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ICAEW

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

• Test your understandings

• 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

Upon completion of this chapter you will be able to:

1. Understand the importance of costing to a business

2. Understand how to classify costs

3. Describe how costs behave

4. Understand how costs help control a businss

5. Identify ethical issues relating to the preparation, presentation and

interpretation of financial information


CHAPTER 1: The fundamentals of costing

OVERVIEW OVERVIEW OF
COSTING
IMPORTANCE
OF COSTING

IMPORTANCE OF CLASSIFICATION OF
COSTING COSTS AND THEIR
BEHAVIOUR

CONTROL
CHAPTER 1: The fundamentals of costing

01 Definitions and differences


Management information
• Planning
• Decision making
• Control
This will include both financial and non-financial information as well as historic, current and
future information

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

01 Definitions and differences


Financial vs Management accounting
Financial accounting Management accounting

Users External Internal

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

Format/Style Prescribed by CA 06, GAAP, IFRS Management discretion

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

Information Mostly financial Financial and non-financial Key Performance


Indicators (KPIs) (e.g. number of customers per
hour)
CHAPTER 1: The fundamentals of costing

01 Definitions and differences


For financial reporting purposes, the names of financial statements are suggested by
the revised IAS1.
For internal reporting purposes, the entity can choose what terminology to use.
Therefore the MI exam will use the following terms interchangeably:
 ‘Statement of Financial Position’ = Balance Sheet
 ‘Statement of Comprehensive Income’ (which incorporates the ‘Statement of
Profit or Loss’) = Income Statement‘Cash Flow Statement’ = ‘Statement of Cash
Flows’
CHAPTER 1: The fundamentals of costing

01 Definitions and differences


Basic cost accounting concepts
Cost object
A cost object is anything for which we are trying to ascertain the cost (e.g. painting
division, product x, machine y, person z...).
Cost centre
A cost centre is a department, process or function where costs can be accumulated
(e.g. goods inwards department, milling machines,
production department canteen...).
Cost unit
A cost unit is a product or service for which costs are determined (e.g. the cost of
making a widget, a batch of marmalade, an audit of a
client...).
Composite cost unit
A composite cost unit is a cost unit made up of two parts. Most commonly it is a
service provided where a unit of ‘production’ is hard to calculate and compare.
CHAPTER 1: The fundamentals of costing

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).

Indirect costs (or overheads)


Overheads are costs incurred which cannot be traced directly and in full to a cost
unit (e.g. glue for tables, supervisor’s salary, depreciation of factory building,
insurance etc...).
CHAPTER 1: The fundamentals of costing

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 Selling overhead: Selling overhead includes costs incurred in raising sales


and customer retention (e.g. sales rep commission, lighting costs of
showroom/shop...).
03 Distribution overhead: Distribution overhead includes costs incurred in
packaging and delivering goods to customers (e.g. postage/courier costs to
send goods out, depreciation of distribution lorries...).
Note: Non production overheads CANNOT be included in the value of inventories.
CHAPTER 1: The fundamentals of costing

02 Cost classification
2.1 Direct vs Indirect costs Total Cost

Direct costs – specifically


Indirect costs – not specifically
attributable to cost unit. (a.k.a. prime
attributable to cost unit (overhead)
cost)

Direct material – all materials


becoming part of the product/service
(components, WIP, primary Overheads are incurred
packaging) because the business makes a
product/service – e.g. you need
a factory to make widgets
(rent), a lorry to distribute
Direct labour – all wages spent on widgets (driver salary) etc. The
product/ service (basic difficulty is how to share these
wage/overtime attributable to job) costs amongst cost units
Overheads are a very
significant cost in most
businesses
Direct expenses – any other
expenses specifically incurred on
product/service (job specific
designs/tools/ equipment)
CHAPTER 1: The fundamentals of costing

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

PRODUCT COSTS PERIOD COSTS

• DIRECT COSTS • ALL NON - PRODUCTION


• PRODUCTION OVERHEAD 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.

TEST YOUR UNDERSTANDING


A business incurs variable costs of £4 per
plant pot made. Calculate total variable
costs and variable cost per plant pot if:

(a) 10 plant pots are made


(b) (b) 2,000 plant pots are made
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.

TEST YOUR UNDERSTANDING (b) 2,000 plant


(a) 10 plant pots
pots
A business incurs variable costs of £4 per
plant pot made. Calculate total variable Total
variable 2,000 × £4 =
costs and variable cost per plant pot if: 10 × £4 = £40
costs £8,000

(a) 10 plant pots are made Variable


(b) (b) 2,000 plant pots are made cost per £4 £4
plant pot
CHAPTER 1: The fundamentals of costing

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.

TEST YOUR UNDERSTANDING


A business pays a £10 monthly line
rental and 10p per minute of calls made.
What is the total telephone expense if:

(a) 10 minutes of calls are made


(b) 50 minutes of calls are made
CHAPTER 1: The fundamentals of costing

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.

TEST YOUR UNDERSTANDING TEST YOUR UNDERSTANDING


A business pays a £10 monthly line
(a) £10 + (£0.10 × 10) = £11
rental and 10p per minute of calls made.
What is the total telephone expense if:
(b) £10 + (£0.10 × 50) = £15
(a) 10 minutes of calls are made
(b) 50 minutes of calls are made
CHAPTER 1: The fundamentals of costing

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.

TEST YOUR UNDERSTANDING


Each supervisor, paid a monthly salary of
£5,000 can oversee the production of up
to and including 3,000 plant pots.
What is the total salary expense if:
(a) 1,000
(b) 3,000
(c) 3,001 plant pots are produced.
CHAPTER 1: The fundamentals of costing

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.

TEST YOUR UNDERSTANDING


TEST YOUR UNDERSTANDING
(a) And Each supervisor, paid a monthly salary of
(b) £5,000 as only 1 supervisor needs £5,000 can oversee the production of up
to be hired to and including 3,000 plant pots.
(c) £10,000 as 2 supervisors will be What is the total salary expense if:
hired (a) 1,000
(b) 3,000
(c) 3,001 plant pots are produced.
CHAPTER 1: The fundamentals of costing

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

03 Ethics and Management Information


The ICAEW Code of Ethics implements the IFAC Code of Ethics.
This code uses a principles-based approach to resolve ethical dilemmas and
ensure professional accountants in business prepare and report information fairly,
honestly and in accordance with relevant professional standards.
Management information should therefore be:
• Clear
• Accurate and complete; and
• Prepared on a timely basis.
CHAPTER 1: The fundamentals of costing

03 Ethics and Management Information


The Code contains 5 fundamental principles:
(1) Integrity – Be straightforward and honest in all professional/business
relationships.
(2) Objectivity – Do not allow bias, conflict of interest or undue influence of others
in
business judgements.
(3) Professional competence and due care – Maintain professional knowledge and
skill at an appropriate level and acting diligently.
(4) Confidentiality – Do not disclose client information without appropriate specific
authority.
(5) Professional behaviour – Comply with relevant laws and regulations and avoid
actions discrediting the profession.
CHAPTER 1: The fundamentals of costing

03 Ethics and Management Information


The threats to objectivity identified by the Code are:

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

Intimidation Deterred from acting objectively by threats, actual or perceived from


client
Advocacy Promotes, or may be perceived to promote a client’s position or
opinion
CHAPTER 1: The fundamentals of costing

03 Ethics and Management Information


Safeguards to eliminate/reduce threats to an acceptable level include consulting
with:

 Superiors
 the line manager
 those charged with governance
 the ICAEW

If the threat cannot be reduced to an acceptable level:


(1) Refuse to be or remain associated with any information determined to be
misleading.
(2) Consider obtaining legal advice when deciding whether there is a requirement to
report.
(3) Consider whether to resign.
CHAPTER 1: The fundamentals of costing

03 Ethics and Management Information


Relevance to management information

Cost accountants prepare and report information to assist management.


Professional accountants should prepare and report information fairly, honestly and
in accordance with relevant professional standards.

Failure to mitigate any of the threats to objectivity could lead a professional


accountant in business to be associated with misleading information. Misleading
information includes false statements, omitted or obscure statements and reckless
statements.
CHAPTER 1: The fundamentals of costing

04 Chapter Summary
Financial
Information

Ethics
 Code
 Fundamental
Principles Financial Management
 Threats to Accounting Accounting
objectivity
 Safeguards
 Further actions
Costing

Direct v Indirect Product v Cost behaviour and activity Controllable v


Materials/Labour Period levels uncontrollable
/Expenses Inventory Fixed/Variable/Semi variable/
value/ Stepped fixed
Expense
Inventory
valuation
CHAPTER
02
CHAPTER 2: Inventory valuation

LEARNING OBJECTIVES
Upon completion of this chapter you will be able to
value inventory using the following techniques:

1. LIFO

2. FIFO

3. Cumulative Weighted Average

4. Periodic Weighted Average


CHAPTER 2: Inventory valuation

01 Identifying direct/indirect costs


Total Cost

Direct costs – specifically


Indirect costs – not specifically
attributable to cost unit. (a.k.a. prime
attributable to cost unit (overhead)
cost)

Direct material – all materials


becoming part of the product/service
(components, WIP, primary Overheads are incurred
packaging) because the business makes a
product/service – e.g. you need
a factory to make widgets
(rent), a lorry to distribute
Direct labour – all wages spent on widgets (driver salary) etc. The
product/ service (basic difficulty is how to share these
wage/overtime attributable to job) costs amongst cost units
Overheads are a very
significant cost in most
businesses
Direct expenses – any other
expenses specifically incurred on
product/service (job specific
designs/tools/ equipment)
CHAPTER 2: Inventory valuation

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.

To charge units of inventory at appropriate amount to cost of production or cost of


sales, the business will consistently use an appropriate basis:

FIFO (First In First Out) basis.


LIFO (Last In First Out) basis.
Averaging basis – cumulative weighted average basis or periodic
weighted average basis.
CHAPTER 2: Inventory valuation

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.

The profit differences are only temporary.


CHAPTER 2: Inventory valuation

03 Chapter summary

Direct Material Cost

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

Inventory valuation Costing methods

Marginal costing Absorption 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

Careful standard costing aids more


accurate budgeting and timetabling of
production in advance of the period.

At the end of the period it is then useful to


compare standard costs to actual costs
incurred. This allows control actions to be
taken by management. This will be
discussed further in chapter 9, variance
analysis.
CHAPTER 3: Calculating unit costs
02 Inventory valuation

There are 2 methods for determining the value of inventory:

(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.

Neither method includes non-production costs in the inventory value.


CHAPTER 3: Calculating unit costs
03 Marginal Costing
Marginal costing values a cost unit at prime cost plus variable production
overheads i.e. variable production cost.
TEST YOUR UNDERSTANDING
Stephanie sells face paint for £11. The direct material costs per unit is £4, the
direct labour costs £0.50 per unit, the variable production costs are £2.50 per unit
and the variable non production costs (selling costs) are £2 per unit.

What is the inventory value using marginal costing?

TEST YOUR UNDERSTANDING ANSWER


Marginal cost = direct material costs + direct labour costs + variable production
costs

= £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.

Apportionment is the process of sharing cost items between cost centres.


CHAPTER 3: Calculating unit costs
04 Absorption Costing
4.2 (Step 2) Reapportion
Costs allocated and apportioned to service cost centres must be reapportioned to
production cost centres on a fair basis.

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.

A blanket absorption rate is only appropriate if individual departmental OARs would


be similar to an overall company OAR.

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.

ABC is a development of traditional absorption costing which aims to establish a better


way of relating overheads to output. This should assist managers with cost control and
the analysis of profitability.
6.1 Calculating product costs using ABC
(1) Identify a business’ major activities e.g. customer orders
(2) Identify the cost drivers – These are the factors causing activity costs to be
incurred. These can be volume related or transaction related e.g. number of
customer orders placed
(3) Collect the costs associated with each activity into cost pools
(4) Calculate an activity absorption rate and absorb overheads into cost units
CHAPTER 3: Calculating unit costs
07 Costing methods
The overall costing method used by a business will depend on the nature of its
operations, not the inventory pricing method or absorption basis.
7.1 Job costing
Job costing is appropriate for specific one-off jobs of relatively short duration e.g. a
plumbing job. Job cost includes prime cost and absorbed overheads.
7.2 Contract costing
Contract costing is appropriate for specific one-off jobs of relatively long duration e.g.
building a hospital.
Contract cost includes prime cost, allocated overheads and absorbed overheads.
CHAPTER 3: Calculating unit costs
07 Costing methods
7.3 Batch costing
Batch costing is appropriate for a group of identical cost units e.g. a batch of
advertising units.
Total batch cost includes prime costs and absorbed overheads.
Unit cost = Total batch cost / Number of units
7.4 Process costing
Process costing is appropriate if there is a continuous flow of operations which
produces identical products e.g. brewing chemicals. Each cost centre is usually one
stage in a bigger production process.
Total process cost includes prime costs and absorbed overheads.

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

7.5 Life cycle costing

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.

7.6 Target costing

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).

Operational requirements for the JIT system include:

• 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

Assigning fixed production overheads:


1 Allocate (give) and apportion (share) Activity Based Costing
2 Reapportion service centre costs to production An alternative method to relate
centres overheads to output
3 Absorb OAR = Budgeted overhead cost /
Budgeted level of activity

Over and under absorption


occurs because OAR budgeted
figures may be different to actual
figures
Marginal costing
and absorption
costing
CHAPTER
04
CHAPTER 4: Marginal costing and absorption costing

LEARNING OBJECTIVES

Upon completion of this chapter you will be able to:

● Distinguish between Marginal and Absorption costing


● Understand the concept of contribution
● Understand that profits may differ under each method
● Reconcile the difference in profits under both methods.
CHAPTER 4: Marginal costing and absorption costing
Overview

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

Adopting either MC or TAC affects


(1) Inventory valuation and therefore cost of sales and profit in any particular period, and
(2) The format of the Profit or Loss account.
CHAPTER 4: Marginal costing and absorption costing
02 Contribution
A big advantage of marginal costing is how it helps with short-term decision making.
In the short-term many costs are assumed to be committed and unavoidable (i.e. fixed
production and non–production costs). These costs should therefore not be considered
when making short term decisions.
A business may have a one-off order or spare capacity. The business needs to decide:
• Should they accept the order?
• What is the minimum price to charge?
• How should the business use the spare capacity? For every unit sold, CPU is the
Contribution per unit (CPU) amount of revenue generated
to pay off fixed costs. NB. It is
not the same as inventory
value using marginal costing.
CHAPTER 4: Marginal costing and absorption costing
02 Contribution
Contribution and profits
We assume in the short-term that fixed costs are unavoidable (e.g. we have to pay rent
no matter how many units we make).
Therefore only changes in production and sales volume can alter profits:
Make and sell more units

More sales revenue

More variable sales and production costs

More contribution (in total)

Fixed costs stay the same

More profit
Profit = Total contribution – Fixed costs
CHAPTER 4: Marginal costing and absorption costing
02 Contribution
Conclusions
From TYU 2 we can note:

 Contribution per unit is constant


 Total contribution rises as volume rises
 Fixed costs remain constant
 Profit per unit rises as activity rises. This is because total contribution rises in line
with activity whereas fixed costs are constant. Therefore fixed costs are ‘spread’
over more units.
 At 2,000 units neither a profit nor a loss is made. This is called the breakeven point.
CHAPTER 4: Marginal costing and absorption costing
03 Profit or Loss account – MC vs. TAC
Format
MC and TAC profit or loss accounts may be presented in different formats.
 MC emphasizes the importance of:  TAC uses the more ‘familiar’ Profit or
Loss format:
Sales (Variable costs) Sales (Cost of sales)
Gross profit
Contribution (Fixed costs)
(non-production costs)
Net profit Net profit
The value of opening and closing inventories will differ depending on whether MC or TAC
is adopted.
• MAC values inventories at variable production cost.
• TAC values inventories at full production cost.
• Therefore, MC expenses all fixed costs in the period in which they are incurred,
whereas TAC will only expense fixed production costs in the period in which the
inventory is sold.
CHAPTER 4: Marginal costing and absorption costing
03 Profit or Loss account – MC vs. TAC
Format
Over/under absorption of fixed production overheads (which occur because OARs are
based on budgeted figures) will only appear in TAC Profit or Loss accounts. TAC, like
MC, must ensure that the correct overall actual production FC value is charged to the
Profit or Loss account.
All values APART from inventory valuations will be the same between MC and TAC:
Different format Profit or Loss account

In any one period, if there is a change in


inventory levels, MC and TAC will lead to
different inventory values and hence different
cost of sales and different net profits. In the
long run, the total reported profit will be the
same regardless of whether MC or TAC was
adopted
CHAPTER 4: Marginal costing and absorption costing
03 Profit or Loss account – MC vs. TAC
Reconciling the difference in reported profits
Remember the ONLY difference between the reported profit figures must be due to
differences in opening and closing inventory valuations because:

• MC treats fixed production overheads as a period cost


• TAC treats fixed production overheads as a product cost therefore the deduction of
closing inventory from cost of sales carries forward some of the fixed cost to the
next period.
Summary

Inventory levels Effect on reported profit ()


Closing inventory > opening inventory TAC  MC
Closing inventory < opening inventory TAC  MC
Closing inventory = opening inventory TAC  MC
CHAPTER 4: Marginal costing and absorption costing
03 Profit or Loss account – MC vs. TAC
Reconciling the difference in reported profits
£

Profit reconciliation statement


Marginal costing profit X
(Closing inventory – Opening inventory) × Fixed OAR X/(X)
–––––
Equals absorption costing profit X
–––––
CHAPTER 4: Marginal costing and absorption costing
04 Chapter summary

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

Upon completion of this chapter you will be able to:

● Calculate practical prices for external sale of goods/services

● Calculate transfer prices for internal sale of goods/services

● Explain, justify and recommend the practical implications of pricing policies.


CHAPTER 5: Pricing calculations

OVERVIEW

PRICING

EXTERNAL
CUSTOMERS INTERNAL SALES
CHAPTER 5: Pricing calculations

01 Practical point

The sales price must be:

 low enough to encourage the purchaser to buy, yet


 high enough to allow the producer to make an acceptable profit.

This can be achieved using a mark-up or a margin.


CHAPTER 5: Pricing calculations

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

03 Full cost plus pricing

There are 2 options:


 Unit sales price = Total production cost plus mark-up
 Unit sales price = Total production cost plus total other costs plus mark-up Both
are acceptable.
Advantages of full cost-plus pricing

 The price is quick and easy to calculate.


 Can justify price increases if costs rise.
 Pricing decisions can be delegated.
 If working at normal capacity, it should ensure a profit is made.
CHAPTER 5: Pricing calculations

03 Full cost plus pricing


Disadvantages of full cost-plus pricing
 Profit maximisation may not be achieved as the relationship between price and
demand is ignored.
 No incentive to control costs.
 Arbitrary absorption of overhead into product costs.
 Vicious circle:

COSTS/UNIT

DEMAND
SALES PRICE/UNIT
FC/UNIT
CHAPTER 5: Pricing calculations

04 Marginal cost
There are 2 options:

 Unit sales price = Total variable production cost plus mark-up.


 Unit sales price = Total variable cost plus mark-up.

Both are acceptable.

Advantages of marginal cost-plus pricing


 Simple
 It avoids the arbitrary apportionment and absorption of fixed costs.
 Very useful for short-term decisions, concerning the use of excess capacity or one
off contracts.
CHAPTER 5: Pricing calculations

04 Marginal cost

Disadvantages of marginal cost-plus pricing

 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

05 Determining the mark-up percentage

The mark-up does not have to be fixed across all products.

 A different mark-up could be applied to each range of products (e.g. 50% mark-up

on food, 35% mark-up on clothing).

 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).

 Achieve target ROI.


CHAPTER 5: Pricing calculations

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

Cost-plus TP works in the same way as cost-plus pricing.


CHAPTER 5: Pricing calculations

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

Cost plus methods


Full cost-plus Marginal cost-plus Marginal / Full cost /
Outside market

Market price method


• adjust

Mark ups (costs 100%) Two-part method


Margins (sales 100%)
Dual method
Budgeting

CHAPTER
06
CHAPTER 6: Budgeting
LEARNING OBJECTIVES
Upon completion of this chapter you will be able to:
● Explain why organizations use budgeting

● Explain the stages in the budget process, including the administrative

procedures

● Identify how data analytics can be used in budgeting and forecasting

● Explain, giving examples, the term ‘principal budget factor’ (or ‘limiting factor’)

● From data supplied, prepare budgets

● Prepare the master budget

● Prepare forecasts

● Discuss alternative approaches.


CHAPTER 6: Budgeting
THE PURPOSES OF
OVERVIEW BUDGETING

BUDGETING

THE STAGES OF BUDGET


PREPARATION

TYPES OF BUDGETS

SALES PRODUCTION MATERIAL LABOUR


BUDGETS BUDGETS BUDGETS BUDGETS

MASTER BUDGETS: Profit or Loss account;


Balance sheet
Cash flow statement

COST ESTIMATION ALTERNATIVE METHODS


High-low method /Least squares OF BUDGETING
CHAPTER 6: Budgeting

01 The purposes of budgeting


Budget theory
A budget is a quantitative expression of a plan of action prepared in advance of the
period to which it relates.
 Budgets give an idea of the costs and revenues that are expected to be incurred or
earned in future periods
 Most organisations prepare budgets for the business as a whole. The following
budgets may also be prepared by organisations
 Departmental budgets
 Functional budgets (for sales, production, expenditure and so on)
 Profit or Loss account (in order to determine the expected future profits)
 Cash budgets (in order to determine future cash flows)
CHAPTER 6: Budgeting

01 The purposes of budgeting


Purposes of budgeting
The main aims of budgeting are as follows:
 Planning for the future – in line with the objectives of the organization
 Controlling costs – by comparing the plan of the budget with the actual results and
investigating significant differences between the two
 Co-ordination of the different activities of the business by ensuring that managers
are working towards the same common goal (as stated in the budget)
 Communication – budgets communicate the targets of the organisation to
individual managers
 Motivation – budgets can motivate managers by encouraging them to beat targets
or budgets set at the beginning of the budget period. Bonuses are often based on
‘beating budgets’. Budgets, if badly set, can also demotivate employees
 Evaluation – the performance of managers is often judged by looking at how well
the manager has performed ‘against budget’
 Authorisation – budgets act as a form of authorisation of expenditure
 Resource allocation – especially if resources are in scarce supply
CHAPTER 6: Budgeting

02 The stages in budget preparation


How are budgets prepared?
 Long-term objectives

– of an organisation must be defined so that the budgets prepared are working


towards the goals of the business.

 Budget committee

– is formed – a typical budget committee is made up of the Chief Executive, Budget


Officer (Management Accountant) and departmental or functional heads (sales
manager, purchasing manager, production manager and so on). The budget committee
is responsible for communicating policy guidelines to the people who prepare the
budgets and for setting and approving budgets.
CHAPTER 6: Budgeting

02 The stages in budget preparation


How are budgets prepared?
 Budget manual

– is produced – an organisation’s budget manual sets out instructions relating to the


preparation and use of budgets. It also gives details of the responsibilities of those
involved in the budgeting process, including an organisation chart and a list of budget
holders.

 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.

 Other functional budgets – are produced.


CHAPTER 6: Budgeting

02 The stages in budget preparation


The entire budget preparation process may take several weeks or months to complete.
The final stages are as follows:
(1) Initial budgets are prepared
– Budget managers may sometimes try to build in an element of budget slack – this is
a deliberate over-estimation of costs or under-estimation of revenues which can make it
easier for managers to achieve their targets.
(2) Initial budgets are reviewed
– and integrated into the complete budget system.
(3) Master budget is prepared
– After any necessary adjustments are made to initial budgets, they are accepted and
the master budget is prepared (budgeted profit or loss account, balance sheet and cash
flow). This master budget is then shown to top management for final approval.
(4) Comparisons between budgets and actual results
– Budgets are reviewed regularly. Comparisons between budgets and actual results are
carried out and any differences arising are known as variances.
Budget preparation
 The preparation of budgets involves the following seven steps and is illustrated as
follows.
CHAPTER 6: Budgeting

02 The stages in budget preparation


BUDGETING SALES BUDGET

PRODUCTION BUDGET

RAW MATERIALS LABOUR FACTORY


OVERHEAD

COST OF GOODS
SOLD BUDGET

SELLING AND DISTRIBUTION GENERAL AND ADMINISTRATION


EXPENSES BUDGET EXPENSES BUDGET

MASTER BUDGET

BUDGETED INCOME STATEMENT

CASH BUDGET CAPITAL EXPENDITURE BUDGET

BUDGETED BALANCE SHEET


CHAPTER 6: Budgeting

02 The stages in budget preparation

 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

A functional budget is a budget of income and/or expenditure which applies to a


particular function. The main functional budgets that you need to be able to prepare are
as follows:
 Sales budget
 Production budget
 Raw material usage budget
 Raw material purchases budget
 Labour budget
CHAPTER 6: Budgeting

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.

Material purchases budget = Material usage budget + Closing inventory – Opening


inventory
CHAPTER 6: Budgeting

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

05 The master budget


The master budget is the budget into which all subsidiary budgets are consolidated.
The master budget normally comprises:

 budgeted profit or loss account


 budgeted balance sheet
 budgeted cash flow statement (cash budget).

The master budgets will be drawn up after all the functional budgets have been
approved.

Budgeted profit or loss account


 The budgeted profit or loss account is prepared by summarising the functional
budgets.
CHAPTER 6: Budgeting

05 The master budget


CHAPTER 6: Budgeting

05 The master budget


Budgeted balance sheet

 The budgeted balance sheet will show the likely financial position at the end of the
budget period.
CHAPTER 6: Budgeting

05 The master budget


The cash budget
A cash budget is a detailed budget of estimated cash inflows and outflows
incorporating both revenue and capital items.
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:

 High-low method – estimates fixed and variable costs of a product/service


 least squares regression – establishes a cost equation.
High-low method
Basic high-low method

 The high-low method is based on an analysis of historical information about costs


at different activity levels. The steps involved in the high-low method are as
follows:
CHAPTER 6: Budgeting

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 variable cost per unit


– Variable cost per unit =
 Step 3 –

– 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:

A Find the variable cost per unit.

B Find the total fixed cost.

C Estimate the total cost if output is 350 units.

D Estimate the total cost if output is 600 units.


CHAPTER 6: Budgeting

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:

Total cost £9,000


Total variable cost = 400 × £10 £4,000
Therefore fixed cost £5,000
C/ If output is 350 units:
Variable cost = 350 × £10 £3,500
Fixed cost £5,000
––––––
Total cost £8,500
CHAPTER 6: Budgeting

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

If these data are plotted on a graph, such a graph is known as a scattergraph or a


scatter chart.
CHAPTER 6: Budgeting

06 Preparing forecasts
Scattergraph showing total costs incurred at various output levels in a factory

 A scattergraph can be used to make an


estimate of fixed and variable costs by
drawing a ‘line of best fit’ through the
points which represents all of the points
plotted.
 The line of best fit has been added to
the scattergraph shown above.
 The line of best fit is a cost equation (or
linear function) of the form y = a + bx
where a = fixed costs and b = variable
cost per unit.
 A technique known as regression
analysis can be used to establish the
equation of the line of best fit, and
therefore, the fixed and variable costs.
CHAPTER 6: Budgeting

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.

– Correlation measures the strength of the connection between two variables.


– One way of measuring ‘how correlated’ two variables are is by drawing a graph
(scattergraph or scatter chart) to see if any visible relationship exists. The ‘line of best fit’
drawn on a scattergraph indicates a possible linear relationship.

 When correlation is strong, the estimated line of best fit should be more reliable.

 Another way of measuring ‘how correlated’ two variables are is to calculate a


correlation coefficient, r, and to interpret the result.
CHAPTER 6: Budgeting

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.

 For example, if the linear function of a scattergraph was estimated to be y = 5,587 +


34.77x, we could get some idea of how reliable our estimated linear function was if
we were to calculate the associated correlation coefficient.

 If we were to calculate the associated correlation coefficient. The correlation


coefficient can only take on values between –1 and +1.
– r = + 1 indicates perfect positive correlation
– r = 0 indicates no correlation – r =
–1 indicates perfect negative correlation
CHAPTER 6: Budgeting

06 Preparing forecasts
Coefficient of determination

The coefficient of determination is the square of the correlation coefficient. and so is


denoted by r2 .

 The coefficient of determination is a measure of how much of the variation in the


dependent variable is ‘explained’ by the variation of the independent variable.

 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

 For example, if r = 0.98, r2 = 0.96

 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

Big Data concerns ‘high-volume’, ‘high-velocity’ and ‘high-variety’ information assets. It is


usually data that is obtained in addition to the traditional management information data
e.g. key words discussed in published social media conversations, or trending video clips
shared through social media. It therefore should provide a deeper understanding of
customer’s needs.
The main characteristics of big data are:
Volume

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.

 Velocity: Timeliness is a key factor in the usefulness of financial information to


decision makers, and it is no different for the users of big data.

 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

Big Data benefits Big Data problems


 A company needs to be seen as
 Allows a substantial amount of
trustworthy to attract customers to
information to be processed, from
share this information
many different sources  Lack of forecasting tools available
 Allows an accurate model of future
 Infringement on privacy
demand to be generated  Security required to hold
 Provides companies with the ability
information
to understand customer’s  Incorrect data
preferences and reactions to new  Lack of skilled data analysts to
products
 Big Data can be used for short term successfully use Big Data
and long term decisions
 Big Data often provides ‘real’ time
information – which means it can be
continually updated
CHAPTER 6: Budgeting

07 Alternative approaches to budgeting


Participation in the budget process
 Managers may be involved in setting budget targets or these may be imposed by
senior management without consultation.
Top down budget
 A budget that is set without allowing the ultimate budget holder to have the
opportunity to participate in the budgeting process. Also called ‘imposed’ budget,
or non-participative.
Bottom up budget
 A system of budgeting in which budget holders have the opportunity to participate
in setting their own budgets. Also called participative budgeting.
Advantages of participative budgets.
 Increased motivation (ownership of budget)
 Should contain better information, especially in a fast-moving or diverse business
 Increases managers’ understanding and commitment
 Better communication
 Senior managers can concentrate on strategy
CHAPTER 6: Budgeting

07 Alternative approaches to budgeting


Disadvantages of participative budgets
 Senior managers may resent loss of control
 Bad decisions from inexperienced managers
 Budgets may not be in line with corporate objectives
 Budget preparation is slower and disputes can arise
 Figures may be subject to bias if junior managers either try to impress or set easily
achievable targets (budgetary slack)
 Certain environments may preclude participation, e.g. sales manager may be faced
with long-term contracts already agreed
CHAPTER 6: Budgeting

07 Alternative approaches to budgeting


Types of budget
There are a number of different types of budget which are all prepared in different
ways. Some of the more common budgets are as follows.
 Continuous/rolling budget
– this type of budget is prepared a year (or budget period) ahead and is updated
regularly by adding a further accounting period (month, quarter) when the first
accounting period has expired. If the budget period is a year, then it will always reflect
the budget for a year in advance. Continuous budgets are also known as rolling
budgets.

 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).

 Zero-based budget (ZBB)


– this type of budget starts the budgeting process from zero because it does not
take anything for granted.
CHAPTER 6: Budgeting

07 Alternative approaches to budgeting


Alternative budget structures
 Product based budgets
– where individual budgets are produced for each product.

 Responsibility based budgets


– where budgets are produced for areas of personal responsibility.

 Activity based budgets


– where budgets are produced on the basis of the activities which drive costs.
CHAPTER 6: Budgeting

07 Alternative approaches to budgeting


THE PURPOSES OF BUDGETING
Planning; Communication Control; Motivation; Co-
ordination; Authorisation Evaluation.

BUDGETING

THE STAGES OF BUDGET PREPARATION


1 Budget committee formed; 2 Budget manual produced ; 3 Limiting factor
identified and its corresponding budget prepared; 4 Initial functional budgets
prepared; 5 Initial budgets reviewed and integrated into complete budget
system; 6 Top management give final approval; 7 Budgets reviewed regularly
and variances arising are investigated

TYPES OF BUDGETS

SALES PRODUCTION MATERIAL LABOUR


BUDGETS BUDGETS BUDGETS 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

● prepare a cash budget

● calculate the cash cycle and appreciate its significance

● calculate liquidity ratios

● recognise how predicted cash surpluses and deficits can be

managed.
CHAPTER 7: Working capital
OVERVIEW
Liquidity WORKING CAPITAL Profitability

Inventory Receivables Payables Cash

Cash operating
cycle Cash budget

Liquidity ratios Managing cash


surplus/deficits
CHAPTER 7: Working capital
01
Introduction to working capital

Working Capital = Current Assets – Current Liabilities


= Inventory + Receivables + Cash – Payables
A firm 'invests' in its working capital to 'oil the wheels' of the business.
When managing its working capital, a balance needs to be struck between two
conflicting objectives:

Profitability Liquidity

For long-term growth For short-term survival


and returns to investors e.g. paying next
month’s wage bill
CHAPTER 7: Working capital
01
Introduction to working capital

Example 1
How should a business manage its receivables?

 Profitability demands generous terms of credit on sales to encourage high sales


volumes – but receivables will be high.
 Liquidity demands cash sales only – receivables will be zero!

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

 The classic textbook rule of thumb is that:


– Long-term assets should be financed by long-term funds (share capital, bank
loans etc).
– Short-term assets should be financed by short-term funds (credit from suppliers,
bank overdraft etc.) i.e. that working capital should be self-financing.
 But short-term finance has its advantages and disadvantages such that the above
rule will rarely be applied rigidly:
Advantages of short-term finance:

 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:

 Renewal risk – an overdraft may be recalled on demand


 Interest rate risk – short-term interest rates can fluctuate.
CHAPTER 7: Working capital
03
Analysing the liquidity position using ratios
The following ratios need to be learned
 Assess the business’ liquidity position
(i) Current ratio =
– a ratio of less than 1 indicates a business will struggle to pay its current liabilities as
they fall due.
(ii) Quick (or liquidity) ratio =
– a more realistic measure of a business’ ability to meet its short-term commitments due
to the length of time that may be taken to turn inventory into cash.
What constitutes an appropriate level for both of the above ratios depends on the type of
business.
 Identify the causes of a liquidity problem
(i) Inventory period (in days) = × 365
(ii) Receivables collection period (in days) = × 365
(iii) Payables payment period (in days) = × 365
CHAPTER 7: Working capital
04
The working capital cycle
The working capital cycle (cash operating cycle) is defined as the length of time
between paying for the purchase of goods and receiving cash for the subsequent sale.

Profitability

Profitability Profitability

Profitability Profitability

It can be calculated as:


Receivables + raw material + WIP + finished – payables
collection inventory inventory goods inventory payment
period holding period holding period holding period method
CHAPTER 7: Working capital
04
The working capital cycle
Calculation aspects
 Receivables collection period =
– (average receivables/annual sales revenue) × 365 days.
 Raw materials inventory holding period =
– (average inventory of raw materials/annual usage) × 365 days.
 WIP inventory holding period =
– (average inventory of WIP/annual cost of sales) × 365 days.
 Finished goods inventory holding period =
– (average inventory of fin goods/annual cost of sales) × 365 days.
 (Payables payment period) =
– (average payables/annual purchases) × (365 days).
 More generally, time period =
– (B/S figure/income statement figure) × 365 days.
 The cycle may be measured in days, weeks or months.
 May use year-end figures where averages are not available.
 Comparison to prior year, industry average, budgeted ratios vital.
 The faster a firm can ‘push’ items around the cycle the lower its investment in
working capital will be.
CHAPTER 7: Working capital
04
The working capital cycle
Illustration 1 – The working capital cycle
A company generally pays its suppliers six weeks after receiving an invoice, whilst
receivables usually pay within four weeks of invoicing. Raw materials inventory is held
for a week before processing begins. Processing itself takes three weeks. Finished
goods stay in inventory for an average of two weeks.

How long is the company’s cash operating cycle?


Solution
Cash operating cycle = 1 – 6 + 3 + 2 + 4 = 4 weeks
CHAPTER 7: Working capital
04
The working capital cycle
The significance of the cash operating cycle

 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 =

Where c = the cost of placing one order


d = demand for the inventory item over the particular period (usually annual
demand)
h = the holding cost of one unit of inventory for that period
CHAPTER 7: Working capital
06
Managing the components of working capital
 There are some alternative systems for inventory control:

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

(ii) Trade payables

 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

Illustration 2 – The annual cost of a cash discount

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

Illustration 2 – The annual cost of a cash discount


 Assess the risk the customer won’t pay by giving it a credit rating.
Consider whether to outsource credit collection and/or financing through:
– Receivables factoring: factor advances (say) 80% of the funds immediately
and takes responsibility for collecting the debt efficiently
– Invoice discounting: no outsourcing of debt collection but the debts are
'sold' at a discount for an immediate cash sum.
CHAPTER 7: Working capital
06
Managing the components of working capital

Illustration 2 – The annual cost of a cash discount


 Minimise the time taken between the placement of the order and the receipt of
cash from the customer.
This can involve:
– Encouraging on-line ordering
– Prompt despatch of goods, invoices and reminder statements
– Preparation of credit control reports which highlight slow-paying
customers.
 Consider whether to take out trade credit insurance against the possible default
and insolvency of is credit customers.
CHAPTER 7: Working capital
07
Treasury (cash) management

 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

– to anticipate cash shortages/surpluses and thus provide information to assist management


in short and medium-term cash planning and longer-term financing for the organisation.
CHAPTER 7: Working capital
08
Cash budgets
Method of preparation

A Forecast sales.

B Forecast time-lag on converting receivables to cash, and hence forecast cash receipts
from credit sales.

C Determine inventory levels, and hence purchase requirements.

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

––– ––– –––


Closing Balance X X X
CHAPTER 7: Working capital
08
Cash budgets
Illustration 3 – Cash budgets
A wholesale company ends its financial year on 30 June. You have been requested, in
early July 20X5, to assist in the preparation of a cash forecast. The following
information is available regarding the company’s operations.

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:

B The accounts receivable at 30 June 20X5 total


£380,000. Sales collections are generally made as
follows: During month of sale 60% In first subsequent
month 30% In second subsequent month 9%
Uncollectable 1%

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

Cash position Appropriate management action

Pay suppliers early


Short-term surplus Increase spending
Make investments
Delay payments
Short-term shortfall Tighten credit control
Overdraft
Make investments
Acquisition
Long-term surplus Pay dividend
Replace assets
Share buy-back

Raise new finance, debt or equity


Sell assets
Long-term shortfall Divest
Close business
CHAPTER 7: Working capital
09
Potential cash positions

WORKING
Liquidity Profitability
CAPITAL

Working capital Separate elements


overall within working capital

Making your working Inventory Payables Receivables Cash


How to finance
working capital capital work
efficiently
Cash budget
Cash operating
cycle
Managing cash
Liquidity surplus / deficits
ratios
Performance
management
CHAPTER
08
CHAPTER 8: Performance management
LEARNING OBJECTIVES

Upon completion of this chapter you will be able to:

● Discuss performance measures

● Calculate performance measures

● Describe the balanced scorecard

● Explain budgetary control.


CHAPTER 8: Performance management
PERFORMANCE
MANAGEMENT

FEEDBACK DECENTRALISATION RESPONSIBILITY


CENTRES

MEASURES COST
BUDGETARY INCLUDING ROI; RI REVENUE
CONTROL AND BALANCED PROFIT
SCORECARD INVESTME
NT
CHAPTER 8: Performance management
01
Performance evaluation

The main functions that management are involved with are:


 Planning
 Decision-making
 Control Planning

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

1 Set objectives for achievement


2 Identify way in which objectives can
be achieved
PLANNING
3 Make a decision as to how objectives
can be achieved based on information
provided

IMPLEMENT DECISION MAKING


DECISION

1 Gather information about actual


results achieved
CONTROL
2 Compare actual results and expected
results – evaluate outcome
3 Revise original objectives if necessary
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

Illustration 1 – Performance evaluation

INPUT SYSTEM OUTPUT

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

 Information is provided to management to assist them with planning, controlling


operations and making decisions. Management decisions are likely to be better when
they are provided with better quality information.
 Clear and comprehensive.
 Exemption basis.
 Based on controllable costs and revenue.
 Produced on regular basis.
 Timely.
 Accurate.
 Communicated.
 Irrelevant data excluded.
CHAPTER 8: Performance management
01
Performance evaluation
Behavioural aspects of performance measurement

Budgets and behaviour


 Individuals react to the demands of budgeting and budgetary control in different ways
and their behaviour can damage the budgeting process
 Behavioural problems include dysfunctional behaviour and budget slack
 Dysfunctional behaviour is when individual managers seek to achieve their own
objectives rather than the objectives of the organisation
Budget bias
 Budget slack (or bias) is a deliberate over-estimation of expenditure and/or under-
estimation of revenues in the budgeting process.
Hopwood’s research
 Research was carried out by Hopwood (1973) into the manufacturing division of a
US steelworks, involving a sample of more than two hundred managers with cost
centre responsibility.
 Hopwood identified three distinct styles of using budgetary information to evaluate
management performance.
CHAPTER 8: Performance management
01
Performance evaluation

Performance evaluation Behavioural effects

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

Performance evaluation Behavioural effects

Non With this style, performance evaluation is With the non-accounting


accounting not based on budgetary information and style, the results were very
style accounting information plays a relatively similar to the profitconscious
unimportant role. Other non-accounting style, except for
performance indicators are as important a much lower concern with
as the budget targets. cost information.

 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

Job-related tension HIGH MEDIUM MEDIUM

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

Divisionalisation and decentralization


 As companies grow, they are likely to split the company into divisions.
 Divisions could be based on geographical location or product provided.
 Divisional managers are given the authority to make decisions regarding their division.
 The more decisions that the managers are free to make, the more decentralised the
company is said to be.

Factors affecting degrees of decentralization


 Management style
 Size of company
 Extent of diversification
 Communication
 Management’s ability
 Technology
 Geographical location
 Extent of local knowledge needed
CHAPTER 8: Performance management
02
Responsibility centres

Advantages and disadvantages of decentralisation


Advantages Disadvantages
Senior managers freed up for strategic
Co-ordinating the business
issues
Better decisions made by local managers Lack of goal congruence
Motivation of managers Loss of control at senior level
Quicker decisions Difficult to evaluate managers
Good training Duplication of costs
CHAPTER 8: Performance management
02
Responsibility centres

Responsibility accounting is a system of providing financial information to management,


where the structure of the reporting system is based on identifying individual parts of a
business which are the responsibility of a single manager.
A responsibility centre is an individual part of a business whose manager has personal
responsibility for its performance. The main responsibility centres are:
 Cost centre
 Profit centre
 Investment centre
 Revenue centre
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

Illustration 2 – 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

Requirements for effective performance measures

 Promote goal congruence


 Controllable factors only
 Long-term objectives considered

Problems with inappropriate 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

A selection of appropriate measures


CHAPTER 8: Performance management
03
Performance measures

Performance measures for investment centres – the working capital ratios


Rate of inventory turnover =

Receivables collection period in days = × 365

Payables payment period = × 365

 These ratios could be found using year-end figures or average figures.


 To calculate in months, × 12.
 In some divisionalised companies some of these liquidity ratios are less important since
the assets are managed centrally.
 Comparison would be made with group standards, other divisions, other periods and
other firms in the same business.
CHAPTER 8: Performance management
03
Performance measures

The Return on Investment (ROCE/ROI) and Residual Income


ROI = Controllable divisional profit/ × 100%
Controllable divisional investment

RI = Controllable – Imputed interest cost on


divisional profit controllable divisional investment

TEST YOUR UNDERSTANDING

An organisation has a controllable profit of £50,000 and capital employed of


£230,000. The cost of capital is 14%. What are its ROI and RI?
TEST YOUR UNDERSTANDING ANSWER
ROI = 50,000/230,000 × 100% = 21.7%
RI = £50,000 – (14% × £230,000) = £17,800
CHAPTER 8: Performance management
03
Performance measures
Illustration 3 – Performance measures
Division X of ABC plc, currently generating an ROI of 12%, is considering a new project.
This requires an investment of £1.4 million and is expected to yield net cash inflows of
£460,000 per annum for the next four years. None of the initial investment will be
recoverable at the end of the project.
ABC plc has a cost of capital of 8%; annual accounting profits are to be assumed to equal
annual net cash inflows less depreciation, and tax is to be ignored.
The NPV of the project is positive (chapter 11) so the project should be accepted.

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

ROI and RI computations will be as follows:

If the manager’s performance is measured (and rewarded) on the basis of RI or ROI he is


unlikely to accept the project. The first year’s RI is negative, and the ROI does not exceed
the company’s cost of capital until year 2, or that currently being earned until year 3.
Divisional managers will tend to take a short-term view; more immediate returns are more
certain, and by year 3 he may have moved jobs.
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

Benefits of RI over ROI


Residual income overcomes many of the disadvantages of ROI, specifically:
 It reduces the problem of under investing or failing to accept projects with ROI’s
greater than the group target but less than the division’s current ROI.
 As a consequence it is more consistent with the objective of maximising the total
profitability of the group.
 It is possible to use different rates of interest for different types of asset.
 The cost of financing a division is brought home to divisional managers.
CHAPTER 8: Performance management
03
Performance measures
Problems for both
There are certain problems common to both measures.
 Calculation of profit – apart from issues such as its controllability there is some scope,
even within the strictures of a group accounting policy, for some variation in treatment of
depreciation. Also the need to increase profit may lead to cutting down on discretionary
costs such as training, advertising and maintenance which, whilst improving short-term
profit figures, will jeopardise the long-term future of a business. Standards for these
should be set and monitored.
 Asset measurement – again group policies should ensure a consistent treatment, but
comparison is difficult when some divisions buy and some lease assets. Thought has to
be given to the treatment of permanent bank overdrafts; are these current liabilities or a
source of finance?
 Conflict with investment decisions – the performance of a division will be influenced by
investment decisions that it makes; however those decisions should be made on the
basis of NPV calculations, whereas the subsequent performance of the division is
assessed by a different criterion. Clearly there is likely to be a problem when a long-term
investment decision is accepted, but the short-term effect on profit is detrimental.
CHAPTER 8: Performance management
04
The balanced scorecard
 Kaplan and Norton developed an approach to performance measurement with the
idea that the business develops a comprehensive framework for translating a
company’s strategic objectives into a coherent set of goals and performance
measures. The goals and measures should be clear and limited in number.
The balanced scorecard approach
 A balanced scorecard for a company would be constructed by considering four
perspectives:
– Financial – how do we create value for our shareholders?
– Customer – what is it about us that customers value?
– Internal – what processes must we excel at to achieve our financial & customer
objectives?
– Innovation & learning – how can we continue to improve and create future value?
CHAPTER 8: Performance management
04
The balanced scorecard

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?

Learning and growth


To achieve our vision,
how will we sustain our
ability to change and
improve?
CHAPTER 8: Performance management
04
The balanced scorecard

 Within each of these categories a company should seek to identify a series of


critical success factors (CSFs) and key performance indicators (KPIs) – financial
and non-financial
 Targets should be set
 Performance monitored
CSFs – those things we absolutely must get right to succeed in relation to a given
perspective.
KPIs – the ways in which we can measure the CSFs.
CHAPTER 8: Performance management
04
The balanced scorecard
Illustration 4 – Performance measures
Some general examples of CSFs/KPIs

NB the ultimate measure of corporate performance (for quoted companies) is the share price.
CHAPTER 8: Performance management
04
The balanced scorecard

Benefits of the balanced scorecard:

 Provides external as well as internal information


 Focuses on factors which will enable company to succeed, including non-financial
ones.

Problems with 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

Reasons for differences sought and


obtained, followed by appropriate
management action
CHAPTER 8: Performance management
05
Budgetary control

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

Illustration 5 – Budgetary control


An example of a budget report is shown below.
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:
£

Direct materials 4,500


Direct labour 22,000
Production overheads 28,000
Administration, selling and distribution overheads 16,500
––––––
Total cost 71,000
––––––

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

Flexed budgets and budget variances


As we have already said, the comparison of actual results against a flexed budget is
much more useful than a comparison against an original fixed budget.
 However, we cannot just ignore the original budget altogether as it forms part of the
operational plan and management will want to see how the actual results compare
with budgeted profits.
 The overall differences between the original budget and actual results are known as
total budget variances.
 Total budget variances can be analysed into volume and expenditure variances.
Consider the budget report shown in the following illustration.
CHAPTER 8: Performance management
05
Budgetary control
Illustration 7 – 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

Investment centre Responsible for:


Cost centre Costs incurred
Responsible for: Costs incurred Revenues earned
Capital invested

Balanced scorecard
Perspectives:
• Financial
• Customer
• Internal business
• Innovation and learning

Fixed budget Flexible budget


• For a single • Realistic budget cost allowance
activity level for actual activity
CHAPTER 8: Performance management
06
Chapter Summary

Investment centre
Responsible for:
Costs incurred
Revenues earned
Capital invested

Performance measures
• related to capital

Return on investment (ROI)


• Dysfunctional focus on Residual income (RI)
short-term performance • Reduces dysfunctional behaviour
• Most useful as a • Encourages marginal investments
comparative measure
Standard costing
and variance
analysis
CHAPTER
09
CHAPTER 9: Standard costing and variance analysis
LEARNING OBJECTIVES

Upon completion of this chapter you will be able to:

● Understand standard costing

● Calculate sales variances

● Calculate cost variances

● Interpret variances including interdependencies

● Reconcile budgeted contribution to actual profit using an operating

statement

● Work backwards from a variance to calculate actual figures.


CHAPTER 9: Standard costing and variance analysis
THE PURPOSES OF STANDARD
COSTING

STANDARD COSTING

STANDARD COSTS PER UNIT

VARIANCE CALCULATION AND


ANALYSIS

MATERIAL LABOUR VARIABLE FIXED


SALES COST OVERHEAD OVERHEAD
COST
VARIANCES VARIANCES VARIANCES VARIANCES
VARIANCES

OPERATINGS STATEMENTS
CHAPTER 9: Standard costing and variance analysis
01
Standard costing

Standard costing is the preparation of standard costs to use in variance analysis. 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, efficiency and price
of resources for each cost unit.
Illustration 1
Standard Cost Card for cement statue
CHAPTER 9: Standard costing and variance analysis
02
Budgets

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:

 Aids more accurate budgeting


 Gives targets for employees
 Provides a framework for scheduling activities
 Simplifies accounting
 Enables management by exception via variance analysis

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

There are 3 different approaches that can be used to calculate variances:

(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

The variance calculated will be different depending on whether a marginal or absorption


costing system is adopted. Only variances calculated using marginal costing is on
the MI syllabus.

The variances you will learn to calculate are:

 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

There are two different sales variances:


 Sales volume variance
 Sales price variance

Sales volume variance


The purpose of calculating the sales volume variance is to determine the effect on
contribution and thus profit, of the actual number of units sold being different from
budgeted units sold.

Therefore the sales volume variance explains the difference in profit between the fixed
and flexed budgets

Sales price variance


The purpose of calculating sales price variance is to determine the effect on contribution
and thus profit, of the actual selling price per units sold being different from budgeted
price.
CHAPTER 9: Standard costing and variance analysis
05
Sales variances

5.1 Tabular approach


Sales volume variance

S×S Budgeted quantity (BQ) × = Budgeted contribution per the


Standard Contribution Per Unit fixed budget (1)
(SCPU)
Sales volume
variance
A×S Actual quantity (AQ) × = What budgeted contribution
Standard Contribution Per Unit would have been for the actual
(SCPU) level of production i.e. per the
flexed budget (2)

If (1) – (2) is positive, the variance is adverse.

If (1) – (2) is negative, the variance is favourable.


CHAPTER 9: Standard costing and variance analysis
05
Sales variances

A×A Actual selling price per unit = Actual revenue (3)


(AP) × Actual quantity sold
(AQ)
Sales price
variance
S×A Standard selling price per unit = What budgeted revenue
(SP) × Actual quantity sold would have been for the actual
(AQ) level of sales (4)

If (3) – (4) is positive, the variance is favourable


If (3) – (4) is negative, the variance is adverse.
CHAPTER 9: Standard costing and variance analysis
05
Sales variances

5.2 Did–Should approach


Extract from a budget
Revenue 500 units @ £4 per unit £2,000

Variable costs 500 units @ £2.50 per unit £1,250

Sales volume variance


Units
Actual sales volume x
Budgeted sales volume (x)
–––––
Difference in units x/(x)
–––––
Sales volume
Valued at Standard CPU [Units × (£4 – £2.50)] £x
variance
–––––
CHAPTER 9: Standard costing and variance analysis
05
Sales variances

5.2 Did–Should approach


If the difference is positive, the variance is favourable.
If the difference is negative, the variance is adverse.
Sales price variance
Units
Actual quantity of units sold did sell for x
Actual quantity of units sold should sell for (Q × £4) (x)
–––––
Sales price variance x
–––––

If the difference is positive, the variance is favourable.


If the difference is negative, the variance is adverse.
CHAPTER 9: Standard costing and variance analysis
05
Sales variances

5.3 Formulae approach


Sales volume variance

(AQ-BQ) × SCPU
If the calculation is positive, the variance is favourable.
If the calculation is negative, the variance is adverse.

Sales price variance

(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

5.4 Possible causes of sales variances


Favourable Adverse
Sales price Supply shortage Supply surplus
variance Fewer quantity discounts than More quantity discounts than
expected expected
Standard selling price too low Standard selling price too high
Sales volume Efficient sales force Demotivated sales force
variance Successful advertising Competitors increased
campaign advertising
Potential market was larger Unexpected fall in demand
than expected due to recession
Additional demand attracted by Failure to satisfy demand due
a reduced price to production difficulties
Budgeted sales volume too Budgeted sales volume too
conservative optimistic
CHAPTER 9: Standard costing and variance analysis
06
Material variances

There are three different materials variances:


 Material total variance
 Material price variance
 Material usage variance
Material total variance
The material total variance explains the difference between the material cost in the
flexed budget and the actual material cost incurred.
The total variance can be analysed into two sub variances: the materials price variance
and the material usage variance.
The material total variance is calculated by adding together the two sub variances.
CHAPTER 9: Standard costing and variance analysis
06
Material variances

Material price variance


The purpose of the material price variance is to ascertain whether the company paid
more or less per kg than expected for materials used or purchased.
Material usage variance
The purpose of the material usage variance is to ascertain whether the company used
more or less material than expected to produce the actual number of cost units
produced. This difference in usage is valued at the standard price per unit of material.
CHAPTER 9: Standard costing and variance analysis
06
Material variances
6.1 Tabular approach

A×A Actual quantity of material (AQ) = Actual expenditure


× Actual Price of material (AP) on materials (1)
Material
price
A×S Actual quantity of material (AQ) = What actual quantity
variance
× Standard price of material of materials used
(SP) should have cost (2) (1) – (2)

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
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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
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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
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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
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Material variances

6.3 Formulae approach


Material price variance
(SP – AP) × AQ purchased
If the calculation is positive, the variance is favourable.
If the calculation is negative, the variance is adverse.

Material usage variance


(SQ used – AQ used) × SP
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
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Material variances

6.4 Possible causes of material variances


Favourable Adverse
Material price Unforeseen discounts received Price increase in the market
variance More care taken in purchasing Careless purchasing
Supplies bought from cheaper Supplies bought from more
source expensive source
Material usage Standard material price too high Standard material price too low
variance Material used of higher quality than Defective material/poorer
standard quality material used than
standard
More effective use of material Excessive waste
Budgeting too much material per job Theft
Stricter quality control
Budgeting too little material per
job
CHAPTER 9: Standard costing and variance analysis
07
Labour approach

There are three different labour variances:


 Labour total variance
 Labour rate variance
 Labour efficiency variance

Labour total variance


The labour total variance explains the difference between the labour cost in the flexed
budget and the actual labour cost.
The total variance can be analysed into two sub variances: the labour rate variance and
the labour efficiency variance.
The labour total variance is calculated by adding together the two sub variances.
CHAPTER 9: Standard costing and variance analysis
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Labour approach

Labour rate variance


The purpose of the labour rate variance is to ascertain whether the company paid more
or less than expected in wages for the actual number of hours employees were paid
for.

Labour efficiency variance


The purpose of the labour efficiency variance is to ascertain whether the employees
worked for more or less labour hours than expected to produce the actual volume of
cost units. The difference in hours is valued at the standard labour rate per hour.
CHAPTER 9: Standard costing and variance analysis
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Labour approach
7.1 Tabular approach

A×A Actual hours (AH) × Actual rate = Actual expenditure on labour


per labour hour (AR) (1)
Labour rate
variance
A×S Actual hours (AH) × Standard = What actual number of labour
(1) – (2)
rate per labour hour (SR) hours should have cost (2)

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
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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
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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
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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
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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.

Labour efficiency variance


(SH – AH) × SR
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
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Labour approach

7.4 Possible causes of labour variances


Favourable Adverse
Labour Use of lower paid workers e.g. apprentices Use a higher grade labour than
rate Less overtime or fewer bonus payments than standard
variance budgeted More overtime or bonus payments
than budgeted
Unexpected wage rate increase
(increase in minimum wage)

Labour Improved motivation (e.g. incentive Lost time in excess of standard


efficiency schemes), equipment, materials or methods allowed
variance (e.g. better supervision or training) leading to
quicker production of output
Consequences of the learning effect
Output lower than standard set
because of deliberate restriction, lack
Budgeting too much time per job of training or sub-standard material
used
Budgeting too little time per job
CHAPTER 9: Standard costing and variance analysis
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Variable overhead variances

There are three different variable overhead variances:

 Variable overhead total variance


 Variable overhead rate variance
 Variable overhead efficiency variance

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
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Variable overhead variances

Variable overhead expenditure variance

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.

Variable overhead efficiency variance

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
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Variable overhead variances
8.1 Tabular approach

A×A Actual hours (AH) × Actual rate = Actual expenditure on


per labour hour (AR) variable overheads (1)
Variable
overhead
expenditure
A×S Actual hours worked (AH) × = What actual variable
Standard rate per labour overhead should have cost (2) variance
hour (SR) (1) – (2)

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
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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
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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
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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
–––

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
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Variable overhead variances
8.3 Formulae approach
Variable overhead expenditure variance
(SR – AR) × AH
If the calculation is positive, the variance is favourable.
If the calculation is negative, the variance is adverse.

Variable overhead efficiency variance


(SH – AH) × SR
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
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Variable overhead variances
8.4 Possible causes of variable overhead variances
Favourable Adverse
Variable overhead Change in type of overheard Change in type of overheard or
expenditure variance or decrease in its cost. decrease in its cost.
Variable overhead Improved motivation, Lost time in excess of standard
efficiency variance equipment, materials or allowed.
(assuming based on methods leading to quicker
labour hours) production of output.
Output lower than standard set
Budgeting too much time because of deliberate restriction,
per job. lack of training or sub-standard
material used.

Budgeting too little time per job.

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
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Fixed overhead variances

9.2 Formulae approach


(AC – BC)
If the calculation is positive, the variance is adverse.
If the calculation is negative, the variance is favourable.
TEST YOUR UNDERSTANDING
The following data relates to selling cement statues in 20X5:
Budgeted costs for selling 1,000 cement statues
£ Total 1,000 units
Fixed overheads 10,000
Actual costs from selling 1,100 cement statues
£ Total 1,100 units
Fixed overheads 8,000
Calculate the fixed overhead variance.
CHAPTER 9: Standard costing and variance analysis
09
Fixed overhead variances

9.3 Possible causes of fixed overhead variances


Favourable Adverse
Fixed
overhead Any element of fixed overhead (e.g. rent) Any element of fixed overhead (e.g.
expenditure being lower than budgeted rent) being higher than budgeted
variance
CHAPTER 9: Standard costing and variance analysis
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Possible interrelationships between variances
The cause of a particular variance may affect another variance in a corresponding or
opposite way. This is known as interrelationships between variances. Here are some
examples:
 If supplies of a specified material are not available, this may lead to a favourable price
variance (cheaper material used), an adverse usage variance (cheaper material
caused more wastage) and an adverse sales volume variance (unable to meet
demand due to production difficulties).
 A new improved machine becomes available which causes an adverse fixed overhead
expenditure variance (because this machine is more expensive and depreciation is
higher) offset by favourable wages efficiency variance (higher productivity).
 Workers trying to improve productivity (favourable labour efficiency variance) might
become careless and waste more material (adverse materials usage variance).
 In each of these cases, if one variance has given rise to the other, there is an
argument in favour of combining the two variances and ascribing them to the common
cause. In view of these possible interrelationships, care has to be taken when
implementing a bonus scheme. If the chief buyer is rewarded for producing a
favourable price variance, this may bring about trouble later if they achieved this by
purchasing shoddier materials which may give rise to adverse usage variances.
CHAPTER 9: Standard costing and variance analysis
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Operating statements
An operating statement, or statement of variances, shows the reconciliation between
budgeted contribution and actual profit.
Illustration 4 – Marginal costing operating statement for cement
£
Budgeted contribution 15,000
Sales volume variance 1,500
––––––
Flexed budget contribution 16,500
Sales price variance (5,500)
––––––
Actual sales less standard variable cost of sales 11,000
CHAPTER 9: Standard costing and variance analysis
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Operating statements
Illustration 4 – Marginal costing operating statement for cement
CHAPTER 9: Standard costing and variance analysis
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Working backwards

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
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Chapter Summary

VARIANCE ANALYSIS

The did/should The Tabular approach


method Did AA Formula
Should As (AQ – BQ) × SCPU = SVV
Difference = variance SS (AP – SP) × AQ = SPV
(SP – AP) × AQ = MPV (SQ
– AQ) × SP = MUV (SR –
AR) × AH = LRV
(SH – AH) × SR = LEV
(SR – AR) × AH = VExpV
(SH – AH) × SR = VEffV
(BC – AC) = FOExpV
CHAPTER 9: Standard costing and variance analysis
12
Chapter Summary

• Use flexed budget so compare like-with-like


• Remember causes and interrelationships
Breakeven
analysis and
limiting factor
CHAPTER analysis

10
CHAP 10: Breakeven analysis and limiting factor analysis
LEARNING OBJECTIVES
Upon completion of this chapter you will be able to:

● Calculate breakeven point, margin of safety and contribution ratio

● Calculate volume to achieve a target profit

● Deal with changing variables

● Calculate production levels if faced with scarce resource

● Decide whether to make or buy resources.


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CHAP 10: Breakeven
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BREAKEVEN ANALYSIS AND


LIMITING FACTOR ANALYSIS

KEY FACTOR MAKE OR BUY


BREAKEVEN
ANALYSIS DECISIONS
ANALYSIS •
• Make >1 product Make >1 product
• How many must
• Resources limited • Resources limited
You sell to break •
• What should you Do Can buy-in
even?
to maximise profit? product externally
• Breakeven charts
• What should you
do to maximise
profit?
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Breakeven analysis

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
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Breakeven analysis

Breakeven point (BEP)


 Re-arranging, Contribution = TFC
 Contribution = Contribution per unit × Quantity (Q)
 Contribution per unit × Q = Fixed costs
 Hence Q (here BEP) is calculated as follows: BEP =

Illustration 1 – Breakeven analysis


A company’s product sells for £20 per unit with variable costs of £12 per unit. Annual fixed
costs are expected to be £120,000.
What is the breakeven point?
Solution
Contribution per unit = Sales – variable costs = £20 – £12 = £8.
BEP = £120,000/£8 = 15,000 units
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Breakeven analysis

The contribution ratio


This measures how much contribution is earned from each £1 of sales.
CS ratio =
or
CS ratio =
Breakeven point in terms of sales revenue =
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Breakeven analysis
Illustration 2 – Breakeven analysis
The following information relates to Product K.
Selling price per unit: £20
Variable cost per unit: £12
Fixed costs: £100,000
A Calculate the breakeven point in terms of number of units sold.
B Calculate the breakeven point in terms of sales revenue.
Solution
A Breakeven point in terms of number of units sold =
Fixed costs / Contribution per unit = £100,000 / £(20 –12) = 12,500 units
B Contribution ratio = 8/20 = 0.4 Breakeven point (in terms of sales revenue) =
Fixed costs / Contribution ratio = £100,000 / 0.4 = £250,000
(Proof: breakeven point in terms of units = 12,500 units @ £20 each = £250,000)
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Breakeven analysis
Margin of safety
Margin of safety = (Budgeted output – breakeven output)/Budgeted output × 100%
or Margin of safety = Budgeted output – Breakeven output
llustration 3 – Breakeven analysis
Arrow Ltd manufactures Product L to which the following information relates.
Selling price per unit: £20
Variable cost per unit: £12
Fixed costs: £100,000
Budgeted sales for the period are 16,000 units.
A Calculate the margin of safety in terms of units. B Calculate the margin of safety as a % of
budgeted sales.
Solution
A Breakeven point in terms of number of units sold = Fixed costs/Contribution per unit =
£100,000/£(20 – 12) = 12,500 units
Margin of safety (in terms of units) = Budgeted sales – Breakeven point sales = 16,000 –
12,500 = 3,500 units
B Margin of safety (as a % of budgeted sales) = (Budgeted sales – breakeven
sales)/Budgeted sales = (16,000 –12,500)/16,000 × 100% = 21.88%
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Breakeven analysis
Margin of safety
The management accountant of a company has calculated his firm’s breakeven point from
the following data:
Selling price per unit: 20 £
Variable costs per unit: 8 £
Fixed overheads for next year: 79,104
It is expected that next year the firm will produce and sell 7,500 units.
What is the margin of safety?
A 12.1%
B 13.8%
C 47.3%
D 89.6%
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Breakeven analysis
Profit targets
 Often, companies need to know how many units they need to make to make a certain
level of profit.
Sales volume for target profit = (Fixed costs + Target profit)/Contribution/Unit
Illustration 4 – Breakeven analysis
Arrow Ltd manufactures Product L and wishes to achieve a profit of £20,000. The following
information relates to Product L.
Selling price per unit: £20
Variable cost per unit: £12
Fixed costs £100,000
Calculate the sales volume required to achieve a profit of £20,000.
Solution
Contribution per unit = £(20 – 12) = £8 Sales volume to achieve a target profit = (Fixed costs
+ Target profit)/ Contribution per unit = £(100,000 + 20,000)/£8 = 15,000 units
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Breakeven analysis

Alteration of costs or revenues


 The breakeven point or profit target calculations may alter if there is a change in
selling price, variable costs or fixed costs.
Illustration 5 – Breakeven analysis
A company makes and sells a product for £20. Its variable cost is £8 per unit. Its current
sales revenue of £300,000 is sufficient to make a profit of £30,000.
If fixed costs increase by 15%, how many extra units will the company need to sell
to maintain its profit?

Continue
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Breakeven analysis

Illustration 5 – Breakeven analysis


Solution
 Current sales volume: £300,000/£20 = 15,000 units
 Calculate the contribution ratio = £12/£20 = 0.6
 Calculate the total contribution for sales of £300,000: £300,000 × 0.6 = £180,000
 From information in the question £30,000 of this contribution is profit so fixed costs
must be £150,000 (£180,000 – £30,000 = £150,000).
 New fixed cost must be 1.15 × £150,000 = £172,500.
 The required contribution to maintain profits is therefore £172,500 + £30,000 =
£202,500.
 Given that contribution per unit is £12, the minimum number of units required to
generate this contribution is £202,500/£12 = 16,875 units
 Sales volume has to increase by 16,875 – 15,000 = 1,875 units.
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Breakeven analysis

CVP assumptions and limitations


 Constant sales prices
 Constant variable costs per unit
 Constant fixed costs
 Production = Sales
 Costs classified easily as fixed or variable
 Applies to single product or a constant mix
 Charts time consuming  Ignore uncertainty of estimates
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Breakeven charts

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

Traditional breakeven charts


 The traditional breakeven chart plots total costs and total revenues at different levels
of output.
CHAPTER
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Breakeven charts

llustration 6 – Breakeven charts


 The traditional breakeven chart is
constructed as follows. (1) Plotting the fixed
costs line as a straight line parallel to the
horizontal axis (2) Plotting the sales
revenue line from the origin (3) The total
costs line is represented by fixed costs plus
variable costs.
 Note the points at which the breakeven
point and the margin of safety occur.
 Breakeven point is the point where the
sales revenue is equal to the total costs.
 Margin of safety is the area between the
breakeven point and the budgeted or actual
sales.
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Breakeven charts

Contribution breakeven charts


A variation on the traditional breakeven chart is the contribution breakeven chart. The
main differences between the two charts are as follows.
 The traditional breakeven chart shows the fixed cost line whereas the contribution
chart shows the variable cost line.
 Contribution can be read more easily from the contribution breakeven chart than the
traditional breakeven chart.
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Breakeven charts

Illustration 7 – Breakeven charts


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Limiting factor analysis
Illustration 8 – Limiting factor analysis
Suppose A Ltd makes two products, X and Y. Both products use the same machine and
the same raw material that are limited to 200 hours and £500 per week respectively.
Individual product details are as follows.
Product X per unit Product Y per unit
Machine hours 5.0 2.5
Materials £10 £5
Contribution £20 £15
We can identify the limiting factor by calculating the number of products that can be made
with the resources available.
200/5 = 40 units of X, or £500/£10 = 50 units of X, or
Machine 200/2.5 = 80 units of Y Materials £500/£5 = 100 units of Y
hours
Therefore, machine hours is the limiting factor because it limits the production of Products X
(40 units) and Y (80 units). Compare this with 50 units of Product X and 100 units of Product
Y when materials are restricted.
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Limiting factor analysis

Key Factor Analysis (KFA) method


 Step 1:
– Calculate contribution per unit for each product.
 Step 2:
– Calculate contribution per limiting factor for each product.
 Step 3:
– Rank.
 Step 4:
– Allocate and determine the optimal production plan.
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Limiting factor analysis
Illustration 9 – Limiting factor analysis
A company is able to produce four products and is planning its production mix for the
following period. Relevant data is given below:
A B C D

Selling price (£) per unit 19 25 40 50

Labour cost per unit (£) 6 12 18 24

Material cost per unit (£) 9 9 15 16

Maximum demand (units) 1,000 5,000 4,000 2,000

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
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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

D 2,000 8,000 3,000 10 20,000

C 1,000 3,000 0 7 7,000

––––––

31,000

––––––
CHAPTER
CHAP 10: Breakeven
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andlimiting
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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

Labour (@ £10 per hr) 15 20

Variable overhead 12 16

Selling price 82 75

Maximum demand (units) 5,200 3,800

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

Metres used if make 5 3

Saving per limiting factor £4/m £7/m

Rank 2nd 1st

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

Uses up metres 11,400 m

Remaining metres 18,600 m

Make (uses 5 m each) therefore 3,720

Contribution (£30, £24) £111,600 £91,200

Buy in remainder 1,480

Contribution (£10) £14,800

Total contribution £217,600


CHAPTER
CHAP 10: Breakeven
9: Standardanalysis
costingand
andlimiting
variancefactor
analysis
analysis
5
Chapter Summary

BREAKEVEN ANALYSIS AND


LIMITING FACTOR ANALYSIS

BREAKEVEN LIMITING FACTOR


ANALYSIS ANALYSIS MAKE OR BUY
BEP = TFC/CONT • Step 1: calculate • Step 1: calculate
Per Unit contribution per saving if make per
To achieve profit = unit unit
TFC + Profit/CPU • Step 2: calculate • Step 2: calculate
Graphs contribution per LF saving per LF
• Step 3: Rank • Step 3: Rank
• Step 4: Allocate • Step 4: Allocate
and determine and determine
Investment
appraisal
techniques
CHAPTER
11
CHAP 11: Investment appraisal techniques
LEARNING OBJECTIVES
Upon completion of this chapter you will be able to:

● Make investment appraisal decisions

● Explain the payback method

● Explain the accounting rate of return method

● Explain the net present value method

● Explain the internal rate of return method.


CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis

INVESTMENT APPRAISAL
TECHNIQUES

NON- DISCOUNTING
DISCOUNTING METHODS
TECHNIQUES

PAYBACK ARR NPV IRR


CHAPTER
CHAP 11: Investment
9: Standardappraisal
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1
The investment decision-making process
 Managers need to decide where they want to ‘take’ the business.
 What investment decision they make is vital to the success and growth of the business.
 Investment decision making has a number of distinct stages:
Origination of proposals –
– where many different alternatives are introduced and discussed
Project screening –
– where the ‘sensible’ projects are looked at with the company’s long term aims in mind
Analysis and acceptance –
– where detailed investment appraisal techniques/financial analysis are undertaken,
together with qualitative issues being discussed
Monitor and review –
– where progress is monitored, comparison to capital expenditure budgets is made and
timing is reviewed.
CHAPTER
CHAP 11: Investment
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2
The payback method
The basics of payback
‘The payback period is the time required to recover the initial investment’
 Companies/managers need to decide on their ‘target’ period i.e. within 5 years.
 Decision Rule:
– Payback period < Target period, Accept Project
– Payback period > Target period, Reject Project
 Payback is considered a ‘first screening’ method – if it passes this test, then more
sophisticated investment appraisal techniques should then be used before a decision
to proceed with this project is made.
 Payback uses cash flows, not profits.
CHAPTER
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2
The payback method

The calculations of payback


Constant annual cash flows
Payback period = Initial payment/Annual cash flow
Illustration 1 – The payback method
An expenditure of £2 million is expected to generate cash inflows of £500,000 each year
for the next seven years.
What is the payback period for the project?
Solution
Payback = £2,000,000/£500,000 = 4 years
CHAPTER
CHAP 11: Investment
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2
The payback method
Illustration 2 – The payback method
A project will involve spending £1.8 million now. Annual cash flows from the project
would be £350,000.
What is the expected payback period?
Solution
Payback = £1,800,000/£350,000 = 5.1429 years
Stated as either:
 5.1 years
 5 years 2 months
Payback in years and months is calculated by multiplying the decimal fraction of a year
by 12 months. In this example, 0.1429 years = 1.7 months (0.1429 × 12 months), which
is rounded to 2 months.
Uneven annual cash flows
 In practice, cash flows from a project are unlikely to be constant. Where cash flows are
uneven, payback is calculated by working out the cumulative cash flow over the life of
the project.
CHAPTER
CHAP 11: Investment
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2
The payback method
Illustration 3 – The payback method
A project is expected to have the following cash flows:
Year Cash flow £000 What is the expected payback period?
0 (2,000)
Solution
1 500 Year Cash flow £000 Cumulative cash flow £00

2 500 0 (2,000) (2,000)

3 400 1 500 (1,500)

4 600 2 500 (1,000)

5 300 3 400 (600)

6 200 4 600 0
5 300 300
6 200 500

The payback period is exactly 4 years.


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CHAP 11: Investment
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2
The payback method
Illustration 4 – The payback method
A project is expected to have the following cash flows:
Year Cash flow £000 What is the expected payback period?
0 (1,900) Solution
1 300 Year Cash flow £000 Cumulative cash flow £00

2 500 0 (1,900) (1,900)

3 600 1 300 (1,600)

4 800 2 500 (1,100)

5 500 3 600 (500)


4 800 300
5 500 800

Payback is between the end of year 3 and the end of year 4


– that is during year 4. Assuming a constant rate of cash flow
throughout the year, payback would be after 3.625 years or 3
years 8 months.
CHAPTER
CHAP 11: Investment
9: Standardappraisal
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2 The payback method
Illustration 5 – The payback method
An asset costs £120,000 and is fully depreciated over 10 years using the straight-line
method.
Profits after depreciation are assumed as follows:
Year £
1 12,000
2 17,000
3 28,000
4 37,000
5 8,000

What is the payback period to the nearest month?

Continued
CHAPTER
CHAP 11: Investment
9: Standardappraisal
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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

Payback is 3 years 27/49 = 3 years and 7 months


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CHAP 11: Investment
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2 The payback method
Illustration 5 – The payback method
Advantages Disadvantages
Simple to calculate Does not measure change in shareholder
wealth
Easy to understand Ignores later cash flows
Concentrates on early cash flows which Requires a target period – difficult to set
are less risky and more reliable and arbitrary
Useful for cash-strapped companies, Ignores time value of money (but can do
hence can focus to enhance liquidity discounted payback)
Unable to distinguish between projects
with same payback
Lead to too many short-term projects
Does not take account of variability of cash
flows
CHAPTER
CHAP 11: Investment
9: Standardappraisal
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3 The accounting rate of return

The basics of ARR


 Expresses profits of project as a percentage of capital outlay
 Decision Rule:
– ARR > Target Rate, Accept Project
– ARR < Target Rate, Reject Project

The calculations of ARR


There are 2 different ways of calculating ARR:
 ARR (initial) = Average annual profit/Initial investment × 100%
 ARR (average) = Average annual profit/Average investment × 100% where average
investment is 1⁄2 (initial investment + final/scrap value).
CHAPTER
CHAP 11: Investment
9: Standardappraisal
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3 The accounting rate of return
Illustration 6 – The accounting rate of return
A project involves the immediate purchase of an item of plant costing £110,000. It would
generate annual cash flows of £24,400 for five years, starting in year 1. The plant
purchased would have a scrap value of £10,000 in five years, when the project terminates.
Depreciation is on a straight-line basis.
Calculate the initial ARR.
Solution
Annual cash flows are taken to be profit before depreciation.
Average annual depreciation = (£110,000 – £10,000)/5 = £20,000
Average annual profit = £24,400 – £20,000 = £4,400
ARR = Average annual profit/Initial capital cost × 100% = £4,400/£110,000 × 100% = 4%
CHAPTER
CHAP 11: Investment
9: Standardappraisal
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3 The accounting rate of return
Illustration 7 – The accounting rate of return
Using the figures above, produce revised calculations based on the average carrying value
of the investment.
Solution
Average annual profits (as before) = £4,400
Average book value of assets = (Initial capital cost + Final scrap value)/2 = (£110,000 +
£10,000)/2 = £60,000
ARR = £4,400/£60,000 × 100% = 7.33%
CHAPTER
CHAP 11: Investment
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3 The accounting rate of return
The advantages and disadvantages of ARR
Advantages Disadvantages
Simple to calculate and understand Does not measure change in shareholder
wealth
Often used by financial analysts to Can be calculated in different ways which
appraise performance may cause confusion
Looks at the entire project Based on profits not cash
Allows project comparison Ignores time value of money
Requires a target rate – difficult to set and
arbitrary
Relative (%)
CHAPTER
CHAP 11: Investment
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4 The Net Present Value method

The basics of NPV


Money received now = more valuable than money received in future
 Why?
– Interest
– Risk
– Inflation
NPV measures change in shareholder wealth as a result of accepting a project
Decision Rule:
 NPV > 0, Accept Project
 NPV < 0, Reject Project
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4 The Net Present Value method

The calculations of NPV


Compounding
 A sum invested today will earn interest. Compounding calculates the future or
terminal value of a given sum invested today for a number of years.
TV = X(1 + r)n
X = Amount invested today
r = interest rate
n = number of years
CHAPTER
CHAP 11: Investment
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4 The Net Present Value method

Discounting to present value


 In a potential investment project cash flows will arise at many different points in time.
To make a useful comparison of the different flows they must all be converted to a
common point in time, usually the present day, i.e. the cash flows are discounted.
 PV = X × Discount Factor
PV = X × 1/(1 + r)n
X = Amount invested in n years’ time
r = interest rate
n = number of years
Assumptions used in discounting
 Cash flows occur at end of each year (unless told otherwise).
 Initial investments occur now (T0) and we will calculate the PV at T0.
 Later cash flows occur at annual intervals, starting at T1 (unless told otherwise).
 31.12.X0 = 1.1.X1
Continued
CHAPTER
CHAP 11: Investment
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4 The Net Present Value method

T0 T1 T2 T3

31.12.00 31.12.01 31.12.02 31.12.03

=1.1.X1 =1.1.X2 =1.1.X3 =1.1.X4

year

0 1 2 3 4

Present value Discounting Terminal value


PV TV

Continued
CHAPTER
CHAP 11: Investment
9: Standardappraisal
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4 The Net Present Value method

The discount factor


The discount factor

Formula Tables
(given in exam)

You can simply find the discount


= 0.621 factor from the present value table by
locating the discount factor at the
10% column and the 5-year row i.e.
0.621

Continued
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
4 The Net Present Value method

Illustration 9 – The Discount Factor


What is the present value of £115,000 receivable in nine years’ time if r = 5%? Show your
answer using both the formula and the discount factor tables.
Solution
PV = X/(1 + r)n = 115,000/(1 + 0.05)9 = 115,000/1.5513 = £74,130 (using formula)
P = £115,000 × 0.645 = £74,175 (using tables)
The difference between the two answers is caused by rounding.

Continued
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
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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
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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.

llustration 10 – Discounting Annuities


A payment of £1,000 is to be made every year for 6 years, the first payment occurring in
one year’s time. The interest rate is 10%.
What is the present value of the annuity?
Solution
The present value of an annuity could be found by adding the present values of each
payment separately.
CHAPTER
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4 The Net Present Value method
llustration 10 – Discounting Annuities

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
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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)

(1-) You can simply find the annuity factor


from the annuity tables by locating the
= (1-) = 4.355
discount factor at the 10% column
and the 6-year row i.e. 4.355
CHAPTER
CHAP 11: Investment
9: Standardappraisal
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4 The Net Present Value method

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
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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
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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
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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
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4 The Net Present Value method

Net Terminal Value


The Net Terminal Value is the value of the project at the end of the project.
The NTV discounted at the project’s discount rate will give the project’s NPV.

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.
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CHAP 11: Investment
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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
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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.
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4 The Net Present Value method

Changing discount rates


 As risk, inflation and interest rates change, so will the discount rate.
 NPV = × 1/(1 + r1) + × 1/(1 + r 1)(1 + r2) + ,,,,,,,,,,
Illustration 16 – Changing discount rates
An investment of £100 is to be made in one year and in two years’ time.
What is the value of the investment today if the interest rate is 10% next year but 15% the
following year?
Solution
Year CF £ DF PV £
1 100 0.909 90.9
2 100 1/1.1 × 1/1.15 = 0.791 79.1
NPV £170.0
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4 The Net Present Value method
The advantages and disadvantages of NPV

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.
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5 IRR

The basics of IRR


 The Internal Rate of Return or IRR is another project appraisal method using
discounted cash flow techniques. It has the following features:
– represents the discount rate at which the NPV of an investment is zero
– can be found by linear interpolation
– either through graph or formula
– projects should be accepted if their IRR is greater than the cost of capital.
NPV  Discount rate which equates
future cash inflows to initial
cash outflow (i.e. DR that gives
DISCOUNT RATE NPV=0)
 Decision Rule: – Discount Rate
< IRR, Accept Project –
IRR Discount Rate > IRR, Reject
Project
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5 IRR
The calculations of IRR
Calculating the IRR using linear interpolation
The steps in linear interpolation are:
(1) Calculate two NPVs for the project at two different costs of capital
(2) Use the following formula to find the IRR:
IRR = L + NL x (H – L) / (NL – NH)
where:
L = Lower rate of interest
H = Higher rate of interest
= NPV at lower rate of interest
= NPV at higher rate of interest
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5 IRR
The diagram below shows the IRR as estimated by the formula.
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5 IRR
Illustration 17 – IRR
A company is trying to decide whether to buy a machine for £13,500. The machine will
create annual cash savings as follows:
Year £
1 5,000
2 8,000
3 3,000
Calculate the project’s IRR. Solution
Step 1
The first step is to calculate the NPV of the project at two different costs of capital. Ideally the
NPV should be positive at one cost of capital and negative at the other.
So what costs of capital should we try? One way of making a guess is to look at the profits
from the project over its life. These are £16,000 over the three years. After deducting the
capital expenditure of £13,500, this gives us a net return of £2,500, or an average of £833
each year of the project. £833 is about 6% of the capital outlay.
The IRR is actually likely to be a bit higher than this, so we could start by trying 7%, 8% or
9%. Here, 8% is used.
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Illustration 17 – IRR

Year Cash flow £ Discount factor at 8% PV £


0 (13,500) 1.000 (13,500)
1 5,000 0.926 4,630
2 8,000 0.857 6,856
3 3,000 0.794 2,382
–––––
+368
–––––

Continued
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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%.
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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
––––
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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.
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CHAP 11: Investment
9: Standardappraisal
costing and
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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

One IRR Discount rate

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

Discounted cash flow techniques:


• Take account of the time value of
money
• Seek to improve shareholders’ wealth

The time value of money


considers: Net Present Value (NPV): Internal Rate of Return (IRR):
• Interest Gives the net surplus • Gives the DCF return earned
• Inflation earned for investors on the project
• Risk • Is the rate at which NPV=o
• Found through Interpolation
IRR = A+ (B – A)
• Quick method for annuities
and
CHAPTER
CHAP 11: Investment
9: Standardappraisal
costing and
techniques
variance analysis
7 Chapter Summary

The time value of money Internal Rate of Return (IRR):


considers: Net Present Value (NPV): • Gives the DCF return earned on
• Interest Gives the net surplus the project
• Inflation earned for investors • Is the rate at which NPV=o
• Risk • Found through Interpolation
IRR = A+ (B – A)
• Quick method for annuities and

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

Advanced annuities/perpetuities: • Delayed


• Ignore To flow annuities/perpetuities: Apply
• Add 1 to the AF /Perpetuity factor as normal
factor • Discount back to T

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