BASIC CONSIDERATIONS

MAS Defined
− Management advisory services refer to the function of providing professional advisory
(consulting) services, the primary purpose of which is to improve the client's use of its
capabilities and resources to achieve the objectives of the organization.

I. Strategic Decisions and Management Accounting — key to a company's success in

creating value for customers while differentiating itself from its competitors.
 Strategic Planning — is the process of documenting and establishing a direction of your
small business by assessing both where you are and where you're
going. The strategic plan gives you a place to record your mission,
vision, and values, as well as your long-term goals and the action
plans you'll use to reach them.
− The five stages of the process are goal-setting, analysis, strategy
formation, strategy implementation and strategy monitoring.
1. Clarify Your Vision
− The purpose of goal-setting is to clarify the vision for your business. This stage
consists of identifying three key facets:
 First, define both short and long-term objectives.
 Second, identify the process of how to accomplish your objective.
 Finally, customize the process for your staff, give each person a task with
which he can succeed. Keep in mind during this process your goals to be
detailed, realistic and match the values of your vision. Typically, the final step
in this stage is to write a mission statement that succinctly communicates your
goals to both your shareholders and your staff.
2. Gather and Analyze Information
− Analysis is a key stage because the information gained in this stage will shape the
next two stages. In this stage, gather as much information and data relevant to
accomplishing your vision. The focus of the analysis should be on understanding the
needs of the business as a sustainable entity, its strategic direction and identifying
initiatives that will help your business grow. Examine any external or internal issues
that can affect your goals and objectives. Make sure to identify both the strengths and
weaknesses of your organization as well as any threats and opportunities that may
arise along the path.
3. Formulate a Strategy
− The first step in forming a strategy is to review the information gleaned from completing
the analysis. Determine what resources the business currently has that can help reach
the defined goals and objectives. Identify any areas of which the business must seek
external resources. The issues facing the company should be prioritized by their
importance to your success. Once prioritized, begin formulating the success. Once
prioritized, begin formulating the strategy. Because business and economic situations
are fluid, it is critical in this stage to develop alternative approaches that target each
step of the plan.
4. Implement Your Strategy
− Successful strategy implementation is critical to the success of the business venture.
This is the action stage of the strategic management process. If the overall strategy
does not work with the business' current structure, a new structure should be installed
at the beginning of this stage. Everyone within the organization must be made clear of
 their responsibilities and duties, and how that fits in with the overall goal. Additionally,
any resources or funding for the venture must be secured at this point. Once the
funding is in place and the employees are ready, execute the plan.
5. Evaluate and Control
− Strategy evaluation and control actions include performance measurements,
consistent review of internal and external issues and making corrective actions when
necessary. Any successful evaluation of the strategy begins with defining the
parameters to be measured. These parameters should mirror the goals set in Stage
1. Determine your progress by measuring the actual results versus the plan.
A. Mission vs Vision
− A Mission Statement defines the company's business, its objectives and its
approach to reach those objectives.
− A Vision Statement describes the desired future position of the company.
 Elements of Mission and Vision Statements are often combined to provide a
statement of the company's purposes, goals and values. However, sometimes the
two terms are used interchangeably.
B. Providing Information about the Sources of Competitive Advantage Michael
Porter's Three Generic Strategies
1. Porter called The Generic Strategies "Cost Leadership" (no frills),
"Differentiation" (creating uniquely desirable products and services) and "Focus"
(offering a specialized service in a niche market).
He then subdivided the Focus Strategy into two parts: "Cost Focus" and
"Differentiation Focus."
 The terms "Cost Focus" and "Differentiation Focus" can be a little confusing,
as they could be interpreted as meaning "a focus on cost" or "a focus on
differentiation." Remember that Cost Focus means emphasizing cost-
minimization within a focused market, and Differentiation Focus means pursuing
strategic differentiation within a focused market.
The Cost Leadership Strategy
− Porter's generic strategies are ways of gaining competitive advantage — in other words,
developing the "edge" that gets you the sale and takes it away from your competitors. There
are two main ways of achieving this within a Cost Leadership strategy:
1. Increasing profits by reducing costs, while charging industry-average prices.
2. Increasing market share by charging lower prices, while still making a reasonable profit
on each sale because you've reduced costs.
− Remember that Cost Leadership is about minimizing the cost to the organization of
delivering products and services. The cost or price paid by the customer is a separate issue!
− The Cost Leadership strategy is exactly that — it involves being the leader in terms of cost in
your industry or market. Simply being amongst the lowest-cost producers is not good enough,
as you leave yourself wide open to attack by other low-cost producers who may undercut
your prices and therefore block your attempts to increase market share.
− The greatest risk in pursuing a Cost Leadership strategy is that these sources of cost
reduction are not unique to you, and that other competitors copy your cost reduction
strategies. This is why it's important to continuously find ways of reducing every cost. One
successful way of doing this is by adopting the Japanese Kaizen philosophy of "continuous
improvement"
The Differentiation Strategy
− Differentiation involves making your products or services different from and more products
or services different from and more attractive than those of your competitors. How you do
this depends on the exact nature of your industry and of the products and services
themselves, but will typically involve features, functionality, durability, support, and also
brand image that your customers value.
To make a success of a Differentiation strategy, organizations need:
− Good research, development and innovation.
− The ability to deliver high-quality products or services.
− Effective sales and marketing, so that the market understands the benefits offered by the
differentiated offerings.
 Large organizations pursuing a differentiation strategy need to stay agile with their new product
development processes. Otherwise, they risk attack on several fronts by competitors pursuing
Focus Differentiation strategies in different market segments.
The Focus Strategy
− Companies that use Focus strategies concentrate on particular niche markets and, by
understanding the dynamics of that market and the unique needs of customers within it,
develop uniquely low-cost or well-specified products for the market. Because they serve
customers in their market uniquely well, they tend to build strong brand loyalty amongst their
customers. This makes their particular market segment less attractive to competitors.
− As with broad market strategies, it is still essential to decide whether you will pursue Cost
Leadership or Differentiation once you have selected a Focus strategy as your main
approach: Focus is not normally enough on its own.
− But whether you use Cost Focus or Differentiation Focus, the key to making a success of a
generic Focus strategy is to ensure that you are adding something extra as a result of serving
only that market niche. It's simply not enough to focus on only one market segment because
your organization is too small to serve a broader market (if you do, you risk competing
against better-resourced broad market companies' offerings).
− The "something extra" that you add can contribute to reducing costs (perhaps through your
knowledge of specialist suppliers) or to increasing differentiation (though your deep
understanding of customers' needs).
− A not-for-profit can use a Cost Leadership strategy to minimize the cost of getting donations
and achieving more for its income, while one pursuing a Differentiation strategy will be
committed to the very best outcomes, even if the volume of work it does, as a result, is
smaller.
 Local charities are great examples of organizations using Focus strategies to get
donations and contribute to their communities.
a. Current Resources — this are indented to give management and idea of
the company's liquidity. There is a trade-off
between liquidity and profitability. If a company
wants to be liquid, most of its assets are in current
assets sacrificing investments and long-term
productive assets needed to generate profits. This
area will be fully discussed in Financial
Management.
1. Cash adequacy
2. Inventory management
 b. Long-Term Productive Assets — important strategic decisions for the
right investments. Long-term assets are needed to
support operating activities to sustain long-term
profitability. This are capital goods needed to
produce the final product or services offered by the
company.
1. Analyze Trends and Measure Efficiencies
− this is intended to determine long-term trends on the proper
utilization of company resources to generate revenues and
profits.
2. Develop Network of Relationships with Customers and Suppliers
− This involves efficient logistics management. The company
has a steady flow of materials or goods that are needed in
production that are converted into finished goods. After
production, goods are delivered to customers on a timely
manner. The objective is to minimize customer waiting time
to attain customer satisfaction.
3. Identify Financial and Nonfinancial Costs and Benefits Associated
with Alternative Choices
− Financial Data are measurable in terms of money such as
revenues or profits.
Examples of Non-Financial Data are:
 Percentage of customer complaints,
 Percentage of defective goods over good units.
− Non-Financial Data are important in attaining operational
efficiency. Decision making involves an analysis of both
quantitative and qualitative information. Quantitative
information affect short-run operations but qualitative
information is a leading indicator of future operations.
c. Intangible Assets — this are assets that lack physical attributes or
existence but generate cash flows for the company.
Examples:
 Franchise,
 Copyright,
 Trademark, etc.
C. Identifying and Building Resources and Capabilities
1. Strategic Analysis — matching knowledge of marketplace
opportunities and threats with company's
resources and capabilities. Apply the principles
of environmental scanning. A common tool used
is the Strength, Weakness, Opportunity, Threats
(SWOT) Analysis. Management creates
strategies that matches its Strength to
overcome the weaknesses, and utilized the
opportunities to mitigate threats.
2. Balance Sheet Information about Assets
 2. Role of Management Accountant — provide managers information in helping
formulate strategy. Managerial
accountants provide relevant information
that helps management identify its
competitive edge.
II. Management Accountant's Role in Implementing Strategy
A. Implementing Strategy — managers taking action by using planning and control
systems to help the collective decisions of an organization.
1. Planning — this stage involves setting the company’s specific targets for attaining
long-term goal.
a. Thinking Process — this involves strategic planning session to determine
progress of attainment of long–term goals. It involves
review of what was attained and what needs to be
attained.
i. Selecting Organization Goals
− this process involves matching the company's strength's and
opportunities to succeed in the market place.
ii. Predicting Results under Various Alternatives of Achieving Those
Goals
− this deals with identifying desired outcomes it plans
materialize.
iii. Deciding How to Attain Desired Goals
− this involves formulating operational plans that is supposedly
intended to attain desired results.
b. Communicating Goals and How to Attain them to Entire Organization
− Top level management uses the planning phase as a communication
tool to cascade long-term plans of the company to lower level
managers and rank and file. This is intended to attain goal
congruence, that is everyone in the organization is geared towards
the attainment of one common goal.
2. Control
a. Taking Actions to Implement the Planning Decisions
− It involves actual implementation of plans to make sure that desired
outcomes are attained. This step involves overseeing day to day
activities to motivate employees and guide them on what needs to be
done.
b. Deciding on Performance Evaluation
− This involves critical success areas that must be achieved from the
individual employee until attainment of the company's Mission and
Vision. The basis of performance evaluation are the minimum
standards that are set by the company. It has to be specific,
measurable, attainable, realistic, and time bound to become a basis
of performance evaluation.
3. Feedback — linking planning and control to help future decision making. This
process involves analysis of plans against actual achievements.
This is the basis of rewarding good performers and creating
 corrective actions for deficiencies. Feedback is very important for the
next planning session.
B. Supporting Managers by Providing Information to Improve Strategic, Planning,
and Control Decisions
1. Three Roles of Management Accountants for Success.
a. Problem Solving — comparative analysis for decision making. It is the role
of the managerial accountant to help top level
management identify its primary problem. After doing
so, the managerial accountant helps in formulating
solutions that will resolve the problem of the client.
The managerial accountant can only give
suggestions, top level management has the sole
discretion to decide for the company.
b. Scorekeeping — accumulating data and reporting reliable results. This is
the process of gathering relevant information that is
needed in decision making. It is a basic skill for a
managerial accountant to identify information that is
needed to a peculiar issue that must be resolved. The
relevance of information depends on the issue at hand.
What is relevant in another situation may not be relevant
in another situation.
c. Attention Directing — helping managers properly focus their attention.
Managerial accountants help management
identify issues that needs top level concern and
attention. Issues are classified according to
severity and priority, most specially for issues that
are significantly detrimental to company
operations.
2. Goals to Assist Managers in Making Better Decisions
a. Different Decisions Emphasize Roles Differently
i. Strategy and Planning — emphasize problem solving.
ii. Control — emphasizes scorekeeping and attention directing.
b. Interaction among Types of Decisions Means Activity/Roles Done
Simultaneously
− The functions of management overlap as it performs its duties. It is
non-sequential in nature.
c. Information must be Relevant and Timely to be Useful
− Management needs information as a basis of formulating sound
business judgement. Relevant information means it can be used in
the decision situation. The timeliness of information will affect its
usefulness. Late information will become stale and will lose its
relevance. Information received the soonest will resolve issues in an
effective and timely manner.
C. Enhancing the Value of Management Accounting Systems by Guiding Managers
to Focus on Challenges
1. Customer Focus — doing business today has shifted from creating shareholder
wealth to satisfying the customer. Customer satisfaction is
 equated with overall profitability. Either way, it is the
customer that will purchase the product or avail of the
services of the company.
2. Value-Chain and Supply-Chain Analysis — value chain is the process or
activities by which a company adds value to an article,
including production, marketing, and the provision of after-
sales service. It is said to be value adding if it satisfies
customer wants and needs and the customer is willing to
pay for it. Supply chain involves all parties in fulfilling a
customer request and leading to customer satisfaction, a
value chain is a set of interrelated activities a company
uses to create a competitive advantage.
a. Companies Add Value Through
i. Research and Development — creating products that will satisfy
the needs of wants of customers. It is
even the creation of a product that the
customer will perceive to be useful.
ii. Design of Products, Services, or Processes — product design is
the aesthetics of the finished product. The
design will significantly affect the long-term
sustainability of producing the product. It
involves outsourcing of the needed
components, evaluation of needed
infrastructure, and the required labor to
create the product.
iii. Production — this is the mass production of the product for
commercial consumption.
iv. Marketing — this is the process of advertising or creating
promotional materials to inform target customers
about the product.
v. Distribution — this involves the efficient distribution of the products
to the customers. The objective is on-time delivery.
vi. Customer Service — this is after the sales support provided to the
customers while the product is being used by
the customer.
b. Managers in All Business Functions are Customers of Management
Accounting Information
− management accountants provide relevant information to the key
decision makers of the company from financial, production,
logistics, marketing, and human resource concerns.
3. Key Success Factors
a. Cost and Efficiency — modern production strategies require production
efficiency meaning elimination of waste and non-
value-added activities. This will lead to significant
cost savings, thus generating more profits for the
company.
 b. Quality — customers demand high-quality products that are affordable.
Quality is relative to the user. It is said to be of quality if it
exceeds the expectations of the customer.
c. Time — on-time delivery is very important to attain customer satisfaction.
d. Innovation — for a company to stay relevant in the competition, it must
be able to offer different products that cater to a broad
spectrum of customers. Failure to innovate will give a
chance to competitors to do better and capture the market.
4. Continuous Improvement and Benchmarking
 A company should continuously innovate the products it offers to its
customers to keep the market interested. Moreover, the company should
unceasingly keep up with the competitors to maintain its market position.
Benchmarking is key in determining the best practices in the industry that a
company may adopt or even lead.

III. Managerial Accounting vs. Financial Accounting

Seven Key Differences as Noted by IMA
MANAGERIAL ACCOUNTING
1. Managerial accounting reports
are for internal users.
 These are intended for
decision-makers such as
management at different levels.
2. Managerial accounting has a
strong emphasis on the future.
 It analyzes the Financial
Statements to predict future
operations. Moreover,
managerial accounting involves
a lot of decision making whose
results will materialize only in
the future.
3. Managerial accounting data
should be relevant.
 Relevance means information
is useful for decision making.
FINANCIAL ACCOUNTING
Financial reports are for external
users.
 These are intended to be
submitted to government
regulatory bodies such as BIR
and SEC.
Financial accounting summarizes
past transactions.
 The end product of financial
accounting is the Financial
Statements, which are a
summary of all of a companys’
transactions.
Financial accounting data should be
objective and verifiable.
 It must abide by the financial
characteristics of objectivity,
which means that for every
transaction there is
corresponding treatment as
required by the financial
accounting standards.
 Verifiable means information
presented in the Financial
Statements can be determined
using different approaches such

4. Managerial accounting focuses
on timeliness of information.
 Timeliness is an important
element to keep information
relevant.
5. Managerial accounting focuses
on segments of a company such
as product lines, sales territories,
divisions, and departments.
 Managerial accounting reports
can be prepared per division,
sales, territory, or department.
This is very evident in
Responsibility Accounting,
which is an internal reporting
system within a company.
6. Managerial accounting is not
bound by GAAP.
 Managerial accounting reports
are intended for internal users,
hence the reports are tailor
fitted to the needs of the
decision maker and the
situation to be resolved.
7. Managerial accounting is not.
 Reports are prepared only when
the need arises.
as Direct and Indirect methods
of Statement of Cash Flows.
Financial accounting focuses on
precision.
 Financial Statements are
subject to audit before it is
released to the intended users.
Financial accounting is concerned
with reporting for a company as a
whole.
 Periodic Financial Statements
are always prepared for the
entire operation of the company.
Financial accounting must conform to
Generally Accepted Accounting
Principles (GAAP).
 The Financial Accounting
Standards require that the
Financial Statements should
comply with the reporting
standards.
Financial Accounting is mandatory.
 The financial reporting principle
of Periodicity or Time Periods
require a complete set of
Financial Statements should be
prepared during the life of a
business entity.

IV. Treasurership vs. Controllership Functions

− In essence, a Financial Controller is the head accountant of the company. They
supervise other accountants and oversee the preparation of financial reports, such as
income statements and balance sheets.
− The Treasurer serves as the protector of a company's value and finances from financial
risks that arises from business activities. Traditionally, a treasurer is under the
accounting department, but has now branched out into a new segment which is known
as the corporate treasury management.
TREASURERSHIP CONTROLLERSHIP
1. Provision of Capital Planning and Control
2. Investor Relation Reporting and Interpreting
 3. Short-Term Financing
4. Banking and Custody
5. Credits and Collection
6. Investments
7. Insurance
Evaluating and Consulting
Tax Administration
Government Reporting
Protection of Assets
Economic Appraisal

V. Characteristics of Managerial Accounting Report

1. Relevance
2. Timeliness
3. Accuracy
4. Understandability
5. Conciseness

VI. Ethical Standards in MAS

− The Code of Ethics in effect in the Philippines automatically covers all managerial
accountants practicing in the Philippines.
− In addition to that is the Code of Ethics developed by IMA. Members of IMA shall behave
ethically. A commitment to ethical professional practice includes overarching principles that
express our values, and standards that guide our conduct.
Principles
− IMA's overarching ethical principles include: Honesty, Fairness, Objectivity, and
Responsibility.
− Members shall act in accordance with these principles and shall encourage others within their
organizations to adhere to them.
Standards
− A member's failure to comply with the following standards may result in disciplinary action.
1. Competence
− Each member has a responsibility to:
i. Maintain an appropriate level of professional expertise by continually
developing knowledge and skills.
ii. Perform professional duties in accordance with relevant laws, regulations,
and technical standards
iii. Provide decision support information and recommendations that are
accurate, clear, concise, and timely.
iv. Recognize and communicate professional limitations or other constraints
that would preclude responsible judgment or successful performance of an
activity.
2. Confidentiality
− Each member has a responsibility to:
i. Keep information confidential except when disclosure is authorized or legally
required.
ii. Inform all relevant parties regarding appropriate use of confidential
information. Monitor subordinates' activities to ensure compliance.
iii. Refrain from using confidential information for unethical or illegal advantage.
 3. Integrity
− Each member has a responsibility to:
i. Mitigate actual conflicts of interest, regularly communicate with business
associates to avoid apparent conflicts of interest. Advise all parties of any
potential conflicts.
ii. Refrain from engaging in any conduct that would prejudice carrying out duties
ethically.
iii. Abstain from engaging in or supporting any activity that might discredit the
profession.
4. Credibility
− Each member has a responsibility to:
i. Communicate information fairly and objectively.
ii. Disclose all relevant information that could reasonably be expected to
influence an intended user's understanding of the reports, analyses, or
recommendations.
iii. Disclose delays or deficiencies in information, timeliness, processing, or
internal controls in conformance with organization policy and/or applicable
law.
Resolution of Ethical Conflict
− In applying the Standards of Ethical Professional Practice, you may encounter problems
identifying unethical behavior or resolving an ethical conflict. When faced with ethical issues,
you should follow your organization's established policies on the resolution of such conflict.
If these policies do not resolve the ethical conflict, you should consider the following courses
of action:
1. Discuss the issue with your immediate supervisor except when it appears that the
supervisor is involved. In that case, present the issue to the next level. If you cannot
achieve a satisfactory resolution, submit the issue to the next management level. If your
immediate superior is the chief executive officer or equivalent, the acceptable reviewing
authority may be a group such as the audit committee, executive committee, board of
directors, board of trustees, or owners. Contact with levels above the immediate superior
should be initiated only with your superior's knowledge, assuming he or she is not
involved. Communication of such problems to authorities or individuals not employed or
engaged by the organization is not considered appropriate, unless you believe there is a
clear violation of the law.
2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics
Counselor or other impartial advisor to obtain a better understanding of possible courses
of action.
3. Consult your own attorney as to legal obligations and rights concerning the ethical
conflict.

COST VOLUME PROFIT (CVP) AND BREAK-EVEN ANALYSIS (BEP)

I. Definition
Cost Volume Profit (CVP) Analysis — a systematic examination of the relationships among
revenues, costs, activity levels or volume, and profit.
Break-Even Point (BEP) — that point of activity level (sales volume, pesos) where total revenues
equal total costs, i.e., there is neither profit nor loss.
 II. Assumptions and Limitations Underlying Break-Even Analysis
1. All costs are classifiable as either fixed or variable.
2. Fixed costs remain constant within the relevant range.
3. The behavior of total revenues and total costs will be linear over the relevant range.
4. In case of multiple product companies, the selling prices, costs, and proportion of units
(sales mix) sold will not change.
5. There is no significant change in the inventory level during the period under review.
Classification of Costs
1. Functional — manufacturing, selling and administrative.
2. Behavioral — variable, fixed, and mixed.
Cost Behavior Assumptions
1. Relevant Range Assumptions — Relevant Range refers to the band of activity within which
the identified cost behavior patterns are valid. Cost and
revenue behavior at this range have a straight line
relationship also known as Linear relationship. Any level
of activity outside this range may have different cost
behavior patterns.
2. Time Assumption — the cost behavior patterns identified are true only over a specified
period of time. The relevant range is only within a short-period of time,
usually within 1 year. Beyond this, the cost may show different
behavior. In the long-run, cost and revenue behaviour patterns tend
to have a parabolic relationship also known as Curvilinear
relationship.
III. Methods of Computing Break-Even Point
1. Equation Methods or Algebraic Approach
 this approach uses an algebraic equation to determine the point where there is neither
profits nor losses. That is Total Revenue (TR) is equal to Total Cost (TC). Usually,
the following equations are used.
Let:
X = Sales Units at Break-Even Point
SPU = Selling Price per Unit
VCU = Variable Cost per Unit
FC = Total Fixed Cost
Where:
TR = SPU.X
TC = FC + VCU.X
Therefore:
BEP TR = TC

2. Graphic Approach
 Total Revenues and Total Cost are presented in a graph where Y axis is in Pesos and
X axis in units. The point wherein the TR and TC will intersect is the Break-Even
Point. The graph is called Cost Volume Profit graph. The most important information
derived in a CVP graph is the relationship of revenues and costs at different levels of
quantity. This is very helpful in profitability analysis.
 3. Contribution Margin Method or Formula Approach
 This approach utilized the concept that the contribution margin at BEP is equal to the
Total Fixed Cost. Please refer to the formula section of this module for a complete list
of the equations.
IV. Margin of Safety
 Indicates the amount by which actual or planned sales may be reduced without
incurring a loss. It is the difference between actual or planned sales volume and break-
even sales. It is the profit area in the CVP graph. It should be noted that profits are
generated only within this range. It is computed by deducting BEP Sales from Total
Sales. Please refer to the formula section of this module for a complete list of
equations.
V. Factors Affecting Profit
 Profit will change as long as any of the factors needed to compute for total revenues
or total cost will change. Most of the time this is used to determine the best course of
action by changing variables and looking at the possible effects. It is important to note
that any peso change in contribution margin will have the same peso effect on profit.
 The factors are:
1. Selling Price per Unit — a change in selling price will affect total sales, total
contribution margin, and profit.
2. Variable Cost per Unit — a change in variable cost will affect total variable cost,
total contribution margin, and profit.
3. Volume or Number of Units — will affect total sales, total variable cost, total
contribution margin, and profit.
4. Fixed Cost — changes in fixed cost will affect total cost, and profit; and
5. Sales Mix — refers to the combination of products if a company sells more that
one product. Changes in sales mix will affect the composite
contribution margin resulting to changes in total contribution margin
and profit. Composite contribution margin refers to the weighted
average contribution margin of a group of products.
NOTE:
− The factors presented in the previous paragraph will affect profit. But all factors except
sales units will NOT affect BEP. Because the BEP is constant in the relevant range
regardless of sales units.
− In addition, change in income tax rates will not affect BEP, because there is no income
subject to tax at BEP.
VI. Degree of Operating Leverage (DOL)
 It is a measure of how sensitive net operating income is to a given percentage change
in sales.
 Let's say if a company has DOL of 4x and Sales will increase by 20%, it is expected
that Profit will increase by 80%. DOL is limited by the assumption that the increase in
sales is attributed to the increase in Sales units and not on Selling Price. It is computed
as:
DOL = Total Contribution Margin / Operating Profit
DOL = Percentage Change in Profit / Percentage Change in Sales
VII. Formulas In BEP Computation
The following equations can be used depending on the given data.
1. BEP Pesos
=Total Fixed Costs / Contribution Margin Ratio
= Total Sales Pesos - MOS Pesos

2. BEP Units
= Fixed Costs / Contribution Margin per Unit
=Total Sales Units - MOS units

3. Contribution Margin per Unit (CMU)

= Selling Price per Unit - Variable Cost per Unit
= Contribution Margin / Total Sales Units
= Fixed Cost / BEP Units
= Profit / Margin of Safety Units
= Change in Fixed Cost / Change in BEP Units

4. Contribution Margin Ratio (CMR)

= CMU / SPU
= Total Contribution Margin / Total Sales Pesos
= Fixed Cost / BEP Pesos
= Profit / Margin of Safety Pesos
= Change in Fixed Cost / Change in BEP Pesos
= 1 – VCR
= NPR / MSR

5. Fixed Cost
= Total Contribution Margin – Profit
= Total Cost - Total Variable Cost
= BEP Units x CMU
= BEP Pesos x CMR

6. Variable Cost Ratio (VCR)

= Variable Cost per Unit / Selling Price per Unit
= Total Variable Cost / Total Sales Pesos
= 1- CMR

7. Margin of Safety Pesos (MSP)

= Total Sales Pesos - BEP Pesos
= Profit / CMR

8. Margin of Safety Units (MSU)

= Total Sales Units - BEP Units
= Profit / CMU

9. Margin of Safety Ratio (MSR)

= MSP / Total Sales Pesos
= MSU / Total Sales Units
= NPR / CMR

10. Profit
= Total Revenues - Total Cost
= Total Contribution Margin - Fixed Cost
 = MSU x CMU
= MSP x CMR
= Total Revenues x NPR

11. Net Profit Ratio (NPR) or Rate of Return on Sales (ROS)

= Earnings Before Interest and Taxes or Operating Income / Total Sales Pesos
= MSR x CMR

12. Total Sales Pesos or Amount of Sales To Earn A Desired Profit

= Total Fixed Costs + Desired Profit before Tax / CMR
= Total Fixed Cost + Desired Profit after Tax
(1 – Tax Rate)
__________________________________________________

CMR
= BEP Pesos + MOS Pesos

13. Total Sales Units or Number of Units To Be Sold To Earn A Desired Profit
= Total Fixed Costs + Desired Profit before Tax / CMU
= Total Fixed Cost + Desired Profit after Tax
(1 – Tax Rate)
____________________________________________________

CMU
= BEP Units + MOS Units

14. Mix BEP Pesos

= Total Fixed Costs / Composite CMR

15. Mix BEP Units

= Total fixed costs / Composite CMU

16. Composite CMR

= (CMR a X Mix Ratio a) + (CMR b X Mix Ratio b) + (CMR nth.. X Mix Ratio nth..)*

17. Composite CMU

= (CMU a X Mix Ratio a) + (CMU b X Mix Ratio b) + (CMU nth.. X Mix Ratio nth..)*

*Mix Ratio — is determined by dividing the Total Sales Units or pesos of a Single Product
by the Total Sales Units or Pesos of All Products Combined.

CAPITAL BUDGETING
I. Overview
Capital Budgeting — the process of identifying, evaluating, planning, and financing capital
investment projects of an organization. It is the process of evaluating the
acceptability of potential investment alternatives. It Involves the ranking of
investment alternatives if a company is faced with a capital rationing problem.
 The process intends to help the financial manager choose the best project
with the best return for a given period of time.
Characteristics of Capital Investment Decisions
1. It Usually Requires Large Commitments of Resources
 The amount of required investment is significant enough that it qualifies as a capitalizable
expense or carried as an asset of the investing company.
 2. It Involves Long-term Commitments
 The investment is able to provide immediate and long-term benefits to the investor.
3. It is More Difficult to Reverse than Short-Term Decisions
 Investment in non-current assets are not easily disposed off if the decision maker made
the wrong choice. Immediate disposal will required great efforts and possible material
losses.
The Capital Budgeting Process
1. Identification of Potential Projects
 This involves looking for possible investment projects that will satisfy the objective of the
company. The proper method of evaluating investment alternatives is highly dependent
on the desired objective. The decision may involve, independent projects, mutually
exclusive projects, or capital rationing. This will be discussed later in detail.
2. Estimation of Costs and Benefits
 Estimating the costs involves measuring the net investment. Net investment is the
required net cash outflow at the date of inception of the project. Please refer to the full
discussion of net investment. The net benefits pertain to the accounting net income and
cash inflows after tax. Net income is intended to measure profitability, while cash inflows
after tax is intended to measure project liquidity. Please refer to the net returns for full
discussion.
3. Evaluation
 This phase involves determining the profitability or liquidity of the project proposals. The
decision maker has the option of using discounted or non-discounted techniques or both
in evaluating projects. Please refer to the tools in evaluating investment alternatives for
full discussion.
4. Development of the Capital Budget
 This phase involves the actual implementation of plans.
5. Re-evaluation/ Post-audit
 This phase determines if the desired objectives were attained. At this point it is advised
that the decision maker should use actual data in evaluating attainment of objectives.
Information gathered from Post-audit is useful in improving the capital budgeting
process of a company.

II. Factors in Capital Budgeting

− These are essential information that should be available and considered in making
capital investment decision. The following are:
1. Relevant Cash Flows during The Project's Life
2. Accounting Net Income
3. Cost of Capital
4. Time Value of Money
5. Income Tax
A. Relevant Cash Flows during the Projects Life
1. Net Investment — the initial net cash outflow at the start of the project. it is
computed as costs or cash outflows less cash inflows or
savings incidental to the acquisition of the investment project.
It is synonymous to the net capitalizable cost of a non-current
asset. It is the total of direct and indirect cash disbursements
 arising from the acquisition of the property net of cash
collections arising from disposal price of old property in case of
replacement. Any gains or losses are subject to tax.
Costs or Cash Outflows
1. The initial cash outlay.
a. Direct Acquisition Price of the Property or Purchase Price of the
Asset.
Example is the acquisition price of a land and building intended to be
the site of a new branch.
b. Incidental Project-Related Costs — are indirect costs necessary to
complete the acquisition.
Example is the brokers fee necessary to facilitate the transaction.
2. Working Capital Requirement — These are current assets needed to
operate the project.
Example is the cash and inventory requirements transferred from Home
Office to Branch. The working capital is needed to sustain Branch
operations.
3. Market Value of an Existing, Currently Idle Asset which was Used in the
Investment — these are any non-current assets that were utilized for the
project to operate.
Example is equipment transferred from Home Office to the Branch.
4. Additional Investment during The Project's Life — these are additional cash
outflows required during the project's life. For
purposes of computing net investment, the present
value of future cash outflows is adjusted to their
present value at the inception of the project or at
time zero.
Savings or Cash Inflow
1. Trade-In Value of Old Asset in Case of Replacement — it is assumed that
trade in transactions involve no cash, hence any
gains or losses are not adjusted for tax effects.
2. Proceeds from Sale of Old Asset to be Disposed due to the Acquisition of
The New Project — net of applicable tax in case there is gain on sale or add
tax savings in case there is loss on sale.
3. Avoidable Cost of Immediate Repairs on Old Asset to be Replaced — net
of tax.
2. Net Cash Inflows from Operations or Cash Inflows After Tax (CIAT)
 It is the annual cash inflows generated from operating activities during the
project's life. This measures a project's liquidity. Net cash inflows are used to
determine if aggregate CIAT can fully recover the initial cost of investment
during the project's life. Cash inflows can either be even or uneven. Even cash
inflows assume a consistent CIAT during a project's life while uneven cash
inflows assume a fluctuating CIAT.
CIAT can also be computed as:
 Sales xxx
Less: Cost of Sales (xxx)
Gross Profit xxx
Less: Operating Expenses (xxx)
EBIT / Operating Income xxx
Less: Tax (xxx)
EBIAT xxx
Add: Depreciation Expense xxx
CIAT xxx
 n.b. Interest Expense is ignored when computing for Cash Flows for Capital Budgeting
purposes because the objective is to determine if cash flows from operations are sufficient to
recover financing cost needed to fund the project.
Alternatively CIAT can be computed as:
Cash Inflows Before Tax (CIBT) xxx
Less: Tax (based on CIBT) (xxx)
Add: *Depreciation Tax Shield xxx
Cash Inflows After Tax (CIAT) xxx
*Depreciation Tax Shield — is the tax savings for recognizing depreciation expense as an
allowable deduction for purposes of taxation. Please refer to the
succeeding discussion on "Income Tax".
3. Terminal Value or End of Life Recovery Value — refers to the net cash proceeds
expected to be realized at the end of the project's
economic life. It is the net cash inflow/outflow
necessary to retire the project.
It is computed as:
Present Value of Freed-up Working Capital xxx
CIAT from the Last-year of Operations xxx
Proceeds of Sale Of Investment Net Of Tax For Gain/Loss xxx
Terminal Value xxx

 Economic Life — is the period of time during which the asset can provide economic benefits
or positive cash inflows.

B. Accounting net income or Earnings Before Interest but After Tax (EBIAT)
 This measures the profitability of an investment project. Interest is ignored
because evaluating capital budgeting projects involves an analysis if the project's
profits can recover financing cost needed to fund the project.
It is typically computed as:
Sales xxx
Less: Cost of Sales (xxx)
Gross Profit xxx
Less: Operating Expenses (xxx)
EBIT / Operating Income xxx
Less: Tax (xxx)
EBIAT xxx
 C. Cost of Capital
 Represents the overall cost of financing to the firm of the Weighted Average Cost
of Capital (WACC). It is also known as Hurdle Rate, Target Rate, Minimum
Acceptable Rate, and Minimum ROI. The cost of capital is the average return that
the company must pay to its long-term creditors and its shareholders. It is the
discount rate used in evaluating capital investment decisions. For purposes of
Capital Budgeting, it is assumed that the WACC is already provided. WACC is
fully discussed in the category "LONG-TERM FINANCING".
D. Time Value of Money
 The Time Value of Money (TVM) is the concept that money you have now is
worth more than the identical sum in the future due to its potential earning
capacity. This core principle of finance holds that provided money can earn
interest, any amount of money is worth more the sooner it is received. Therefore,
projects that promise earlier returns are preferable to those that promise later
returns. The capital budgeting techniques that best recognize the time value of
money are those that involve discounted cash flows. Effects of time value of
money will be presented under the sub-topic "Discounted Techniques."
E. Income Tax
 The income tax usually has a significant effect on the cash flow of a company
and should be taken into account while making capital budgeting decisions. An
investment that looks desirable without considering income tax may become
unacceptable after considering income tax. The three concepts of income tax are
After-tax Benefit, After-tax Cost, and Depreciation Tax Shield.
1. After-Tax Benefit or Cash Inflow
 These are the tax imposed on Taxable revenues or cash inflows. When
reduced by the income tax, it is known as after-tax benefit or after-tax cash
inflow. When income tax is considered capital budgeting decisions, after-tax
cash inflow is used. An example of taxable cash inflow is cash generated by
a company from its operations.
2. After-Tax Cost
 These are expenses or costs that can be deducted against revenues for
purposes of computing income tax. Tax deductible costs reduce taxable
income and help save income tax. A cost net of its tax effect is known as
after-tax cost.
It is computed as:
After-Tax Cost = (1 — Tax rate) x Tax Deductible Cash Expenses
3. Depreciation Tax Shield (DTS)
 Depreciation is a non-cash tax deductible expense that saves income tax
by reducing taxable income. The amount of tax that is saved by depreciation
is known as depreciation tax shield.
It is computed as:
Depreciation Tax Shield = Tax Rate x Depreciation Expense
III. Non-Discounted Technique
 These are capital budgeting techniques that do not consider the time value of money.
1. Payback Period
2. Accounting Rate of Return
 A. Payback Period
 It is the length of time required by the project to recover the initial cost of investment. It
is a test of a project's liquidity. A project is acceptable provided that the payback period
is less than a company's acceptable payback period. The lower the payback period the
better.
 A major advantage of payback period is it is easy to compute. The payback method can
serve as a screening tool to help identify which investment proposals are acceptable
based on company policy. It can help companies that compete in industries where
products become obsolete rapidly to identify products that will recoup their initial
investment quickly.
 Payback period has its own limitations. It does not consider the time value of money. It
ignores cash flows after the payback period, thus it has no inherent mechanism for
highlighting differences in useful life between investments. And it tends to be misleading
because a shorter payback period does not always mean that one investment is more
desirable than another.
 The formula to compute payback depends on the behavior of CIAT.
 Even CIAT = Initial investment / Annual Net Cash Inflows
 Uneven CIAT = When the cash flows associated with an investment project change from
year to year, the unrecovered investment must be tracked year by year.
Cash inflows in each specific year starting with year 1 is deducted against
the Initial Investment until fully recouped. A full year's cash inflow is
considered as 1 year and a faction is prorated during that year.
B. Accounting Rate of Return — AROR (also called Book Value Rate of Return, Financial
Statement Method, Average Return on Investment, Simple Rate of Return, and Unadjusted
Rate of Return) is a test of projects profitability. It determines if net income is sufficient to
settle financing cost associated with the project.

 A project is acceptable if AROR is equal or greater than WACC. If AROR is equal to WACC,
it signifies that net income is just enough to settle financing cost. It is better if AROR is greater
than WACC, it signifies that the project can recover financing cost and can generate profits.
It is computed as:
Accounting Rate of Return
AROR on Initial Investment = Average Annual Net Income / Investment
AROR on Average Investment = Average Annual Net Income
____________________________________________________

(Investment + Salvage value) / 2

IV. Discounted Techniques
− These methods consider the time value of money also known as discounted cash flow
methods.
1. Net Present Value
2. Profitability Index
3. Internal Rate of Return
A. Net Present Value
 Net Present Value (NFV) is the difference between the present value of cash inflows
and the initial cost of investment. NPV is used in capital budgeting and investment
planning to analyze the profitability and liquidity of a proposed project. NPV is usually
used when dealing with "Independent Projects".
  The project is acceptable if NPV is zero or positive. An NPV of zero indicates that the
present value of cash inflows is sufficient to recover initial investment, it is acceptable
because the discount rate used for NPV computations is the minimum acceptable rate
of return. A project with a zero net present value has a return that is equal to the
minimum required rate of return and is therefore acceptable. But, a positive NPV is
better because it connotes that present value of cash inflow is more than enough to
recover investment and can generate absolute cash returns. A positive net present value
indicates that the project's return exceeds the discount rate. On the other hand, a project
with a negative net present value has a return that is less than the minimum required
rate of return and is therefore unacceptable.
 A major advantage of the NPV is the discount rate can be changed during the projects
life to reflect the appropriate degree of risk during its life. The discount rate used in NPV
computations is usually the WACC. However, the company can use the discount rate
specific to the financing used for the project or a discount rate the company deems
appropriate to reflect risk. However, a disadvantage of NPV is it does not determine the
true rate of return of the project.
 NPV has two simplifying assumptions. The first assumption is that all cash flows other
than the initial investment occur at the end of periods. And, the second assumption is
that all cash flows generated by an investment project are immediately reinvested at a
rate of return equal to the discount rate.
Net Present Value can be computed as:
1. Present Value of Cash inflows - Cost of Investment
2. Present Value of Cash inflows - Present value of the Cost of Investment
3. Present Value of Cash inflows - Present value of Cash outflows

B. Profitability Index or Present Value Index

 The Profitability Index (PI), alternatively referred to as Value Investment Ratio (VIR) or
Profit Investment Ratio (PIR), is an index that represents the relationship between the
initial cost of investment and the present value of its future cash flows. The PI is used in
ranking various projects because it lets investors quantify the value created per each
investment unit. It is a test of liquidity and profitability.
 A project is acceptable if PI is equal or greater than 1.0. A profitability index of 1.0 is
logically the lowest acceptable measure on the index, as any value lower than that
number would indicate that the project's present value (PV) is less than the initial
investment. If PI is 1.0, the project's NPV is zero. The higher a project's PI will
increase its financial attractiveness. It connotes that the NPV is positive. A PI that is
less than 1.0 indicates unrecovered investment or a negative NPV, hence should be
rejected.
 A major advantage of the PI is that it allows comparison of different investment
alternatives with different sizes. It eliminates the misleading notion of peso figures.

Profitability Index is computed as:

1. Total Present Value of Cash Inflows / Cost of Investment
2. Total Present Value of Cash Inflows / Total Present Value of Cash Outflows
 Related to PI is Net Present Value Index (NPVI), it is NPV converted into a price index. NPVI
is acceptable if it is equal or greater that zero.
It is computed as:
= Net Present Value / Cost of Investment
 C. Internal Rate of Return (IRR) or Discounted Cash Flow Rate of Return (DCFRR)
 The internal rate of return is the true rate of return of an investment project over its useful
life. It is sometimes referred to as the yield on a project. The internal rate of return is the
discount rate that will result in a net present value of zero. This method is ideal if the
cash flows are even. It is a test of liquidity and profitability.
 If the internal rate of return is equal to or greater than the minimum required rate of
return, then the project is acceptable. An IRR of equal to the cost of capital connotes a
NPV of zero hence is acceptable. But an IRR of greater than cost of capital means the
NPV is positive hence the project is liquid and profitable therefore acceptable. If IRR is
less than the cost of capital, it indicates that NPV is negative, hence reject.
 A major disadvantage of IRR is it implicitly assumes that projects cash inflows are
reinvested at the project's own rate of return. This assumption is unrealistic. Moreover,
IRR is not appropriate to use if a negative cash inflow occurs during the project's life.
This will give rise to more than 1 IRR's depending on the number of negative cash
streams.
 IRR can be computed using two methods. The first method is by NPV Trial and Error.
NPV is recomputed by changing the discount rate until such time that the NPV will be
zero. The discount rate that generates a zero NPV is the IRR.
 The second method utilizes Interpolation of Present Value Factors, the following two
steps will be followed:
1. Determine the Present Value Factor (PVF) for the III using the formula:
PVR for IRR = Cost of Investment / Net Cash Inflows
2. Using Present Value Annuity Table, match the economic life the PVF obtained in
step 1. The corresponding rate is the IRR.
 Related to IRR is Payback Reciprocal, it is a rough estimate of IRR if the two simplifying
assumptions are met:
1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of the project.
It is computed as:
= Net Cash Inflows / Investment
OR = 1 / Payback Period
V. Project Analysis
Types of Capital Budgeting Decisions
1. Independent Projects
 It involves screening decisions relate to whether proposed projects pass a preset hurdle.
For example, a company may have a policy of accepting projects only if they promise a
minimum return of 18%.
 NPV is the preferred method to use when dealing with independent projects. If the
project's NPV is positive, it is acceptable. NPV supports the principle of goal
congruence.
 IRR can also be used for independent projects. Accept if IRR is greater than the cost
of capital. The acceptability of an investment project may be different between NPV
and IRR if the projects under consideration have unequal lives and unequal cost of
investments.
 PI can be used in screening independent projects. Accept if PI is greater than 1. The
ranking of investment alternatives may differ between NPV and PI.
 2. Mutually Exclusive Projects
 It refers to preference decisions relate to selecting among several competing courses of
action. The decision maker is constrained of accepting only 1 acceptable proposal. For
example, a company may be considering several different machines to replace an
existing machine on the assembly line.
 The preferred method to use is PI. It allows the comparison of multiple investment
alternatives by a comparing price indexes stated into a common base. It eliminates the
misleading notion of high peso returns but with low percentage margins.
 IRR can be used but it is not as reliable as the PI. The IRR is crippled with its weakness
of assuming project's cash flows are reinvested to its own rate of return.
3. Capital Rationing
 Capital rationing is a strategic decision of placing restrictions on the amount of new
investments or projects undertaken by a company. It is the allocation of available funds
across multiple investment opportunities, increasing a company's potential profitability.
The company accepts the combination of projects with the highest Total Net Present
Value (NPV). The number one goal of capital rationing is to ensure that a company does
not over-invest in assets. This is accomplished by imposing a higher cost of capital for
investment consideration or by setting a ceiling on specific portions of a budget.
In general, there are two primary methods for capital rationing:
1. The first type of capital, rationing, is referred to as "Hard Capital Rationing." This occurs
when a company has limited sources of long-term debt and equity. Simply stated the budget
is limited. The rationing arises from an external need to reduce spending and can lead to a
shortage of capital to finance future projects.
2. The second type of rationing is called "Soft Capital Rationing," or “Internal Rationing”. This
type of rationing is self- imposed due to the internal policies of a company.
Typical Capital Budgeting Decisions
1. Plant Expansion Decisions.
 Should a new plant or warehouse be purchased to increase capacity and sales?
2. Equipment Selection Decisions.
 Which of several available machines should be purchased?
3. Lease or Buy Decisions.
 Should new equipment be leased or purchased?
4. Equipment Replacement Decisions.
 Should old equipment be replaced now or later?
5. Cost Reduction Decisions.
 Should new equipment be purchased to reduce costs?

VI. Sensitivity Analysis

 Sensitivity analysis is widely used in capital budgeting decisions to assess how the
change in such inputs as sales, variable costs, fixed costs, cost of capital, and marginal
tax rate will affect such outputs as Net Present Value (NPV) of a project, Internal Rate
of Return (IRR), and Discounted Payback Period. It also provides a better understanding
of the risks associated with a project. It is intended to help the decision maker identify
the best course of action to take.
 Sensitivity analysis allows identification of input variables that represent the greatest
vulnerability for the project.
Sensitivity is measured as:
% change in output / % change in input
The following steps are done in sequence to measure sensitivity
1. Determine input and output variables.
2. Calculate the baseline value of the output variable using the baseline input variables value.
3. Change the value of one of the input variables while others remain constant and calculate
the new value of the output variable.
4. Calculate the percentage change of both output and input variable compared to baseline
values.
5. Calculate the sensitivity of the output variable to the change in the input variable using the
sensitivity formula.