ACA - MI - Lecture
ACA - MI - Lecture
ACA - MI - Lecture
Certificate Level
Management
Information
INTRODUCTION
The aim of ICAEW MI is to enable
students to prepare essential financial
information for the management of a
business.
INTRODUCTION
Specification grid for MI
INTRODUCTION
E-assessments
The 'Certificate' modules:
• Computer based e-assessments.
• 1.5 hours in length.
The MI assessment will contain:
• 1 scenario-based question, worth 20% of the marks.
• This will cover a single syllabus area: either costing and pricing;
budgeting and forecasting; performance management; or
management decision making.
The remaining 80% of the marks are from 32 multiple choice, multi-
part multiple choice or multiple response questions, each worth
2.5 marks.
The total assessment is worth 100 marks. This provides an
approximate time allocation of 18 minutes for the scenario-based
question and 2.25 minutes for the multiple-choice questions.
You will not be able to take any open books into the exam but you will
be able to view relevant extracts from discount tables on screen.
INTRODUCTION
Each chapter contains:
• Learning objectives
• Chapter diagram
• Content
• Illustrations
• Summary diagram
learning outcomes
Syllabus and
Costing and pricing &
01 (5) Ethics
02 Budgeting and
forecasting
03 Performance
management
04 Management
decision making
The
fundament
als of
CHAPTER costing
01
LEARNING OBJECTIVES
OVERVIEW OVERVIEW OF
COSTING
IMPORTANCE
OF COSTING
IMPORTANCE OF CLASSIFICATION OF
COSTING COSTS AND THEIR
BEHAVIOUR
CONTROL
CHAPTER 1: The fundamentals of costing
Management accounting
• The identification, generation, presentation, interpretation and use of relevant
information to prepare management accounts and schedules.
• A subset of management information
Cost accounting
• The production of cost information to assist management.
• A subset of management accounting.
CHAPTER 1: The fundamentals of costing
Purposes Record historical financial performance Assist management in planning and controlling
and position the business to make effective decisions
Law Required by statute (CA 06) No legal requirements
Scope Historical, cover business as a whole, Flexible, includes historical, current and future
usually gives minimum required information which can focus on specific parts of
information the business
02 Cost classification
2.1 Direct vs Indirect costs
There are 3 elements of direct costs:
Costs that can be directly traced in full to a cost unit (e.g. a table).
01 Direct material costs: Direct material costs are costs of material used to
make and sell a cost unit (e.g. wood).
02
Direct labor costs: Direct labor costs are costs of labor used to make a
cost unit (e.g. wages paid to carpenter).
03
Direct expenses: Direct expenses are other costs incurred in full as a
direct consequence of making a table (e.g. license fee per table made).
02 Cost classification
2.1 Direct vs Indirect costs
Overall cost of running business
Production overheads
Production overheads (are also called manufacturing or factory overheads) are
costs incurred (other than direct production costs) in producing the product or service.
It includes indirect materials, indirect wages and indirect expenses.
Production overheads ONLY production overheads can be included in the value of
inventories.
CHAPTER 1: The fundamentals of costing
02 Cost classification
2.1 Direct vs Indirect costs
Other (non-production) overheads
Non production overheads are overheads, other than production overheads, incurred
in operating the business.
Administration overhead: Administration overhead includes costs incurred in
01
directing, controlling and administering the business (e.g. FD salary, bad
debt expenses, depreciation of office computers...).
02 Cost classification
2.1 Direct vs Indirect costs Total Cost
02 Cost classification
2.2 Product v Period costs
01 Product costs
Product costs are any costs incurred in the manufacture of goods/services.
Product costs are included in inventory valuation and are therefore part of the
cost of sales expense.
Product costs include:
Direct production costs (direct materials, direct labour, direct expenses)
Production overheads
02 Period costs
Period costs are costs deducted as an expense in the income statement in a
particular period.
Period costs are not included in inventory valuation.
CHAPTER 1: The fundamentals of costing
02 Cost classification
2.2 Product v Period costs
Summary
TOTAL BUSINESS COSTS
INCLUDE COSTS
IN INVENTORY EXPENSE COSTS TO
VALUATION AND INCOME STATEMENT
COST OF SALES AS INCURRED
CHAPTER 1: The fundamentals of costing
02 Cost classification
2.3 Cost behaviour
Costs incurred by the business MAY change with activity levels. Activity levels could
be e.g. the number of units made, units sold, hours worked.
01 Fixed costs
Fixed costs (FC) remain constant in total over a range of activity levels (e.g.
salaries, rents, rates, straight-line depreciation).
Fixed costs per unit of activity will fall as the activity level increases because the FC
are being ‘spread’ over more units.
CHAPTER 1: The fundamentals of costing
02 Cost classification
2.3 Cost behaviour
02 Variable costs
Variable costs (VC) change in total as the level of activity changes (e.g. total
direct materials cost increase as output levels increase). Variable costs per
unit of activity remain constant as activity level changes.
02 Cost classification
2.3 Cost behaviour
02 Variable costs
Variable costs (VC) change in total as the level of activity changes (e.g. total
direct materials cost increase as output levels increase). Variable costs per
unit of activity remain constant as activity level changes.
02 Cost classification
2.3 Cost behaviour
03 Semi-variable costs
Semi-variable costs have both a fixed and variable element. They are
therefore partly affected by a change in the level of activity.
Semi-variable costs are also called semi-fixed or mixed costs.
02 Cost classification
2.3 Cost behaviour
03 Semi-variable costs
Semi-variable costs have both a fixed and variable element. They are
therefore partly affected by a change in the level of activity.
Semi-variable costs are also called semi-fixed or mixed costs.
02 Cost classification
2.3 Cost behaviour
04 Stepped-fixed costs
Costs are constant within the relevant range for each activity level but when a
critical activity level is reached, the total cost incurred increases to the next
step.
02 Cost classification
2.3 Cost behaviour
04 Stepped-fixed costs
Costs are constant within the relevant range for each activity level but when a
critical activity level is reached, the total cost incurred increases to the next
step.
02 Cost classification
2.4 Costs and control
Responsibility accounting
Responsibility accounting is a system ensuring that responsibility for all the activities (costs
and revenues) of the business can be assigned to individual managers in order to monitor and
assess performance.
Responsibility centre
A responsibility centre is a department/function/process/division/product etc. whose
performance is the responsibility of a specific manager.
Controllable costs
Controllable costs can be influenced/changed by a manager’s decisions.
Uncontrollable costs
Uncontrollable costs cannot be influenced/changed by a manager’s decisions within a given
time period. Most VCs are controllable in the short term (e.g. change supplier, alter labour mix
used...). Most FCs are uncontrollable in the short term (e.g. rent) but are controllable in the
long term (e.g. rent a different factory). A manager may not be able to control a cost because
of the action of another manager (e.g. factory manager has a high reject rate and therefore
higher cost due to poor quality materials bought by the purchase manager).
CHAPTER 1: The fundamentals of costing
Threat Definition
Familiarity Becomes too sympathetic to the interests of clients because of a
close business or personal relationship
Self-review Responsible for reviewing subject matter for which the firm or
individual were previously responsible
Self-interest
Could benefit from a financial or other interest in client
Superiors
the line manager
those charged with governance
the ICAEW
04 Chapter Summary
Financial
Information
Ethics
Code
Fundamental
Principles Financial Management
Threats to Accounting Accounting
objectivity
Safeguards
Further actions
Costing
LEARNING OBJECTIVES
Upon completion of this chapter you will be able to
value inventory using the following techniques:
1. LIFO
2. FIFO
02 Inventory valuation
Inventory valuation is important for:
Financial reporting: Inventory is recorded in the financial statements at the lower
of cost and net realisable value.
Costing – Once inventory cost has been determined, a sales price can be
determined using e.g. a mark-up.
02 Inventory valuation
FIFO
FIFO assumes that materials are issued out of inventory in the order in which they
were delivered into inventory.
FIFO is appropriate for many businesses (e.g. retailer selling fresh food using sell-by
date rotation techniques).
CHAPTER 2: Inventory valuation
02 Inventory valuation
FIFO
Advantages: Disadvantages:
Logical – reflects the most Cumbersome.
likely physical flow. In times of rising prices
Easily understood. (inflation), reported profits are
Inventory values at up-to- high due to lagging issue prices
date prices i.e. replacement and high closing inventory
cost. valuations.
Acceptable to HMRC and Cost comparisons between jobs
per IAS2. are difficult
CHAPTER 2: Inventory valuation
02 Inventory valuation
LIFO
LIFO assumes that materials are issued out of inventory in the reverse order to
which they were delivered.
LIFO is only appropriate for a few businesses (e.g. a coal merchant who stores
coal inventories in a large ‘bin’).
CHAPTER 2: Inventory valuation
02 Inventory valuation
LIFO
Advantages: Disadvantages:
Issue prices are up-to-date. Rarely reflects physical use of
In times of rising prices, inventors.
reported profits are reduced Cumbersome.
as closing inventory is Not usually acceptable to HMRC
valued at a lower cost. or per IAS2.
Makes managers aware of Inventory values may become very
recent costs. out-of-date.
Cost comparisons between jobs
are difficult.
CHAPTER 2: Inventory valuation
02 Inventory valuation
Cumulative Weighted Average
Cumulative weighted average values all issues and inventory at an average price.
The average price is recalculated after each receipt.
Cumulative weighted average price = Running total of costs / Running total of units
The cumulative weighted average method could be appropriate for businesses such
as oil merchant, where deliveries are fully mixed in with existing inventory.
CHAPTER 2: Inventory valuation
02 Inventory valuation
Cumulative Weighted Average
Advantages: Disadvantages:
Acceptable to HMRC and Issue prices and inventory
per IAS2. values may not be an actual
Logical because units all purchase price.
have the same value. Inventory values and issue
Fluctuations in prices are prices may both lag behind
smoothed out. current values.
CHAPTER 2: Inventory valuation
02 Inventory valuation
Periodic Weighted Average
Periodic weighted average values each issue at the same average price which is
based on all purchases for the period.
Periodic weighted average price = Total costs for the period /Total units for the period.
In the exam, only use the periodic weighted average method if you are specifically
told to.
The difference in profit calculated under each method is due to the difference in
closing inventory valuations. Which differ due to the values that the inventory will be
recorded at, under the different methods.
03 Chapter summary
Cumulative Periodic
FIFO LIFO
Weighted Average Weighted Average
Calculating unit
costs
CHAPTER
03
CHAPTER 3: Calculating unit costs
LEARNING OBJECTIVES
Upon completion of this chapter you will be able to:
● Understand standard costing
● Calculate unit costs using absorption costing and marginal costing
● Understand how to allocate, apportion, reapportion and absorb
overheads for absorption costing.
● Calculate and understand over/under absorption.
● Discuss Activity Based Costing as an alternative to absorption
costing.
● Determine which costing method is appropriate for an
organisation’s operations.
CHAPTER 3: Calculating unit costs
OVERVIEW Standard costing
Assigning fixed
Activity Based Costing production overheads:
1 Allocate and apportion
2 Reapportion
3 Absorb
Over and
under absorption
CHAPTER 3: Calculating unit costs
01 Standard costing
A standard cost is the expected, or budgeted, cost per unit of output. A standard cost
card is drawn up in advance of a period and shows the expected usage of resources
and price of resources for each cost unit.
Illustration 1 – Absorption, marginal and standard costing
(a) Absorption costing – Inventory is valued at full production cost i.e. including
both variable and fixed elements of production cost.
(b) Marginal costing – Inventory is valued at variable production cost only.
= £4 + £0.50 + £2.50
= £7
The variable non production costs (selling costs) of £2 per unit are not included in
inventory value.
CHAPTER 3: Calculating unit costs
04 Absorption Costing
Marginal costing values a cost unit at prime cost plus variable production overheads
i.e. variable production cost.
Absorption costing is also called full costing. There are 3 stages to assigning fixed
production overheads to a cost unit under absorption costing:
(1) Allocate and apportion
(2) Reapportion
(3) Absorb
4.1 (Step 1) Allocate and apportion
There are two types of fixed production overhead: overheads that arise in a department
and overheads that are factory wide.
Allocation is the process of charging whole cost items directly to a cost centre.
Production cost centres physically work on the cost unit. Service cost centres support
the production activities but do not physically work on the cost unit.
If there is more than one service centre for which costs need to be reapportioned,
either:
(1) Firstly reapportion service cost centre with the biggest costs, or;
(2) Firstly reapportion the service cost centre which gives the biggest proportion of
its services to other service cost centres.
CHAPTER 3: Calculating unit costs
04 Absorption Costing
4.3 (Step 3) Absorb
All production overheads, now only included in production cost centres, are then absorbed
into cost units using a predetermined Overhead Absorption Rate (OAR).
OAR =
Predetermined, or budgeted, figures are used so that cost can be determined at the start
of the period. This is necessary as business usually use costs to set sales prices for the
period i.e. before actual overhead costs are known.
The level of activity chosen should realistically reflect the characteristics of that cost
centre and thereby provide a reasonably accurate estimate of overhead costs for cost
units. This is a matter of judgement. Possible measures of activity are:
• Number of cost units
• Prime cost
• Direct labour cost
• Direct materials cost
• Labour hours
• Machine hours.
CHAPTER 3: Calculating unit costs
04 Absorption Costing
4.3 (Step 3) Absorb
Blanket absorption rate
A blanket absorption rate uses the same absorption rate for all cost units irrespective
of the department in which they were produced.
This method is not appropriate if there are a number of departments and different cost
units do not spend an equal amount of time in each department.
Blanket absorption rates are also called a single factory absorption rate.
CHAPTER 3: Calculating unit costs
05 Over and under absorption of overheads
The OAR is calculated at the start of the period based on budgeted figures. It is likely
that actual overheads and actual levels of activity are different to what was budgeted.
Therefore total overheads absorbed will be different to total actual overheads.
(a) Over absorption occurs if absorbed > actual
(b) Under absorption occurs if absorbed < actual
To calculate over or under absorption follow 3 steps:
1. OAR =
2. Overhead absorbed = actual activity × OAR
£
Actual overhead incurred X
Overhead absorbed (step 2) (X)
––––
Under/(over) absorbed X/(X)
CHAPTER 3: Calculating unit costs
06 Activity Based Costing (ABC)
For most modern businesses, overheads form a significant proportion of total costs. It
is therefore important that absorption of overheads is accurate so managers can
identify and control unit costs.
Unit cost =
The overall costing method used by a business will depend on the nature of its
operations, not the inventory pricing method or absorption basis.
CHAPTER 3: Calculating unit costs
07 Costing methods
Life cycle costing tracks and accumulates actual costs and revenues attributable to
each product over its entire life cycle. The life cycle runs from research and
development through to withdrawal from the market. Analysing the life cycle cost avoids
decisions being made solely on initial costs.
Market research is conducted to estimate the price customers would be willing to pay
to allow the business to achieve the required market share. The required profit is
deducted from this price to generate the target cost. The business determines if it can
achieve this target price. If not, profit margins will be eroded or the product will not be
proaduced.
CHAPTER 3: Calculating unit costs
08 Just in time
Just in time (JIT) is an approach to operations planning which aims for goods and
services to be produced exactly when they are needed.
Therefore zero inventory is held, but the customer does not have to wait. This is
desirable because holding inventory is expensive (storage costs, insurance, risk of
obsolescence).
• High Quality
• Speed
• Reliability
• Efficient production planning
• Reliable sales forecasting
CHAPTER 3: Calculating unit costs
09 Chapter summary
Standard costing
Budgeted costs
Costing methods
Inventory valuation JIT
Job, Contract,
Never include non Aim to hold nil
Process, Batch
production costs inventory
Life cycle
Target
Absorption costing
Marginal costing
Value inventory at full
Value inventory at variable
production cost
production cost only
LEARNING OBJECTIVES
MC VS. TAC
CONTRIBUTION
PROFIT OR LOSS
ACCOUNT
CHAPTER 4: Marginal costing and absorption costing
01 Marginal costing (MC) vs.Total Absorption costing (TAC)
There are two methods for determining the value of inventory:
(a) Absorption costing (TAC)
(b) Marginal costing (MC)
Each element of cost is classified as a period or product cost.
• Period costs are costs charged in full to the profit or loss account in the period in which
they are incurred.
• Product costs are costs that are included in inventory valuation. Therefore product
costs are matched against the sales revenue they generate.
MC and TAC classify fixed production costs differently.
Types of cost MC TAC
Variable production cost Product cost Product cost
Fixed production cost Period cost Product cost
Variable non-production cost Period cost Period cost
Fixed non-production cost Period cost Period cost
More profit
Profit = Total contribution – Fixed costs
CHAPTER 4: Marginal costing and absorption costing
02 Contribution
Conclusions
From TYU 2 we can note:
MC VS. TAC
Difference in profits due
to inventory valuation
CONTRIBUTION
Short term
Linked to profits
PROFIT OR LOSS
ACCOUNT
Formats Quick
methods
Pricing
calculations
CHAPTER
05
CHAPTER 5: Pricing calculations
LEARNING OBJECTIVES
OVERVIEW
PRICING
EXTERNAL
CUSTOMERS INTERNAL SALES
CHAPTER 5: Pricing calculations
01 Practical point
02 Cost-plus pricing
Introduction
COST
plus
PROFIT
gives
SALES
PRICE
What cost do we use?
Full costs To achieve the same sales price, and
– Production cost therefore ensure all costs are
– Production cost + non production cost recovered, the percentage must be
different under each cost option.
Marginal (variable) costs
– Variable production cost The business must decide whether to
– Variable production cost + variable include anticipated inflation in costs.
non production costs
CHAPTER 5: Pricing calculations
COSTS/UNIT
DEMAND
SALES PRICE/UNIT
FC/UNIT
CHAPTER 5: Pricing calculations
04 Marginal cost
There are 2 options:
04 Marginal cost
May make losses in the long term if sales price does not cover fixed costs.
May not be relevant to businesses with heavy fixed cost base (e.g. Kaplan!).
Profit maximisation may not be achieved as the relationship between price and
demand is ignored.
CHAPTER 5: Pricing calculations
A different mark-up could be applied to each range of products (e.g. 50% mark-up
The mark-up could vary according to the nature of the customer (e.g. major v
minor customer) or the strategy being pursued (e.g. lower margin while spending
on product promotion).
06 Transfer Pricing
What is Transfer Pricing?
A Transfer Price (TP) is the amount charged by one part of an organisation for the
provision of goods or services to another part of the same organisation.
EXTERNAL
DIVISION A DIVISION B
CUSTOMER
If Division A only ‘gives’ its product to Division B, Division A must be a cost centre
(rather than a profit centre or investment centre).
To make Division A a profit centre (so that profit related bonuses can be paid to
managers of Division A) it needs a ‘revenue’ from a TP.
To make Division B realise that Division A does not make the goods for free, Division
B needs a ‘cost’ from a TP.
The TP is therefore a signalling mechanism, hopefully to encourage divisional
managers to act in a way to maximise shareholder wealth (goal congruence).
CHAPTER 5: Pricing calculations
06 Transfer Pricing
Aims of transfer pricing
Measure divisional profits
Measure costs and revenues
Autonomy to managers
Encourage goal congruence
Profit maximisation
How much should the TP be?
There are 4 practical methods which can be used to determine a TP:
(1) Market price
(2) Cost-plus price
(3) Two-part transfer price
(4) Dual pricing
CHAPTER 5: Pricing calculations
06 Transfer Pricing
(1) Market Price
In a perfectly competitive market, the optimum TP is the market price providing the
supplying division is operating at full capacity. This should be reduced for cost savings
from internal transfers. This includes:
Packaging
Advertising
Distribution
Irrecoverable debts
(2) Cost-plus price
06 Transfer Pricing
Issues with cost-plus TP:
A predetermined standard cost should be used rather than actual cost. This prevents
divisional profit being distorted due to inefficiencies being transferred between divisions.
The TP should be based on total cost to ensure overheads are recovered by the
supplying division.
- However, the supplying divisions fixed costs will then be perceived as variable by
the receiving division.
- The supplying division may also ‘over recover’ its fixed costs. This may lead the
recovering division to outsource purchases when this is suboptimal for the overall
business.
CHAPTER 5: Pricing calculations
06 Transfer Pricing
(3) Two-part transfer pricing
As the name suggests, the transfer is accounted for in two parts:
Part 1 TP = standard variable cost.
Part 2 = periodic fixed charge.
This ensures the recovering division is aware of the cost behaviour patterns of the
supplying division.
(4) Dual pricing
Each division records the TP at a different amount to encourage optimal decision
making.
Supplying division – records revenue at market price or total cost-plus.
Receiving division – records purchases at the supplying divisions standard
variable cost only.
CHAPTER 5: Pricing calculations
07 Chapter Summary
PRICING
Be practical
EXTERNAL INTERNAL
MARKET TRANSFERS
Aims of TP
CHAPTER
06
CHAPTER 6: Budgeting
LEARNING OBJECTIVES
Upon completion of this chapter you will be able to:
● Explain why organizations use budgeting
procedures
● Explain, giving examples, the term ‘principal budget factor’ (or ‘limiting factor’)
● Prepare forecasts
BUDGETING
TYPES OF BUDGETS
Budget committee
Limiting factor
– is identified – in budgeting, the limiting factor is known as the principal budget factor.
Generally there will be one factor that will limit the activity of an organisation in a given
period. It is usually sales that limit an organisation’s performance, but it could be anything
else, for example, the availability of special labour skills. If sales is the principal budget
factor, then the sales budget must be produced first.
PRODUCTION BUDGET
COST OF GOODS
SOLD BUDGET
MASTER BUDGET
The diagram shown is based on sales being the principal budget factor.
Remember that if labour were the principal budget factor, then the labour budget
would be produced first and this would determine the production budget.
Once the production budget has been determined then the remaining functional
budgets can be prepared.
CHAPTER 6: Budgeting
03 Sales budgets
Budget preparation – functional budgets
03 Sales budgets
Illustration 1 – Sales budgets
A company makes two products – PS and TG. Sales for next year are budgeted to be
5,000 units of PS and 1,000 units of TG. Planned selling prices are £95 and £130 per
unit respectively.
Prepare the sales budget for the next year.
Solution
Total PS TG
Sales units 6,000 5,000 1,000
Sales values £605,000 £475,000 £130,000
Workings
Sales – PS = 5,000 × £95 = £475,000
Sales – TG = 1,000 × £130 = £130,000
CHAPTER 6: Budgeting
04 Production budgets
Production budgets
- Budgeted production levels can be calculated as follows:
Budgeted production = Forecast sales + Closing inventory of finished goods –
Opening inventory of finished goods.
Illustration 2 – Production budgets
A company makes two products, PS and TG. Forecast sales for the coming year are
5,000 and 1,000 units respectively.
The company has the following opening and required closing inventory levels.
CHAPTER 6: Budgeting
04 Production budgets
Material budgets
There are two types of material budget that you need to be able to calculate, the usage
budget and the purchases budget.
The material usage budget is simply the budgeted production for each product
multiplied by the number of kgs required to produce one unit of the product.
The material purchases budget is made up of the following elements.
04 Production budgets
Illustration 3 – Production budgets
A company produces Products PS and TG and has budgeted to produce 6,000 units of
Product PS and 1,000 units of Product TG in the coming year. The data about the
materials required to produce Products PS and TG is given as follows.
PG per unit TG per unit
Kg of raw material X 12 12
Kg of raw material Y 6 8
Direct materials:
Raw material: TG per unit
X Kg Y Kg
Desired closing inventory 6,000 1,000
Opening inventory 5,000 5,000
Standard rates and prices:
Raw material: X £0.72 per kg
Raw material Y: £1.56 per kg
Prepare the following: A The material usage budget. B The material purchase budget.
CHAPTER 6: Budgeting
04 Production budgets
Illustration 3 – Production budgets
Solution
CHAPTER 6: Budgeting
04 Production budgets
Labour budgets
Labour budgets are simply the number of hours multiplied by the labour rate per hour as
the following illustration shows.
Illustration 4 – Labour budgets
A company produces Products PS and TG and has budgeted to produce 6,000 units of
Product PS and 1,000 units of Product TG in the coming year.
The data about the labour hours required to produce Products PS and TG is given as
follows.
Finished products:
PS per unit TG per unit
Direct labour hours 8 12
CHAPTER 6: Budgeting
The master budgets will be drawn up after all the functional budgets have been
approved.
The budgeted balance sheet will show the likely financial position at the end of the
budget period.
CHAPTER 6: Budgeting
06 Preparing forecasts
In order to prepare budgets, historic data is often used to predict future costs
and revenues.
Equation of a straight line
The equation of a straight line is a linear function and is represented by the following
equation: y = a + bx
Graph of linear function y = a + bx
‘a’ is the intercept, i.e. the point at which
the line y = a + bx cuts the y axis (the
value of y when x = 0).
‘b’ is the gradient/slope of the line y = a +
bx (the change in y when x increases by
one unit).
‘x’ = independent variable.
‘y’ = dependent variable (its value depends
on the value of ‘x’).
CHAPTER 6: Budgeting
06 Preparing forecasts
Cost equations
Cost equations are derived from historical cost data. Once a cost equation has
been established, it can be used to estimate future costs. Cost equations have the
same formula as linear functions: y = a + bx
‘a’ is the
– fixed cost per period (the intercept)
‘b’ is the
– variable cost per unit (the gradient)
‘x’ is the
– activity level (the independent variable)
‘y’ is the
– total cost = fixed cost + variable cost (dependent on the activity level).
CHAPTER 6: Budgeting
06 Preparing forecasts
Cost equations
Suppose a cost has a cost equation of y = £5,000 + 10x, this can be shown
graphically as follows:
Graph of cost equation y = 5,000 + 10x
CHAPTER 6: Budgeting
06 Preparing forecasts
Cost estimation
A number of methods exist for analysing semi-variable costs into their fixed and
variable elements. The two main methods are:
06 Preparing forecasts
Step 1 –
– select the highest and lowest activity levels, and their associated costs
– (Note: do not take the highest and lowest costs)
Step 2 –
– find the fixed cost by substitution, using either the high or low activity level.
– Fixed cost = Total cost at activity level – Total variable cost
CHAPTER 6: Budgeting
06 Preparing forecasts
Illustration 5 – Preparing forecasts
Output (Units) Total cost (£)
200 7,000
300 8,000
400 9,000
Required:
06 Preparing forecasts
Illustration 5 – Preparing forecasts
A/ Variable cost per unit = (£9,000 – £7,000)/(400 – 200) = £2,000/200 = £10 per unit
B/ Total fixed cost by substituting at high activity level:
06 Preparing forecasts
Linear regression – Line of best fit
Consider the following data which relates to the total costs incurred at various output
levels in a factory:
Output Total cost
(Units) (£)
26 6,566
30 6,510
33 6,800
44 6,985
48 7,380
50 7,310
06 Preparing forecasts
Scattergraph showing total costs incurred at various output levels in a factory
06 Preparing forecasts
Advantage of the linear regression method
All data points are taken into account when calculating a and b.
Correlation
Two variables are said to be correlated if a change in one variable brings about a
change in another variable.
When correlation is strong, the estimated line of best fit should be more reliable.
06 Preparing forecasts
Different degrees of correlation
Variables may be either perfectly correlated, partially correlated or uncorrelated.
The different degrees of correlation can be shown graphically on scattergraphs as
follows.
CHAPTER 6: Budgeting
06 Preparing forecasts
Perfect correlation
– means that if all the pairs of values were plotted, they would lie on a straight
line. This is because a linear relationship exists between the two variables.
Partial (or moderate) correlation
– means that there is no exact linear relationship between two variables but that
high/low values of one variable tend to be associated with high/low values of the other
variable.
Uncorrelated
– means that there is no correlation between the two variables.
Perfect negative correlation
– means that low values of one variable are associated with high values of
another (and vice versa).
Perfect positive correlation
– means that high values of one variable are associated with high values of
another OR low values of one variable are associated with low values of another.
CHAPTER 6: Budgeting
06 Preparing forecasts
The correlation coefficient
An alternative to drawing a graph each time you want to know whether two variables are
correlated, and the extent of the correlation if there is any, is to calculate the correlation
coefficient (r) and to interpret the result.
The correlation coefficient, r, measures the strength of a linear relationship between
two variables. It can therefore give an indication of how reliable the estimated linear
function is for a set of data.
06 Preparing forecasts
Coefficient of determination
The variation not accounted for by variations in the independent variable will be due
to random fluctuations, or to other specific factors that have not been identified in
considering the two-variable problem.
CHAPTER 6: Budgeting
06 Preparing forecasts
Illustration 6 – Preparing forecasts
This means that 96% of the variation in the dependent variable (y) is explained by
variations in the independent variable (x). This would be interpreted as high
correlation.
TEST YOUR UNDERSTANDING
The linear function y = 5,587 + 34.77x is plotted (as a ‘line of best fit’). The associated
correlation coefficient was calculated to be 0.957.
What is the coefficient of determination and determine what that means?
This means that 92% of the variation in total costs is explained by variations in the level
of activity. The other 8% of variations in total costs are assumed to be due to random
fluctuations.
CHAPTER 6: Budgeting
06 Preparing forecasts
Big Data, data analytics and data mining
Big Data
Velocity
Variety
Veracity
CHAPTER 6: Budgeting
06 Preparing forecasts
Volume: The scale of information which can now be created and stored is
staggering. Advancing technology has allowed embedded sensors to be placed in
everyday items such as cars, video games and refrigerators. Mobile devices have led
to an increasingly networked world where people's consumer preferences, spending
habits, and even their movements can be recorded. Advances in data storage
technology, as well as a fall in price of this storage, has allowed for the captured data
to be stored for further analysis.
Variety: Big data consists of both structured and unstructured data. While the
sources of data have grown, the software tools for interpreting the data have not kept
pace with this change. The challenge is bringing together both structured and
unstructured information to reveal new insights.
Veracity: Another challenge to users of big data is keeping the information 'clean'
and free from bias.
CHAPTER 6: Budgeting
06 Preparing forecasts
Data analytics
The process of collecting, organising and analysing large sets of data to generate trends
and other information to aid decision making.
Data mining
The process of sorting through data to identify patterns and relationships between
different items, usually with the use of statistical algorithms. E.g. identifying a customer’s
buying trends in order to send focused marketing data to each customer.
Structured data
Data that is contained within a field in a data record or file (E.g. databases and
spreadsheets).
Unstructured data
Data that is not easily contained within structured data fields, such as pictures, videos,
webpages, PDF files, emails or blogs.
Purpose in Budgeting
Many companies are now analysing Big Data in order to identify trends and other
correlations in information, to improve forecasting and overall profitability.
CHAPTER 6: Budgeting
06 Preparing forecasts
Incremental budget
– this type of budget uses the previous period’s budget as a starting point and then
adds ‘increments’ as it sees necessary (for example, adjustments for inflation).
BUDGETING
TYPES OF BUDGETS
Note that if sales is the limiting factor (principal budget factor) then sales
demand is what limits the activities of an organisation and so the sales
budget must be prepared first. Once the sales budget has been prepared,
the production budget can be prepared, followed by the material, labour
and overhead budgets.
Working capital
CHAPTER
07
CHAPTER 7: Working capital
LEARNING OBJECTIVES
Upon completion of this chapter you will be able to:
● identify the different elements of working capital and how they can
be managed
managed.
CHAPTER 7: Working capital
OVERVIEW
Liquidity WORKING CAPITAL Profitability
Cash operating
cycle Cash budget
Profitability Liquidity
Example 1
How should a business manage its receivables?
Similar dilemmas arise with the management of inventory, payables and cash levels.
CHAPTER 7: Working capital
02
How to finance an investment in working capital
Relatively cheap – shorter period of risk exposure to lenders. Trade credit comes
interest-free. Note, though, an unsecured overdraft will not be cheap!
Flexible – a bank overdraft, for example, is only used when needed.
Disadvantages of short-term finance:
Profitability
Profitability Profitability
Profitability Profitability
As the cycle gets longer and sales increase (hence inventory and purchases
increase), more cash is tied up in the cycle.
If the cycle is out of balance, extra short-term finance is needed.
Causes
Overtrading – occurs when a small business grows quickly but on a small capital base
and, although revenue and profits are healthy, the business soon runs out of cash.
This is because the amount of cash needed to fund the cash operating cycle increases
as: Sales (and hence purchases of inventory) increase
The cycle gets longer as suppliers insist on short periods of credit and customers
insist on long periods of credit from a business with no established reputation as yet.
CHAPTER 7: Working capital
05
Liquidity problems – causes and cures
Cures
Inject some further long-term capital into the business
Raise cash by selling off non-essential non-current assets
Slow down the rate of growth of the business
Reduce the length of the cash operating cycle (without jeopardisingprofitability) through:
– Lower levels of inventory
– Faster collection of debts from credit customers
– Increasing the proportion of cash sales
– Slower payment of debts to suppliers.
CHAPTER 7: Working capital
06
Managing the components of working capital
The tension between profitability and liquidity can be seen in the stance a business
adopts in managing its inventory, receivables, payables and cash.
(i) Inventory
The levels of inventory a business holds is the result of judging the right balance
between the:
– Benefits from holding inventory e.g. continuity of production or sales
– Costs of holding inventory e.g. warehousing, capital tied up
There are essentially two inventory issues to address:
– How much to order?
– When to order?
The Economic Order Quantity (EOQ) model calculates how much inventory to order
each time if the objective is to minimise the costs that are directly affected by the order
size: annual inventory holding costs plus annual inventory order costs.
CHAPTER 7: Working capital
06
Managing the components of working capital
The tension between profitability and liquidity can be seen in the stance a business
adopts in managing its inventory, receivables, payables and cash.
(i) Inventory
EOQ =
Inventory control system How much to order When to place a new order
Re-order level system A pre-calculated When inventory falls to a
economic order size predetermined level
Periodic review system Variable Regular inspections of inventory
levels e.g. weekly
ABC system Variable Inspections now prioritised according
to importance of each item – so used
when there are many different items
in inventory
Just-in-time system Supplier delivers to Give supplier the customer order
customer order book on a regular basis
Perpetual inventory system Economic order size Automatically generated by
computerised system
CHAPTER 7: Working capital
06
Managing the components of working capital
Trade credit is a cheap form of short-term finance – if a business does not pay its
trade debts for a further month, it has obtained a further month’s use of its cash.
But excessive use of this facility for liquidity reasons could have consequences
that affect profitability:
– Favoured customer status is lost and future supplies disrupted
– Supplier raises prices to compensate for the extra interest being incurred
– Opportunity of a cash discount for prompt payment has been forgone
CHAPTER 7: Working capital
06
Managing the components of working capital
(iii) Trade receivables
The only benefit from granting trade credit to customers comes from
maintaining/increasing sales volumes.
The costs of extending credit:
– Finance costs of capital tied up in trade receivables
– The risk of irrecoverable debts
– Administrative costs of running a credit control department
Policies need to be established for the control and collection of customer debts.
These will include the following:
– Setting the terms of credit
– the length of the credit period and whether a cash discount is to be offered. This can
be an expensive form of short-term finance.
CHAPTER 7: Working capital
06
Managing the components of working capital
Sloppycred Ltd usually takes 2 months to collect its debts from credit customers. It has just
issued an invoice to Slowpay Ltd of £100 and offers a cash discount of 2% if payment is
made in 1 month.
What is the equivalent annual cost of the discount if Slowpay does settle in 1 month?
Solution:
Sloppycred receives £98 1 month earlier than normal. The cost of this arrangement is
therefore a £2 lost receipt on an invoice of £100 i.e. 2% per month.
Assuming compound interest, this is the equivalent of 1.0212 – 1 = 26.8% per year.
This is an expensive means of obtaining the use of cash earlier than normal.
CHAPTER 7: Working capital
06
Managing the components of working capital
There are 4 reasons why a company would want to hold cash either in a cash float or a
bank current account
(i) Transactions motive – to meet day-to-day obligations e.g. payroll, paying suppliers’
invoices
(ii) Finance motive – to cover major items e.g. loan repayments or purchase of non-
current assets
(iii) Precautionary motive – to cover against unexpected outlays e.g. accidents
(iv) Investment/speculative motive – to take advantage of new investment opportunities
e.g. opportunity to purchase a competitor business.
CHAPTER 7: Working capital
07
Treasury (cash) management
The profitability objective would minimise the holdings of cash – as an idle asset, profit is
being forgone by failing to invest the funds.
The liquidity objective would maximise the holdings of cash to ensure that the firm’s
cash obligations can always be met – payments of supplier invoices, wages to staff and
dividends to shareholders.
Therefore the primary aim of good cash management is to have the right amount of cash
available at the right time.
Essential elements in this process are:
– Efficient cash transmission procedures – prompt banking of receipts and the allowing of 3-
4 days before the funds can be drawn upon (unless both parties bank at the same branch)
– The preparation of timely and accurate cash budgets.
CHAPTER 7: Working capital
08
Cash budgets
A cash budget is a detailed budget of estimated cash inflows and outflowsincorporating both
revenue and capital items.
The preparation of cash budgets or budgeted cash flow statements has two main
objectives:
– to provide periodic budgeted cash balances for the budgeted balance sheet
A Forecast sales.
B Forecast time-lag on converting receivables to cash, and hence forecast cash receipts
from credit sales.
D Forecast time-lag on paying suppliers, and thus cash payments for purchases.
E Incorporate other cash payments and receipts, including such items as capital
expenditure and tax payments.
F Collate all this cash flow information, so as to determine the net cash flows.
CHAPTER 7: Working capital
08
Cash budgets
Typical layout of a cash budget is:
Receipts Month 1 Month 2 Month 3
From receivables X X X
Cash sales X X X
Payments
To payables X X X
Cash purchases X X X
Non-current assets X
Loan repayment X
––– ––– –––
Net cash flow X X X
Add: Opening Balance X X X
A Management believes that the 20X4/20X5 sales level and pattern are a reasonable
estimate of 20X5/20X6 sales. Sales in 20X4/20X5 were as follows:
Continued
CHAPTER 7: Working capital
08
Cash budgets
Illustration 3 – Cash budgets
C The purchase cost of goods averages 60% of selling price. The cost of the inventory
on hand at 30 June 20X5 is £840,000. The company wishes to maintain the inventory,
as of the first of each month, at a level of three months’ sales as determined by the sales
forecast for the next three months. All purchases are paid for on the tenth of the
following month. Accounts payable for purchases at 30 June 20X5 total £370,000.
D Payments in respect of fixed and variable expenses are forecast for the first three
months of 20X5/20X6 and are as follows.
£
July 160,620
August 118,800
September 158,400
E It is anticipated that cash dividends of £40,000 will be paid each half-year, on the
fifteenth day of September and March.
Continued
CHAPTER 7: Working capital
08
Cash budgets
Illustration 3 – Cash budgets
F During the year unusual advertising costs will be incurred that will require cash
payments of £10,000 in August and £15,000 in September. The advertising costs are in
addition to the expenses in item (d) above.
G Equipment replacements are made at a rate which requires a cash outlay of £3,000
per month. The equipment has an average estimated life of six years.
H A £60,000 payment for corporation tax is to be made on 15 September 20X5.
I At 30 June 20X5 the company had a bank loan with an unpaid balance of £280,000.
The entire balance is due on 30 September 20X5, together with accumulated interest
from 1 July 20X5 at the rate of 12% pa.
J The cash balance at 30 June 20X5 is £100,000. You are required to prepare a cash
forecast statement, by month, for the first three months of the 20X5/X6 financial year.
The statement should show the amount of cash on hand (or deficiency of cash) at the
end of each month. All computations and supporting schedules should be presented in a
clear and concise form. Continued
CHAPTER 7: Working capital
08
Cash budgets
Illustration 3 – Cash budgets
Solution
Many of the costs can be entered straight on to the cash flow statement, e.g. expenses,
dividends, capital expenditure, etc.
There are three supporting schedules needed.
(1) Cash received from sales
Continued
CHAPTER 7: Working capital
08
Cash budgets
Illustration 3 – Cash budgets
(2) Payments to trade payables
Continued
CHAPTER 7: Working capital
08
Cash budgets
Illustration 3 – Cash budgets
(2) Payments to trade payables
CHAPTER 7: Working capital
09
Potential cash positions
WORKING
Liquidity Profitability
CAPITAL
MEASURES COST
BUDGETARY INCLUDING ROI; RI REVENUE
CONTROL AND BALANCED PROFIT
SCORECARD INVESTME
NT
CHAPTER 8: Performance management
01
Performance evaluation
Planning
Planning is one of the main duties of the management accountant.
Planning involves establishing the objectives of an organisation and formulating
relevant strategies that can be used to achieve those objectives.
Objectives are the aims or goals that an organisation has.
Planning can be either short-term (tactical planning) or long-term (strategic planning).
CHAPTER 8: Performance management
01
Performance evaluation
Decision-making
Decision-making, as its name suggests, involves considering information that has been
provided and making an informed decision.
In most situations, decision-making involves making a choice between two or more
alternatives.
The first part of the decision-making process is planning.
The second part of the decision-making process is control.
CHAPTER 8: Performance management
01
Performance evaluation
Control
Control is the second part of the decision-making process. Information relating to the
actual results of an organisation is reported to managers.
Managers use the information relating to actual results to take control measures
and to re-assess and amend their original budgets or plans.
Internally sourced information, produced largely for control purposes, is called
feedback.
The ‘feedback loop’ is demonstrated in the following illustration.
CHAPTER 8: Performance management
01
Performance evaluation
Compare
PLAN/BUDGET
Control action
Here, management prepare a plan which is put into action by the managers with
control over the input resources (labour, money, materials, equipment and so on).
Output from operations is measured and reported (‘fed back’) to management and
actual results are compared against the plan in control reports.
Managers take corrective action where appropriate, especially in the case of
exceptionally bad or good performance.
Feedback can also be used to revise plans or prepare the plan for the next period.
CHAPTER 8: Performance management
01
Performance evaluation
Features of effective feedback
Budget Here, the main emphasis in performance evaluation With the budgetconstrained
constraine is the manager’s success in meeting budget targets style, much attention was given
d style in the short term, with no consideration for other to costs and there was a high
aspects of performance that are not targeted in the degree of job-related pressure
budget. A manager is criticised for poor results and tension. This often led to
compared to the budget, for example if his actual the manipulation of data in
spending exceeds the budget limit. accounting reports.
Profit The performance of a manager is measured in terms With the profit-conscious style,
conscious of his ability to increase the overall effectiveness of there was still a high
style his area of responsibility, in relation to meeting the involvement with costs but less
longer term objectives of the organisation. At a cost job-related pressure.
centre level of responsibility, performance might be Consequently, there was less
judged in terms of reducing costs over the longer manipulation of accounting
term, rather than meeting short-term cost targets. data. Relationships between
Short-term budgetary information needs to be used managers and their colleagues
with care and in a flexible way to achieve this and superiors were also better
purpose. than with a budget-constrained
style.
CHAPTER 8: Performance management
01
Performance evaluation
Hopwood found some evidence that better managerial performance was achieved
where a profit-conscious or non-accounting style was in use. Poor performance was
often associated with a budget-constrained style.
CHAPTER 8: Performance management
01
Performance evaluation
Style of evaluation
Budget Profit Non-accounting
Involvement with
HIGH HIGH LOW
costs
Manipulation of LITTLE
EXTENSIVE LITTLE
data
Relations with
POOR GOOD GOOD
supervisor
Relations with
POOR GOOD GOOD
colleagues
CHAPTER 8: Performance management
02
Responsibility centres
Cost centres
A cost centre is a production or service location, function, activity or item of equipment
whose costs are identified and recorded for the purpose of providing management
information.
For a paint manufacturer cost centres might be: mixing department; packaging
department; administration; or selling and marketing departments.
For an accountancy firm, the cost centres might be: audit; taxation; accountancy;
word processing; administration; canteen. Alternatively, they might be the various
geographical locations, e.g. the London office, the Cardiff office, the Plymouth office.
Cost centre managers need to have information about costs that are incurred and
charged to their cost centres.
The performance of a cost centre manager is judged on the extent to which cost
targets have been achieved.
Care needs to be made to distinguish between controllable and uncontrollable costs.
CHAPTER 8: Performance management
02
Responsibility centres
Profit centres
A profit centre is a part of the business for which both the costs incurred and the
revenues earned are identified.
Profit centres are often found in large organisations with a divisionalised structure
and each division is treated as a profit centre.
Within each profit centre, there could be several costs centres and revenue centres.
The performance of a profit centre manager is measured in terms of the profit made
by the centre.
The manager must therefore be responsible for both costs and revenues and in a
position to plan and control both.
Data and information relating to both costs and revenues must be collected and
allocated to the relevant profit centres.
CHAPTER 8: Performance management
02
Responsibility centres
For a paint manufacturer, profit centres might be the wholesale division and the
retail division. For an accountancy firm the profit centres might be the individual
locations or the type of business undertaken (audit, consultancy, accountancy
etc). Clearly all profit centres can also be cost centres, but not all cost centres can
be profit centres. For instance the costs of an employees’ canteen can be
ascertained, thus it could be a cost centre. But if it earns no revenue, then it
cannot be a profit centre.
CHAPTER 8: Performance management
02
Responsibility centres
Investment centres
An investment centre is a profit centre with additional responsibilities for investment and
possibly also for financing, and whose performance is measured by its return on capital
employed.
To operate an investment centre, it is necessary to collect data to provide information
on costs, revenues and capital employed (amount invested).
Managers of investment centres are responsible for investment decisions as well as
decisions affecting costs and revenues.
Investment centre managers are therefore accountable for the performance of capital
employed as well as profits (costs and revenues).
The performance of investment centres can be measured in terms of the profit earned
and the capital invested (employed).
The relative measure is known as the return on capital employed (ROCE).
ROCE = Profit/Capital employed.
The absolute measure is known as residual income (RI).
RI = Profit – %(capital employed).
CHAPTER 8: Performance management
02
Responsibility centres
Revenue centres
A revenue centre is a part of the organisation that earns sales revenue. It is similar to a
cost centre, but only accountable for revenues, and not costs.
Revenue centres are generally associated with selling activities, for example, a
regional sales manager may have responsibility for the regional sales revenues
generated.
Each regional manager would probably have sales targets to reach and would be
held responsible for reaching these targets.
Sales revenues earned must be able to be traced back to individual (regional)
revenue centres so that the performance of individual revenue centre managers can
be assessed.
CHAPTER 8: Performance management
02
Responsibility centres
Shared service centres
Common processes within a business are often carried out by a shared service centre,
such as human resources or IT. The aim of a shared service centre is to significantly
reduce costs while improving service levels. A fair transfer pricing policy is important to
ensure success.
To aid common processes a company may choose to use cloud computing, where
the software packages and applications are accessible from anywhere at any time,
as long as there is internet connection. This can often be cheaper as the software
can be rented, rather than bought outright.
Cloud accounting is an example of cloud computing, where accounting software is
provided in the cloud by a service provider. This is often managed by an external
provider, which means small businesses do not have to worry about installing
expensive security measures, worry about regularly updating the systems and there
is no need for expensive computers to run the software.
Cloud software however does need regular internet access and a breach of security
could impact the company negatively.
CHAPTER 8: Performance management
02
Responsibility centres
Shared service centres
Advantages Disadvantages
Reduced headcount due to economies of
Loss of business and specific knowledge
scale
Possibly removed from the day-to-day
Reduction of floor space running of the business, which could lead
to mis-informed decisions
Knowledge sharing to improve quality of
Weakened relationships
service
Standardisation of approaches and
Cost inefficiencies
processes
CHAPTER 8: Performance management
03
Performance measures
Manipulation of data
Demotivational
Stress between staff
Short-term verses long-term conflict
Division comes before company as a whole
CHAPTER 8: Performance management
03
Performance measures
What are the ROI and RI for the 4 years of the project and will the managers accept
or reject the project on the basis of these figures?
Solution
ROI and RI using straight-line depreciation
Annual depreciation on a straight-line basis will be £1.4m/4 = £350,000 per annum.
Continued
CHAPTER 8: Performance management
03
Performance measures
Advantages of ROI
As a relative measure it enables comparisons to be made with divisions or
companies of different sizes.
It is used externally and is well understood by users of accounts.
The primary ratio splits down into secondary ratios for more detailed analysis.
ROI forces managers to make good use of existing capital resources.
The nature of the measure is such that it can clearly be improved not just by
increasing profit but by reducing capital employed; it therefore encourages reduction
in the level of assets such as obsolete equipment and excessive working capital.
CHAPTER 8: Performance management
03
Performance measures
Disadvantages of ROI
Disincentive to invest – a divisional manager will not wish to make an investment
which provides an adequate return as far as the overall company is concerned if it
reduces the division’s current ROI. Existing assets may be sold if, by doing so, ROI
is improved even though those assets are generating a reasonable profit.
Most conventional depreciation methods will result in ROI improving with the age of
an asset. This might encourage divisions hanging on to old assets and deter them
from investing in new ones. Alternatively a division may try to improve its ROI still
further by leasing its assets. It is suggested that gross book value or even
replacement cost should be used when evaluating performance. Also complex
depreciation calculations are recommended by academics to overcome some of
these difficulties.
Corporate objectives of maximising total shareholders’ wealth or the total profit of the
company are not achieved by making decisions on the basis of ROI.
CHAPTER 8: Performance management
03
Performance measures
Financial perspective
To succeed financially,
how should we appear to
our shareholders?
internal business
process
Customer perspective To satisfy our
To achieve our vision VISION AND shareholders and
how should we appear to STRATEGY customers, what
our customers? business processes
must we excel at?
NB the ultimate measure of corporate performance (for quoted companies) is the share price.
CHAPTER 8: Performance management
04
The balanced scorecard
Selection of measures
Obtaining information
Information overload
Conflict between measures.
CHAPTER 8: Performance management
05
Budgetary control
Budgetary control cycle
Budgetary control involves comparing the plan of the budget with the actual results and
investigating any significant differences between the two.
The budgetary control cycle can be illustrated as follows.
Budget agreed
Expenditure
Feedback for incurred
revision of Feedback for
next budget revision of
Differences between budget
and actual analysed performance
Fixed budgets
The simplest form of budget report compares the original budget against actual results
and is known as a fixed budget.
Any differences arising between the original budget and actual results are known as
variances. Variances may be either adverse or favourable.
Adverse variances (Adv) or (A) decrease profits
Favourable variances (Fav) or (F) increase profits.
CHAPTER 8: Performance management
05
Budgetary control
The fixed budget shown above is not particularly useful because we are not really
comparing like with like. For example, the budgeted sales were 1,000 units but the
actual sales volume was 1,200 units.
The overall sales variance is favourable, but from the report shown we don’t know
how much of this variance is due to the fact that actual sales were 200 units higher
than budgeted sales (or whether there was an increase in the sales price).
Similarly, actual production volume was 50 units less than the budgeted production
volume, so we are not really making a very useful comparison. It is more useful to
compare actual results with a budget that reflects the actual activity level. Such a
budget is known as a flexed budget.
CHAPTER 8: Performance management
05
Budgetary control
Flexed/flexible budgets
A flexible budget is a budget which recognises different cost behaviour patterns and is
designed to change as the volume of activity changes.
When preparing flexed budgets it will be necessary to identify the cost behaviour of the
different items in the original budget.
In some cases you may have to use the high-low method in order to determine the
fixed and variable elements of semi-variable costs.
CHAPTER 8: Performance management
05
Budgetary control
Illustration 6 – Budgetary control
Wye Ltd manufactures one product and when operating at 100% capacity can produce
5,000 units per period, but for the last few periods has been operating below capacity.
Below is the flexible budget prepared at the start of last period, for three levels of activity at
below capacity: Level of activity
70% 80% 90%
£ £ £
Direct materials 7,000 8,000 9,000
Direct labour 28,000 32,000 36,000
Production overheads 34,000 36,000 38,000
Administration, selling and distribution overheads 15,000 15,000 15,000
–––––– –––––– ––––––
Total cost 84,000 91,000 98,000
–––––– –––––– ––––––
Continued
CHAPTER 8: Performance management
05
Budgetary control
Illustration 6 – Budgetary control
In the event, last period turned out to be even worse than expected, with production of
only 2,500 units. The following costs were incurred:
£
Continued
CHAPTER 8: Performance management
05
Budgetary control
Illustration 6 – Budgetary control
Use the information given above to prepare the following.
A A flexed budget for 2,500 units
B A budgetary control/variance statement
Solution
A Flexed
C budget for 2,500 units £
Direct materials (W1) (2,500 × £2) 5,000
Direct labour (W2) (2,500 × £8) 20,000
Production overheads (W3) 30,000
Administration, selling and distribution overheads (W4) 15,000
––––––
Total cost 70,000
––––––
Continued
CHAPTER 8: Performance management
05
Budgetary control
Illustration 6 – Budgetary control
Workings
(1) Material is a variable cost – £2 per unit Variable material cost = £7,000/(70% ×
5,000) = £2 per unit
(2) Labour is a variable cost – £8 per unit. Variable labour cost = £28,000/(70% ×
5,000) = £8 per unit
(3) Production overheads are semi-variable. Using the high-low method, the variable
cost is £4 per unit and the fixed cost is £20,000. The cost for 2,500 units therefore =
£20,000 + (2,500 × £4) = £30,000.
70% activity = 70% × 5,000 = 3,500
90% activity = 90% × 5,000 = 4,500
Variable cost per unit = £(38,000 – 34,000)/(4,500 – 3,500) = £4 per unit
Continued
CHAPTER 8: Performance management
05
Budgetary control
Illustration 6 – Budgetary control
Total fixed cost by substituting at high activity level:
Total cost = £38,000
Total variable cost = 4,500 × £4 £18,000
Therefore fixed cost = £20,000
(4) Other overheads are fixed
B
Continued
CHAPTER 8: Performance management
05
Budgetary control
Continued
CHAPTER 8: Performance management
05
Budgetary control
Illustration 7 – Budgetary control
The total variance is the difference between fixed budget and actual results.
(£40,000 and £39,600 = £400F)
The volume variance reflects the difference in costs which are due to the actual
activity level being different to budgeted activity level. The volume variance is the
difference between the fixed and flexed budget. (£3,000F)
The expenditure variance reflects the difference in costs due to actual expenditure.
The expenditure variance is the difference between flexed budget and actual results.
(£2,600A)
We can analyse these expenditure variances further in order to establish reasons
why the variances have occurred. We will be looking at expenditure variances further
in the next chapter.
CHAPTER 8: Performance management
06
Chapter Summary
PERFORMANCE
MANAGEMENT
FEEDBACK
• Clear and comprehensive
• Exception principle
Hopwood’s three styles of
• Highlight controllable items
evaluation
• Regular and timely
• Budget constrained
• Sufficiently accurate
• Profit conscious
• Exclude irrelevant detail
• Non-accounting
• Communicated to correct
manager
DECENTRALISATION
The authority for certain decisions is
delegated to less senior managers
CHAPTER 8: Performance management
06
Chapter Summary
DECENTRALISATION
The authority for certain decisions is
delegated to less senior managers
RESPONSIBILITY CENTRES
Revenue Investment
Cost centre centre Profit centre centre
Responsible for: Responsible Responsible Responsible for:
Costs incurred for: Revenues for: Costs Costs incurred
earned incurred Revenues
Revenues earned
earned Capital invested
CHAPTER 8: Performance management
06
Chapter Summary
Balanced scorecard
Perspectives:
• Financial
• Customer
• Internal business
• Innovation and learning
Investment centre
Responsible for:
Costs incurred
Revenues earned
Capital invested
Performance measures
• related to capital
statement
STANDARD COSTING
OPERATINGS STATEMENTS
CHAPTER 9: Standard costing and variance analysis
01
Standard costing
A budget is the financial plan for a period of time. Budgets are compiled
by referring to the standard cost card.
Illustration 2
Budget for selling 1,000 cement statues
A fixed budget is the original budget set for the anticipated level of production and
sales for the period.
A flexed budget is the fixed budget adjusted for the actual level of production and
sales.
CHAPTER 9: Standard costing and variance analysis
03
Standard costing advantages
Providing standard costs are monitored to ensure they are reasonable and reliable,
advantages of standard costing include:
Variance analysis is the comparison of actual costs with budgets. This allows control by
exception, i.e. management ignore activities which conform to expectation and
concentrate on activities which exceed acceptable tolerable limits.
CHAPTER 9: Standard costing and variance analysis
04
Variance analysis
Illustration 3
Budgets and variances for selling cement statues
CHAPTER 9: Standard costing and variance analysis
04
Variance analysis
(1) Tabular approach – What has been the change in profit due to the ‘x’ being different
to budget
(2) Did–Should approach – What did I actually pay/receive? – What should I have
paid/received given actual volume? – The difference is the variance
(3) Formulae You only need to be able to calculate variances using one of the above
methods.
CHAPTER 9: Standard costing and variance analysis
04
Variance analysis
Sales variances
Materials variances
Labour variances
Variable overhead variances
Fixed overhead variances A favourable variance (F) occurs if actual profit is higher
than budgeted profit. An adverse variance (A) occurs if actual profit is lower than
budgeted profit.
CHAPTER 9: Standard costing and variance analysis
05
Sales variances
Therefore the sales volume variance explains the difference in profit between the fixed
and flexed budgets
(AQ-BQ) × SCPU
If the calculation is positive, the variance is favourable.
If the calculation is negative, the variance is adverse.
(AP-SP) × AQ
If the calculation is positive, the variance is favourable.
If the calculation is negative, the variance is adverse.
CHAPTER 9: Standard costing and variance analysis
05
Sales variances
Material
S×S Standard quantity of material to = Budget material usage
make the actual number of cost per the flexed budget variance
units produced (SQ) × (3) (2) – (3)
Standard price of material (SP)
CHAPTER 9: Standard costing and variance analysis
06
Material variances
6.1 Tabular approach
NB: Material price variance is based on the actual quantity of material purchased whilst
the material usage variance is based on actual quantity of material used
If (1) – (2) is positive, the material price variance is adverse.
If (1) – (2) is negative, the material price variance is favourable.
If (2) – (3) is positive, the material usage variance is adverse.
If (2) – (3) is negative, the material usage variance is favourable.
CHAPTER 9: Standard costing and variance analysis
06
Material variances
6.2 Did–Should approach
Extract from a standard cost card
Direct materials: 7kg @ £3 per kg £21
Material price variance
£
Actual quantity materials purchased did cost X
Actual quantity materials purchased should cost (materials × £3) (x)
–––
Material price variance X
–––
If the difference is positive, the variance is adverse.
If the difference is negative, the variance is favourable.
CHAPTER 9: Standard costing and variance analysis
06
Material variances
6.2 Did–Should approach
Extract from a standard cost card
Direct materials: 7kg @ £3 per kg £21
Material usage variance kg
Actual quantity of cost units produced did use x
Actual quantity of cost units produced should use (units × 7kg) (x)
–––
Difference x/(x)
–––
Valued at standard material cost per kg (kg × £3) £x Usage
variance
–––
If the difference is positive, the variance is adverse. If
the difference is negative, the variance is favourable.
CHAPTER 9: Standard costing and variance analysis
06
Material variances
S×S Standard hours for actual = Budgeted labour per the Labour
number of cost units produced flexed budget (3 efficiency
(SH) × Standard rate per labour variance
hour (SR) (2) – (3)
CHAPTER 9: Standard costing and variance analysis
07
Labour approach
7.1 Tabular approach
If (1) – (2) is positive, the labour price variance is adverse.
If (1) – (2) is negative, the labour price variance is favourable.
If (2) – (3) is positive, the labour usage variance is adverse.
If (2) – (3) is negative, the labour usage variance is favourable.
CHAPTER 9: Standard costing and variance analysis
07
Labour approach
7.2 Did–Should approach
Extract from a standard cost card
Direct labour 12 hours @ £8 per hour £96
Labour rate variance £
Actual hours paid did cost X
Actual hours paid should cost (hours × £8) (x)
–––
Labour rate variance X
–––
If the calculation is positive, the variance is adverse.
If the calculation is negative, the variance is favourable.
CHAPTER 9: Standard costing and variance analysis
07
Labour approach
7.2 Did–Should approach
Labour efficiency variance
£
Actual quantity of cost units produced did take X
Actual quantity of cost units produced should take (units × 12 hours) (x)
–––
Difference X
–––
Valued at standard labour rate per hour (hours × £8) £x Efficiency
variance
–––
If the difference is positive, the variance is adverse.
If the difference is negative, the variance is favourable.
CHAPTER 9: Standard costing and variance analysis
07
Labour approach
7.3 Formulae approach
Labour rate variance
(SR – AR) × AH
If the calculation is positive, the variance is favourable.
If the calculation is negative, the variance is adverse.
The most common exam question assumes that variable overhead costs vary with
labour hours worked.
Variable overhead total variance
The variable overhead total variance explains the difference between the variable
overhead cost in the flexed budget and the actual variable overhead cost.
The variable overhead total variance can be analysed into two sub variances: the variable
overhead expenditure variance and the variable overhead efficiency variance.
The variable overhead total variance is calculated by adding together the two sub
variances.
CHAPTER 9: Standard costing and variance analysis
08
Variable overhead variances
The purpose of the variable overhead expenditure variance is to ascertain whether the
company paid more or less per hour than expected for variable overheads.
The purpose of the variable overhead efficiency variance is to ascertain whether the
company used more or less variable overheads by working more or less labour hours
than expected.
CHAPTER 9: Standard costing and variance analysis
08
Variable overhead variances
8.1 Tabular approach
Variable
S×S Standard hours for actual = Budgeted variable overheads overhead
number of cost units produced per the flexed budget (3) efficiency
(SH) × Standard rate per labour variance
hour (SR) (2) – (3)
CHAPTER 9: Standard costing and variance analysis
08
Variable overhead variances
8.1 Tabular approach
If (1) – (2) is positive, the variable overhead expenditure variance is adverse.
If (1) – (2) is negative, the variable overhead expenditure variance is favourable.
If (2) – (3) is positive, the variable overhead efficiency variance is adverse.
If (2) – (3) is negative, the variable overhead efficiency variance is favourable.
CHAPTER 9: Standard costing and variance analysis
08
Variable overhead variances
8.2 Did–Should approach
Extract from a standard cost card
Variable overheads 12 hours @ £4 per hour £48
£
Actual hours worked did cost X
Actual hours worked should cost (hours × £4) (x)
–––
Variable overhead expenditure variance X
–––
If the calculation is positive, the variance is adverse.
If the calculation is negative, the variance is favourable.
CHAPTER 9: Standard costing and variance analysis
08
Variable overhead variances
8.2 Did–Should approach
Labour efficiency variance
£
Actual quantity of cost units produced did take X
Actual quantity of cost units produced should take (units × 12 hours) (x)
–––
Difference X
–––
Efficiency
Valued at standard variable overhead rate per hour (hours × £4) £x
variance
–––
Note that the possible causes of variable overhead efficiency variances are the same as
those for the labour efficiency variance.
CHAPTER 9: Standard costing and variance analysis
09
Fixed overhead variances
Fixed overhead variances are the difference between budgeted and actual expenditure on
fixed overheads during the period.
There is no volume related variance because the very definition means that the total fixed
cost is constant regardless of activity level (i.e. fixed budget fixed costs = flexed budget
fixed costs)
Therefore the variance must only be caused by expenditure differences.
9.1 Tabular approach and Did–Should approach
£
Actual expenditure X
Budgeted expenditure (x)
–––
Fixed overhead variance X
If the calculation is positive, the variance is adverse. –––
If the calculation is negative, the variance is favourable.
CHAPTER 9: Standard costing and variance analysis
09
Fixed overhead variances
Although it has no application in the real world, to test whether you have a thorough
understanding of variances, the MI examiner may require you to work backwards.
You may be asked to calculate:
Actual figures from variances and standards
Standards from variances and actual figures
TEST YOUR UNDERSTANDING
ABC Ltd uses standard costing. It purchases a small component for which the following
data is available:
Actual purchase quantity 6,800 units
Standard allowance for actual production 5,440 units
Standard price £0.85/unit
Material price variance (ADVERSE) (£544)
Calculate the actual price per unit of material.
CHAPTER 9: Standard costing and variance analysis
12
Chapter Summary
VARIANCE ANALYSIS
10
CHAP 10: Breakeven analysis and limiting factor analysis
LEARNING OBJECTIVES
Upon completion of this chapter you will be able to:
Contribution
Some problems are easier to solve by focussing on contribution rather than, say,
profit, especially in the short term.
The breakeven point (BEP) is when profit = 0.
Profit = Total Revenue (TR) – Total Variable costs (TVC) – Total Fixed costs (TFC).
Hence, you break even when:
– TR – TVC – TFC = 0
– (TR – TVC) – TFC = 0
– As Contribution = TR – TVC then
– Contribution – TFC = 0
– Contribution = TFC
CHAPTER
CHAP 10: Breakeven
9: Standardanalysis
costingand
andlimiting
variancefactor
analysis
analysis
1
Breakeven analysis
Continue
CHAPTER
CHAP 10: Breakeven
9: Standardanalysis
costingand
andlimiting
variancefactor
analysis
analysis
1
Breakeven analysis
The charts
Breakeven charts
The measures that we have calculated can also be determined by drawing and
interpreting the following graphs.
– Traditional breakeven charts
– Contribution breakeven charts
Labour is paid £6 per hour and labour hours are limited to 12,000 hours in the period.
Determine the optimal production plan and calculate the total contribution it earns for
the company.
Continue
CHAPTER
CHAP 10: Breakeven
9: Standardanalysis
costingand
andlimiting
variancefactor
analysis
analysis
3
Limiting factor analysis
Illustration 9 – Limiting factor analysis
Solution
Remember to allocate the scarce resource (labour hours) to the highest-ranking product
first A. Once the demand for the highest-ranking product is satisfied, move on to the next
highest-ranking product D. and then the next C. until the scarce resource (labour hours) is
used up.
Continue
CHAPTER
CHAP 10: Breakeven
9: Standardanalysis
costingand
andlimiting
variancefactor
analysis
analysis
3
Limiting factor analysis
Illustration 9 – Limiting factor analysis
Solution
Optimal production plan
Product Units Hours used Hours left Contribution per Total contribution
unit (£) (£)
A 1,000 1,000 11,000 4 4,000
––––––
31,000
––––––
CHAPTER
CHAP 10: Breakeven
9: Standardanalysis
costingand
andlimiting
variancefactor
analysis
analysis
3
Limiting factor analysis
Restriction to the optimal level of production
There may be circumstances where you may be restricted by a factor other than a
scarce resource.
A contract with a customer can’t be cancelled.
A minimum quantity of each product must be produced to maintain customer
goodwill.
The method remains the same except you must fulfil the restriction first.
CHAPTER
CHAP 10: Breakeven
9: Standardanalysis
costingand
andlimiting
variancefactor
analysis
analysis
4
Make or buy decisions
The basics
If demand exceeds production capacity, a firm needs to decide whether to buy-in
resources from external suppliers.
The firm also needs to decide which products to manufacture itself and which to
subcontract out.
STEP 1
Calculate cost saving if made internally per unit by taking the difference between the
outside buying price and the variable cost per unit of producing in-house
STEP 2
Calculate saving per limiting factor
STEP 3
RANK
STEP 4
Allocate and determine the optimal production plan
CHAPTER
CHAP 10: Breakeven
9: Standardanalysis
costingand
andlimiting
variancefactor
analysis
analysis
4
Make or buy decisions
Make or buy method
Illustration 10 – Make or buy decisions
Products M and N have the following costs:
Product M £ per unit Product N £ per unit
Material (@ £5 a metre) 25 15
Variable overhead 12 16
Selling price 82 75
Only 30,000 metres of material is available. Completed M and N can be purchased from an
outside supplier at the following costs:
Product M £ per unit Product N £ per unit
Buy in price 72 72
What is the optimal production and buy-in plan and what contribution is made?
CHAPTER
CHAP 10: Breakeven
9: Standardanalysis
costingand
andlimiting
variancefactor
analysis
analysis
4
Make or buy decisions
Make or buy method
Illustration 10 – Make or buy decisions
Solution
Product M £ per unit Product N £ per unit
Buy in price 72 72
VC of making 52 51
Saving if make 20 21
Continue
CHAPTER
CHAP 10: Breakeven
9: Standardanalysis
costingand
andlimiting
variancefactor
analysis
analysis
4
Make or buy decisions
Make or buy method
Illustration 10 – Make or buy decisions
Solution
Optimal production plan
Product M Product N
Make 3,800
INVESTMENT APPRAISAL
TECHNIQUES
NON- DISCOUNTING
DISCOUNTING METHODS
TECHNIQUES
6 200 4 600 0
5 300 300
6 200 500
Continued
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
2 The payback method
Illustration 5 – The payback method
Year Profit (£) Depn (£) Cash flow (£) Cum (£)
(120,000) (120,000)
1 12,000 12,000 24,000 (96,000)
2 17,000 12,000 29,000 (67,000)
3 28,000 12,000 40,000 (27,000)
4 37,000 12,000 49,000 22,000
5 8,000 12,000 20,000 42,000
T0 T1 T2 T3
year
0 1 2 3 4
Continued
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Formula Tables
(given in exam)
Continued
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Continued
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Adding up all the present values
To appraise the overall impact of a project using discounted cash flow (DCF)
techniques involves discounting all the relevant cash flows associated with the
project back to their present value.
If we treat outflows of the project as negative and inflows as positive, the net present
value (NPV) of the project is the sum of the present values of all cash flows that arise
as a result of doing the project.
The NPV represents the surplus funds (after funding the investment) earned on the
project, therefore:
if the NPV is positive –
– the project is financially viable.
if the NPV is zero –
– the project breaks even.
if the NPV is negative –
– the project is not financially viable.
if the company has two or more mutually exclusive projects under consideration it
should choose the one with the highest NPV.
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Discounting annuities
An annuity is a constant annual cash flow for a number of years. The present value can
be found using an annuity formula or annuity tables.
However, you can see from the table that the sum of all the discount factors is 4.354.
Therefore the present value can be found more quickly: £1,000 × 4.354 = £4,354
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
The annuity factor (AF) is the name given to the sum of the individual discount factors.
The present value of an annuity is found using the formula.
PV = Annuity × AF
= (1-)
For a 6 year annuity at 10%:
The annuity factor
Formula or Tables
(given in exam)
Discounting perpetuities
A perpetuity is an annual cash flow that occurs forever. It is often described by
examiners as a cash flow continuing ‘for the foreseeable future’.
The PV of a perpetuity is found using the formula:
PV = cashflow/r or
PV = cashflow × 1/r
Illustration 11 – Discounting Perpetuities
A company is expecting to receive rental income of £24,300 for the foreseeable future, the
first receipt to occur in one year’s time.
What is the present value of the rental income if the interest rate is expected to be 4%?
Solution
PV = £24,300 × 1/0.04 = £607,500
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Advanced annuities and perpetuities
Some regular cash flows may start at T0 rather than T1.
Calculate the PV by ignoring the payment at T0 when considering the number of cash
flows and then adding one to the annuity or perpetuity factor.
Illustration 12 – Advanced annuities and perpetuities
A 5 year £600 annuity is starting today. Interest rates are 10%.
Find the present value of the annuity.
Solution
This is essentially a standard 4 year annuity with an additional payment at T0. The PV could
be calculated as follows:
T0 T1 T2 T3 T4
600 600 600 600 600
• • • • •
PV 600 + 600 × 4 year 10% AF
PV = £600 + (£600 × 3.17) = £600 + £1,902 = £2,502
The same answer can be found more quickly by adding one to the annuity factor:
PV = 600 × (1 + 3.17) = 600 × 4.17 = £2,502
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Illustration 13 – The Net Present Value method
A perpetuity of £2,000 is due to commence immediately. The interest rate is 9%.
What is the present value?
Solution
This is essentially a standard perpetuity with an additional payment at T0. The PV could be
calculated as follows:
T0 T1 T2 T3 T4…
2,000 2,000→∞
• •
PV 2,000 + 2000 × 9% perpetuity formula
£2,000 + £2,000 × 1/0.09 = £2,000 + £22,222 = £24,222
Again the same answer can be found more quickly by adding one to the
perpetuity factor:
£2,000 × (1 + (1/0.09)) = £2,000 × 12.11 = £24,220
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Illustration 14 – Delayed Annuities
What is the present value of £200 incurred each year for four years, starting in three years’
time, if the discount rate is 5%?
Solution
Step 1
Discount the annuity as usual
£200 × 4yr 5% AF = £200 × 3.546 = £709.2
Note that this gives the value of the annuity at T2
Step 2
Discount the answer back to T0
£709.2 × 2yr 5% DF = £709.2 × 0.907 = £643
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Discounted payback
The discounted payback period (DPP) is the amount of time that the project’s cumulative
NPV takes to turn from being negative to positive.
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Illustration 15 – Discounted payback period
A project is expected to have the following cash flows:
Year Cash flow Discount factor
£000 @10% (from tables)
0 (1,500)
1 500 0.909
2 500 0.826
3 400 0.751
4 600 0.683
5 300 0.621
6 200 0.564
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Illustration 15 – Discounted payback period
What is the expected discounted payback period if r = 10%?
Solution
Year Cash flow Discount factor PV Cum PV
£000 @10% (from tables)
0 (1,500) 1 (1,500) (1,500)
1 500 0.909 454.5 (1,045.5)
2 500 0.826 413 (632.5)
3 400 0.751 300.4 (332.1)
4 600 0.683 409.8 77.7
5 300 0.621 186.3
6 200 0.564 112.8
The DPP is towards the end of year 4.
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method
Advantages Disadvantages
Shows increase in shareholder wealth in More complicated
absolute (£) terms
Accounts for time value of money
Considers relevant cashflows (cover later)
Can factor in risk by adjusting company’s
discount rate (cover later)
Clear, unambiguous decisions.
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
5 IRR
Continued
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
5 IRR
Illustration 17 – IRR
The NPV is positive at 8%, so the IRR is higher than this. We need to find the NPV at a
higher cost of capital. Let’s try 11%
Year Cash flow £ Discount factor at 11% PV £
0 (13,500) 1.000 (13,500)
1 5,000 0.901 4,505
2 8,000 0.812 6,496
3 3,000 0.731 2,193
–––––
(306)
–––––
The NPV is negative at 11%, so the IRR lies somewhere between 8% and 11%.
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
5 IRR
Illustration 17 – IRR
Step 2
The next step is to use the two NPV figures we have calculated to estimate the IRR.
We know that the NPV is + 368 at 8% and that it is – 306 at 11%.
Using the formula we can find the IRR:
IRR = 8% + [(368/(368 + 306)) × (11 – 8) % ] = 8% + 1.6% = 9.6%
An estimated IRR is therefore 9.6%.
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
5 IRR
Calculating the IRR of a project with even cash flows
There is a simpler technique available if the project cash flows are annuities:
(1) Find the cumulative discount factor, Initial investment/Annual flow
(2) Find the life of the project, n
(3) Look along the n year row of the cumulative discount factors until the closest value is
found
(4) The column in which this figure is found is the IR
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
5 IRR
Illustration 18 – IRR
Find the IRR of a project with an initial investment of £317,000 and four years of inflows of
£100,000 starting in one year.
Solution
NPV calculation:
Cash flow Discount PV £000
£000 factor at c%
Time
0 Investment (317) 1 (317)
1–4 Inflow 100 (b) (a)
––––
Net present value (£000) NIL
––––
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
5 IRR
Illustration 18 – IRR
The aim is to find the discount rate (c) that produces an NPV of nil.
Therefore the PV of inflows (a) must equal the PV of outflows, £317,000.
If the PV of inflows (a) is to be £317,000 and the size of each inflow is £100,000, the
discount factor required must be 317,000 ÷ 100,000 = 3.17.
The discount rate (c) for which this is the 4 year factor can be found by looking along
the 4 year row of the cumulative discount factors shown in the annuity table.
The figure of 3.17 appears under the 10% column indicating an IRR of 10%.
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
5 IRR
Calculating the IRR of a project where the cash flows are perpetuities
IRR of a perpetuity = Annual inflow/Initial investment × 100%
Illustration 19 – IRR
Find the IRR of an investment that costs £20,000 and generates £1,600 for an indefinitely
long period.
Solution
IRR = Annual inflow/Initial investment × 100% = £1,600/£20,000 × 100% = 8%
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
6 NPV vs IRR
Mutually-exclusive projects
Both NPV and IRR are investment appraisal techniques which discount cash flows and
are superior to the basic techniques discussed at the start of this chapter. However only
NPV can be used to distinguish between two mutually exclusive projects, as the diagram
below demonstrates:
The profile of project A is such that it has a lower
IRR and applying the IRR rule project B would be
preferable. However in absolute terms, project A
has the higher NPV at the company’s cost of
capital and would therefore be preferable in this
situation.
NPV is therefore the preferred technique for
choosing between projects.
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
6 NPV vs IRR
Non-conventional cash flows
Until now, we have considered the usual ‘outflow followed by inflow’ cash scenario
NPV
DISCOUNT RATE
IRR
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
6 NPV vs IRR
For non-conventional cash flows, the IRR method is not recommended as it gives
ambiguous results
Two IRRs
NPV
No IRRs
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
7 Chapter Summary
NON-DISCOUNTING
PAYBACK ARR
Formula Formula
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
7 Chapter Summary
Advantages:
• DCF technique
• Absolute Advantages:
• All cfs considered • DCF technique
compounding Discounting: • Can use to choose • %: understood
Calculates a Calculates a • Superior method Disadvantages:
terminal present i.e.
value: TV = Disadvantage: • Estimate
T0 value • Complex • Complex
X(1+r)
• May mislead where:
+ Choice
+ Unusual cfs
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
7 Chapter Summary
Discounting: Calculates a
present i.e. T0 value
Present value of an
PV of a single sum: Present value of a
annuity: Annuity x AF
PV = X X 1 / perpetuity: Perpetuity X 1/r
where AF is (1 - / r