MA2 MANAGING

COST & FINANCE

Sunway TES

Study Guide
Part 2
(Student Copy)

Version: March 2020

MA2 MANAGING COST AND FINANCE
CONTENTS Sunway TES

CONTENTS
CONTENTS ....................................................................................................................... 234
CHAPTER 11: SERVICE COSTING ..................................................................................................... 238
11a. Characteristics of Service Costing................................................................................................ 239
Topic Review (TLO C5a) .................................................................................................... 240
11b. Practical Roles.............................................................................................................................. 241
Topic Review (TLO C5b) .................................................................................................... 242
11c. Use of Service Costing ................................................................................................................. 243
Topic Review (TLO C5c) .................................................................................................... 244
11d. Cost Units for Service Costing...................................................................................................... 245
Topic Review (TLO C5d) .................................................................................................... 246
11e. Calculation of Service Costs ......................................................................................................... 247
Topic Review (TLO C5e) .................................................................................................... 248
Chapter 11 Summary ............................................................................................................................ 250
CHAPTER 12: COST-VOLUME-PROFIT (CVP) ANALYSIS ..................................................................... 251
12a. The Contribution Per Unit and the Contribution/Sales Ratio...................................................... 252
Topic Review (TLO D1a) .................................................................................................... 253
12b. Break-Even and Margin of Safety ................................................................................................ 254
Topic Review (TLO D1b) .................................................................................................... 257
12c. Calculate the Sales Required to Achieve a Target Profit ............................................................. 258
Topic Review (TLO D1e) .................................................................................................... 259
12d. Interpretation Break-Even and Profit/Volume Charts for a Single Product or Business ............. 260
Topic Review (TLO D1f) .................................................................................................... 262
Chapter 12 Summary ............................................................................................................................ 263
CHAPTER 13: OPTIMAL PRODUCTION PLAN (OPP) .......................................................................... 264
13a. The Contribution Per Unit and the Contribution/Sales Ratio...................................................... 265
Topic Review (TLO D2a) .................................................................................................... 266
13b. The Limiting Factor in Given Situations ....................................................................................... 267
Topic Review (TLO D2b) .................................................................................................... 268
13c. The Optimal Production Solution When There Is a Single Resource Constraint ......................... 269
Topic Review (TLO D2c) .................................................................................................... 272
Chapter 13 Summary ............................................................................................................................ 273
CHAPTER 14: RELEVANT COSTING .................................................................................................. 274
14a. The Concept of Relevant Costs .................................................................................................... 275

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Topic Review (TLO D2e) .................................................................................................... 278

14b. The Concept of Relevant Costs in Business Decisions ................................................................. 279
Topic Review (TLO D2f) .................................................................................................... 286
Chapter 14 Summary ............................................................................................................................ 287
CHAPTER 15: MAKE OR BUY-IN DECISIONS ..................................................................................... 288
15a. The Make and Buy-In Problems When There Is a Single Resource Constraint............................ 289
Topic Review (TLO D2a) .................................................................................................... 294
Chapter 15 Summary ............................................................................................................................ 295
CHAPTER 16: PRINCIPLE OF DISCOUNTED CASH FLOW .................................................................... 296
16a. Simple and Compound Interest, and Nominal and Effective Interest Rate................................. 297
Topic Review (TLO D3a) .................................................................................................... 301
16b. The Compounding and Discounting ............................................................................................ 302
Topic Review (TLO D3b) .................................................................................................... 303
16c. The Distinction of Cash Flow and Profit....................................................................................... 304
Topic Review (TLO D3c) .................................................................................................... 305
16d. Discounted Cash Flow for The Net Present Value and Internal Rate of Return Methods ........... 306
Topic Review (TLO D3d) .................................................................................................... 311
16e. Present Value Using Annuity and Perpetuity Formulae .............................................................. 313
Topic Review (TLO D3e) .................................................................................................... 315
16f. Payback........................................................................................................................................ 317
Topic Review (TLO D3f) .................................................................................................... 319
16g. Interpretation Capital Investment Appraisal ............................................................................... 320
Topic Review (TLO D3g) .................................................................................................... 321
Chapter 16 Summary ............................................................................................................................ 322
CHAPTER 17: CASH MANAGEMENT ................................................................................................ 323
17a. The Cash and Cash Flow .............................................................................................................. 324
Topic Review (TLO E1a) .................................................................................................... 326
17b. The Sources of Cash Receipts and Payments .............................................................................. 327
Topic Review (TLO E1b) .................................................................................................... 329
17c. The Relationship Between Cash Flow Accounting and Accruals Accounting .............................. 330
Topic Review (TLO E1c) .................................................................................................... 331
17d. The Cash Flow Pattern of Different Types of Organisations........................................................ 332
Topic Review (TLO E1d) .................................................................................................... 335
17e. Cash Flow Management, and Impact on Liquidity and Company Survival.................................. 336

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Topic Review (TLO E1e) .................................................................................................... 338

17f. Treasury Functions ...................................................................................................................... 339
Topic Review (TLO E2a) .................................................................................................... 340
17g. Cash Handling Procedures ........................................................................................................... 341
Topic Review (TLO E2b) .................................................................................................... 342
17h. The Management of Cash Balances in Public Sector Organisations............................................ 343
Topic Review (TLO E2c) .................................................................................................... 344
17i. Trends in the Economic and Financial Environment ................................................................... 345
Topic Review (TLO E2d) .................................................................................................... 346
Chapter 17 Summary ............................................................................................................................ 347
CHAPTER 18: CASH BUDGETS AND FORCEASTING ........................................................................... 348
18a. Surplus Cash and Cash Deficit...................................................................................................... 349
Topic Review (TLO E4a) .................................................................................................... 350
18b. Short Term Investments .............................................................................................................. 351
Topic Review (TLO E4b) .................................................................................................... 355
18c. Ways of Raising Finance .............................................................................................................. 356
Topic Review (TLO E4c) .................................................................................................... 358
Chapter 18 Summary ............................................................................................................................ 359
CHAPTER 19: CASH BUDGETS AND FORCEASTING ........................................................................... 360
19a. The Objectives of Cash Budgeting ............................................................................................... 361
Topic Review (TLO E3a) .................................................................................................... 362
19b. The Statistical Techniques Used in Cash Forecasting .................................................................. 363
Topic Review (TLO E3b) .................................................................................................... 373
19c. The Cash Budget .......................................................................................................................... 374
Topic Review (TLO E3c) .................................................................................................... 378
19d. Mechanism for Monitoring and Control...................................................................................... 379
Topic Review (TLO E3d) .................................................................................................... 380
Chapter 19 Summary ............................................................................................................................ 381
APPENDIX A SUMMARY OF FORMULAE.......................................................................................... 382
1. Costs ............................................................................................................................................ 382
2. Variances ..................................................................................................................................... 383
3. Materials...................................................................................................................................... 384
4. Labour.......................................................................................................................................... 385
5. Expenses ...................................................................................................................................... 386

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6. Overheads ................................................................................................................................... 387

7. Profit reporting ............................................................................................................................ 388
8. Job and Batch Costing.................................................................................................................. 390
9. Service Costing ............................................................................................................................ 390
10. Process Costing ............................................................................................................................ 391
11. CVP analysis ................................................................................................................................. 391
12. Optimal Production Plan ............................................................................................................. 392
13. Relevant Costing .......................................................................................................................... 392
14. Make or Buy-in Decisions ............................................................................................................ 392
15. Capital investment appraisal ....................................................................................................... 393
APPENDIX B PRESENT VALUE TABLE ............................................................................................... 394
APPENDIX C ANNUITY TABLE ......................................................................................................... 395

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CHAPTER 11: SERVICE COSTING Sunway TES

CHAPTER 11: SERVICE COSTING

Learning Outcomes

At the end of the chapter, you should be able to:

TLO C5a. Describe the characteristics of service costing,

TLO C5b. Describe the practical roles relating to the costing of services.

TLO C5c. Identify situations (cost centres and industries) share the use of service costing is

TLO C5d. appropriate.

TLO C5e. Illustrate suitable cost units that may be used for a variety of services.

TLO C5f. Calculate service unit costs in a variety of situations.

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11a. Characteristics of Service Costing

Learning Outcome (ACCA Study Guide Area C, Topic C5a):
Describe the characteristics of service costing.

Service costing is an accounting method for services. It is applied

in service cost centres in manufacturing organisations, and in
service organisations. This costing method applies to
organisations like transportation companies (such as buses and
trucks), hotels, hospitals, accountancy firms and law firms.

Service costing is the costing method to use in service

organisation such as hotels, transport companies and hospitals.
This is not an easy application as the cost units for different
organisations are different.

Service costing is different from other costing methods primarily

because services are intangible – services cannot be physically
held on to.

Let’s take Jack, an airline ticket agent. The product he produces

and sells at the same time is his service to his customers on finding
out whether a flight is available at a certain time, how much the
flight would cost, booking a flight seat for the customer, accepting
payment, and printing of the flight ticket. What Jack is doing here
is simply offering his services, which cannot be physically seen or
touched, except for the ticket which is a proof of the services
provided.

On top of that, it must be reminded that the entire service may be

different for different customers – for example, some customers
require a longer service time while some require much lesser,
some customers may have already checked out the flights and are
there just to collect the ticket, and so on. So, the services provided
here are heterogeneous, which means, different each time – each
service is not exactly the same for every customer

Also, take note that the service was produced and consumed at
the same time, meaning that as Jack provides the necessary
information (providing service), the customer is receiving the
„output‟ too – the production and consumption of the product
(service) was simultaneous.

Jack’s service to his customer cannot be stored or copied for

another customer, simply because, the service is provided based
on each customer’s unique ad hoc request during the delivery of
the service. So, the service is perishable. That means, services
cannot be obtained at one time, stored and sold at a completely
different time. However, the advancement in technology is
evidently trying to beat that by trying to come up with suitable
software and similar technologies.

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Topic Review (TLO C5a)

Learning Outcome (ACCA Study Guide Area C, Topic C5a):
Describe the characteristics of service costing.

1. State which of the following are characteristics of service costing.

i. High levels of indirect costs as a proportion of total costs.

ii. Use of composite cost units.
iii. Use of equivalent units.

A. i only.
B. I and ii only.
C. ii only.
D. ii and iii only.

2. Service costing has four specific characteristics.

i.

ii.

iii.

iv.

Answers:
1. B

2.
i = Intangibility
ii = Simultaneity
iii = Perishability
iv = Heterogeneity

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11b. Practical Roles

Learning Outcome (ACCA Study Guide Area C, Topic C5b):
Describe the practical roles relating to the costing of services.

(1) Since the production output of service organisations (which are

services) are intangible in nature, it is a difficult task to
establish an appropriate cost unit. It must be reminded that
different service organisations have different cost units, unlike
manufacturing organisations which usually goes by total costs
of production (units or batch) divided by unit (or batch)
production volume.

(2) Service organisations are usually more labour intensive than

the manufacturing organisations. The consumption or use of
direct materials is usually much lesser than of direct labour,
direct expense and overheads. This is definitely in line with the
nature of services, where the product is not a tangible item,
but is something that must be listened to or felt or
experienced. Therefore, there will naturally be very little use
of tangible items to produce that service.

(3) Generally, the total cost of the services or the organisation

itself would comprise of a relatively huge portion of
overheads. This is again because the nature of services where
it is difficult to establish cost units, and to trace the labour
hours and cost of facilities back to individual services provided.

(4) Referring to point (3), the overheads here are usually fixed in
nature, and not variable. Then again, this may differ according
to the business functions in the organisations. The costs in an
airline-ticketing agency may be mainly fixed, but in a
consultancy firm, the variable costs may be greater as the
consultants are paid by the hours of consultation they provide
and the commission and allowances given to them for bringing
in a customer.

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Topic Review (TLO C5b)

Learning Outcome (ACCA Study Guide Area C, Topic C5b):
Describe the practical proles relating to the costing of services.

1. The companies that produce many different products usually use:

A. Process costing
B. Job Order Costing
C. Service Costing
D. None of the above

2. When is service costing used?

A. When indirect costs are a small proportion of total costs
B. When overhead absorption is straightforward
C. When the absence of a physical product makes it impossible to determine unit costs
D. When the output is intangible

Answers:
1. B
2. D

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11c. Use of Service Costing

Learning Outcome (ACCA Study Guide Area C, Topic C5c):
Identify situations (cost centres and industries) where the use of service costing is appropriate.

The services costing is the directly concerned with the classification

and accumulation of the services cost towards services rendered by
undertakings. The services provided by an enterprise can be
categorized as follows from the costing point of view.

a. Transport services: airways, railways, vehicle, shipping, cable car

etc.
b. Welfare services: hospital, nursing home, libraries, canteen,
hotel.
c. Supply services: gas supply, electricity supply, water supply,
telephone, electricity authority etc.
d. Municipal services: steel lighting, road maintenance etc.

These services may either be rendered by a company to the public

or some of these could be local level to a factory, for its own internal
use, e.g. canteen, delivery van, township maintenance etc. a canteen
in a factory can either be run by a factory itself or it can be let out to
a contractor at an agreed rate.

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Topic Review (TLO C5c)

Learning Outcome (ACCA Study Guide Area C, Topic C5c):
Identify situations (cost centres and industries) where the use of service costing is appropriate.

1. Which one of the following is most likely to operate a system of service costing?
A. A printing company.
B. A hospital.
C. A furniture manufacturer.
D. An air-con manufacturer.

Answers:
1. B

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11d. Cost Units for Service Costing

Learning Outcome (ACCA Study Guide Area C, Topic C5d):
Illustrate suitable cost units that may be used for a variety of services.

Very often, the cost units for service costing are composite cost
units. Composite cost units are not single cost units. Common
examples include tonne-km and guest night.

Owing to the nature of services, the costing process has a minor

difficulty in establishing an appropriate cost unit. Examples of
cost units can be seen in Table 8.1 below:

Service Cost units

Transport Tonne-km, passenger-km
Hospitals Patient-night, out-patient visit
Hotels Occupied bed-nights
Food and beverages Meals served
Consultancy firms Client hours
Table 11.1 Cost units for various services

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Topic Review (TLO C5d)

Learning Outcome (ACCA Study Guide Area C, Topic C5d):
Illustrate suitable cost units that may be used for a variety of services.

1. Which of the following would be appropriate cost units for a transport business?

i. Cost per tonne-kilometre

ii. Fixed cost per kilometre
iii. Maintenance cost of each vehicle per kilometre

A. i only.
B. i and ii only.
C. i and iiionly.
D. All of them.

2. Match up the following services with their typical cost units.

Service Cost unit

Hotels
Education
Hospitals
Catering organisations

A = Meal served

B = Patient day

C = Full-time student

D = Occupied bed-night

Answers:
1. C

2. D, C, B, A

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11e. Calculation of Service Costs

Learning Outcome (ACCA Study Guide Area C, Topic C5e):
Calculate service unit costs in a variety of situations.

In services costing, a statement is prepared for analysing the

operating cost incurred. The operating cost sheet is analysed into
three parts namely fixed costs, variable costs and semi-variable
costs. It also shows the comparison between the actual cost and the
estimated or budgeted cost. Thus, the cost sheet can be used to
measure the efficiency of operation, and operating cost incurred.

Cost per cost unit = Total costs

Total cost units

Calculation of cost units

1. In transport costing, a composite unit such as passenger-mile

or ton-km is often selected.
a. Total km= no. of vehicle x no. of days x no. of trips x 2
(for round trip) x distance
b. Total passenger km= total km x normal seating
capacity x actual capacity percentage
c. Total ton km= total km x normal capacity in no. or tone
x actual capacity %
2. In hotel industry, total operating cost is divided by number of
room nights

Total room-nights= No. of rooms x nights in a month x %

occupied

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Topic Review (TLO C5e)

Learning Outcome (ACCA Study Guide Area C, Topic C5e):
Calculate service unit costs in a variety of situations.

1. Calculate the most appropriate unit cost for a distribution division of a multinational company using
the following information.

Miles travelled 636,500

Tonnes carried 2,479
Number of drivers 20
Hours worked by drivers 35,520
Tonne/miles carried 375,200
Costs incurred $562,800

A. $0.88
B. $1.50
C. $15.84
D. $28,140

2. The formula used to calculate the cost per service unit is:
Cost per service unit = C/ D

C=
D=

3. Happy Returns Ltd operates a haulage business with three vehicles. During week 26 it is expected
that all three vehicles will be used at a total cost of $10,390; 3,950 kilometres will be travelled
(including return journeys when empty) as shown in the following table.

Journey Tonnes carried Kilometres

(one way) (one way)
1 34 180
2 28 265
3 40 390
4 32 115
5 26 220
6 40 480
7 29 90
8 26 100
9 25 135
280 1,975

i. The total of tonne-kilometres in week 26 =

ii. The average cost per tonne-kilometre for week 26 = $ per tonne-kilometre (to the nearest
penny).

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Answers:
1. B

2. C = Total costs per period

D = Number of service units in the period

3. i. $66325
ii. $0.16

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Chapter 11 Summary

1. Service costing is an accounting method for services. It is applied in service cost centres in
manufacturing organisations, and also in service organisations.

2. Service costing is not easy to apply because cost units for different organisations are different.

3. Often cost units in service costing are composite units.

4. Common features of service costing include:

a. Services are intangible in nature, so it is difficult to establish appropriate cost unit.
b. Service organisations are usually more labour intensive than the manufacturing
organisations. Use of direct materials is usually much lesser than of direct labour, direct
expense and overheads.
c. Total cost of the services comprises of a relatively huge portion of overheads.
d. Overheads are usually fixed in nature.

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CHAPTER 12: COST-VOLUME-PROFIT (CVP) ANALYSIS Sunway TES

CHAPTER 12: COST-VOLUME-PROFIT (CVP) ANALYSIS

Learning Outcomes

At the end of the chapter, you should be able to:

TLO D1a. Calculate contribution per unit and the contribution/sales ratio.

TLO D1b. Explain the concept of break-even and margin of safety.

TLO D1c. Use contribution per unit and contribution/sales ratio to calculate break-even point and
margin of safety.

TLO D1d. Analysis the effect on break-even point and margin of safety of changes in selling price and
costs.

TLO D1e. Use contribution per unit and contribution/sales ratio to calculate the sales required to
achieve a target profit.

TLO D1f. Interpret break-even and profit/volume charts for a single product or business.

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12a. The Contribution Per Unit and the Contribution/Sales Ratio

Learning Outcome (ACCA Study Guide Area D, Topic D1a):
Calculate contribution per unit and the contribution/sales ratio.

Introduction
Cost-volume-profit (CVP) analysis (also known as the break-even
analysis) evaluates the effects of changes in costs, volume and selling
price on profits. It is useful for profit planning, pricing decisions,
production capacity decisions and sales mix decisions.

One of the main features of CVP analysis is the identifying the break-
even point of an activity. The point at which a company or an activity
breaks even is when it achieves neither profit nor loss. It is the
position where total revenue exactly covers all costs – total revenue
equals total costs.

Contribution per unit

CVP analysis assumes that selling price per unit, variable costs per
unit and total fixed costs remain constant at all levels of activity. As
such, it also assumes that contribution per unit remains constant.

Contribution per = Selling price per unit – ALL variable

unit costs per unit

Total = Contribution per unit x Sales

contribution volume

= Total sales revenue – Total variable

costs

= Total sales revenue x

Contribution/sales ratio

For example, if a product, Delta, with variable cost per unit of $5 and
total fixed costs of $2,000 is sold for $10, then the contribution per
unit would be:

Contribution per = Selling price per unit – Variable

unit costs per unit

= $10 - $5

= $5

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Topic Review (TLO D1a)

Learning Outcome (ACCA Study Guide Area D, Topic D1a):
Calculate contribution per unit and the contribution/sales ratio.

1. Budgeted sales of a product in a period is 15,000 units, at a selling price of $55 per unit, producing
a total contribution of $345,000. Fixed costs are $120,000 based on the budgeted sales quantity.
What is the budgeted variable cost per unit?

2. A product has the following unit cost card:

Variable production $8.50

Variable non-production $1.20

Fixed production $3.60

Fixed non-production $0.40

The product is sold at $32.50 per unit

What is the contribution/sales ratio?

Answers:
1. $32
2. 70%

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12b. Break-Even and Margin of Safety

Learning Outcome (ACCA Study Guide Area D, Topic D1b):
Explain the concept of break-even and margin of safety.

Use contribution per unit and contribution/sales ratio to calculate break-even point and margin of safety.

Analysis the effect on break-even point and margin of safety of changes in selling price and costs.

Break-even point
The break-even point refers to the volume and its respective
revenue when the company or the activity makes no profit and no
loss. The break-even quantity is the minimum volume that should be
sold to avoid losses; and the break-even sales refer to minimum
amount of revenue required to cover all costs.

Basically, break-even analysis employs the marginal costing profit

reporting method. Using marginal costing method, and working
backwards from profit equals to zero, break-even point can also be
said as the point at which total contribution equals to total fixed
costs.

When profit/loss = 0:

Contribution – FC = 0 profit = contribution – FC

Contribution = FC total contribution = Revenue – VC

Sales – VC = FC

Sales = VC + FC Sales = TC

To calculate break-even quantity, qe, based on selling price (Sp), unit

variable cost (VC unit) and total fixed costs (FC), work from:

Profit = 0

Contribution = FC

(Contribution per unit) × qe = FC

(Sp – VC unit) × qe = FC

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By replacing the given values into the last line of the working above,
the qe can be obtained. For example, if a product, Delta, with unit
variable cost of $5 and total fixed costs of $2,000 is sold for $10, then
the break-even quantity would be:

(Sp – VC unit) × qe = FC

($10 – $5) × qe = $2,000

qe = 400 units

The break-even sales would then be 400 units × $10 = $4,000

Margin of Safety
When actual sales or expected sales exceed break-even sales, the
company is very much saved from making a loss. The excess of sales
is called margin of safety. It can be measured in volume of sales, in
monetary terms or even in percentage.

𝐌𝐚𝐫𝐠𝐢𝐧 𝐨𝐟 𝐒𝐚𝐟𝐞𝐭𝐲
= Actual/Expected sales volume − Break-even volume
= Actual/Expected sales in $ − Break-even sales
Actual/Expected sales − Break-even sales
=
Actual/Expected sales

Contribution to sales (C/S) ratio

The contribution to sales (C/S) ratio is a measure of how much
contribution is earned from every dollar of sales revenue. It can be
expressed in decimal numbers or in percentage. C/S ratio is
sometimes called the contribution margin ratio.
𝑐
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑡𝑜 𝑠𝑎𝑙𝑒𝑠 ( ) 𝑟𝑎𝑡𝑖𝑜
𝑠
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
= 𝑜𝑟
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

It must be reminded that at break-even point, total contribution

equals to total fixed costs and the sales is called break-even sales.
Hence:

𝑐 𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑡𝑜 𝑠𝑎𝑙𝑒𝑠 ( ) 𝑟𝑎𝑡𝑖𝑜 =
𝑠 𝐵𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠

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The C/S ratio for product Delta is ratio of the contribution per unit
to its selling price:

𝐶 $10 − $5
𝑟𝑎𝑡𝑖𝑜 𝑓𝑜𝑟 𝐷𝑒𝑙𝑡𝑎 = = 0.50 𝑜𝑟 50%
𝑆 $10

With that information, if at one point, Delta’s sales were $20,000, its
contribution would be C/S ratio multiplied with the sales revenue:

𝐶
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝑟𝑎𝑡𝑖𝑜 𝑥 𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝑆
= 50% 𝑥 $20,000 = $10,000

Again, that information would easily help to find the profits for that
amount of sales.

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 − 𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠

= $10,000 − $2,000 = $8,000

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Topic Review (TLO D1b)

Learning Outcome (ACCA Study Guide Area D, Topic D1b):
Explain the concept of break-even and margin of safety.

1. A company sells a single product for $55 per unit. Fixed costs total $125,000 per period and the
contribution to sales ratio is 25%.

How many units must be sold each period to break-even?

A. 2,273
B. 5,000
C. 9,091
D. 10,375

2. A company makes product E. Budgets have been prepared for the year ahead and include production
and sales of 85,000 units with a break-even of 62,000 units.

What is the margin of safety ratio?

A. 15%
B. 27%
C. 37%
D. 73%

3. What will be the effect on the margin of safety if unit variable costs and total fixed costs both
increase, assuming no change in selling price or sales volume?
A. Decrease.
B. Increase.
C. Stay the same.
D. Impossible to determine.

Answers:
1. C
2. B
3. A

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12c. Calculate the Sales Required to Achieve a Target Profit

Learning Outcome (ACCA Study Guide Area D, Topic D1e):
Use contribution per unit and contribution/sales ratio to calculate the sales required to achieve a target
profit.

CVP analysis can also be used to calculate volume of sales and sales
revenue that would be required to achieve a target level of profit. A
business would have to earn enough contribution to cover its total
fixed costs to make the required amount of profit.

Total sales – Total variable costs – Total fixed costs = Profit

Contribution – Total fixed costs = Profit

Targeted sales units = Fixed Costs + Targeted Profit

Contribution per unit

Targeted sales revenue ($) = Targeted sales units x Selling price per unit ($)

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Topic Review (TLO D1e)

Learning Outcome (ACCA Study Guide Area D, Topic D1e):
Use contribution per unit and contribution/sales ratio to calculate the sales required to achieve a target
profit.

1. A firm has the following fixed costs:

Production $56,000

Non-production $27,000

Variable costs of the firm’s product are $5.20 and the selling price is $8.00 per unit.

What sales revenue (to the nearest $’000) is required to make a profit of $15,000?
A. $25,000
B. $35,000
C. $203,000
D. $280,000

Answers:
1. D

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12d. Interpretation Break-Even and Profit/Volume Charts for a Single Product or Business
Learning Outcome (ACCA Study Guide Area D, Topic D1f):
Interpret break-even and profit/volume charts for a single product or business.

Charts
It is usually easier to use graphical tools to make decisions. In CVP
analysis, there are two charts that can be very helpful in decision
making – the break-even chart and the profit/volume chart. These
charts provide the graphical representation of critical values used in
costing and pricing decision making.

The initial drawing of both charts will require the following values:
 Total fixed costs;
 Total variable costs; only then, the total costs line can be
drawn
 Total sales revenue; and
 Break-even point

Break-even chart (CVP graph)

Sales

Budgeted
profit

Total costs

BE Variable costs

Fixed Fixed costs

Cost

0
Margin of safety

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Profit-volume (P/V) chart

$

PROFIT
Profit

0 Level of activity

BEP Contribution
LOSS Fixed
Cost

Fixed
Cost

Limitation of CVP analysis

Although CVP analysis is a very useful in ascertaining appropriate
volume and pricing, it only works by the following assumptions:

1. Fixed costs are constant for the given output volume.

2. Unit variable costs are constant for the given output volume.
3. Selling prices are constant for the given output volume.

Clearly, the CVP analysis ignores the fact that in reality, all the
assumptions above do not hold true. Costs, volume and selling prices
do change after a relevant range of activity. There will be instances
where the fixed costs are stepped costs as well, or the unit variable
cost changing due to supplier pricing and discount policies, or even
selling prices changing based on customer demands.

Also, this analysis only works for a single product or a single mix of
products. It is usually not easy to apply the break-even analysis
organisation-wide if the organisation manufactures and/or sells a
huge range of products.

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Topic Review (TLO D1f)

Learning Outcome (ACCA Study Guide Area D, Topic D1f):
Interpret break-even and profit/volume charts for a single product or business.

1. What statement is true with reference to the following break-even chart?

A. Company A has a lower break-even sales revenue than Company B.

B. Company A has a higher contribution to sales ratio than Company B.
C. Company A has higher fixed costs than Company B.
D. Company A has higher profits than Company B.

Answers:
1. A

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Chapter 12 Summary

1. CVP analysis evaluates the effects of changes in costs, volume and selling price on profits. It employs
the marginal costing profit reporting method.

2. One main feature of CVP analysis is to identify the break-even point of an activity, where there is
neither profit nor loss.

3. Break-even quantity is the minimum volume that should be sold to avoid losses.

4. Break-even sales refer to minimum amount of revenue required to cover all costs.

5. At break-even point,
a. total revenue equals total costs.
b. total contribution equals total fixed costs.

6. The contribution to sales (C/S) ratio is a measure of how much contribution is earned from every
dollar of sales revenue. C/S ratio stays constant as long as selling price and variable cost per unit stay
constant.

7. When actual sales or expected sales exceed break-even sales, the company is saved from making a
loss. The excess of sales is called margin of safety.

8. Two charts used in CVP analysis are break-even chart and profit/volume chart.

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CHAPTER 13: OPTIMAL PRODUCTION PLAN (OPP)

Learning Outcomes

At the end of the chapter, you should be able to:

TLO D2a. Explain the importance of the limiting factor concept.

TLO D2b. Identify the limiting factor in given situations.

TLO D2c. Formulate and determine the optimal production solution when there is a single resource
constraint.

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13a. The Contribution Per Unit and the Contribution/Sales Ratio

Learning Outcome (ACCA Study Guide Area D, Topic D2a):
Explain the importance of the limiting factor concept.

Introduction
An optimal production plan is a revised production plan that brings
in maximum profit after considering resources‟ limiting factors. It is
also known as the profit maximisation plan.

Once a production plan has been established based on products‟

demand, the availability of resources is checked. Resources will refer
to all input required to produce an output (to make a product) –
money, material, machine, manpower and land or space.
Sometimes, there can be scarcity or shortage of resources. The
resource that is found to be insufficient becomes the limiting factor.

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Topic Review (TLO D2a)

Learning Outcome (ACCA Study Guide Area D, Topic D2a):
Explain the importance of the limiting factor concept.

1. State which of the following the types of resources that may be short in supply in a company.

i. Money
ii. Material
iii. Machine hours
iv. Manpower

A. All of the above

B. i and ii
C. ii and iv
D. i, ii and iii

Answers:
1. A

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13b. The Limiting Factor in Given Situations

Learning Outcome (ACCA Study Guide Area D, Topic D2b):
Identify the limiting factor in given situations.

Limiting factor
A limiting factor is also known as key factor or principal budget
factor. It limits the organisation’s activities, preventing it from
implementing all alternatives to achieve goals and targets set. An
organisation’s limiting factor may change from time to time.
Common limiting factors in a production plan are material, machine
hours and labour hours.

Let’s say a local company, Golly Ltd produces two products, J and K,
using a common raw material, Q. Available material Q for the month
is 30,000 kg, while direct labour hours are 35,000. The following
details are related to a month’s production plan.

J K
Demand 2,000 units 5,000 units
Raw material per unit 5 kg 3 kg
Labour hours per unit 4 6

From the details provided, production of J and K require a total of:

 25,000 kg of material Q, and
 38,000 direct labour hours.

There is sufficient material for the production plan. However, there

is a shortfall of 3,000 direct labour hours. So, the limiting factor here
is the direct labour hours.

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Topic Review (TLO D2b)

Learning Outcome (ACCA Study Guide Area D, Topic D2b):
Identify the limiting factor in given situations.

1. A company sells a single product for which cost details are as follows.

$ per unit

Direct material ($4.50 per kg) 22.50

Direct labour ($6 per hour) 18.00

Production overheads 8.50

Total production cost 49.00

There are 28,000 kg of materials and 12,000 hours of labour available. Management anticipates that
demand for the next year would be 5,000 units.

Which of the following are the limiting factors for the period?
A. Material
B. Labour
C. Both material and labour
D. Neither material nor labour

Answers:
1. B

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13c. The Optimal Production Solution When There Is a Single Resource Constraint
Learning Outcome (ACCA Study Guide Area D, Topic D2c):
Formulate and determine the optimal production solution when there is a single resource constraint.

Optimal production plan (OPP)

Given the presence of a limiting factor, the production plan has to
be revised to use the scarce resource as efficiently and wisely as
possible to attain maximum profit. The organisation will have to
produce products requiring the limiting factor element in
appropriate volumes upon examining the contribution factor.

Weighing the contribution per unit of the products alone does not
determine the right volumes of production for maximum profit. The
contribution per unit per limiting factor has to be computed, and
the products should be produced according to a rank or a priority list
– the production of the product with the highest contribution per
unit per limiting factor will be prioritised.

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Figure 13.1 presents the steps and explanations involved in deriving the OPP.

1. Limiting factor
Identify which resource is insufficient.

2. Contribution per unit (CPU)

Compute the CPU for each product requiring the limiting factor.
(CPU = Selling price LESS Variable cost per unit)

3. Contribution per unit per limiting factor (CPUPLF)

Compute the CPUPLF for each product.
(CPUPLF = CPU ÷ Limiting factor required per unit of product)

4. RANK
Product with the highest CPUPLF will be ranked first, and the lowest will be
ranked last.

5. PRODUCE – OPP
The revised plan – OPP – is to produce products according to the ranking or
priority order, until the limited resource is entirely used up. (Make product
Rank 1 first)

Figure 13.1 Steps in optimal production plan

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Let’s go back to Golly Ltd and its two products, J and K. For the given month, the limiting factor is the direct
labour hours. There is a shortage of 3,000 direct labour hours.

Assuming the selling prices and the unit variable costs given, the OPP can be derived in the following
manner:

J K

Demand (units) 2,000 5,000

Selling price ($) 20.00 40.00

(-) VC per unit ($) (10.40) (19.00)

Contribution per unit ($) 9.60 21.00

÷ Direct labour hours per unit (hours) 4 6

Contribution per unit per direct labour hour($) 2.40 3.50

RANK 2 1

Allocated direct labour hours (hours) 5,000 30,000

*according to ranking

Optimal production plan (units) 1,250* 5,000

(*5,000 hours ÷ 4 hours per unit)

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Topic Review (TLO D2c)

Learning Outcome (ACCA Study Guide Area D, Topic D2c):
Formulate and determine the optimal production solution when there is a single resource constraint.

1. A firm produces two products, A and B which have the following information:

A B

($ per unit) ($ per unit)

Selling price 20 50

Direct labour ($3/hr) 3 12

Other variable costs 2 8

Fixed costs 1 5

Demand (units) 300 150

If direct labour is restricted to a supply of 500 hours, what is the profit-maximising mix?
A B
Units Units
A. 0 125
B. 50 300
C. 300 50
D. 500 0

Answers:
1. C

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Chapter 13 Summary

1. A limiting factor refers to a resource found to be in shortage, thus limiting level of activity.

2. An Optimal Production Plan (OPP) is a revised production plan that brings in maximum profit by using
the scarce resource as efficiently and wisely as possible.

3. The deciding element in OPP is the contribution per unit per limiting factor.

4. Steps involved in deriving the OPP:

a. Identify which resource is insufficient.
b. Compute the contribution per unit for each product requiring the limiting factor.
c. Compute the contribution per unit per limiting factor for each product.
d. Product with the highest contribution per unit per limiting factor must be ranked first
e. Produce products according to ranking order – make product ranked one first

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CHAPTER 14: RELEVANT COSTING

Learning Outcomes

At the end of the chapter, you should be able to:

TLO D2e. Explain the concept of relevant costs.

TLO D2f. Apply the concept of relevant costs in business decisions.

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14a. The Concept of Relevant Costs

Learning Outcome (ACCA Study Guide Area D, Topic D2e):
Explain the concept of relevant costs.

Relevant Cost
A relevant cost refers to a cost that matters in a decision. It can also
be said as a direct result of a decision.

Relevant costs have concern with issues and projects that are going
to happen, and not what has already happened. They are future cash
flows, which are incremental in nature.

The Elements
Element of relevant costs include:

 All incremental costs.

 All future cash flows.
 Selected variable costs.
 Selected fixed costs.
 Avoidable costs
 Opportunity costs

Elements of relevant costs do not include:

 Sunk costs, which are costs that have already incurred and
therefore does not affect future decisions.

 Costs that do not show additional cash outflow, such as

depreciation and notional costs (such as notional interest and
notional rent).

 Committed costs – costs that will be incurred regardless of

any current and future decision (such as building rental and
insurance which are bound by agreements).

 Allocated costs which refer to apportioned share of fixed

costs, such as fixed overheads.

 Unavoidable costs regardless of which option is chosen or

decision made.

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Variable and Fixed costs

Are they relevant?

It is usually assumed that variable costs are relevant to decision-

making. As such, variable costs will be part of relevant costs.
Sometimes, variable costs may be sunk costs, and as such, are not
relevant to decision-making. Such variable costs are called as non-
relevant variable costs.

Usually, fixed costs are not relevant to decision-making because

they usually come under the category of committed and/or
allocated costs – which are not affected by any decisions to scale up
or to scale down activities. These costs are regarded as general fixed
costs. Therefore, fixed costs are usually not part of relevant costs.

Then again, sometimes, fixed costs may be relevant costs. Such fixed
costs are regarded as specific or directly attributable fixed costs.
Specific fixed costs also appear to be constant only within a relevant
range of production, which means that these costs are stepped
costs. So, these fixed costs may increase once a certain production
limit is exceeded. They may even decrease if activities are scaled
down or worst yet, stopped. This implies that specific fixed costs will
not incur in the absence of the related activity.

For example, basic salaries of cinema counter staff, which is a fixed

cost. The salaries will only incur if the cinema is operational. If the
cinema stops its operations (which means, it closes down), the
counter staff will have to be laid off, and as such, there will not be
any payment of counter staff basic salaries. Hence, the cinema does
not incur that fixed cost.

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Avoidable and unavoidable costs

Avoidable costs are costs whose incurrence depends upon the
course of action chosen from alternatives which are under
consideration. Unavoidable costs are cost which will be incurred
regardless of the course of action chosen. Unavoidable costs are
irrelevant to the decision-making process.

For example, a manufacturing company may be considering whether

to continue to manufacture, or instead to buy-in, one of the many
components that it currently produces in its factory.

Many of the costs incurred in the factory will be unavoidable

whichever of the alternatives is chosen because the factory will
continue to be used for the production of many other components.
Factory rent, and factory manager’s salary are examples of
unavoidable costs, which happen to be fixed costs as well. This
means that such costs are not relevant costs in deciding whether to
continue manufacturing the component, or to buy it in.

However, other costs may be avoidable according to alternative

chosen. For instance, if the component is bought-in, the costs of
materials and labour hours required to manufacture the same
component can be avoided altogether. Here, the material and
labour costs are avoidable costs, which are relevant to the decision
of whether to manufacture or buy the component in.

[Make or buy-in decisions are discussed at length in Chapter 15.]

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Topic Review (TLO D2e)

Learning Outcome (ACCA Study Guide Area D, Topic D2e):
Explain the concept of relevant costs.

1. What term is used to represent the benefit sacrificed when one course of action is chosen in
preference to an alternative?
A. Indirect cost
B. Opportunity cost
C. Sunk cost
D. Future cost

2. Which of the following are characteristics associated with relevant costs?

i. Opportunity cost
ii. Avoidable cost
iii. Allocated cost
iv. Incremental cost

A. i and ii
B. i and iii
C. i, ii and iii
D. i, ii and iv

Answers:
1. B
2. D

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14b. The Concept of Relevant Costs in Business Decisions

Learning Outcome (ACCA Study Guide Area D, Topic D2f):
Apply the concept of relevant costs in business decisions.

Relevant Cost of Materials

The relevant cost of materials for an activity depends on whether:

 The materials have already been purchased or they need to

be purchased;
 The materials are in regular use or just a one-time specific
use.

Note:

a) Basically, when materials need to be purchased, the relevant cost

of materials would be the replacement cost, which is usually the
purchase cost.

b) When a material is in regular use, the relevant cost of using that

material would be its replacement cost. This is because even if
the existing inventory can be (and is) used for the current job or
project, the inventory amount must be replaced so that there is
enough for continuous usage. This implies that the inventory
amount must be purchased anyway.

c) The relevant cost of purchased materials with resale value but no

other use (except for that activity), would be their net realisable
value.

d) However, if materials have alternative use (they can be used for

to replace other materials which need to be replenished), then
the relevant cost would be the lower incremental cost between:
• Their current resale value; and
• The replacement cost of the other material.

e) If the purchased materials have neither resale value, nor other

use, the relevant cost of materials would be ZERO.

f) (Remember: Purchase costs incurred are sunk costs that do not

affect future costs.)

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Example
JWM Ltd has just received an offer for a special job that requires
the following materials:

Material kg kg in NRV per Purchase cost

required stock kg ($) per kg ($)

P 500 0 – 3.50

Q 600 700 3.50 5.00

R 300 300 1.50 4.00

S 500 400 2.00 5.50

Additional information on the materials:

 Q is in regular use by JWM Ltd.

 R has restricted use. At the same time, it can be used in

another project as substitute for 500 units of material T.
There is no stock of T, and as such, it has to be bought at a
cost of $2 per unit.

 S is a result of previous over-buying, and there appears to be

no other use for it, except for this special job.

Calculate the relevant cost of materials for this job, providing

explanations where necessary.

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Example Answer
The relevant cost of materials for this special job can be
summarised as:

Material kg required Working Total ($)

P 500 500 kg * $3.50 1,750

Q 600 600 kg * $5.00 3,000

R 300 300 kg * $1.50 450

500 units of T * $2.00 1,000

S 500 400 kg * $2.00 800

100 kg * $5.50 550

TOTAL 7,100

Explanation:

(a) Material P is out of stock, and as such, all 500 kg have to be

bought at the replacement cost of $3.50.

(b) Material Q is in regular use. That means, once used up, stock
of Q has to be replenished. Therefore, the relevant cost of Q
is charged at its replacement cost of $5.

(c) Material R can be a substitute to material T. There is no need

for replacement of R, but when it is used for this special job,
it can no longer replace T in the other project. As a result,
when R is used at its net realisable value (NRV) $1.50, 500
units of T has to be bought at $2 – T’s material cost amounts
to $1,000. This means, for the other project, using R instead
of T is more beneficial. So, when R is used for the special job,
there is an opportunity cost of $1,000. Hence, the relevant
cost of R in this project is $1,000 and not $450.
(d) Material S does not have any other use at the moment. The
existing stock is charged at its net realisable value (resale
value) of $2, and the remainder kilograms are bought at its
replacement cost of $5.50.

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Relevant Cost of Labour

The relevant cost of labour varies according to different
situations. The computations differ in these different cases:

 Extra labour must be hired, either from outside the

organization, or the department

When extra labour must be hired, workers are brought in

from another company or from another department or
division of work. In such a case, the relevant cost of labour
would be the variable costs of labour only.

Remember: Fixed costs are not included in relevant costing,

unless said so by the examination question, or logically, it
is necessary to include the fixed costs of labour, if any.

For example, if 100 hours of labour is required for Job K56,

and workers need to be hired from outside the division at
a rate of $5 per hour, then the relevant cost of labour here
would be $5 × 100 hours = $500.

 Availability of spare capacity (paid labour, but the workers

are not working – idle time)

If there are workers who have already been paid (or are
being paid) for their current task(s) who are free, and are
available to take up extra work without additional cost,
they are categorised as spare capacity of labour. Spare
capacity hours will be paid anyway – more like a fixed cost
– with no extra (labour) costs. So the amount paid or
payable to the worker(s) would be considered as sunk or
fixed cost – both irrelevant to decision making. Hence,
relevant cost of spare capacity is ZERO.

For example, out of the 100 hours of labour required for

Job K56, if 60 hours of work can be undertaken by workers
from another division which has 60 hours spare capacity,
then the relevant cost of labour here would be $5 × (100 –
60) hours = $200 only. The relevant cost of the 60 hours
spare capacity would be zero.

 Shortage of labour supply, resulting in workers being

temporarily pulled out from an existing production line
and/or overtime has to be performed

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When labour is in short supply for a new activity, then, there are
usually two options of solutions here:

1. To temporarily pull out workers from another activity into the

new one

In this case, the relevant cost of labour for the new activity
would be the labour cost itself, plus the opportunity cost of
not making the product from existing activity. When workers
are pulled out from another activity, they are not able to make
the existing products. As such, there will not be any
contribution from those products. Therefore, that loss is
regarded as the opportunity cost.

The basic assumption is that the labour cost of the new activity
is an additional cost that incurs due to newer job. As such, the
labour cost is considered as a relevant cost element.

"𝑹𝒆𝒍𝒆𝒗𝒂𝒏𝒕 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒍𝒂𝒃𝒐𝒖𝒓 = 𝑳𝒂𝒃𝒐𝒖𝒓 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒏𝒆𝒘 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒚 +

𝑳𝒐𝒔𝒔 𝒐𝒇 𝒄𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝒇𝒓𝒐𝒎 𝒆𝒙𝒊𝒔𝒕𝒊𝒏𝒈 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒚"

However, there is an exception in this case. If the workers that

have been pulled out of another activity are on guaranteed or
fixed wage scheme, then their wages cost would not be
considered as part of the relevant cost. Then,

𝑹𝒆𝒍𝒆𝒗𝒂𝒏𝒕 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒍𝒂𝒃𝒐𝒖𝒓

= 𝑳𝒐𝒔𝒔 𝒐𝒇 𝒄𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝒇𝒓𝒐𝒎 𝒆𝒙𝒊𝒔𝒕𝒊𝒏𝒈 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒚

2. To work overtime

When workers perform overtime, then the relevant cost of

labour would be the overtime pay (the basic pay for the
overtime work added with the overtime premium), and where
necessary, the employer’s NIC.

Relevant cost of labour = Overtime pay due to the newer

activity

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Example
KB Ltd is considering a project that requires 50 hours of labour.
At the moment, KB makes and sells a single product called Z,
which has the following cost details:

Volume Unit volume price Cost per unit of Z ($)

Direct materials 3 kg $2 per kg 6

Direct labour 4 hours $5 per hour 20

Total variable costs 26

Selling price 50

Contribution 24

What would be the relevant cost of labour in the following cases:

(a) if the entire labour has to be hired from outside?

(b) if there is spare capacity of 50 hours?

(c) if there is shortage of labour?

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Example Answer
Notice that, contribution per unit of Z per direct labour hour

= $24 ÷ 4 direct labour hours per unit of Z = $6.

The relevant cost of labour will differ, based on the following situations:

(a) If labour has to be hired from outside

The relevant cost of labour for the new project = 50 hours * $5 per hour = $250

(b) If there is spare capacity (assuming there is 50 hours of idle time)

The relevant cost of labour for the new project with regard to spare capacity = $0.

However, if the spare capacity is not as high as 50 hours, then

the relevant cost will not be a flat zero. Let’s say, there are
only 30 hours of spare capacity, which means that the
remaining 20 hours of the 50 hours will result in an additional
labour cost. Then,

The relevant cost of labour for the new project = (30 hours * $0) + (20 hours * $5) = $100

(c) If there is shortage of labour

The relevant cost of labour for the new project

= Direct labour cost of the new project + Loss of contribution from Z

= (50 hours * $5) + ($6 contribution per unit per labour hour * 50 hours)

= $550

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Topic Review (TLO D2f)

Learning Outcome (ACCA Study Guide Area D, Topic D2f):
Apply the concept of relevant costs in business decisions.

1. A company is planning to use Material X for a special order. A sufficient quantity of the material is
available from stock for the special order, which would otherwise not be used in the business.

What is the relevant cost per kg of Material X in the evaluation of the special order?
A. Nil.
B. Replacement cost.
C. Net realisable value.
D. Purchase cost.

2. Company A uses Material Y regularly and paid $5,000 for 2,500kg of Material Y a year ago, which are
still in inventory. Material Y has a resale value of $1.20 per kg if sold today and may be purchased at
$2.70 per kg from a supplier.

What is the relevant cost of 2,800kg of Material Y required for a special project?
A. $3,360
B. $3,810
C. $5,000
D. $7,560

Answers:
1. C
2. D

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Chapter 14 Summary

1. A relevant cost refers to a cost that matters in a decision.

2. Element of relevant costs include:

a. All incremental costs
b. All future cash flows
c. Selected variable costs
d. Selected fixed cost

3. Elements of relevant costs do not include:

a. Sunk costs – costs that have already been incurred
b. Costs that do not show additional; cash outflow
c. Committed costs – costs that will be incurred regardless of any current and future decision
d. Allocated costs which refer to apportioned share of fixed costs

4. General fixed costs are not relevant costs.

5. Specific fixed costs are relevant costs.

6. Relevant cost of materials depends on whether:

a. The materials have already been purchased or they need to be purchased
b. The materials are in regular use or just a one-time specific use

7. Relevant costs of labour varies in different cases:

a. Extra labour must be hired
b. Availability of spare capacity
c. Shortage of labour supply
i. To temporarily pull out workers from another activity in the new one
ii. To work overtime

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CHAPTER 15: MAKE OR BUY-IN DECISIONS

Learning Outcomes

At the end of the chapter, you should be able to:

TLO D2a. Solve make/buy-in problems when there is a single resource constraint.

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15a. The Make and Buy-In Problems When There Is a Single Resource Constraint
Learning Outcome (ACCA Study Guide Area D, Topic D2d):
Solve make/buy-in problems when there is a single resource constraint.

Introduction
When a business is started, the owners and/or management have
the right to decide on whether they should make the items and/or
the components of the items within the business organisation, or
whether to buy them in.

There are two types of make or buy-in problems – buying

components from a supplier, and outsourcing tasks or projects to
another organisation. Outsourcing means subcontracting, which
refers to giving out a job to external organisations

Make or Buy-in – Cost factors

Usually the concern to make or buy-in does not arise unless:

There is some kind of scarcity of resources (limited resources), OR

A supplier or a subcontractor comes up and claims to produce the

component(s) or finish the job at a remarkably low cost.

Naturally there are critical aspects to consider because making a

choice. The main thing to examine would be whether there is savings
of money when the items or components are made or bought-in.
That directly relates to the issue of cost. Which is the cost-savings
decision? To make or to buy-in? Again, what costs? Fixed? Variable?

The primary deciding factors are the organisation’s specific fixed

costs (also known as directly attributable fixed costs), variable costs
of production and variable costs of buying.

If the variable costs of buying (or outsourcing) are much lower than
the total of specific fixed costs and variable costs of production, then
it is advisable to buy-in. Otherwise, it is best to make the
component(s) with internal resources. In other words, if savings of
cost is greater when the components are bought-in compared to
them being manufactured, then it is wise to buy them in.

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Make or Buy-in – Non-cost factors

After analysing the cost factors, it is very important to examine to
non-cost related factor such as quality of the components being
bought-in, reliability of the supplier and employee motivation.

Although the costs analysis shows that it is profitable to buy-in a

particular component, it is best to conduct sufficient research on
the quality of the items the particular supplier provides, and the
reliability of the supplier company itself – issues such as whether
it delivers on time and its defect rate.

If the organisation intends to make the components itself, then it

should look at its operations control and availability of resources.
Then again, if and when it decides to buy in components, the
organisation should have a clear idea of what to do with its spare
capacity (of labour) and materials it has. It should also be wary of
its workers’ feelings and impressions when an outsider (supplier)
is asked to make the components when the workforce is efficient
enough to produce them.

Only after weighing the relevant costs of making and buying-in

and after considering the non-cost related aspects will the
management make its final decision on obtaining the
components or on finishing the given project

Limiting factors
Sometimes, analysis of make or buy-in problems may suggest the
components to be made or the project be carried out in-house.
However, that solution does not materialise entirely due to
shortage of needful resources, namely material, machine hours
and labour hours.

In such a case, the extra variable cost of buying per limiting factor
saved has to be computed. The component with the maximum
extra variable cost of buying per limiting factor saved should be
manufactured in-house, and the one with minimum extra
variable cost of buying per limiting factor saved can be bought in.

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Example
In a different production line of Molly Makes Ltd, the company makes four components – P12, Q35,
R46 and S79. The details for a particular quarter are available as follows:

P12 Q35 R46 S79

Budgeted production (units) 3,000 5,000 2,500 4,500

$ $ $ $

Quotation (for a minimum of 100 units) 95 75 65 175

General fixed overheads per unit 7 2 4 15

Variable costs per unit:

Direct material 74 54 50 90

Direct labour 8 6 16 30

Variable overheads (machine hour basis) 5 10 5 25

Total unit variable costs 87 70 71 145

The variable overheads relate exclusively to machine utilization

which costs $5 per hour. Two of the machines have been found
to be defective and unsafe to use. As a result only 24,000 machine
hours are available. Molly Makes Ltd knows that it has to buy in
one or more of the components to meet the shortfall of machine
hours.

What are the quantities of manufacture and purchase for each

product?

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Example Answer
First, the shortfall in machine hours must be identified. Then, the
extra variable cost of buying per machine hour saved must be
calculated. Finally, a priority-to-buy list needs to be produced.

To find out the shortfall:

P12 Q35 R46 S79

Variable overheads $5 $10 $5 $25

(at $5 per machine hour)

Machine hours per unit 1 2 1 5

Budgeted production (units) 3,000 5,000 2,500 4,500

Total machine hours required 3,000 10,000 2,500 22,500 38,000

Available machine hours 24,000

SHORTFALL 14,000

To ascertain the extra variable cost of buying per machine hour

saved and the priority list:

P12 Q35 R46 S79

Variable cost of buying $95 $75 $65 $175

(-) Variable cost of making ($87) ($70) ($71) ($145)

Extra variable cost of buying $8 $5 ($6) $30

÷ Machine hours saved per unit 1 2 1 5

Extra variable cost of buying per machine

$8 $2.50 ($6) $6
hour saved

RANK/PRIORITY to buy 4 2 1 3

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Based on the priority-to-buy list, it is evident that P12 incurs the

highest savings of variable cost if it is made in-house, and R46 has
the least extra variable cost of buying per machine hour saved.

So, the production and purchase plan will be as follows:

Component Available Required Units Units Allocated Machine Budgeted

Priority to machine hours per production
machine machine made bought
make hours unit units
hours hours
1 P12 24,000 3,000 3,000 0 3,000 1 3,000

2 S79 21,000 22,500 4,200 300 21,000 5 4,500

3 Q35 0 10,000 0 5,000 0 2 5,000

4 R46 0 2,500 0 2,500 0 1 2,500

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Topic Review (TLO D2a)

Learning Outcome (ACCA Study Guide Area D, Topic D2a):
Explain the differences between a group and a team.

1. An organisation manufactures and sells 4 products and the following information is provided.

Bee Cee Dee Eee

$ per unit $ per unit $ per unit $ per unit
Variable production cost 10 12 14 16
Purchase price 15 18 21 24
Direct materials (kg) 5 5 5 5

Should the materials be restricted in supply and any quantities of the products can be bought in
from a supplier, what is the best product to buy-in to maximise profit?
A. Component Bee
B. Component Cee
C. Component Dee
D. Component Eee

Answers:
1. A

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Chapter 15 Summary

1. There are two types of make or buy-in problems – buying components from a supplier, and
outsourcing tasks or projects to another organisation.

2. Make or buy-in dilemma arises when:

a. There is some kind of scarcity of resources (limited resources), or
b. A supplier or a subcontractor comes up and claims to produce the component(s) or finish the
job a remarkably low cost.

3. The primary deciding factors are the organisation’s specific fixed costs, variable costs of production
and variable costs of buying.

4. If the variable costs of buying (or outsourcing) are much lower than the total specific fixed costs and
variable costs of production, then it is advisable to buy-in. Otherwise, it is best to make the
component(s) with internal resources.

5. It is important to examine non-cost related factor such as quality of the components being bought-in,
reliability of the supplier and employee motivation.

6. If the organisation intends to make the components itself, then it should look at its operations
control and availability of resources.

7. If the company decides to buy in components, the organisation should have a clear idea of what to
do with its spare capacity (of labour) and materials it has.

8. When there is a shortage of needful resources, extra variable costs of buying per limiting factor saved
gas to be computed. The component with the maximum extra variable cost of buying per limiting
factor saved should be manufactured in-house, and the one with minimum extra variable cost of
buying per limiting factor saved can be bought in.

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CHAPTER 16: PRINCIPLE OF DISCOUNTED CASH FLOW

Learning Outcomes

At the end of the chapter, you should be able to:

TLO D3a. Explain and illustrate the difference between simple and compound interest, and between
nominal and effective interest rates.

TLO D3b. Explain and illustrate compounding and discounting.

TLO D3c. Explain the distinction between cash flow and profit and the relevance of cash flow to capital
investment appraisal.

TLO D3d. Explain and illustrate the net present value (NPV) and internal rate of return (IRR) methods
of discounted cash flow.

TLO D3e. Calculate present value using annuity and perpetuity formulae.

TLO D3f. Calculate payback (discounted and non- discounted).

TLO D3g. Interpret the results of NPV, IRR and payback calculations of investment viability.

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16a. Simple and Compound Interest, and Nominal and Effective Interest Rate
Learning Outcome (ACCA Study Guide Area D, Topic D3a):
Explain and illustrate the difference between simple and compound interest, and between nominal and
effective interest rates.

Introduction
Capital investment appraisal is about evaluating huge amount
investments. It is about weighing the income and profits to be
earned after putting in a large amount of money into short term
or long term projects, and into purchase of fixed assets, such as
land, machinery and technologies.

In the evaluation, it is very important to remember that the value

of money changes over time – hence, time value of money!
Today’s one dollar does not have the same value as tomorrow’s
one dollar. Today’s one dollar is (usually) worth more tomorrow;
tomorrow’s one dollar is (usually) worth lesser today. Some of the
few but strong reasons for that are inflation rates, and national
and worldly growth. In order to compute the changing dollar
values, the knowledge of interests and the concept of time value
of money are crucial.

Interest
Interest refers to the extra amount earned when money is kept
or held over a certain amount of time. It is a form of earning.
Interests come from investments into projects, fixed assets (such
as machinery, vehicle and land) and current assets (such as
inventory and cash in bank and mutual funds). There is an interest
rate that determines the amount of interests that can be earned
over a given period of time.

There are basically two types of interest – simple and compound.

Simple Interest
Interest is calculated by multiplying investment amount with the
interest rate and the duration of investment.

𝑺𝒊𝒎𝒑𝒍𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
= 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒂𝒎𝒐𝒖𝒏𝒕 × 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆
× 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 𝒐𝒇 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

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For example, if an individual, Sally, deposits $10,000 into a savings

account that pays at a simple interest rate of 4% per annum, and
never withdraws until the end of 5 years, the interest earned
would be $10,000 × 4% × 5 years = $2,000. That means, she will
have $12,000 in her account at the end of five years. But in reality,
is that how it works? No.

Most interests depend on compound interest rates.

Compound Interest
Interests earned are subjected to earn interests as well. Let’s say,
in Sally’s case, the interest rate is 4%, compounded per annum.
What happens here is that the interest that is earned in the first
year becomes part of the investment amount for year 2, and the
interest earned in the second year becomes part of the
investment amount for year 3, and so on, until the end of
duration.

The following table reflects the changes in interest-bound

amount, and the interests earned for the five years of investment.

Year n Amount at Amount at the

Interest ($)
the end of year n
beginning of ($)
year n ($)
1 10,000.00 4% × 10,000 × 1 = 10,000 + 400
400.00 = 10,400.00
2 10,400.00 4% × 10,400 × 1 10,400 + 416
= 416.00 = 10,816.00
3 10,816.00 4% × 10,816 × 1 10,816 +
= 432.64 432.64 =
11,248.64
4 11,248.64 4% × 11,248.64 × 11,248.64 +
1 = 449.95 449.95 =
11,698.59
5 11,698.59 4% × 11,698.59 × 11,698.59+
1 = 467.94 467.94=
12,166.53

The final amount at the end of five years is $12,166.53 and not
$12,000 as computed with simple interest. Obviously, the using
compounded interest has resulted in more interest than one with
simple interest.

This is what compounding is all about, interests on interests!

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The amount earned, S, on an investment amount, P, after a number

of n years at a compound interest rate of r goes by the following
formula:
n
𝑺 = 𝑷(𝟏 + 𝒓%)

Using the formula, Sally’s $10,000 at the end of 5 years is $10,000 ×

5
(1 + 4%) = $12,166.53, which is the same amount calculated in the table above.

Nominal Interest and Effective Annual Rate (EAR)

Although interest rates are quoted per annum, often the interests
are compounded at shorter intervals – half yearly, quarterly,
monthly, weekly and even daily. For instance, if an interest rate of
12% per annum is compounded quarterly, the interest is
calculated and added to the investment amount every 3 months,
and not at the end of 12 months. However, it does not mean, the
interest compounded quarterly is 12% of the investment; it is a
lower rate.

The 12% per annum is called the nominal rate of interest, which
is the interest rate expressed as a percentage per annum. When
a nominal interest rate is compounded at a shorter time period,
the effective annual rate (EAR) must be computed to reflect the
actual interest applied on the investment amount.

𝒓% 𝒏
𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒂𝒏𝒏𝒖𝒂𝒍 𝒓𝒂𝒕𝒆(𝑬𝑨𝑹) = (𝟏 + ) −𝟏
𝑵

Where r refers to interest per time period, and n refers to the time
period which reflects on the number of times the interest is
compounded

For example, when a nominal interest rate of 12% per annum is

compounded quarterly, then r = 12% ÷ 4 quarters = 3% and the
effective annual rate of interest (which is the actual interest on
4
the investment amount) is (1 + 3%) – 1 = 12.55%. So, for an
investment of $1,000 with a nominal interest rate of 12% per
annum compounded quarterly, the interest available at the end
of the first year would be

$1,000 × 12.55% =$125.50 and not $1,000 × 12% = $120.00

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But when the nominal interest rate of 12% per annum is

compounded monthly, then the effective annual rate of interest
12 times
would be [1 + (12% ÷ 12 months)] – 1 = 12.68%, and the
interest earned at the end of the year would be $126.80.

Naturally, the more often the interest is compounded, the higher

the effective annual rate of interest.

Sometimes, the nominal rate is mentioned directly. Instead, the

compound interest rate for the short interval is provided, such as
daily rates, weekly, monthly, quarterly and half yearly. For
example, an interest rate of 2% per month, compound. That
means, the nominal interest rate is 2% × 12 months = 24% and the
12
effective annual rate of interest would be (1 + 2%) – 1 = 26.82%.

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Topic Review (TLO D3a)

Learning Outcome (ACCA Study Guide Area D, Topic D3a):
Explain and illustrate the difference between simple and compound interest, and between nominal and
effective interest rates.

1. A building society adds interest monthly to investors' accounts even though interest rates are
expressed in annual terms. The current rate of interest is 6% per annum.

An investor deposits $1,000 on 1 January. How much interest will have been earned by 30 June?
A. $30.00
B. $30.38
C. $60.00
D. $300

2. A one-year investment yields a return of 15%. The cash returned from the investment, including
principal and interest, is $2,070. The interest is
A. $250
B. $270
C. $300
D. $310.50

3. If a single sum of $12,000 is invested at 8% per annum with interest compounded quarterly, the
amount to which the principal will have grown by the end of year three is approximately
A. $15,117
B. $9,528
C. $15,219
D. $30,924

Answers:
1. B
2. B
3. C

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16b. The Compounding and Discounting

Learning Outcome (ACCA Study Guide Area D, Topic D3b):
Explain and illustrate compounding and discounting.

Discounted cash flow – Present and Future values

Discounted cash flow refers to the fact that today’s dollar can be
invested for a particular period of time at a particular interest
rate to obtain an increased dollar amount in future. It is about
finding out how much money should be invested now, at which
rate, and for how long to obtain a desired amount of money in
future, or how much can be earned in future with a current
investment amount.

In short:

S = P(1+r%)n→ FV = PV(1+r%)n

For example, $50,000 invested today at an interest rate of 10%

3
per annum would be 50,000 × (1 + 10%) = $66,550 in three
years’ time (PV = $50,000, r = 10% and n = 3). The future value of
today’s $50,000 is $66,550.

This computation can also be done using the Present Value Table
(PVT) (see Appendix B). The table provides discount factors for
different years at corresponding interest rates. The formula for
the discount factors in this table is (1 + r%)-n.

PV = FV(1+r%)-n→ PV = FV × Discounted factor from PVT

Based on the formula above, the future value of a current

investment amount can be obtained by dividing the present value
over the discount factor for r% and n years, from the Present
Value Table (PVT). For PV = $50,000, r = 10% per annum and n =
3, the future value would be $50,000 ÷ 0.751 = $66,577.90.

There may be a slight difference in values being computed using

compound interest formula and the Present Value Table (like the
one in this example), but the difference is usually insignificant, as
it is normally caused by rounding of decimal numbers.

What if $50,000 is desired at the end of 3 years? In this case, using

the Present Value Table (PVT), the present value should be $50,000
× 0.751 = $37,550. That means, if $37,550 were invested today at
an interest rate of 10% per annum, at the end of three years, the
money would have increased to $50,000, which is the future value
of $37,550.

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Topic Review (TLO D3b)

Learning Outcome (ACCA Study Guide Area D, Topic D3b):
Explain and illustrate compounding and discounting.

1. Which is worth most, at present values, assuming an annual rate of interest of 8%?
A. $1,200 in exactly one year from now.
B. $1,400 in exactly two years from now.
C. $1,600 in exactly three years from now.
D. $1,800 in exactly four years from now.

2. A sum of money was invested for 10 years at 7% per annum and is now worth $2,000.

The original amount invested (to the nearest $) was

A. $1,026
B. $1,016
C. $3,937
D. $14,048

3. Find the present value of ten annual payments of $700, the first paid immediately and discounted
at 8%, giving your answer to the nearest $.
A. $4,697
B. $1,050
C. $4,435
D. $5,073

Answers:
1. D
2. B
3. D

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16c. The Distinction of Cash Flow and Profit

Learning Outcome (ACCA Study Guide Area D, Topic D3c):
Explain the distinction between cash flow and profit and the relevance of cash flow to capital
investment appraisal.

It is important to remember that Discounting Cash Flow (DCF)

techniques are based on the cash flows of a project, not the
accounting profits. DCF is concerned with liquidity, not profitability.
Cash flows are considered because they show the costs and
benefits of a project when they actually occur. For example, the
capital cost of a project will be the original cash outlay, and not the
notional cot of depreciation which is used to spread the capital cost
over the asset’s life in the financial accounts.

The basic principle of discounting involves calculating the present

value of an investment. The present value of an investment is the
amount of money which must be invested now (for a number of
years) in order to earn a future sum (at a given rate of interest).

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Topic Review (TLO D3c)

Learning Outcome (ACCA Study Guide Area D, Topic D3c):
Explain the distinction between cash flow and profit and the relevance of cash flow to capital investment
appraisal.

1. A company is considering investing $160,000 in a project which will generate the following positive
cash flows.

Year Profit $ Depreciation $

1 15,700 16,000

2 163,000 16,000

3 32,900 16,000

The Net Present Value of the project’s cash flows, at a cost of capital of 24%, is (to the
nearest $500):
A. –$84,000
B. $167,500
C. $38,500
D. $7,500

Answers:
1. D

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16d. Discounted Cash Flow for The Net Present Value and Internal Rate of Return Methods
Learning Outcome (ACCA Study Guide Area D, Topic D3d):
Explain and illustrate the net present value (NPV) and internal rate of return (IRR) methods of discounted
cashflow.

Capital investment appraisal

Capital investment refers to investment of huge amount of money
into fixed assets, projects or long term plans. Capital investments
must be properly evaluated or appraised before undertaking them.
Appropriate methods of computation and relevant analysis must be
applied to avoid making huge financial mistakes that can jeopardise
the entire organisation’s operations and existence. The results of the
research done must prove the investment to be a viable or a
worthwhile one.

There are three methods to assess the profitability and the

financial consequences of a capital investment:

1. Net present value method;

2. Internal rate of return;

3. Payback period – non-discounted and discounted methods.

Net present value (NPV) method

This method acknowledges the time value of money, and as such,
requires the present value (PV) of cash flows to be computed.
Based on the cost of capital, r %, given, the present value for each
year will be calculated and totalled up. The investment is a
worthwhile one if, and only if the total present value of all cash
inflows exceed the total present value of all cash outflows for the
duration specified – time during which there will be cash flows
from the investment. That means the net present value (NPV) of
all cash flows has to be a positive number.

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𝑵𝑷𝑽 = 𝑷𝑽 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘𝒔 − 𝑷𝑽 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒇𝒍𝒐𝒘𝒔

NPV Result Decision

PV of cash
inflows > PV Worthwhile –
Positive
of cash accept!
outflows
PV of cash
outflows > PV Not worthwhile –
Negative
of cash reject!

Table 16.1 Summary of decision making process with NPV method

Year Cash Discount Present value

0 (X) 1.000 (X)
1 P a P×a
…. Q b Q×b
…. R c R×c
NET PRESENT VALUE (NPV) XXX
Figure 16.1 Analysis format with NPV method

A construction company, Bina All Ltd is considering a $100,000

capital investment, where the estimated cash inflows are as follows:

Year Cash flow

1 60,000
2 40,000
3 80,000
4 50,000

The company’s cost of capital is 15%.

The first to do is to draft out the NPV format and compute the PVs.
Then, calculate the NPV. If the NPV is positive, then Bina All Ltd
should make the investment; else, it’s best to reject.

Year Cash flow r = 15% Present

($) Discount Value($)
factor
*
1.00
0 (100,000) 0 (100,000)
1 60,000 0.870 52,200
2 40,000 0.756 30,240
3 80,000 0.658 52,640
4 50,000 0.572 28,600
NPV 63,680
* The discount factor for the current year, at any cost of capital, is
always 1.000.

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It appears that the investment has a positive NPV of $63,680. As

such, the investment is acceptable.

(It must be noted though, the cash flows are mere estimations, and
decision makers must leave room for uncertainties and should
accommodate rate of inflation as well.)

Internal rate of return (IRR)

Internal rate of return (IRR) is the cost of capital at which the net
present value of the investment is zero. It is in fact the return on the
investment (also known as return on capital employed). As long as
IRR exceeds the minimum acceptable rate of return, it is a
worthwhile investment. That means any project with an IRR below
the minimum acceptable rate of return should not be undertaken.

So, if an investment’s minimum acceptable rate of return is 10%, but

its IRR is 8%, then this investment is not worthwhile, and as such,
should not be undertaken.

There are two ways of determining the IRR:

1. Graphical method

The first thing to do here is pick a suitable range of cost of capital

rates – about 3 or 4 discount factors – and find the PVs of the cash
flows for each relevant year. Then, find the NPVs for each of these
discount factors. It is best to ensure that there is a balance
between positive and negative NPVs, so that the graph can
provide sufficiently accurate results.

Let’s look at another Bina All Ltd project. It requires an

investment of $800,000, and the cash inflows are as follows:

Year Cash flow ($)

0 (800,000)
1 400,000
2 300,000
3 200,000
The NPVs for some chosen cost of capital rates are tabulated and
plotted on a NPV vs cost of capital graph:

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45,000

40,100

35,000

25,700
30,000

20,000

15,000

10,000
(900)

Cost of capital(%)

r (%) 4 5 7 8
NPV ($) 40,100 25,700 (900) (13,700)

The x-intercept of the NPV vs cost of capital graph is the IRR for
this project – because NPV equals to zero at that point. From the
graph, the IRR seems to be slightly lower than 7%. If the
company’s minimum acceptable rate of return is 10%, then this
project has to be rejected.

This is undoubtedly a troublesome method because:

 Calculating the NPVs for the range of cost of capital rates is

tedious and is time- consuming;

 Drawing the graph requires high level accuracy of scale and

values, and is time consuming as well.

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Formula

A much easier approach is to apply the following formula:

[(𝑨)(𝒃 − 𝒂)]%
𝑰𝑹𝑹 = 𝒂% +
(𝑨 − 𝑩)

where
a = the lower cost of capital
b = the higher cost of capita
A = NPV obtained using cost of capital, r = a
B = NPV obtained using cost of capital, rate r =b

The relevant information for the IRR computation are tabulated

this way:

r = 8% Present r = 6% Present
Year Cash flow
Discount Value Discount Value
($)
factor ($) factor ($)
0 (800,000) 1.000 (800,000) 1.000 (800,000)

1 400,000 0.926 370,400 0.943 377,200

2 300,000 0.857 257,100 0.890 267,000
3 200,000 0.794 158,800 0.840 168,000
Net present value, NPV (13,700) 12,200

From the table above, a = 6%, b = 8%, A = $12,200 and B =

($13,700)

IRR = 6% + [ 12,200 × (8%-6%)]

(12,200 + 13,700)
= 6% + 0.942%
= 6.942%

Note:

The NPV decreases with the increasing cost of capital. This is

because the faster the value of money changes (higher the r value),
the lower the present value of money. As such, the total PVs of future
cash inflows are lower, thus NPV decreases.

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Topic Review (TLO D3d)

Learning Outcome (ACCA Study Guide Area D, Topic D3d):
Explain and illustrate the net present value (NPV) and internal rate of return (IRR) methods of discounted
cashflow.

1. Which is worth most, at present values, assuming an annual rate of interest of 8%?
A. $1,200 in exactly one year from now
B. $1,400 in exactly two years from now
C. $1,600 in exactly three years from now
D. $1,800 in exactly four years from now

2. A project requiring an investment of $1,200 is expected to generate returns of $400 in years 1 and
2 and $350 in years 3 and 4. If the NPV = $22 at 9% and the NPV = –$4 at 10%, what is the IRR for
the project?
A. 9.15%
B. 9.85%
C. 10.15%
D. 10.85%

Answers:
1. D
2. B

Model Question 1
An investment project has the following expected cash flows over its economic life of three years:

Year, n $
0 (142,700)
1 51,000
2 62,000
3 73,000

a) Calculate the NPV of the project at discount rates of 10% and 20% respectively.

b) Determine the IRR for this project.

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Model Question 1 Answer

a)
r = 10% r = 20%
Year Cash flow ($) Discount factor PV ($) Discount factor PV ($)

0 (142,700) 1.000 (142,700) 1.000 (142,700)

1 51,000 0.909 46,359 0.833 42,483
2 62,000 0.826 51,212 0.694 43,028
3 73,000 0.751 54,823 0.579 42,267
NPV = 9,694 NPV = (14,922)

b) IRR = 10% + [$9,694 × (20% – 10%)]

($9,694 + $14,922)
= 13.94%

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16e. Present Value Using Annuity and Perpetuity Formulae

Learning Outcome (ACCA Study Guide Area D, Topic D3e):
Calculate present value using annuity and perpetuity formulae.

Annuity
Annuity is a constant amount of cash flow for a given period of time.
If one receives $1,000 at end of every year for 5 years, starting from
now, the annuity amount is $1,000. The present value of the total
amount receivable from now, until the end of five years is calculated
using the Present Value Table (PVT) or the Annuity Table (AT).
Assuming the interest rate is 8%, using discount factors from Present
Value Table (PVT), the present value of the annuity can be computed
as follows:

Cash flow r = 8%
Year ($) Discount factor Present value ($)
1 1,000 0.926 926
2 1,000 0.857 857
3 1,000 0.794 794
4 1,000 0.735 735
5 1,000 0.681 681
Present value of $1,000 annuity for 5 years = 3,993

However, the exercise (above) can be time consuming, especially

where long duration of cash flow is concerned. So, it would be wiser
to use the Annuity Table (see Appendix C). The present value of an
annuity is the product of annuity amount and annuity factor (from the
Annuity Table.

𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂𝒏𝒏𝒖𝒊𝒕𝒚 = 𝑨𝒏𝒏𝒖𝒊𝒕𝒚 × 𝑨𝒏𝒏𝒖𝒊𝒕𝒚 𝒇𝒂𝒄𝒕𝒐𝒓

From the Annuity Table, the annuity factor for r = 8% for n = 5 years is
3.993, which is the same as the total of the 5 discount factors used in
the previous calculation (see computation table above) – 0.926 + 0.857
+ 0.794 + 0.735 + 0.681 = 3.993. The Annuity Table provides the total
of discount factors from the Present Value Table for a particular year
and corresponding interest rate.

Using the annuity factor, the present value of the annuity would be
$1,000 × 3.993 = $3,993. Applying the formula is faster than the
computing present values year by year.

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Perpetuity
Perpetuity is an annuity that lasts forever, meaning it is a cash flow
that lasts for a very, very long time. Good examples are never-ending
payments from hereditary trust funds to beneficiaries, insurance
payments and bonus returns, mutual fund returns and similar
investments.

Present value of perpetuity starting in a year’s time, is computed

as the annuity amount divided by the interest rate.

𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒑𝒆𝒓𝒑𝒆𝒕𝒖𝒊𝒕𝒚 𝒔𝒕𝒂𝒓𝒕𝒊𝒏𝒈 𝒏𝒆𝒙𝒕 𝒚𝒆𝒂𝒓

𝑨𝒏𝒏𝒖𝒊𝒕𝒚
=
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆

Let’s say Julie is supposed to receive $50,000 per year in

perpetuity, starting in a year’s time. The interest rate is 8% per
year.

The present value of the annual amount is $50,000 ÷ 8% = $625,000,

which means if Julie did not want to be paid $50,000 a year in
perpetuity, she can accept a one-time estimated payment of
$625,000.

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Topic Review (TLO D3e)

Learning Outcome (ACCA Study Guide Area D, Topic D3e):
Calculate present value using annuity and perpetuity formulae.

1. Find the present value of ten annual payments of $700, the first paid immediately and discounted
at 8%, giving your answer to the nearest $.
A. $4,697
B. $1,050
C. $4,435
D. $5,073

2. An investor is to receive an annuity of $19,260 for six years commencing at the end of year 1. It has
a present value of $86,400.

The rate of interest (to the nearest whole percent) is %

3. How much should be invested now (to the nearest $) to receive $24,000 per annum in perpetuity if
the annual rate of interest is 5%?

Answer = $

Answers:
1. D
2. 9%
3. $480,000

Model Question 2
a) An investor has funds to invest now to produce an annuity of $1,500 per year for 10 years
commencing in one year. If prevailing interest rates are 6%, what is the maximum amount that should
be invested?

b) A firm buys a material on a long term contract which stipulates a yearly price increase of 5%
compound. The current price is $250 per kg, the price in three years will be?

c) A person is to receive a ten-year annuity of $5,000 per year, received at the end of each year. At what
interest rate does this have a present value of $30,725?

d) The annual rent of a building is $1,000 payable in advance at the beginning of each year. At an interest
rate of 12%, the present value of the rental payments is $4,037. The length of the lease?

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Model Question 2 Answer

a) Present value of annuity = Annuity × Annuity factor
= $1,500 × 7.360
= $11,040

b) Future value of the material = PV (1 + r%)n = ($250) (1 + 5%)3

= $289.41

c) Annuity × Annuity factor = Present value of annuity

$5,000 × Annuity factor = $30,725
Annuity factor = 6.145

From the annuity table, for year n = 10, the corresponding r is 10%

d) Annuity × Annuity factor = Present value of annuity

(excluding the $1,000 paid at the beginning)

$1,000 × Annuity factor = $4,037 – $1,000

Annuity factor = 3.037

From the annuity table, for year r = 12%, the corresponding n is 4. The length of the lease must include
the year of the initial payment (year = 1), which results in a total of 5 years.

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16f. Payback
Learning Outcome (ACCA Study Guide Area D, Topic D3f):
Calculate payback (discounted and non- discounted).

Payback period
This is a method of determining the time or year at which the total
cash inflows are equal to the total cash out flows – basically
finding out when the net cash flow is no longer a negative number,
and starts to be a positive number.

A project is viable when the computed payback period is within

the time limit set by the organisation. However, where two or
more projects are concerned, the one with the shortest payback
period would be the favourable one. Then again, other related
factors do play a role in final decision of the management.

Apparently, payback period is computed prior to calculating the

NPV or the IRR in most organisations.

There are two ways of computing the payback period – non-

discounted, and discounted.

Non-discounted method
Here, the time value of money is ignored. The cash flows are used as
they are estimated.

Let’s try the following example. There are two projects in

consideration. The capital investment for both projects is $60,000.
The estimated yearly cash inflows are as follows:

Year Project A Project B

1 20,000 50,000
2 30,000 20,000
3 40,000 5,000
4 50,000 5,000
5 60,000 5,000

Project A appears to show positive net cash inflow at the end of year
3. To be more precise, the payback period is
2 years + $10,000 × 12 months = 2 years and 3 months
$40,000

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Project B‟s payback period seems to be much earlier:

1 year + $10,000 × 12 months = 1 year and 6 months.

$20,000

The project with the shortest payback period is Project B – the

chosen project.

Discounted method
A more logical and realistic approach, this method takes into
consideration the time value of money. The payback period is the
time taken for cumulative NPV – total of all cash flow PVs at the end
of the year – to change from a negative number to a positive one.

The suggested format of the computing the discounted payback

period is:

Year Cash Discount factor Present value Cumulative net

flow ($) ($) present value ($)
0 (X) 1.000 (X) (X)
1 P a P×a (X) + P × a
…. …. …. …. ….
…. …. …. …. ….
Figure 16.2 Format to calculate Discounted payback period

Let’s go back to Project A. Assuming the cost of capital is 10%, the

relevant information is first presented in the following table.

Year Cash flow r = 10% Present value Cumulative net

($) Discount ($) present value ($)
0 (60,000) 1.000 (60,000) (60,000)
1 20,000 0.909 18,180 (41,820)
2 30,000 0.826 24,780 (17,040)
3 40,000 0.751 30,040 13,000
4 50,000 0.683 34,150 47,150
5 60,000 0.621 37,260 84,410

From the computation in the table above, it appears that the

discounted payback period is in year 3 – it is between the end of year
2 and the end of year 3. The cumulative NPV is a negative value at
the end of year 2, but is a positive one at the end of year 3.

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Topic Review (TLO D3f)

Learning Outcome (ACCA Study Guide Area D, Topic D3f):
Calculate payback (discounted and non- discounted).

1. A capital investment project has an initial investment followed by constant annual returns.

How is the payback period calculated?

A. initial investment ÷ annual profit
B. initial investment ÷ annual net cash inflow
C. (initial investment – residual value) ÷ annual profit
D. (initial investment – residual value) ÷ annual net cash inflow

The following data is relevant for questions 2 and 3

Diamond Ltd has a payback period limit of three years and is considering investing in one of the following
projects. Both projects require an initial investment of $800,000. Cash inflows accrue evenly throughout
the year.

Year Alpha $ Beta $

1 250,000 250,000

2 250,000 350,000

3 400,000 400,000

4 300,000 200,000

5 200,000 150,000

6 50,000 150,000

The company's cost of capital is 10%.

2. The non-discounted payback period of Project Beta = years and months.

3. The discounted payback period of Project Alpha is between and years.

Answers:
1. B
2. 2 years 6 months
3. 3 and 4 years

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16g. Interpretation Capital Investment Appraisal

Learning Outcome (ACCA Study Guide Area D, Topic D3g):
Interpret the results of NPV, IRR and payback calculations of investment viability.

Advantages and disadvantages of NPV, IRR and Discounted payback

The various methods of capital investment appraisal discussed in
this chapter have their advantages and disadvantages of application
in the real world scenario. In fact, usually the appraisers use a
combination of methods to determine and decide whether an
investment is worthwhile or not. There are other indicators and
methods of appraisal used as well, such as the accounting rate of
return, which is not covered in this paper’s syllabus.

Appraisal Advantages Disadvantages

Net  Simpler to  Not widely used in
present calculate. practice.
value  Technically
(NPV) superior to IRR.
 Preferred in
assessing mutually
exclusive projects.
Internal  Easier  Ignores the relative
rate of understanding of size of investments.
return information by  Should not be used
(IRR) non- financial when there are
managers. non-conventional
 Widely used in cash flows, as this
practice. will lead to multiple
IRRs.
Discounted  Simple to calculate  Unable to
payback and understand. distinguish
period  Screening device in between projects
first. Stage with the same
 Favour short term payback period.
projects- minimise  Ignores timing of
financial risk cash flows within
 Use cash rather payback period
than profits after end of
payback period and
total project return

The summary of advantages and disadvantages of methods are

provided in Table 16.2 below.

Table 16.2 Advantages and disadvantages of NPV, IRR and

Discounted payback

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Topic Review (TLO D3g)

Learning Outcome (ACCA Study Guide Area D, Topic D3g):
Interpret the results of NPV, IRR and payback calculations of investment viability.

1. The following statements relate to an investment project that has been discounted at rates of 10%
and 20%:

i. The discounted payback period at 10% will be longer than the discounted payback period at
20%.
ii. The discounted payback period at 20% will be longer than the discounted payback period at
10%.
iii. The non-discounted payback period will be longer than the discounted payback period.
iv. The non-discounted payback period will be shorter than the discounted payback period.

Which of the statements are true?

A. i and iii
B. i and iv
C. ii and iii
D. ii and iv

Answers:
1. D

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Chapter 16 Summary

1. Interest refers to the extra amount earned when money is kept or held over a certain amount of
time.
a. Simple interest is calculated by multiplying investment amount with the interest rate and the
duration of investment.
b. Compound interest refers to interest earned on interest. Using compounded interest has
resulted in more interest than one with simple interest.

2. Nominal rate of interest is interest rate expressed as a percentage per annum.

3. Discounted cash flow is the amount of cash flow after applying discount rates.

4. Annuity is a constant amount of cash flow for a given period of time. Perpetuity is an annuity that
lasts forever.

5. Capital investment refers to investment of huge amount of money into fixed assets, projects or long
term plans.

6. Three methods of capital investment appraisal:

a. Net present value (NPV) method
b. Internal rate of return (IRR)
c. Payback period – non-discounted and discounted methods

7. NPV is the difference between present values of cash inflow and cash outflow. The investment is a
worthwhile one if, and only if the total present value of all cash inflows exceed the total present
value of all cash outflows for the duration specified, which means NPV has to be a positive number.

8. The IRR is the cost of capital at which the NPV of the investment is zero. As long as IRR exceeds the
minimum acceptable rate of return, it is a worthwhile investment.

9. There are two ways of determining the IRR:

a. Graphical method – this can be troublesome because:
i. Calculating the NPVs for the range of cost of capital rates is tedious and is time
consuming;
ii. Drawing the graph requires high level of accuracy of scale and values, and is time
consuming as well.
b. Formula method

10. NPV decreases with the increasing cost of capital. This is because the faster the value of money
changes (the higher the r value), the lower the present value of money.

11. Payback period is a method of determining the time at which cash inflows are equal to total cash
outflows. A project is viable when the computed payback period is within the time limit set by the
organisation. When there are many projects involved, the one with the shortest payback period
would be the favourable one.

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CHAPTER 17: CASH MANAGEMENT

Learning Outcomes

At the end of the chapter, you should be able to:

TLO E1a. Define cash and cash flow.

TLO E1b. Outline the various sources of cash receipts and payments (including regular/exceptional
revenue/capital receipts and payments,and drawings.

TLO E1c. Describe the relationship between cash flow accounting and accruals accounting.

TLO E1d. Distinguish between the cash flow pattern of different types of organisations.

TLO E1e. Explain the importance of cash flow management and its impact on liquidity and company
survival. (note: calculation of ratios is not required)

TLO E2a. Outline the basic treasury functions.

TLO E2b. Describe cash handling procedures.

TLO E2c. Outline guidelines and legislation in relation to the management of cash balances in public
sector organisations.

TLO E2d. Describe how trends in the economic and financial environment can affect management of
cash balances.

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17a. The Cash and Cash Flow

Learning Outcome (ACCA Study Guide Area E, Topic E1a):
Define cash and cash flow.

Introduction
Cash flow refers to movement of funds from and into a business.
The balance between cash inflows and outflows determines the
liquidity level of the business, and is necessary to ensure the
existence and survival of the business. Different cash flows have
different patterns – some are predictable, some are not; some are
consistent flows, some are occasional ones.

At times, cash flow can be considered as more important than

profits. This is because failure to make profits may bring the business
down in the long run, but lack of cash can shut the business out
within a few months. There are many organisations that have
appeared profitable on paper but had to file bankruptcy because
there was no cash to run the business. Survival of a business depends
on its ability to generate cash. Negative cash flow from operations
over a prolonged period could signal financial distress.

In order to ensure sustainable growth of a business, management

should therefore plan its sales growth and ensure that it has enough
liquidity (cash balance or new debt) to finance its growth. A business
is said to be liquid if it has access to enough liquid assets to meet its
financial obligations when they fall due. Liquid assets consist of cash
and other assets that can be converted into cash within a short
period of time

A company can make losses but still have positive net cash flow. For
example, a disposal of non-current assets at a loss reduces profit,
but the sales proceeds are recorded as cash inflows. Issuance of
shares has no immediate impact on the profit but results in cash
inflow. Similarly, a company can make profits but is experiencing
negative net cash flow.

A company enjoying a healthy profit margin and its sales are stable
would usually experience lesser cash flow difficulties from its trading
operations (cash receipts from sales and payment to suppliers).
Difficulty in generating sufficient cash flow from operations is more
likely to be encountered when a company is making a little profit,
while expanding rapidly.

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Cash budget is essential for short term financial planning. Financial

manager can identify the short term financial needs and
opportunities. It allows us to spot any cash flow gap on a cash flow
time line.

The idea of cash budget is straight forward. It records the estimates

of cash receipts and disbursements. It indicates whether the
business is able to generate enough cash to meet their business
obligations.

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Topic Review (TLO E1a)

Learning Outcome (ACCA Study Guide Area E, Topic E1a):
Define cash and cash flow.

1. A financial statement that shows the inflows and outflows of cash during a particular period of time
is known as:
A. Income statement.
B. Statement of retained earnings.
C. Balance sheet.
D. Statement of cash flows.

Answers:
1. D

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17b. The Sources of Cash Receipts and Payments

Learning Outcome (ACCA Study Guide Area E, Topic E1b):
Outline the various sources of cash receipts and payments (including regular/exceptional revenue/capital
receipts and payments,and drawings.

Cash transactions, inflows and outflows

There are three types of cash transactions:

i. capital and revenue

ii. exceptional or unexceptional
iii. regular or irregular

Cash flows can be classified into revenue receipts and payments

which arise in the normal course of the business. Examples are cash
sales and receipts from credit sales. Example of cash payments are
purchase of goods, salary payments and rental payments.

Capital receipts arise out of investment in a company. Examples are

proceeds from sale of shares, proceeds from loan receivables and
proceeds from sale of non-current assets. Example of capital
payments are payments for the purchase of non-current assets such
as machines, computers, buildings and payments of loans.

Exceptional receipts and payments are irregular transactions.

Example of exceptional capital receipt is a receipt from sale of
shares. Examples of exceptional capital payment are payments to
compensate supplier for breach of contract.

A company that makes profit would usually distribute profit to its

shareholders (owners). This is known as dividends. Distributions of
profit to a sole trader or partners in a partnership are known as
drawings

Cash inflows can arise from:

a. Financing
Funds received from government in the form of grants, money
received from shareholders from issuance of shares, long term
loan from banks and other financial institution.

b. Other income
Excess space available can be rented out from which rental is
collected.

c. Sale of non-current assets no longer needed in the business.

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Cash outflows can be classified into the following:

a. Payments of accounts payables.

These are payments for goods or services for example raw
materials. Payments are usually made after purchase.
Purchases made are dependent on sales forecast.

b. Wages, taxes and other expenses.

These include all other normal costs of doing business that
require actual expenditures. Depreciation though included in
the Income Statement as an expense; is a non-cash flow item
and hence is excluded from Cash Budget.

c. Capital expenditures.
These are payments of cash for long term assets.

d. Long term financing.

This includes interest and principal repayments on long term
outstanding debt and dividend payments to shareholders.

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Topic Review (TLO E1b)

Learning Outcome (ACCA Study Guide Area E, Topic E1b):
Outline the various sources of cash receipts and payments (including regular/exceptional revenue/capital
receipts and payments,and drawings.

1. Which of the following is not an operating cash flow?

A. Collection of cash from receivables.
B. Payment of income tax.
C. Payment of cash for operating expenses.
D. Purchase of equipment for cash.

2. Which of the following is not an investing cash flow?

A. Purchase of marketable securities for $20,000 cash.
B. Sale of land for $281,000.
C. Sale of 4,000 shares of common stock for $15 each.
D. Purchase of equipment for $500 cash.

3. Which of the following is not a financing activity?

A. Issuance of bonds payable.
B. Sale of investment.
C. Purchase of treasury stock.
D. Issuance of common stock.

Answers:
1. D
2. C
3. B

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17c. The Relationship Between Cash Flow Accounting and Accruals Accounting
Learning Outcome (ACCA Study Guide Area E, Topic E1c):
Describe the relationship between cash flow accounting and accruals accounting.

Cash accounting and accruals accounting

Accounting profit shown in Profit or Loss Account is different from
the net cash flow reflected in the Cash Budget.

Profit or Loss Account is prepared according to accruals concept

which tries to ensure income and expenditures are matched. Cash
budget is prepared on a cash basis, with receipts as cash inflows and
payments reflected as cash outflows.

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Topic Review (TLO E1c)

Learning Outcome (ACCA Study Guide Area E, Topic E1c):
Describe the relationship between cash flow accounting and accruals accounting.

1. According to accrual concept of accounting, financial or business transaction is recorded:

A. When cash is received or paid.
B. When transaction occurs.
C. When profit is computed.
D. When balance sheet is prepared.

2. What is the objective of the accruals basis of accounting?

A. To match cash inflows with cash outflows.
B. To match expenses with revenue earned.
C. To match expenses with cash received in the period.
D. To provide financial information to help investors determine the current cash flows.

Answers:
1. B
2. B

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17d. The Cash Flow Pattern of Different Types of Organisations

Learning Outcome (ACCA Study Guide Area E, Topic E1d):
Distinguish between the cash flow pattern of different types of organisations.

Working capital cycle

Net working capital is made up of current assets less current
liabilities.
Receivables + Inventory + Cash – Payables

The calculation of cash cycle focuses on the length of time between

a business paying out cash for inputs and receiving cash for goods
sold. It could also be referred to as the working capital cycle. The
cycle is normally measured by days.

For example, a company called Wines Ltd buys raw materials on 2.5
months‟ credit, holds them in store for 1 month and then issues
them to the production department. The production cycle takes 2
months. Finished goods are sold within a couple of days of
production being completed and customers take an average 1.5
months to pay.

The cash cycle/ working capital cycle can be diagrammatically

illustrated as follows:

0 2.5 3 4.5
Goods Suppliers Goods sold Cash received
Purchased paid to customers from customers

Working capital cycle = 2 months

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The four methods of reducing the working capital cycle are as

follows:

a. Reducing the stock-holding period for both finished goods and

raw material.

b. Reducing the production period, by either using alternative

machinery or alternative working methods.

c. Reducing the credit period extended to debtors, and tightening

up on cash collection methods.

d. Extending the period of credit taken from suppliers, considering

the advantages and disadvantages of taking early settlement
discounts.

The duration of the length of the cycle (and therefore the amount
invested in working capital) is affected by:

a. type of the industry; in retailing for instance the cycle is short

while in house- building it is much longer.

b. liquidity v profitability trade off (Refer introduction part).

c. efficiency of management of inventory, receivables and

payables.

The management of working capital is concerned with the liquidity

position of the company, so the main aim is to turn the cash around
as soon as possible whilst ensuring that profitability is thereby not
undermined.

The level of working capital directly affects the amount of growth

the business can sustain organically from its own internal resources.
Growth in sales volume means additional inventories and
receivables. Even if no further capital expenditure is required to
achieve growth, the underlying working capital invested in a
business will still need to increase.

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Types of working capital

Different types of business have different working capital
requirements.

a. A large national supermarket chain.

 High investment in inventory (food and non- food items
such as clothing and electrical goods) in shops and
warehouses. Low investment in receivables (as most sales
are in cash).

 Ability to take long credit terms from suppliers. Cash

operating cycle may be negative ie. cash comes in before it
is paid out to suppliers.

 Cash operating cycle is relatively stable as there is not that

much seasonal activity. Non-food may have longer cycle
where items spend much longer in inventory (turnover is
less frequent) i.e. overall cycle may be made up of distinct
elements.

b. A civil engineering firm with many large projects

 Relatively low investment in raw material inventory as each
job is unique and supplies may be bought when needed.

 Long work in progress and receivables days. Progress

payments are used to offset outflows but there may be
money held back by the customer until the job is deemed
satisfactory.

c. Manufacturer of toys
 Due to seasonal nature of the business, working capital
requirements will fluctuate significantly during the year.

 Receivables will increase as customers (retailers) stock up

for Christmas but will be much lower earlier in the year.

 The manufacturer is likely to spread its production process

over the year to smooth production, with inventory building
in the run up to the peak period.

 Cash flow is likely to be disjointed- outflows whilst inventory

is built up with majority of inflows concentrated in a later
period of the year. Cash operating cycle therefore likely to
vary significantly depending on the time of the year.

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Topic Review (TLO E1d)

Learning Outcome (ACCA Study Guide Area E, Topic E1d):
Distinguish between the cash flow pattern of different types of organisations.

1. The amount of working capital is most likely to increase when

A. Work-in-progress falls.
B. Selling prices increase.
C. The credit period allowed to customers is reduced.
D. The credit period taken from suppliers is increased.

Answers:
1. B

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17e. Cash Flow Management, and Impact on Liquidity and Company Survival
Learning Outcome (ACCA Study Guide Area E, Topic E1e):
Explain the importance of cash flow management and its impact on liquidity and company survival. (note:
calculation of ratios is not required.

Cash flow, liquidity and company survival

Liquidity
Liquidity is ability of the business to convert its assets into cash
without a significant loss in value. Liquidity is obviously of crucial
importance to the financial stability of a business. The
mismanagement of a firm’s liquidity position may result in it being
unable to pay its debts which, in turn, may result in corporate
bankruptcy. A business’s liquidity determines its ability to survive.
This can be illustrated as follows:

a. Cash
A business requires a particular level of cash (or overdraft
facility) in order to pay debts when they fall due, and
particularly to take advantage of any generous discounts
offered for prompt payment. However, a better return could be
earned by investing any cash surplus in a high yielding
investment. By ensuring that it has sufficient liquid assets
(cash), therefore, a business is reducing its chance of owning
more profitable assets.

b. Receivables
A business could decide that it does not want to offer credit to
customers because the delay of payment jeopardizes its
liquidity position. If it tried to adopt this policy however,
customers would be driven away, revenue would fall and
profits would fall.

c. Inventory
In order to satisfy customer demand, manufacturing and
retailing firms need to maintain finished goods inventory, to
keep production runs moving without disruption, raw materials
inventory also need to be maintained. This means that a
business will have money tied up in inventories that, again, it
might feel it could use more profitably elsewhere. However, if
inventories were not available when required, a potential sale
might be lost. The cost of a broken production facility may be
higher than the cost of holding inventory.

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d. Payables
To improve its cash position a business might decide not to pay
suppliers until after two or three months, rather than after the
normal one month. Apart from the obvious cost of lost discount
opportunities, the business runs the risk of alienating its
suppliers and even losing sources of supply.

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Topic Review (TLO E1e)

Learning Outcome (ACCA Study Guide Area E, Topic E1e):
Explain the importance of cash flow management and its impact on liquidity and company survival. (note:
calculation of ratios is not required).

1. In order to improve operational cash flows, indicate whether a business needs to increase or
decrease each of the following.

Receivables
A. Increase
B. Decrease

Inventory
C. Increase
D. Decrease

The credit period from trade suppliers

E. Increase
F. Decrease

2. Trant plc has a two-stage trading process:

Stage 1: buy a large quantity of goods on credit

Stage 2: immediately sell them on credit at a profit

Which of the following will increase after Stage 1?

A. Receivables and inventory.
B. Current assets and non-current assets.
C. Payables and cash.
D. Current assets and current liabilities.

Answers:
1. B, D, E
2. D

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17f. Treasury Functions

Learning Outcome (ACCA Study Guide Area E, Topic E2a):

Outline the basic treasury functions.

Treasury management
Association of Corporate Treasurers defines treasury management
as the corporate handling of all financial matters, the generation of
external and internal funds for business, the management of
currencies and cash flows, and the complex strategies, policies and
procedures of corporate finance.

Treasury management is concerned with managing the funds of a

business, namely cash and other working capital items plus long-
term investments, short-term and long-term debt and equity
finance.

Treasury management involves managing cash surpluses and deficits

by making short-term investments, and also managing working capital
from day to day so as to optimise cash flow, including inventory,
receivables (credit control) and payables management. Credit control
in many businesses is managed jointly by the treasury management
and recording transactions (receivables ledger) departments, via a
separate credit control department. Management accounting will
attend to capital investment appraisal.

Treasurer roles
According to Association of Corporate Treasurers, the roles of a
treasurer include:

a. Corporate financial objectives- financial aims and strategies,

financial and treasury policies and systems.
b. Liquidity management – working capital and money
transmission management, bank relationships and
arrangements and money management. Good treasury
management ensures that liquid funds are available when
needed and surplus funds are invested to generate returns.
c. Funding management – funding policies and procedures,
sources of funds and types of funds.
d. Currency management – exposure policies and procedures,
futures and options for exchange dealing
e. Corporate finance – raising finance for example, share capital
either ordinary or preference, dividend policy, mergers and
acquisitions.
f. Risk management- swaps and options.

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Topic Review (TLO E2a)

Learning Outcome (ACCA Study Guide Area E, Topic E2a):
Outline the basic treasury functions.

1. Maureen is employed in the finance function of Gralam plc. Her duties involve ensuring that the
company always has sufficient funds available to meet both its short-term and long-term financial
requirements. It is clear, therefore, that Maureen is employed by Gralam plc in its:
A. Financial reporting section
B. Management accounting section
C. Treasury management section
D. Transaction processing section

2. Identify whether the following tasks are normally undertaken by the treasury department of a large
business.

Credit control
A. Yes
B. No

Short-term investment
C. Yes
D. No

Capital investment appraisal

E. Yes
F. No

Answers:
1. C
2. A, C, F

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17g. Cash Handling Procedures

Learning Outcome (ACCA Study Guide Area E, Topic E2b):
Describe cash handling procedures.

Describe cash handling procedures

Cash is one of the riskiest assets in an organisation. Cash, credit card
receipts, debit card receipts and cheques needs to be safeguarded.
The following are examples of cash handling procedures: -

a. Procedures and Policies on Uses of Cash – The policy manual

should illustrate the procedures to authorise payments, purchase
of non-current assets and investing of surplus funds. The
procedures should also state the detailed responsibility of the
person tasked to carry out their relevant tasks, such as
authorising the payment.

b. Segregation of duties – Example of tasks to be segregated are

collecting cash, recording cash and preparing reconciliations.

c. Physical security – Cash not banked should be kept in a safe

which should regularly change its combinations and usage of
guards in accompanying personnel to banks to deposit large
amounts of cash.

d. Reconciliations – A reconciliation should be prepared to ensure

amounts recorded in the ledger could be reconciled to the bank
statement. Any unexplained discrepancies should be
investigated.

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Topic Review (TLO E2b)

Learning Outcome (ACCA Study Guide Area E, Topic E2b):
Describe cash handling procedure.

1. When come to cash handling, accuracy is more important than speed.

A. True
B. False

2. What is the most common reason the cash account is out of balance?
A. The recording job is too hard.
B. Computer failure.
C. Customers do not complete their forms correctly.
D. The bookkeeper is lack of concentration.

Answers:
1. A
2. D

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17h. The Management of Cash Balances in Public Sector Organisations

Learning Outcome (ACCA Study Guide Area E, Topic E2c):
Outline guidelines and legislation in relation to the management of cash balances in public sector
organisations.

Cash balances in public sector organisations

Section 43 of the Local Government and Housing Act 1989 a local

authority may borrow money for any purpose relevant to their
functions under any enactment.

Section 111 of the Local Government Act 1972 states that the local
authorities have the power to lend their excess funds to facilitate
discharge of their functions.

The Local Government Act 2003 has a new prudential framework

that regulates the capital financing and treasury management
arrangements of local authorities. The purpose is to encourage
authorities to place their funds in forms of deposits that are
relatively safe and could be assessed quickly.

These sections can be found in http://legislation.gov.uk

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Topic Review (TLO E2c)

Learning Outcome (ACCA Study Guide Area E, Topic E2c):
Outline guidelines and legislation in relation to the management of cash balances in public sector
organisations.

1. Which of the following is a local authority that may borrow money for any purpose relevant to their
function under any enactment?
A. Section 43
B. Section 34
C. Section 111
D. Section 110

Answer:
1. A

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17i. Trends in the Economic and Financial Environment

Learning Outcome (ACCA Study Guide Area E, Topic E2d):
Describe how trends in the economic and financial environment can affect management of cash balances.

Economy and cash management

In times of an economic boom, customers would spend a lot on
purchasing goods. This would increase the cash balances of
companies and companies would use the money to invest in surplus
funds.

In times of an economic recession, customers would save their

money. This would result in less spending and cash balances would
be low. This may lead to severe impact to the company’s survival.

When interest rates rise, it would be costlier to borrow money and

thus company may not borrow money. When interest rates fall, it
would be less costly to borrow money and thus company may
borrow money for their respective needs.

A strong domestic currency may lead consumers to buy from

overseas consumers and this will lower the cash balance of the
domestic companies. In contrast, a weak currency may lead
consumers to buy from domestic companies and this will increase
the cash balance of the domestic companies.

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Topic Review (TLO E2d)

Learning Outcome (ACCA Study Guide Area E, Topic E2d):
Describe how trends in the economic and financial environment can affect management of cash balances.

1. When the interest rates rise, it would be cheaper for the company to borrow money and thus the
company may borrow more money.
A. True
B. False

Answer:
1. B

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Chapter 17 Summary

1. Cash flows determine the liquidity level of a business and can be classified into:
a. Revenue receipts and payments
b. Capital receipts and payments
c. Exceptional receipts and payments

2. Calculation of the working capital cycle allows businesses to manage the liquidity position of the
company as it focus on the length of time between paying cash for input and receiving cash for goods
sold.

3. Treasury management is also involved in managing cash surplus and deficits.

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CHAPTER 18: CASH BUDGETS AND FORCEASTING

Learning Outcomes

At the end of the chapter, you should be able to:

TLO E4a. Explain the objectives of cash budgeting.

TLO E4b. Explain and illustrate statistical techniques used in cash forecasting including moving averages
and allowance for inflation.

TLO E4c. Prepare a cash budget/forecast.

TLO E4d. Explain and illustrate how a cash budget can be used as a mechanism for monitoring and
control.

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18a. Surplus Cash and Cash Deficit

Learning Outcome (ACCA Study Guide Area E, Topic E4a):
Explain how surplus cash and cash deficit may arise.

Surplus funds
Surplus funds mean excess funds held by the business. They are not
needed to finance business operations. Cash surplus may arise due
to excess cash from trading, lower costs to cost savings measures,
efficient working capital management, sales of non-current assets
and seasonal factors such as extra sales during festive seasons.

Cash deficit may arise due to less cash from operations, inefficiencies
and poor working capital management.

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Topic Review (TLO E4a)

Learning Outcome (ACCA Study Guide Area E, Topic E4a):
Explain the differences between a group and a team.

1. Cash surplus may arise due to:

i. Sale of non-current asset
ii. Efficiencies in working capital management
iii. Increase in cost of sales

A. i only
B. ii only
C. i and ii
D. All of the above

Answer:
1. C

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18b. Short Term Investments

Learning Outcome (ACCA Study Guide Area E, Topic E4b):
Explain the following types of short term investments and the associated risks/returns:

i. bank deposits
ii. money- market deposits
iii. certificates of deposit
iv. government stock
v. local authority stock

Investment of surplus funds

Excess funds could be invested in the following types of short term
investments: -

a) Certificates of deposit
Certificates of deposit (CD) are negotiable instruments in bearer
form. Title belongs to the holder and can be transferred by
delivering the CD to the buyer.

Bank and building societies issue CDs. The amount of the deposit
and the date of repayment will be stated on the certificate. The
deposit amount will usually be at least $100,000 and the
repayment date will be anything from one week to five years.

Repayment is obtained by presenting the CD to the issuer on the

designated date. Since CDs are negotiable, the holder can sell
them at any time. This makes them far more liquid than a money-
market time deposit with the same bank.

CDs usually offer an attractive rate of interest and a low credit

risk. They are useful for investing funds in the short term (liquid)
since they can be sold at any time on the secondary market.

If a high level of liquidity is not required, however, an investor

may prefer to place money on a time deposit which, being less
liquid, will probably pay a higher level of interest.

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b) Gilt edged securities

These are marketable British Government securities. The
government issues them to finance its spending, but also uses
them to control the money supply. Most gilts have a face value
of $100 at which the government promises to buy the gilt back
on a specific date in the future.

Gilts usually have fixed interest rates, although there are also
various index-linked gilts. Where they are the index-linked type,
both the interest and the redemption value are linked to
inflation, ensuring that a decent real return is gained.

Gilts may be 'Shorts' (repaid in less than five years), 'Mediums'

(repaid in five to 15 years), or 'Longs' (repaid in more than 15
years). Some of the older gilts, such as 3.5% War Loans, are
irredeemable.

If a company buys a gilt and holds it until it is repaid by the

government, the return received will be fixed from the outset. As
the government will not default on the debt and the interest to
be earned is known in advance, this makes it a low-risk
investment.

Gilts are also traded on the stock market. Their price can go up
or down, depending on what people think will happen to interest
rates. When interest rates are expected to fall, the price of the
gilt rises, and when interest rates are expected to rise, the gilt
price falls. Using gilts in this way makes them a riskier
investment, but still relatively safe when compared with buying
shares on the stock exchange.

Gilts are transferable on the secondary market in multiples of a

penny, but if they are bought from new, the minimum
investment is $1,000. There is no maximum investment limit.
They are easy to transfer and nowadays the title can even be
passed electronically.

Gilts are a good choice of investment for risk-averse investors.

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c) Money Market Securities

The market for short term marketable securities is called the
money market. The maturity of short term financial assets that
trade in the money market is one year or less and hence, it is
highly marketable. The money market deposit invests in stocks
and bonds. Investments in money market have high liquidity as
funds could be withdrawn within a few days. Investment in
money market deposits requires a minimum amount of
investment, which is usually $50,000. However, the returns from
money market are low as inflation can reduce the returns.

d) Other investments
i. High street bank deposits
All of the high street banks offer different types of interest-
earning accounts into which an investor could transfer some
of its surplus funds.

ii. Sight deposits and time deposits

There are two types of deposits - 'sight deposits', which give
instant access to cash, and 'time deposits', which require
notice to be given before cash can be withdrawn. Time
deposits will always offer higher interest rates because of
the restriction it places on the customer.

iii. High interest accounts

When investors have a large amount of money to invest,
they can place the money in a high interest account. These
usually give instant access to funds.

iv. Option deposits

Banks also offer 'option deposits' to customers. Option
deposits are arrangements for set periods of

investment, ranging from two years to seven years. Interest

rates are generally linked to base rates, giving a guaranteed
return in real terms. Restricted access to funds is the price
paid for higher guaranteed interest rates. As an investor,
cash position must be assured for the next two years before
considering investing in an option deposit account.

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e) Local Authority Stock

The local authority stock is issued by the local government
authorities with a period of maturity of within 2 days to 15 years.
The stock pays a fixed rate of interest. However, it is much riskier
gilts, which could be why they have higher returns compared to
gilt

Risks of investments
Investments which have low risk to high risk are government stock,
local stock, convertible loan stocks, preference shares and ordinary
shares.

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Topic Review (TLO E4b)

Learning Outcome (ACCA Study Guide Area E, Topic E4b):
Explain the following types of short term investments and the associated risks/returns:

i. bank deposits
ii. money- market deposits
iii. certificates of deposit
iv. government stock
v. local authority stock

1. Which of the following statements about the gilt edged securities are correct?

i. The risk is higher than local authority stocks.

ii. The risk is lower than ordinary shares.
iii. Most have a face value of $100.
iv. Most have fixed interest.

A. i and iii
B. ii and iii
C. i, ii and iii
D. ii, iii and iv

2. A 6% treasury stock is currently valued at $90 and is redeemable in one year’s time. What is the
redemption yield?
A. 18%
B. 15%
C. 10%
D. 6%

Answers:
1. D
2. A

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18c. Ways of Raising Finance

Learning Outcome (ACCA Study Guide Area E, Topic E4c):
Explain different ways of raising finance from a bank and the basic terms and conditions associated with
each financing.

Types of Bank Loans

 Short term loans are usually paid back one year or less. Purpose
is for financing purchases, working capital management,
purchase of non-current assets, and so on.

 Intermediate loans are usually paid back within one to five years.
It is used to purchase non-current assets such as equipment.

 Long term loans are usually paid back within 5 to 7 years and may
extend to 40 years. It is used to purchase non-current assets such
as buildings.

 Unsecured loans are loans that the borrower does not need to
put in security.

 Secured loans are loans that the borrower requires security such
as the business’s assets.

 Bullet Loans are loans where the whole amount of principal is

paid at the end of the period.

 Balloon Loans are loans where most the loan principal are repaid
at the end of the period.

 Amortised loans are loan principals which are repaid regularly.

Regular payments consist of interest and some principal
payment. Loan interest can be fixed throughout the loan or
variable.

 Overdrafts are flexible short term borrowing for customers. It is

repayable on demand and covers short term deficit. The banks
have a right not to renew the overdraft facility. Interest is only
paid when the account is overdrawn.

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Covenants
The loan should specify the terms of agreement, tenure of loan,
interest rate payable and the frequency of interest payments.

Loan covenants (restrictions) are imposed by the bank to the

borrower.

 Positive covenant – borrowers must submit management

accounts every six months
 Negative covenant – borrowers not allowed to pay dividend
 Quantitative covenant – borrowers not allowed to take extra
loans above their share capital amounts

Lending criteria of a bank

A bank’s decision whether or not to lend will be based on several
factors as follows: -

a. Character of the borrower

b. Ability to borrow and repay
c. Margin of profit
d. Purpose of the borrowing
e. Amount of the borrowing
f. Repayment terms
g. Insurance against the possibility of non-payment

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Topic Review (TLO E4c)

Learning Outcome (ACCA Study Guide Area E, Topic E4c):
Explain different ways of raising finance from a bank and the basic terms and conditions associated with
each financing.

1. An organisation has an overdraft limit of $100,000 at an interest rate of 8% per annum. To-date,
$15,000 has been overdrawn. How much is the interest payable?
A. $1,200
B. $2,500
C. $5,000
D. $8,000

Answers:
1. A

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Chapter 18 Summary

1. Cash surplus can be managed through different investments based on investors risk appetites and
investment needs such as:
a. Certificates of deposit
b. Gilt edged securities
c. Money market securities
d. Local authority stocks

2. Different bank loans can also be taken when a business face cash deficit.

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Learning Outcomes

At the end of the chapter, you should be able to:

TLO E3a. Explain the objectives of cash budgeting.

TLO E3b. Explain and illustrate statistical techniques used in cash forecasting including moving
averages and allowance for inflation.

TLO E3c. Prepare a cash budget/forecast.

TLO E3d. Explain and illustrate how a cash budget can be used as a mechanism for monitoring and
control.

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19a. The Objectives of Cash Budgeting

Learning Outcome (ACCA Study Guide Area E, Topic E3a):
Explain the objectives of cash budgeting.

Cash Budgeting
A cash budget is used to plan and anticipate future cash surplus and
shortages. If there are future cash surpluses, the management can
plan ahead to invest the funds. If there are future cash shortages,
the management can plan ahead by implementing strategies to
improve sales or borrow funds. Through preparation of cash budget,
actual cash flows can be compared with budgeted cash flows.

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Topic Review (TLO E3a)

Learning Outcome (ACCA Study Guide Area E, Topic E3a):
Explain the objectives of cash budgeting.

1. A company’s cash budget for next year shows a cash deficit for the months of April and May. For the
remaining months there will be a cash surplus.

Which TWO of the following management actions would be most appropriate in response to the
expected cash position in April and May?
A. Increase inventories of raw materials.
B. Arrange a bank overdraft.
C. Delay the payment of suppliers as much as possible.
D. Issue additional share capital.

2. Which of the following is not a functional budget?

A. Production budget.
B. Distribution cost budget.
C. Selling cost budget.
D. Cash budget.

Answers:
1. B and C
2. D

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19b. The Statistical Techniques Used in Cash Forecasting

Learning Outcome (ACCA Study Guide Area E, Topic E3b):
Explain and illustrate statistical techniques used in cash forecasting including moving averages and
allowance for inflation.

Introduction of time series analysis

A time series analysis is a series of figures or values recorded at
regular intervals over a long period of time. Examples of time series:

i. Daily output of a factory for a month

ii. Monthly sales for the last three years
iii. The Retail Price Index for the last three years

A graph of a time series is called a histogram. An example of a

histogram of yearly sales of a company for six years is in the
following figure:

Time series equation

The constituent parts of a time series will include: -

Trend

This is caused by factors that slowly changes. A trend will be of great

significance to management who will want to know whether the
business's results are on an improving or worsening trend. The main
problem is to isolate a trend from the other factors, thereby causing
variations in results.

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Cyclical variations or fluctuations

This is due to the influence of booms and slumps in industry. The
distance in time from one peak to another will often be 5 – 7
years.

Cyclical variations are medium-termed changes in results caused

by circumstances which repeat in cycles. Economic cycles may last
a few years, and thus cyclical variations are longer-term than
seasonal variations.

Seasonal variations or fluctuations

This is a regular rise and fall over specified intervals of time. These
variations are of a periodic type with a fairly definite period.

Seasonal variations are short-term fluctuations in recorded values

which affect results at different times of the year, on different
days of the week, or at different times of a day, due to different
circumstances.

Random or residual variations or fluctuations

This covers any other variations which cannot be ascribed to the
above factors. These happen entirely at random due to
unpredictable causes.

The main problem in time series analysis is how to identify the

trend, seasonal variations, cyclical variations and random or
residual one-off variations in a set of results over a period of time.

A time series could incorporate all four components, and as such,

Y=T+S+C+R

where,
Y = the actual time series
T = the trend
C = the cyclical component
S = the seasonal component
R = the random component.

However, in examination questions, it is unlikely that the cyclical

and random components will be required. As such, the
mathematical model used, called the additive model will exclude
any reference to C and therefore,

Y=T+S

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An alternative to the additive model is the proportional model

which is also known as the multiplicative model. Using this
approach, a time series is expressed as

Y= T x S

The trend will be the same, but the values of the seasonal and
random components will now be different. The proportional model
is better than the additive model because when the trend is
increasing or decreasing over time, the seasonal variation is likely
to be increasing or decreasing as well.

To distinguish trend from seasonal variations, moving averages

may be used. A moving average is an average of the results of a
fixed number of periods. Since it is an average of several time
periods, it is related to the mid-point of the overall period.
(Example: Refer Model Question 16.1). If moving average were
taken of the results in even number of time periods, the basic
technique would be the same, but the mid-point of the overall
period would not relate to a single period.

However, moving averages has its weakness that is when there is

a steeply rising or steeply declining trend, the moving averages
trend will either get ahead of or fall behind the real trend.

Problems in Forecasting
All forecasts are subject to errors, but the type and severity of
errors will depend upon a number of factors.
a) The further into the future, the more unpredictable will be the
costs, and therefore the reliability of the forecast will depend
upon the budget period.

b) The more data are available and used, the more reliable is the
forecast.

c) The pattern of trend and seasonal variations may not continue in

the future.

Random variations mayupset the pattern of trend and seasonal

variation.

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EXAMPLE

Year Sales Units

2000 390
2001 380
2002 460
2003 450
2004 470
2005 440
2006 500

Take a moving average of the annual sales over a period of three years.

ANSWER

Year Sales Moving total of 3 Moving average of 3

years’ sales year’s sales (†3)
2000 390
2001 380 1,230 410
2002 460 1,290 430
2003 450 1,380 460
2004 470 1,360 453
2005 440 1,410 470
2006 500

Calculation:
Average sales in the three-year period 2000 – 2002 = (390+380+460)/3 = 410

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Index Numbers

Index numbers standardise the way of comparing the values such as prices, wages and volume of output,
over time. In economics, these indices summarise movements of a group of related variables. Indices
are economic data that reflect price or quantity when compared with a base value (equals 100). The
index number is usually expressed as 100 times the ratio to the base value. For example, if an item costs
twice as much in 2008 as it did in 1998, its index number would be 200 relatives to 1998.

Index numbers are commonly used in business, government and commerce. For example:

i. The Retail Prices Index (RPI) as a measure of inflation by measuring changes in retail prices
paid by consumers
ii. The Financial Times All Share Index
iii. Department for Work and Pensions (DWP)

Indices are constructed to highlight the associated issues related to business activity, the cost of living,
country’s purchasing power parity and employment.

Price and Quantity Indices

When only one item is under consideration, a single item index can be calculated using:

i) Pn
Price index = x 100
Po

ii) Qn
Quantity index = x 100
Qo

Where:
Pn is the price of the period under consideration
Po is the price of the base period
Qn is the quantity of the period under consideration
Qo is the quantity of the base period

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EXAMPLE

The following table shows the changes in price and sales volume of a product over the years:

Year $ per unit Sales Volume

20X3 2.39 12,000
20X4 2.60 11,700
20X5 2.75 12,890

Calculate both the price and quantity indices for year 20X4 and 20X5 using year 20X3 as a base year.

ANSWER

Price Index
Year $ per unit Price index
20X3 2.39 100
20X4 2.60 109 [2.60/2.39 x 100]
20X5 2.75 115 [2.75/2.39 x 100]

Quantity Index
Year Sales Volume Quantity
index
20X3 12,000 100
20X4 11,700 98 [11,700/12,000 x 100]
20X5 12,890 107 [12,890/12,000 x 100]

There are two ways in which index relatives can be determined:

A. Fixed base method

A base year is first selected (index 100) and subsequently being measured against by all ensuing
changes. It must be noted that, the basis nature of the commodity should remain unchanged over
time if this method is to be used.

B. Chain base method

It calculates changes with respect to the value of the commodity in the period immediately before
the change was made. This approach caters for any set of commodity values, but if the basic nature
of the commodity is changing over time, it must be used.

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EXAMPLE
The following table shows the change in price over the years of a product:

Year $ per unit

20X3 4.15
20X4 4.52
20X5 4.89
20X6 5.01

Construct both a fixed base index and a chain base index for the years 20X3 to 20X6 using 20X3 as the
base year.

ANSWER

Fixed base method:

Year $ per unit Index Workings
20X3 4.15 100 [Base year]
20X4 4.52 109 [4.52/4.15 x 100]
20X5 4.89 118 [4.89/4.15 x 100]
20X6 5.01 121 [5.01/4.15 x 100]

Chain base method:

Year $ per unit Index Workings
20X3 4.15 100 [Base year]
20X4 4.52 109 [4.52/4.15 x 100]
20X5 4.89 108 [4.89/4.52 x 100]
20X6 5.01 102 [5.01/4.89 x 100]

Comments:
The chain base relatives show the rate of price changes in a yearly basis, whereas the fixed base
relatives show prices changes relative to the base year.

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Composite Index Numbers

Most practical indices cover more than one item (a basket of goods or services) and are hence termed
composite index numbers. The RPI, for example, measures components such as consumer goods and
services purchased by households. An index of housing costs might consider components such as finance
payments, repair costs, insurance and so on.

Simple aggregate price index

The price index for a basket of items can be calculated using:

Σ Pn
Simple aggregate price index = x 100
Σ Po

EXAMPLE

Calculate the cost of living index based on the following:

Product 20X3 20X4

[Base year]
A $3.20 per box $3.65 per box
B $1.20 per litre $1.40 per litre
C $2.65 per roll $2.95 per roll
Σ Po $7.05 Σ Pn $8.00

ANSWER

Year Σ Pn / Σ Po Simple Aggregate Price

Index
20X3 7.05 / 7.05 x 100 100
20X4 8.00 / 7.05 x 100 113

The major drawback of this approach is that it ignores the amounts of Product A, B and C which were
consumed during these years. A better approach to measure the value of a basket of items is by including
a weighting factor.

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Weighted aggregate indices

This method of weighting involves multiplying each component value by its corresponding weight and
adding these products to form an aggregate. This is done for both the base period and the period in
question. The aggregate for the period under consideration is then divided by the base period aggregate.

Formulae:
Weighted aggregate price index = Σ PnQo x 100
Σ PoQo

Weighted aggregate quantity index = Σ PoQn x 100

Σ PoQo

Note:
Price indices are weighted by quantities, likewise quantity indices are weighted prices.

EXAMPLE

Calculate the cost of living index based on the following:

Product 20X3 [Base year] 20X4

Po Qo Pn Qn
A $3.20 per box 20 $3.65 per box 27
B $1.20 per litre 65 $1.40 per litre 74
C $2.65 per roll 72 $2.95 per roll 83

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ANSWER

Weighted aggregate price index:

Product 20X3 20X4

Po Qo PoQo Pn PnQo
A $3.20 per box 20 64 $3.65 per box 73
B $1.20 per litre 65 78 $1.40 per litre 91
C $2.65 per roll 72 190.8 $2.95 per roll 212.4
Σ 332.8 Σ 376.4

376.4
Index in 20X4 = x 100 = 113
332.8

Weighted aggregate quantity index:

Product 20X3 20X4

Po Qo PoQo Qn PoQn
A $3.20 per box 20 64 27 86.4
B $1.20 per litre 65 78 74 88.8
C $2.65 per roll 72 190.8 83 219.95
Σ 332.8 Σ 395.15

395.15
Index in 20X4 = x 100 = 119
332.8

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Topic Review (TLO E3b)

Learning Outcome (ACCA Study Guide Area E, Topic E3b):
Explain and illustrate statistical techniques used in cash forecasting including moving averages and
allowance for inflation.

1. A time series is defined as:

A. A set of values for some variable which varies with time.
B. A trend which varies with time.
C. Figures which are fixed over a period of time.
D. A set of values which do not change over time.

2. Which of the following is not a component of a time series?

A. Cyclical movement.
B. Seasonal movements.
C. Random movements.
D. Actual movements.

3. The general direction in which the graph of a time series appears to be moving over a long period of
time is termed?
A. Basic trend.
B. Actual trend.
C. Seasonal trend.
D. Upward trend.

Answers:
1. A
2. D
3. A

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19c. The Cash Budget

Learning Outcome (ACCA Study Guide Area E, Topic E3c):
Prepare a cash budget/forecast.

The Process
Process of preparing a cash budget: -

a) Identify and calculate cash receipts from customers;

b) Identify and calculate other income;
c) Identify and calculate cash payments to suppliers;
d) Identify and calculate other cash payments.

Format of a cash budget: -

Receipts X
Less: Payments (X)
Net cash flow in month X or (X)
Opening cash balance b/f X or (X)
Closing cash balance c/f X or (X)

Sample Cash Budget Question (CAT Managing Finance – June 2011

question)
M Co is a company which mixes paints. The company buys in white
paint and colour pigments. The colour pigments are added to the
white paint and mixed in order to produce a paint that is coloured
to customer specification.

Sales
Sales of the mixed paint are made to two types of customer,
companies and individuals. Individuals pay cash at the time of sale.
The credit terms given to the companies are payment in the month
following sale, however, M Co has poor control over the
management of receivables and the recent payment history has
been:

50% in the month following sale

45% two months after sale
5% bad debts

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The popularity of the product has risen and there is now a three
month wait for orders to be produced, so sales for April to June can
be predicted with certainty:

February March April May June

Actual Actual Forecast Forecast Forecast

Sales Sales Sales Sales Sales

Sales orders 44 45 58 34 53
from
companies
$‟000
Sales orders 10 15 14 10 13
from
individuals
$‟000

Production Costs
Production costs are 90% of the sales revenue. No finished good
or raw material inventory is held. 60% of the production costs
relate to materials and 80% of the material cost is the cost of
pigments. The remaining 20% of the material cost is the cost of
the white paint.

The supplier of the pigments is paid in the month of purchase. This

supplier offers a 10% bulk discount for any order totalling $24,000
or more. The discount applies to the whole order.

It is M Co’s policy to take the discount if possible, but not to

increase order sizes above that which is required to meet the
production needs of the company.

The supplier of the white paint is paid one month in arrears. No

bulk purchase discounts are available from this supplier.

The remaining 40% of the production cost is labour and

overheads, which is paid in the month incurred.

Non-production overheads

Rent and rates for the factory are estimated to be $12,000 per
annum, paid quarterly in advance. The last payment was made in
January. Depreciation is estimated at $1,000 per month.

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Other information
On the first of April, M Co’s bank account is expected to be $5,000
overdrawn. The overdraft limit agreed with the bank is $12,000.

Required: -
(a) Prepare a cash budget for the three months ended June for M
Co (work to the nearest $’000). (15 marks)

April May June

$ 000‟s $ 000‟s $ 000‟s

Receipts

From companies 43 49 43

From individuals 14 10 13

Total receipts 57 59 56

Payments

Material pigments 28 19 25

White paint 6 8 5

Labour and production overheads 26 16 24

Rent and rates (12/4) 3

Total payments 63 43 54

Net cash flow (6) 16 2

Opening balance b/fwd (5) (11) 5

Closing balance c/fwd (11) 5 7

Workings
February March April May June

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$ 000‟s $ 000‟s $ 000‟s $ 000‟s $ 000‟s

Receipt from debtors

Sales to national companies 44 45 58 34 53

50% in the month following sale 23 29 17

45% two months after sale 20 20 26

Total receipts from companies 43 49 43

March April May June

Payments $ 000‟s $ 000‟s $ 000‟s $ 000‟s

Total sales 60 72 44 66

Production cost 90% 54 65 40 59

Labour and overheads 40%

(Paid in the month incurred) 22 26 16 24

Materials 60% 32 39 24 35

Pigments 80% 26 31 19 28

Discount obtained? yes yes no yes

Cost after 10% discount (Paid in the month 23 28 19 25

incurred)

White paint 20% (Paid in one month in arrears) 6 8 5 7

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Topic Review (TLO E3c)

Learning Outcome (ACCA Study Guide Area E, Topic E3c):
Prepare a cash budget/forecast.

1. A Local Authority is preparing a cash budget for its refuse disposal department.

Which of the following items would NOT be included in the cash budget?
A. Capital cost of new collection vehicle
B. Depreciation of the refuse incinerator
C. Operatives’ wages
D. Fuel for the collection vehicles

2. A cash budget has been drawn up as follows:

Receipts June July August

Credit sales 10,000 11,000 12,500

Cash sales 5,000 4,500 6,000

Payments

Suppliers 6,500 4,200 7,800

Wages 2,300 2,300 3,000

Overheads 1,500 1,750 1,900

Opening Cash 500

The closing cash balance for August is budgeted to be:

A. $5,800
B. $12,450
C. $17,750
D. $18,250

Answers:
1. B
2. D

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19d. Mechanism for Monitoring and Control

Learning Outcome (ACCA Study Guide Area E, Topic E3d):
Explain and illustrate how a cash budget can be used as a mechanism for monitoring and control.

Actual cash flows must be monitored with budgeted cash flow at a

periodic time such as daily, weekly and monthly. This is to enable the
finance manager to make decisions regarding the investment of
surplus cash flows and to source for funds regarding cash deficit. If
actual receipts are below the budgeted receipts, the company should
devise ways to increase its sales.

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Topic Review (TLO E3d)

Learning Outcome (ACCA Study Guide Area E, Topic E3d):
Explain and illustrate how a cash budget can be used as a mechanism for monitoring and control.

1. A company’s cash budget highlights a short-term surplus in the near future.

Which TWO of the following actions would not be appropriate to make use of the surplus?
A. Increase inventories and receivables to improve customer service.
B. Buy back the company’s shares.
C. Increase payables by delaying payments to suppliers.
D. Invest in a short term deposit account.

2. Which TWO of the following actions would be appropriate if the cash budget identified a short
term cash deficit?
A. Issue shares.
B. Pay suppliers early.
C. Arrange an overdraft.
D. Implement better credit control procedures.

Answers:
1. B and C
2. C and D

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CHAPTER 19: CASH BUDGETS AND FORCEASTING Sunway TES

Chapter 19 Summary

1. Time series analysis and index numbers are cash forecasting techniques which may be used.

2. Cash budgets allow businesses to plan and anticipate future cash surplus and shortages to either
invest funds or implement strategies to improve sales or borrow funds.

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APPENDIX A SUMMARY OF FORMULAE Sunway TES

APPENDIX A SUMMARY OF FORMULAE

1. Costs
Production costs = Prime costs + Production overheads

which is the same as:

Production costs = Material costs + Labour costs + (Other) Expenses

Prime costs = Direct material costs + Direct labour costs + Direct expenses

Production overheads = Indirect material costs + Indirect labour costs

+ Indirect production expenses

High-Low Method

Step 1 Review past records of cost

 Select highest & lowest levels of activity

Step 2 Determine:

 Total cost at highest level of activity, HC*

 Total cost at lowest level of activity, LC*

 Highest level of activity, HU

 Lowest level of activity, LU

HC* – LC*
Step 3 VC per unit =
HU - LU

Step 4 FC = HC* – (HU × VC per unit) or FC = LC* – (LU × VC per unit)

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2. Variances
Formulae for Sales Variances

 Total sales revenue variance = Actual revenue ~ Original Budgeted revenue

 Sales Price Variance = Actual Sales ~ (Actual units sold x Budgeted selling price)

 Sales Volume Variance = (Actual units sold x Budgeted selling price) ~ Original budget

Flexed budget
Formulae for Cost Variances

 Total cost variance = Actual Cost ~ Original Budgeted cost

 Price Variance = Actual Cost ~ (Actual units produced x Budgeted unit cost)

 Volume Variance = (Actual units produced x Budgeted unit cost) ~ Original budget

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3. Materials
Free inventory = Inventory in hand + Ordered inventory – Scheduled inventory

For finished goods:

Opening inventory + Production volume = Sales volume + Closing inventory

For materials:

Opening inventory + Purchases = Issues + Closing inventory

Value of opening inventory + Value of purchases = Value of issues + Value of closing inventory

PWA stock valuation method

Value of all receipts/purchases + Value of opening inventory

Average issue price =
Total volume of purchases + Volume of opening inventory

Stock control

Reorder level = Maximum usage × Maximum lead time

In the absence of maximum values:

Reorder level = safety stock + (average usage × average lead time)

2cD
Economic order quantity (EOQ) = √
h

Minimum stock control level = Reorder level – (average usage × average lead time)

Maximum stock control level = Reorder level + reorder quantity

– (minimum usage × minimum lead time)

Ordered stock level

Average stock = + Safety stock
2

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4. Labour
Labour costs

Overtime premium = Overtime hours × (Overtime rate – Basic rate of pay)

Idle time pay = Idle time × Basic rate of pay

Basic pay = (Normal hours + Overtime hours) × Basic rate of pay

Normal pay = Usual or Normal working hours × Basic rate of pay

Direct labour cost = Basic pay of direct workers – Idle time pay of direct workers
+ Overtime premium (if necessary)
Indirect labour cost = Overtime premium of direct workers (if necessary)
+ Idle time pay of direct workers
+ Bonuses, allowances and incentives, if any
+ Gross wages of indirect workers
Gross wages = Direct labour cost + Indirect labour cost

= Basic pay of all workers + Overtime premium of all workers

+ Bonuses, allowances and incentives, if any
= Normal pay of all workers + Overtime pay of all workers
+ Bonuses, allowances and incentives, if any
Net wages = Gross wages – PAYE Tax – Employee’s NIC

Labour cost to employer = Gross wages + Employer’s NIC

Labour turnover

change in number of employees

Labour turnover rate = × 100%
average number of employees

# O/employees + # C/employees
Average employees in a period =
2

Labour efficiency ratios

Standard hour per unit of output × Actual output

1. Efficiency ratio = ( ) × 100%
Actual hour worked

Actual hour worked

2. Capacity ratio = × 100%
Budgeted hours

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Standard hour per unit of output × Actual output
3. Activity ratio = ( ) × 100%
Budgeted hours

Labour utilisation ratios

Idle hours
1. Idle time ratio = × 100%
Total hours

Number of hours/days absent (in a given period)

2. Absenteeism = × 100%
Total hours/days paid/worked (in a given period)

Number of days off work due to sickness (in a given period)

3. Sickness = × 100%
Total no. of days paid/worked (in a given period)

Overtime hours worked

4. Overtime = × 100%
Total hours worked

5. Expenses

Straight line method

Cost of purchase – Estimated disposal value

Depreciation using =
Economic useful life

Reducing balance method

First year’s depreciation = depreciation percentage × purchase cost

Subsequent years’ depreciation = depreciation percentage × NBV of the asset

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6. Overheads
OAR process:

Step 1: Allocation and apportionment

Step 2: Re-apportionment

Step 3: Calculate OAR

Overheads after re-apportionment

Overhead absorption rate (OAR) =
Total machine hours or labour hours

Absorbed overhead = Predetermined overhead absorption rate × Actual level of activity

(Budgeted OAR)

Over/(under) absorbed overheads

= Fixed production cost per unit × (Difference between Actual and Normal production Volumes)

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7. Profit reporting
Marginal costing

Variable cost of sales = Variable production costs of goods sold

+ Variable non-production costs of goods sold

Contribution = Sales revenue – ALL Variable costs

MC Profit statement:

$ $
Sales x
Less:Variable cost of sales
Opening stock x
Add: Production x
Less: Closing stock (x)
Other variable costs x
Total variable cost of sales (x)
Contribution x
Less: Fixed costs
Production x
Non-production x
Total fixed costs (x)
NET PROFIT xx

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Absorption costing

Costs of production = Variable costs of production + Fixed cost of production

Fixed production cost per unit = Fixed production cost ÷ Standard production volume

Over/(under) absorbed overheads

= Fixed production cost per unit × (Difference between Actual and Normal production Volumes)

AC Profit statement:

$ $
Sales x
Less:Cost of sales
Opening inventory x
Add: Production x
Less: Closing inventory (x)
Total cost of sales (x)
GROSS PROFIT x
Less: Underabsorbed overhead (x)
OR
Add: Overabsorbed overhead x
ADJUSTED GROSS PROFIT x
Less: Non-production costs
Fixed x
Variable x
Total non-production costs (x)
NET PROFIT xx

Profit reconciliation statement

Profit from marginal costing method X

Increase/(Decrease) in stock units × fixed production overhead absorption rate X/(X)

Profit from absorption costing method X

Marginal costing profit = Absorption costing profit + FCunit

× ( Opening inventory – Closing inventory)

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8. Job and Batch Costing

Job cost card

Direct materials X
Direct labour X
Direct expenses X
PRIME COST X
Factory overhead X
TOTAL PRODUCTION COST/FACTORY COST X
SDA overheads
Fixed X
Variable X
Total SDA overheads X
TOTAL COST X
Profit X
SELLING PRICE X

Batch costing

Total cost of the batch production

Cost per unit =
Total units in the batch

9. Service Costing

The number of occupied room-nights for a month (of 30 days)

= number of rooms × nights in a month × occupation percentage

Cost of room services

The room services cost per occupied room-night per month =
Occupied room-night

Total costs of journeys

Cost per tonne-km =
Total tonne-km

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10. Process Costing

Total costs of production – Scrap value of normal loss
Cost per unit of good output =
Total input – Normal loss volume

Net production costs

 Cost per unit of good output =
Expected output

Equivalent units = Incomplete units × % of completion

11. CVP analysis

When profit/loss = 0:

Contribution – FC = 0 profit = total contribution – total fixed costs (FC)

Contribution = FC total contribution = total revenue – total variable costs (VC)

Sales – VC = FC

Sales = VC + FC  Sales = TC

Break-even quantity, qe = FC ÷ (Sp – VC unit)

Total contribution Contribution per unit

Contribution to sales (c/s) ratio = or
Total sales revenue Selling price

Total fixed costs

At break-even point, Contribution to sales (c/s) ratio =
Break-even sales

Margin of safety = Actual/Expected sales volume – Break-even quantity

= Actual/Expected sales in $ – Break-even sales

Actual/Expected sales – Break-even sales
= × 100%
Actual/Expected Sales

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12. Optimal Production Plan

Step 1 Identify limiting factor

Step 2 Find contribution per unit

Step 3 Find contribution per unit per limiting factor

Step 4 Rank

Step 5 Produce

13. Relevant Costing

Relevant cost of labour = Labour cost of the new activity
+ Loss of contribution from the existing activity

14. Make or Buy-in Decisions

Relevant cost of manufacture > Relevant cost of buying-in  BUY-IN

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15. Capital investment appraisal

Simple interest = Investment amount × Interest rate × Duration of investment

r% n
Effective annual rate (EAR) = (1 + ) –1
n

FV = PV(1 + r%)n FV = future value; PV = present value;

r = interest rate; n = time period

PV = FV(1 + r%)-n  PV = FV × Discount factor from PVT

Present value of annuity = Annuity × Annuity factor

Annuity y
Perpetuity =
Interest rate

NPV = PV of cash inflows – PV of cash outflows.

A
IRR = a% + [( ) (b – a)] % a = lower of the two rates of return used
A–B

b = higher of the two rates of return used

A = NPV obtained using rate r = a

B = NPV obtained using rate r = b

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APPENDIX B PRESENT VALUE TABLE Sunway TES

APPENDIX B PRESENT VALUE TABLE

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APPENDIX C ANNUITY TABLE Sunway TES

APPENDIX C ANNUITY TABLE

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