would be an improved vision of the future for the company also. And improved perception of what is important for the company.

And also an improved perception of changes in the environment, in a dynamic marketplace. So there are a lot of benefits from this sort of strategic management. Now the strategic management model basically has four components. Let's go over the four components. Number one there's environmental analysis, number two, strategy development, number three, strategy implementation and number four, evaluation and control.

Those are the four components to strategic management. Let's talk a little bit about each one. When we talk about environmental analysis, we are talking about analyzing both. The external environment and the internal environment, both you're trying to identify factors. You're trying to identify factors that will have an impact on future performance.

And these factors are not necessarily within the short-term control of management. So when I say that, We're going to evaluate the environment. What's the environment. First of all, you look at general trends the aging of the population the percent of baby boomers in the marketplace.

So you look at general trends, you look at industry trends. It could be that people are really concerned about food additives in your industry. So there are industry trends. You look at. Also you look at societal trends, are they more single-person households now do more people use email to more people use cell phones, what kind of societal changes are you dealing with?

And also you consider the internal environment as well. What is the corporate culture? What is the chain of command? What are the corporate resources? That's all part of the environment. That is environmental analysis. The first part of strategic management, the second part is strategy development.

Strategy development is the formulation of a long-term plan to seize advantage of opportunities. That's what it's all about. You're trying to take advantage of opportunities. You're also trying to manage threats. You try to do that as well. And basically in terms of strategy development, you start by defining your mission.

What is the purpose of the company's existence? You define your mission. And sometimes as a separate statement, a company will do a vision statement. What the company is seeking to become in the future and what it all leads to is a master plan. That's really what you're really trying to develop with.

Strategy development, a master plan, what is to be done. And by what deadline, and also in the master plan, what plans do you have for expansion corporate growth? How are you going to manage corporate growth? Is it going to be vertical growth? Vertical growth is assuming functions that were previously done by some of your suppliers.

By some of your distributors that's vertical growth. It could be that you're planning on horizontal growth is increasing your market share within your current industry. Maybe you're going to diversify. There are two types of diversification could be concentric. Concentric diversification is expanding into a related industry.

An industry related to the current industry that you're in con a conglomerate strategy would be expanding into an unrelated industry, but that's all part of the master plan. How are you going to manage corporate growth as well? That's all part of strategy development in terms of strategy implementation.

That's really all about developing programs, budgets, and procedures. To implement the strategy. That's what I mean by strategy implementation. You're coming up with budgets. You're coming up with programs. You're cutting, coming up with procedures to implement our overall strategy. And then by the fourth and final step evaluation and control, we simply mean over a period of time.

You have to monitor the performance of the strategy. And take corrective action where it's needed. So try to remember the four basic components of the strategic management model, the environmental analysis, strategy development strategy, implementation, and evaluation and control.

Let's do a couple of questions on strategic management. In number one, question number one says, which of the following is the least beneficial result of strategic management, least beneficial result a says a focus on the future. No, that's what it's all about. Strategic. Management's all about long-term planning.

B says our perception of the environment. Now that's part of it. Environmental analysis is a big part of strategic management vision. Of course, that's a big part of it trying to improve your vision, but D having a written plan that's that is that's the least benefit. That's the least beneficial result of doing strategic management fact that you've written down a plan of all the ones listed that as the least beneficial answer.

Date question number two.

What is the typical link? That two businesses being combined in a conglomerate diversification strategy have what is their typical link? If it's a conglomerate strategy, remember the company is expanding into an unrelated industry unrelated, so they don't have a common customer base answer a, they don't have be a common distribution network.

They don't have, they don't have D. Common management skills. They don't have E common technology. No, their link is probably financial answer C because a conglomerate strategy means you're expanding into an unrelated industry. Your link is really financial question. Number three.

What strategy involves increasing your market share in the same industry? Same industry. How about concentric? Answer a now concentric, you are expanding into a related industry, not the same industry. Be a conglomerate growth, no conglomerate growth. Remember, you're expanding into an unrelated industry.

Can't be Bay about D vertical, no vertical. Remember is you're you're assuming responsibilities functions that were previously done by somebody else within your industry. Like you are. Doing functions that were previously done by suppliers or distributors, but in terms of increasing your market share in the same industry, that's the definition of horizontal growth.

That's what horizontal growth is. It's insist increasing your market share in the same industry. And the answer is C horizontal growth.

Let's go to question number four. In question number four, we have a question about regression analysis and regression analysis studies. The relationship between a dependent variable and one, a more independent variables. If you're talking about simple regression analysis, just simple regression analysis, you're comparing the change in one dependent variable.

And you're associating that change with one other independent variable with multiple regression analysis, you are studying the relationship between the change in one dependent variable, associating it with the change in more than one independent variable. So if you look at this graph that they gave us sales would be the dependent variable.

And income levels increasing would be the independent variable. This is a simple regression analysis. Now what you're looking for is a correlation. The measure of correlation, what they call the coefficient of correlation is always measured between a plus one and a minus one. In other words, a perfect.

Positive correlation where both variables are moving in the same direction, a perfect correlation where both variables are moving in the same direction would be a plus one, a perfect correlation where the variables are moving in an opposite direction would be a perfect minus one. The plus one and minus one is trying to measure the degree of linearity, how linear the relationship is.

If you look at this graph, what you'll notice is there's a negative correlation as income is rising. Sales are going down, right? So it's not a positive correlation. It's negative. And if you just notice that is income levels are rising, sales are going down. If you notice it's a negative correlation, it can't be C or D because C and D has a positive correlation.

So when they ask you, what is. The coefficient of correlation, can't be CRD. It's gotta be a minus answer. It makes no sense at all because it's a minus 9.0. Remember the coefficient of correlation is always measured as either a plus one or a minus one. It's always in regard to one, one being perfect correlation, a plus one being perfect positive correlation, a minus one being a perfect negative correlation.

Your best answer here is the answer B. A little less, P minus point 93, it's a negative correlation, not quite perfect, but it's a very strong correlation where if income rises in this case, sales are going down. Question number five is a probability question we're involved in a lawsuit and a vendor has offered Wyatt a $25,000 settlement.

A lawyer comes along and says, no, let's bring them to court. If we bring them to court, I think I can win 75,000. You know what you do? We've already got a $25,000 settlement in hand. Lawyer thinks if we go to court, we could win 75,000 notice. There's a 60% probability. We'll win that case. So let's work it out.

What is the expected value of going to court? What is the expected value of litigation here? If we go to court, there's a 60% chance we'll win seventy-five thousand, but we've got to pay the lawyers retainer, no matter what happens. That's 12,000 plus the lawyer gets a contingency fee. Lawyer gets 50% of everything over 35,000.

So if we win 75,000 with 40,000, over 35,000, Lauria gets 50% of that or another 20,000. So if we go to court and we win. We don't get 75,000. We get 75,000 minus 12. The retainer minus 20,000 lawyer gets 50% of everything over 35. What we net out of  the win in court is 43,000 because there's a 60% chance that'll happen.

I multiply by 60%. The expected value of that outcome is $25,800. Now there's also a 40% chance we'll go to court and we'll lose. So do I multiply 40% times? Nothing? No. If I lose, I still pay the lawyer, the $12,000 retainer. So there's a 40% chance that I have to pay a $12,000 retainer and end up with nothing else.

That's a $4,800 loss. The expected value of going to court is a 60% chance that I'll get 25,800, a 40% chance. I'll have a $4,000 loss. The expected value of going to court is 21,000. So the answer is C right now. It's not see, I already have a twenty-five thousand dollar offer in hand, they've offered a $25,000 settlement.

My expected value of going to court is just 21,000, but if I litigate, I'm expecting a $4,000 loss answer a

that concludes our discussion of decision-making and. Planning and measurement. I want to wish you the best of luck on the exam. Study heart.

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Hi, I'm Jennifer Lewis and the hotspot that I'm going to be leading you through is corporate governance. But before we get started, let's talk about a few study hints. First of all, make sure that you treat study like a job. This means that you're going to put your best effort forward and you're going to devote sufficient time to your studying efforts.

Remember, there's a very important performance evaluation at the end of all this, which is passing the CPA exam. You also want to make sure that you're balancing your lifestyle though, and that you're taking sufficient breaks when needed. We all need to take those mental and physical breaks. So as we go through these materials, make sure that you stop at appropriate times.

Get up, walk around, clear your head, and then come back. Now, whenever you're starting back up again from taking a break, it's important to go back and at least look through the viewer guide to scan through the material that's already been covered to make sure that you refresh your memory on those things.

And then you can start back up with the video and we can continue on. There's a few things that you want to make sure that you really are committing to memory, and that's going to be the key definitions that I'm going to provide to you as we go through the materials. And then there's other things that you're going to need to know.

So for example, with corporate governance, one of the things that you're going to need to know is the authority of the boards of a board of directors and what types of qualities do those board members need to have and what are their duties and responsibilities? We're also going to talk about audit committees as being a subgroup of the board of directors.

And we're going to talk about the purpose of that audit committee and why they are compose that the way they are. And then as a governance structure, we also can't forget the officers and senior management and other employees that play an important role in governance. And so we'll cover the duties and responsibilities and authority of those people.

We also are going to talk about internal controls because it becomes an important aspect of governance is going to have, is going to be, to have sound internal control over reliable financial reporting. And so we'll talk about the important elements of internal control. And we'll also talk about the role of just managing risks.

In an organization. So as part of corporate governance, it's going to be to make sure that they're looking at enterprise risk management. And so we'll talk about some of the foundational principles of enterprise risk management. We'll delve in a little bit more detail about some of the more important elements of internal control over financial reporting.

As it relates to governance. One of the areas is going to be the control environment, which is the foundation of all the other elements of internal control. We'll talk about the importance of making sure that there is appropriate oversight over the financial reporting process. And we'll talk about the purpose and the benefits of actually monitoring the effectiveness of internal controls over financial reporting.

We'll talk about some of the types of monitoring as well as some of the other practical application concepts, as it relates to monitoring. We'll talk about the importance of having good, strong information that's used in the monitoring process. And so we'll cover some of the important qualities that information should have that management's using in their monitoring efforts.

And we'll talk about how monitoring. The operating effectiveness of controls over financial reporting, how that actually strengthens and improves the overall risk assessment process of an organization to make sure that they're managing their risk appropriately. And if there are changes that need to be made to a system of internal controls, because there are weaknesses or deficiencies in internal controls over financial reporting, what's the change control process that needs to be undertaken.

So the first topic that we're going to cover is going to be. An overview of what we mean when we say corporate governance refers to the manner in which an entity is managed and governed. So this could include a lot of different individuals, depending on the nature, size and complexity of a business.

This is going to naturally include management, senior management and other personnel within the organization that provide oversight, supervision and review of an organization. It also is going to include those charged with governance. Now, just in a moment, I'll give you a. More precise definition of what those charged with governance is, but keep in mind now that those charge of governance typically for a larger, more complex type entity is going to include a board of directors and potentially an audit committee.

But an entity does not have to have a board of directors. It may have other person or persons that are responsible for overseeing the strategic direction of the entity. The benefits of having a solid corporate governance. Function is that it helps in multiple ways. It's going to help an organization ensure that they have effective and efficient operations.

It's going to make sure that they have a compliance with laws and regulations and contracts and agreements that are important to the organization. And it's also going to make sure that they're generating reliable financial information that's used by the organization internally, as well as outside third party users as appropriate.

So the role of governance is focused in a lot of different areas with operations compliance and financial reporting. Now, when we talk about internal controls over financial reporting, it is a process that's affected by the board of directors management and other personnel. It's designed to provide reasonable assurance regarding the reliability of financial statements.

Now notice there's a couple key concepts there. One of them is that internal controls as a process. So when we talk about governance and governance, focusing on ensuring that there's a good, solid system of internal controls over financial reporting, we're talking about them, looking at them. All of the controls that are relevant to the organization, not just one specific aspect of controls, but looking at the process of all the controls that all work together and interrelate with each other to ultimately lead to reliable financial statements.

And ultimately they're looking to make sure that the financial statements are not. Materially misstated. So there's only the sense of that you're looking to provide reasonable assurance that the financial statements are reliable, not absolute assurance because we can never give absolute assurance because of the fact that there's human error, there's subjectivity.

There is just situations where people make mistakes, their system back system breaks downs. We want to make sure that we're focusing on getting the best information out there to the users of the financial statements, realizing that no system is ever going to be perfect. Those charged with governance is a relatively new term.

That's evolved to broaden out, to think about governance from the aspect that not every organization has a board of directors. In some instances, entities are required to have a board of directors in other cases they're not. And so they may optionally decide to have a board of directors. Or they may decide to have a group that they just call the governance structure.

And so the governing structure could be person, one person, or it could be multiple people. And their role is to oversee the strategic direction of the entity and its obligations, including the financial reporting process. It may include a board of directors. It may include an audit committee, or it may just include a owner of a business and that sole owner or that sole trustee of the business may be the person that is charged with governance.

Some or all of the members of a governance structure may be part of management. So there may be an organization that has an executive management team that functions as the governance role. When you're looking at, who is, are those charged with governance? Sometimes it's very easy to identify who those charged with governance are or who those are, who the person charged with governance is, but it really can vary from entity to entity, depending on the nature, size and complexity of the organization management.

Is going to be those that are responsible for achieving the objectives of the entity directly. So they are the ones that actually have the authority to establish policies and make decisions. Those people are going to be the ones that are directly responsible for the financial statements. And they're going to be directly responsible for designing, implementing, and maintaining effective internal control over.

Financial reporting that generates these financial statements. So when we talk about management, we're thinking about those that are a part of the organization that are, that could be someone like the controller, the CEO, the CFO, those individuals are going to be considered management. When we talk about those charged with governance, it's going to be an executive management team.

It could be the owner of the business. It could be. Or it could be an audit committee. It's going to be somebody, a group of individuals or a single individual that is overseeing management. Another term that you're going to hear me refer to a lot in this topic is going to be Kozo is the committee of sponsoring organizations.

That's what Kozo stands for. And it's comprised of representatives from various financial and accounting regulatory type bodies. And you'll hear something called the COSO internal control integrated framework. And this integrated framework is a gold standard, as you might say, of the components and elements of internal control, that really should be in place to mitigate the risks of an organization.

And to make sure that an organization is able to achieve its operating financial and compliance objectives. It's the most widely accepted framework out there for designing a sound system of internal control. And it's the framework that most organizations use when they are thinking about internal control over financial reporting.

You'll also hear me mention a periodically in this hotspot about materiality and materiality is a fundamental concept that helps distinguish the importance of matter. So what would really be a trivial situation, maybe a trivial error versus one that is more significant to the impact on the financial statements.

And so it helps people go through the concept of thinking about. How is it that I need to address issues that I come across. And so it helps determine what are those thresholds that I need to give attention to. So are there things that I could perhaps ignore, or are there things that perhaps I could set aside and deal with on a later basis?

Or are there things that I want to bring to the forefront and deal with immediately? Because it could be something that would actually. Alter the financial decision-making of an organization or the intended users of the financial statements, their economic choices could be altered or influenced because there is this misstatement in the financial statements.

So as you go back and think about when we discussed internal controls over financial reporting, and we said that it's to give reasonable assurance. About the reliability of the financial statements, that's where materiality comes in, because we want to make sure that there's not material misstatements due to fraud or error in the financial statements or in the disclosures to the financial statements that would cause the user of the financial statements to make a different economic choice.

So we need to have some context around what is considered to be material. So before we begin forward with this topic, I'd like you to shut down the video and do the next series of multiple choice questions. When you're done with those multiple choice questions, I'd like you to turn it back up again, and then we will debrief those questions and we will move forward with the next topic after that.

Welcome back to the program. Now, hopefully you've gone through and you've looked at the multiple choice questions on your own. And now let's go through and debrief those multiple choice questions. Let's start with this one, which of the following is a true statement related to corporate governance?

Is it a that it refers to the manner in which an entity is managed and governed B that it excludes entity management C that it requires entities to have a board of directors or D it is a uniquely distinct concept from those charged with governance. The correct answer is a, it refers to the manner in which an entity is managed and governed.

It does not exclude entity management. Remember I said that those charts, when we talk about governance, it could include management. It could include a board of directors and it could include other appropriate personnel within the organization. Remember an entity does not have to have a board of directors.

It may be required to through legal or regulatory type requirements that the entity has to deal with because of the nature of the organization. Like it's a publicly traded organization, but smaller, privately held companies are not required to have boards of directors. And when we talk about governance and I talk about those charged with governance, it's it really is a concept that is interrelated.

Those charged with governance can be and should be a part of corporate governance.

the next question reads, which is not an element of those charged with governance. Is it a. Those charge of governance are responsible for overseeing the strategic direction of the entity. Is it B those charge of governance encompasses the board of directors and audit committee relevant? Is it C those charged with governance does not vary by entity, or is it D those charged with governance may include responsibility for approving entities, financial statements.

The answer up there that is not a true statement and is not an element of those charge of governance is C it will vary by entity, depending on the nature, the size and the complexity of the organization. Those charged with governance will look vastly different in some situations.

The next question for this section reads as follows, which of the following is a state, a true statement regarding materiality as it relates to corporate governance? Is it a, there is no concept of materiality relevant to corporate governance. B it is a foundational concept that helps distinguish the important from the trivial C users of financial statements are not relevant to determining materiality.

Or D does not permit decision makers to omit issues from consideration. The answer there. That is a true statement regarding materiality is B it is a fundamental concept that helps distinguish the important from the trivial in the governance role and responsibility. There is. A sense of materiality.

There is a sense of things that maybe are less consequential. And when thinking about what's material for a particular organization, it's important to go through the thinking of what would be important to the users of my phone. Financial statements. Certainly materiality is something that those chargers governance need to keep in mind as they're fulfilling their role and their responsibility.

Let's talk a little bit more around the authority of a board of directors. So a board of directors would be a formal board that is elected or appointed to oversee the activities of a company or an organization. You often, sometimes we'll hear it referred to as a board of trustees. A lot of times when we're talking about colleges or universities, they might have a board of trustees.

You might hear them referred to as a board of governors, a board of managers and executive board, regardless of the specific term that is. Use to describe this board the fundamental concepts around what their authority and responsibilities are, is going to be similar. So their activities are going to be determined by a, the powers and the duties and the responsibilities delegated to it, or conferred on it by an authority outside itself.

And so often this is going to be the organization's bylaws. So the entity is going to put together some sort of bylaws. If it's a corporation, they would have corporate bylaws. That would say, how many board members do we need to have? How are they going to be selected? One of their primary roles and responsibilities.

And so everything would be laid out in the bylaws of the organization now, above and beyond the bylaws of the organization. The other area that might influence. A board of directors is going to be if there's any specific legal responsibilities that are conferred on it because of the fact that it's publicly traded.

So the sec, for example, has very specific rules around how they want the board of directors to, to be established and who can sit on that board. And what are the things that they're expecting that board of directors to do? So the nature of the entity could confer upon this board of directors, certain legal responsibilities.

There also could be some responsibilities that are conferred on it because of the jurisdiction that the organization operates in. So for example, a not-for-profit organization might be required to have a board of directors based on the legal geographic jurisdiction that it operates in. Depending on the nature of the entity, there's going to be different ways that this board of directors might be structured.

And there's going to be different people that might sit on this board of directors, organizations with voting members. So if we talk about a publicly traded organization that has shareholders, these shareholders often elect. This board of directors to act on their behalf. So the actions of this board of directors are really subordinate to the entities, full assembly of all of the voting members of the organization.

Now, the sec, as I mentioned, does require issuers, which are, is another term for publicly traded entities that they require these issuers to have boards and. The way that this is done is through what you hear when you hear the Sarbanes Oxley act. So the Sarbanes-Oxley act is the rule that has the statutory and regulatory things that a board of directors must follow in order to comply with the SCCs rules.

In large public companies, boards sometimes tend to have de facto power. Now what's de facto power doesn't mean that they have direct authority to be able to approve transactions and guide the direction of the organization. Because remember I said that they are subordinate to the full assembly when they are Representing all of the voting members of an organization, all of the shareholders that have a say in running the business, what does sometimes happen though?

Is that in large public companies, they might have defacto power because they really comprise a large voting block. So a lot of times either they own shares of the organization or they are. Members of management within the organization, or they are a convert voting authority because somebody is giving them their proxy vote and say, here, however you vote is how I'm going to vote as well.

So in essence, sometimes because they can put together these large voting blocks, they have defacto power or have an over an organization. Small private companies don't have shareholders that need to be represented in the same way that large public companies have. So small private companies often have directors that are a part that are also a member of management.

Or directors that are also the owner of the business, or might be some, a small group of individuals that jointly share ownership of an organization that all might sit on what they call Holly board. So there's really no reason you'll division of power per se, in a small private company. There is in a large publicly traded organization.

Even if a small private company is not required to have a board of directors. It's important that if they do have a board of directors or another governance type structure, an executive management committee, or even a sole trustee, because it's a solely owned business, they need to look at the concepts that apply.

Two boards of directors and try to adopt those concepts and those underlying foundational principles and to still apply them to whatever their governance structure is. When we have an organization that has different types of directors on it, like at large publicly traded organization, they're going to have varying different types of directors.

Some of them are going to be. Owners or managers of the business. And so they're called inside directors are the ones that have a vested interest in the organization. They're there. They're interested. Directors would be the another term that you hear them called. So they're insiders to the organization.

You also sometimes are going to refer to directors who are also managers. They sometimes are called executive directors. So if you hear the term inside directors or executive directors, these are all interested parties in the organization that also happened to be members of the board of directors.

Now a board of directors also should have members who are not owners or they're not managers of the business. And so these are often referred to as outside directors. So outside directors are more independent. They're not executives, they're not owners. They don't have a vested interest. They are more independent and objective and fulfilling their governance responsibilities.

So those chartered governance should be. Ideally comprised of a mix of inside directors and outside directors in order to fulfill their roles and responsibilities appropriately, really large companies also sometimes have something called an advisory group and an advisory group would not be a group of individuals that's elected, but they are.

Somebody that the board of directors turns to get advice around specific issues and advisory group has no decision-making authority. They have no voting with authority. They highly have no direct responsibility to the entity other than it's just a group of individuals put together to provide advice.

So in advisory group is not the same thing as a board of directors, and it doesn't have the same responsibilities as a board of directors. Now, as we mentioned in the introduction, the board of directors is governed by the bylaws of the organization. And the bylaws of the organization may say that the org, that the board of directors needs to have a subgroup called the audit committee.

And the audit committee often is established by a charter through the bylaws. So the charter of the audit committee typically defines what the audit committee's responsibilities are. So they need to go through and say, okay, what are the activities that we should be undertaking? And his charter is going to guide them in that process.

There also is going to be things like minutes. So if we have minutes to a meeting, the minutes to the meeting are just the documentation of what are the key topics of discussion. Would it be important decisions that were made? And they're going to also talk about. As a, keep a record of any internal control deficiencies that might've been identified and discussed.

If there were any known instances of fraud that were brought to the attention of the board or the audit committee, any important financial reporting issues that may have been discussed and resolved. So it's to provide a trail of documentation that somebody could go back and really understand what were the key topics of discussion.

What were the important conclusions and maybe what were some of the things that were voted on and decided by the board or by the audit committee, the other piece of documentation that you may find as it relates to boards and audit committees, is this concept of having certifications of independence.

Certifications of independence may be required at least annually by audit committee members to have them say. Outright that they have no related party interest in the organization because the audit committee really, you want them to be even more independent. You want your audit committee be comprised of outside directors as much as possible.

And so you want to make sure that if they are involved in. Management of the business or have any sort of conflict of interest with the organization. If they have any immediate family members that are part of management of the business, if there's any way where their independence or objectivity might be influenced that they need to disclose that in a certification of independence.

So it's more to make sure that the. Organization  and that senior management of the organization and other members of the board of directors know where there might be a conflict of interest that might be influencing the judgment and the advice that's being provided by these individuals.

What I'd like you to do now is to once again, shut down the video and to open up your books and do the next series of questions.

Welcome back to the program. Let's go ahead and deep reef, the questions that you should have answered regarding the board of directors, which of the following is not a true statement related to the board of directors. A, that it may be elected or appointed B that it's typically governed by an entities, bylaws, C legal responsibilities do not vary due to the nature of the entity or the jurisdiction that it operates in, or D it's sometimes referred to as a board of trustees, a board of governors or an executive board dancer.

That is not a true statement is C. If you recall, we talked about how legal responsibilities are going to vary depending on the nature of the entity, a publicly traded organization and its board of directors is going to have vastly different responsibilities than a small privately held organization that may not even be required to have a board of directors.

So C would be the incorrect response up there as far as it not being a true statement.

The next question says, which of the following is a true statement related to types of directors, a owners who are directors are called outside directors, B managers may not serve as directors. See a board is not permitted to contain any inside directors. We're D managers who are directors are often called executive directors.

So this question is looking for which of those four options is a true statement. And then the true statement is answered D managers who are directors are often called executive directors, owners who are directors are inside directors. So that's why I answer a is not correct. Managers may serve as directors.

And that's why they're called executive directors or outside directors. So that's why answer B is not correct. And answer C is not correct because we really want a board to have as many outside directors as possible, but there may be some inside directors that may be included as long as there's an appropriate number of outside directors.

Balancing that out.

The next section that we're going to cover is called qualities and duties of the board of directors. So let's talk a little bit about what are some of the qualities that we really want a board of directors to have in order to appropriately exercise their oversight role. First of all, we want them to have some sort of financial reporting expertise.

We want them to understand financial statements and how financial statements are used to run and manage a business and make economic decisions. We also want them to have an in-depth knowledge of business operations and, the industry that the organization and the entity operates in. So they have some context around some of the operational.

Business decisions that need to be made and any sort of compliance issues that need to be considered as they're making a key choices about the organization and authorizing certain transactions and events. So beyond the technical knowledge that we need somebody to have, they also want somebody that has some of the non-technical qualities, like having the commitment to carry out their responsibilities with due care.

And what that means is that we need a board of directors that operate rates in a way such that they keep the company's interests in the forefront or the shareholders of the stakeholder's best interests in mind. So to make sure that they're always making choices around what's in the best interest of the company or the shareholders or the stakeholders, not just what's in their own best interest or what's in the best interest of management.

So in doing that, you're really counting on this board of directors to operate in good faith and to act honestly, and have a good sense of integrity and ethical values. And they want to make sure that we can count on that board of directors to exercise their authority for proper purpose. So that means that we want to make sure that they don't have any conflicts of interest.

So when we look at conflicts of interest, we want to know, or that they don't use the entities assets, or they don't use the access to information that they have by being a part of the governance structure of an organization for their own profit or their own benefit. Now sometimes there might be some transactions or some events that they get involved with that involve the organization, but they really should only be doing that with the informed consent of the entity and the management and other members of the board.

So there may be some things that they do where there's overlap in the interests of the individual and the interests of the entity that they're governing. But those. Where there is that overlap. It just needs to be brought to the attention of appropriate parties so that everybody is informed of it and can approve of the transaction of the event moving forward.

Despite the fact that there might be some sort of perceived conflict of interest. Now, one of the things that you really don't want a board member to do though, is to compete directly with the company. So we want to make sure that they're not engaged in a business that competes with the company, and we want to make sure that they are also not acting as a director on the board of a competing company.

Because the board of directors is privy to a lot of important information and a lot of key decisions are authorized or approved by the board of directors. And so we wouldn't that wouldn't want that inside information to become readily available to the competition. A board member should also not enter into transactions that are significant to the point where there starts being a conflict between.

What is in their best interest in what is in the best interest of the company. And so when we talk about individual transactions, like if they are engaging in a contract to buy a product or a service that the organization. Is involved with, if there's negotiations involved in this contract, if there is terms of the arrangement that could be modified and is, and there's not a set fixed price list somewhere, then there could be a conflict there because the individual board member would want to get the best benefit for themselves.

So they're going to be constantly negotiating for the cheapest price and the current terms of the arrangement that would be to there. Individual benefit, but they also have a duty to the organization for them to maximize the profits and to get as much possible out of the arrangement and the transaction for the company.

And so you can see where there would just be a natural conflict there. And so if there is going to be any transactions that are entered into between. A board member and the entity that they're governing, it really needs to be ratified or approved by management and disclose to the rest of the board. So one of the things that is really important about a board is to try and have as many of those independent directors as possible.

Now, the Sarbanes-Oxley act actually for a publicly traded company, says that they need to have a critical mass of independent directors that are sitting on the audit committee and they define critical mass as having at least two. So you need to have preferably at least two people that have, that are independent, that are those outside directors of the organization.

And the reason they discuss that for that type of organization for a publicly traded organization is because it's, they're the ones that need to be. Appropriately monitoring senior management and providing objective council to really oversee all of the inside directors or the executive directors that also might be serving on a board.

So it's keeping sure, making sure that there is an objective party that can sit and look with an unobstructed viewpoint and maintain the appropriate level of skepticism regarding some of the decisions and the judgments that are being made by management and by the full board of directors. So their job for, with these outside directors or these independent directors is to really ask probing challenging questions of management, and to make sure that they fully understand and have all the information available as they are making approvals for certain transactions and events to occur.

If there are some requirements to have independent outside directors, whether it's required by law, like through the Sarbanes-Oxley act for publicly traded organizations, or even if it's something that is voluntarily done by a private organization, just through the charter of the audit committee or through the corporate bylaws for the board.

It's there. It's going to be a need to periodically reevaluate the continued independence and objectivity of these outside directors. So there needs to be a means of capturing information where there might be some real or perceived conflicts of interest because of changing relationships or changing circumstances that occurred throughout the period.

So periodically probably at least annually, the, if the independent. Outside directors of an organization should fill out some paperwork that describes any related party interests that they might have with the organization. And to describe any sort of affiliations or relationships that really might be perceived as being a conflict yeah.

Of interest

challenges that a smaller entity has is that. They do not have the same ability to attract independent directors. It's easy to get inside directors involved. So if there's somebody that's the management of a company or has a share interest in an organization, so stakeholders are automatically going to be going to want to be involved in a board of directors because they have a vested interest in the success of the company.

Outside directors though are supposed to be independent and they're not supposed to have that same level of vested interest. And so how do you attract them to want to be a part of the board? Sometimes there is some compensation that's provided to these directors. And so that might be the motivational factor for them to be involved.

Smaller entities have a more limited ability to provide appropriate compensation for these board members. And they're also sometimes with smaller entities where things might not be as formal and as a structured, as a large entity might have their board or their governance structure set up. Sometimes there's some concerns for smaller entities for board members to be concerned about the potential for personal liability.

So as they're approving transactions and events for these smaller entities, would they potentially be personally liable for an unfavorable outcome? Of those transactions or events. And then the other thing that they encounter sometimes is that there's a real resistance from management or from those inside directors to share governance responsibility with the outside directors.

A lot of times the inside directors or smaller entities think that they have a larger view.

So what I'd like you to do now is to shut down the video. Go through and answer the next series of questions related to this topic and then come back and we'll debrief those questions.

So welcome back. Let's debrief the questions that you should have responded to on your own first and the first one deals with the important qualities. For a member of a board or directors and which, and the question is which of the following is true, except so what are important qualities for a member of a board of directors, including all of the following, except a, that there's financial literacy be that they have a lack of industry expertise.

See that there's a commitment to carry out responsibilities with due care or B. Or D that there's an ability to maintain the entities interest in the forefront. So important qualities for a member of a board of directors include all of the following, except B lack of industry expertise. We obviously want the board of directors, do you have adequate industry expertise and to have adequate knowledge about business and their operations, including having a good sense of financial literacy and having some of those.

Concepts like a commitment to carry out their responsibilities with due care. And they're making sure that they have an ability to maintain the interest of the company and the stakeholders of that company. And to keep that in the forefront above and beyond their individual vested in it.

Another question was which of the following is an appropriate duty for a board of directors, a. Do not enter into transactions with the entity unless disclosed and ratified by management B use the entities assets for personal profit C compete directly with the entity or D act as a director for a competing entity.

So which of those followings. Would be an appropriate duty for a board of directors. That's obviously a, that they should not enter into your hand into transactions with the entity, unless it's disclosed and ratified by management. Whoever is a member of a board of directors should make sure that they are maintaining some sort of barrier between their own personal interests and the best interests of the organization.

And so they should not look at it as an opportunity to enhance the personal profit and they should not compete directly with the entity or act as a director for a competing entity.

Let's talk a little bit more about the responsibilities of a board of directors or those charged with governance for entities that don't have a formal board of directors. One of the key general responsibilities that they're going to have is to make sure that they're objectively reviewing the significant judgements that management makes, as it relates to financial reporting and financial statements.

Their job is to look at the financial information that's provided by management to help identify and diagnose any unusual activity that potentially may impact the financial statements. Their job is to make sure that things are properly presented and disclosed and classified within the financial statements to ensure that there's no misrepresentations that could impact the food stamp by the financial statement users need of those financial statements and their ability to be able to make good economic decisions based on those financial reports.

So beyond making sure that there's reliability of the financial statements, they also are focused around the controls. That are involved in the processes and procedures that are generating those financial statements. So one of the things that they're going to do is they're going to be there to listen to any recommendations that internal audit or external audit makes to the organization about how to improve the overall quality of the entities controls over financial reporting.

They also are there to be a part of the system of internal controls because they're. Job is to offset any potential improper management override that might be occurring with that might relate to fraudulent financial reporting or misappropriation of assets. So their job is to oversee management.

Management's job is to oversee. Other personnel within the organization to take primary responsibility for generating the financial statements. And then those charged with governance are there to make sure that management isn't doing anything that's improper. So their job is to monitor management's performance in relation to all of the internal control components.

Okay. Boards tend to have agendas. And so they will go through and they will establish a standard agenda item. And often those standard agenda items are put forth by the bylaws of the company or with an audit committee may be in the charter of the audit committee to go through and have the. Key things that they really need to make sure that are being addressed.

And one of those key things is to make sure that they are involved in approving any significant decisions that the entity makes, which would include if they are going to adopt a new accounting policy. And there may be alternatives to how you could. Adopt that particular accounting policy. And so the selection among those alternative alternatives and deciding how it's going to be implemented in the company is something that's very important for those charge of governance to be involved with, to make sure that the company is making the best decisions possible for the entity and for its stakeholders.

So generally with the standard agenda items, there's going to be some sort of calendar of how many times a year they're going to meet and what does the key topics and discussions that are routinely going and to be held at each board meeting? Okay. Part of the things that they might have on there is to make sure that they are reviewing.

He performance reports. So for example, there might be budget to actual reports that are generated every year, quarter. And so the, those charges governance might have a standard agenda item every quarter to meet, to talk about these budget, to actual reports and to discuss any significant variances with management.

They also will participate in major decisions of the company, such as if they wanted to do an acquisition of another company, or if they wanted to spend money, making a major capital expenditure of some means it's important for them to look at the best use of the resources of the company, which may also include any sort of compensation arrangements, particularly incentive compensation arrangements that would include raises or bonuses or things of that nature.

They're not necessarily going to get involved in the individual compensation arrangements of everybody in the company, but they will sometimes establish a range that management could use in. Spending money as it relates to compensation, they may say you can have a give the company a three to 5% wage increase.

And then the individual management members would go through and determine how to use those resources. However, they often will get involved in the compensation arrangements for management. So reviewing and approving any sort of incentive compensation arrangements that they have as it relates to weight, a wage increases and bonuses and similar type arrangements.

Beyond how to spend the money of the company and looking at the financial results of that company. They also are going to be the critical link between the company and its auditors, which would include internal audit and external audit. They'll look at the audit plans that internal and external auditors have and make sure that they're comfortable with the scope of the services that are being provided and making sure that all of the various areas of the business are being addressed as they think is necessary.

For the external auditors, they're going to be the ones that would actually engage the external auditor in most cases. So management would make a recommendation around which CPA firm they wanted to hire. And then the governance structure would the. Whoever those charged with governance is, or are, they would be the ones to make the ultimate decision of which CPA firm to hire and determine the fees that they would be paying the timing of the engagement, the full scope of services that they're comfortable with the auditor providing and a large part of that is that they are the ones that are looking for any possible issues, where there might be independence issues for the auditor.

And so then being the objective party, looking at who's being selected and what they're doing and how much they're being paid is are critical elements in them to make sure that auditor independence is being maintained and safeguarded to the fullest extent possible. Other things that those charged with governance might do on a routine basis is to look at what the results are of any internal control assessments.

So whether the. Deficiencies are identified by internal audit or external audit, or whether deficiencies are identified through management and some self-assessment work that they might be doing their job is to look at any identified deficiencies and to make sure that they're being remediated or fixed on a timely basis.

They also should get periodic updates from management on what's management, the entities approach to adopting any new, significant accounting standards or any changes that they're making to significant estimates that are reflected in the financial statements, or if they are modifying or enhancing any other types of standards or principles that they have been using to create the financial statements for the company as a whole.

The last thing that they should do is they should periodically assess themselves. And so there needs to be a means of showing that they really are committed to the spirit of continuous improvement and engaging in an open and honest dialogue about internal controls over financial reporting and generating reliable financial statements.

And then they, so they at least once a year, should look at their charter and look at their composition and to make sure that. That they have included everything and done everything they can on their end to ensure that they are a good sound governance structure, fulfilling the roles and responsibilities that they're expected to fulfill in order to really strengthen the reliability of financial reporting for the organization.

Yeah. As a whole, one of the things that. Board members are going to need to have in order to do their job well is to make sure that they are getting timely and relevant information. They need to feel as if they have the time to explore and understand and resolve any potential issues that come to their attention.

And they also need to feel comfortable that they have adequate resources to be able to. Hire a consultant perhaps to come in and explore a particular issue that might be of importance to the financial statements as a whole. They might have a valuation expert come in to go  and come behind management to look at how they valued a particular.

Piece of property that they own, or they may bring somebody in to actually do an assessment of internal controls over financial reporting, and they might compare those results to what management is doing on a regular basis. And so they need to feel as if they could go out and engage specialists, which may include legal counsel to explore relevant issues and to make sure that they're governing the organization appropriately.

Most boards rely on management to provide information to them, and they rely on management to make certain representations to them about the financial statements. But you have to keep in mind that management often will put their own spin on information. And this is particularly going to be true if they're trying to conceal or misrepresent the true facts.

Or the financial state of the organization. And so there needs to be a sense of professional skepticism that board members have in order for them to make sure that they're fulfilling their obligate.

What I'd like you to do now is to shut down the video and to answer the next series of appropriate questions. Before we continue with the program.

Welcome back to the program. Let's look at the questions that you should have answered on your own, which of the following would be an appropriate responsibility for a board of directors, a performing performance evaluations of lower level staff. Be participating in daily routine decisions, see rubber stamp management's judgements or D engaging.

The external auditor. The most appropriate responsibility for the board of directors is going to be D to engage the external auditor. Those charged with governance, including a board of directors really should not be too heavily involved in the day-to-day decision-making and routine things, including doing performance evaluations of lower level staff.

Although they may be involved in doing performance evaluations of management. They also need to make sure that they're not just rubber stamping management's judgements, but that they are objective in looking at the judgements that are brought to them for review and approval, and to make sure that they're making decisions in the best interest of the entity and the stakeholders of the entity.

The next topic that we're going to cover is audit committees. The purpose of the audit committee is to take an active role in overseeing the entities, accounting and financial reporting policies and practices. So they're going to assist the larger board in fulfilling their fiduciary responsibilities.

So they're often a subset of the board of directors. There needs to be a process to make sure that the audit committee is informed of significant issues on a timely basis so that they can adequately fulfill this fiduciary responsibility to oversee accounting and financial reporting policies, practices, results, and key decisions.

So the audit committee needs to make sure that they understand how management is identifying and monitoring and controlling the financial reporting risks that could affect the organization and the reliability of the financial statements. They also need to make sure that there's a direct line of communication with the internal and external auditors to discuss any relevant matters that come up that are significant to the financial statement.

So if there is an audit committee, the audit committee is the one that will meet with the internal auditors. They'll meet with the external auditors. They'll talk to management most directly around things that influence financial reporting and internal controls over financial reporting. And then they in essence will share that information with the larger board in a more executive type forum.

It's important that they meet with the external auditors because they need to make sure that they understand the auditor's objective and independent perspective around the reasonableness of the financial reporting process and the system of internal controls. That's generating the financial statements.

They also want to know if the auditors have any significant findings or recommendations that the organization should take into account to strengthen and improve the reliability of their financial statements. They're going to be talking with the external auditors about what's going on within the organization, but they also were there to be the second set of eyes to make sure that the external auditor is maintaining their independence and objectivity and performing the services.

So their job is to make sure that if they feel as if there is a real or perceived an independence issue, that they bring it to the attention of management and the auditors and that they ensure that independence issue gets resolved to their satisfaction, which may include changing the staff that are assigned to engagement, or it may include changing CPA firms to do atta services for them.

Sometimes they may be asked to interact with regulators. So if the sec sends somebody in to deal with a particular issue that they think may not be handled appropriately, or if the. Government accounting office, send somebody in to look at the financial statements related to somebody that gets federal funding.

There may be questions that arise around compliance with laws and regulations or whether or not something's been properly presented or disclosed or classified in the financial statements. And the audit committee would be the one that would be the link between the. That would be there to link between management and the regulators, and also to be the speaking voice of the board and trying to resolve those types of issues.

So they have a lot of authority and to make decisions, but all of those decisions are going to be sometimes there wouldn't be necessary to get the larger board to review and approve them. So they're the first stop on the train, but they're not necessarily the final stop on the train. So oftentimes they'll bring issues to the forefront.

Discuss them investigate them and then have some preliminary decisions and recommendations that they make to the full board, which could include engaging or replacing or determining external auditor compensation.

The organization is a publicly traded organization. The Sarbanes Oxley act is the law that's in place that deals with audit committees and what their purposes are and how they need to be assigned responsibility. And who could sit on these audit committees. So there's formalized rules that need to be followed.

If the entity is a publicly traded entity or an issuer. So this sense of accountability really tries to build into the system of internal controls. What are the direct responsibilities of these directors that are sitting on these boards of publicly traded organizations? And more specifically what's the responsibilities of the audit committees?

One of the requirements that a public publicly traded company has to follow is that they have to have more than half of its members. Be outside directors are independent directors. So the audit committee has to be comprised of outsider, independent directors, and they have to make sure that at least one of those outside directors is financially literate, meaning that they need to be able to understand financial statements.

Understand, generally accepted accounting principles, understand alternatives and treatment of accounting principles that an organization might face as far as some of the decisions they have to make. So there has to be one person that qualifies as being financially literate and more than half of the members needs to be independent or outside directors.

In addition, if it's a publicly traded company by law, it's required that the internal audit function of an organization report directly to the audit committee in order for there to be that extra line of oversight. And to ensure that management can't interfere in the communications between the internal auditors and those charged with governance.

When we talk about being financially literate or being a financial expert, there are no hard and fast rules that the Sarbanes-Oxley act puts in there. There's no real checklist to go through and complete, but they do give some general criteria of what they're looking for in an individual that satisfies that criteria.

And some of it is likely going to come from their training or the experience now. They could have had training or experience as a outside public accountant. They could have been somebody that was a controller or a CFO for a private company or a publicly traded company. It doesn't have to be that they had training or experience in the exact.

In the exact type of company, the exact nature of company, but they do need to make sure that they understand the general accounting principles that are relevant to the organization and that they understand the general business purpose of the organization and that they are somebody that's willing to take on the responsibility of getting brought up to speed on any particular industry specific issues that the organization might be dealing with.

So in essence, they want to make sure that they're comfortable, that they would understand the key elements that are going into the financial statements that they're supposed to be reviewing and approving and overseeing the preparation of this would include any type of estimates or accruals or reserves where there's subjectivity involved in coming up with the amounts that are being presented in the financial statements.

They need to have experience around understanding internal controls and con and key controls that are important to creating the financial statements. And they also need to make sure that they understand what their role and responsibility is. And so they need to understand how an audit committee functions.

In looking for people to sit on an audit committee, it's important for an organization to do appropriate due diligence, which is going to include performing background checks of getting independent references of looking to see what else are they involved with as far as their. Business affiliations, professional affiliations, whether they're also a director of any sort of other company, particularly if it's an entity that might be competing with the organization, that's looking to bring somebody on as a member of the audit committee, they want to make sure that they are comfortable enough with this information so that they can be comfortable about their technical skills there.

Means  of what sorts of conflicts of interest they might have with the existing organization. And then also just whether or not they think that there'll be able to fulfill their responsibilities with due care and professional skepticism. Sometimes you might use an independent search firm to go out and look for these individuals.

Larger, publicly traded entities are often going to expend those resources to make sure that they're finding the best candidates possible. There also often might be a nominating committee within the board of directors that also might oversee the due diligence process of deciding which members of the full board of directors would be appropriate to establish as the audit committee within the board of directors.

If there are issues with independence and ethics that need to be dealt with, you want to make sure that anything that's identified as being potential issues is updated on an annual basis at a minimum. And that you also look for things that changed over the course of the year, that might actually influence a director's independence and objectivity.

So there needs to be a constant revisiting of who is most appropriate to sit on this board. As circumstances change the chairperson particularly plays a critical part of that audit committee, because they're the ones that really need to make sure that they have an appropriate level of financial reporting expertise.

They're the ones that are going to potentially be. The one that's going to be the direct line of communication between the auditors and the audit committee itself. So if there is going to be conversations where the auditor calls up, somebody from the audit committee to talk to them about significant issues and potential issues with fraud or something there, they think that accounting treatment not be, it might not be handled appropriately.

They're often going to start with the audit committee chair person as being their main contact. So there needs to make sure that there is an open channel of candid and ongoing dialogue with all appropriate parties between the audit committee, which would include the internal, a lot of director, the external auditor partners.

As direct lines of communication with executive management and members of the board, it's appropriate for the external auditors too. We meet with the audit committee in private and to discuss things like. Audit findings and the quality of the internal controls over financial reporting and the scope of the audit and how management's doing any disagreements they may have had with management, any difficulties in performing the audit.

So if there is a audit committee, it's expected that they would have a separate meeting with out management, present management present in order for them to discuss these things in an open and honest, meaningful way.

Let's take the time to go ahead and answer the next series of questions. So turn off the video, answer the questions on your own, and then turn the video back on and we'll debrief them.

So welcome back. Let's go through and look at the questions that you answered on your own and discuss why the answer that we suggested as being the most appropriate is the best choice. Which of the following is not an appropriate purpose of an audit committee. Is it a to give they give adequate the iteration to understanding how management identifies monitors and controls financial reporting risks, B that they assist the board in maintaining a direct line of communication with both internal and external auditors.

See, they only meet with auditors with management present. Or D review the full scope of external auditor activities. The answer up here that would be not a w that would not be inappropriate purpose of an audit committee would be C only meet with auditors with management presence. As we discussed, it's important for the auditors to meet with the audit committee and an executive session without management present.

So there can be a full on robust and open dialogue about potential issues and concerns.

Which of the following is an indicator of financial expertise. Is it a no formal accounting education B an understanding of generally accepted accounting principles? See lack of experience with internal accounting controls or di no understanding of how an audit committee should function. The items that would be an indicator of financial expertise would be an understanding of generally accepted accounting principles.

We need them to have as a financial expert, somebody that does have adequate training and experience and understands financial statements and understands internal controls over financial reporting and understands how an audit committee should function and fulfilling their roles and responsibilities.

The next thing we're going to talk about is the duties, responsibilities, and authority officers and other employees of the organization. So senior management is an important part of governance. Often when we think about governance, we think about. The board we think about an audit committee. We may even think about an executive management team or an owner, but senior management also plays an important role in governing an organization.

A large part of it is that senior management is so influential in establishing the tone and the control consciousness of an organization. So their attitude would trickle down to the lower levels within the organization. It's important for them to have a high understanding of generally accepted accounting principles to understand the financial reporting standards and their specific application to their industry and the nature of their business and best practices that might be important for the organization.

So they need to have a high level understanding of everything that's relevant, important to generating reliable financial statements. And they also need to make sure that there's a good, solid system of internal controls over financial reporting. They're the ones that are primarily responsible for the design implementation and monitoring of the financial reporting system.

And they play an important role in preventing and detecting fraud, as well as air in these financial statements. Their response ability would include making sure that all companies, staff accepts responsibility for their part and their role in internal controls over financial reporting. So that's where that monitoring element becomes critical is they can describe to company staff what they want them to do and how they want them to do it when they want them to accomplish it by.

But it's their job as senior management to do some monitoring, to make sure that things are happening as intended. It's also their responsibility to make sure that there are adequate financial reporting competencies throughout the organization. They need to be able to identify what do we need our employees to have as far as their skills and experiences and education in order to support accurate and reliable financial reporting.

If they don't have someone on staff, that's able to fulfill those roles and satisfy those obligations, then they may need to retain somebody or use an outside service provider to ensure that all those competencies are ultimately met. The organization should regularly evaluate and maintain the needed competencies.

So as things change, as the business gets more complex, as new accounting principles come out, as the organization grows and evolves, they may need to add people to the system of generating financial statements in order to ensure that the reliability of the financial statements is preserved. Smaller entities sometimes really struggle with that because they don't have the ability to go out and hire the best and the brightest and to necessarily have, to add two, three people to the accounting staff in order to ensure proper segregation of duties and reliable financial statements.

So what they need to do is they need to make sure that they are trying to design. Their system of internal controls to avoid any unnecessary complexity in the structure of transactions or the structure of the organization, to make sure that they are looking at, not that they can't stretch themselves and try to get engaged in some complex transactions, but they want to make sure that they're making a choice, that if they decide to go down that path, that they're going to need to make sure that they supplement their financial reporting competencies to ensure that somebody is.

Has the skillset needed in order to process those activities, review those activities, approve those activities and make sure that everything ends up in the financial statements appropriately. At the end, this may involve making sure that senior management gets additional training and development to keep their skillsets up-to-date and current with the types of transactions and events that the organization is engaging in at that point in time.

It's time to do some more questions. So go ahead and shut off the video and answer the next series of questions before we begin again.

Welcome back. Let's debrief the correct answers to the questions that you answered. Which of the following is not an important consideration for senior management of an entity and fulfilling governance responsibilities. Is it a adequate amount understanding of financial reporting standards in their application?

B ensure that all entity employees accept responsibility for their role in internal controls over financial reporting. See that they devote resources to hiring and retaining qualified individuals. Or is the correct answer, D abdicate responsibility of monitoring financial reporting to the external.

Water's the answer that is not an important consideration for senior management of an entity and fulfilling their governance responsibilities is D you can't abdicate your responsibility for monitoring financial reporting. Senior management is primarily. Responsible for the financial statements and they're primarily responsible for designing and implementing and monitoring internal controls over financial statements.

They can not. Abdicate that responsibility to external auditors. However, they do need to make sure that they are doing a, B and C to make sure that they understand financial statements, standards themselves, that they make sure that everybody understands their role and responsibility in internal controls over financial reporting.

And they want to make sure that adequate resources are devoted to hiring and retaining qualified individuals to ensure that you have adequate financial reporting competencies.

The other question was, which of the following is a management control method that most likely could improve management's ability to supervise company activities effectively. Is it a monitoring compliance with internal control requirements imposed by regulatory bodies. Be limiting direct access to assets by physical segregation and protective devices.

See, establishing budgets and forecast to identify variances from expectations or D supporting employees with the resources necessary to discharge their responsibilities. So what's going to enable management to improve their ability to supervise company activities. Effectively. The best answer is C to establish budgets and forecasts to identify variances from expectations.

We're now going to discuss yes. Internal control over financial reporting. And if you remember from an earlier section, when we were talking about different definitions, I said that the definition of internal control over financial reporting was a process. Affected by the company's board of directors management and personnel, that's designed to provide reasonable assurance regarding the reliability of financial statements.

So if you recall correctly, we talked about it being a process where it was an integrated system of controls that all work together to reduce risk, to ensure reliable financial reporting. The effectiveness of internal control over financial reporting involves a lot of judgments because the design of the system is a matter of professional judgment to determine what's necessary to put in the system versus not, and to try and make some judgment calls also around what things need to be functioning effectively for there not to be a material weakness in the financial statement.

So there's really five components of internal controls that are important elements of a good system of internal control over financial reporting. Now, this doesn't mean that all five components have to function at the same level. And it also does it mean that there's a set. Design of controls that needs to be in existence for every single entity.

In order for it to say that it has a effective system of internal controls over financial reporting. But what it does mean is that you have to understand the five different components of internal controls so that you can properly design the system, using elements of each of those in order to create a process as a whole.

So controls in one component may serve the purpose of controls that might normally be in another component. Or there might be several controls that all work together in order to meet that sat to satisfy, actually meet the objective of generating the reliable financial statements. So let's talk about the different components of internal controls and the components that we're going to discuss are the ones that are in the COSO internal control, integrated framework.

So you remember from our earlier section, Kozo stands for the committee of sponsoring organizations and it designed this integrated framework that is the most widely. Used framework in the world, as it relates to designing internal controls over financial reporting. The very first component out of this COSO integrated framework is the control environment.

So the control environment sets the control consciousness of the organization and sets the standards that everybody follows around ensuring reliable financial statements. It's the foundation for all other components. And in fact, in a later section, we're going to talk more about the control environment in more detail.

The second component of the COSO integrated framework is risk assessment and what's involved with risk assessment is identifying, evaluating, and analyzing. Things that might keep an organization from having reliable financial statements. So those are risks. So you identify risks that were either happened to an organization because there's things that could occur internal to the organization, like turnover of key staff, or it could be a risk that happens outside of the control of the organization or an external risk, like changes in the economy or interest rates.

So the job of management and governance is to properly identify all the things that could impact a entities, financial statements, and to evaluate the magnitude and likelihood of those things happening and to analyze and decide which of those risks they need to design controls around to manage those controls and mitigate those controls so that you're not creating misstatement in the financial statement.

So risk assessment is going to look at the ability the, of the organization to record and process and summarize and report financial data. That's consistent with the management's financial statement, assertions. It may be a very formalized process, or it might be something that's less formalized and less structured for smaller entities because smaller entities are naturally going to face fewer risks.

So out of the five components, we talked about the control environment and we've talked about risk assessment. The third component of the COSO framework is information and communication. It has two aspects to it. One of them is. The information systems used or that are used to produce reports containing operational financial and compliance related information.

That's critical for running and controlling the business. This information is going to include all internal and external information. That's pertinent to the financial statements and the things that must be identified and captured and communicated in a form and a timeframe that enables people to carry out their responsibilities effectively.

So in essence, it's the nerve center of an internal control system. So beyond the information systems themselves, there also is this aspect of communication and communication means that there is a robust and open dialogue about the data and the information necessary to create reliable financial statements.

So that's information that must flow up through the organization from the lower levels of the organization, upwards to management, the things that must be communicated from management down. Things that must be communicated across departments or must be communicated with legal counsel or the external auditors or regulatory bodies.

So it's looking at all forms of communication that enable and support the understanding, the execution of internal control objectives, processes, and responsibilities. It's important for this communication to emphasize that people need to have a clear message from the top about the seriousness of their internal control responsibilities, and they must understand their role in the system of internal controls and how their activities that they perform relate to the work of others.

So the interrelationship of all the controls and how, what the activities, that one individual performs, how it impacts the ability of other individuals to fulfill their responsibilities as well. And as we mentioned, this communication is not just internal, but also who does the organization need to communicate with external to the entity, which may include customers, suppliers, shareholders, external auditors, regulators, and similar type bodies.

So with the five components of the COSO integrated framework, we've discussed control environment, we've discussed risk assessment, we've discussed information and communication. And the fourth thing we're going to discuss is control activities. So once an organization has set the right tone in the organization around the importance of internal controls.

And once they have decided what risks they need to manage, they need to go through the process of managing those controls. And so the control activities are the actual policies and procedures that help ensure that management's directives are carried out. It's the actions that are necessary to address the risks that were identified as possibly influencing the achievement of the entities, financial reporting objectives, control activities can occur throughout the organization at all levels of the organization, in any function of the organization.

It's the things that happen all the way from when things are. Processed initiated and authorized and processed through the system to the reconciliation and review of activities that come out of the system all the way through creating the financial statements. So the range activities can be very diverse and it can be something that's done through various levels, various people, various functions, it's everything from processing and recording things.

Approving things, reconciling things and reporting things in the financial statements. Control that  is different than control objectives. And so I want to make sure that you don't get confused about that. The two different terms are very distinct in their meaning. It control objective is the target that management establishes that sets that the goal that they're trying to meet.

So it's typically stated in terms that describe the nature of the risk that this control is designed to help manage or mitigate. So for example, A control objective might be that all transactions should be properly authorized. So the objective is to ensure that all transactions are properly authorized.

The control activity is going to be the actual authorization of transactions. Who does it, when do they do it? How do they do it? How is it documented? So it's not the why we're doing something, which is the control objective. It's the control activity is the, what you're doing when you're doing it, how you're doing it.

So the four components of the COSO integrated framework that we've talked about so far control environment, risk assessment, information, and communication and control activities. The fifth one that we're going to discuss. And it's the final component of the COSO framework is monitoring. Monitoring.

Helps make sure that all these controls that were designed to function a particular way, that's, what's actually happening over the course of time. So it's an ongoing assessment around the quality of the internal control process. And it also involves considering whether or not there needs to be corrections made into the system in order to strengthen and improve the system of internal controls over financial reporting.

Monitoring could include separate evaluations, things that are done periodically by internal audit or through a control self assessment or things that had done that are performed every year. As you close out the financial state events, or it could be things that are or performed or activities that are performed on an ongoing basis, just through the normal course of business and how people generally carry out their risks, abilities.

So monitoring ensures that controls are. Or appropriately operating as effectively as possible. And they're also looking to see whether or not there needs to be modifications or changes to controls because of changing circumstances in the entity, its environment. This may involve communications from outside of the organization, like customer complaints may alert somebody within the organization to let them know that perhaps.

Goods are being shipped out without the right number of items being in the package. So the monitoring can also include external parties and the information that you might gather from them about the operating effectiveness of controls. So we've talked about the five components of the COSO integrated framework, communication, the control environment, risk assessment, information, and communication.

The. Control activities themselves and monitoring. What I'd like you to do is to go ahead and answer the next series of questions. And then we'll pick back up with our material.

Welcome back. Let's debrief the answers to the questions that you should have answered on your own already. Okay, which of the following is not a component of an entity's internal control? Is it a control risk B control activities? See the information and communication systems or D the control environment.

The answer, the correct answer is a controlled risk. The one that is not a component of an entities, internal controls is control risk.

The components of the control internal control are, as you recall, the control environment, risk assessment, information and communication control activities and monitoring.

Which of the following factors would most likely be considered an inherent limitation to an entity's internal control? Is it a, the complexity of the information processing system, B human judgment in the decision-making process? See the ineffectiveness of the board of directors or D the lack of management incentives to improve the control environment.

The answer that would most likely be considered an inherent limitation in an entity's internal control is a, the complexity of the information processing system itself.

Talk about enterprise risk management and enterprise risk management, or erm, as you're commonly going to hear it refer to is a principle that takes the COSO integrated framework. Related to internal controls and enhances it to have it really start thinking about how do we use our systems to provide value to all of our stakeholders.

So that's the underlying premise of, erm, is that every entity exists to provide value for its stakeholders. And management's challenge is to determine how much uncertainty to accept as it is striving to grow that stakeholder value. Management needs to be able to effectively deal with uncertainty and associated risk and opportunity while still enhancing value for its stakeholders.

That means they have to make choices. They have to go through the process of saying how much risk am I willing to accept in order? For me to expand my revenues or for us to reduce our costs or for us to make an acquisition  to grow our business, geographically, all of those things are opportunities that are available to accompany to that may enhance.

Shareholder value or stakeholder value, but there is going to be some relative risk that those decisions will not end up in the way that we would hope they would. So in order to ensure that they are meeting those objectives of creating value, the organization also has to look to see how it is that they're looking at compliance with laws and regulations and operational effectiveness and efficiency and generating reliable financial statements.

There's lots of objectives that all are important to the organization and all of them are going to have consequences for the organization. If those objectives aren't achieved. So enterprise risk management is a process that's affected by an entities board of directors management and other personnel, which is applied in strategy setting across the enterprise.

It's designed to identify the potential events that may affect the entity and helps management to decide what their appetite is for risk and helps them decide how it is that they could design controls and activities to provide reasonable assurance that they're achieving entities objectives within that risk appetite that they've established.

Elements of enterprise risk management, start with making sure that they know what risk appetites are for the organization and what are the different strategies that they could apply in trying to align their alternatives with their objectives that they're trying to achieve and tried to figure out what are the mechanisms that we're going to develop to manage these related risks.

Sounds a little complicated, but let's talk a little bit more about it. And I think it'll start making a little bit more sense to you. They have to decide when they identify a risk and that's going to be very similar to back. When we were talking about the COSO internal control integrated framework, we said that you're going to identify the internal and external things that could occur.

In an organization and decide what's the likelihood and magnitude of that happening, and then deciding what it is that you're going to do about it. It may be in some situations that the risk is there, but the magnitude of the risk wouldn't be all that great. It would be relatively inconsequential or trivial.

So while it's possible for this threat to occur, it really wouldn't have a big impact on our financial statements in that case. The entity may decide to just accept that risk. It's a risk we're willing to live with. In other cases, the impact of the risk might be so material and so significant to the financial statements that the entity might decide to avoid the risk.

And they might decide not to engage in that particular strategy. They also might decide that they could reduce the risk. So it's a big risk that something that could go wrong, but we can put some mitigating or compensating controls in place to try and reduce the risk down to an acceptable level.

And then the fourth strategy that they could take in looking at how to respond to risk would be to share the risk. And so a lot of times where you see organizations that joint venture with another organization is to too. Get into a particular product or service line or to engage in, in acquiring a company.

They might decide to do that with an another organization in order to share the risk. And so then their portion of the risk is at an acceptable level. So what they're trying to do is to rigorously identify what could go wrong and to try and decide. What do we want to do about it? What is the possible responses that we could have to these risks that we identified?

I can either avoid them. I can accept them. I can reduce my risk or I can share my risk. The goal at the end of the day is to try and reduce any surprises that might. Come along that would severely impact the financial statement. So you're trying to minimize your losses. You're trying to make sure that you are doing this process in such a way that you're reducing any surprises in any associated costs or losses that would come along with those surprises.

Things that we didn't anticipate, because hopefully you've gone through a very rigorous process of identifying all the things that could go wrong so that when they. If they do go wrong, you've already dealt with the situation by already have made that decision about what we knew this was going to happen.

And we decided to accept the risk and it's okay.

Enterprise risk management or erm, By calling it enterprise risk management is emphasizing that governance needs to think about the enterprise as a whole. So you're trying to look across multiple business units. You might be looking at a multi-national operations, something that happens on a worldwide operation and trying to go through and identify the most important things that could go wrong for the entity as a whole.

Erm, isn't necessarily appropriate for looking at things on a business unit by business unit level. It's really looking at managing risk at an enterprise level and looking at the interrelationships of. All the different risks that are out there that might exist at the individual business unit level.

So that's a key part of, erm, is that it's enterprise wide, that it's focused on identifying risks or what could go wrong. And it's emphasizing rigorously trying to go through the process of deciding what way, in what way do I want to respond to those risks? Do I want to void them, reduce them, share them or accept them.

Okay. When you're looking at all of the potential things that could have happened, that could occur all the internal and external events that could occur and you're identifying them. And you're trying to figure out what the outcome could be. You're also making decisions about how to use your resources.

And how to deploy your capital within the organization. Management needs to think about where they have the biggest opportunity to meet their objectives. Be at a financial reporting, objective and operational improvement, objective compliance with laws and regulations, objective, or a strategic objective.

Where's our biggest opportunity and let's make sure that we're looking at our capital needs and our allocation of capital to all those needs, and that we're appropriately allocating our capital in the ways that are gonna ultimately hopefully result in the biggest opportunities for the organization.

So it's important for management to use information, that's going to help them in their oversight role to ensure that they're moving towards the achievement of what they've determined to be their most critical.

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My name is Kevin Kemmer and I'll be your instructor for today's discussion on the area of economics. Economics is the study of the allocation of scarce resources among alternatives. Again, the economics is the study of the allocation of scarce resources among alternatives. So you can tell by the definition of what economics is that we're assuming that resources are limited.

And human desires of people are unlimited. And so we have this problem of how to allocate those limited resources among alternatives. There are two major areas in economics that we typically think of micro economics and macro economics. And I'd like to begin today's discussion with micro economics.

And you can just take the word from micro economics, micro outta there, that microscope. And that's what we're going to do. And microeconomics is take a really close look. So Weicker economics deals with the economic decisions of individuals that is buyers or consumers, and the firms that are providing the goods or services.

Those are the sellers in pursuit of maximizing satisfaction. Again, microeconomics deals with the economic decisions of individuals and firms in pursuit of maximizing satisfies.

Now the law of demand says that the quantity purchased of a good or service is inversely related to the price, all other things being equal. So what does that mean? If the quantity purchased of a good, a services inversely related to the price, that means that when the price goes up, demand is going to go down.

And when the price goes down, demand is going to go up several times. Factors could affect demand for our product, a good or a service first factor that we'd like to talk about is closely related goods. Okay. What I'm talking about here is something called the cross elasticity of demand. How related goods can influence the demand on other goods.

And the more closely that two goods are related, then the greater, the influence on the change in demand of the other product. For example, let's talk about substitute guts, substitute goods, or closely related goods. For example, margarine and butter. I go to the store and I could buy margarine or I could buy butter, I can use them interchangeably.

And so if the price of one of them is going up, then I might choose to buy the alternative. They're just like, they sound that one is a substitute for the other examples of substitute goods would include things like Manet's and coolant movies at the theater versus renting a movie and watching it at home.

Buying chicken or buying Turkey, chicken, and Turkey or substitutes again, when the price of one good goes up with substitutes, the demand for that product tends to decrease as some consumers purchase the substitute. So what's going to happen is the price of butter goes up. Then I'm going to stop buying butter and I'm gonna Stipe start buying margarine so we can see that substitutes.

With substitutes that when the price affects one, the D the price goes up. Demand is going to go down. We'll just go and buy the substitute. Instead, other closely related goods would include compliments. And these are items that are, that go together. For example, hot dogs and hot dog buns, peanut butter, and jelly camera's and rolls of film razors and razorblades.

And my favorite surfing turf, a little prime rib and lobster, and with compliments, when the price of one of the goods goes up, the demand for that product, as well as its compliment tends to decrease again with compliments, when the price of one good goes up, the demand for that product and its compliment tends to go down.

And of course the opposite is true. If the price of one good goes down, The demand for that product and its compliment will tend to increase, but there are other factors that can also affect the demand for goods. The next factor I'd like to talk about is income. Now as personal income increases, as my income increases, the demand for normal goods tends to also increase.

And conversely, if my income goes down, Then the demand for normal goods will go down. For example, steaks. When my salary goes up, I may buy steaks once a week instead of once a month. And if my salary goes down, then I may choose to not buy any steaks at all and just eat hamburgers. Another example of a normal good would be something like airline tickets.

As personal income increases demand for airline tickets goes up, but if personal income decreases the demand for airline tickets goes down. On the other hand, there are some products when our income increases that the demand for those goods will actually go down. For example, when my income goes up, I may choose to buy less potatoes.

In that case, this is called an inferior. Good and inferior. Good. When you have inferior goods, the increase in personal income will result in a decrease in the purchase of those inferior goods. And the opposite is true as well as personal income decreases. Then the demand for inferior goods is going to increase.

So if all of a sudden I have a big cut and my income, then I will probably stop buying normal clothing and start buying used cars, clothing, which is usually perceived as an inferior. Good. Another factor that affects demand for goods is future price, expectations, future price expectations. If consumers expect that prices are going to go up in the future.

Then the current demand will increase as people look to buy those goods and services and enjoy them. Now, before the price increases take effect again, if consumers expect future prices to be higher, the current demand is going to increase because people want to enjoy those goods and services now at the lower prices and not buy them later when the prices are higher.

And of course the opposite is true in this situation. If consumers expect future prices to decrease or to lower than the current demand is going to decrease, as people will defer the purchases until prices go down. Other factors that affect the demand for goods include things like consumer preferences and market size group actions like boycotts as far as preferences go.

Consumer preferences can change over time. So during a certain period of time, certain styles of clothing might be in fat or in fashion. And therefore the demand for those goods would be larger or higher or greater. And in other times, maybe those fashions would no longer be fashionable. And the demand for those goods would decrease with respect to market size.

When the population tends to increase, there also tends to be changes in demand and they could be increases or decreases. And certainly things like boycotts, boycotts are going to result in no demand. When people boycott something, then they stopped buying it all together.

I'd like to do it. This time is to take a look at a graph. I know a lot of students get a little hesitant about these graphs and get a little bit concerned about them. So I want to make sure that you're able to read the typical graph that we use in economics. And if you would look in your viewers guide the first figure that I have, it's titled the demand curve for video conferencing time.

I'd like for you to take a look at that. And I want you to notice we have two axes you'll recall that the vertical axis usually known as the Y axis. You'll notice that I have it labeled there. It's the price per hour of video conferencing time. The X axis is the horizontal axis and that typically has the quantity of units.

Excuse me, the quantity of units in this case would be the thousands of hours of conferencing time. So again, you've got PS and QS and teachers and people used to tell you, your parents used to tell you to mind your PS and QS. So you can remember that graphs are a bunch of PS and QS. The P's are on the vertical axis, the Y axis and the QS, the quantity go on the X axis.

Now what I have there. When you look at that graph, you see a curve and this is a demand curve for video conferencing time to make sure that everyone's comfortable with reading this. If you go to the Y axes and go down the prices per hour, dollar $90 80, until you get down to a dollar 50, you'll notice that I have a line drawn from a dollar 50 over to the demand curve and then align.

Downward or vertical from there down to the x-axis so that you can see at that point, when the price per hour video conferencing times a dollar 50, the demand is 4,000 hours. Now this demand curve represents a whole series of demands at various prices. So we can move down this curve. In fact, if you move down the Y axis from a dollar 50 to a dollar 30, you'll notice that we slide down the curve.

And if you follow the horizontal line from the dollar 30 over to the demand line, and then the follow the vertical line from the demand curve down to the X axis, you'll find that the demand at the price of a dollar 30 per hour is six, a thousand hours. Does this follow what we said about demand? It doesn't it?

We said that the demand is inversely related to price. So as price goes down, demand will increase. And that's what happens here is price went from a dollar 50 down to a dollar 30. The demand would increase from 4,000 hours to 6,000 hours. You find another third figure in your, another graph in your viewers guide.

And this is titled demand curves, and I have not just one curve on here, but I actually have three curves for representing demand for video conferencing time. And excuse me, what I'd like you to note is that there are three demand curves. The middle one is labeled just D let's start with just D there you'll notice that using the demand curve labeled D the price, I have a line drawn from the price of a dollar 45 over to the demand curve, and then down to the X axis.

And you'll find that at a dollar 45 consumers are demanding 5,000 hours of video conferencing time. What the other curves represent are shifts in demand. This is different than sliding down the demand curve like we did in the previous graph. If you look at the demand curve labeled D sub one, you'll notice that what happens here is as you follow that dollar 45 line.

From the price per hour though, the Y axis, he followed that over to diesel one. You'll find that the intersection of that demand curve is 7,000 hours. So what's happened between the curve D and the demand curve diesel one is we've experienced a shift in demand at the same price, a dollar 45 consumers under the D one curve are demanding 7,000 hours.

Instead of 5,000 hours now, why would there be a shift in demand like that? One example could be that there was an increase in the price of a substitute. Maybe there was an increase since we're talking about video conferencing time. It might be a little bit of a stretch here, but let's say that the prices of airline tickets go up and therefore we're not, companies don't want to send as many employees out to visit other companies.

So they would rather do teleconferencing video teleconferencing. So because the airline prices are going up, there'll be less demand for airline prices, which will result in an increase. In this particular kind of substitute instead of demanding 5,000 hours now demand is 7,000 hours. There are other reasons why there would be a shift to the right or an increase in the demand curve from D to D S of one.

We could also have a decrease in the price of compliments. For example, let's assume that these demand curves related to prime rib and lobster, or I'm sorry, let's just say prime rep. Okay. And the price of lobster goes down. If the price of lobster goes down, then more people like me will want to buy more surf and turf, which means that the demand for prime rib will go up since the demand for lobster is going to go up because of the decrease in price of lobster.

So that would cause a shift from D to D sub one. Another reason why the demand curve would shift to the right. Is an increase in consumer income. If I get a 20% raise from one year to the next, then I might be more inclined to go out and buy more surf and turf. And that's going to shift the curve to the right and increase in demand.

What about diesel to the demand curve? Diesel two represents a decrease in demand. A shift to the left is a decrease in demand here and. Why would that happen? One possible explanation would be a decrease in the price of a substitute. So if maybe we had a decrease in airline tickets, then we'd be more inclined to send people face-to-face to meet our clients.

And not as much demand would exist for video conferencing. Since we're sending the people out to the companies, meet them face to face. That would result a shift to the left. Another reason for shifted left would be an increase in the price of a compliment notice. This is just the opposite of the shift to the right we've shifted to the right.

We had a decrease in the price of compliment. If we have an increase in the price of a compliment, it's a shift to the left and of course, decrease in income. If we have a decrease in income, then I'm going to buy less prime rib, or I'm going to buy less video conferencing time. So we'll have a shift to the left.

The other thing that I wanted to mention about these demand curves is you'll notice the direction that they go. They tend to be downward sloping. And again, that represents the fact that the quantity demanded is inversely related to the price. So as the price goes down, the demand will increase. That means we're going further over to the right.

So it's going to. Be a downward sloping curve. And the way you can remember that is down for demand or demand slopes down the D and demand and downward.

What I'd like to talk about now is talk about supply. Supplies the quantity of a good or service that sellers are prepared to sell at a given price at a given point in time. Again, supply simply represents the quantity that of good or a service that sellers are prepared to sell at a given price at a given point in time.

And the law of supply says that the quantity of a good or service sold is directly related to the price. All other things being equal. Again, the quantity of a good or service sold is directly related to the price, all other things being equal. And what that means is that when the price goes up, supply is going to increase.

And when the price goes down, supply is going to decrease you stop and think about it. We said all other things being equal. If the price of a good goes up and all of the things were being equal, including the cost to produce that good. Aren't the companies that produce the good one, going to want to sell more since it's at a higher price and it has higher profit margin.

Absolutely. And that's why when the price goes up, the supply increases, when the price goes down, the supply is going to decrease. Now, there are several factors that can affect the amount of supply. The first we'll talk about is production costs. If production costs were going to increase, for example, let's say that there are taxes that are now enacted they're slapped on video conferencing time.

What is the effect of taxes on our video conferencing time going to have to do have on our supply? What's going to end up happening is all of the things being equal with the production costs being higher. There's going to be a decrease in supply. Why? Because if the price hasn't changed, remember all of the things being equal.

If the price has not changed and there's an increase in the cost to produce that product, then the profit margin is going to be less. And so there's going to be less reason or less incentive for the company to supply that. So they'll decrease the supply of the goods adversely, any decreases in production costs due to things like lower wages to our employees lower supply costs, maybe subsidies.

All of these things would result in a reduction in our production costs. And if you keep everything equal, including the price. Then that's going to result in higher profit margins for the company, and they're going to be willing to supply more at a higher profit margin. So any decreases in costs are going to result in an increase in supply technology also affects supply.

If we experienced technological improvements in the production, then that will result in an increase in supply because typically the technology improvements is going to decrease the cost, or we're going to be able to produce more. For the same cost overall. So the average cost of production is going to go down and that's going to increase profit margins.

So the company is going to be willing to supply more. A third factor affecting supply is the prices of other goods. Let's say that both goods, X and Y are made with the same inputs, the same materials, but the price of Y has gone up. Now if the price of Y goes up, then producers are going to want to produce more of why, because as long as the costs haven't changed, but the price of Y goes up higher profit margins and the less of good X that they're going to produce, because if the price of the materials have not changed, then the supplier will make a higher profit margin on Y.

So the prices of other goods as those prices change. Could impact what the supplier is going to produce.

A fourth factor affecting supply would be price, expectations, an anticipated increase in the price of a good will cause a firm to supply less. Now. And more later when that anticipated price increase arrives again, because they can sell it later at a higher profit margin, if they're anticipating a price increase.

So price expectations affect supply.

If you'll go back to your viewers guide, like for you to look at another graph, I have a graph in there that's titled supply curves for video conferencing time and it has three supply curves. And you'll notice right away that, in that graph that the supply curves are all upward sloping. Okay. They're all Oprah sloping, which pretty much reflects the fact, excuse me, that for supply, when the price goes up, suppliers are willing to supply more.

So I remember the supply is an upward sloping because the UPP and supply and the, and upward, so demand is downward sloping. The supply curve is upward sloping. Now let's look at the middle curve here, the one that's just labeled. Yeah. Ask at a price of a dollar 45 cents per hour. Suppliers are willing to supply 7,000 hours of video conferencing time.

Again, all I have to do is follow the line going from a dollar 45 on the Y axis until it intersects the S demand curve, and then follow the intersection going down to the X axis. And we follow that line down. We come to 7,000 hours. Okay. What happens if we go from S to say as to why would there be a change here?

I think I want to point out we're not moving up and down the same curve what's happening here is you go from S to you're experiencing an increase in supply. Y will follow that dollar 45 cent line over until it reaches S two. And then you go down to the x-axis and you'll see that at dollar 45 on the S two supply curve, suppliers are willing to supply 9,000 hours as opposed to the 7,000 hours they were willing to supply for the demand curve, just labeled S so what would cause that increase in supply from 7,000 to 9,000 hours?

One reason might be a decrease in production costs. If the company is able to produce those video conferencing hours for a cheaper price, whether it's due to an improvement in technology or some other production costs, then they're willing to supply more because they now have a higher profit margin.

Again, we're holding everything else. Equal price being equal. We have a lower production cost. That's going to be a higher profit margin. Suppliers will be willing to supply more. Another reason why there might be a shift from the S demand curve to  an example would be a decrease in the price of other goods if other goods decrease in price.

Okay. Then the profit margin is not as good. And so it'll shift. What about shifting from S to S one what's happening there? We have a decrease in the supply. And that could be caused because of an increase in production costs. If our costs are going up, whether it's because wage increases or just supply costs are going up or subsidies have been discontinued, all of those would result in higher production costs.

If we have higher production costs, but the price that we sell it at doesn't change. What happens to your profit margin? It goes down and so suppliers don't want to sell it at a lower profit margin. So they'd be willing to supply less. So there would be a shift from 7,000 hours to 5,000 hours.

One more graph that I'd like for you to take a look at and I've titled it demand supply and market price for video conferencing time. And what I've done here is I put both a demand curve and. A supply curve on this graph. And this is important to us because when we put the demand curve and the supply curve on a graph, we'll be able to determine what the equilibrium point is in a free market.

What is the quantity of goods that will be supplied and at what price. And so if what we would do is find the intersection of the demand curve and the S curve there, this demand curve and supply curve. And I've labeled that point E and I've drawn a line, a horizontal line over to the y-axis. So you can see what the price is, a dollar 30, and I've drawn a vertical line down to the X axis to six.

And that at a price of a dollar 30 per hour. Suppliers and buyers they'll have an equal Librium exchange of 6,000 video conferencing hours.

I'd like to talk about now is the concept of elasticity. They last too city is the measure of the sensitivity or the responsiveness. Of quantity demanded or supplied to a change in a determinant of that demand or supply. The reason why say demand or supply is because there are different measures of elasticity.

And the first one that I'd like to talk about is the price elasticity of demand. So if we're talking about the price elasticity of demand, we're talking, measuring the sensitivity or responsiveness of quantity, demanded. To a change in the price of the good again, the price elasticity of demand is a measure of the responsiveness of the quantity demanded to a change in price.

So if prices change, how does the demand? There's a couple of people that we can determine how elastic the demand is. And the first way that we could go about it is by using a formula approach. Now the measure of sensitivity or responsiveness or quantity demanded and using a formula. What we have to do is we have to look at the responsiveness of the change in demand, and that's going to be one measure.

And then we're going to divide that by the percentage change in price. Which is in the denominator and then put those two together. So it's a sort of a large formula and we actually have two different formulas. There are two different methods of approaching the formula for the price elasticity of demand.

So let's begin with the simple method and just it sounds, it's simple. It's easier. What you're looking at is the response on this quantity demanded. The percentage change in demand. We're going to take the demand after the price change, subtract out the demand before the price change and divide it by your starting point the demand before the price change.

And so that gives you the percentage change in demand. That will be your numerator for the price elasticity of demand. Then in your denominator, you're going to look at the percentage change in price. So prices are going to change from P one, the P two. You're going to look at the change in price. That will be P two minus piece of one or P one.

And then you'll divide that difference by the original price, the starting price. So it's very simple in that, in your little calculations that. Little denominators, if you will, are just the starting points. So when you look at the percentage change in demand, you're using the original demand. When you look at the change in price, the percentage change in price, you're looking at the price.

Okay. And one thing that I need to comment on here in doing the computing, the price elasticity of demand is that we use absolute values. So price goes down, say from a dollar to 75 cents. You actually have a decrease in price. And when you take that change in price, it'll be minus 0.25. For price elasticity of demand, we'll take the absolute value instead of just use 0.25 instead of using the minus point.

Let's look at an example, using this simple formula. Let's assume that we have a hot dog vendor and every day at the rush lunch hour. The hotdog vendor sells his hotdogs for a dollars per hot dog, $1 per hot dog. And in the normal lunch hour, when he has that price of a dollar, the vendor's able to sell 100 hot dogs.

Let's say the supplier, the vendor wants to change the price and see what happens to demand. And the vendor decides to reduce the price to 75 cents per hot dog. And when the vendor changes the price of the hotdogs to 75 cents results in 150 hot dogs being sold well, let's compute the price elasticity of demand for the hot dogs using the simple formula.

Now, again, the simple formula is the percentage change in demand, divided by the percentage change in price. So let's do our percentage change in demand first. The demand originally was a hundred, went up to 150. So to get the change, we take the 150 after the price change, subtract out the starting point of a hundred.

So 150 minus a hundred, we'll give you 50. And then we have to divide that by what our starting point simple formula using just that one starting point and the starting demand was 100. So we've got a 50 unit change divided by a hundred that's 50% now let's do the denominator. That's looking at the percentage change in price went from $1 to 75 cents.

So we're going to take D two or excuse me, P two, the price after the change that was 75 cents subtract the starting price of a dollar P one. And you're going to get minus 0.25. Again, we didn't use the absolute value. So make sure you just use 25 cents here. And then in the denominator, we're going to divide that by the starting point, the original price, which was a dollar.

So we've got 25 cents divided by a dollar, and that's going to give you 25%. So we've got 50% in the numerator, 25%, the denominator, the price elasticity of demand for hotdogs here is two. Now what that number tells us is how elastic demand is. And there's a rule when. The coefficient is greater than one.

Then we say that demand is elastic. In other words, it's responsive to price changes.

Now let's look at the computing, the price elasticity of demand using the arc method. Now the arc method, instead of using. One starting point. In other words, the original demand or the original price, depending on which part of the formula end, you actually want to use an average. So the formula for price elasticity of demand would be the change in demand B two minus D one divided by the average demand.

While the average demand is D one plus D two divided by two. So now in the denominator for that part of our formula, we've got a lot more than just that original . We'll do the same thing in the percentage change in price. Part of the formula, we'll take P two minus P one and we'll divide that by the average price.

In other words, P one plus P two divided by two. So if we use go back to our same example with the hotdog vendor, a dog vendor was selling a hundred hot dogs. And the lunch hour at a dollar each. And when the vendor reduced the price to 75 cents, the demand went to 150 hot dogs. Let's fill in our numbers here for formula using the arc and method.

We're going to have 150 hot dogs minus a hundred. So we have a 50 hot dog increase, and we're going to divide that by the average demand or the average demand. A hundred plus 150 divided by two is 125. And that's going to give us 40% as the percentage change in demand for hotdogs 40%. Now let's look at the denominator part of the formula.

Let's look at the percentage change in price. That's going to be the new price P two, which is 75 cents. Minus the starting price. Dijuan which is a dollar we're going to have a minus 25 cents. And again, we'll take the absolute value. So we're going to have 25 cents in the numerator here for the percentage change in price.

We're going to divide that by the average price. We had a dollar plus 75 cents divide that by two, and you're going to get about 87 and a half cents. So the percentage change in price comes out to be about 0.2857. Now we have our numerator 40% divided by our denominator of almost 0.29. And the price elasticity of demand using the arc method would be 1.4.

So even though we're using a different method, we still come up with the coefficient that is elastic because it's greater than one. So again, this indicates that this demand of hotdogs is very responsive to changes in prices. No. What I'd like for you to do is to look in your viewers guide. And I have a graph there that I've entitled demand curve showing different elasticities, and you'll find three curves actually on this graph one's labeled D one D w sub one. Once the sub two let's look at the middle. A line here, that's labeled D and it says that it's unit elastic.

What is that? And how do we know? The man is unitary elastic or unit elastic. If the price the coefficient is equal to exactly one. How are we going to compute that? Let's look at that D demand curve. You'll notice that I have a line drawn from the Y axis, which is where we have the price.

And we have a price there equal to 10 and draw the line over from 10 over to the demand curve and then down to the X axis. And we see that it intersects at a quantity of 1,600. So at that point on the demand curve at a price of 10, there's a demand of 1,600. Now, if we want to get the price elasticity of demand for this demand curve, we have to pick out another point that we're interested in.

Let's say that we dropped the price to $8 again, go to the Y axis where the price is eight and nine. Draw a line over to the D demand curve and then down to the X axis. And that the quantity demanded. On the curve there at the price of $8 is 2000 units. So by dropping the price from $10 to $8, demand goes from 1,600 to 2000.

So it is responsive to the price change. And the question is, how responsive is it now in coming up with this graph, I've assumed that we're going to use the arc method and computing the price elasticity. So let's compute the price elasticity using the arc method as we change from the price of $10 to the price of $8.

What's our formula. We want the percentage change in demand. We've got an increase of demand of 400 units, and we're going to divide that by the average demand. The average would be 1,800. Because we have the 1600 plus the 2005 by two. So we've got four divide, excuse me, 400 divided by 1800. As the percentage change in price.

Let's look at the percentage percentage change in advance. Excuse me. Now let's look at the percentage change in price. We went from 10 to eight. That's a decrease of two. Of course, since we're dealing with the price elasticity demand, we're going to use the absolute value. We're just going to worry about the difference, which is two.

Not worried about that. The price went down. So it's a price of two price change of two. We're going to divide that by the average price. 10 plus eight divided by two is going to give you nine. So we have in the percentage change in price, $2 divided by $9 and 400 divided by 1800. Then divide that by two divided by nine and you have 1.0.

So that demand curve is indeed unit elastic using the arc method. What about diesel one? The suborn is labeled elastic demand and elastic demand. As I mentioned previously means that the coefficient must be greater than zero. And we can compute that if we looked at. Use the art method you're going to find.

And I encourage you to do that on your own that the coefficient will be greater than one. If you were to look at diesel too, as the price changes from 10 to eight and compute the coefficient of the price elasticity of demand, you're going to get a number that is less than one. And when the coefficient is less than one, that indicates that demand is in elastic.

Now in looking at this graph with these three different curves, we've come up with three different types of elasticity, elastic, unit elastic, and inelastic. But one of the things that I want to make you aware of is just because you look at the change from one price to another price on a demand curve.

That doesn't mean that prices all along that curve are the same elasticity. In other words, the sub one, when we looked at here is elastic, but only from the price of 10 to eight, if you go to your viewers guide, I have another graph also called demand curve, showing different elasticities, and it's simply one curve.

And again, if you are to compute the price elasticity of demand, as you go from the price of 10 down to the price of five, You'll find that demand is elastic as we go through that price change. As we go through the price change of five down to zero, you'll find that demand is in elastic so we can have one demand curve and different parts of that demand curve will represent different levels of elasticity.

What goods tend to be elastic and what goods tend to be any lasted. Why did he give you some example of goods that have a tendency to have a price elasticity of demand that we would consider Lastic? In other words, greater than one luxury items tend to be elastic, large expenditures, durable goods, refrigerators, cars, substitute goods tend to be elastic.

And goods that have multiple uses. Again, lasted goods, include luxuries, large expenditure items, durable goods, substitute goods, and multiple use items. Goods that tend to be inelastic include necessities, small expenditures, perishable goods, complimentary goods, and those that have limited uses yeah. Goods that tend to be inelastic include necessities, small expenditures, perishable goods.

Complimentary goods. And those with limited uses, I have another set of graphs in your viewers guide. I'd like for you to take a look at, just to give you almost all the different possibilities. If you go to the graph and your viewers guide, that's entitled three demand curves showing different elasticities.

You'll see that it has three, three graphs in there. We actually have a graph B and a graph C graph, a simply represents the demand curve. That is completely horizontal. In other words, at the same price, we would have various demands, various quantities demanded that demand curve is perfectly elastic.

In other words, there's no change in price yet. We have a great responsiveness in the quantity. Demanded graph B you have a vertical line for a demand curve. And this demand curve is perfectly any Lastic. In other words, we can change the price a lot, but it's not going to change. The quantity. Demand is not responsive to changes in price.

In the last example, in section C, there you have a curve that represents perfectly unit elasticity.

Now another approach to. Determining elasticity would be using the total revenue approach. Number revenue, total revenue is simply price times quantity. So since in looking at elasticity, we're wondering how does demand change with changes in price? What we can do is look at the change and total revenues, and we have a number of possible situations here.

If prices were to increase in total revenues were going down. Demand would set to be elastic. Remember the coefficient is the responsiveness to the changes in demand to the changes in price. Okay. So if prices increase in total revenues, go down, we're having a bigger impact on quantity than the change in price.

If prices increase and total revenues remain the same, this is an example of unitary elastic. In other words, we have exactly the same pertinent percentage change in demand. As we have change in price. If prices increase and total revenues go up, then demand is any Lastic. We've looked at three situations where price increase.

How about if prices decrease? If prices decrease in total revenues, go down, then demand is said to be inelastic. Because consumers are not responding to the change in price. They're not. The demand is not as responsive as the change in price. If prices decrease and total revenues remain the same.

Again, we have Unitarian elasticity. It's unit elastic. If prices decrease and total revenues go up, then the coefficient is going to be greater than one. It's going to be elastic.

Let's talk about some other measures of elasticity. Let's talk about the price elasticity of supply. This is the measure of the sensitivity or responsiveness of the quantity supplied to a change in the price. Again, this is the measure of the sensitivity or responsiveness of the quantity supplied to a change in the price of the gut.

So in our numerator, we're going to be having the percentage change in quantity supplied. That's going to be the quantity supplied after the price change, minus the quantity supplied before the price change divided by either your starting supply. If you're using the simple method or by the average supply, if you're using the arc method, then we would divide that by the percentage change in price.

P two minus P one divided by either your P one or your average price. Depending again, if you're using the simple method or the arc method example, we might be interested in looking at how a 5% increase in the price of regular unleaded. Gasoline would affect the quantity supplied. So we could measure that with the price elasticity of supply and determine how elastic the.

Quantity supplied is two changes in price. The next measure of elasticity is the cross elasticity of demand. And what this measures is the responsiveness of the quantity demanded for a particular good relative to a change in price of a different good. In other words, our formula is the percent of change in the quantity.

Demanded for good. Let's say X divided by the percentage change in price of good Y. We have a different, good in the numerator and a different good. And the denominator, for example, this would be like looking at how the price of filet mignon changes, how that price change would affect the quantity demanded for hamburger.

So a filet mignon prices went up by 20%. How responsive would the quantity demanded for hamburger B now? One of the things I want to warn you about here with the cross elasticity of demand. We don't want to use absolute values here. We're going to come up with numbers that are either positive or negative, and we're going to use those coefficients to identify whether the goods are substitutes, compliments or unrelated.

So by not using absolute values, we could come up with negative numbers. If we compute this cross elasticity of demand and the coefficient is greater than zero, we consider these goods substitutes. If the coefficient ends up being negative, then we consider these goods to be compliments. And if it's exactly equal to zero, that means these goods are unrelated.

The final measure of elasticity that I like to talk about is the. Income elasticity of demand and the income elasticity of demand measures the sensitivity or the responsiveness of the quantity demanded to change as an income. So we're going to have the percentage change in quantity, demanded, divided by the percentage change in income.

For example, let's say we have a 10% increase in income and an 8% increase in steak. We have more income. We have more steak, which is. What we would normally think of? When we compute this coefficient again, we're not going to use absolute values. If the coefficient ends up being greater than zero, then we know the good is a normal good.

And we know before that stake is a normal good. So if we have a 10% increase in income and an 8% increase in steak, we know the coefficient is going to be positive. It's going to be greater than zero and steak is indeed a normal good. Let's look at another example, let's say that we had a 12% increase in income and it resulted in a 5% decrease in potatoes.

In other words, consumers are making more money. They're buying less potatoes. When we compute the coefficient for the income and plasticity of demand, we're going to end up with a negative number because remember we're not using absolute values and any coefficient, that's less than zero for the income elasticity of demand.

Indicates that the good is an inferior. Good.

A little bit about the market. The market is the interaction between buyers and sellers of a good, so you can have a market for airline tickets. You can have a market for potatoes, and as we've discussed previously, the point at which the demand and supply curves meet. It's called the equilibrium point.

Okay. The price at which that equilibrium point occurs is called the equilibrium price for the market price. So you can think of the market as an automatic system of allocating resources. Essentially what happens is we end up allocating resources and the goods to those that are willing to pay for them in the market.

If there's a shortage of goods, we know that the market price is going to increase. And once the market increases, we know that the quantity demanded will decrease. So there's going to be a shifting here. There's going to be a moving around and eventually that shortage will be eliminated. We'll find a new equilibrium point.

Conversely, if there's a surplus, the price is going to decrease resulting in an increase in demand. Eliminating the surplus.

The market, as we just talked about, it is a free market. However, sometimes the market's not always so free government sometimes intervene and they set mandatory or artificial prices. They can utilize price, floors, or price ceilings. Now a price floor is a government mandated minimum price that can be charged for a good, a service.

Yeah, price floor is a government mandated minimum price. The floor is as low as you can go as the floor, right? It's the minimum price that can be charged for a good a service. And we have a little bit of a problem if the government sets that floor above the market, or in other words, above the equilibrium point above the market price.

And if the floor is set above the market or the equilibrium price, a surplus will develop. Let's look at the figure in your viewers guy titled surplus of video conferencing time.

You look at the figure we have demand curve and the supply curve, and I've marked the original equilibrium point. You'll notice where E. Is that's the intersection of a price of a dollar 30 and 6,000 hours. So that was the original equilibrium price. Now, if the government comes in and mandates a floor of a dollar 50, now a dollar 50 is above that equilibrium point of a dollar 30.

If they mandate a floor of a dollar 50, what's going to be the impact. What I've done is I've drawn a line. Over from a dollar 50 over to both the supply and the demand curves. And if you follow that line across, until it reaches the demand curve, then we can see that at a price of a dollar 50, the demand is only going to be 5,000 units.

But how much are the suppliers willing to supply? If you follow the line from a dollar 50 over to the supply curve, you'll notice it intersects the supply curve where the quantity is equal to 8,000 units or 8,000 hours. So at a price of a dollar 50 suppliers will be willing to supply 8,000, but consumers are only demanding 5,000 hours.

That's going to result in the surplus of video conferencing time of three.

talk a little bit about how shifts in the supply and the demand curves, interact with each other and their impact on price and an output. We have a lot of different possible combinations here. I'm going to start with looking at changes in demand and holding the supply. Constant. If demand increases and supply is held constant, what's going to happen to the price.

You've got more people demanding the goods, but there's not additional supply. It's the same amount of supply. The price is going to increase if demand decreases, however. And supply remains constant. Then it's going to result in a decrease in price because suppliers aren't getting rid of all the goods that they would like to.

So they're going to have to lower the price in order to reach a new equilibrium. Let's look at changes in supply and let's hold the man constant if we were to increase supply, but hold demand constant. What would be the impact on price? If you increase supply and decrease steam and hold the demand constant.

There's going to be a resulting, decrease in price. Why? Because there's more goods out there in the market, but demand hasn't changed in order for the people, the suppliers to get rid of those goods. They're going to have to lower their price. If we have a decrease in supply and demand remains constant, then we're going to have to increase our price, or they're not going to have to increase it.

The price is going to increase because there's less supply. What if. Both increase if supply and demand increase, we know that more goods would be demanded, more goods are available and there, we know output is going to increase, but we don't really know what the effect is on the market price. It really depends upon what the slope of the demand and the supply curves are.

Same is true with decreasing supply and demand. And that we really don't know what the effect on the market price is going to be. If you have a decrease in supply and a decrease in demand, the only thing that we know is that the output is going to decrease, but we don't know the change in the price.

Again, that's dependent upon what are the slopes of the demand and supply curves. A couple more possibilities. What if we have a decrease in income? I'm sorry, a increase in demand, a decrease in demand and a decrease in supply. If there's an increase in demand and a decrease in supply, it will result in an increase in the market price.

Just think about it. If demand increases, if you didn't do anything to supply, that's going to increase the price. If supply decreased and you didn't do anything with demand, the price is going to increase. So the combination of the two is also going to result in an increase in market price. However, we wouldn't be able to figure out whether output is going to increase or decrease.

That would be dependent upon slopes of the curves. What if there is a decrease in demand and an increase in supply? If there's a decrease in demand and you didn't change anything else, what would happen? A decrease in demand would result in a decrease in market prices. One, if there's an increase in supply increases in everything was held cost.

There would be a decrease in market prices. So when you combine the two, there has to be a decrease in market prices, but the effect on the quantity of output, it's going to be indeterminable Oh, we've covered quite a bit of them. I think it's time to see what you've learned, what you've picked up in this BEC CPA Review course.

What I'd like for you to do is to stop your tape. Go to your viewers guides do questions one through 13. When you get your answers, come back. We'll go over them together.

Oh, have you tried? These let's go over them together. The first question says if a law establishes a maximum price for product Y in a competitive market and the ceiling price is above the market or equilibrium price for product X. What let's stop thinking about it before we read any of the answers.

Remember ceiling prices, a maximum price that the, so the price cannot go above it. And a floor would be a minimum price here. The ceiling price is set above the market. So what we're saying is that you can't go any higher than that ceiling. The market is not higher than that ceiling, so there's not a problem.

Is there. So look at land answer a says the law has no effect on the market of good. Why it's not going to have any effect because it does not. It does not cause a problem that would cause a problem. If the ceiling was below the equilibrium price, only when the ceiling is below, whether it be an effect and that would result in a shortage.

Look at the second question. The demand for cigars in Miami is relatively elastic and Miami imposes high taxes on cigars that result in higher cigar prices than in Miami. A, the quantity of cigars demanded would increase. Now, if cigar prices go up, the demand is going to decrease. So is not correct. B the demand for cigars would increase.

No, that may have cigars is not going to increase. It would decrease. See the demand curve for cigars would become vertical. In other words, that's perfectly inelastic. Why would it change in price? Because the demand curve to become vertical about D expenditures on cigars would fall. And that's the correct answer.

If you remember, when we talked about the total revenue approach to measuring elasticity, We said that when prices go up, if total revenues or in this case expenditures go down, then the elasticity of demand is elastic. It is elastic demand. Number three, if the coefficient of elasticity is too. Then the consumer demand for the product to send, to be what?

We said that when we have a coefficient that is greater than one, then demand is elastic. And so the answer is letter B. Now you might want to make a little bit of notes here. Letter a says, unit elastic, or remember that is where the coefficient is equally. Excuse me, exactly. Equal to one letter C says any Lastic.

Remember any lasting city. Or being inelastic, the coefficient would be less than one D says perfectly inelastic. In that situation, the coefficient would be zero because demand is constant at all prices. So again, the answer to number three is B. The next question says if the average household income decreases, and there is no change in the price of a normal good.

And normal is important here because that's going to have the opposite effect than an inferior. Good. Then the, what letter a says supply curve will shift to the right. When income decreases supply, that has no effect necessarily on supply curve, that would impact the quantity demanded. It would cause the demand curve to shift.

So age not right. B. The quantity demanded will move farther up the demand curve. But when there's an increase in income or a decrease in income, as in this case, there's a shift of the curve. It's not moving up or down the curve, but an actual shift of the curve to the left of the right. So B is not correct.

See, demand will shift to the right. The man will shift to the right if income increases not decreases, because if we had more income, we could buy more, but income here decreases. So the answer is letter D demand curve will shift to the left. Number five. This is an increase in the price of a complimentary good we'll do what?

Member complimentary goods, they tend to move in the same direction. And if you have an increase in the price of a complimentary good, then what's going to happen to the demand for that. Good. The demand for that good is gonna decrease, right? So it's also going to have an effect on the joint commodity or the compliment commodity let's read through the answers, see what we have, let her ACEs shift the demand curve of the joint commodity to the right.

No, that, that means that we would be. Demanding more. If the price of a complimentary good has increased would be demanding less. So a is not correct. B will decrease the price paid for a substitute. Good. Now we're talking about complimentary goods, not substitutes. See a shift, the supply curve of the joint commodity to the right.

Okay. The supply curve to the right. An increase in the price of a complimentary good is not necessarily going to have a determinable impact on the supply curve D shift the demand curve of the joint commodity to the left. Yes, that's going, there's going to be a decrease in the demand for the complimentary good.

Or for the complimentary goods, because there's an increase in the price of one. Good. There'll be a decrease for that. Decreased demand for that. Good. As well as its compliment. Number six, shoes are part of the consumer's basket of goods and the consumer price index increased by 6% for the year. While the price of shoes increased by 2%.

Then what, if you don't read the whole question, you might get misled here. If you just looked at the price of shoes increasing by 2%, you might be thinking, Oh, the prices are going up. So the demand is going to go down. What you have to understand is that we are given the consumer price index, which is for basket of all goods and all goods went up in price by 6% in overall.

But the price of shoes individually. Just as a type of good increased by only 2%. So relative to all the other goods, it did not, the price did not go up as much as the other. So it effect that sort of like a decrease in price. And what that really means is that now shoes are more attractive than that.

That relatively speaking, the price is less. So the demand curve will actually shift to the right. The answer is letter C.

Next question says X and Z or I'm sorry. Y and Z are substitute guts. What would cause a shift in the supply curve to the right for Y. Which happens to be a normal good, not an inferior. Good. So what's going to cause a shift in the supply curve to the right, which means that suppliers are going to be willing to supply more at the same price.

They're usually going to do that. If you recall our discussion earlier, they will be willing to supply more at the same price. If their costs decrease. Technology causes improvement wages go down. And if you look at answer D it says cost saving technological improvements in the production process for Y.

And that will cause a shift in the supply curve to the right. So the answer to number seven is letter D. Next question says the market for product a is elastic. And purely competitive. If the market price of product a increases, what is the effect on total revenue? We said that if a product is elastic, the demand for that product is elastic using the total revenue approach.

Total revenues would actually decrease if the price of that product increase. So the answer is a decreases. The next question, we have a demand schedule for Kendall tomatoes and apparently Kendall tomatoes has three customers, Michael Kevin and Gabriel. And we have the demand for Kendall tomatoes at different price levels.

And it says, assuming that these three are the only customers of Kendall tomatoes, which of the following sets of prices and levels of output would be on the market demand curve. Let's look at. Let her a one set data point is $4 and three units. If you go up to the table at a price of $4, Michael's demand is one Kevin's is two and Gabriel's a zero.

So the total demand is three. So that first data point would be on the demand curve. Let's look at the second data point in letter, a. $3 and 12. If we go to the price of tomatoes, when it's $3, Michael will demand three, Kevin will demand six and Gabriel will demand two three and six and two that's 11, not 12.

So a is not the correct answer because one of those data points, the second one does not fit on the curve. Look at letter B says $4 and 10 units. We already determined in letter a that $4 at $4. The demand would be three units, Michael, Juan and Kevin too. So that we know that in be the first data points wrong.

So that can't be the correct answer. Let's go to let her see. The first data point is $3 and 11. When we analyzed letter a, that's what we came up with the demand for $3. Again, if you go to the price of $3, Michael demands, three. Kevin demands, six Gabriel to three plus six and two 11. So that data point fits.

How about the second data point in letter C $4 and three? Yeah, that's the same correct. One that we did and let her a price of $4. My goal will demand one and Kevin will demand two and Gabriel zero. So that's $4 and three letter C is the correct answer there. So D should be wrong. Shouldn't have to go through it, but sometimes a good idea to make sure that the other answers are wrong.

Let's real quick. Take a look at it. Two 50 and 17. At $2 and 50 cents Michael demands for Kevin eight and Gabriel five. That is 17. How about the second data $0.40 and 10. Now we said $4 and 10. Was it right? At $4? The demand is three. So D is wrong. The answer to this question is letter C. The next question asks an improvement in technology that in turn leads to improved worker productivity would most likely result in a wage decreases B wage increases, see a shift to the right and supply curve and a lowering of the price of the output or D a shift to the left and the supply curve and the lowering of the price of the output.

If we have an improvement in technology that leads to improve worker productivity, we said that results usually in lower costs and a shift to the right and supply curve. And the only one that has that in the answer is C a shift to the right and supply curve and lowering of the price of the output.

Now, why would the price of the output lower? Because usually when you have technology increases, increased worker productivity, you're able to manufacture the units at a lower price. And so C does fit with the question here with a and B w just because we have improved technology and improve worker productivity that can't tell us in what direction wages might go.

Okay. And D is wrong because it's a shift to the left, as opposed to the shift in the right, the supply curve. The next question says an increase in the market supply of coffee would result in. A, an increase in the price of coffee. Supply went up, prices normally would go down, right? So A's not right.

B decrease in the demand for coffee. Just because there's an increase in the supply, you don't really know whether or not there would be a decrease in the demand. Why would that impact it? Other than an increase in the market supply of coffee would usually result in a decrease. And the price of the coffee.

But how does that impact the demand  for coffee? How's it going to decrease it? If the increase in market supply of coffee, that would result in a lower price that would result in an increased demand, right? Because there's price goes down, demand is inversely related to it. And so I answer D is that the correct answer?

Because quantity of coffee demanded will indeed increase because of the decrease in price. See is wrong, says increase in the price of tea coffee and tea. I guess the assumption here is that they might be substitutes. If there's an increase in the market supply of coffee, there would be a lower price for coffee, which means more people would buy coffee and less people would buy tea.

And if less people are buying tea, then there would be a decrease in the price of see can't be right. It isn't the letter D the next question it says. In any competitive market, an equal decrease in both demand and supply can be expected to always what if there's an increase in demand and in supply, we said that we would know what the effect would be on prices.

So a, B and C all tell you a change in prices, but we can't determine that. The only thing that we do know is that with an N excuse me, a decrease in demand and supply, there will be a decrease in the number of. Units that are exchanged and that would be, see a decrease in the market. Clearing quantity.

Number 13, it says if a legal price floor of $5 is declared in the diagram below what will be the result? If we look at that diagram, we can see that where the demand and supply curves intersect the equilibrium price was $3 and 50 cents and the quantity was 70,000. But if there's a law that establishes a price minimum, a price floor of $5, we need to draw a line going from $5 over.

And when it connects the demand curve, you can see that demand is only going to be 60,000 units. And if you extend the line from $5 on over to the supply curve, you'll see that. Suppliers would be willing to supply 80,000 units. So supplies 80,000 demand is only 60,000 and therefore there's going to be a surplus of 20,000 gallons.

So the answer to number 13 is a

let's review, some terms. Utility is the satisfaction derived from a good or service. This is totally a subjective kind of concept. So from a consumer's perspective, their utility might be different from another user's utility, but it's simply the amount of satisfaction that they get from buying a good or a service.

Now marginal utility is the additional utility obtained from one more unit. Now you want to make sure that you understand this concept of marginal, because we're going to use marginal the term marginal many times marginal. If you remember from like cost accounting is similar to incremental, it's the increase.

It's the difference? It's the amount from that next unit. So again, marginal utility is the additional utility, not total, but the additional utility obtained from one more unit. So if I already have 10 units of something, The marginal utility of the 11th unit is just the utility that I derive from that 11th unit.

That don't include any of the utility from the previous 10 units. The concept of diminishing marginal utility says that each additional unit provides less satisfaction. Again, diminishing, marginal utility says that each additional unit provides less satisfaction. When I go out and I get my New Zealand lobster tail, that first New Zealand lobster tail is just absolutely magnificent and I really enjoy it.

And that second one is really good too, but it's not quite as good as the first. And by the time I get to that fifth lobster tail, I'm not getting that much satisfaction from it. I'm just getting way too stuffed. I think you understand the concept of diminishing marginal utility a little bit less satisfaction from each additional unit.

Now an individual's objective under this utility theory is to maximize their utility, given that individual's income. Okay. And individual's objective under utility theory is to maximize their utility. What do they want to make themselves as happy as they can given their available income? Now, the objective is achieved and this is important.

The objective is achieved when the utility obtained from the last dollar spent on each commodity purchased is the same. So we're going to derive equal satisfaction from each of the last dollars that we spend on each commodity. Okay. Let's say that again. The objective is achieved. We've maximized our utility.

When the utility obtained from the last dollar that we've spent on each commodity purchased. Is the same. Now, one of the ways that we can represent this utility is through the use of something called indifference curves. Now an indifference curve is a curve on a graph, a various combinations of X and Y or whatever the two goods or services are, which is use X and Y it's a combination.

It's the various combinations of those two goods that give equal utility. Okay. So it's a curve and some of the characteristics of that curve, it's, non-linear, it's not a straight line. It is curved. And we have a lot of indifference curves in all the indifference curves that an individual have are parallel to each other.

So they're not going to intersect at all. Each indifference curve is negatively sloped. With the convex to the origin and then each curve represents a different level of utility. So the further to the right and up that we go represents a higher level of utility. Now, what are we gonna use? These indifference curves or utility curves for?

We're gonna try to do is eventually we're going to figure out where the utility is maximized by looking at the indifference curves. And when the highest possible in different curve becomes tangent to the budget constraint line. Let's talk about that budget constraint line. The budget constraint line consists of all the possible combinations of two commodities for X and Y that an individual can purchase given a set level of income and it given prices.

Again, the budget can straight line. It consists of all the possible combinations. Zero of X. So many of Y one of X, so many of Y, et cetera, all these possible different combinations that an individual can purchase given their level of income and given prices for X and Y. As I mentioned a minute ago, an individual's utility is maximized where that budget constraint line is tangent to the highest possible indifference curve.

Then you're going to know exactly how many X and Y you should buy based upon your income to maximize your utility.

Now, two different factors of production. You should be aware that there are four factors of production in economics. Land is a factor. Labor is a factor capital. Is a factor and management or entrepreneurial activity is a factor. So we've got four factors, land, labor, capital, and management activity, or entrepreneurial activity.

Now each of these factors can be measured by their return or their costs land, the return or the cost. There is rent for labor it's wages for our capital it's interest. And for management or entrepreneurial activity it's profits

talk about now is various cost classifications. And it seems like there's just so many terms here, but it's really important that you have an understanding of each of these terms. And that's why I have them in the presentation. I want to make sure that you understand these and that you're prepared in case when you get to the exam you come across questions that include these.

In the questions let's start with fixed cost. Now, remember what fixed costs are when we talk about a cost being fixed or variable for that matter, what we're talking about is the total amount of costs. Okay. Fixed costs are fixed because the total fixed costs remain exactly the same, regardless of how much output there is, regardless of the activity.

Okay. Again, total fixed costs are fixed because the amount of fixed costs don't change. The amount of fixed cost does not change as output or the quantity changes. Now, what about fixed cost per unit or average fixed cost? To get average fixed costs, you would take the total fixed costs and divide it by your quantity by your output.

Now that is going to change. It's the total fixed cost doesn't change, but the average fixed cost or the fixed cost per unit does change with output because what you're doing is spreading the same amount of total fixed costs over a different number of units. So as we go up the X axis, because as X increases, excuse mirrors, Q the quantity increases the.

Average fixed cost is going to decrease. We're spreading the same amount of fixed costs over an increasing number quantity of units resulting in decreasing fixed costs as fixed. Excuse me. As activity decreases, the fixed cost per unit is going to increase as activity increases that denominator gets larger and larger fixed costs.

The average fixed cost, excuse me, is going to decrease. How about variable costs? Variable costs. Again are variable. We talk about the total cost of these and the total variable cost will vary as activity changes or as output changes as queue changes. But the average variable cost is usually constant.

The average variable costs. In other words, take total variable cost and divided by the quantity of it output. And that is a constant figure. He used to really love to confuse my students and say fixed costs are fixed and variable is variable, but sometimes fixed or variable and variable fixed. And that's because it depends if you're looking at the total or if you're looking at the per unit again, total fixed costs are constant they're fixed, but the fixed cost per unit varies total variable costs vary, but the variable cost per unit or average variable cost varies.

How about total costs? Total costs of course, would be the sum of the variable cost and the fixed cost. That's all we have to do to get total costs. We'd sum up the variable cost and the fixed. Now the term you need to know is the average total costs. What you do here is take the sum of the variable and the fixed and divide it by the output member.

The average variable cost is constant, but the average fixed costs decreases with activity. So your average total cost is going to decrease with activity as long as activities increasing. Your average total costs will also decrease because you're spreading those fixed costs over more and more units.

Now, one way that economists look at costs is by talking about costs in the short run versus the long run. Costs in the short run. What we're assuming here is that at least one input is fixed. In other words, the short run is such a short period of time that there's a cost that can't be changed. It's fixed.

On the other hand, when we talk about cost in the long run, we're talking about such an extended period of time that we have enough time to vary all the inputs. In such a way that all the costs are variable. So in the short run, we have variable and fixed costs. We have variable and at least one in the short run in the long run, all costs are considered to be variable.

Other ways of classifying costs, we have explicit costs, explicit meaning straight out Obvious. These are actual expenditures. Okay. Explicit cost or actual expenditures, as opposed to implicit costs. Now implicit costs are not actual expenditures, but there are amounts that would have been received or are paid.

If resources had been used for other purposes, it's like an opportunity cost it's amounts that would have been received. If resources had been used for other purposes. In other words, implicit costs is because you've given up something, you use the resource for one thing. So you gave up the use of that asset, or excuse me, resource for something else.

Some more costs terms. Let's talk about opportunity costs to give a good formal definition of opportunity costs. Opportunity costs are costs that are forgotten. By not engaging in an alternative activity. Yeah, it sounds very similar to those implicit costs. Okay. Opportunity costs or costs for gone by not engaging in an alternate tentative activity.

Economic costs is the income and entity must provide to attract resource suppliers. Definition of economic cost is the income and entity must provide to attract resource suppliers. What about economic profit? How do we determine economic profit? Not accounting, profit, not a cruel basis. Profit, but economic profit is equal to total revenue minus all economic costs.

Remember we gave factors of production while ago we said land labor, capital. Okay. These are factors of production. Okay. So these are all economic costs. Economic profit is total revenue minus all economic costs. That's cost of land. Remember that's rent, labor, that's wages, capital that's interest. I want to point out here the difference between economic profits and accounting profits.

And the difference is that in accounting, accountants do not subtract out the cost of investors' capital. Oh, yeah, we'll subtract out the cost of the land and labor, but not the cost of investors' capital.

Now let's talk about more marginal concepts, have a number of marginal concepts. I want to make sure you're aware of again, remember marginal is incremental. It's an increase. Let's start with marginal revenue. Marginal revenue is the revenue that's provided by selling an additional unit of product.

Okay. What is the revenue from selling one more unit of product that's marginal revenue, marginal cost is the cost of producing one more unit. Again, it's incremental concept. It's marginal the cost of producing an additional unit of output. One more unit. So your marginal profit is the difference between your marginal revenue and your marginal costs, which just can take marginal revenue minus marginal costs.

How about marginal product what's marginal product is additional output obtained by adding one more unit of an input. So if we added one more cook to the kitchen, how many more meals could we put out an hour? That's the additional output obtained by adding one more unit of input, marginal revenue, product, not marginal product.

But marginal revenue product. I know there's just a ton of terms here and you're going to should be able to know what these are. You should be able to identify these marginal revenue product is the additional revenue provided by using one more unit of input. Similar to the marginal product. Marginal product was additional output.

It was in terms of units like meals, but marginal revenue product is actually revenue, additional revenue. Provided by using one more unit of input. Okay. Marginal resource costs. What's marginal resource cost. The marginal resource costs is the change in total cost of a resource from using one more unit of resource.

So these last three terms, marginal product, marginal revenue, product, marginal resource costs. We're talking about adding one more unit of input. One more unit of resources. Now need to be aware of the term diminishing returns are experienced when additional units of variable inputs contribute less and less to total production.

So even though we're adding one more unit, we're not getting the same amount of output out of that additional unit. It's diminishing returns, we're getting less for each additional input. In other words, marginal production is declining. Diminishing returns is where marginal production marginal product is declining.

As we add more and more units. Let me give you an example. If we have a 100 units of input results in an increase in output of 150. Okay. Let me see, let's try this again. Here. We have 100 units of input and with those 100 units, we get out 150 units of output, but then we add one more unit and that one more unit results in an increase that is less than the previous unit resulted in.

Say 145, we're experiencing less output for each unit. Again, if we have 100 units, if the 100 unit make sure I said this properly, if 100 unit, just the one unit, the 100th results in an increase of output of 150. Okay. One unit of input gives us 150 output. Then the next unit. If I put in a hundred and first unit and that results in an increase of only 145 more units, I have diminishing returns.

Okay. So you're getting less for each unit of input,

a couple of just overall things that you need to know, just statements that you really ought to memorize. First thing that I really want you to make sure that you have in your notes and you spend time on a case, it comes up in questions. When do we maximize profits? Maximization of profits occurs.

Ren re when marginal revenue is equal to marginal cost. Again, we will maximize profits when marginal revenue is equal to marginal cost. In other words, increase in one more unit sold that revenue is equal to the cost of that. One more unit sold at that point will be maximizing profits. Does it matter what the market structure is?

Does it matter? We haven't talked about market structure, but if it's a monopoly or a monopolistic competition, doesn't matter. We're going to maximize profits when marginal revenue is equal to marginal cost. Awesome. Another sort of statement here that I'd like for you to make sure case you see this firms should demand additional resources until the marginal revenue product is equal to the marginal resource cost.

Okay. You should demand additional resources until you reach the point that marginal revenue product is equal to marginal resource costs.

Let's talk about long run costs in the long run, the cost curve, the long run cost curve it's U shaped. And what that shape represents is that initially companies experience economies of scale. In other words, the average costs are decreasing over time. Again, they're spreading out those fixed costs over more and more units, but eventually.

They experienced this economies of scale, which results in the average cost increasing. And that's what makes it a U shape. You start out going down and then the average cost start to increase because of dis economies of scale. Why would the economies of scale exist? Three reasons. I want you to make sure you're aware of increased specialization and division of labor that are used in specialization of management and more efficient machinery.

Now this economies of scale tend to result from the difficulty associated with managing a large scale editing. One last time blanket statement. I want to make sure that, it's one of these things I want you to memorize. We talked about marginal and average cost curves. Whenever the average total cost is that a minimum or a maximum that average total cost will be equal to the marginal cost.

So hopefully you can take all these blanket statements. I know it's a lot, but I thought I'd spend a little bit of time of memorizing these come in handy when you're answering questions and preparing for the exam.

Let's talk about market structures. There are four major market structures that I want to spend some time talking about. The first being pure competition, and really it's going to help. If you understand a lot of the assumptions about pure competition. When we talk about pure competition, we have a large number of buyers and sellers, large number of buyers and sellers, and all these competitors are selling a homogenous or in other words, they standardized product.

So all these lots of buyers and sellers, and they're all buying and selling a standard product and then purely competitive environment like that. There's free entry and exit into the market. Also, we assume in pure competition that there's perfect information that there's no price controls, no ceilings, no floors.

There's no non-price competition. In other words, no advertising or brands. Now in a pure competition in the short run, the producer is a price taker. They take whatever price they can get for their product. And in the long run, they're not going to make any economic profits at all. Okay. And pure competition.

There's no economic profits. And the allocation of the resources and pure competition is completely optimal. It's the best that they can be. And that's because of the price. Is equal to the marginal cost. Again, here in the long run, the company's not going to make any economic profits. And the allocation of resources is considered to be opted because price is equal to marginal costs.

Now in a pure competitive environment like this companies are going to produce a quantity such that the average cost is at its lowest point. Okay. Production is going to occur. And quantity where the average cost is at its lowest point. And the market price is going to be equal to the marginal revenue, which is equal to the average revenue again.

And in a purely competitive market, the market price will be equal to the marginal revenue, which will be equal to the average revenue. Okay. This is the best possible situation. Resources are optimally allocated. No one's making any economic profits and this is going to result in the largest quantity of goods of all the market structures.

It's the largest quantity of goods that are going to be produced. Let's talk about pure monopoly, for example at one point in time, telephone service in the United States used to be a monopoly. There was one seller of telephone service. And that's the first assumption of a pure monopoly is that there's only one single seller and that monopolist has a unique product also in a pure monopoly.

There's blocked entry. Okay. It's hard to get in or almost impossible to get in. There's perfect information. Like we assumed in pure competition and with a monopoly, there are significant price controls. As opposed to pure competition, there was no price controls, but with the pure monopoly, there are significant price controls.

And we also assume that there's Goodwill advertising. Remember we said in pure competition, there is no real advertising or brand competition. Okay. So again, the assumptions for a pure monopoly, single seller unique product blocked entry into the marketplace. Perfect information. Significant price controls and Goodwill advertising.

Now to maximize profits in a pure monopoly, the producer will produce at a point where the marginal revenue is equal to the marginal cost. Remember I said that previously I've said that to maximize profits. This is one of the things that you ought to just memorize to maximize profits. Marginal revenue should be equal to marginal cost at that point.

Profits will be maximized. Doesn't matter what structure profits we maximize there. Of course it a pure competition. There are no profits, so it's hard to maximize no profits, but in a pure monopoly, there are profits they're maximized where marginal revenue is equal more, no cost except one condition.

Okay. Marginal revenue can be equal to the marginal cost, but if the price of the product is less than the average cost, then we're going to stop production. Okay. Yeah. And if price is less than the average cost that we're going to stop production because we're not making any profits at all. Okay. If the price is less than the average cost, in terms of the short run and a pure monopoly, the demand is negatively sloped and the marginal revenue curve is less than the demand and it's negatively sloped in the long run.

In a pure monopoly, blocked entry allows an entity to earn an economic profit. Okay. So there is economic profits and a pure monopoly. Also in a pure monopoly. The price is going to be greater than the marginal cost. Again, the prof excuse me, the price is going to be greater than the marginal cost. And this is going to result in an under allocation of resources member in a pure competition.

It was optimal allocation of resources, but in a pure monopoly, there's only one, one seller resources are going to be under allocated. Okay. Also in a pure monopoly production is less than ideal. The output is less than ideal. Remember in a pure competition kind of market, the production of the output was the maximum.

It was best. It was ideal. It was optimal. Okay. Pure monopoly. It's less than ideal. Also in a pure monopoly, the price is higher. And output, like I said is lower than in the competitive market. Okay. The price will be higher than in pure competition and the output is going to be low.

The next concept that I want to talk about, excuse me, the next market structure here is monopolistic competition.

Now in monopolistic competition, we assume that there are a large number of firms and the products are differentiated. Again, there's large number firms and the products are different. It's relatively easy to enter the market. There are some price controls and there is considerable non-price competition.

In other words, brands and advertising. Again, the assumptions for monopolistic competition are large number of firms. There are differentiated products. It's relatively easy to enter into the market. There's some price controls and considerable non-price competition. What about profit maximization? As I told you earlier, prof or maximized when marginal revenue is equal to marginal cost, unless.

The price is less than the average cost. We have the same exception here. If the price is less than the average cost, we're going to see production in terms of the short run, the demand is negatively sloped, but it's not as negatively sloped as it is in a pure monopoly. In other words, demand here in a monopolistic competition.

It's more elastic than it is in a monopoly. Also here in the short run. Marginal revenue is less than demand and it's negatively sloped. Okay. So in the short run demand is negatively slope, less than it is in pure monopoly. And therefore demand is more elastic and marginal revenues less than demand is negatively slope.

What about the long run? With monopolistic competition in the long run they're limited entry allows an entity to earn a normal profit, not an economic profit. But a normal profit. And in this situation, the long run, the price will be greater than the marginal cost. So again, we have an under allocation of resources.

The only time that you really have the proper optimal allocation of resources is under pure competition. Okay. With pure monopoly monopolistic competition, you have under allocation of resources. The production is less than ideal. Okay. The price is higher than pure competition, and the output is lower than pure competition, but they're still better than a monopoly.

In other words, the price in monopolistic competition is lower than a monopoly. The output is higher than an, a monopoly. The fourth structure that I want to emphasize is oligopoly. Okay. A good example of oligopoly is airline services. In an oligopoly, you have few sellers, just a few sellers, and there are barriers to entering the market.

And these could be natural barriers or they could be created barriers. And when I say natural barriers, it just means that there's a cost advantage to them. They're just better able to control those costs by created barriers, talking about things like advertising and patents. Okay. So in an oligopoly, we have few sellers and we have some barriers to entering the market.

Some of them are natural. Some created in an oligopoly, rivals actions are observed, okay. They watch each other, but their products can be differentiated or standardized. Okay. They can be differentiated or standardized. Remember with a pure monopoly, they were unique with monopolistic competition. They were differentiated.

Okay. And purely competitive environment. There were standardized. Okay. Now they could be differentiated or standardized. The one other characteristic of oligopoly that you ought to know is they have sticky prices. What does that mean? There's price leadership occurring here. In other words, if one airline lowers their prices than the other airlines also tend to lower their.

Airline prices, ticket prices. These firms are so closely related in the competition and that's why they call it sticky prices. Okay. They follow the leaders for the most part. Now there's another market structure that's not as major, and it's really a more specific and in detail, it's a monopsony and I just wanted to let you know what a monopsony was.

Okay. And that's where one buyer. Exists for all sellers. Okay. Usually it's because of like geographic location. There's only one buyer for all of them. You could talk about Munis monopsony mystic demand for in employment, where there could be just one employer in an area and everyone gets their job at the local Walmart or whatever that one employer is.

What I'd like for you to do now is to stop your video. And I'd like for you to try some questions. If you go to your viewers guide, I want you to do questions. Number 14, through 29.

Let's look at this group of questions together. The first question says in the economic theory of production and cost, the short run is defined to be a production process. A which spans a time period of less than three months in length. Oh, we didn't say anything about less than three months in length.

What we did say was that in the short run, there was at least one fixed cost. Let's look at B. In which all inputs employed are variable. Now that's definition of the long run. See that is subject to economies of scale. That may be the case that may not, it may be in the long run or not D in which both fixed and variable inputs are employed.

Yes. With at least one fixed input. That's definition of the short run. The next question says all the following are true. About perfect competition, except that you've got to always watch out for words like except, and always and never. And, but Hey firms are price takers. Is that true about perfect competition?

Yes. B there are a large number of buyers and sellers. That's true about perfect competition C there is a standardized product. Yeah, we sit in perfect competition. All the products are the same. They're standardized. D in the long run and increase in profits will have no effect on the number of firms in the market.

That's not true. Remember we said in perfect competition in the long run, there, there would be no real economic profits. If there's any profit at all in the short term, then there will be an increase in the number of firms in the market, because they're going to went in to try to get into that profit.

And eventually in the long run, there will be no profit. So D is the exception and the answer. Next one. This says all the following are characteristics of monopolistic competition, except that, okay. So three of these are characteristics of monopolistic competition, and one is not let's start with old letter D it says price is higher than in pure competition.

That's true. That's true. In pure competition, the price is the lowest monopolistic competition. It's higher. That's the true answer. It's not an exception. See, firms tend to earn normal profits. Yeah. We said that's true. Monopolistic competition firms do or normal profits B the firms tend not to recognize the reaction of competitors when determining prices.

That's true. We really don't. Don't look at that. Remember that was an oligopoly when they did to look that was sticky prices, oligopoly, but B is true of monopolistic competition. A. The firms sell a homogeneous product. No that's pure competition where they sell a homogeneous product, novelistic competition.

They sell a differentiated product. So the answer is a, that is the exception.

The next question, an industry that is oligopoly cystic would be best characterized by what a many firms selling unique products. No. We said not oligopoly that there would be few sellers be a single firm selling a unique product. No, that's not correct either. It could be a differentiated or a unique product.

C significant barriers to entry. Yeah. There are significant barriers to entry in an oligopoly. Okay. They could be natural or created. D horizontal or flat demand curve. So the output of individual firms now that's not the characteristics of an oligopoly and the answer is C. And the next question they're asking us about the law of diminishing returns and which of those four possible answers is a best description of law of diminishing returns.

Let's remember what diminishing returns are. We said that diminishing returns are experienced when additional units of variable inputs, additional use of input contribute less and less to total production. Let's say a small furnace is less efficient than a large furnace. Going from small to large, that is an economy of scale kind of thing.

That is an increasing return. The small furnace is less efficient, the large furnaces, more efficient. That's good. That's not the right answer B manufacturing company purchases. It's supplier of materials. No, that would result in economies of scale, not diminishing returns C at the no place like home restaurant four cooks can prepare 160 meals in the evening.

While three cooks can prepare 150 meals. On w we can't do, we don't see the difference between two cooks and three cooks, but three cooks can prepare 150 meals on average. That's about 50 meals, a cook, but four cooks can only prepare 160 meals on average that's 40 meals per cook. So overall, we seem to be getting less out of that fourth cook.

C is an example of the law of diminishing returns. Let's look real quick at D just make sure it's not a correct answer. John's landscaping can mow an acre in 10 minutes and two acres in 15 minutes. So by adding just five more minutes, John's landscaping is able to do twice as much, twice as many acres.

Okay. For the first 10 minutes they mowed one acre. And for five more minutes, going up to 15 they mowed an additional acre. So it took them less time to do one more acre than it took to do the first acre that's economies of scale, not dimensioning return. So the answer is C the next question reads a corporation's net income as presented on its income statement is usually a.

Less than its economic profits, because opportunity costs are considered in calculating net income. No, we don't consider opportunity costs and calculating that income. So it can't be the right answer B the net income is more than its economic profits because economists consider interest payments to be costs.

Both accountants and. Economists consider interest payments to be costs. That's not going to cause a difference between economic profits and net income. So B's not right. C equal to its economic profits. Usually that's not going to be the case. It's, it shouldn't be the case. Remember the difference between accounting income and economic profits is that economic profits.

They also suppressed out the cost of the capital look at letter D it says net income is higher than its economic profits because opportunity costs are not considered in calculating net income. And that is the correct answer and accounting. We do not consider opportunity costs the cost of the capital.

Next question, the competitive model of supply and demand predicts a long run shortage. Only when. The one situation that we came across, where there was a shortage was where the maximum price was set below the equilibrium price and that's letter B. Okay. Again, whenever the maximum price the max is below the market, there's going to be a shortage.

The next question says Clegg company's average cost is decreasing over a range of increased output. What is Clegg experiencing? This is just the definition of economies of scale. We said that economies of scale is when average cost is decreasing. The answer is yes. The next question deals with the monopolist it's as a monopolist tends to and comparison with firms in a perfectly competitive market produce.

Say more or less sell at a higher price or lower price. We'll remember. In a monopoly, there's an under allocation of resources and the amount of output the production is less. So we can immediately eliminate a and B because monopolous will produce less. Now, what about prices where they sell at a higher or lower price?

They're going to sell at a higher price. Remember they're the only ones in the market and they can sell at a higher price. They don't have any competition. So the answer is D. The next question to ask, how does the company maintain a natural monopoly? This is really asking the difference between a natural and a created one.

When you create one, you can create it by things like advertising and patents but a natural monopoly. It just exists typically because you are the best doing it, or it's only cost efficient for one to do it. And if you look at letter C, this is technological or economic conditions permit only one efficient supplier.

So C is the answer. The next question says companies and monopolist and monopolistic, competitive markets maximize profits. When I told you this, I said, this is one of those blanket statements. You just got to memorize you maximize profits when marginal revenue is equal to marginal costs. So it didn't matter what market structure you were in.

That's the answer. Let her be marginal costs is equal to marginal revenue.

We have a fact pattern that goes with the following three questions. We have information regarding the number of units produced and the average selling price for different levels of workers. If we have 20 workers, 21 workers or 22 workers, the first question for this fact pattern asks about the marginal physical product.

It says, what is the marginal physical product? When one worker's added to a team of 20 workers. So if we add one worker to a team of 20, that would give us 21. So we're obviously looking at the first two lines of this. What happens when we go from 20 workers to 21? Now this is where it's important that you remember.

I used all those terms we talked about previously, and that is. The marginal revenue, marginal product, et cetera. What is marginal product, which is what they're asking about the marginal physical product is the additional output is the additional output obtained by adding one more unit of an input. So by going from 20 workers to 21 workers, how many more units do we produce?

With 21 workers, we produced 45, where with 20, we had only produced 40 units. So we are producing. Five additional units. Based upon that, one more input that one more worker, the answer is C five units. The next question deals with the marginal revenue per unit says, determine the marginal revenue per unit.

When one worker is added to a team of 21 workers, not from going from 20 to 21, but adding to 21 worker. So we're going to go from 21 to 22. And again, to recall, what is the marginal revenue product here? It's the additional revenue provided by using one more unit of input. So by using one more worker, how much more revenue are we going to get?

So we need to use the average marginal revenue product over three units. Because if you look from 21 to 22, we're going up three units, not one unit. So we can't really get the exact. Marginal revenue per unit from going from 47 to 48, but we can get the information from going from 45 to 48, determining what the marginal revenue product is over those three units and just average it out.

So what we need to do is figure out what is the selling price at 21 units, or excuse me, I'm sorry. 21 workers. We produce 45 units. At 45 units. We are able to sell them at an average selling price of $69. So if you sell 45 units at $69, that's $3,105. What's how much sales revenue do you have when you produce 48 units?

When you have the 22nd worker there? You're selling those 48 units at an average price of $67 and 50 cents. So the revenue. For those 48 units would be 3000, $240. All we have to do is take the difference between the revenues for 48 units of product subtract out the revenues for 45 units of product.

In other words, the 3,240 minus the 3,105. We know that the increase in revenue is $135, but remember that's over three units, not one unit. It's over one unit of workers, but not one unit of product. Okay. So if we take the 48 and minus the 45, that gives us 335 divided by three is $45. Okay. I'm going to ask about the marginal revenue product.

Okay. The marginal revenue product. And remember the marginal revenue product is the additional revenue by using one more unit of input. And one more unit of input is the 22nd worker. So here, all we're looking for is the difference between the 32 40 and 3,105 that we computed in the last question, in other words, $135.

So the answer is let C and it's just the additional revenue by using one more unit of input, which is the 22nd worker.

The fact pattern that goes with the next two questions. We have the total units of a product they're six, seven, eight, nine, an average fixed cost and average variable costs. And then the average total, and the first question for this pattern, it says the total cost of producing seven units is what remember total cost is what it's average.

Plus variable. We could really do this two ways here. We have the average fixed cost and we have the average variable cost, but we also have the average total cost. The average total cost. All we really have to do is take the seven units of product, multiply it by the average total cost of $39 and 29 cents.

And we're going to get the cost of producing those seven units is $275 and 3 cents. That's letter C. Of course we could have taken a longer way and added the average fixed cost. The 1429, excuse me, not added it, but multiplied that 1429 times seven and then add it to the average variable cost of 25 times the seven units.

But why take the long way? Just take the average total cost of 39 29. Multiply by seven that's question asks us for the marginal cost of producing the ninth unit. Again, marginal means the increase. The increase in cost, marginal cost of producing the ninth unit. In other words, as you go from unit eight to unit nine, what's the extra amount of costs in order for us to figure that out, we would have to know what the cost of producing aid is, and then compare that to the cost of producing that nine units subtract, not the cost of producing all nine.

From, excuse me, we can subtract from the cost of producing all nine. We can subtract the cost of producing eight to figure out what the cost of producing that ninth unit is. So what's the cost of producing eight units? Eight units, times $37 of average. Total cost is $296. For nine units, we had an average cost of $35 and 36 cents that would result in total cost of $318 and 24 cents for the nine units subtracting the cost of producing eight from the cost of producing nine units.

And we're gonna get the difference of $22 and 24 cents. The answer is C.

Let's talk about macro economics. Remember we say macro economics. We're talking about the big picture as opposed to micro economics, which looks at the small picture, the individuals and the firms with macro economics. We're talking about dealing with aggregates. We're looking at the big picture, allocating resources to maximize social welfare.

Again, macro economics deals with the aggregates and allocating resources to maximize social welfare. And we'll look at things like total production and total employment, these aggregate kinds of numbers. We need to discuss a number of measures that are used in macro economics. And you're going to notice that there is a progression here.

We're going to start at the very top with a very big number, and we're going to go through various other measures that start with that bigger number. And continue to subtract things away. And sometimes some things were added, but the numbers tend to get smaller. As we go through these, this progression of measures, the first measure, the start of it all is GDP or the gross domestic product.

Now the gross domestic product is equal to the total market value of all final goods and services produced within a country. Again, GDP is equal to the total market value of all the final goods and services produced within a country. Say the U S for example, now I emphasize the final goods and services because something like an automobile engine is not a final good.

And therefore it's not counted, at least not until it becomes part of the automobile finished car. And that way we avoid double counting. So it's just the total market value of all final goods and services. The other thing I wanted to emphasize is that it's all produced within a country. So if we're talking about us GDP, then this would include goods are produced by foreign companies, as well as United States companies.

As long as those goods are produced within the U S borders, it doesn't matter. Who the manufacturer is, as long as it's being produced within the U S it's part of the U S GDP. The next measure is GNP the gross national product. Now the gross national product is equal to the total market value of all final goods or services, goods, answers that are produced with resources from a specified country.

It's a little bit different than the GDP. Okay. All the goods and services produced with resources from a specified country. So this is going to include goods and services produced outside the United States, but using us resources. And this is not as common of a measure. As in years, past GDP is a little bit more common of a measure, a macro measure.

The next macro measure we need to talk about is net domestic product. As I said, we typically are going down through a progression here. The net domestic product and DP is equal to the gross domestic product minus depreciation. Okay, so NDP is equal to GDP minus depreciation. Sounds like we're mixing up a bunch of alphabet soup here, but it is important that you have an understanding of all these measures.

So you're going to have to spend some times effort in making sure that you can identify compute all of these measures. Can we start with GDP? Next basically is NDP. We're going to take GDP and subtract out depreciation. The next measure in the progression is national income. So we're going to start with the previous measure net domestic product, and we have to make some adjustments to get to national income.

National income is equal to NDP the net domestic product. Plus us net income earned abroad minus indirect business taxes. Okay. Again, national income is equal to NDP net domestic product. Plus the U S debt income earned abroad minus indirect business taxes. What are indirect business taxes? The things like sales taxes are indirect business taxes.

The next measure, and the progression is personal income. And of course, to obtain personal income, we're going to start with the previous measure. And that was national income. Personal income is equal to national income minus corporate income tax and undistributed profits. Minus social security contributions, plus transfer payments.

Now, what do I mean by transfer payments. I'm talking about things like social security, benefits, not contributions, but social security benefits that are received and dividends. So again, personal income is equal to national income minus corporate income tax and undistributed profits, minus social security contributions.

Plus these transfer payments. Then we get to disposable income, which again, starts with the previous measure. That's personal income, the disposable income as personal income minus personal income taxes. Okay, disposable income is equal to personal income minus personal income taxes. And basically what disposable income measures is.

It's what people have left over that they can use to consume on goods and services, make interest payments, and save money. So basically we're spending or saving, consuming, or saving. You can think of the making interest payments as spending. But that's what disposable income is used for consumption and savings.

One final macro measure is the real per capita output and real per capita output is equal to GDP divided by the population and then adjusted for inflation. So there's quite a few measures there and you're going to need to take some time and learn how to compute all of those.

I can talk about business cycles. And when we talk about business cycle, it really would help for us to look at a graph. And so if you go to your viewers guide, I have a graph in there that's labeled the phases of the business cycle. And you'll notice that has a squiggly line that looks a little bit like a cursive N.

And what we want to do is look at this business cycle, this curve curvy line here, and talk about the different parts of that business cycle. The first part that I like to highlight, if you go down to the bottom where the line first starts towards the origin, and you go up as you reach that top, as you reach the top of the mountain there, so to speak, that's the peak.

That's the highest level of economic activity at a particular cycle. Okay. Again, that peak, there is literally called the peak of the business cycle and this involves the highest level of economic activity. And this is where pretty much the full use of resources is taking place. Now, as you go over that peak and start heading down.

Okay. Think about over the peak, but not down to the very bottom. In between there on that way down is the part of cycle there's called a re contraction or a recession. And basically during this period of time, we notice a drop in the level of business activity. Employment is decreasing and inventories typically grow.

Okay. So we have a recession era contraction. Contractional kind of period of time. Again, we have a drop in business activity. Employment is decreasing and inventories are typically growing as you reach that very bottom, that's called a trough and that trough is the lowest level of business activity at a particular business cycle.

And obviously way down here, not as much as going on, therefore we're not really utilizing our resources. We have under use of our resources. And then we start to go back up again. And as we head back up the last part of that curve, the end, so to speak, that's called the expansion or recovery. And this is a period of time where we have rising level of economic activity.

Let's go back and describe some of these areas in a little bit more detail. Let's start with the trough. I'd like to give you a number of characteristics about that trough part of the cycle, the very bottom. Okay. Remember I said that this was a low level of business activity, so there's a lot of things that are occurring at low points here in the trough.

You have low level of outputs. Employment is low. Income is low. Prices tend to be low costs are low. Profits are low and investment is low. So we have low output, low employment, income prices, costs, profits, and investment. But the one thing that's high at this point in time is pessimism because everything's looking sort of bad business activity is at a real low and people aren't feeling very good.

And so pessimism is high. At that point. Let's talk about the recovery or the expansion period of the cycle. What's happening here? During the recovery, we usually have low interest rates. A lot of times the interest rates are low trying to spur honor or activate some of that recovery, get some business activity going also during the expansion recovery period of time.

We're replacing depleted inventories. Investment starts to increase. Demand also starts to increase. As well as employment and income, a lot of the things that were at Lowe's at the trough are starting to now increase. So in the expansion period, we have low interest rates, but the replacement of depleted inventories, investment demand, employment and income are all increasing.

What about the peak? Which is just the opposite of the trough. The trough was the lowest point. Peak is the highest point. So if you can remember a lot of the characteristics for the trough or the peak, then you can just do the reverse for the other. Okay. At the peak number of things we're at highs, output is at a high employment is at a high income prices, profits and investment.

They're all at highs. And of course, if all these things are at highs, What's that a low pessimism is that a low, but on the other hand, you can look at it this way. Be optimistic. Optimism is at a high we're at the peak. Things are going really well. So people are optimistic at the peak in the final section of this business cycle that I want to give a little bit more detail on.

Is the contraction or the recessionary period what's happening during the recession? During the recession, Output employment and income are all at their peak or reach their peak already. And at this point, consumer demand begins to taper off and because demand begins to taper off prices begin to level out.

They're no longer at that high and inventories are beginning to increase because the demand has tapered off. Not as much as being purchased. Also during the recession costs tend to increase and the profit margins diminish because the costs are increasing, but demand is tapering off businesses. Aren't willing to pass on increased cost to the customer because they'll just lose more sales.

So the profit margins diminished during this period of time. Also during the recession demand slackens. So I mentioned the consumer demand, Tapper tapering off and firms reduce their excess inventory course output begins to become cut and therefore, so is income and employment. Also during the recession, investments are discouraged and the outlook becomes pessimistic in nature.

The next area of macro economics that I'd like to discuss with you is indicators. And there are two kinds of indicators we typically talk about. You may hear in the news, if you're ever listening to the one of the business channels or the nightly news or reading the wall street journal, leading indicators are used to forecast future trends.

Get leading indicators are used to forecast future trends. They're trying to give us an indication about what's to happen. What's coming up. You may be familiar with a private research group called the conference board and the conference board computes a number of composite indices that use these leading indicators.

I don't want to try to give you an exhaustive list. Cause  there's a lot of them that are used, but I'd like to give you an idea of some of the leading indicators that are used by the conference board and others. Some leading indicators would include the average hours worked per week by manufacturers workers.

Now the leading indicators, the weekly initial unemployment claims. Stock prices of 500 common stocks, new housing permits, new orders for durable goods changes in the money supply. Again, these leading indicators include average hours worked by per week by manufacturer workers, weekly initial unemployment claims stock prices of 500 common stocks, new housing permits, new orders for durable goods.

And changes in the money supply. There are also a number of trailing indicators. Obviously they're not doing any predictions, they're not forecasting trailing indicators or indicators that change after the change in the phase of the cycle, as we're moving from the peak down or from the trough up and starting to expand.

Okay, these are going to give you the indication after the change in the phase. Some examples of trailing indicators include average prime rate charged by banks. The average length of unemployment in terms of weeks and the change in CPI for services. Again, three examples of trailing indicators, the average prime rate charged by banks, the average length of unemployment and wakes and the change in CPI for services.

I'd like to discuss with you now, or a couple of the major models of economic analysis. Let's begin by talking about the classical model under the classical model. Equilibrium occurs only at full employment, and if it's not at full employment, it's assumed that the market will correct itself again.

Equilibrium is assumed to occur only at full employment and full employment doesn't exist in the market is assumed to correct itself. How does the market go about correcting itself or the driving force behind the market? It seem to be, as competition will move the economy towards equilibrium point.

For example, if there's any unsold inventory, then prices will be decreased. So that the inventory can be sold. We also assume that the company petition eliminates any unemployment because of the competition between war workers. In contrast, the Keynesian model of economics assumes that the market, it can reach an equilibrium point.

The economy can reach an equilibrium point with significant levels of unemployment, not full employment, but unemployment with some unemployment. And it's also, so the economy cannot take care of itself. It's not self-regulating as it is in the classical model. And therefore the government needs to come in and act in order to pull the economy out of recessions.

Now, two very important variables that exist in these economic models are consumption and savings. You'll recall in previous. Parts of the class that disposable income is income to the consumer that the consumer can either spend or save as disposable income increases. You have more money. So what can you do with it?

You can spend it or save it. Do you always spend everything that you get an income increases? No, we're going to assume that some of it is going to be saved. So will we have the economists use are two measures of the changes and disposable income and their impact on consumption and savings.

The first measure, let's talk about the marginal propensity to consume M P C marginal propensity to consume. And what that measure is simply a ratio. Of the change in consumption, spending to the change in disposable or after tax income. Again, the marginal propensity to consume is the ratio of the change in consumption, spending to the change in disposable or after tax income.

So the ratio is going to fall between zero and one. For example, let's assume that we have an MPC of 0.4. What that says is that for every dollar of increases in disposable income, we're going to take 40 cents of that and consume it. We're going to spend it on something. So what are we going to do with the other 60 cents, right?

We're going to save it. And that leads us to the next measure, which is the marginal propensity to save marginal propensity to save is the ratio of the change in plan saving to the change in disposable income. And as you probably have already realized when you have a dollar increase of disposable income and 40 cents of it is going to be spent 60 cents of it's going to be saved.

That's all that there is. So the, some of the marginal propensity to consume and the marginal propensity to save must be equal to one. So if you ever know one of those ratios, one of those measures and you don't know the other, you can always subtract that other measure from one. To get the measure. You don't know.

So for example, if you don't know what marginal propensity to consumers, you can simply subtract the marshal propensity to say from one,

let's talk a little bit about savings and their viewpoints and the different economic models. Now in the classical model, it's assumed that savings depends entirely on the interest rate, but Kings. Kings believed that savings habits were based primarily on consumers income again, on the classical model, the assumption was that savings dependent upon interest rates under the Keynesian model.

Consumer savings depends on income. What about investments? Classical economics economists believe that the most important determinant of planned investment spending. Is the interest rate Kings on the other hand, argued that profit expectations are the most important determinant of investment spending by businesses.

The next item we need to talk about is the multiplier effect as expenditures are made it results in a larger impact on the national output or national income. Again, this multiplier effect. What it does is it measures the relationship between the change in the aggregate expenditure and the resulting larger change in national.

The way that we compute the multiplier effect is simply to take one and divide it by the marginal propensity to save. Of course, if you don't know the marginal propensity to save, you could mult you could compute this multiplier effect by taking one. Divided by one minus the marginal propensity to consume now the larger this multiplier excuse me, the larger, the marginal propensity to consume then the larger, the multiplier, or now the way to look at it as the smaller, the marginal propensity to save.

The larger the multiplier. So the marginal propensity to consume and the marginal propensity to save, have opposite effects on that multiplier. Remember they're equal to one minus the other measure. So they're going to have opposite effects when they get in that denominator of the multiplier effect.

Let's talk about money, supply, money supply. Can be measured and different ways. The first measure is M one is the most liquid definition of money. And in M one will include currency Traveler's checks and checkable deposits. I'm going to talk about currency. Of course, I'm referring to paper, money and coins.

When I talk about checkup with deposits, I'm talking about checking accounts at banks talking about now accounts. Automated transfer service accounts and share draft accounts. M two is equal to M one, but it includes more variables. So to get them to what we'll do is we'll take M one and we'll also add savings accounts.

We'll add small time deposits. These are deposits less than a hundred thousand dollars, and we'll also add in money market funds. So M two is equal to M one. Plus the savings deposits. The small time deposits less than a hundred thousand, the money market accounts. Now, when I refer to savings deposits or savings accounts, I'm talking about interest bearing accounts that do not allow for automatic transfer services.

If you have a savings account that allows for automatic transfer services, that's part of the  supply time deposits or the small time deposits I was talking about. I'm talking about CDs here. Certificates of deposits. These are funds that earn a fixed rate of interest. It must be held for a specific period of time.

Money market funds, deposits, held and accounts invested in a broad range of financial assets. Okay. So M to include saving deposits, time deposits like CDs and money market funds. MP3 is the largest measure of money supply. It's going to include . Plus, we're going to add in large negotiable CDs. These are the CDs that are over a hundred thousand dollars and we'll also include Euro dollars.

And the MP3 measure now you're right. Dollars are simply us dollars that are deposited in foreign banks. And therefore they're really outside the jurisdiction of the United States. Again, Euro dollars are us dollars. They're deposited in foreign banks and therefore they're out of the jurisdiction of the United States.

How does money get created? First somebody takes some new money and they deposited it in the bank. Now, when a customer deposits money in the bank must retain a certain percentage and reserve. This is known as the reserve ratio. So for example, if I deposit a thousand dollars and the reserve ratio is 20%.

Then the bank is going to have to maintain or keep on hand $200 of that $1,000 deposit. The rest, the difference the $800 are considered excess reserves and that money can be loaned out. Now when a bank loans out money from its excess reserves, it's creating money. It's increasing the money supply. Now the effect of this increase on the money supply is measured through what we call the money multiplier.

Now the money multiplier is very easy to compute. It's simply the reciprocal of the reserve ratio. So the money multiplier is equal to one divided by the reserve ratio. So let's look at a little example. Let's say that we have an increase in deposits at a bank of a thousand dollars. The reserve ratio is let's say 10%.

Then we can measure the fact that this deposit has on the overall money supply in the banking system. What we can do is get the money multiplier compute the money multiplier, but that's one divided by the reserve ratio. The reserve ratio is 10%. One divided by 10% would be 10. So if we have an increase in deposits of a thousand dollars, we can multiply that by the money multiplier of 10.

And that would result in an overall money supply increase in the banking system of $10,000.

Who controls the money supply? I hope, it's the federal reserve board. They control the money supply. Now the federal reserve has general controls that affect the overall supply of money. They also use some selective in trolls that we'll talk about now, the most important, okay.

Of all the controls that the federal reserve uses are open market operations. And what I'm talking about here is when the federal reserve buys and sells government securities. And by buying and selling government securities, they're impacting the money supply. When they purchase securities, it encourages the expansion of the money supply.

They're putting more money into the banking system. And of course that gets impacted by that money multiplier. When they sell securities that leads to a contraction of the money supply. They're taking money out of the money supply. For example, if the federal open market committee buys $50,000 of securities, they're putting $50,000 into the bank and supply, but the money multiplier, if we assume that the reserve ratio is 10% say, then the money multiplier member is 10, 10 times.

So by putting $50,000 in they're buying $50,000 of securities, then they're going to increase the money supply by 500,000. The $50,000 times the money multiplier of 10.

So you can see there's an importance to these excess reserves, the effectiveness of the federal reserve board's efforts to either limit or expand the money supply, depending on the status of these excess reserves. Again, if they purchase securities in the open market, they're trying to expand the money supply.

And if they sell they're reducing the money supply,

what is the discount rate you may have heard of the discount rate before? The discount rate is the interest rate at which depository institutions can borrow funds from the federal reserve banks. Okay. This Carroll rate is an interest rate that reserve banks can borrow. From the federal reserve from each other.

Okay. This is usually very short term, barring like overnight. Now the federal reserve can affect these discount rates and they lower the discount rate. Then the fed is signaling that they want to encourage the expansion of the money supply. If the federal reserve raises the discount rate, it gives the opposite signal.

In other words, they're trying to contract the money supply.

Some other rates that you might ought to be familiar with include commercial loans and federal funds rates. Okay. You've probably, I'm sure you've heard of the prime rate and make sure what the prime rate is. The prime rate is the rate at which individuals and firms with the best credit can borrow.

Okay. Prime rate is the rate at which the individuals and firms with the best credit ratings can borrow the federal funds market rate. The federal funds market, excuse me, is a fairly well-organized market where the banks borrow. And again, we've talked about the federal funds rate a little bit earlier.

That's the rate at which each of these federal funds banks can borrow from each other. How about price indexes? A price index is simply a number, a method that we can compute that allows us to compare the average price of anything in one period of time with its price. At another point in time. In other words, we can compare, let's say, for example, how much a loaf of bread costs today. To how much a loaf of bread costs one year ago.

So price index just measures the average the price for a good, in one period relative to a base period, and you can develop price indices or price indexes for variety of items. We could group goods together. We could group goods and services together and compare prices in one period, two prices and another period.

Now the way that you determine the price index is you simply take the price of whatever good or goods that you're interested in a given year, divide that by the price of goods and the base period. And then if you want to, you can multiply it by a hundred. Some people do some don't. Let me give you a numerical example.

Just to make sure that you're following me here, if the price of goods or a good in one year. This year is $1,200. And if we bought the same good, let's say one year ago, our base period, and that good would have cost us $1,000. Then what would be the price index for the current year? We would be comparing the price of that good 1,200 to the base period price of a thousand.

So we have 1,200 divided by 1000 and we would get 1.2. If we multiplied it by a hundred, we would get 120 either way. It gives us the same information. If we don't multiply it by the 100 and we just have 1.2 or 1.20, what you can do is subtract out one. That's what you start with. And the difference 0.2 or 20% indicates how prices have changed.

In other words, from our base year to the current year, there's been a 20% increase. If you had multiplied it by a hundred, you would be comparing, or you would have a price index of 120 to figure out how prices have changed since the base period, you would subtract out a hundred. So 120 minus a hundred would be 20.

And that indicates that prices went up by 20%. So you really can compute that using the 100 in there or not. It's up to you now. Price index, a commonly used price index. In our economy is the CPI, the consumer price index. Now the consumer price index compares the price of a group of basic goods and services as purchased by urban residents.

Again, the CPI is an index that basically compares the price of a group of basic goods and services as purchased by urban residents today. Compare that to some base period. Now you might be interested in as to what goes into the CPI. I don't think the BEC CPA Exam is going to ask you any percentages, but some of the things that go into the computation, the CPI include food and beverages, housing, apparel, transportation, medical care, recreation, education, and communication, as well as some other items.

Now the CPI does have some limitations that you ought to be aware of, basically what the CPI does, measures the relative change in the cost of living. How have prices changed from relative to some base period? And and by doing that, what it does not measure is the actual cost of living. It does tell us how the cost of living has changed, but not what the actual cost of living is.

And it's really not a completely pure index. In fact, it's recognized that there's usually a little bit of upward bias in there each year. Now the other common index that you probably ought to be aware of for the BEC CPA Exam is the producer price index. The producer price index or PPI is a measure of the average prices received by producers and wholesalers.

So the consumer price index is looking at how price has changed for consumers. The producer price index is looking for how prices change for the producers, what they're able to receive for their products. But I'd like for you to do is to stop your video and do questions 30 through 41. When you get your answers, come back, we'll go over them together.

Let's do this group of questions together. The first four questions relate to this fact pattern for Nick and in these questions were asked to compute a number of these macro economic measures that we've previously discussed. The first question asks us to compute the net domestic product. You recall that the net domestic product is equal to GDP minus depreciation.

So all that we have to do here is take the 4,500,000 talents of GDP subtracted appreciation of 500,000 talents, and we'll get 4 million talents. The answer is D the next question we are requested to compute national income. You'll recall that national income is defined as net domestic product. Plat plus any income earned abroad minus any indirect business taxes.

So what we're going to do is we'll start off with the net domestic product we got in the previous question, the 4 million talents we're going to subtract out a hundred thousand dollars of income earned abroad. Excuse me. I'm sorry. We're going to add the a hundred thousand talents of income earned abroad.

We're going to subtract out the hundred and 75,000 talents of indirect business taxes, and we get our answer of 3,925,000 talents. The third question of this pattern Aspers to compute personal income. You'll recall that personal income is defined as the national. Excuse me, personal income is defined as the national income minus the corporate income taxes minus any undistributed corporate profits minus any retirement contributions and plus any transfer payment.

Here, we're going to take the national income that we computed in the previous question, the 3,925,000 talents. We're going to subtract out a hundred thousand talents for the corporate income taxes. We're going to subtract out 50,000 in undistributed corporate profits. We're going to subtract out 300,000 and the retirement and the retirement contributions.

And we'll add the 600,000 talents of transfer payments. And we'll get the answer of 4 million, 75,000 talents. The last question, the pattern asks us to compute disposable income. Recall that disposable income is defined as the personal income that we just computed minus any personal income taxes. So we're going to take the 4,075,000 talents of personal income.

It will subtract out the personal income taxes of 150,000 talents. Sorry, the answer is B 3,925,000 talents. The next question says the recessionary phase of a business cycle is characterized by what about a high levels of economic activity? No. In a recessionary phase, remember that economic activity is decreasing.

Be shortages of resources. No, here we're actually going to have beginning to have increases in supplies of resources because we're not operating at full capacity. See potential national income will exceed actual national income or D the reverse situation. It's going to be C the potential national income is going to exceed the actual national income again, because not all our resources are being used.

So we're not operating at full capacity. Therefore we're not realizing the full potential. The full potential is greater than actually what's occurring. Answer is C. The next question asks us about the multiplier effect. What does it explain? Remember we said the multiplier effect is basically explaining how a change in investment can impact the larger number that the national output.

That's letter a, a small change in investment can have a much larger impact on gross domestic product.

Two questions. We have another fact pattern, and this is deals with gross domestic product. What you have to remember about gross domestic product is that it's a measure of all the final members, a market value of all the final goods and services produced in a country. Consumption, investment represents what's being Done in that country, but it also includes net exports because you're exporting from our country or whatever the national country is into another country.

So GDP, the equilibrium GDP occurs when consumption investment and net exports all add up to be the real GDP. So the first question asks us, what is the equal equilibrium point for gross domestic product. And if we look at the data we have to go through and see where consumption investment added to net exports is equal to the real GDP at that level.

And when we go through that list, go down to 420 real GDP. You'll notice that the consumption and investment is 412 and the net exports are eight. When you add that together, you get the real GDP 420. So the answer is letter B. And the next question, it says, what is the equilibrium real GDP? If net exports are increased by $6 at each level we have to go back to this data and we're going to have to add $6 to the net exports, which is going to break all those negative net exports equal to 14.

Then we'll add for each level of the consumption and investment and see where that equals the real. Gross domestic product. And we're going to come up with 460 because at 460, we have consumption investment of four 46, plus the net exports now of 14. So again, the answer is C the next question it asks if the marginal propensity to consume is 0.3, five, a $30 increase in net exports will cause an increase.

An equilibrium, real GDP of what? Remember net exports is a part of real GDP. And when you increase expenditures, then that's going to increase or have a bigger impact. So what is the impact of this? Remember marginal propensity to consume being 1.35 that makes the marginal propensity to save 0.6, five.

And so we're going to get the multiplier. We'll take one divided by the 0.65, the marginal propensity to save, multiply that by the $30 and that's $46 rounded. So the answer is letter B. The next question asked about what action would the federal reserve board take to implement an expansionary monetary policy?

If they want to expand. I have an expansionary monetary policy. They want to increase the money supply. Let's look at the choices. Letter a says, increase the reserve requirement and decrease the discount rate. If you increase the reserve requirement, remember what that does. That money multiplier.

You're going to have one divided by a larger reserve ratio. That's going to make that multiplier smaller, so that's not expansionary. Hey is not correct. If we look at B. B says, purchase us government, securities and decrease the discount rate. When the federal reserve purchases us government securities, they're putting in money into the money supply.

That's going to be expansionary. What about the discount rate? It says and decrease the discount rate. Federal reserve, when they decrease the discount rate, they're trying to expand. Monetary policy. They're trying to expand the money supply. So that's correct. Letter B is the answer. If you look at C and D it's usually a good idea, make sure they're wrong.

I feel pretty good about B let's look at C real quick. It says increase the reserve requirement and the discount rate. We send a letter, a increase in the reserve requirements. Gonna not have an expansionary monetary effect. It's going to decrease the monetary supply. So C is wrong and D it says increase the discount rate.

If you increase the discount rate, that's not expansionary. That's contractionary. It's going to contract the money supply. So the answer is big. Next question. Also deals with money in the banking system. This is a banking system with the reserve ratio, excuse me, of 25% and a change in reserves of 750,000 can increase its total demand deposits by how much?

Again, I'll use the multiplier. We're going to take one divided by the reserve ratio of 25%. Your multiplier is four. So you take four times the change of reserves of 750,000 and you get $3 million. The answer is C. The next question deals with Carlton bank. This is Carlton bank has deposit liabilities of a hundred thousand dollars.

It has reserves a 45,000. And a required reserve ratio of 25%. Let's stop and think about that. If they have a hundred thousand dollars of deposits on hand and a required reserve ratio of 25%, the only amount that they are required to keep on hand is the 25% of the a hundred thousand, which is $25,000.

So they have $20,000 of excess reserves. Let's read what the question says is therefore Carlton bank and the banking system can increase loans respectively, by how much? Since Carleton has $20,000 of excess reserves, they can loan that money out. So that immediately cancels out B and D. They can't be right because they say 45,000 and 50,000 as the increase in loans by Carlton.

They could only loan out $20,000. So it's gotta be a or C well, what's the effect on the banking system? Again, the multiplier one divided by 25% is four. When they loan $20,000 out, that has an impact on the banking system of four times. That mountain was, which is $80,000. So the answer is a.

Let's talk about economic, ah, excuse me, international economics. One of the issues that we're interested in this area is what should we be producing for exchange with other countries? And there are a couple of concepts for us to look at. One is called the absolute advantage. The absolute advantage is the ability to produce a good or a service.

Using fewer resources than other producers use. Again, the absolute advantage is the ability to produce a good or service using fewer resources than other producers use. Another concept that we talk about is comparative advantage. This is the ability to produce a good or service at a lower opportunity cost than other producers.

Again, competetive advantage is the ability. To produce a good or service at a lower opportunity cost than other producers. Ideally parties should produce the good in which it has the lower opportunity cost. If you go to your viewers guy, I have an example of two nations and their ability to produce cotton and wheat.

We have countries Southland and Northland. Now, if you look at the data for Southland, Southland is able to use three units of resources to produce 30 bales of cotton, and they can use two units of resource and produce 60 bushels of wheat Northland. Using three units of resource can only produce 15 bales of cotton.

And using two units of resource is able to produce 40 bushels of wheat. So at all, with both countries using six units of resources to produce cotton, they get 45 bales of cotton and producing wheat using four units of resource, they're able to produce a hundred bushels wheat. Let's look at these concepts of absolute advantage and conflict of advantage with relation to this data, let's start with absolute advantage.

Let's figure out who has the absolute advantage and producing cotton. Remember the absolute advantage is the ability to produce a good or service using fewer resources than other producers. Let's look at Southland. Southland can produce 30 bales of cotton using three units of resource, but we need to know how much they can produce using one unit of resource.

So take the 30 bales of cotton divided by the three units of resource. They're able to produce 10 bales of cotton for each unit of resource. What about North linen producing cut? They produce 15 bales of cotton using three units of resource. So per unit, they're only able to produce five bales of cotton.

So Southland has the absolute advantage. They're able to produce 10 bales of cotton per unit of resource. Whereas Northland can only produce five units of resource. Again, South end has the absolute advantage over Northland and producing cotton. How about the absolute advantage in producing wheat? Okay.

Let's start with Southland. Southland's able to produce 60 bushels of wheat when they utilize two units of resource. So per unit, that would be 30 bushels of wheat. Northland is capable of producing 40 bushels of wheat. When they use two units of resource. So per unit of resource that's 2020 per unit of resource.

So Southland has the absolute advantage over Northland and producing weight. They're able to produce 30 bushels of wheat compared to Northlands 20 bushels of wheat. So Southland has the absolute advantage in producing both cotton and wheat. And that's a little bit of a problem because we want to have company, excuse me, countries producing what they're best at, but some countries are better producing a lot of goods.

They're more efficient. So what we can do is look at the competition advantage.

Ideally, what we'll do is have the countries produce those goods, that they have a comparative advantage in. And when we look at cognitive advantage, only one country will have a conflict of advantage and a resource. When we're looking at a two resource situation like this, and then the other country will have the competitive advantage and the other resource.

So under competetive advantage, The parties will produce the good in which it has the lowest or lower opportunity cost. So what we're going to have to do is compute the opportunity costs of these countries in producing cotton and wheat. Let's look at producing cotton and what we really need to do.

It's a lot easier if you look at the output based upon just one unit of resource. So for Southland.

when we talk about cotton, they were able to produce 30 bales of cotton using three units of resource. So that translated into 10 bales of cotton per unit. They could also use that unit of resource to produce a Bush bushels of wheat, how much we could self-learn use. Cause if we're going to talk about the opportunity cost of cotton, remember that's the cost of not producing wheat?

With wheat. They're able to produce 60 bushels using two units of resource or 30 bushels per unit of resource. So for Southland using one unit of resource, they could either produce 10 bales of cotton, or they could produce 30 bushels of wheat. If we wanted to express this in terms of the opportunity cost of producing cotton.

Again, the opportunity costs of producing cotton. The cost of producing cotton is 30 bushels of wheat to 10 bales of cotton because that's what happens if they use one unit of resource, they could make 30 bushels of wheat or 10 bales of cotton. So the cost, the opportunity cost of producing cotton is three it's, 30 divided by 10.

What about the opportunity? Cost of Northland to produce cotton? Again, let's put this cotton and wheat production in terms of one unit, how many bales of cotton can Northland produce using one unit of resource? They had 15 bales of cotton when they use three units of resource. So that translated to five bales of cotton using one unit of resource when they produce wheat.

That was 20 bushels of wheat for one unit of resource. It was the 40 divided by two units. So how do we compute the opportunity cost of producing cotton for Northland? Again, we're going to take the. 20 bushels of weight that we could, they could produce using a unit of resource divided by the five bales of cotton that they could produce using the one unit of resource and the opportunity cost to produce in cotton or less as four.

So who has the lower opportunity costs of cotton? Southland has an opportunity cost of cotton three compared to Northlands four. So Southland should produce cotton. We said that the parties should produce the goods in which they had the lowest opportunity cost. So South and will produce cotton.

Therefore Northland must have a competitive advantage in producing wheat, but let's make sure let's figure out the opportunity cost of producing wheat for both the countries. Let's start with Southland. What's the opportunity cost to producing wheat? In that case, They would have to give up the 10 bales of cotton they could produce in order to produce the 30 bushels of wheat using one unit of resource.

So the opportunity costs is one over three. With respect to Northland, the opportunity cost of wheat would be the five bales of cotton divided by the 20 bushels of wheat. They could produce using one unit of resource that's one fourth. Which one of those opportunity costs a smaller one over three or one over four, one over four is the smaller number.

So Northland has the lowest opportunity cost to producing wheat. So Northland should produce the wheat. So you can see that comfort of advantage is good and identifying who has, who should produce what unit, because there's only one country that will have a conflict of advantage in a particular product.

If we use that competetive advantage and Southland produces cotton and Northland produces wheat, and they use all their resources for producing those items. How much cotton, how much we will be the result. Southland produces nothing but cotton. Remember they were able to produce 10 bales of cotton for every unit of resource.

If they were say, have five units of resource. Because remember they had three units that they were using for cotton and two for wheat. They had five units of resource before. Now they can take those five units of resource. Instead of doing some cotton wheat, they can produce all cotton. They would get 10 bales of cotton for each unit of resource.

They would make 50 bales of cotton Northland. On the other hand, had a conflict of advantage and producing wheat. So they're going to take all their resources and make wheat. And in the original data, Northland was using three units of resources for cotton and two for wheat. Now they're going to take all five of those resources and make wheat well, they were able to produce 20 bushels of wheat for every resource.

So using all five units of resource, they'll make a hundred bushels. So how many bales of cotton and bushels of wheat are there after the companies? Excuse me, countries begin to specialize. Now they're making 50 bales of cotton and a hundred bushels of wheat. So overall, there's more production when the countries produce you, the item that they have a conflict of advantage in.

So using conference of advantage, it's better for everyone because there's more units being produced.

If countries are making products hand, Working with each other. And they're exchanging, there has to be a way of making that exchange easier. In other words, it needs to be some foreign ex common medium of exchange. And if countries are using different currencies, then we need to come up with an exchange rate.

And the exchange rate is the rate at which one currency can be exchange for another currency. Now when a currency can buy more of another currency. For example, if the U S dollar can buy more Swiss francs or any other Mexican pesos, if they could buy more with one us dollar than the us dollar is said to have appreciated.

If on the other hand, the U S dollar can buy less pesos. That dollar is said to have depreciated. Where did the exchange rates come from? We have different kinds of exchange rates. Floating exchange rates is where the market determines what that exchange rate should be. Okay. A floating exchange rate is where the market itself determines what that rate should be.

On the other hand, a fixed exchange rate is an exchange rate. That's fixed by a particular government. Again, a fixed exchange rate, this fixed by a particular government. Now we could have some sort of cross between these two systems and have what we call a managed float, managed, float, and manage float.

The market is the primary determinant of the exchange rate, but sometimes governments intervene to maintain stability.

Talking about foreign exchange. We have more rates to talk about. We have spot rates and foreign exchange rates. What is a spot rate? A spot rate is the exchange rate paid for currency right now on the spot. Again, a spot rate is the rate. Of exchange for currency right now. So if I went out right, this moment exchanged U us dollars for pesos that would be done using the spot rate, the forward exchange rate is a rate agreed upon to be paid at a specified point in the future.

If I knew I was going to have a transaction and I would have to pay a certain amount of pesos in the future, I could owner enter into a Ford contract using a Ford exchange rate, and we could agree. I would agree with the bank or wherever I was getting. The pace was from at a certain rate at a certain period of time.

That's the Ford exchange rate, the amount that will be exchanged at a specified period of time. And these two usually are not the same. Usually they, the Ford rate and the spot rate are different. What happens if the Ford rate is greater than the spot rate? Again, the Ford rate is greater than the spot rate.

In this case, the currency is said to be at a premium. The Ford rate is at a premium that's more than the spot rate. And what that says is that they're expecting the value of that currency to increase. Again, if we have Ford rate greater than a spot rate, then it's at a premium and the value is expected to increase and the opposite.

Would be where the Ford rate is less than a spot rate. And that currency, the Ford exchange rate would be at a discount to the spot rate. In other words, investors are expecting the currency to decline in value. Now, these exchange rates are affected by interest rates, whether these Ford rates are less than, or more than the spot rate is often determined by the relationship between interest rates in one country.

To that or the other country. So what kind of relationships exist there? If the domestic rate is greater than the foreign interest rate? Again, the domestic interest rate is greater than the foreign countries interest rate. Then this Ford exchange rate is going to be at a premium and the opposite is true.

The domestic rate is less than the foreign interest rate. Then it's going to be at a discount.

Items of importance here in the area of international economics is the balance of payments. We're talking about exchanging between these countries. Sometimes some countries import more than they export. And so we have a difference and the accounts, there's a difference to how much the countries owe each other.

There's a couple of accounts that we need to talk about. One is called the current account. Now the current account includes the balance of goods and services net of any interest in dividends and any unilateral transfers. Again, the current account includes the balance of goods or services and services, the net interest and dividends and net unilateral transfers.

So what is the balance of goods and services? The way you need to look at balance of goods and services is this it's the imports, which you can say that their debits less exports, which are credits. In other words, the imports that's, what's coming in exports. That's what's going out now. There is a difference between this balance of goods and services and something else called balance of trade.

Remember the current account is the balance of goods and services and the net of interest in dividends and net of unilateral transfers. But the balance of trade is a little bit different and you may come across that term. It's the same thing as the balance of goods and services, except it excludes the services.

So if you come across a question and it says the balance of trade, then you're going to just look at the imports minus the exports. Not. Including the services just goods, but in the current account, we typically are using the balance of goods and services. So you want to include the services in the imports and exports.

What about the interest in dividends? Okay. How do we handle that? If interest is being paid out, because for example, you're paying interest on a foreign loan. That's like an export that's going out. What we're really looking at in this current account is where's the money going? Is it coming in or is it going out?

So if you're making payments for interest in dividends going out overseas, then that is basically a credit. If it's coming in, then that's a debit. Same with the unilateral transfers. These were things like four and eight. When the United States sends aid to foreign countries, we're exporting our money. If we're sending pension payments overseas, for some reason, that's an export, that's a credit.

Now the capital account is another account that deals with the balance between countries and what the capital account looks at is the result of the exchange and fixed or financial assets. In other words, things like equipment and securities.

next topic that we need to talk about with international economics is trade barriers and control strategies. And I just wanted to mention a few here, some of the relationships that exist between countries and this balance of trade, some countries will have import quotas. In other words, this is a limit on the imports.

And this is a strategy to try to keep the difference for the balancing trade. More balanced countries will use these import quotas. And for example, if the U S imports more goods from like Japan than they're exporting, the United States might decide to use import quotas and limit the number of imports coming in from Japan.

Tariffs is another control strategy. And what a tariff is, it's simply a tax on imports. Okay. So it's a tax on imports, which means that the imports are going to cost more to the consumer in this country. So if there's a tariff say on Japanese automobiles, then that's going to increase the price that us citizens pay on those Japanese automobiles.

Another control strategy is export incentives. Things like subsidies sometimes. A country like the United States may make payments to producers in the United States to send goods overseas. They'll pay them a little bit of money to add onto the price because the price overseas isn't large enough and that's considered a subsidy, but I'd like for you to do is to stop your video and do questions 42 through 51.

Let's do this group of questions together. We have a fact pattern here for the first three questions that deals with North Korea and South Korea and their ability to produce corn and potato chips. You using one unit of resource. We're told that North Korea could produce five bushels of corn, or they could produce 1000 units of potato chips.

South Korea. On the other hand can produce. 10 bushels of corn using one unit resource or 1,500 units of potato chips. Let's just do a little bit of analysis on our own. Before we get into the questions let's look at, who has the absolute advantage in producing corn and who has the absolute advantage in producing potato chips?

Remember absolute advantages, how much you can produce using one unit of resource, whoever can produce more using one unit of resource has the absolute advantage. North Korea is able to produce five bushels of corn using one unit of resource, but South Korea can produce 10. So South Korea has the absolute advantage in producing corn.

They also have the absolute advantage in producing potato chips because they're able to produce 1,500 potato chips compared to North Korea is 1000 units. We're a little bit luckier in this particular problem because the data is already given to us. On a per unit basis. I've seen other problems, like the example we've done previously, where it wasn't based upon the one unit of resource and you had to figure out what the amount of production would be for one unit of resource.

What about the competition advantage? Who has the competitive advantage and producing potato chips? Remember the country that has the competent advantage in producing potato chips has the lowest opportunity cost of producing the chips and the compute, the opportunity cost to producing chips. You have to compare the bushels of corn.

You would have to give up to the number of units of chips that you would be able to produce. So looking at North Korea, they would give up. Five bushels of corn in order to produce the thousand units of potato chips. In other words, that's an opportunity cost of one over 200 for South Korea would have to give up 10 bushels of corn in order to produce 1,500 units of potato chips.

So 10 divided by 1,500 would be one over 150. And of course, one over 200. The opportunity cost for North Korea is lower than the opportunity cost for South Korea of one over 200, a one over 150. So North Korea has the competition advantage in producing potatoes chips. What about producing corn? Again, the country that has the conflict of advantage and producing corn, it's going to have the lowest opportunity cost, which means if you're going to produce corn and you're going to give up producing potato chips.

So what is the opportunity cost for North Korea? North Korea would give up a thousand units of potato chips in order to produce five bushels of corn. That's an opportunity cost of 200 for South Korea. They would have to give up 1,500 units of potato chips in order to produce 10 bushels of corn.

1,500 divided by 10 would be 150. So South Korea has the lowest opportunity cost, and therefore has the competence advantage in producing corn? Knowing this, we should be able to answer these questions. The first question it says in trade between North Korea and South Korea, what? We already saw that.

South Korea has a confident advantage in producing corn. And that is the answer in B let's look at the other answers, make sure that they were wrong. ACE has North Korea has an absolute advantage in producing corn. We said that South Korea had the absolute advantage in producing both corn and chips. So a is not right.

See North Korea has confident advantage in producing corn. No, that's the opposite of the correct answer, which is letter B, which we've already computed. D South Korea has a conflict of advantage in producing chips. Now we said that North Korea had the conflict of advantage in producing chips. So B is the only correct answer.

And that question in the next question, it says, if there are free trade between the two countries, which one of the following statements would be true, Hey, only North Korea will gain from free trade. No. Theoretically everyone is going to gain from free trade, because then we're going to have the maximum amount of output you saw.

In our previous example that after specialization, there was more bushels of of cotton bales of cotton and wheat being produced. Okay, so specialization is going to benefit everybody. That'd be more output B South Korea would specialize in the production of both chips and corn. No South Korea is going to just produce the corn because they have the comfort of advantage in corn.

North Korea had this conference of advantage and chips will be, is not correct. See, South Korea will export ships to North Korea. No South Korea has comparative advantage in core, and they're not going to be exporting any chips to North Korea. North Korea can produce chips better than North Korea is going to specialize in the chips.

The answer must be D North Korea will specialize in the production of chips. Now the third question is a little bit more difficult. This is assuming free trade between the. South Korea and North Korea, the relative prices of the corn and the chips would be what? The answer here is going to be big.

It's going to be between 150 and 200 chips for one bushel of corn. Now, why is that correct? Where we call that North Korea is opportunity cost to produce one bushel of corn is 200 units of chips. South Korea is opportunity costs for producing one bushel of corn is 150 units of chip chips. That's the lowest price that South Korea would charge would be 150 and North Korea wouldn't pay more than excuse me.

The North Korea would only be willing to pay around 200. So the answer is B. Next question says, what is the consequence of tariffs on imports of a product? Remember we said that tariffs is a tax on these imports, and that makes the cost of the final consumer higher. And the answer is C a higher cost for the consumer, the important product. A's not correct because it's not going to result in higher consumption.

The cost is going to be higher. And because the cost is higher, we know that there would be less demand. So a is not correct B there would be lower profits on rivaled domestic products. The tax on imports is not really going to affect the domestic products. And in fact, by taxing or providing a tariff on these imports that makes the domestic products a little bit more competitive and that they don't have to reduce the price in order to compete with.

The imports. So the profits are not going to be affected on rivaled domestic products. These are lower cost for the consumer on rival domestic products. No, it's not going to result in any lower costs. It's still going to be charging the same price. So the answer is C the next question, it says been a spot exchange rate for the us dollar against the Euro dollar of 1.209 in a 90 day forward rate of 1.1956.

We said that when the Ford rate is lower than the spot rate, that Ford rate was at a discount. And that's the answer to see the Ford Euro dollar. Is it a discount against the dollar?

The next question says if the us dollar British pound exchange rate is $1 for 0.5, eight British pounds. A product priced at 45 pounds will cost us consumer. How much we have to do is convert the pounds in the U S dollars. And the exchange rate is $1 4.58 British pounds. All we're going to have to do is multiply the 45 pounds times $1 divided by 0.58 British pounds.

The pounds will council cancel out leaving us $77 and 58 cents. The answer is B.

Next question, what would be the likely result of a decline in the value of the us dollar relative to the currencies of the trading partners of the U S? The value of the us dollar is declining. That means that the foreign currencies are getting stronger. And what that means is that U S exports to other countries will become cheaper for those foreign countries, because their dollar is stronger.

They're able to buy more. Items of us exports. So the U S exports will increase. The answer is C

the last question says generally how our balance of payment deficits and surpluses eliminated. We have typically in the currency markets. Flexible exchange rates or floating exchange rates. And just by the market mechanism of the floating exchange rates, this is how balance of payment depths and surpluses are eliminated.

The answer is C a says by adopting a common monetary unit. That's not going to help reduce any deficit surpluses because some countries will still import more or export more to certain countries. Be set by adopting tight monetary policies. That's not going to necessarily affect the opera. The exchanges between countries, it might impact a little bit in this country.

They'll have the change, but not necessarily in the other country. This has by taxing imports as necessary for import and export quantities to match not a really great thing to do. Usually tariffs and other control strategies. Sometimes backfire. And don't work the way that they're intended to. It's not really the best way to do it.

C is the best answer. Just let the market reach its own equilibrium. That's the end of our discussion on economics. On behalf of all of us here at bisque, I'd like to encourage you to study to lots and lots of questions. There's a very high correlation between doing lots of questions and doing well on the exam.

We'd like to wish you the best of luck.

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hello and welcome to our coverage of financial management. My name is Kevin Kimmer. And I'll be your instructor today. Before we get started, I wanted to give a little bit of advice. Nice to those of you that are sitting for the exam. The first time most of the candidates that I have instructed that have been successful demonstrated a few characteristics, one, all of them that made a choice to pass the BEC CPA Exam too.

They all set a plan. They all have a plan about how they're going to go about succeeding. And that plan usually incorporates a number of different avenues, including studying from textbooks using software, watching videos. But I think the biggest key you have to remember is that when you take the CPA exam, the BEC CPA Exam is questions.

And I think one of the. Better ways to prepare, although not the only way is to answer a lot of questions. And I've really encouraged you to answer as many questions as you can in preparing for the exam, because that gets you very involved with the topic that helps that information to sink in better than if you were just reading it or you were just watching it.

And whenever we go through this videotape today, and I. Have you do questions? I will tell you to stop the tape that's because I want you to get involved with it. I don't want you to sit back and just watch me answer the questions because you won't learn as much from that approach. So you need to get involved and the third aspect or positive characteristic, these people that are passing the CPA exam is they stick.

To their plan. They don't get sidetracked. They don't let in-laws distract them. They don't let the game on Friday night, get in the way. But when they plan to study, they actually follow up through with that in mind, let's go ahead and get into our topic. The first area under the topic of financial management, we'd like to talk about is working capital management.

I think call from your classes that working capital is equal to current assets minus current liabilities. Sometimes this is also referred to as net working capital. Again, networking capital is current assets minus current liabilities. And this concept working capital is a measure of liquidity.

Refers to the ability of the firm to meet its short term debts and obligations as they come due. So working capital is going to give us some indicator as to the ability of the firm to pay its short-term debts as they come due. So if you compute working capital and you take current assets minus the current liabilities, you have three possible situations.

One, you could get zero. If current assets were exactly equal to current liabilities, then working capital would be zero. And that's pretty unlikely. More likely situation would be if current assets were greater. Then current liabilities and of current assets are greater than current liabilities, then working capital is positive and that implies that the company is able to meet its short-term debts as they come due.

On the other hand of current assets are less than current liabilities, then working capital is negative, and this would suggest that the firm might experience some difficulties in satisfying their short-term debt. Now a related measure of liquidity is known as the current ratio and it uses the same information that the working capital concept does.

And that is current assets and current liabilities. And all it does is it expresses a ratio and with the current assets and the numerator and the current liabilities and the denominator. So if current ratio is. Greater than one. That means that the current assets are greater than the current liabilities.

So a positive or excuse me, a current ratio that is greater than one corresponds to a positive working capital. Also a current ratio that would be less than one would correspond to a working capital. That would be negative. So again, they give you the same kind of information. Just expresses it in a different way.

Now to compute working capital or the current ratio, we need to make sure that we remember what current assets consist of. And you'll recall that current assets consist of items like cash, marketable, securities accounts, receivables, prepaid items, and inventory. Again, current assets would include items like cash, marketable securities accounts, receivables.

Prepaid items and inventory. Examples of current liabilities would include accounts, payable, wages, payable, taxes, payable utilities payable, and unearned fees. Now I really think that the CPA exam is most likely to ask you how. Certain transactions would affect working capital. I really think that they're probably going to test your understanding of how transactions would affect working capital.

So I want you to do a number of questions. At this point, I want you to stop your tape and you go to your viewers guide and answer questions one through four. And when you get your answers, then you can come back. Then we'll go over them together. They get, I want to encourage you here. You really need to stop your tape.

If I tell you to stop your tape and do the questions you do that because you need to get active. You need to be a participant in this process. That's the best way to learn. So go ahead, stop your tape. Do questions one through four and come back. We'll do them together.

Welcome back. Let's go through these questions together. Number one says which of the following would increase the networking capital of a firm. So what you really have to do in a question like this is check all the possible answers. You really have to stop and do the analysis, and you have to know what working capital is.

Remember working capital. Current assets minus current liabilities letter a, it says the payment of wages payable. If you're going to pay wages payable, you're going to pay cash. So you know that you're going to have a decrease in cash, which is a decrease in a current asset. You also, we're going to pay off wages payable and that will decrease your liabilities, your current liabilities.

So you have both the decrease in current assets and a corresponding decrease in current liabilities. So when you take the decrease in current assets, minus the decrease in current liabilities, they really offset each other. And there's no effect on working capital. If you have any problems, seeing that, conceptually, if you like me, where you might want to do is make up some numbers, make up an example.

And if you're sitting in the exam, you've got some scratch paper, something you could write down some numbers here. For example, let's say that prior to the payment of wages payable here, you had current assets equal to 10, and you had current liabilities equal to eight. So your working capital is to the 10 minus the eight is to let's say that you then go on and you pay wages payable of two.

So you're going to decrease your current assets because cash is being used up. You're going to decrease it by two. That'll bring current assets down to eight. Your current liabilities will have gone from eight down to six because you paid $2 of liabilities. So your working capital after the payment is the eight minus the six equals two.

You still have working capital equal to two. And so a doesn't change working capital look at big collection of accounts receivables. In this case, we'd be collecting cash. That's an inflow, that's an increase in current assets, but you're going to be decreasing accounts receivables because you're not going to have that right anymore.

So you have a increase in current assets and a decrease in current assets that offset each other. And B is not the right answer because working capital is going to change. You look at letter C, it says refinancing short-term note payable with a three-year note payable. Okay. So we're going to be taking a short term note off the books and that's going to decrease current liabilities, but the incurrence or the issuance of the three-year note payable is a long-term liability.

It's not going to affect working capital at all. So only the payment of the short-term note payable, the refinancing of it is going to affect working capital by decreasing current liabilities. So you have the same amount of. Current assets minus a smaller number four or current liabilities. So your working capital is going to be higher.

And that answers the question, see results in an increase in the net, working capital of affirm. Now, what you want to do usually is check all the answers. You find it, the answer that you think is right, and C certainly appears to be the right answer. I also suggest it's a good idea. Read all the answers.

Sometimes you might find the answer. That's better. I don't think we'll find one. That's better than C, but let's check the, anyway, this has a purchase of a new building finance with the 25 year mortgage. Building is long-term asset. So acquiring a building. Is it going to change working capital and issuing a 25 year mortgage is a long-term debt and that's not going to affect working capital.

So a D is definitely not a right answer. The answer to number one is C. And the second question they ask you to determine the effect of the issuance of common stock for cash on the company's working capital and the current ratio. And what I suggest here in this kind of problem, take it one at a time.

Look at working capital first. Okay. And really would help maybe to think about what the journal entry is. The issuance of common stock for cash, we would be debiting cash would be receiving cash and that's a current asset. So current assets would be increasing when we issue the common stock we'll credit, common stock.

That's an owner's equity account, that's not a current asset or current liability. So the only part of this transaction that affects working capital is the increase in cash. So that will have an increase on the working capital because current assets went up. Current liabilities didn't change.

So we have an increase in working capital. So we know for number two, we want an answer for working capital that says increase. So it's either going to be a or C and we can eliminate B and D. Now let's go to the current ratio. What effect will having the issuance of common stock for cash have on the current ratio?

Again, cash is a current asset and that will be increasing. So our numerator is increasing. And the common stock is not a current asset or current liability, so it doesn't affect the ratio. So we have an increase in the numerator, no change in the denominator. And that's also going to increase the current ratio.

So the answer here would be letter C increase. One of the things I want to warn you about an analyzing working capital and current ratio. Is just because one increases like in this case, working capital increased doesn't necessarily mean that the current ratio will always increase and you might be wondering does that, does it sound right?

Sometimes you have to play with the numbers and I want you to be careful when you're doing questions that just because you have an increase in working capital doesn't mean you have an increase in current ratio or so mother Change like working capital doesn't change. What will happen to the current ratio?

You have to analyze every circumstance individually, because you can't always say that an increase in working capital will always be an increase in current ratio. For example, remember back in number one, letter a, when we were analyzing the payment of wages payable, I gave you that numerical example where we had current ratio, excuse me, working capital of two.

Remember that was 10 minus. The eight is equal to two. And then we paid off the two and that gave us eight of current assets and six of current liabilities. And we still had a working capital of tilt. That was no change in working capital. So you think maybe there was no change in current ratio, but if you analyze that situation, you find that there is the current ratio prior to the payment of wages payable would have been the 10 of current assets.

Divided by the eight of current liabilities. And that would give you 1.25. After the payment of the wages payable, you had current assets of eight and current liabilities of six, that would be eight divided by six. And that would give you a current ratio of 1.33. So although the working capital did not change.

The current ratio went from 1.25 to 1.3, three and increased. So be very careful, excuse me. And analyzing, working capital and current ratios. One might go in one direction, but that doesn't mean that the other will always go in the same direction. Let's look at number three, Adam company. Okay. Adam's company, board of directors was I densifying for courses of action.

And of course we want to choose. The course of action, that's going to maximize the networking capital. So you again, have to look at all four options and find out what happens to working capital. So let's start with option one option. One said that it would result in an increase in current assets by a hundred, and it would decrease current liabilities by 30.

So what effect does that have on working capital? If current assets go up by a hundred. Current liabilities go down by 30, that would actually have an increase of $130. So for option one, we have an increase of 130 option. Two says that current assets would increase by 160 and current liabilities would also increase by 40.

So you have an increase of one 60 minus an increase of current liabilities of 40. That's an increase of $120. Okay. That's less than an option. A, so we know B's not already answer option three said there would be a decrease in current assets by 150 and an increase in current liabilities of 50. Wow. If we have a decrease in current assets and increase in current liabilities, we're going to have a decrease in working capital.

In fact, that's a decrease in working capital equal to $200, right? Yeah. $150 decreased current assets. That's a negative minus an increase in current liabilities of 50 that's minus 200 option four resulted in a decrease in current assets of $120. That's going to reduce working capital. We also have a decrease in current liabilities of 85.

So that'll offset some of that decrease in current assets. You have the minus one 20 minus N. Decrease in current liabilities that's minus. Remember, that's really a plus 85. So 120 negative Mo plus 85 would give you a decrease of working capital of 35. So the answer here is a option. One gives us the biggest increase of $130.

The next question deals with Jean company. And gene company is evaluating a plan to expand its capacity. And if you go to the question that says, what is the estimated effect of the expansion on Jean's working capital? So what we have to do is we have to analyze what the current working capital is and compare that to what the planned results would be.

Now, you've got a list of a number of financial statement items. They're cash of securities. And the first thing you have to think about is are all of these related to working capital. In other words, I would go down this list and you have to identify the current assets and the current liabilities. And if you look down this list, fixed assets are not a current asset, not a current liability.

I would cross fixed assets out. Now we have two mortgages. We have a mortgage payable or current portion. So obviously that's a current liability. We also have mortgage payable, longterm. That's not a current liability you would want to cross through. That line and also the retained earnings.

That's not a current asset or current liability. So what we want to do here is let's start with the current, we'll take the cash of 4,000, the marketable securities of 20,000 accounts receivables of 45. The inventory of 43,000, those are all current assets. And then we would want to deduct the current liabilities, the accounts payable of 37,000, the mortgage payable of 18,000.

And you would end up with current or excuse me, working capital for the current situation of $57,000. Now let's go to the planned results again. We've crossed out the fixed assets. The long-term mortgage payable and the retained earnings. So if we add the cash of 10,000, the market securities have 11 counts receivables of 60,000 inventory of 53,000 and then subtract out the accounts payable, 46,000 and current mortgage payable, 34,000 we'll get working capital equal to $54,000.

So the company would have gone from 57,000. Dollars of working capital to 54,000, that would actually result in a decrease of working capital equal to $3,000. So the right answer here is letter D decrease of $3,000. Hope you did well on that set of questions certainly would encourage you to do more questions.

And if you're with me to that point, I think the next topic I'd like to talk to you about is cash management.

Now, one of the first things I'd like for you to learn about cash management is reasons why firms hold cash in the first place. Now, if you were to ask me Kevin, why the firms hold cash, I'd have to turn around to you and say, look, firms hold cash. Because cash is the special toilet paper of the future.

Okay. And I know I'm not off my rockers, but this is a little memory tool that I've come up with. Tell me, remember the five reasons why firms hold cash and the first letter in cash and special and toilet and paper and future all stand for one of the reasons. So cash is the special toilet paper of the future.

The C in cash represents compensating balance. Now a compensating balance is an amount that a. Company needs to maintain in their bank account to compensate the bank for services that they receive from the bank. Again, a compensating balance of simply an amount that the bank excuse me, the amount that the firm has to maintain in their bank account to compensate the bank for services that the bank provides them.

The S in special. Stands for speculation. And we talk about speculation. What we're referring to here is sometimes firms come across some bargain purchases that they didn't plan for. So speculative reasons or speculation here is unplanned bargain purchases firms like to keep some money on hand, just in case they come across a bargain, the tea and toilet stands for transactions.

These are the every day routine. Transactions of the company like meeting payroll buying inventory on a periodic basis. Okay. So transactions, the tea and toilet stands for transactions. The P and paper stands for precautionary measure. This is more or less a contingency for uncertainty. When companies prepare cash budgets, they prepare them w under certain expectations and.

The company needs to maintain some little bit extra cash as a contingency in case their forecast is not accurate. So it's just a consent contingency measure. Okay. That P for precautionary, the F and future stands for future cash requirements, companies will keep cash on hand or special outlays that they're planning for, right?

Like dividend payments, making debt payments and tax payments. So again, cash is the special toilet paper, the future, one of the things that you might want to keep in mind think about doing and your preparation for the CPA exam. Some of my more success students use flashcards. And this is a situation where you could write down C S T P F or cash as the special toilet paper, the future.

And on the other side, put compensating balance speculation. Transactions precautionary measures and future cash requirements. And then you can develop all these flashcards and use them. I know some people feel silly. They feel like it's something that they did in elementary school. And I certainly remember using them to learn like the multiplication tables and they work.

And so I really strongly encourage you to use a variety of techniques to help you learn things. Also using pneumonic tools like coming up with funny phrases, Cassius, special blood people of the future can help you and grasping all this material that you have to learn for the exam. Now, a good financial manager is going to understand the number of items.

A number of things so that they can increase the firm's cash balance. A good financial manager is going to increase the firm's cash balance. There's basically two ways that they could go about doing this. They could either speed up the cash collections of the firm, or they could also, and, or they could slow down any disbursements or payments.

And a good financial manager is going to have an understanding of something called float and take advantage of float. Now float is the time between when a customer mails a payment and when it becomes available in the firm's bank account. Again, float is the time between when a customer mails, the payment and when it becomes available in the firm's bank account.

And this float is composed of three items, mail, float, processing, float, and check clearing float, male float. Is the time between when the customer mails that payment and when the company actually receives it again, male floats a time when customer mails it and when the cust company receives it, processing float is the time that we, when the company receives the payment.

And when the check is actually deposited in the bank, they're actually processing it inside the company. Then check clearing float is the time between when the payment or the check is deposited at the bank. And when the funds actually become available to the company. Now, there are several ways that we could go about speeding up cash flows.

If you stop and think about it, you have a bunch of customers that also probably understand float, and they're going to be taking advantage of that float. And as a good financial manager, That manager would be interested in speeding up those cash flows and trying to eliminate some of that float here and there.

So we need to come up with some ways of speeding up those cash. Now I want you to stop think for a moment if you're coloring, acting cash slowly, in other words, cash collections are being delayed or a delay. That's not a good thing for your firm because that's keeping you from cash that you could be using.

Investing and making a return on, so it delays, not a very good thing. In fact, you might even say that delay is a crime. Now, if you had a crime, who would you call the law? In this case, when you have a delay, you're not going to call it the law, but the law. Again, I have a little memory aid here to help you remember five ways in speeding up cash inflows.

Okay. D E L a w. The law will help prevent the delay. What is the law Stanford or the law stands for D de-centralized collection centers, E electronic data interchange. The L stands for lockbox system. A stands for automated clearing houses and the w stands for wire transfers and depositary transfer checks.

So let's talk about each of these items, make sure you know what these are. Let's begin with decentralized collection centers. Let's say we have a company that has a centralized collection center, for example, located in Tampa, Florida, and this company has customers all over. The United States and they're mailing payments in from places like Hawaii and Oregon and Wyoming and New York and Texas and Alabama.

Okay. All coming into Tampa, Florida. Now the company would like to get access to their money a little bit faster. And they would be able to do so if they were to decentralize the collection process. In other words, instead of having everybody send their checks into Tampa, We can cut down some of that mail float by having decentralized centers.

For example, the company may open up a collection center in California to handle their Hawaiian and West coast customers and another in Texas for their customers in the Southwest. And maybe another collection center in New York for all their customers in new England, maybe one in Tampa for their Southeastern customers.

So decentralized collection centers will help us cut down on that mail float, and we'll get our money a little bit faster, but there is a trade off. Remember if you're going to open up these other collection centers, then you're also going to incur cost and having these collection centers open. So you really have to figure out whether or not you have more benefits coming in from having these decentralized collection centers.

Then the cost of those collection centers. Basically we have to look at how quickly we can get that money and how much faster we're getting money and figuring out how much interest or return we're getting on that excess funds. The fact that we have our money faster, we can invest it in overnight securities money market funds.

What have you. And so that's where we're going to get our benefits. Now, the E and the law stood for electronic data interchange. Electronic data interchange is simply the exchange of electronic documents from one computer to another computer. For example, some businesses accept payments for items that they sell on the internet through companies like PayPal.

And that's simply a form of electronic data interchange, which enables individuals to transfer money. To another individual or company at very little, if any cost and wow. If you have people transferring money electronically, there goes all that mail float. So we're going to get our money much quicker.

The L and D law stands for lockbox system. Now a lockbox system is an arrangement between a company and a bank. And in this arrangement, the bank is going to go to a special post office box that is there just for payments for that company. And sometimes they'll send employees over once two, maybe even three times a day, take the money, the payments out of that post office box and they'll deposit the funds, the checks into the bank account of the company.

Then they'll send the remittance advices to the company. And what happens in this arrangement is the check clearing process is actually beginning before the check processing process. Remember, before, when we talked about float, you thought of it more sequentially that you had the male float, then you had the check processing float, and then the check clearing float.

Here, we're taking that sequence and we're letting two of the items happen side by side. Okay. The check. Processing process actually is beginning before the check. Excuse me. I'm sorry. The check clearing process is actually beginning before the check processing process. The a and the law stands for automated clearing houses.

Now automated clearing houses are simply networks of banks. They're electronic networks that are operated by the federal reserve. Okay. And these networks, because they're electronically connected, it makes it easier to exchange information and move the funds from one bank to another. In fact, usually we're able to move banks of, excuse me, funds from one bank to another bank in less than one day.

Now the w and the law stands for wire transfers and the pository transfer checks. And again, this is a very fast way to move funds. However, it's very cool.

Now I want to go back to one of these items in the law. I want to go back to the lockbox system and go through an example with you. Because as I was saying, when we have these different approaches to speeding up cash inflows, we can't just blindly say let's do it because. Some of these items cost money.

And what you really have to do is make sure that the benefits that you receive from taking on one of these special approaches is going to exceed the cost of that approach. And so I want to look at lockbox system. As an example, if you go to your viewers guide, I have example number one on a lockbox system.

In the example, it says that a firm has daily cash receipts of $200,000 every day. The company receives $200,000. On average in a commercial bank has offered to reduce the collection time by three days. How by setting up this lockbox system, where the bank again goes to the special post office, pulls the money out automatically deposited in the company's bank account and starts that check clearing process before the check.

Excuse me, the check clearing process before the check processing process has even started now on the problem, it says the money market rates will average 12% during the year. Should the firm adopt the lockbox system and why? I broke it down into really four steps. Here they come across a lockbox system.

The first step. Is compute the increase in funds available because we're speeding up cash inflows where you get money faster. Now, remember the problem said that this company is receiving cash on average of $200 per day. And because of this lockbox system, we're going to be able to reduce the collection time by three days.

So we're going to take the $200,000 collections per day times the three days that we're speeding it up. Multiply that out. We get $600,000 increase in cash. So on average, during the year, we'll have $600,000 more cash on hand. And what do you do with that cash? You invest it. So in step two, what we'll do is we're going to compute the amount of interest that we can generate from those extra funds.

You all remember the interest formula. Interest is principal times rate times time, we're going to take that $600,000 of excess cash or increase in cash that we've got in step one. And we're going to invest that at the money market rate, which they gave him, the problem was 12%. So that's our interest rate and multiply it by the time we're assuming one year, 600,000 times the 12% we're going to have $72,000 more money due to the interest that is generated on these extra funds.

That's step two, step three. We need to compute the cost of the lockbox. Remember this isn't free. And in the problem, it mentioned that the bank offered to do this for fee of $4,000 per month. So this operates for 12 months, we'll take the $4,000 per month. Multiply it by the 12 months we get the $48,000.

That's the cost of operating the lockbox. Finally, you can go to step four. And you can compute the net benefit by taking the extra funds that we have from step three, the increase in interest of 72,000 subtract the cost of the lockbox that we computed in. Step three, the 72,000 minus the 48,000 will give us a net benefit of $24,000.

So in this case, the company would enter into a lockbox system with the bank. Cause they would be better off at $24,000.

Now that we've talked about speeding up cash inflows, I'd like to talk about slowing down cash outflows. In other words, how are we going to keep the money from flowing out so quickly? And we can do that in a number of ways. First is pay by draft. In other words, make full use of the float that we now have a good understanding of.

Pay by the check, put it in the mail, make it go through the mail and take all that time through the mail, float the check process and float and check clearing float. The second means of slowing down cash outflows. Be using something we call payable through drafts. Now payable through drafts pass. Our drafts.

Number of check is a draft, but this is not a check. A payable through draft is not payable on demand. And in this case, the draw is the payee. What happens a payable through draft must be presented to the issuer and then accept it. Now this is slower, but it's more expensive than using regular checks. So what cause it has higher processing costs and most businesses do prefer checks, but it is one way that we could slow down our cash disbursements.

A third means of slowing down our cash disbursements. Is to utilize what is known as a zero balancing checking account. This is an account that always maintains zero balance. Of course, when you write a check on an account that has a zero balance in it, then you have an overdraft. And what the bank does is that then because of that resulting overdraft, it will cover that overdraft by funds from a parent account.

So they have to wait until the funds are transferred from the parent account. To the zero balancing checking account to cover the overdraft. Again, the cost may be higher because the bank probably is going to charge a fee for the service. Now, another means of slowing down cash disbursements is to simply pay beyond the normal credit terms.

And this is not really advisable but it is possible. You could do this. Of course, you're going to risk ill will with your supplier and you could incur interest charges. Would like for you to do is try some questions, see how you're doing here. Make sure that you understand about float and speeding up cash inflows and slowing down cash outflows.

So at this point, I'd like you to stop your tape and do questions five through nine, get your answers, then come back and we'll do them together.

Welcome back. Hopefully you tried these questions and did well. Let's go over them and see how you did the question. Number five says four major motives for holding cash are well, remember what we talked about a number of moments ago, and that is. There are five major reasons for holding cash. And we learned that special memory aid cash is the special toilet paper of the future.

Remember the S stands for our, excuse me, I'm sorry. The C in cash stands for compensating balance and the S stands for speculative reasons. And the T stands for transactions. And the P stands for precautionary measures and the F stands for future requirements. So if you're in the exam, you got some scratch paper.

You sit down you're right. Cash is special. Toilet paper, the future, the C the S the T the P, and the F. And you write those down there. You can go through these quite these answers. Let's go through them and see what we have ACEs speculative. Yeah. That was one of the reasons social. No, that wasn't on list.

The estimate for speculative. So a is not the right answer. Go to B says speculative. Yes, that was one of them F fiduciary. Now we said the F was for future needs. Okay. So B's not the right answer. C we have transactional. Yes. That was the T P psychological. No, the P that we had was precautionary measures.

Let's look at D make sure that it's the right answer. A, B and C seem to be wrong. D. Transactional. Yes, that was the T the P precautionary, the C compensating balance and the aspect of the purposes and the answer to number five is letter D no number six asks us, which of the following would not result in accelerating cash inflows.

Remember here we were talking about the fact that the law would help prevent the leg. Okay.  If you keep that in mind, that decentralizing its collections would result in it. Remember D for DeLoss they had for decentralized collections, E stood for electronic data interchange. The L stood for lockbox systems.

The a stood for automated clearing houses and the w stood for wire transfers. Let's look at these answers and see what we have. Let's start with letter D says, initiating controls to accelerate the collection and deposit of checks over 225. If you initiate controls to accelerate the collection, it will result in accelerating cash inflows.

So that's not the answer. Again, the question says which of the following would not resolve. You have to find the one that would not result in accelerating cash flows, D does result in accelerating cash inflows, see lockbox arrangement. That was the L and D law that results in accelerating cash in flow.

So that's a good method of accelerating and that's not our answer here. Be decentralized it's collections. That was the D and the law. How about a compensating balances? Compensating balances. Doesn't accelerate cash in flows. Okay. That was a reason why we hold cash. So the answer to number six is letter a number seven, which of the following is a method of slowing down cash outflows.

Again, we talked about four methods of slowing down cash, outflows paying by draft payable through draft zero balancing checking account, and just paying beyond the normal credit terms. And you can see letter B. Probably standing right out there. Zero balancing checking account. That was one of the four.

Okay. So the answer to number seven is B number eight is about compensating balances. It says a compensating balance, a there's a level of inventory held to compensate for changes in the average quantity used over a four-month period of time. We haven't talked about inventory yet. We'll talk about it later.

That's not what compensating balances are. We remember compensating balance is a balance. There's an amount that the company must maintain its bank account to compensate the bank. And that's B says, compensates a bank for the services. It renders to the company. The answer is letter B, but again, as I mentioned before, it's always good to read all the answers.

Make sure there isn't a better one. So let's look at C is the amount of money withheld by a bank on a discounted note? No, that would simply, that's not a compensating balance. They might hold money. From a, on a note, discounted at the bank and that's going to represent their interests, but that's not called a compensating balance.

Date is used to compensate for possible losses than the company's longterm portfolio of securities available for sale. Now, we never talked about any such thing, these not the right answer. It is B number nine deals with camera court. This is a pretty unusual question because I've yet to ever see. A question on the BEC CPA Exam that is about Kimra court.

You don't see my name on there. Camera Corp uses a central collection system that requires all checks to be sent to it's Miami, Florida headquarters. And an average of five days is required for mail checks to be received. That's the mail float four days to process them check processing flow, and two days for the checks to clear the bank, the check clearing flips.

So there's a total of 11 days there. A lockbox system would reduce the mail and process time to five days and the check clearing time to one day. So this lockbox system is going to take the total float time down to six days. We had 11 prior to the lockbox six after we, we're going to say five days, we're going to collect money five days faster.

Now it says Kimra corporation has an average daily collections of $150,000. If care Corp adopts the lockbox system. How much would it average cash balance increased by? That was step one that we showed you earlier in the four steps of determining the benefit, the net benefit of a lockbox system. We don't have to go through the whole process.

We're just asked what the increase in average cash balances. And that's going to take the 11 days of float time. Minus six days, we've decreased five days of float. So we're going to get our $150,000 a day times our five days. Is $750,000. And our answer is let her be seven 50.

Now that we've discussed how good financial managers increase the firm's cash balance. The question then becomes what are those financial managers going to do with that extra cash? And need to keep in mind that they ought to take that excess cash and they should invest in liquid assets that provide a high return and yet imposed little risk, such as money market instruments that I've included in a table in your viewers guide.

If you go to your viewers guide and look at table one, I put this table together to give you a feel. For the different kinds of money market instruments that exist and what kind of maturities they have, how marketable they are. And one of the things that I want to state right off the bat about this table is that as we go down the table from top to bottom, as we go from the U S treasury bills on down the yields on these instruments tend to increase.

And as generally, because as we go down this list, The risk is also increasing. Remember that interest returns are usually can measure it with risk. So us treasury bills being up at the top are your less, or your least risky money market instruments. And as you can see there, they have a variety of maturities, basically three months, six months in a year.

And these are  very highly marketable securities, very safe investments, and probably the most popular investment. When companies want to invest in something and have quick access to the cash later, us treasury bills are going to be a safe investment and very marketable. So they'll be able to get their cash back relatively easily below the U S treasury bills.

You'll see federal agency issues. Now there's five major federal agencies, and I'm not sure that you would really need to learn all five major agencies that will issue. Money market instruments, but they're pretty easy to recognize because four of them have the word federal in their name. So you're on the BEC CPA Exam and you come across an agency that's issued a money market instrument.

It's probably one of those big five. If it's got the word federal in there, for example, a Fannie Mae, the federal national mortgage association issues, money market instruments, and these instruments vary maturity from just a few days to even a year. And there's a really good market. For this they're very highly marketable.

We also have short-term municipal securities. These are securities that can be issued by States and local governments. Again, there's a variety of maturities. They could be one month up to a year. They're not as marketable as the U S treasury bills, however, or the federal agency issues, but they're still fairly marketable.

Continuing on. You also see that we have negotiable certificates of deposits. These are rather, usually rather large amounts issued by banks and again, a variety of maturities and there's a fairly good market there. Now commercial paper is basically promissory notes issued by your bigger firms.

There's not a really big secondary market here. A lot of this commercial paper gets issued. Directly to an investor, for example, IBM might issue some commercial paper and get directly to an investor and they tend not to trade that commercial paper, even though it's negotiable instrument, they tend not to have much of a secondary market.

There are a number of other firms not. Is big like IBM or any of those Dow 30 or whatever, some of your smaller firms, when they issue commercial paper, they sometimes have to go through a broker. So there is somewhat of a market there, but it's not strong like the market for a us treasury bills and federal agency issues also have repurchase agreements, also known as repos.

We have bankers acceptances, which are backed by the bank. We have Euro dollar deposits, money market funds and money market accounts. So you might want to spend some time in your studies looking at this table. And again, keep in mind that as we go from the top of the list, down to the bottom, the yields are going to increase because usually the risk is increasing.

What I'd like for you to do is take a few moments and look at some questions after you've had a chance to look at this table We're likely to do a stop at your tape at this point. Study that table a little bit and then answer questions 10 through 14. And when you have your answers, then you can come back and we'll go through them together.

Okay. Welcome back. Let's start with number 10 says which of the following is the least appropriate. Substitute for cash. Get on an exam. You have to be very close attention to the wording. You want to look for words like most. Least you want to work? Look for words like not. Okay. So least appropriate substitute for cash.

A banker's acceptance. That's an appropriate substitute for cash. That's on our list of money market instruments, B commercial paper. That's also on our list. C convertible bonds. They're not on a list. A convertible bonds are more long-term in nature. D U S treasury bills. That was on our list and TAC that's the most popular substitute for cash.

So our answer to number 10 is letter C convertible bonds,

11 deals with commercial paper. Number 11 is commercial paper. A generally has interest rates that are lower than treasury bills. Again, if you go back to that table, I said that generally the rates increase as you go down. Okay. Okay. And as you go down that table and commercial paper is below the treasury bills.

So it's going to have a higher interest rate typically than treasury bills is not a correct answer. There B is commercial paper, a secured promissory note. What is a, basically a promissory note, but it's not necessarily secured by anything. So B's not the right answer. Let her see says typically does not have an active secondary market.

Yes, we said that was one of the characteristics of commercial paper is a lot of times this paper is issued directly to the investors and there isn't that much of a secondary market. There is one, but it's not very active. C looks like the best answer. Let's check. D says has maturities of greater than one year.

Now the commercial paper we want to talk about here, we're talking about. Short term investments and these not right. The answer to number 11 is C number 12 says short term notes issued by the federal national mortgage association. Fannie Mae are called what again? I mentioned, if you see any federal agencies, these are agency securities.

The answer is a short-term notes issued by Fanny Mae are called agency securities. Number 13, 13 says which of the following is most often used as a cash substitute most often. And that would be E as we mentioned, treasury bills because they're the safest short-term investment. Okay. Again, as we go through that list, I'll put the top treasury bills are the safest.

They have the lowest yields. Number 14 are the following. The marketable security with the least default risk is again, we know that E treasury bills. Okay. But as you can see, what if treasury bills wasn't on that list and you had to choose between agency, securities and bankers acceptances.

That's why it's a good idea that you take a look at that table and keep in mind as you go down the list, the default risk or the risk involved tends to increase as you go down the list, which is why the returns. Normally increase as you go down that list. So I think you ought to spend some time studying that table to make sure that you can make comparisons about the safety and the interest rates involved with these various money market instruments.

Yeah, that I'd like to get into next is receivables management. Now, when a company is establishing credit policies, they often don't have a lot of room to work with because credit policies and setting credit standards across industries is usually fairly competitive. But firms do occasionally need to tweak their credit policy.

And when they're considering making credit policy changes, they ought to analyze the impact of those changes on company profits. Now to really understand credit policy, you need to make sure that, The different variables that compose the company's credit policy that includes credit standards, the credit standards, or the financial attributes of the customers you give credit to.

And you have to realize that these standards are going to affect your bad debt expenses. It's going to affect your investment in receivables and your collection costs. And so as we change these standards, that will have an impact on. These items, we also have credit quality. Basically when you establish certain credit standards, we can pretty much predict what the probability of default is for a particular class of customers.

Okay. So even though we don't know specifically who won't end up paying, we do know that for a particular class of customers, that a certain percentage of those receivables will go back. Credit period is also a credit policy variable. And this is simply the duration of the credit. We also have cash discounts, Tash cash discounts, the discounts that we offer to entice our customers to pay more quickly.

And of course, if we offer attractive cash discounts, then more of our customers may pay more quickly and that will reduce some of our expenses and collection efforts. Another credit policy variable is collection policies, and these are procedures that relate to how we handle our overdue accounts. Again, collection policies relate to the procedures that we use to handle our overdue accounts.

Now ratios are really important and analyzing accounts receivables, and I think you need to know this. For the financial management section of the exam, the first ratio is receivables turnover ratio. And I always tell my students whenever you hear a ratio and it says turnover, you simply turn over, back on top of the word that comes before the turnover.

In other words, receivables is going to end up being in the denominator. So for receivables turnover ratio, we will compute it by taking sales and dividing by average accounts receivables. Again. We have receivables turnover. You turn over or put receivable. Let's look at another. Look in your viewers guide at question number 15, dealing with big company, big companies, budgeted sales for the coming year are expected to be $540 million of which 80% are expected to be credit sales.

It terms net 30. Now big is estimating that by using credit standards, they'll be able to increase the credit sales by 30%. And that's going to result in an increase in the average collection period from 25 days up to 40 days, the question asks us about the proposed relaxation to credit standards. Will it result in an increase in the average accounts, receivables balance?

How much of an increase in the average accounts receivables balance? Okay. First, we need to determine the average balance of accounts receivables. If there is no change, if we don't change that policy sales are still expected to be $540 million. But remember that only 80% of those are on account.

So in terms of our receivables, the $540 million of sales and account excuse me, $540 million of sales times 80% on account. Is $432 million of actual credit sales. So now that we have the $432 million of sales and account for a year, what's the average daily sales on account. Okay. So we're going to take that yearly amount.

The fi excuse me, 430, $2,000. Try to get it right here. $432 million. We'll spread that over the 360 days. And our average daily sales and account would be 1 million, $200,000. But again, that's daily sales on account. We need to know what our average investment is. And on average, we have an average collection period of 25 days.

So those sales will sit in our accounts receivables on average for 25 days. That will give us a $30 million average balance of receivables under the old credit policy. Now, what about if we change the policy? If we changed the policy, it says that sales would increase by 30%. So what we have to do is remember that only 80% of those sales were on account.

What we can do is start with the $432 million of credit sales that we had before. The change number we took. 80% of the 4 million of the 4 million make $540 million. We'd take an 80% of that to get the $432 million. Now we can increase that by 30% multiply the 432 million by 1.3 and we'll get $561,600,000 in credit sales for the entire year.

If we divide that by average daily sales, excuse me, by 360 days, we will get the average daily sales on account. That would be 1,560,000. Yeah. We take the annual amount of credit sales divided by three and 60 days. We get the $1,560,000 of sales on account on a given day. But how long are we going to hold these under the new credit policy?

I said 40 days. So we multiply it by the 40 day average collection period. We'll get 62 million, $400,000 of average receivables. So what's the increase we've gone from 30 million up to three 60, 2 million, 400,000. That's an increase of 32 million, $400,000. And the answer is big. Now what I'd like for you to do is.

Stop your tape and do a question on your own. See how you handle it. I want you to stop your tape, do question number 16. And when you get your answer, come back and we'll do it together.

Now. Number 16 deals with Smith wholesale company, and they have average daily sales on account $50,000. This is assuming a 360 day year. And all of their sales are on credit terms where they offer 2% discount. If customers pay within 10 days, otherwise the full amount is due within 45 days. This is customers representing 30% of sales pay on day 45.

So 30% don't take the discount at all. They just wait 45 days and then they pay. But the remaining amount, which of course would be 70%, take the discount and pay on day 10. And the question asks, what are the Smith's average daily collections from customers? On any given day, Smith will be collecting from two different sources.

Smith will be collecting a hundred percent of sales that for those customers that aren't taking advantage of the discount, and it's not a hundred percent of the sales, but remember we said that the customers that aren't taking the discounts 30%, 30% of your average daily sales are going to be coming in on a given day 45 days later.

Also on any given day, we'll be collecting 70% of the average daily sales where our customers have taken advantage of the discount. So all we have to do is take the 30% of the customers that don't pay. Within the discount period, they pay the full amount, multiply that by the average daily sales of 50,000.

And we get $15,000 that's every day, we're going to receive $15,000 from customers that don't take the discount. We're also going to receive on any given day, 70% of 50,000. In other words, customers, 70% of our customers take the discount. So we're going to collect on the other $35,000 of average daily sales, but we don't collect the full 35,000 member.

They're taking advantage of a discount. If they get a 2% discount, they're only going to pay 98%. So we'd have to take the $35,000 of receivables that we should be collecting on in a given day and multiply it by 98%. We get $34,300. And so the total amount that we collect is 49,300. And our answer is letter C.

Now, if you're with me to here, what I'd like to talk about next is inventory management.

Now an inventory management companies are trying to minimize the number of costs, ordering costs, carrying costs. Stockout costs. And we talk about ordering costs. We're talking about those costs consisting of placing an order and receiving an order for goods. Again, ordering costs consists of cost of placing and receiving an order of goods what's included in ordering costs.

This would include things like quantity discounts, lost shipping costs. Purchasing costs and set up costs in a manufacturing environment. Again, examples of ordering costs would be quantity discounts, lost shipping costs, purchasing costs and setup costs, carrying costs consist of holding inventory for a given period of time.

Just like it sounds carrying cost of holding inventory for a given period of time. And the cost that we would include in here would be handling costs. Interest on the invested capital storage costs and obsolescence again, carrying costs would include handling costs, interest on invested capital storage costs and obsolescence.

Now stock at costs are incurred when a firm is unable to fill an order. In other words, you risk ill will with customers because you aren't able to make the sale. They're not able to get the product that they want. Sometimes this causes you to have a backlog and you have to incur some extra costs to catch up.

And so you might have overtime costs. And so you want to avoid stockout costs. The stockout costs are never good. Now most firms use an economic order quantity model, and hopefully you remember from. Your courses at school, the economic order quantity, the basic economic order quantity is computed by taking the square root of two times.

The ordering cost per order times the annual demand and divided by the carrying cost per order. Or I've put there in your viewers guide that formula. I put the square root of two O D. Over see, and in fact, I have a nice little memory tool that I use to remember this that is too Odie. Oversea makes you a square root.

Okay. So you can imagine if you were to die oversea, to overdose overseas, that would be bad news. Right? Square root of two times. Oh times the oversea. So to overdose, oversea makes you a square root. No. What I'd like to do is look at illustration and the viewers guy about how we can approach a number of issues related to inventory management.

So if you look at the Florida electronic tools example, it says that Florida electronic tools uses integrated circuits and manufacturing calculators, and we have information regarding various costs and demand. Demand is for 110,000 units a year. The integrated circuits cost $2 each. It costs us an average of 30 cents per year to carry one integrated circuit in inventory.

And it costs us $41 and 25 cents to place an order. It takes about 15 days from the time an order is placed until it is received. And Florida electronics assumes that there are 250 working days per year, and there are calculations. Okay. So the first thing that we would like to do is to determine the economic order quantity, what is the amount that they should purchase every time so that they minimize the ordering and the carrying costs.

So all I do is fill in our formula again, remember EOQ is to overdose. Oversees makes you a square root. So in the numerator, we have the two, the cost of placing an order was $41 and 25 cents D the annual demand is 110,000 integrated circuits. And our denominator will have see the carrying costs per unit, which is 30 cents.

And when we compute that we get the economic order, quantity of 5,500 units. That's pretty basic, but what if they asked you how many orders you would have to place each year? The way that you would compute the number of orders that you place each year is you would take the annual demand and divide that by the economic order quantity.

We know that we need 110,000 units every year. If we're ordering them in batches of 5,500 units, then we're going to have to place 20 orders during the year. What's the reorder point. At what point is Florida electronics going to put in their order? The reorder point is the level of inventory in which we must place an order so that we don't run out of inventory.

So in other words, we have to have some idea as to how much we're going to use over a period of time after we've placed the order until we receive that order, that time between when we placed the order. And when we receive, it's known as lead time. So your reorder point is equal to your lead time in days, times your daily demand.

On the problem that told us that the lead time is 15 days and we would multiply that by our average daily demand to get the daily demand, you'd have to take your annual demand divided by the number of years and excuse me, the number of days in the year. So we're going to take 110,000 units.

Divide that by 250 days to get 440 units per day multiplied by the 15 days of lead time. And we would need to reorder when Florida electronics was down to 6,600 units. Now, what about the safety stock? The safety stock is like an extra amount. It's a buffer it's a contingency plan. In case your expectations regarding lead time are incorrect because there can be some variability associated with our estimates.

So some firms like to carry what they call safety stock in a mountain case they're wrong. So let's assume that Florida electronics decided to maintain a two day safety stock. What they would do is they would keep enough inventory on hand for an extra two days. Remember, they're using 440 units a day for two days.

That's 880 units. So instead of reordering at 6,600 units, they would reorder it 7,480. Okay. The 6,600 reorder point before we computed plus the 880. Okay. What I'd like for you to do now is to try a number of questions, dealing with inventory management, like for you to stop you take, do questions. Number 17 through 21.

When you get your answers, come back. We'll do them together.

Welcome back. Number 17 says the economic order quantity for a product is 1000 units. However, new orders require five working days. Lead time during which a hundred units will be used. Given this information, what's the correct economic order quantity. They told us the economic order quantity is a thousand units.

What's this about the lead time we need five days lead time. Five days lead time that has no effect on economic order quantity. Remember your formula for economic order, quantity to overdose oversees makes you a square root. There's no lead time in there. Okay. The answer to number 17 is letter big 1000 units.

In number 18 says an inventory in inventory management, the safety stock will tend to decrease if what? Okay. What's going to make our safety stock decrease. Let's start with the letter D says the carrying costs decrease. Okay. If the carrying costs decrease, then we can carry more units for a, and for the same amount of money that we were before.

In which case we could increase our safety stock. So these not the right answer. Let her see. This is variability of the usage rate increases our variability. That means our uncertainty are our estimates. Our estimates of the usage rate are going to increase well. If our usage rates increase, then we're going to want to increase our safety stock to make sure that we don't run out.

So C is not the right answer. It's not going to cause us to decrease our safety stock. How about letter B says variability, the lead time decreases. Also, we have a decrease in variability, a decrease in uncertainty. So we're more sure about it. If we're more sure than we can keep less on hand because we don't have that variability, we don't have that broad uncertainty in there.

So B is the correct answer. We'll be able to decrease the amount of safety stock let's check letter a make sure it's not correct. Let her ACEs cost of running out of stock increases. If our costs of running out of stock increases, you're going to want to increase your safety stock because member, it costs us to run out.

We don't want to have stockout costs. So that would cause an increase in safety stock, not a decreased. Again, the answer to number 18 is letter B. Number 19 says an increase in which one of the following variables would decrease. Our economic order quantity. Okay. Which one of these is going to cause a decrease in EOQ remember what your equation is for EOQ to overdose oversees X, U a square root.

Okay. Let's start with letter D cost per order. Okay. Where did our cost per order go in our formula? Did we even have a cost per order in our formula, we had a carrying cost. We have an ordering cost, but we didn't say anything about the cost of ordering. You go back to that Florida electronics example.

You remember that each integrated circuit costs $2. We never even used that. We weren't concerned with the cost for the order. We're concerned about the carrying costs and the the ordering cost and the carrying cost. Part of EOQ is not the cost of the items. Let's go to let her see annual sales. Annual sales is part of our formula.

It's in the numerator, right? What it says in the question and increase in which one of the following what impact would an increase in sales have if you had an increase in sales, your numerator would increase, which means that number under the square root sign is getting larger. And at the number of that square root sign is getting larger than the overall EOQ is going to be getting larger.

That's not causing a decrease. So C is not the right answer. B safety stock level is in that Yoku formula. It's not going to have an impact on our EOQ, so B's not the right answer. It must be a, but let's check it and make sure that AA is indeed the right answer. What about caring costs?

Does an increase in carrying costs cause a decrease in EOQ well, carrying costs is the C to overdose. Oversees makes you a square root. So our denominator is getting larger and if your denominator gets larger in a fraction, then your overall numbers is going to get smaller. And if you take the square root of a smaller number, it's going to be even smaller.

So yes, the answer to number 19 is a carrying costs when they increase, do decrease Voq number 20, what costs are included in carrying costs and the economic order quantity model. Okay. We talked about this earlier about some of the examples of carrying costs is a shipping cost part of carrying costs. No that's more ordering, right?

B quantity discounts loss. Ah, that's an ordering cost. How about C handling costs? Yes, that's a cost of carrying the inventory. So he is the correct answer for number 20. And again, let's check number 26 would be letter D to make sure that it's not right purchasing costs. It's purchasing costs, including carrying costs.

No, it's not. So the answer to 20 is let her see. Number 21. It says, which of the following is least likely to affect the inventory stock safety stock level. Okay. Least likely let's read through them. See letter a says degree of customer intolerance for back orders. If your customers are

Or excuse me, which of the following is least likely to affect the inventory safety stock level? Will the degree of customer tolerance affect safety stock level? Yes, it does. Absolutely. If your customers are intolerant, then they're going to go elsewhere for their products in the future, and you don't want that.

So that's going to increase the stockout costs and that's going to have a big effect on your safety stock level. So a is not least likely. It is very likely to have an impact. How about letter B degree of sales forecast uncertainty? We've mentioned before that if you have increased, if you have uncertainty that will increase stockout costs, okay.

The increased uncertainty causes our safety stock level to increase C degree of shipment lead time uncertainty. Uncertainty as to when we were going to receive orders will increase the level of Stacey safety stock. So that has a likely effect on our safety stock level. How about D order placement costs?

Order placement costs is going to affect our EOQ, but how is it going to affect our safety stock level? I don't see it. How about letter E stockout costs? Yeah, stockout costs are going to affect our safety stock level. So the answer is D for number 21 order placement costs is your answer.

Talking about working capital management. And we said working capital is current assets minus current liabilities. So we've talked about a number of topics related to working capital management. We've talked about cash management, receivables management, and inventory management. So it's time to move on to talking about some of the current liabilities talking about short term credit.

One of the most interesting things about short term credit is the annual financing costs. And what I'd like to look at first is a situation where we try to decide when we should take the cash discount when a supplier offers a cash discount so that we would pay our payable more quickly to them. And so you might wonder when should we pay, when should we take advantage of that discount?

And the answer is the firm should pay within the discount period. If the firm's cost of capital, what they can borrow, it is less than the cost of not taking the discount. Okay. In other words, there is a certain cost associated with not taking that discount and that's called annual financing costs. Now in your viewers guide.

I've given you a general form of computing, annual financing costs, and you really need to look at it in two parts. The first part is the cost associated with borrowing divided by the funds that are basically available from that borrowing. Okay. But we have to recall is that we may not always borrow for a whole year.

And if we want to put this in terms of an annual financing cost, We have to annualize it. So there's a second component, a second part to computing annual financing costs. And that is annualizing. It, what you do in the second part is take the days in the year divided by the term of the loan. So how do we relate this general formula to a cash discount?

Again, we're going to take advantage of the cash discount. If we can borrow at a rate that is lower. Than the average or excuse me, the annual financing costs it's implied by not taking this cash discount. So how do we compute the annual financing costs associated with a cash discount or not taking that cash discount?

Again, there's a formula I put there in the viewers guide for you. Annual financing cost is equal to, again, the first part, remember what the first part of the formula was costs associated with the loan. Annual financing costs. When we're talking about cash discounts is related to not taking the cash discount.

So the cost associated with the loan is the discount that we're not taking advantage of. So in our numerator, in the first part of our formula, we have discount percentage where we want to divide that first part by the funds that are made available. If we were to borrow the amount of money that we would have had to pay on this.

Would be a hundred percent minus that discount. So the denominator is a hundred percent minus the discount percentage. Then we have to annualize it over in the second part of the formula. We've got 360 days in a year. And the numerator again, problem could specify that it's 365 days. You just have to pay attention to what's in the problem in the denominator.

We want the term of the loan. The term of the loan or this annual financing cost, the cost of not taking this discount is related to that period. That goes from the discount period to the end of the credit period. There is what we have to do is take the full credit period. If the terms were two, 10 net 30, we will be taking the full credit period of 30 minus the 10 days.

That's the discount period. Okay. Yeah, we're going to do an example here. If you look in your viewers guide, I have an example of the cost and not taking the discount. When the credit terms are one 15 net 30. And what we simply do is plug in our numbers into our formula. We'll plug in the 1% discount.

Number one slash 15 stands for 1% discount paid within 15 days. So we're going to have a 1% of the numerator for the first part of the formula, the denominator, a hundred percent minus the discount percentage. Discount presents 1%. We're going to end up with 99% that denominator. Then we have to annualize it.

We're going to multiply it by 360 days. And we'll divide that by that period associated with not taking the discount. The full amount is due within 30 days. We'll take 30 days minus the 15 days. That's the day that we have to pay. If we're going to take advantage of the discount. And our denominator will be 15 days.

And when you multiply that out, you get 24.2, 4% annualized interest.

I look at a problem together. Let's look at question number 22. Says the annual interest cost associated with a company offering credit terms of two, 10 net 30 based on a 360 day year is what again, use your formula. The discount percentage is 2%. So we're going to have 2% divided by 98%. We need to annualize that 360 days divided by 20 days.

Why we had 30 days to pay the full amount. We had 10 days to pay within the discount period. So the is the 30 days minus the 10 or 20 days and we'll get 36.7, 3% annualized interest. And the answer to number 22 is D I'd like for you to do, is to stop your tape and try it a couple more questions I'd like for you to try questions.

23 and 24. And then we'll come back and go over the answers.

Okay. Welcome back. Let's do number 23 together. Number 23 says affirm requires payment within 45 days, but allows customers to take a discount of 2%. If paid within 15 days, swimming a 360 day year, what's the annual cost of the trade credit terms. Yeah, we fill in our formula. Our discount is 2%. Our denominator for the first part of our formula is going to be 98%.

Cause we're going to take a hundred percent minus 2% terms of annualizing it. We have 360 day year, and then the denominator part of the annualization. We're going to take the full discount, excuse me, the full credit period of 45 days minus the 15 days of the discount period. And in that case, we'd have 30 and they'd denominator and we'll get 24.4, 9% annualized interest.

The answer is letter B. Okay. Number 24. So as an organization would usually offer credit terms of two, 10 net 30. When, what a. So as the cost of capital is approximately the prime rate. We haven't said anything about the prime rate. The fact that our cost of capital is approximately that's great, but why would that cause us to offer credit terms of two, 10 net 30 B the organization can borrow funds at a rate that exceeds the annual financing costs?

That's not necessarily a good thing. It'd be better if we could borrow funds at a lower rate, but again, why would we offer the terms two, 10 net 30 C. All of its major competitors are offering the same terms and the organization has a shortage of cash. Remember I said much earlier on in the video that our credit terms are often driven by our competitors because the industry there for credit is very competitive.

And so that's a good answer. We have a shortage of cash and that's a good reason to offer a. Discount of 2%, because if we have a shortage of cash, we need to get the cash in sooner. So C sounds like a very good answer. Let's look at D says the organization and borrow funds at a rate less than annual financing costs.

Again, that's a good thing. It's great that we can borrow money at less than that, but what does that have to do with extending credit terms? So the best answer here for number 24 is letter C.

Okay. Now I wanted to show you one more thing about this annual financing costs, what we've done so far, the formula that I've given to you does give us an annualized interest rate. But what it fails to do is take into consideration compounding, okay. Compounded interest. And so if you look in your viewers guided example, number five, I have in there a situation where we're to determine the cost of not taking the discount when the credit terms are one 15 net 30.

And what we're to do is to assume compounded interest. And I've given you the formula there, the annual financing cost, if we want to assume compounded interest is equal to one, plus the discount rate divided by the amount that you borrow. But then we take that whole quantity and we raise it to the power of 360 days divided by the discount period.

And then we subtract one and you can see there in the viewer's guide that will we plug in all the numbers, we get 27.3% annualized interest, and you might be interested in comparing that to one of the earlier examples where we looked at having a 1% discount if paid within 15 days. And in that situation, We had annualized interest of 24.2, 4%.

That was example number four. So you can see that indeed by compounding the interest using this formula, we do get an annual financing cost that is greater because it does take into consideration the effects of compounded interest.

Talk about another possible situation. Let's look at an example or a situation where I have annual financing costs when the interest is not specified. If you look in your viewers guide question number 25 on AC Inc. You'll notice that it says that AC incorporated issues three month commercial paper with a face value of 500,000.

But they issue it for $490,000. They issue it for a discount and they also incur a transaction cost of a thousand dollars since the effect of annualized percentage cost of the financing based on a 360 day year will be what, remember what your general formula is? Your general formula for annual financing cost is equal to the cost of borrowing divided by the cash proceeds.

Okay. What is it going to cost AC to borrow in the situation? Okay they're issuing paper with the face value of 500,000. They're only getting four to 90,000. We think of that $10,000, usually as an interest charge, that's taken out up front discounting that paper, but they also incur a transaction cost of a thousand dollars.

So the true cost of borrowing for AC here is $11,000. Remember, we want to divide that by. What basically the proceeds that are available from the borrowing. So what does AC really have that's available after they're done borrowing and incurring this discount and the transaction costs we'll take that 500,000.

We subtract out the $10,000 discount. Get us down to four 90 and we also incur the transaction cost of a thousand. They're not going to have access to that thousand dollars. You're giving that up. So truly the denominator, the cash proceeds that are available from the borrowings $489,000. So we take the 11,000, the cost of borrowing divided by the 489,000.

Remember, you have to annualize it, the commercial papers for how long it's for three months. So basically we're assumed 90 days here. Part two of the formula for annual financing cost to annualize it 360 days divided by that borrowing period. That's 90 days, we're going to take the 11,000 divided by four 89.

Multiply it by basically four and we get 9%. And the answer then is letter D. Another situation I'd like to cover with you is the matter of compensating balances. We discussed this a little bit earlier when we were talking about the reasons to hold cash. Let's look at question number 26. Together. Number 26 says what is the effective interest rate on a loan?

If a firm borrows $400,000 at 8% and is required to maintain a $50,000 balance as a minimum. Compensating balance at the bank. And we're to assume a 360 day year, you can go back to your general formula. In the first part, we have the cost of borrowing divided by the cash proceeds. What is the cost of borrowing here?

We're going to borrow $400,000 and we have to pay 8%. That's our interest rate. So for a year, our cost of borrowing is going to be equal to $32,000. We want to divide that by the cash proceeds what's available. From this from this amount, remember we borrowed 400,000, but we're required to maintain $50,000 as a minimum compensating balance.

So we really don't have access to that 50,000. The only amount that we really have access to is the 400 minus the 50 or $350,000. So we'll put 32,000. The cost of borrowing divided by $350,000. The cash proceeds from borrowing will annualize it. This is for a year. So it's going to be 360 days over 360 days, just one.

And we're going to get 9.1%. So the answer to this question is letter B 9.1%. What I'd like for you to do is to stop you, take, try some questions and see how you're doing using our general formulas for annual financing costs. I'd like to do questions. Number 27 through 31. Like you stop your tape, get your answers.

Remember no pain, no gain. You're going to have to be active participant in the learning process. It's all part of gaining that knowledge. So try questions 27 through 31. When you get your answers. Come back to we'll go over them.

Question number 27 deals with Hardy company. And it says that Hardy needs to maintain a compensating balance of $60,000 in his checking account, as one of the conditions of its short term. 8% bank loan of $600,000. So they're borrowing money and in the process, they have to compensate the bank for $60,000.

Now Hardee's checking account earns 3% interest. Ordinarily Hardy would maintain a $50,000 balance in the account and they ask us to figure out what's the effective interest rate of this loan. Again, we know the formula for annual financing costs. The cost of borrowing, divided by the cash available through borrowing, and then we need to annualize it.

What is the cost of borrowing here? We know that Hardy takes out a $600,000 loan, which they have to pay 8%. So we'd be taking 8% times, $600,000 that we would get 48,000. But there's a little bit more here. Remember, ordinarily Hardy would maintain a $50,000 balance in the account. As part of this loan, we have to maintain a $60,000 balance.

So we have to maintain $10,000 more in the account than we ordinarily would. And because we're keeping $10,000 more in the account than we ordinarily would, we're getting more interest. Hardee's getting more interest than they ordinarily would. They're getting 3% interest on that $10,000. What we have to do is take the $10,000 excess or extra balance multiplied by 3%, we get the $300.

We're going to net that out with the cost of the 48,000 of the loan. So we're going to end up with $47,700. And the numerator in the denominator. Remember we have the cash funds that are available, where we borrow 600,000. And it says that we have to maintain a balance of 60,000. So maybe you were thinking 600,000 minus 60,000.

No, we don't need to do that. Remember ordinarily Hardy keeps 50,000 in there. So the only amount that we need to keep in there out of the 600,000 that we're borrowing since we already have 50,000 in there. Because we need to take 10,000 out of that loan to keep in the account. So really the amount of proceeds that are available from the loan is 590,000.

So we take the 47,700 divided by 590,000. We're going to get 8.08%. And the answer to the question then is letter B 8.08%.

So we also had a fact pattern here for Fox company and said that we were to use this fact pattern for questions. 28 through 30 says Fox companies need, excuse me, Fox company needs to pay a supplier's invoice of $50,000 and they want to take a cash discount of two, 10 net 30. Okay. Stop right there. If they want to take a cash discount.

They have to pay within the 10 days. How much are they going to pay? They're going to get a 2% discount in 2% of 50,000 is going to be a thousand dollars. So they're not going to have to pay 50,000. If they take the discount, they're only going to have to pay 49,000. Now it says the firm can borrow the money for 20 days at 10% per year with 8% compensating balance.

So we borrow money. We have to pay 10% annual interest on it for the period of time that we have it. And we'd have to maintain an 8% balance to work to assume a 360 day year question number 28 says the amount Fox must borrow to pay the supplier within the discount period and cover the compensating balance is how much.

Remember, if we paid the supplier within the discount period, we're going to pay $49,000. So the question becomes, how much do we have to borrow, keeping in mind that we need to maintain an 8% compensating balance on whatever the loan is? Okay. We need to do here is come up with an algebraic formula.

Something that a lot of people don't know we love, but our formula here, the amount of the loan should be go to the 49,000 that we want to pay to the supplier to take advantage of the discount. Plus, whatever it takes to cover the compensating balance, what does it take to cover the compensating balance?

8% of whatever the loan is. So we've got loan as equal to 49% plus 8% of the loan if you solve for loan. Okay, we get 92% of loan is equal to 49,000. We take the 49,000 divided by 0.9 to 92% and we get $53,261. That's the amount that Fox is going to have to borrow. And the answer to number 28 is letter C number 29 says if Fox company borrows the money on the last day of the discount period and repays it 20 days later, what's the effective interest rate on the loan?

Again, the annual financing costs were the effective interest rate here is equal to the cost of the F of the funds that we borrow divided by the funds available. And we annualize that. Now number 28, we computer what the amount of the loan was. And that loan was $53,261. We're going to have to pay interest on that loan and that's going to be 10% per year, but we pay the money back in 20 days.

So the interest incurred on the loan is equal to remember the interest is equal to principal times rate times time we get the $53,261 times the 10% interest rate. Time's the time? That's 20 days out of 360. The amount of the interest is going to be $295 and 89 cents. But what's the effective interest rate?

To get it effective interest rate, remember we have to take the cost divided by the funds available. What funds were available? 49,000. Okay. Remember. They have to maintain some of that $53,261 loan as compensating balance. So remember what we needed to do there was borrow enough so that we could pay the discount price of 49,000.

That's truly the amount of funds that were available is what we were paying the supplier. Okay. So we're going to take the $295 and 89 cents divided by the $49,000 that we effectively are paying to the supplier. There that's the funds available. We need to annualize it. The period that we're holding this loan that we have this loan is 20 days.

So we're going to have 360 divided by 20. We multiply that out. We're going to get 10.8, 7%. And the answer is letter B. How about number 30. It says a Fox fails to take the discount and pays on the 30th day. What's the effective rate of annual interest is paying the vendor. We're failing to take the discount.

Remember what we said, annual financing costs at the cost of not taking the discount. So we just go back to that basic formula discount percentage divided by 100% minus that discount percentage where you take 2% minus nine miles divided by 98% multiply by the 360 days. And then divide it by 20 days.

Why to annualize it, we take the full. Payment period, 30 days minus the discount period. That we have to pay within 10 days, the 30 minus the 10. It's the 20. When we fill all those numbers into our formula, we get 36.7, 3% annualized interest. And the answer to number 30 is letter D R excuse me, B number 31.

Number 30. One says a firm is considering factoring its accounts receivables. The finance company requires a 5% reserve and charges one and a half percent commission on the amount of the receivables. So right off the bat, we're going to have six and a half percent taken out. In addition, the amount advanced to the firm is also reduced by the annual interest charge of 12%.

So when we, you take out the amount that they could hold back, the reserve and the commission, then we have the net amount of our loan. And then we're going to have to pay interest on that net amount, 12%. What is the amount of the proceeds the firm will receive from the finance company at the time a $200,000 account is due in 90 days.

What are we going to get if it's factored? First of all, we'll start with that $200,000 and we're going to have to compute the amount that the factory is going to hold back for reserve, which was 5%. So 5% times the 200,000 is $10,000. Secondly, the factory is going to deduct one and a half percent for commission one and a half percent of that 200,000 is $3,000.

That's going to get us down to $187,000. And that is the amount that we have to pay interest on says the factory is also going to reduce the proceeds given to the firm for the interest on the 187,000. That discount rate was 12%. And this is going to be out in 90 days. So we're going to take 187,000.

We're going to multiply it by the 12% multiply by 90 divided by three 60. We'll get $5,610. When we subtract that from the 187,000, we're going to get $181,390. And the answer to number 31 is let her be. I hope you did well on those questions. And as always, I encourage you to do as many questions as possible.

The more that you see, then the more you see the possible tricks that the BEC CPA Exam can throw at you. Okay. And so I want you to be ready for all of those. Now, if you're with me to that point, what I'd like to talk about next is capital structure.

Now capital structure relates to how a company, finances its assets. In other words, using debt or using owner's equity issuing common stock or preferred stock. Okay. So capital structure is how we finance our assets. We talk about optimal capital structure. We're talking about a mixture of debt and preferred and common stock.

We're talking about that mix at which the company's stock price is maximized again, optimal capital structure is the mix of financing at which the company stock prices maximize. And there's really no set way of determining what that optimal capital structure is, but there is a theoretical, optimal capital structure.

Now optimal capital structure involves the trade-offs of higher expected return on equity and earnings per share. Again, it's higher risk. Again, optimal capital structure involves trade-offs of higher expected return on equity and earnings per share against higher risk. Now the companies targeted the target capital structure.

Is that mix of debt preferred stock, Mark and common equity with which the company intends to raise capital. So they might have an idea thinking about what their optimal capital structure might be, but then they might have a certain target at which they're going to use. Remember they can't compute the optimal, they don't know exactly what it is.

So they'll come up with a targeted capital structure and that's based upon the company's intentions, how they intend to raise the capital. Now the concept of leverage refers to the relative amount of fixed costs in a firm's capital structure. And typically the more fixed costs than you're able to spread those fixed costs out.

But then there's a certain point which it's too much fixed costs. We need to talk about here deals with this concept of leverage. And we have two concepts of leverage the first. The degree of financial leverage. Okay. The degree of financial leverage, a degree of financial leverage is simply an expression of the relationship between the change in earnings available to common shareholders and the change in that operating income.

Again, degree of financial leverage is an expression of the relationship between the change in earnings available to common shareholders and the change in net operating income, which we often. Referred to as earnings before interest and taxes, the EBI T now financial leverage causes the firm's earnings per share to fluctuate at a rate, which is greater than that, of the change in earnings.

Before interest in taxes, over the operating income. Again, financial leverage causes the firm's earnings per share to fluctuate at a rate, which is greater than that change in earnings before interest in taxes or operating income. Okay. And there's a couple of ways that we can measure this financial leverage.

And I'll give you a couple of formulas in just a moment now, firms that have a higher degree of financial leverage are considered in general to be riskier than firms with lower degrees of financial leverage. Okay. Just in general, this is a general statement not a hundred percent all the time, but mostly firms that have higher degrees of financial leverage are usually considered to be riskier.

And how do we compute the degree of financial leverage? The first formula, and I think I put it there in the viewer's guide for you. The degree of financial leverage is again, that expression of a relationship between earnings per share and operating income. And so the first formula is the percentage change in earnings per share, divided by the percentage change and operating income or earnings before interest in taxes.

However there's other ways that we could also measure this. And the second way that we could measure the degree of financial leverage is to take the earnings before interest in taxes and divided by the earnings before interest in taxes, after we've deducted out interest. And we've deducted out the preferred dividends that have been divided by one minus the tax rate.

It's quite a formula there. Okay. Let's talk about the degree of operating leverage. The degree of operating leverage is an expression of the relationship between operating income and sales. Again, it's another expression. It's a ratio of sorts. It's an expression of the relationship between operating income and sales.

And again, I have a couple of formulas that we can use here. The first is you take the percentage change in earnings before interest in taxes and divide that by the percentage change in sales. Okay. Percentage change earnings before interest in taxes divided by the percentage change in sales.

Alternatively, we could take contribution margin divided by earnings before interest in taxes. Member contribution margin is sales minus variable costs. Okay. Contribution margin sales minus variable costs. Now the degree of operating leverage involves the use of assets with a fixed cost. Now the more for mixed use of assets with the fixed costs, the more this operating leverage, then the greater, the variability of earnings before interest and taxes.

And again, there are four there's going to be more business risk. What I'd like for you to do is I'd like for you to stop your tape and using the formulas that I've given you for financial leverage and operating leverage. And see if you can answer questions, numbers 32 and 33. So stop your tape, get your answers.

Come back. We'll go over them together.

It says when company sells 200,000 jars of pickles annually and they sell them for $200 per jar. The variable costs are $60 per excuse me, 60 cents per jar and fixed costs are $70,000 annually. When has annual interest expense of $60,000 and a 30% income tax rate in question number 32, they ask is what the company's degree of operating leverage is.

The first formula I gave you for the degree of operating level leverage changes, uses the changes in earnings before interest and taxes and the changes in sales. And we don't know those. So we have to look at that second equation that I gave you. And that is the degree of operating leverage is equal to the contribution margin divided by earnings before interest in taxes.

Let's figure out what the contribution margin is. Member that's. Sales minus the variable cost. What are your sales here? We're selling 200,000 jars at $2 per jar. That's $400,000 and our costs are variable costs for each jar is 60 cents, 200,000 jars that 60 cents per jar. It would be $120,000. So we've got 400,000 minus 120,000.

That gives us $280,000 of contribution margin. Now to get the earnings before interest in taxes in this, where we're going to have to do is take our contribution margin and subtract out our fixed cost of 70,000. I'll take the two 80. Minus the 70,000 that gives us $210,000 in our denominator. And our degree of operating leverage is 1.33.

So the answer to our question is letter C. Now about the degree of financial leverage, number 33, we're asked to compute the degree of financial leverage. And again, we need to use the second of the formulas that I gave you. So hopefully you picked up the earnings before interest in taxes. We just computed that number 32, that was $210,000.

So our numerators $210,000 in our denominator, we're going to have to subtract out the interest. We'll have to subtract out any preferred dividends that have been divided by one minus the tax rate. What's the amount of interest in the problem. Okay. According to the information, our annual interest expense is $60,000.

So we have to take 210,000 minus the 60,000. There were no preferred dividends. We've got 150,000 and our denominator divided into 200, $10,000 of earnings. Before interest in taxes. We get a degree of financing, financial leverage equal to 1.4. And the answer to number 33 is C.

In our discussion of capital structure, we said that the company can finance it at its assets, many ways that common stock preferred stock. So what we want to talk about now is the cost of capital because by borrowing money or by using other people's money, whether it be borrowing through debt, Or whether we're using the owner's money, there is a cost associated with it.

We all know it can't be free, although we'd like for it to be free. So talk about the cost of capital and the cost of capital. Really the company doesn't have any say over that. The cost of capital is determined in the capital markets and what that cost of capital is depends upon the risk that's associated with the firm's activities.

So the cost of capital is simply what the firm must pay. It's the return that's required by investors. They are going to demand for the use of their money that you pay them a certain mountain. That's the cost of capital. Remember we have several sources of capital. The first is debt, and obviously there's that cost associated with debt.

And we usually think of that as the interest rate. Now on your viewers guide, I've given you the formula for the cost of debt, but you'll notice that the cost of debt is not simply just the interest rate on the debt being issued. We have to remember is that we're able to get a tax break because interest is deductible.

So the cost of debt is actually equal to that interest rate times one, minus the tax rate. And that reflects that tax shield that we all know now preferred stock. When we issue preferred stock, what kind of cost is associated with it? Remember that preferred stock holders have to get paid dividends before any comms, Docklands get paid.

So the costs associated with preferred stock or the dividends that the preferred stock holders would expect to receive. And again, in your viewers guide, you have the formula there. The cost of preferred stock is equal to the dividend on the preferred stock, divided by the net issuance price. Now, when we talk about common stock or the cost of equity, our number of formulas that we could use.

And it depends upon the circumstances, the first, the cost of using it, retained earnings. In other words, internal equity, and I've got formula there. And the viewer's guide that indicates that the cost of college stock from internal equity is the dividends that you expect to receive one year from now.

Divided by the price of common stock right now. And then we would add to that the percentage rate of growth. I've also given you the formula for the capital asset pricing model that you can use to determine the cost of common stock. Theoretically, we should get the same cost of common stock that we would use in the first formula and the cost of capital on common stock using the capital asset pricing model.

It's basically equal to the risk-free interest rate, plus the beta coefficient for the firm times. The difference between the market rate and the risk-free rate. Finally, the third formula that we could use for computing, the cost of capital, the cost of common equity would be when we were issuing new common stock, as opposed to using the common stock that's already been issued the internal equity.

Now we're talking about issuing new common stock that's external equity. The formula is very similar to internal equity. It's the dividends that are going to be received by the common stock holders one year from now divided by the net receipt of the issuance of the stock, as opposed to the current stock price.

So that's the difference is the denominator. And then of course we would add the percentage growth rate. So it was very similar formula. It's just in the denominator. We're using the net. Issue price would like for you to do is to try some problems on your own using these formulas. I'd like for you to stop your tape, try multiple choice questions, numbers 34 through 39.

See how you do get your answers, come back and we'll go over them together.

Cool come back. So let's go over these questions together. Now we're given information about Jimmy incorporated. He's interested in, or he, the company is interested in measuring its cost of capital. It has gathered a bit of data here for you. Data about issuing the bonds issuing preferred stock, issuing common stock.

The fact that Jimmy expects to have a hundred thousand dollars of retained earnings in the coming year. And they plan on using those retained earnings first. And once those are exhausted, then the company will issue new common stock and they also gave you a targeted capital structure. So is it Jimmy prefers to issue 20% long-term debt, 30% preferred stock.

And then the other 50% of the financing has to come from common stock. So let's answer the questions together. Question number 34 says the cost of funds from the sale of common stock for Jimmy Inc is what? Okay. So we're selling common stock. Remember the formula for computing, the cost of equity. When you're using new common stock, new equity or external equity, is that evidence being received one year from now divided by the net issue price, plus the growth rate.

We know that the dividends that are going to be received next year by common stockholders is $6. What's the net issue price. If you go back to the data, it said that when we issue or when Jimmy issues, the common stock that the stock will have to be underpriced by $5 per share. And that the flotation costs are expected to amount to $4 per share.

So really in order to put this stock out on the market, they're going to have to take away $9 from the current price. We know that the current price is equal to a hundred. So when we deduct the $9 from the a hundred, we get 91. They're assuming here a growth rate of zero. So we get $6 divided by $91.

And our cost of equity is 6.59%. So the answer to the question number 34 is letter D let's look at 35 35 asks about computing, the cost of funds from retained earnings. Now the cost from a funds from retained earnings is the cost of common equity, internal equity. A very similar formula to what we just used.

Remember the denominator is different. We have dividends received one year from now divided by the current stock price. So we can take the $6 divided by the current stock price of a hundred. We would add the growth rate. There is a zero growth rate assumed in the questions. So we have 6% is the cost of funds for retained earnings.

The answer to number 35 is letter a.

Number 36 asks us to compute the cost of funds from the sale of the bonds. It's a little bit of a tricky question. They already gave you the answer. Actually, if you go back to the heart of the problem, it tells you in the last sentence, in that bullet, that the estimated after tax cost of the funds is 4.8%.

So the answer here is letter a. We didn't have to use the formula. The answer was already given to us, I guess they wanted to try to trick you into Puting it. Number 37, compute the cost of funds from the sale of the preferred stock. Now, when we sell preferred stock, we want to take the dividends on preferred, divided by the net issuance price.

So hopefully you took the dividends on the preferred, which is $8 and 10 cents per share, divided by the net issue price of the preferred stock, which was $90. And you get 9%. The answer to number 37 is C. Number 38 says if Jimmy incorporated needs a total of $500,000, what's the firm's weighted average cost of capital.

I didn't give you the formulas for a weighted average cost of capital. I wanted to see how you would do here. Weighted average cost of capital is simply just it sounds it's a weighted average. We would take each of the cost of capitals, whatever that cost is and multiply it by the weighting.

Remember in the problem that Jimmy wants to targeted capital structure. Of 20%, 30% and 50%. So if Jimmy needs a total of $500,000, you can recall that half of it 50% is targeted to come from common stock. So that would be $250,000 of the 500,000 that Jimmy needs would be coming from common stock. But the first $100,000 is supposed to come from retained earnings.

So if we need two 50 from common stock or from equity and a hundred thousand is coming from retained earnings, then we're going to have to issue $150,000 of common stock. So all we have to do here to get the weighted average cost of capital is to multiply the cost of the three sources of financing by their weighting factors.

Now, the long-term debt number, the cost of capital is 4.8%. That's going to account for 20% of the financing. What we do is take 20% times the 4.8% get 0.96. Then the preferred stock member that Jimmy's targeted preference here is 30% of financing coming from preferred. So we're going to take 30% times the cost of capital societally with issuing preferred, which is 9%.

We get 2.7%. Now we will get the common stock number. We have to break it down into the retained earnings portion and the new external stock. Now 50% of the financing comes from common stock. How much of it was coming from retained earnings? A hundred thousand dollars of retained earnings divided by the total financing of 500,000.

That's 20%, 20% of what Jimmy wants here. 20% of the 500,000 is going to come from retained earnings. The cost of capital associated with the retained earnings was 6%. We didn't take 20% times the 6% to get 1.2%. And the remainder awaiting must go to the new external. That must be 30%. We've done 20 for longterm.

We've done 30 for preferred. We'd done 24, 20% for retained earnings. That leaves 30%. Of course we could also figure, cause we know that the new issuance, so common stock must be $150,000. What's our total financing needs 500,001 50 divided by the 530%. So the weighting of this new external issue of stock is 30% multiply that by the cost of capital of that new issue, 6.59%.

And we get 1.98. We sum up all our weightings there, we get 6.8, 4%. So the answer to number 38 is letter B. Now number 39 says that Jimmy needs a total of a million dollars. What would be the weighted average cost of capital? So it's very similar to the number 38, except that we need to compute it on the basis of a million dollars.

So we still know that the long-term debt of 20% times the 4.8% 30% of it's going to come from preferred stock at 9% cost of capital. That's 2.7%. Now the common stock, the retained earnings. Remember it's a hundred thousand dollars out of a total financing needs of a million dollars. That's 10%. So 10% times the 6% would give you six or excuse me, 0.6, zero less than 1% 0.6 and the new external.

Would then account for 40% and 40% times the 6.59. And then we would add all of this up and we would get 6.8%. The answer to number 39 is letter C.

What I'd like to do now is make a few comments about interest rates. And if you'll look in your viewers guide and I'll try to put it up here on the screen have a graph there about interest rates and they're charted over time. And if you look at that graph, you'll notice that there are basically three components to interest rates.

We can think of the real risk-free rate. And that is a flat rate. Typically over time there, we also have a component due to inflation expectations about inflation called the inflation premium. And then there's also a component dealing with maturity risk. The longer something is outstanding, there's usually a greater risk associated with that maturity.

Now this graph represents interest rates and their relationship from short-term intermediate long-term financing based upon certain assumptions. Interest rates are not always like this, although they tend to be. And what you'll note here is one interest rates are not linear. There is a curve associated with this.

The other thing that I wanted to point out about this graph is that you'll notice that curve it's an upward sloping curve as the term of maturity is increasing. The yield is increasing. Now the upper slope is also due to an increase in expected inflation. If people expected inflation to not exist there actually to be deflation throughout could actually be a downward sloping to this.

But most of the time we are expecting inflation in the future. And because of that and the increasing risk associated with the increase in time, usually the slope is upward

topic we need to cover is security valuation. Now, when I refer to security valuation, I'm simply talking about the process of figuring out what a security is ought to sell for. And the first security that I want to look at is bonds. How would we value bonds? Let's remember what a bond is. A bond is a debt security where an issuer is promising to pay the face of Mount the face value amount of that bond at some specified future date, also known as the maturity date.

Now, usually this issuer is going to promise to pay a specified rate of return, a specified interest rate. We usually call that the stated rate or the contract rate or the coupon rate, but not all bonds sell or not all bonds. Excuse me, have a specified rate on there. And typically things like junk bonds don't necessarily have a specified rate of interest.

Now bonds, how are we going to value them? What are they going to sell for? Bonds will typically sell for the present value of the future cash flows associated with that bond. And you'll recall there are two types of cash flows associated with a bond there, of course, is the principal repayment at the end of the specified period at the maturity date.

And then if the bond issuer also promises to pay interest, then there is. Interest cash flows. The company is going to actually make cash interest payments in the future. Now I mentioned that the bond is going to sell for the present value of these cash flows. So now's a good time for us to do a little bit of a review of the time value of money.

Remember that something received one year from now is not worth the same amount today. It's worth less today because of the time value of money because of interest. Now when you're doing a bond problem, when you're trying to figure out what a bond is going to sell for, we said that there were two components, the two types of cash flows, the principal happens to be, yeah, single Psalm that's being received or paid one time at some point in the future.

So for example, if a bond was a five-year term bond, Then the company would be paying a certain amount five years from the time that it was issued. That's one time, five years into the future. We also have the interest payments. Now you recall that the interest payments really represent what it represented an annuity.

In fact, they represent an ordinary annuity. We're also known as an annuity and arrears. We call what an annuity is. It's a series of an equal payments. Okay. And that's the beauty of bonds for the issuing company, is that when they write the checks out for bonds, they know what the amount is every time, because they're promising on the face of the bond to pay a specified rate of interest based upon that face value.

So they're always writing the checks out for the same amount, as long as the same number of bonds are outstanding, which is usually the case in a term bond issue, as opposed to a serial bond issue. In which case the. Face value changes every year, because they're constantly retiring some

now in terms of reviewing the time value of money would be wise to point out here that there is another kind of annuity. I want you to recall there's annuities and advance. This is where the payment in this case, maybe interest would occur at the beginning of the period, but for our bonds, The payments usually occur at the end of the period for which the interest is being paid.

So for bonds, we're going to be talking about ordinary annuities, but just keep in mind nuity dues. That's where the payment occurs at the beginning of the day period. Now we talk about these bonds and we talk about valuing bonds. We, to be very careful about keeping straight, that coupon rate, that contract rate, the amount that's stated on the face of the bonds and understand what its purpose is and keep it separate.

From another rate known as the effective rate, sometimes known as the market rate or the realistic rate. And so I want to make sure that you're very clear upon what these different rates are used for. Now, the coupon rate, the amount that stated on the face of the bonds is used to determine the cash interest payment.

This is the actual amount of cash. This is what the. Company is going to write the checkout for whoever's holding the bonds at a certain point in time. They send in that coupon and the company writes a check out to that bond holder. Okay. And that's based upon the face of the bonds. So whenever you think, when you're ever trying to figure out the cash flows, the cash interest payment, you must use, what's stated on the face of the bonds, the face value and the coupon rate.

And we'll do an example in a few moments, make sure that you can do that. Now the effective rate is the rate that the market is really going to get on their investment. And that's really the effective amount of interest that the company has to pay. They might say that they're going to pay a certain amount according to the face of the bond, the coupon rate, but that's not necessarily the effect of non-interesting.

You can go back to our discussion about annual financing costs. When you take into consideration the cost of borrowing and divided by. The proceeds available. Okay. See, the market is going to determine what the cost of the capital is talked about. That earlier, the cost of debt it's determined by the market.

The market is going to get the rate at which they want, and that's the effective rate, the market rate or the realistic rate. And you'll recall that rate is the rate that we used in getting the present value factors. When we do the present value calculations. Now let's talk for a moment about the relationship between these two.

Now let's assume for a moment that the effective rate on a bond, the market is demanding 12%, but the company is only offering a 10% stated rate or coupon rate what's going to happen. The market wants 12% and the company is only paying 10%. Is anybody in the market going to want to buy those bonds at that company?

Not at face value because their effective rate would end up being the 10%, which is a state of rate. And that's not what they want. The only way that the market can get what they want. The effective rate is if these bonds sell for discount face it, there is no demand for 10% bonds when the market wants 12%.

So in order for them to get their rate in order for them to get the return that the market wants. The price will have to come down. And in that case, the bond sell for discount. On the other hand, if the effective rate the market let's say is wanting 10% and the company is paying a stated rate, according to the face of the bonds of 11%.

Then in this case, everybody in the market wants 10%, but the market excuse me, the company is paying 11%. Everyone's going to flock over and try to buy those bonds that are paying 11%. What's going to happen. Simple law of supply and demand, right? As everybody demands, those bonds that are paying 11% is going to be such an increase in the demands.

So many people going over there that the price of those bonds is going to go up. So in this case, the bonds are going to sell for premium. Let's look at an example of bond valuation, make sure that we can use the tables for. Present value calculations. If you go to your viewers guide and look at example, number one for hound incorporated, it says on January 1st, 2005 hound incorporated issues a hundred thousand dollars of 10% five-year bonds.

So that's the face. The face value is a hundred thousand dollars. They're promising to pay 10%. That's the state rate or the coupon rate. And the term of the bonds is five years. Is the bonds pay interest? Semi-annually. On June 30th and December 31st. And the effective rate is 12%. We'll stop. Let's think about it.

If the company is paying 10%, the market wants 12. What do we say? These bonds are going to sell for a discount, right? Because the market wants 12%. The only way they're going to get their 12% is that the price goes down. It's all a matter of that annual financing cost kind of formula, the effective rate, effective interest rate formula.

The cost of bonds or the cost divided by the proceeds. Okay. Let's make sure that this does indeed sell for discount. Let's see if we can compute the present value of these bonds and what they would sell for now. I've got a little hint here. I suggest that any time that you take the present value of the cash flows associated with bonds, start with the interest.

First start with the annuity first. So let's start with that. And the first thing we have to do is know what the cash flows associated with the bond interest with associated with the bonds is what is the interest payments? How much cash is the company going to pay? Remember the cash interest payments is based upon the face of the bonds.

And the stated rate. We know that the formula for interest is principal times rate times time. The principal here is the face amount, a hundred thousand dollars. And we're gonna multiply that by the stated rate, the 10%. And we have to multiply it by time. It's not one member. The interest here is paid semi-annually.

So we're gonna multiply this by one half of a year. Number, your interest rate and your time. These have to be on the same basis. If your interest rate is an annual rate, that time has to be expressed relative to a year. And since interest is being paid semi-annually that's one half of a year. So the cash interest payment that the company is going to make every six months is $5,000, again, a hundred thousand times, 10% times a half of a year.

So now how is going to make, how many of these interest payments? There's five years and they're making these interest payments twice a year. So five annual. Five years, times two semi-annual interest pay. It's going to give you 10 payments each of $5,000. So let's set up our calculation here for the present value of the interest, which we know is really present value of an annuity.

And you recall the way I like to write present value of an annuity formula is SQL to the rents times, the present value of an annuity factor for Inn. The rents are $5,000. Remember, all I have to do is take one. Interest payment date $5,000. You don't have to add up 5,010 times. The present value of annuity factor is going to take care of that for you.

It's going to take the $5,000 rents, multiply, very present value of annuity factor. Now comes the real issue. What's the interest rate that we want to use the I, and what's the end. Since interest is paid semi-annually we need. To have 10 payments. There are 10 interest periods and needs to be 10 here.

And if your ad is semi-annual your eye, your interest rate also has to be semi-annual. So the question is what we're going to use. Are we going to take the 10% divided by two and get 5% or we didn't take the 12% divided by two. Remember we said for present value calculations, you want to use the.

Effective rate the market rate. And that was 12% in this case. So we're going to take 12% divided by two, we get 6%. We're going to look for a present value of an annuity factor for 6% in 10 periods. So we'd go to that present value in annuity factor table. And we'd go over to the column where it says 6% and we would go down to where N is equal to 10.

And when we do that, we're going to get a factor of about 7.36. Rounded two decimal places. We're going to multiply that by $5,000 of the rents and the present value of our interest is 36,800, but we're not done there. Remember, we need to take the present value of all the cash flows and there's another cash flow we haven't taken the present value of that's the principle.

What is the principle? It's the amount that the company is promising to pay the face value of a hundred thousand dollars, which they're promising to pay five years from now. And that's a single sum. It's only being paid one time. So the present value of a single song is equal to the future value times, the present value factor for Inn.

And the reason why I had you do interest first is because whatever you use for I and N for the calculation of the present value of the interest, you also want to use for the present value of your principal. So we're going to be looking for a present value factor here. 6% and an equal to 10. So we go to the table and we're going to go to the present value of a single sum, present value of a dollar.

We'll go over to the 6% column. We'll go down to where N is equal to 10. We're gonna get a present value factor of 0.5, five, eight. And we multiply that by a hundred thousand dollars. That's the future value. We're gonna get $55,800 for the present value of the principal, which will add to the present value of the interest.

36,800. These bonds, the present value of these bonds is equal to $92,600. Indeed. That's what we said. We said that these would sell for discount. These are selling for less than their face value. So indeed we have a discount here. Let's look at one more example. I just want to ensure that you do understand how to use the tables.

Okay. How to value the bond. So let's look at example, number two, in your viewers guide on bond valuation. It says January 1st, 2005 hound, Inc issues, a hundred thousand dollars of 12% five-year bonds. The bonds pay interest semi-annually on June 30th and December 31st. And the effective rate is 10%. So all we have here, same situation is example one, except what the interest rates were swapped.

Now the stated rate, the coupon rate is 12% and the effective rate is 10%. And remember our relationship here hound is paying 12%. Everybody in the market is wanting 10% for the risk associated with these bonds. So everybody in the market is going to flock to the hound, bonds and buy everyone. Flocking to them.

Demand is gonna be so great that the price is going to increase and it's going to increase so that we get to a point where hound is going to sell these bonds for premium. So let's figure out what they're going to sell for. And what do I say, always compute the present value of what first the interest.

So let's compute the present value of the interest for we do that. We have to know what the interest payments are. How do we base? How do we compute our interest payments number? They are based on the face of the bonds or interest payments are equal to the face value. A hundred thousand times the stated rate, the coupon rate of 12% times.

The time is a half a year. They're making semi-annual interest payments. So that's going to give us $6,000 in interest payments. Every six months hound is going to write out a check for $6,000. So now let's compute the present value of the interest. Again, this is an annuity. Each one of the rents is how much $6,000.

The present value of an annuity is equal to the rents times. The present value of an annuity factor for Inn. What am I an end? Are we going to use right? The effective rate was 10%. That's the market rate. That's what we want to use. And since it's somewhat annual periods, we're going to take the 10% divided by two, have it.

We're going to get 5% and we're going to take the number of years, which was five multiply by two semi-annual payments every year we'd get 10 payments. So we look for a present value of an annuity factor, 5%, 10 periods. We'll go to the table. Present value of an annuity table. Find a factor by looking at the column where it has 5% at the top, go down to where the N is 10.

Find the intersection and we get a present value of annuity factor of 7.72 to multiply by our $6,000 cash interest payments. Our rents, we get 46,332, but we're not done there. We haven't taken the present value of the principal yet. Remember always do the present value of the interest first, then do the present value of the principal and you have to use the same Inn.

We know the present value of a principal is a present value of a single some kind of situation. And that formula is equal to future value times the present value factor for Inn and we'll use the same Inn. So future value is a hundred thousand dollars. Multiply that by the present value factor, 5% and 10 periods.

If you go to your table, You go to the 5% column and as equal to 10, find the intersection you find the factor 0.614. It gives a $61,400 for the present value of the principal. What are these bonds can sell for present value of the interest? 46,332. Plus the $61,400 present value of the principal. It's going to give us $107,732.

And this bond sells for a premium again, because the company was paying more 12% than the market wanted, which was 10%.

So that's bond valuation. If you're with me there, we can go on to stock valuation

stock valuation is pretty much the same thing as with bonds. Except stocks are different from bonds, but what's the same is that stocks can be basically modeled or valued upon the present value of the future cash flows associated with the stock. Now, some people buy stocks because they expect to receive dividends.

If you have that kind of situation, your stock price that someone's willing to pay today is really the present value of all the future dividends for that company. Now, some people purchase stocks for stock price appreciation. They just think the price is going to go up. In other words, what you could sell it for in the future.

Now the stock price is still going to be equal to the present value of the future cash flows. Okay. Because the present value of future dividends. You would discount the dividends you expect to receive. And then the purchaser would be valuing the stock, the present value of the future cash flows that point in time.

So it's still the present value of the future cash flows. Now we have what we call the constant growth model and we can model or value of the stock members to the present value. We can simplify it to some degree and that's equal to the dividends received one year from now. Divided by the required rate of return minus the growth rate.

So let's look at an example. I have there in the viewer's guide using the growth model for Dixon company says Dixon is deciding what price to pay for one share of IMB common stock. I am be paid a dividend of $2 per share. This year. Dixon anticipates IMB dividends to grow at a constant rate of 6% and desires to earn a rate of return of 8%.

At what price should Dixon buy the shares of IMB stock? What we want to do there. Remember we want the dividends one year from now. Do you want, we've got the dividends. This year is $2. If dividends are expected to grow at a rate of 6% per year, then the dividend one year from now will be $2 times. 1.06, $2 and 12 cents.

We went to divide that by. The difference between the required rate of return in this case 8% and the growth rate, 6%, the difference eight minus six gives you 2%. We're going to take the $2 and 12 cents divided by 2%. This stock would sell for $106. So Dixon would be willing to buy the stock if it was selling for either a hundred, $6 or less, because the way Dixon's valuing it, their expectations of future dividends.

Causes them to believe that the price is worth or a stock is worth a hundred, $6. Now, what if Dixon expected zero growth in dividends? How much would this sell for? If there's no growth in dividends, then the dividend next year will still be $2. And we take the required rate of return of 8%. We'll be subtracting zero.

So it's 8%. The denominator will have $2 divided by 8%. And in that case, the stock is only going to sell for $25. Dickson would only pay $25 for it, which is very big difference. So the fact that companies expect or dividends to grow is going to cause really big factor there in computing, the price of stock.

If there's no growth in the dividends, then the stock price is going to be much lower than if you expected growth in dividends.

Hello. Talk about now is decision models, the various models and techniques that we use for evaluating projects. The first is the payback period. The payback period is simply represents the amount of time that it takes for a project to pay itself off. In other words, it's the number of years for the cumulative net after tax cash flows from the project teak its initial cash outlay.

And this payback period has several advantages over the others. One is it's very simple. It's also based on cash flows. It provides a measure of project liquidity and it provides a measure of risk. So it's simple. It's based on cash flows provides a measure of liquidity and it provides a measure of risk the longer, the time.

For the payback period, then the greater the risk in terms of disadvantages, the payback period is not really a true measure of profitability and it ignores the cash flows after the payback period. So once they determined that the project is paid back, then all those future cash flows associated with the project are totally ignored.

It also ignores the time value of money. Now, if you look in your viewers guide, I have an example there relating to the major corporation and major corporation is considering purchasing a new machine. It'll cost them $5,000 and have an estimated life of five years and no salvage value. And the estimated after tax cash flow is $2,000 a year.

For five years, major uses the straight line method of depreciation has an incremental borrowing rate of 10%. And then they provide us with present value factors, which of course we're not going to need because the prey back mirror, payback method, doesn't utilize time value of money. Okay. So they were just throwing that stuff in, throw you off.

So it's using the payback method. How many years will it take to pay back Meijer's initial investment in the machine? So we had to do use the payback method is divided that initial investment, which was $5,000 by the annual fee. After tax cash flows, which is $2,000. And that's going to give us a payback of two and a half years.

The next decision-making model I want to talk about is the accounting rate of return. Now the accounting rate of return is equal to the average annual net income divided by average investment in the project. The great thing about this accounting rate of return is that accountants understand it. That's very easily understood.

However, since it uses a cruel numbers, which accountants understand and not cash flows is not as good as the cashflow based methods of making decisions. It also ignores the time value of money. Get in the viewers guide. If you look at example, number seven, dealing with Tam company says that Tam companies negotiating the purchase of equipment that would cost a hundred thousand dollars and they have expectations that $20,000 a year would be saved.

And after tax cash costs, if they were to acquire the equipment. Now the estimate of useful life is 10 years with no salvage value and it would be depreciated by the straight line method. Now Tam's predetermined minimum desired rate of return is 12%. And we're asked to compute the accrual accounting rate of return based on the initial investment now to compute this accounting rate of return, based on the initial investment, what we need to do is divide the average net income related to that investment by the initial investment.

The average net income is $20,000 per year in after tax cash cost savings. But remember, they also have depreciation since we're using a cruel numbers, we have to subtract out the depreciation, the cash cost savings didn't calculate the depreciation. So we're gonna subtract the depreciation of 10,000.

We'll get $10,000 average net income divided by the. Initial investment of a hundred thousand dollars, and that's going to give us a 10% rate of return. The next method is the internal rate of return. Now the internal rate of return is the rate of discount that will equate the present value of net cash flows of a project with the present value of the net investment.

Now in this situation our assumptions are that the internal rate of return is going to assume that the cash flows are reinvested at that internal rate of return. In terms of advantages, the internal rate of return will take into consideration the time value of money. Obviously it uses cash flows and in the process, we're basically estimating the project's rate of return.

Now, in terms of disadvantages, This is the internal rate of return is more difficult to use and the cash flows are assumed to be reinvested at a rate earned by the project, as opposed to the normal rate of return on our investments. Let's look at question number 40 together.

Question number 40, again, deals with Tam companies, negotiating for the purchase of that equipment. That would cost a hundred thousand expecting after tax cash flows of 20,000. We know it's life 10 years and no salvage value. And we used a straight line depreciation so that Tam's predetermined minimum desired rate of return is 12% there.

They give us discount factors for the present value of an annuity. A dollar at 12% for 10 periods, 5.65 to give the present value of a single sum for 10 periods at 12% is 0.3, two, two, and were to estimate the internal rate of return that factors, or excuse me, in estimating the internal rate of return.

The fact that here's in the table of present values of an annuity should be taken from the columns closest to what number. Okay, so we're working backwards here. We're trying to figure out where in the tables we should be looking now, remember that the internal rate of return is the rate of discount that equates the present value of the net cash flows of the project with the present value of the net investment.

So what is the present value of the net investment? That's a hundred thousand dollars that occurs right now at time. Zero. Remember the present value of anything today is itself now. The net cash flows, there would be savings of $20,000 per year after tax. And that would represent an annuity. So what we have there is $20,000.

The annuity times, the present value annuity factor for I and 10 periods is equal to a hundred thousand dollars. Remember, we're equating the two. And so we solve for the unknown, the present value factor that we're going to be looking for is five it's the a hundred thousand divided by the $20,000. And the answer to number 40 is C

the next method that we need to talk about is the net present value method.

What we do in the net present value method is we take the present value of the future cash flows from a project, and we subtract out the project's net investment. Okay. Now the rule here is that if net present value is greater than zero, the method is acceptable. What that means is you're earning your desired rate of return.

The advantage of this method is that it considers the time value of method. Excuse me, time value of money. But on the other hand, it's not very easily understood. A lot of people have difficulty with understanding the time value of money concept. Now, the assumption under the net present value method is that the cash flows over the project's life are reinvested at K the required rate of return.

Now, there is some relationship between the net present value of the internal rate of return. Many times they'll give you the same responses. In other words, What we need to do is decide when would we use one method over the other, if they disagree, and if they disagree, we're going to use the net present value method.

That method is preferred. Now in general, if the net present value is greater than zero, then the internal rate of return. If you were to use that method would give you a rate that is greater than the required rate of return. And if the net present value is less than zero than the internal rate of return is less than the required rate of return.

Let's look at example, number eight in your viewers guide, helm foundation is a tax exempt organization. They invest $400,000 in a five-year project. Helm estimates, the annual cash savings will amount to $130,000. Now the $400,000 of assets will be depreciated over their five-year life on a straight line basis, 80,000 a year.

For investments of this type Helm's desired rate of return is 12%. And the information regarding present value factors is given and they give you factors at 12%, 14% and 16%. Remember what percentage do we want to use in present value calculations? It's usually the market rate, the desired rate. Okay.

In this case, we're talking about Helms desired rate 12%. So we're interested in the present value factors that use the 12%, which the net present value of this project take the present value of the future cash inflows member. Every year they're expecting after tax cash savings 130,000. We're going to multiply that by the present value of an annuity factor for five periods at 12%, the 3.6 that will give us $468,000.

We'll subtract out the net initial investment member that occurs right now. So the present value of that is $400,000. So the net present value would be $68,000. The next method that we need to discuss is the profitability index, which is very similar to the net present value method. The profitability index is the ratio, the present value of the future cash flows over the life of the project.

To its net investment. So basically it's the same thing as net present value, but in a different form. And the rule here is if we have a profitability index that is greater than zero, the project is acceptable. That means we're earning our desired rate of return vantage of this method. Like the net present value method is that it considers the time value of money and it assumes like the net present value method did that the cash flows were reinvested at K the required rate of return.

So if we have a net present value situation, which is greater than zero, and we accept the project, what's the situation with the profitability index, the profitability and X would be greater than one under the net present value method. If NPV, the net present value was zero, we would be indifferent. We would be earning exactly the desired rate of return.

So how does that equate with the profitability index? Profitability index in that same condition would be equal to one. Okay. If the profitability index is less than one, that's similar to when the net present value is less than zero, we would reject the project because we're not earning the desired rate of return.

Return on investment is another method that companies can use to evaluate a project. I've given you a couple of formulas there, and your viewers guide return on investment is generally considered to be equal to net income divided by average total assets. But. Some people break that formula down into two parts into margin and turnover.

Margin is net income divided by sales and the turnover is sales divided by average assets. And you'll notice that if you multiply those out the sales and the denominator for the margin would cancel out with the sales and the turnover, giving you the net income divided by average total assets. Let's look at.

Example number nine to see if we can use this or one of these formulas to compute the return on investment. So this is the following data is pertaining to Beasley company for 2010 sales or 10 $500,000. The operating income is $50,000. The capital turnover is four and the imputed interest rate is 10%.

And were asked, what is the return on investment? Remember return on investment secret and net income divided by average total assets. We know net income is 50,000 here, the operating income, but we don't know what average total assets are. So we can't quite yet answer the question. We do know turnover is equal to four.

Remember the formula for turnover is sales. Divided by average total assets. We can use that formula and compute what the average total assets. So filling in what we know, four is equal to the sales divided by average total assets where the sales are 500,000. The average total assets would be equal to $125,000.

Now we can go back to our OIA ROI computation and fill in the average total assets of 125,000, dividing it into the net income of 50,000 and our return on investment. Would be 40,000 or excuse me, 40%. Now we also could have computed the ROI using the equation that breaks it down into margin turnover.

Remember ROI as you go to margin times, turnover, margin being net income divided by sales. That income was 50,000 in sales was 500,000. There's your 10%. And we multiply by the turnover, which is sales divided by total assets. We will know sales and total assets, but we know the turnover was four. And so we get 10% times four gives us 40%.

Next one. Talk about residual income. Now residual income is another method for evaluating projects. And what we do under residual income is we take our operating income. What we're. Earning and we would subtract out a desired return on our investments in our average assets. That's I times the average assets let's look at example, number 10 and illustrate this again.

We have Beasley company and the sales, the operating income, and the turnover. Now, residual incomes equal to operating income. We know that's $50,000 and we would subtract out the. Desired rate of return on our investment. That's 10% is our interest rate times our average total assets. And remember we computed average total assets previously.

It was $125,000. So 10% times 125,000 would be $12,500. Subtract that from the $50,000 of operating income and you'll get $37,500 of residual income. What I'd like for you to do is to stop your tape and try some questions on your own. We look at questions, numbers 41 through 45, get your answers and come back and we'll go over them together.

Welcome back. Let's go through these questions together. Number 41 says which of the following capital budgeting techniques implicitly assumes that the cash flows are reinvested at the company's minimum required return. Remember what we said about net present value? We said that net present value method, we do assume that the cash flows are reinvested at the minimum required rate of return.

So the answer under that column would be yes. Now internal rate of return, we said that the cash flows would be reinvested at the projects internal rate of return. That's not the required rate of return necessarily. So the answer there would be no, the answer to number 41 is letter B. Number 42 says a proposed project has an expected economic life of eight years in the calculation of the net present value of the proposed project.

Salvage value would be. A excluded from the calculation and net present value? No, we would include it. Number salvage value is a cashflow and under net present value. You want to take the present value of all the cash flows associated with that project. B is it included as a cash inflow at the future amount of the estimated salvage value?

No, not at the future amount. We wouldn't take present value. That's why it's called net present value. Let her see included as a cash inflow at the estimated salvage value. No, that would be as if it was received today, the present value of itself. And that's not the case salvage values in the future. So the answer must be D let's check it.

These says included as a cash inflow at the present value of the estimated salvage value. That is correct. The answer to number 42 is letter D. Now number 43 deals with new company. Okay. New is considering a purchase of an investment that has a positive net present value based on news 12% hurdle rate.

Now, what does that mean? Net present value means that company, that project is going to generate a return greater than the minimum, which is 12%. So it's going to be greater than 12%. And we say when the net present value is positive, that the internal rate of return would be also earning more than the 12%.

So the answer is C. Greater than 12%

in number 44, it says which of the following characteristics, representative vantage of the internal rate of return technique over the accounting rate of return technique. Number one recognition of the project salvage value. I don't remember any advantage there. I don't think one is correct. Two, it says emphasis on cash flows.

That's true because the internal rate of return does emphasize cash flows and the accounting rate of return is based upon a cruel numbers. So two is appropriate. Three says recognition to the time value of money. Yes. The internal rate of return does use the time value of money. Counting rate of return does not.

So that is an advantage. So two and three are both correct. That would be letter C. So the answer to number 44. Is letter C numbers two and three number 45 deals with para company pairs reviewing following data relating to an energy saving investment proposal cost 50,000 expects a residual value of $10,000.

At the end of five years, we have some present value factors. This is what would be the annual savings needed to make the investment realize a 12% yield. What we're doing there is equating the present value of the net investment in the present value, the future net cash inflows. This is an internal rate of return kind of question.

The present value of the initial cost 50,000 is itself 50,000. Now we have that salvage value of 10,000 being received five years in the future, we would need to discount that back 10,000 times 0.57, the present value factor. Of a single Psalm that's $5,700, 5,700. So the present value of that net investment is $44,300.

Remember we went to in the internal rate of return, equate the present value of the net cash flows of the project with the annual cost savings, the present value of those, the annual cost savings. We don't know. However we do know that the cost savings would be over a five-year period at the 12% discount rate.

So we know that we'd use the factor 3.6. We need to equate the $44,300 present value of the net investment with the annual cost savings. The present value of that, which we don't know what the annual savings that's X times 3.6. All we have to do is solve for the X. We get $12,306. And the answer to number 45 is letter C.

That wraps up our discussion here of financial management. And I'd like to encourage you as always to do as many questions. You can have a complete study program and get that plan, stick to it, have a very positive attitude that you're going to pass this exam. And from all of us here at bisque, like to wish you the best of luck.