MBA, Accounting course
Financial. Accounting focus. On communicate. People outside the company primarily. Lenders. And investors, who, are providing money to the company to buy its assets, that's, the primary audience, so remember financial, reporting people, outside the company really, these financial reports can be thought of as three pieces, of paper the, balance sheet report the. Income statement report and the statement of cash flows report it's amazing. How, much information can be summarized, about a company, on just three, pieces, of paper think, about Walmart and their ten billion, customer visits per year the, results of all of that can be summarized in boom boom boom three. Pieces of paper the summary, reports to people outside the company so let's remind ourselves let's, review what's, on the balance sheet three. Things structured. Around our favorite. Equation, it wasn't our favorite equation before today maybe but it is now the accounting equation assets. Equal. Liabilities plus, equity if. I've got assets I had to get the money to buy those assets from somewhere I either borrowed, it liabilities. Arose provided, to the company by shareholders equity. Assets. Equals, liabilities plus, equity that's, the balance sheet the income statement, revenues. Minus expenses is, net income revenue. Is the amount of assets generated, for doing business expenses. The amount of assets consumed, in doing business and what we would hope in a company is that you generate, more assets than you consume in your business operations, that's, the income statement statement of cash flows the, baby only 25. Years old there. Are three. Categories of cash flows operating. Cash flows the things that you do every day investing. Cash flows investing, in the productive capacity, of the business buying more buildings, and trucks and what-have-you, and financing. Activities getting. The money to buy the stuff that I need repaying. Loans paying, dividends, to shareholders all. Those three, operating. Investing, and financing which. One is the most important, yeah you remember operating. Activities because that summarizes, the cash results, of things that we do on a daily, routine basis. Those, three, reports, that, you see right in front of you summarize. Everything, about a company's, performance and that's. Given, to people outside the company that, is financial, accounting, you. Let's, talk about the balance sheet in a little bit more detail, the balance, sheet is built around one, of the, most awesome creations. Of the human mind the accounting, equation there. It is assets, equal liabilities plus, equity now, I can tell you're underwhelmed. You thought I was expecting, a little bit more of something like a e equals mc-squared well this is just as great as e equals mc-squared let. Me tell you where this accounting equation comes from first, the assets side well you know what that is list, of assets here's, the thing people have been listing assets, for, thousands, of years I told you that there's evidence that, farmers. Were keeping lists of assets, 7,000. Years ago in ancient, Mesopotamia. There's no great insight there how, many cows do I have how many goats do I have how much wheat do I have a list of my assets the, insight. Behind this accounting equation was, created. A little bit over 500 years ago in Italy the traders, in Venice and another traders in Italy they, had this insight, listen, let's. Keep it a list of our assets like we've always been doing but let's also every, time we get an asset let's write down where. We got the money to buy that asset, we. Write down the asset and we write down the source of the financing, to buy that asset, did I borrow the money to buy the asset, was it invested, by the owners if I borrow the money then, liabilities. Is the name I give to the source of the financing, to buy that asset if the. Money was invested by owners I say equity, was the source of the money to buy the asset, so we got the two sides of the accounting equation the. First side, the asset side that's the real world there you can go touch a company's, assets that's. The real part of a company the, other half of the accounting equation just says where did you get the money to, buy those assets, it's the discipline, of the accounting equation it seems so simple but this discipline, is the foundation. Of all the sophisticated, financial reporting, that we now have in the world and we've, been using this for 500 years it's, an awesome invention. I tip my hat to those medieval accounts, in Italy who invented the accounting equation assets, equal, liabilities plus, equity assets. And we're also going to keep track of the sources of financing to buy those assets, so.
What Are assets, we kind of have an intuitive sense of this they're resources, owned, or, controlled by a company that will by probable, future, benefit, so. Let's take the simplest example, if you look at the balance sheet of Apple, you, see they got lots of cash lot, of billions, of dollars of cash is, that a resource, that will provide probable future benefit yeah cash is a good asset that's not the only asset, if. You're a financial institution like, MasterCard. Like Wells Fargo, Bank like Bank of America your. Biggest asset, is an asset we call accounts, receivable, or loans, receivable. The asset you're, going to collect money from people in the future based on contracts, that exist in place right now so if I have a piece of paper that somebody has signed or they promise to pay me back, $10,000, in the future is that, a valuable, thing is that an asset sure it is the, primary, asset, of any bank is. Accounts. Or loans, receivable. Master cars an example. Citibank. They, have over a trillion, dollars in, accounts. Or loans receivable that's trillion, with a, t huge. Asset. Money that they expect to collect in the future from, the people who have borrowed it from them in the first place how about Walmart let's do a little mental, trip, into a walmart, location. So or close, your eyes drive. Into the Walmart parking lot get out of your car you're, walking across the parking lot you're walking, on one of Walmart's, assets, they own that land it's a Walmart asset you walk into the building then you know in that building that's another Walmart asset, stand, in the middle of the store and look around at all the stuff on the shelves that's, called the inventory, the stuff that you can buy from Walmart those are all very important, assets, for Walmart, Delta. Airplanes. FedEx. Airplanes, United, Airlines airplanes. These are resources, owned or controlled by the company that provide probable future, benefit, the things that a company uses, to provide services, to its customers so that their customers, will pay them these. Are all assets, the. Balance sheet also lists the liabilities. Of a company the obligations. That will require the probable, future sacrifice, either, by paying assets, or by delivering. Some service, I'll explain what I mean so let's talk about some examples Walmart, accounts, payable payable. As a hint they're an obligation. To pay in the future when. Walmart buys, inventory. They, promised their suppliers, Procter, & Gamble, or Black, & Decker or whoever will, pay in the future we're not going to pay a cash now we'll pay in the future well, that's an obligation now, Walmart better write that down Walmart, better not just write down hey we just bought some inventory, from Procter & Gamble they better also write down oh yeah, and we owe them for it we got to pay them later you got to write down the asset you write down how, you bought the asset in this case you promise to pay it later accounts payable is one liability, Home, Depot and Target. And Walmart, and almost, every other business in the world has, the employees worked for a few weeks and then they pay them Home Depot doesn't, gather all the employees together at the end of a day and say okay we're, gonna pay you cash for whatever you earn today no thanks.
For Working for us today we'll pay in a couple weeks when it's payday, so if Home Depot or Walmart or, Target we're to do a balance sheet at the end of any given day they, would be required to write down okay wages, payable how much of our employees, earned that, we haven't paid them yet another liability, the same thing works for taxes. Taxes. Build up slowly over time and if you're to do a balance sheet you better write down okay as of today here's how much tax we owe though we haven't paid yet ExxonMobil there's, a lot of accounting for taxes, they pay taxes, of all sorts around the world they pay property, taxes, they pay income taxes, they pay sales taxes. They, pay, import-export. Fees all kinds, of taxes, and they don't pay them up in cash at the end of every day so, when they do a balance sheet they have to list down here the taxes, that we are, gonna pay them next, month or a couple of months or now sometime in the future long-term. Borrowing. Disney. Has, some long term debt on their balance sheet that means money that, they have borrowed that they're gonna pay back sometime. Far in the future five years from now ten years from now 20 years from now the, reason I've got Disney here is they're interesting, because a number of years ago they, got some really long, term. Debt they, borrowed some money and promised. To pay it back in not one year not, five years a hundred. Years, would. You loan money to somebody on a promise that they'll pay you back in a hundred years well you would do that for many companies but you do it for Disney, there. Are only a few companies, in the United States who have borrowed money on such a long-term, basis, but it's listed in Disney's balance, sheet long-term debt a hundred, years from now we got to pay this back a little, bit different liabilities this last one on the list United, Airlines unearned revenue, about. The last time he rode on United, Airlines or Delta Airlines or American. Airlines there any other airline did, you pay for your flight before. You flew or after. You flew, before. They always make you pay before all, right well, they then have an obligation if, you've paid for a flight and they haven't given it to you yet they have an obligation to, give you a ride on an airplane that's, what this unearned revenue, is there are two ways to get the money to buy assets borrow. It in which case we call it liabilities, or have it invested, by the owners, then we call it owner's equity owner's, equity is the amount that owners.
Have Invested, in a company for the company then to use to buy assets, well. There are two ways for owners to invest in a business one the simplest way to visualize. Is the owners just say okay my business needs some, money to buy assets I'm just going to pull it out of my personal pocket for my personal, savings I've, done some work elsewhere, I've been prudent I've saved my money I'm not gonna pull it out of my pocket and put it into my business and the business will then use those, assets to buy assets we, call that paid in capital the, amount that owners take out of their personal savings and invest in their business or capital. Stock or capital, contributions, they all mean the same thing so that's one way that owners, invest, in a business not. A way that owners invest in a business is this the. Business generates. Some income who owns the income, generated, by a business well the owners do it's theirs it's their business they own the profits, well, the owners can choose what to do with those profits, sometimes, the owners will say okay my business generated, some profits I'm gonna take those out or some of those out to, use for, personal uses to pay tuition to, buy a boat to do whatever we, call those dividends, when owners pull profits, out of the business but. More often than not owners. Will say okay my business generator profits, I take, out a little bit of dividends but most of it I'm gonna put back in the business for expansion use, these profits, to buy more buildings, to buy more equipment to buy more inventory, if. The profits are kept in the business then, the label we give to that source of owner's equity is retained, earnings, owners. Can invest directly, we call that painting capital owners could say let's keep the profits in the business that's another way that owners invest into business both those two things together paid, in capital and retained earnings the sum of those two is, equal to owner's equity another, source, of financing, to buy assets. The. Income statement contains. Two items revenues. And expenses. Revenues. Minus expenses, equal. The net income that's it that's the income statement now. You shouldn't be seeing yourself okay that's not that bad you're right the counting is not that bad in fact we can make a stronger, statement a County's great. What, does the word revenue, mean it's. Kind of subtle but important, remember, revenues. Are the amount of assets, created, from the sale of goods or services so, how do companies generate, assets through. Profitable, business, operations, well depends. On what the business is Microsoft. For example generates. Assets, by collecting it from you and me through, selling software, and hardware we call that Microsoft's, revenues, how does Walmart generate. Assets through doing business well they sell products, to you and me and they sell us memberships, in their Sam's Club so. That's the way Walmart generates, assets, through doing business so those are Walmart's, revenues.
Disney. Disney. Has five, major. Business. Segments, they're media networks they're, cable TV and television, networks Parks and Resorts Disneyland. Studio. Entertainment, Pixar. Marvel. The, Disney Studios themselves Lucas Films Star Wars Disney, has all those consumer. Products, yeah you still got that lunchbox. That you bought when you were a kid that's got the Disney logo on that they make money from that and the fifth one not listed on the slide here they're interactive. Division, so, Disney, generates. Assets. Through in doing business in many different ways they're all called revenues, revenues, are ways, that companies. Generate. Assets through doing business and whatever your company is that's. The way you're going to generate revenue differs, depending on what industry you're in what. All there are revenues but they're also expenses. Like. What well, Microsoft, in order to generate those revenues, by selling, software, and hardware to you and me they got to pay programmers, they got to buy equipment there all kinds, of things that they have to pay for they got to pay for electricity. They've. Got to pay for maintenance on all, their facilities that they have those, are expenses, Walmart. What. Is their major expense, their major expenses, the cost of the goods that they sell to you and me on average. If. They sell something you and me for a dollar that thing cost them about seventy-five cents so that's an expense that's assets, consumed, in generating. Revenues, they. Also have buildings, that they build and slowly wear out over time those are all assets, being consumed, in generating, revenues, McDonald's. What. Are their expenses, well they have to buy the food that they sell to you and me they have to buy the paper that they sell to you and me they got to pay the employees, that are working behind the counter there are also all expenses. Involved, in generating the revenues so expenses. Are technically defined as the amount of assets, consumed, in generating revenues, now. Another way that expenses. Are created, is by. Generating. Liabilities. For, example, let's, say I've got employees that work for me for the year I pay them their wages that's fine those are expenses, that's easy but what if I also promised. Them, a pension, 30, or 40 years from now when they retire and they also earn those pension, benefits this year that's. Also, an expense, even, though I'm not going to pay them for 30 or 40 years they earned the, benefits, this year and so, I'm going to report as an expense this year the definition, of expense in that case is when, I create. Liabilities. Through doing business, another common, and unfortunate, liability, is environmental. Liability. If, I'm ExxonMobil, through, sucking oil and gas out of the ground and transporting. It around the earth I'm going to do some damage to the environment every year I don't necessarily have to pay to clean it up this year but, I did the damage this year those.
Are Also business, expenses, recorded. This year, expenses. Consuming. Assets or creating. Liabilities, through doing business those are expenses. So. The income statement revenues. Minus. Expenses equals. Net income it's as simple as that now this net income, is the. Overall measure of a company's economic, performance during the period that's the one number that, summarizes. All the economic, things that the company did it's an economic, measure accounting. Net income we've been working for over 500 years to. Fine-tune. The accounting, rules to, properly measure revenues, and expenses so that number net, income the difference between revenues, and expenses, for the year is the, economic, performance for. The year, is a good measure of a company's economic, performance. A statement. Of cash flows statement, of cash flows is the baby of the financial, statements the balance sheet income statement have been around for over 500 years. Statement. Of cash flows is just this let's take all the cash flows cash. Collected, cash paid by, a company and again that's a pretty easy concept cash. We'll just focus on cash how much cash did you collect how much did you pay and we're gonna separate, those into three categories, operating. Activities, investing activities. And, financing activities. And let me tell you what those three activities, are and then we'll look at examples of each one operating, activities are the things that you do every single, day your. Operations. So. When would you collect cash, from operating activities, if you sell some goods if I'm Walmart I sell you something if you provide some services, if I'm a consulting, company I provide consulting services to you and you give me cash so, those are cash inflows, from operating, activities cash, outflows, from operating activities, you pay wages you pay your chilies you pay your taxes you pay your interest those are all things that you do every single, day so operating activities, it's just the routine stuff that you do hundreds, of times a day. Investing. Activities, hear. The word investing, means investing. In the productive capacity, of the business so. Cash, outflows, from investing, activities down at the bottom here is buy. New buildings, buy, new land, investing. Spending, cash to, enhance, the productive capacity of the business those, are cash outflows. From investing, activities cash, inflows from investing, activities well when I'm done with a truck when I'm done using some land I sell them I don't need them anymore so I'm gonna sell them for some cash those would be cash inflows, from investing, activities how, often do i do investing, activities well occasionally, but not every day these are not routine things I don't go out buy a building for my business every single day so. Investing activities, happen, occasionally, and it's investing, in the productive capacity, of the business and I'm generally spending. Money to enhance the productive capacity of my business, the. Third category of cash flows financing. Activities, financing. Activities is just what it sounds like I'm getting the cash to, do what I want to do in my business I'm borrowing, some money I'm getting, new investment, from owners those are cash inflows. From financing. Activity, cash, outflows, well, I'm repaying, those loans I am, paying dividends, to my owners those are cash outflows, from financing, activities and how, often do I do those things occasionally, not, very often so. Operating, activities those are the things that I do every, single day repetitively. Over and over it's what I exist, for, investing. Activities, I want to expand, the productive capacity of my business I'm spending, money to enhance that productive activity. Financing. Activities I'm getting. The, cash to do what I need to do I'm borrowing money and I'm repaying it back I'm getting cash from shareholders and I'm paying dividends, to them that.
Is The statement of cash flows it's only been around for 25 years, but, it's been 25. Awesome. Years. Managerial. Accounting, is all about, communicating. To people inside, the company it's the information, that's used on a detailed, basis every, single day inside. The company managerial. Accounting its secret, its detailed, its daily. Let. Me illustrate the, difference between managerial. Accounting, and financial accounting, with this simple example we'll, talk about Walmart again we saw before that. Walmart's, sales four, hundred and sixty six billion dollars, now at four hundred sixty six billion is, that a financial accounting, number or a managerial, accounting, number yeah, it's a financial accounting number we saw it in their income statement that's report, made available to, people outside the company so that's four hundred and sixty six billion dollars is that sales number is a financial, accounting, number now, let's imagine for, a second that you run, Walmart. You're the CEO, of Walmart let's go crazy in our imaginations. Here and, you're running the business that means you're making daily decisions, about what needs to happen in a Walmart and the. Financial, accounts come and say hey our sales last year four hundred sixty six billion and. You say okay that's nice thanks, but I'm trying to run a business here I need to know more details, about that number four hundred sixty six billion I need that sliced, and diced and, I need to cut down I need, to know more specifics. I need detail, I need daily detail. So, let's think what additional. Things would you like to know about that one number four hundred sixty six billion we're only talking about the sales that financial. Accounting number if you were to try to run Walmart, what additional, things would you like to know about that one number the four hundred sixty six billion I say. List ten additional things we could list hundreds, of additional things but, here's a few that I thought of, in. Addition to knowing that the total sales are four hundred sixty six billion I don't want to know okay how. Many of, those sales were in North America, and how many of them were, in Mexico and South America and how many in Europe and how many in Asia I want to know it by region, by country, in, fact I want to know what my store, and I don't want to just know it by store I want to know how much did, we have last year in that same store and what was our target for this year and that's too so that we have more than last year and we have more than we thought we were gonna have I want, it at the store level now let's go down even further I want to know by department, are we selling mostly groceries, are we selling mostly children's, clothing men's, clothing.
Outdoor. Lawn, care, kind of stuff what, are our sales specifically, in fact let's go to specific, items how. Many of this kind of shoe did we sell how much milk did we sell how many bananas, did we sell how many LA Moors did we sell I wanted, over my specific items, I want to drill down to as much detail, as possible because I'm running a business here I wanted. To identify my best sellers my worst sellers I want to make a plan. 466. Billion total sales doesn't give me enough information to, make a specific, plan of running my business on a daily basis, how, about physical, location, in the store, top, shelf bottom, shelf in shelf. Back of the store front of the store you tell, me how, we can, influence ourselves by where we play stuff in the stores and there are some things that are safer to put in the back people won't forget about him and there are some things that unless, we put him in the front nobody's, gonna buy him I want to know that stuff I want, to know how much is sold by seasons, what's. Sold in January what's, sold in February what's. Sold during the holiday selling season in fact I want to go a little bit deeper, how, about day of the week what. Happened on Mondays Tuesdays Wednesdays by, time of day should. We be, open 24, hours should, we even open before noon you tell me the sales by, hour by. Region. By, item, tell me all this stuff when it's raining outside what. Sales when it's hot outside, what, sells, hey, we ran a bunch of ad campaigns, I want you to show me the impact of those ad campaigns, on the sales numbers what were they the week before what are they the week after by, payment method, how many people pay cash how many use this credit card I'm gonna use that credit card show we have our own credit card so we even accept, cash. The. Demographics, of the buyer this is where it gets quite interesting, because, if. People pay with, a credit card I've got their name attached, to their list of purchases, so I know what. They buy and if they buy on a regular basis, from Walmart Walmart I can develop a pattern. Of purchases, and maybe it's been more, than six months since they bought those certain shoes, they like or since they bought that certain grocery, item that they seem to want to buy if I've somehow managed to get their email address, from them maybe through some buyer, loyalty, program, then, I can email them, a coupon and say why don't you you haven't bought bananas in six months well here's a coupon for 50%, off bananas, if you buy under day I could use this specific, information to target two specific, buyers, so. The Financial Accounting number is. 466. Lat. One in a Walmart I didn't, know details, that I can use on a daily basis, to run this business that's, managerial. Accounting inside. Secret. Daily, detail, I want, to run through some specific illustrations. Of managerial.
Accounting, Applications. Product. Costing, how, much does it cost to make my product, if I'm making wood furniture how much does it cost me to make that, wood furniture if I'm making industrial, equipment how much does it cost me to make that industrial, equipment, if I'm Boeing, how, much does it cost me to make a Boeing, 777. Aircraft if. I'm delivering the service, if I'm Southwest. Airlines how much does it cost me to get a passenger, from, New, York to San Francisco, what does it cost product. Costing, then, we'll do breakeven, I'm. Going to open up a store location, I want to know if there's going to be enough sales, for, me to break-even to avoid having a loss so, we'll do some examples of break-even budgeting. Numerical. Planning, running. Your business plan out on paper first, to identify any, problems, before they happen in the real world hopefully. When we talk about budgeting you're going to think about your own personal budgeting. Practices and. Finally, the, last managerial, accounting illustration, that I want to give us performance, evaluation. We'll see the key concept, that is this you. Get what you measure if you, measure certain, aspects of performance of, your employees they're going to focus they're going to hone in on those aspects, performance. Evaluation, product costing breakeven, budgeting, performance, evaluation, let's duel astray shion's of each one of those. One. Important, function of managerial, accounting, is computing. The internal, costs of providing, our, products, or our services, let's do an illustration what. Does it take to make wood, furniture, what, do you need well you need some wood but what else do you need so, we're gonna want to compute the cost of all the, things required. To, make wood furniture we're gonna follow the flow of cost through, this company, it's August 17th, the customer comes in and orders one custom-made. Dining, table a beautiful. Piece of work made, out of oak it's, about 20, feet long they want to be able to fit a lot of people and they want it finely honed and maybe they want their own coat, of arms carved, into the top they want a very nice table. It's. August 17th, they say okay I'm, going around to various furniture, makers describing. To them the table that I want I need a bid how much will you charge me to make this table for me so. Okay if I want to make an intelligent bid I better first figure out how much it's gonna cost me, to make that table so what's it gonna take to. Make a custom-made. Dining. Table, well. First it's going to take the wood and a managerial, accounting setting we call this direct materials the actual stuff, that, the, item is made out of so in this case it's wood for, making the automobiles, and to being metal and rubber and the other things that go into making automobiles. So. Direct materials that's, pretty easy to estimate you, describe the size of the table and the design it's, gonna use, wood that cost me about $1,000. By the way I'm not telling any of this to the customer I'm doing this privately, in a back room on a piece of paper so, direct material is about a thousand, dollars but. The wood doesn't form itself into a table, how, many hours, is I can take my workers, my skilled, craftspeople. To, make this thing happen well again. I can estimate that pretty well it's about 30 hours we, call these people the direct labor people they're the skilled craftspeople, who, actually do, the work and it's going to take them 30 hours and I pay them a wage rate of $30, per hours that's gonna end up being $900. Okay, am I done if I, go out into the desert somewhere. With. A pile of wood and some. Workers do. I have myself a nice oak custom-made. Dining, table, although. I need some machine. And, I can estimate alright it's gonna take me about 200. Machine hours to, finally, plane, and polish, and make the wood so it looks just so-so the, direct materials thousand. Dollars direct, labor nine hundred dollars and I want to stop and make sure that you understand these two numbers are easy anybody. Who makes furniture can easily. Estimate the. Amount of direct materials, they might have oak in this case it's going to take to make this dining table and the, number of hours is going to take their direct labor-hour people the skilled craftspeople to do this thing and they know how much they pay these people so this one thousand, plus nine hundred that's, pretty easy but. Is this it no it can't be it, you, need infrastructure. Over. A head we call it you've, got to have a roof over your head you got to have Supervisors you got to have maintenance, people you. Got to have quality control inspectors. You got to pay property taxes, you got to have insurance you, got to have all of this, okay. So how much of my overhead, costs I've got my factory, building here I'm, working on this, oak table, right here I'm working on a children's desk over there other people I've got some bookcases going, on over here I've got a china, cabinet over there and, I've got one, supervisor, kind, of supervising, all those jobs how.
Much Of that supervisor, salary, should be assigned to this oak table, how, much the property taxes on this building should be assigned to this oak table, how, much of the wages that I paid on my maintenance people how much of that should be assigned to this oak table, right here how. Can we do that see that's the hard part the overhead, is the hard part direct, materials direct labor they come together that's pretty easy to estimate but. The overhead cost that's, hard and here's the thing to remember, somebody's. Got to pay for these overhead costs whoo well. There are two choices either. I build it into the cost and build a customer, for it so the customer, pays or I got to pay it myself well. I guess I could pay it for myself for a while but then I'm gonna go out of business so, I got a factor, in how much overhead cost should be assigned to this particular. Dining. Table. Remember. The customer came in on August 17th that wants to buy this table. Well. The, overhead cost I'm really not sure but let's go back and Tom let's go to the month before in July here's, what I do know. Month in July, I had, total overhead costs total for the whole factory. $500,000, in, addition. My skilled craftspeople, work 10,000, hours and I, use my machines, a total of 25,000. Hours okay. Well who cares about my direct labor people because, they're not part of my overhead who cares about my machines, well. It's this because. I got to figure out how to assign that, 500,000, total overhead and so let's think about this a little bit let's, say I've got two projects, going I got this big fancy, dining. Room table made out of oak going on and I got 15, workers gathered, around doing various things and I, get a little child's desk project, on the other side of the factory over there there are two workers there working, on that one which. One of those two, projects. The big dining room table project here or the little child's desk project over there which one of those two is going. To consume. More, overhead cost well. Where, there's more workers, so. One way to think of assigning, the overhead cost is just to say okay as a, rough estimate, if you got more worker hours you ought to be assigned more overhead door, if we say well it's not worker, hours not direct labor hours it's machine hours the more you use the machines, the, more overhead costs should be assigned well that kind of makes a little bit of sense because the bigger a job is and the more involved it is it creates, more overhead, cost so. That might be one way we could do this overhead, and, we have to use old information, we're going back to July but it's, better than nothing it's better than paying for the overhead cost ourselves so let's think about this, perhaps. We could say this listen, last month the, way it worked was we had five hundred thousand dollars in total overhead, cost ten. Thousand and direct labor-hours are skilled craftspeople so, it was about $50. Per direct labor-hour now let's be careful about this number 50 because how much we'll be paying those direct labor to our workers were actually paying them a wage of $30, a piece this, is something different roughly, speaking for, every hour one. Of my skilled craftspeople, works, on a project, a dining room table or a child's, desk or a bookcase, for every one of those hours they are consuming. Or requiring. About $50. Worth of overhead cost the, supervisors. Come over there using electricity, the maintenance people have to come over let's their share their property, taxes, about $50. Per hour it's not exact, but, it's better than nothing so that's one way that we can assign overhead. To each individual, project you tell me how many direct labor hours the workers are going to work on a certain project and I'll tell you how much overhead should be assigned, to that particular project, or maybe we'll say nah machine, hours, is the right way to do it last month we, had $500,000, of overhead and we used our machines a total of 25,000. Hours the. More you use the machines the more they're going to break down the more maintenance work is going to have to happen the more the supervisors, can have to come over the more electricity, you're using so, maybe we say machine hours is a better way to do this and in that case it would be 20 dollars per machine hour if, I make, a plan for making this oak table and it's, going to require 200.
Hours Of machine. Work well, then that's going to create twenty. Dollars of overhead, for every machine out roughly, speaking based on last month's data or. Maybe. There's some combination, a little bit of the overhead maybe is more directly. Related to direct, labor hours maybe that's the part about the supervisors, and the more workers I've got then, the more the supervisor, cost should be assigned to a project or, maybe, some the machine hours the more I use the machines, than the more electricity, that I use the more maintenance cost there's going to be so some combination this could get quite complex, but you see the basic idea we've got to do something the overhead cost has to be assigned to individual, projects, that child's desk that bookcase this. Oak table, on some, rational, basis can. We do it in proportion to the amount of skilled, craftspeople, hours, some. Proportion, of the amount of machine, hours we've got to do something, well. Let's do it on the basis of direct labor hours of direct materials thousand, dollars direct, labor nine hundred dollars an overhead. Well, we got thirty hours, of direct, labor work and we, said roughly speaking based on what happened last month, that. It's about, fifty dollars of overhead costs are created for every hour that my workers work on a job remember it's not what I paid them but, it's the amount of overhead, cost that they create, through doing there and work 30. Hours times $50 per hour that's another $1,500, so I could say that total cost of this tables, 3400, just add up the three a thousand, plus nine hundred plus fifteen hundred now look at those three numbers one, of them we're not really sure about two of them we know for sure how about the direct materials yeah you can estimate that pretty closely how much wood are you gonna use about. The direct labor you've had some experience with your workers you know how long it's going to take them to make a project, like this and you, know how much you're paying them $30 per hour it's the overhead, that we're not so sure about so, let's try a different way to do it let's, assign the overhead based on machine hours, based, on how much we use the machines, that's how overhead, and gets created, well, the director shows us the same thousand, dollars direct labor is the, same nine hundred dollars if, we base the overhead on machine hours this particular, oak table, job is going to require two hundred hours of using our machines and. We decided based on data that happened last month that, would create about twenty, dollars of overhead for every hour we'll use our machines so. Two hundred machine, hours times twenty dollars of overhead created per every hour we use our machines that's four thousand dollars thousand. Plus nine hundred plus, four thousand that's five thousand. Nine hundred now. Stop because you might say well wait a second, why don't you just wait until, the end of August so you can figure out more current, data based. On the August, data well. You could do that it, would still be an estimate plus you. Can't say to your customer listen I really can't tell ya how much it's gonna cost to. Make your table and therefore I can't set a reasonable price because it's not the end of the month you're gonna have to come back at the end of the month and then I can tell you what, your customer are gonna say your customer says listen if you can't quote me a price now look go to one of your competitors there's.
Another Example of good managerial, accounting being a competitive tool if I can understand, my cost well enough so, I can get an estimate the cost of the direct materials direct labor and overhead BAM right now on August 17th when the customer comes in if I can do that right now then. I can quote him a price and that. Gives me a chance to get this job here's. The problem oh I got two different costs here depending on how I sign the overhead I got three thousand four hundred then I got five thousand, nine hundred, which. Is the right cost, what. Does it cost to produce this table it's a three thousand four hundred where. We assign the overhead based on the proportion, of direct labor-hours, skilled craftspeople, usage, is, it five thousand, dollars, where we assign the overhead based on that how intensively, we use the machines or is it something else some combination. Of the two or something else entirely, okay. What difference, does it make Wow, makes a huge difference, first of all let's, say that the number is five thousand, nine hundred and a customer comes in and says I'll give you five thousand, for the table, well you do your calculations and you, say no I won't. Accept a price of five thousand, because if I do that I'm going to lose money I compute, my cost to be five thousand, nine hundred in fact, if my cost really is five, thousand, nine hundred what I will suggest to the customers why don't you go to my competitor, down the street because, if I can get my competitor, to, do this job, for five thousand dollars what I'm pretty sure that it's going to cost them five thousand nine hundred dollars to do it I can, help drive my competitor, into bankruptcy now I would not be a nice thing to do but hey it's business, but. What. If and you'd listen to me closely what, if the real cost what if the right way to assign, overhead, is by direct labor-hours, suggesting, that the real costs at three thousand four hundred but, I don't know that I mistakenly. Think that I should be assigning, overhead based on machine hours so, I mistakenly. Think that my cost is five thousand, nine hundred customer. Says I'll pay you five thousand, you, mistakenly. Think based on your incorrect. Assignment, of overhead cost it, cost. Me five thousand ein hundred to do it you're offering to pay me five thousand forget about it but. In reality if. The, overhead should be assigned based on direct labor-hours, the real cost is only three thousand four hundred if you tell your customer to go away you're sending, away profit, they're willing to pay you five thousand, to give them something that only cost you three thousand four hundred to make so. Should we make this table or not yeah. It makes a big difference how we assign the overhead and at what price should we sell the table if we don't understand, our cost we, don't know how to intelligent, make our prices, and if we don't know how to set our prices intelligently, and our competitor. Down the street does know how to estimate their costs appropriately, and so can set their prices appropriately, our competitor, is going to beat us, cost. Flows and product costing, there, are three kinds of cost in a production setting direct. Materials that's easy, direct, labor the skill craftspeople that's easy it's this overhead. Thing how much overhead should be assigned to each project that's where it gets hard that, where the art is involved, we can't have an entire, course, a series, of courses a year-long, seminar. On just, this one thing, but, you can see why it's a crucial, issue. Budgeting. Is another, important. Topic in managerial, accounting remember, manager, Lee County detailed. Stuff, that we use every, day inside, a business not the kind of thing that we're going to reveal the people outside it's the kind of stuff that we're going to be using inside budgeting. Making a systematic, plan on paper, so, we can see problems before they arise in the real world because budgets, help, you see problems in advance and probably solve them in advance before they ever actually happen, so. It's a how much excitement do you want in your life if you want to have your excitement in other ways do, budgets, that'll. Allow your business your, personal, affairs to run more smoothly so then you can save your excitement for, other things so. What are the benefits of a cash budget in particular. In this case and a budget in general, well.
Would You budget, things it really means you're running a simulation of how your company is going to operate, for the next few months and. You say well ok we need to make advance arrangements, for this we need to arrange that loan a well, in advance if when we actually have to make it the, budget allows you to have realistic targets, a budget, gives you hope this is especially, important, for startup, companies because startup companies have some lean times they, burn through a lot of cash for example, it's nice to have a cash budget the. Budget creates, the light at the end of the tunnel and the budget helps us identify and, solve. Problems, on paper. Before, they ever happen, in the real world there are huge, benefits to, budget for all organizations, for, businesses, and, for you and me personally. There, are four flavors of accounting, standard. Bookkeeping, to gather all the information financial. Accounting, reporting to outsiders. Managerial, accounting reporting. Inside, the company that detailed, information that we need to make daily decisions and finally. Income. Taxes, let's talk more about income, taxes, income, tax accounting. Is its, own specialized. Field there are elements of income tax compliance. Let's, make sure that we're obeying the law there are elements, of income tax planning let's. Make sure that we structure our affairs so that we don't have to pay any more tax than we need to and for, you and me there's just the element of faylene I love our tax form well, here in this discussion, we'll talk about some general principles with, respect, to income taxes we won't drill down to the level of actually filling out your tax form that would be a discussion for the other day but, let's make sure that we understand the general concepts, the basic terms, with. Respect to income, tax accounting. To. Facilitate, our discussion. Of income, tax systems I've designed a very simple, income tax system here that contains, the important elements of all income, tax systems around the world so, in this simple system for income. From 0 to $50, you don't pay any income tax at all you're allowed to make that money tax-free, in this, governmental, tax system that I've designed for all income over $50. You got to pay a tax rate of 50, percent so this is going to make our calculations simple. So. Again this has all the elements of the tax system in the United States and in, the European Union. And Hong Kong and, China everywhere, else so we'll use this to represent tax, systems, around, the world so we'll answer these, questions, under this tax system how much tax would you pay if you made $50. What, have you made fifty one dollars what do you made $100. Let's, do the computations. In each one of those three cases if. You make $50, you don't pay any income tax under this system first. $50, are tax free so, that's a pretty easy to computation, to do alright but what if you make fifty one dollars okay. The first $50. Still you pay no tax that, fifty first dollar you're, going to pay the rate of fifty percent so your total tax that you're going to pay is 50, cents this. Illustrates, the important notion of the tax bracket. You'll sometimes hear people the Mon the fact that oh I got a race on I'm and next tax bracket. Well, that's kind, of a naive comment. And I'll show you why the. Tax bracket, is this. The first tax bracket, in this case is from zero to $50, and the rate on that first $50, is always, zero, no matter how much you ever make so, when you make the fifty first dollar when you go into the next tax bracket, where income, is taxed at the rate of fifty percent that. Is not applied retroactively, Lee you don't have to go back and pay the fifty percent rate on the first fifty that first $50, is never taxed, the rate is always zero. That's the first tax bracket, the, second tax bracket, in this simple example is everything over $50 in that second tax bracket yes the tax rate is 50% but let's think should. We be sad that we got a raise in this case we, went from making $50, to $51. Does that cost us any money well no it does not because. When, I make $50, I have the $50, and I don't pay any tax if I make $51. Yes it's true that I now have to pay half of that 50 first dollar in tax so, I have to pay 50 cents in tax but I get to keep the other half so, if I make $51 I have the first 50 tax, free and I get to keep half of the 51st dollar so I have 50 dollars and 50 cents going. To the next tax bracket, doesn't cost you any money it just means you have to pay a different, rate on the extra income that you're going to make so don't be afraid of making more money and going into the next tax bracket, that's a cause for celebration.
Under. This simple tax system how much tax do you pay if you make $100. Well. Again the first 50, is never taxed, at all so the tax that you pay is 0 the, second 50 is taxed. At the rate of 50 percent so you're going to pay a total of $25. Tax if your taxable. Income is $100. This. Allows, us to, discuss two important, concepts, the average tax rate and the marginal, tax rate the. Average tax rate is simply. The tax that you owe, 25. Dollars in this case divided. By how much you made $100. In this case 25 dollars divided by $100, that's 25 percent that's, the average tax rate and it's a very intuitive, notion what's the average tax rate for all taxpayers, in the United States oh it's somewhere between 17. And 20, percent the average tax rate the tax that they have to. /. The amount, that they make so 25%. Average, tax rate in this case if you make $100. Economists. Say that a more important, rate than the average, tax rate is the marginal, tax rate, what's, the rate you're going to pay on the next dollar that you make and the reason that's an important concept from an economic standpoint is that's, the rate that I have in mind when I'm considering, Oh should I put in some extra time and make more money because, on the extra money that I make I'm gonna have to pay the marginal, tax rate the tax rate on the next dollars that I'm going to make I'm an entrepreneur with good business ideas should, I work hard and devote my time and energy to. Starting, that business and making money because if I start, that business and make extra, money I'm gonna have to pay the marginal. Tax rate 50% in this, case so, the marginal rate that's the number that people have in mind as they consider whether they should work harder, the average tax rate just, takes all the elements of the tax system and what's the average amount of your income that you pay marginal. Tax rate what, rate am I going to pay on the next dollar that I make average, tax rate just, how much to attack so I pay given all the complexities, and tax brackets in the system divided by how much I made in this case if you make $100, your average rates 25%. Marginal. Rate is 50%, and that marginal, rate is the rate that you look at as you consider should I work hard start. My own business put, in some extra hours to make a little extra money you. Might be asking yourself so. Why exclude. Some income from taxation, in this simple system why let people make that $50.00, without paying any tax at all well. The concept, here is that there is a fixed cost to living I have to have a certain amount of money to put a roof over my head and put, food on the table and clothes on my back so let's not tax any of that money because. Those are the essentials, of life once I've got those things taken care of okay now the government, could start to take some, tax from me so that's the very simple. And appropriate. In my opinion a concept, behind this notion of allowing, some income, not to be taxed and this is true in all income, tax systems around, the world there's a fixed cost to living if I take money away from a person who's not making very much they're gonna have to give up some important, things their, food won't be so good. The quality or quantity won't, be as good as it otherwise would, be so let's let them, keep that money let's, instead. Collect, tax money from those who are making a surplus, because, they're not giving up the necessities, of life so that's why some income is always excluded, from taxation in all income tax systems, around the world another. Phrase that you might have heard is progressive. Tax system, what's a progressive, tax system well. This simple tax system that we've been talking about is a progressive, tax system let. Me show you why if, you make $50 as we saw you pay no tax so your average tax rate is 0%, if you make $100. We did the calculations, and saw that you, pay tax of $25, so your average tax, rate is 25%. In, this. System if you were to make a thousand. Dollars the first 50 is not taxed at all the, second 950. Is taxed at a 50%, rate so you'd pay four hundred and seventy five dollars in tax your average tax rate would, be forty seven point five percent so what you see is the, average, tax rate goes up the, more money you make that. Is a progressive, tax system and, all. Income. Tax systems around the world are progressive. Systems the more you make the higher your average tax rate and again that makes sense because people who are making more money can, afford to pay a more tax because there won't, be denied.
The Necessities, of life so, the more money you make the higher your average tax rate I've, been careful here to say that income, tax systems around the world are progressive, not, all tax systems, are progressive, for example, the sales tax is an example of a regressive, tax, the. Less money you make the more percent, of your income you're going to pay as sales tax and why is that if you don't make very much money most. Of the money that you do make is used, on buying. Goods and services on which you will frequently have to pay sales tax whereas, if you make lots of money a lot of the money that you make is going to be put in investments, and other things where you're not buying goods and services and are not paying sales tax so the sales tax is an example of a regressive, tax, the. Lower your income the higher your, percentage, of income that is paid in the form of sales tax but income tax systems around the world are progressive. Just, as we've seen here. You. What, is the impact of a tax deduction, in our simple tax system so let's say you make $100. Remember. The first 50 is never taxed, the second 50 would be taxed at the 50% rate so you're gonna pay 25, dollars in tax total, now. Let's say that of that hundred dollars you make you decide to spend ten dollars in a way that the government favors. Perhaps. You spend that ten dollars as a charitable. Contribution or, you spend that ten dollars paying, mortgage, interest, on your home, so the government says yeah we want to encourage that behavior that's a good way to spend ten dollars then you're going to get a tax deduction for that ten dollars so how does that enter into the payment of your taxes, well, now you have to compute your taxable, income you, made $100. But, ten of that you spent in a special, way which is tax deductible so. Your taxable income is only $90. So, first 15 is still tax-free. Now, the second, 40 is taxed at the 50 percent rate so you're going to pay tax of $20. So, you see here that the tax deduction, of ten dollars reduces, your income taxes, from twenty five dollars initially to, twenty dollars after you subtract the tax deduction, again, what are tax deductions, they, are expenditures. By individuals, that the government favors for charitable contributions, for. Investing. In your IRA or, your, 401k. Plan for. Paying, interest, on your home mortgage they're, also business, tax deductions, five, a business, and I make $100, but then I use ten dollars of that to pay wages, to my employees, or pay electricity, on my building or pay property taxes on my building any legitimate, business expense, that's also a tax deduction so there are really two kinds of tax deductions tax, deductions, legitimate. Business expenses, and tax. Deductions spending. By individuals, that the government wants to encourage. Charitable. Contributions. 401k. Investments. Payment. Of interest on the mortgage of your home and. We see that what a tax deduction does is reduces, your taxes now you say well that's great I should, get the largest, mortgage and pay the most interest, that I possibly can because I'll get all these tax deductions, no no no let's be careful here in order, to get this $10 tax deduction, I had to spend $10, on my home mortgage interest so I had to spend $10, don't, to a charity so $10, is gone yes. The pain is eased a little bit by the fact that I now get to reduce the taxes that I pay to the government by five dollars but there's still a cost I spent, ten dollars for, charity, or whatever else in order to save five dollars in taxes, so you got to make sure still that you want to spend the ten dollars but the government, is easing, the pain by giving you a deduction. For that ten dollars so that's a tax deduction. How. About a tax credit it's, a difference between the tax deduction, and the tax credit, let's. Go back to the our same example you make a hundred dollars in our system you the first 50 you pay no tax the second 50 you pay the rate of fifty percent so you're gonna pay twenty-five dollars tax great now. Let's say that you spend, ten of those dollars in a very, favored. Way according, to the government maybe you spent the ten dollars increasing. The energy efficiency, of your home you put solar, panels on, your roof you did something that the government really wants to encourage in this, case they're going to give you a tax credit, again, this is determined by, the government through a governmental process, we're gonna give you a ten dollar tax credit so how is that difference from a tax deduction, well you compute your tax you. Pay no tax on the first 50 dollars you pay a rate of 50 percent on that second, $50 so you pay 25 dollars in tax but, the government, says if, it's a tax credit you spent that money so, well you, spent it just the same way we would have so, what we're gonna say is you can reduce that directly from your taxes you owe us 25 dollars in taxes just reduced that ten dollars that tax credit so you only have to pay us fifteen dollars this, is evidence, that the government really, approves, of the way that you spent that ten dollars I've reduced my tax, directly.
By The whole ten dollar tax credit, so, which is better a tax, deduction, or a tax credit well, we see that the ten dollar tax credit in this case reduces. My income taxes from twenty five dollars down to fifteen dollars that. Same ten dollars if it's a tax deduction, reduces. My taxes, only from twenty five dollars down to twenty dollars tax, deduction. Reduces, my taxes by five dollars tax. Credit, reduces, my taxes, by ten dollars, so if somebody gives you your choice you, want a ten dollar tax deduction, or a ten dollar tax credit you show them how wise you are, you take the tax credit. Let's, talk about the two different kinds of income, out there there's, ordinary, income and there's capital gains income. Ordinary. Income is just, like it sounds it's ordinary, income the, wages, that you get from the job that you have your, salary, let's, say you've got savings. Account in the bank you're in interest that's ordinary income dividends, you've got some investments, you get some dividends that's all ordinary. Income, capital. Gains income is when, you make an investment let's say you buy a stock, portfolio and, hopefully you're going to buy low and sell high, let's say I buy at $1,000. And sell, at $1,300. That $300, that went up that's called capital, gains income, so. There's ordinary income wages, salary interest dividends and there's capital, gains income income. From investments. Worldwide. In particularly, the United States capital, gains income is typically taxed, at a lower rate, now, we could get in a long, philosophical. Discussion, about whether this is right or wrong let me just give you other rationale, on both sides the, reason that capital gains income is typically taxed at a lower rate is one. Governments. Want to encourage, people to invest, invest. In businesses, and invest, in portfolios. For savings purposes, so to encourage that will tax any capital gains income as a lower rate in addition, people say listen if, I'm going to invest money in a stock portfolio I already paid tax on that money when I originally, made it he, can attacks me again when I invest, it so that's the rationale, in favor, of taxing. Capital gains at a lower rate on the, other side hey, income. Is income if. I work through the sweat of my brow and make money, I should pay tax on that if I, invest, my money and my investments.
Go Up in value I should have to pay tax on that there's no difference it's just a different way to make income, capital. Gains income should be taxed the same rate as anything else those. Are the arguments on both sides the, fact is that in, most jurisdictions, around, the world capital, gains income is taxed, at a lower rate in fact in some places capital. Gains income is not taxed, at all in, the United States ordinary. Income is taxed at one rate capital. Gains income is taxed at a lower rate. Let's. Go back to our simple tax system for income from zero to $50 you know pay any tax at all that's the first tax bracket, for income above $50. The tax rate is this if it's ordinary, income, you pay a rate of 50 percent if it's capital gains income, you, pay a rate of 20 percent so, we're introducing the notion of ordinary income and capital gains income to different rates it's, how much income tax would you pay if you made a hundred dollars let's, think about this. If. The hundred dollars that you make is ordinary, income meaning you just went to your job and that's your wage or that's your salary, or you had, some, interest. That you made on a savings account or dividends and you got from investments. That. Hundred dollars an ordinary income is going to be taxed zero. On the first $50 and at, the rate of 50 percent on the second, 10 t5. Dollars tax the same thing that we saw before the ordinary, income if on, the other hand this, $100, income that you made is capital gains income you. Invested, $100. In a mutual fund and it, went up to $200, so it doubled, in value awesome. I'd like to see that invest. $100, it doubles in volume goes up to $200, that hundred, dollars in your making capital gains the increase, in the value is taxed capital, gains rate so the first 50 not. Taxed at all it's a zero, percent tax, bracket the. Second, 50 would, be taxed at the capital, gains rate of 20 percent in our simple system here so you'd only pay 10 dollars tax.
So. If somebody gives you your choice do. You want to classify this income, as ordinary income and pay $25. Tax or capital gains income, and pay $10. Tax which would you prefer to do well if it's legal you'd prefer to pay the ten dollars and here. Is where a lot, of the complex. Tax, shelter. Arrangements, arise you've heard of tax shelters, tax. Shelters take on many forms one. Form is doing. This, structuring. Your affairs, so that income, can be classified as capital, gains income rather, than ordinary income for obvious reasons capital gains income is taxed, at lower rates and lots. Of things both, legitimate and shady. Have been done to create tax shelters to change the nature of income from ordinary income to capital gains income. So, when you hear discussions, of tax shelters, and this and that this is one thing that people are talking about changing. The nature of income from ordinary income to capital gains income because. Capital, gains income is typically taxed at lower rates people, prefer to have any income they make classified. As capital, gains income if at all possible. Let, me summarize our, discussion of income, taxes, first. There's the notion of the tax bracket. Income. Is taxed, in chunks. The, first part of income in almost every tax system, around the world is not taxed,