Chapter 1

Introduction
The most widely used type of business analysis is financial analysis. This probably does not surprise you too
much since the point of any business is to make a profit. So it's only natural that as a business analyst, you will
need to do a variety of financial analyses.
There are several important areas of financial analysis. I will touch on several of these. However, before
discussing the specific topics, I want to make an important distinction between accounting and financial
analysis.
In accounting practice, there are many types of costs. The purpose of these costs is:
1. To accumulate costs by cost centers to assist planning and control by assigning responsibility for
the costs.
2. To cost products for purposes of inventory valuation and income determination.
In contrast, the modeler deals with relative, future and relevant costs. Do not think of the accounting and
economic viewpoints of cost as competing concepts, but simply concepts that are equally valid, and whose
purposes are quite distinct from one another.
Chapter 2
Cost Concepts
The analyst often has to 'capture' some relevant costs, such as the cost of a product, or a project, or a system,
or operations. The basic approach is the same for all four areas of activity. The analyst must determine what it
costs (or will cost) the business to produce the product, or complete the project, or develop and run the system,
or to carry out the specified operation.
Read the following examples to see how to proceed with a cost estimate.

Cost Example #1: The guard at the back door
Let's say your company wants someone to sit at the rear entrance to the building to let in people that need to
use that door and to keep out those who have no business entering by that door. What is the cost of this
activity? The answer depends on exactly how the door is guarded.
If your company hires someone to perform this job, then the cost is the guard's paycheck (including benefits)
and the cost of a chair and possibly a desk. However, your company may ask a current employee to move his
desk near the rear door. This employee now has two jobs, guarding the door and his regular job. What is the
cost to your company?
It depends on how the new responsibility will impact the other job that the person is doing. If, for example, he
files papers and similar other jobs, then he will not be as productive if he also has to monitor the back entrance.
It's possible a part-time person will have to be hired to make up the work that this person is not able to do. In
this case, the cost of guarding the rear door is the pay of the part-time person.

Cost Example #2: Left-hand Widgets
Let's say your company decides to sell left-hand widgets (LHW's). The design engineer determines that all the
parts are available from outside manufacturers. He obtains bids from a variety of manufacturing firms and
determines that the (minimum) total cost of all parts are $5.12, not including shipping costs which are $120 per
thousand LHW's.
Your company determines that if they hire three semi-skilled employees, at a wage of $18,000 each per year,
the employees can assemble and test the parts before shipment. Your company estimates that the three
employees will be able to assemble, test and ship at least 30,000 LHW's per year. What is the cost of each
LHW?
Total wages for the three employees is 3 x $18,000 = $54,000. Shipping costs for these 30,000 units are $120
per 1000, or $120 x 30= $3,600. So the total costs to assemble and ship 30,000 units is $57,600.
The assembly cost per unit = $57,600/30,000 = $1.91 each. Add this to the purchase cost and we get $5.12 +
$1.91 = $7.03 per unit cost.

Relative Costs
In modeling, you are rarely interested in absolute costs but rather in relative costs for purposes of cost
comparisons. For example, the modeler doesn't care what product A will cost to produce, but does care about
the difference in production costs between products A and B.
The current cost of a firm's logistic function isn't as important as the potential impact of doing business
(including the cost of the logistic function) that may result from a modified logistics system. That is to say, you
want to know what the relative costs are to perform the logistics function for the current and the potential future
systems.

Future Costs
The modeler is only interested in future costs, since past or sunken costs have no impact whatever on
decisions to be made today that will affect the firm in the future. Hence, the modeler is always dealing with cost
estimates, and not usually with 'actual' costs.

Relevant Costs
The modeler is only interested in relevant costs, that is, expected future costs that will differ under various
alternatives to be considered. If the costs in question don't pertain to any of the alternatives that are being
considered, you simply ignore them.

Comparative Costs
Many managers fail to understand that if you compare two alternatives, you need to consider the comparative
costs of each alternative, in addition to considering other, non-cost factors. Rather, these managers think in
terms of costs that would normally appear in an accounting report. This thinking leads to faulty decision
making.

Tracking Electronic Parts
The following example (from the author's own experience) will serve to illustrate. A firm considered the
feasibility of marking and tracking electronic parts. A key issue was the relative costs of maintaining the current
system and implementing the new tracking system. The point of the proposed tracking system was to preclude
opportunities for theft that were evident from an analysis of how the entire logistic system functioned. Stated
another way, faulty system design allowed people to steal expensive parts from the company.

Accounting Viewpoint
The managers approached the comparison from an accounting viewpoint to determine how much inventory
was 'actually' lost during the year to pilferage by employees. The accounting system failed to show the potential
losses the firm could suffer if the current system was maintained. Hence, the proposed 'expensive' tracking
system was rejected on the basis that current losses were practically nil.

Faulty Accounting Viewpoint
It was subsequently determined by the firm's security organization working in conjunction with local and state
police agencies, and the FBI that the firm was, in fact, suffering large losses that the accounting system was
unable to detect. The relatively minor cost of the proposed tracking system would have been more than offset
(by a factor of 20 to 1) by the savings to the firm resulting from theft prevention.
The decision makers failed to understand that the 'economic opportunity' afforded to thieves by a faulty logistics
system had to be considered as much a 'real' cost as any other accounting cost. In fact, the modeling costs
were far closer to the truth that the 'actual' costs reflected by the accounting system.
It is vital that decision makers understand the above-described distinctions between costs used in the
accounting sense and costs used in the modeling, or economic sense. This distinction is not only a matter of
differing definitions, but one of different fundamental concepts that could make the difference between faulty
and effective decisions.
Chapter 3
Break-Even Analysis
The business world offers many circumstances in which you must choose between option A which requires
more initial investment, but is cheaper in the long run, and option B which initially doesn't cost as much as
option A, but is more expensive in the long run. I will investigate this situation with what is commonly referred to
as break-even or B-E analysis.
Read the following two typical problems that will serve to illustrate the concept of B-E analysis.

Sam's New Home
Sam Adams (no relation to the historical figure) and his fianc, Wanda, are planning to get married in a few
months, so they are looking for a place to live. They have narrowed down their choice to purchasing a small
home on a 15-year mortgage, and renting a luxury apartment.
The house and the apartment are both about the same size so the cost of furniture will be the same in each
case.
The apartment will require a (non-refundable) security deposit of $1,000 and a monthly rent of $1,150. The
home will require closing costs of $2,200 with monthly payments (for principal, interest and taxes) of $950 a
month.
How long will it take (if ever) for the total cost of the home to equal the total cost of the apartment?
The formula for apartment costs is
A = $1,000 + $1,150 x M, where M = # of months
The formula for house costs is
H = $2,200 + $950 x M, where M = # of months
See how to plot these two equations as shown in Figure 9.1.

Fig. 9.1
Notice that the costs of the house and apartment are the same in month six, at $7,900. This is the point at
which the two cases 'break-even.' Before the sixth month, the apartment is less expensive. After the sixth
month, the house is cheaper. In this case, I believe that most people will choose the house.
Be aware that the graphical method can only be employed with cost equations that have a single variable.
Otherwise, they cannot be plotted on a flat, two-dimensional paper.
I determined the break-even point by graphical means. That is, I plotted both equations and observed that the
two lines cross at month number six. Can you think of another way to determine this break-even point?
Let's do it by use of simple algebra and some common sense.
First, consider the fact that the above two equations give you the respective total costs for each case (the
apartment and the house) by simply plugging in the value of the month.
If you want to determine what month (by number) the two costs will be the same, simply set one equation equal
to the other equation and solve for M, that is, the month at which both costs are equal. Look at the following
steps to perform the equation.
Step 1 Let one cost equation equal to the other cost equation:
$1,000 + M($1,150) = $2,200 + M($950)
Step 2: Move the two terms containing M to the left side of the equal sign. Be sure to put a minus sign in front
of a term when you move it from one side to the other. Your equation is:
$1,000 + M($1,150) - M($950) = $2,200
Step 3: Move the two constant terms to the right side of the equal sign. Your equation becomes:
M($1,150) - M($950) = $2,200 - $1,000
Step 4: Collect (add) terms on each side of the equal sign. Your equation is:
M($1,150 - $950) = $1,200
or, M($200) = $1,200
Step 5: Divide both sides of the equation by 200.Your equation is:
M = $1,200/$200 = 6
This is the same answer you got by using the graphical method. Notice that the dollar signs also cancel out and
the pure number six is your answer.
So by using two different methods, you determined that if Sam and Wanda purchase the new home, they will
'break-even' in six months, after which it will be less expensive if they purchase the home rather than rent an
apartment.
Notice, however, that you can only use the graphical method if there is a single variable in the equation (in this
case, the variable M for the month at which you break even). If you have more than one variable, you can't plot
the cost curves in two dimensions on a flat graph paper. You would need more dimensions and this is not
possible.

Roger's Plastic Works
Roger has just completed a discussion with a buyer from an office supply chain. Roger offers to get back to the
buyer with a cost proposal for an inexpensive plastic book holder designed to wholesale for $3. Roger's task is
to estimate what it will cost him to manufacture this product so that he can quote a reasonable selling price to
the buyer.
In order to produce this product, Roger realizes that he has several fixed costs that are independent of the
number of units produced. These include: purchase of the plastic forming machine, for $8,800 delivered and
set up for production, purchase cost of a small shed in which to work (which Roger will locate on his own
property) for $900. He estimates his electricity costs to operate the machine at $50 per 10,000 units.
In addition to the fixed costs totaling $9,700, Roger will have to purchase plastic sheets at $20.22 each. Each
sheet will provide enough material to make 20 book holders. Roger must determine his break-even point.
Stated another way, he wonders how many units he will have to make and sell in order to pay all his investment
costs. He proceeds as follows.
Roger reasons that the break-even point will occur when his receipts are equal to his payments. His receipts
are $3 x N, where N = the number of units.
Next, he develops the variable cost equation, that is, the equation that expresses his variable costs.
Variable Costs = (N/10,000 x $50) + (N/20 x $20.22)
= $.005 N + $1.011 N
= $1.016 N
So the variable cost of each unit is $1.016.
He completes his equation by setting equal the following receipts and costs:
$3 x N = $9,700 + $1.016 x N
Collecting the N terms, his answer is:
N x (3.000 - 1.016) = $9,700
or N x 1.984 = $9,700
or N = $9,700/1.984 = 4,890 units
Once he reaches this mark, Roger will make a profit of $1.98 on each unit that he sells.
These two examples give you a good idea as to how to go about doing a break-even analysis, which is
applicable to many business situations.
Chapter 4
Benefit/Cost Analysis
Benefit/Cost Analyses, also known as Cost Effectiveness Analysis can be applied to a commercial business
venture, but are more frequently applied to government projects. There are two basic approaches you can use
to do this type of analysis.
The first approach is to express all benefits of the project in question in monetary terms and then to equate the
gains (benefits) with the losses (costs) to see how the proposed project works as an investment.
The second approach is to quantify the benefits of the project using an arbitrary but consistent scale between
two or more projects.

Benefit/Cost Example #1
Let's look at a simple example. Let's say you want to compare two competing projects. Project A will cost $2.5
million and has a safety rating of 60 points out of a maximum of 100 points. Project B will cost $3.2 million and
has a safety rating of 85 points.
The benefit/cost ratio for project A is 60/2.5 = 24. The benefit/cost ratio for project B is 85/3.2 = 26.6 Therefore,
Project B has a higher benefit/cost ratio or cost-effectiveness than does Project A.
In this example, the benefit of the two projects is based on safety factors and is expressed as a number from 0
to 100. An appropriate person, the analyst or the client, makes the subjective judgement of a number
representing safety for each of the two projects.

Benefit/Cost Example #2
To further illustrate the concept of benefit/cost ratio, let's take a non-detailed look at a more complex example.
This example project entails choosing between two routes from city A to city B to replace the current road. The
current road is a dangerous route involving many fatalities, and takes a long time to drive. The state highway
department has considered various alternatives and has reduced the project to a choice of one of two routes.
What factors do you think the highway department will take into consideration in making the final decision?
Here are some of the factors that were considered:
Total cost of each of the two routes.
Amount of private property that will have to be taken by eminent domain for each case.
The time required to build each route.
Driving time for each route.
The degree of safety for motorists for each route in terms of expected fatalities per year.
The expected total number of vehicle accidents per year.
The preferred route based on polls taken of motorists and property owners.
Available state and federal highway funds (not necessarily the same for both routes.)
Degree of disruption of businesses along the current route.
Impact of each route on personal and business property values.
As you can see from the above (incomplete) list of factors, this situation is highly complex. For this reason, I
won't cover the details of how this problem is solved. However, this does not mean that it is too complex to
analyze and arrive at a decision based on a sound analysis. Although the details of this analysis are beyond
the scope of my course, I want you to be aware of the type of problem that can be effectively addressed by
using benefit/cost analyses.

More on Benefits
Benefits can be difficult to express in monetary terms (though it may be possible to do so), but may be
measured in other ways. For example, a benefit may include emissions reductions. If you design a power plant
that burns coal to generate electricity, you can invest a certain amount of money to reduce harmful emissions
into the atmosphere. An alternative is to spend more money for a more effective filtering system that reduces
the amount of harmful emissions much more than the first system does.
Let's put numbers on this example to see how the benefit/cost approach works.
Analyze both systems to determine total cost for the life cycle of the two systems. That is, for the period of time
that the systems are expected to function. This includes initial costs and maintenance costs. Consider the
amount of emissions that each system will capture and prevent from entering the atmosphere.
Your results will be:
System A: Total cost = $67 Million, Emissions reduction = 54 tons/year. Benefit/Cost ratio = 54/67 = 0.81
System B: Total cost = $88 Million, Emissions reduction = 92 tons/year. Benefit/Cost ratio = 92/88 = 1.05
If you only consider the total cost of the two systems, you will select System A, with a cost savings of $88 - $67
million = $21 million dollars. But this pure cost approach is not nearly as effective in maintaining clean air.
System B is 29.6 percent more effective than System A in removing pollutants (divide 1.05 by .81 to obtain a
value of 1.296).
The benefit/cost ratio that you used to compare the two filtration systems is the tons of emissions per million
dollars spent. The system with the highest ratio is generally preferred, given that sufficient funds are available
for the more expensive system.
In general, benefits can include any non-monetary organizational, governmental or societal impacts.
Benefits may or may not be directly measurable. For example, an organization's morale is difficult to measure,
although a well-designed survey might give management a pretty accurate indicator of morale.
Another benefit that is difficult to measure is the degree of safety of, say, an automobile design. However,
comparative road tests may give you useful information on the relative merits of two different automotive
designs.
I point out that in general, the 'real' world includes many significant factors other than cost. The lowest cost
option is rarely the best choice. You must consider other potential benefits and drawbacks when making
decisions, whether in the corporate world, or in society in general.
So the next time your community considers several competing projects, don't automatically support the least
expensive alternative. It may not be the alternative with the highest benefit/cost ratio.
Chapter 5
Summary
In this lesson, I introduced you to the basics of financial analysis, which is the most commonly used analysis in
the business world. I explained the difference between accounting and financial analysis as two different, but
equally useful areas of endeavor. I discussed cost estimating, and various types of business costs. I introduced
the concepts of break-even analysis and benefit/cost analysis, both of which play a vital role in business
analysis.
In the next lesson, I will introduce you to Project Management PERT/CPM. See you then!
Supplementary Material
Cost Evaluations Reveal Artificiality Behind Safety and Security Programs
http://www.findarticles.com/m0UBT/31_15/77048895/p1/article.jhtml?term=september+21
Browse an article which discusses the limitation of cost-benefit analysis for aviation security and air safety
programs. From the FindArticles August 2001 archive.
Environmental Economics
http://library.thinkquest.org/26026/Economics/economics.html
This educational site presents fundamentals of tradable pollution permits, cost-benefit analysis and the
theory of the Tragedy of the Commons.
FAQs
Q: Would a cost analyst ever need to obtain data from the accounting department?

A: Yes, frequently. In order to do a quality analysis, it is important that the input data be realistic, and the
accounting department is charged with this task.

Q: It seems to me that it is not very easy to measure benefits as part of a benefit/cost analysis. Do you agree,
and if so, how do you get around this handicap?

A: Yes, in general, it is quite difficult to obtain a quantitative measure of benefits. Please refer to the text again
and you will see several examples of how you can do this.
Assignment

List 5 factors other than salary that you would consider in choosing between two potential jobs.